Tuesday, October 9, 2007

The Domino Effect



The subprime mortgage crisis promises to create ripples throughout the financial services and banking industry...not just because people are defaulting on their loans but because these mortgages, once closed, are often sold, grouped together in tranches and packaged as financial instruments for institutions.

Derivatives are another strata of financial instruments that are tied to these investments and create a leveraged effect on the increase or decrease in value of these instruments. They are employed by large institutions to hedge other positions or add exposure to certain sectors in their portfolios. And of course, to speculate.

Sometimes a small movement in a sector can create large movements in the derivatives tied to them. A large movement can be devastating. The fallout of this effect may be "packaged" by PR departments in way that minimizes the underlying mayhem that may be going on behind the scenes.

Here is an interesting tidbit from our friend and periodic contributor John H.:

MORE PROOF THAT “SUBPRIME” IS A CODEWORD FOR “DERIVATIVES LOSSES”

There isn’t a sentence in here about Merrill really financing home purchases for borderline home buyers.

Enjoy this coded derivatives synopsis, for which Ive added emphasis for shock value.

-John H.

October 6, 2007
A Big Loss at Merrill Stirs Unease
By JENNY ANDERSON

Since becoming chief executive of Merrill Lynch in 2002, E. Stanley O’Neal has been credited with making the investment bank leaner and more disciplined.

But analysts raised questions yesterday about the extent of that discipline after Merrill announced that it would take its first loss since the end of the technology boom and would write down $5 billion primarily in its fixed-income sector: subprime loans, complex debt instruments and leveraged, or risky, loans.

Merrill said it expected to lose up to 50 cents a share for the quarter, compared with a profit of $3.17 a share, or $3 billion, for the quarter a year ago. The size of the write-down was second only to one for $5.9 billion taken by Citigroup, which is three and a half times the size of Merrill.

“While market conditions were extremely difficult and the degree of sustained dislocation unprecedented, we are disappointed in our performance in structured finance and mortgages,” Mr. O’Neal said in a statement. “We can do a better job of managing this risk, as we have done with other asset classes.”

Richard X. Bove, a financial services analyst at Punk, Ziegel & Company, wrote that Merrill’s problems show that “the company doesn’t have a consistent path in fixed income like Lehman or Bear or JPMorgan.”

Two ratings agencies, Moody’s and Fitch, quickly downgraded Merrill’s long-term debt outlook to negative from stable. Moody’s said the write-down, which had been forecast at about $4 billion, exceeded expectations. “As a result, Moody’s assessment of the quality of risk management at Merrill Lynch has diminished.”

In its report, Fitch said that the size of the loss and this week’s departure of crucial fixed-income executives raised questions about whether Merrill had adequate risk controls in place.

Yesterday’s warning was the latest among banks as they try to deal with the fallout from losses in the origination and packaging of subprime loans as well as lending to private equity firms. UBS has announced a $3.4 billion write-down, and Deutsche Bank, $3.1 billion. And Washington Mutual, the savings bank, warned that third-quarter income would decline 75 percent.

More bad news is expected. Analysts at Sanford C. Bernstein & Company said yesterday that they expected JPMorgan Chase to write down about $2 billion, and the Bank of America Corporation about $1 billion.

Merrill, however, will be the first big bank to report a loss. Its closest rivals, including Goldman Sachs, Lehman Brothers and Bear Stearns, all made money. (All had the benefit of June, which was a strong month. Merrill does not include June in the quarter but does include September.) “They lost more than others,” Mr. Bove said. “Merrill tended to focus its efforts in the highest-risk areas because that’s where the rate of return was the greatest.”….

When the credit business hit a wall in July, Merrill got caught with commitments to lenders that it could not resell and complex debt instruments, called collateralized debt obligations, that deteriorated sharply in value. It wrote down $4.5 billion worth of subprime loans and collateralized debt obligations and $463 million, net of hedges, in commitments to fund loans. As a result of the losses, Mr. Semerci, 39, and Dale M. Lattanzio, the head of structured credit products, were dismissed, and David Sobotka, 50, was made the head of fixed income.

What does the average consumer or investor need to do about this? Nothing. Stay very diversified, and stay invested. And enjoy the drama as speculators realize the risk that was always there. And for God sakes, don't listen to Jim Cramer.

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