Toomre Capital Markets LLC

Real-Time Capital Markets -- Analytics, Visualization, Event Processing, and Intelligence

Federal Reserve Ben Bernanke: How Bad Are Subprime Losses Now?

Tomorrow, on Wednesday April 2nd 2008, Federal Reserve Chairman Ben Bernanke is scheduled to testify before the U.S. Senate Banking Committee. His testimony last July 19th resulted in headlines like Subprime losses could hit $100 billion: Bernanke. After today's whopper of a $19 billion write-down from UBS, Bloomberg is now tallying total sub-prime losses at approximately $232 billion. What will tomorrow's headline be? Perhaps Chairman Bernanke might suggest that the subprime losses might hit $500 billion or even more?

Back on July 21, 2007, Toomre Capital Markets LLC ("TCM") created the post Does $50 Billion in Sub-Prime Losses Mean Anything? At the end of that post, Lars Toomre concluded with:

TCM worries that many investors do not fully appreciate how much the investment game of the past several years is changing. Liquidity is going to be a much more valuable commodity than many realize or appreciate. Perhaps the Great Unwind is truly approaching?

The Great Unwind reference was to the provocative research piece that Stefan-Michael Staimann and Susanne Knips at Dresdner Kleinwort put out in early 2007 detailing how closely hedge funds were linked to the investment banking industry and how that business model was likely unsustainable. They strongly declared:

We believe that the great unwind is inevitable, but impossible to time. It looks like the process of building up leveraged spread bets has already run quite far. Risk premia in many markets are very low, making it increasingly difficult to find spread bets for new money. Market volatility has been driven to record lows (remember: selling a put is like shorting volatility). The process may not have much more room to run and may start to be more sensitive to factors that could threaten its delicate balance (such as a deterioration of corporate credit risk).

Lars Toomre followed up the Dresdner Research: "The Great Unwind is Coming" post with one on February 12th 2007 entitled Hedge Funds, Investment Banks and the Value of Liquidity? In that post, Lars wrote:

On Friday February 9th 2007, Toomre Capital Markets LLC ("TCM") posted a note entitled Dresdner Research: The Great Unwind is Coming. Over the weekend, there has been considerable website traffic resulting from search variations of "Dresdner hedge fund", "Stefan-Michael Staimann" and "Susanne Knips." The unusual interest has been truly world-wide and makes TCM wonder why this particular piece of research is resonating so.

Do not readers already know how dependent the large investment banks have become both reliant on and very much like the hedge fund and private equity industries? A substantial portion of the investment banks' profits -- in new and highly profitable businesses like prime brokerage, mortgage-backed securities, credit default swaps, equity derivatives and investment banking fees from private equity funds -- are a direct result of the growth of hedge funds and other alternative investment funds.

Economic times presently are pretty good world-wide. When the inevitable turn in the vastly more inter-connected global economy next comes, credit spreads surely will widen and the valuation of various financial instruments will come under stress. Are hedge funds (and by proxy the investment banks) prepared for coming "Great Unwind" forecast by Mr. Stiamann and Knips? Some hedge funds inevitably will do very well then, while others will fail, perhaps as spectacularly as Amaranth Advisors did in September 2006.

The financial markets now are full of much liquidity. Are investors, speculators and their bankers appreciating and pricing in liquidity risk? Toomre Capital Markets LLC would suggest that liquidity risk presently is greatly under-valued in the search for "alpha", absolute return and portfolio yield. The stretch to get ten percent return (after fees) appears to be making rational people start to do irrational things.

After the TCM post earlier today UBS: How About $19 Billion More in Write-downs? and a concurrent equity market rally led by the financials that pushed up the DJIA by almost 400 points, several smart readers called to discuss the question of "What now?" A couple were quite eager to put cash or cash equivalents to work in some quite frankly amazing investment opportunities. However, Lars reminded all that a credit bubble does not deflate overnight, in a quarter or even in a year.

There likely will be further downdrafts in this credit crisis and the value of liquidity is even greater today than it was a year ago. Hence, if Lars were currently running institutional fixed-income money, he would be inclined to sell less liquid positions into rallies, move Treasury durations out into the 4-6 year sector of the curve and excessively concentrate spread investments in the FNMA and FHLMC pass-through coupons just above and below par. And run a very hefty cash position…

There are more chapters still to come in the Great Unwind. While Lehman Brothers and UBS were able to secure capital today through their respective preferred and rights offerings, what will it be like when an institution that you depend on is something like the 100th bank to need to raise great amounts of equity capital? Can you afford to hold onto your current investments for three years or more? The value of liquidity is still underappreciated and the sovereign wealth funds ("SWF") are not likely to be present to bail out that need for capital.