Saturday, July 28, 2007

Summer School for Investors Is in Session

By GRETCHEN MORGENSON
Fair Game
The New York Times
July 29, 2007

It’s still summer but as the financial markets declared last week, back-to-school season for United States investors has arrived.

With the equity markets off sharply for the week and the credit markets seizing, investors are being forced to relearn some of the basics forgotten during the private-equity, easy-credit, corporate-buyout boom of recent years.

Our lessons for today:

HIGH GRADE DOES NOT NECESSARILY MEAN HIGH QUALITY Wall Street’s ability to spin straw into gold rivals that of Rumpelstiltskin, to be sure. But that doesn’t mean investors should buy it. They did with gusto, however, as the subprime mortgage mess starkly shows.

WHAT LOOKS LIKE A DUCK MAY NOT QUACK LIKE A DUCK In the burgeoning world of financial derivatives, where mortgage traders and investors play, a security’s structure — especially its use of collateral to cushion buyers from losses — can earn it a blessing from rating agencies. But that structure may not be enough to withstand a credit shock like the one now gathering momentum, which threatens even the higher-grade market for mortgages. These structures look even shakier when the collateral cushion is, as is often the case, risky bonds — not cash.

DON’T SWIM IN THE DEEP END OF THE POOL Investment pools known as collateralized debt obligations have been all the rage, and many of them contain oodles of mortgage-backed securities. (Derivatives of derivatives, in other words.) As Josh Rosner, an expert on mortgage securities at Graham Fisher in New York noted in a research piece last week, the leverage used to put such securities pools together can amplify losses. For example, a 4 percent loss in a mortgage-backed security held by collateralized debt obligations can turn into almost a 40 percent loss to the holder of the C.D.O. itself.

LOSSES CAN BECOME VIRAL Lang Gibson, a Merrill Lynch analyst, characterized the potential for losses in C.D.O. pools in a recent report. After Standard & Poor’s notified investors that it had raised its loss forecast to 11 percent to 14 percent for subprime mortgages made in 2006 (the previous estimates had been 6 percent to 8 percent), Mr. Gibson said that such a rate would put most classes of asset-backed C.D.O.’s at risk of principal loss. The only class not at risk in such a scenario is the highest-ranked securities. But the junior AAA-rated classes, as well as those rated AA, A or BBB, are all at risk as well, he said.

Investors bought into the myth of highly rated securities even though their generous yields should have alerted them to risks. We have not yet seen the downgrades of collateralized debt obligations, because they typically don’t occur until loans in the underlying securities are close to default. But we will.

EARNINGS ACTUALLY HAVE TO BE EARNED Corporate profits are healthy, but that doesn’t mean stock prices can’t drop. As stocks raced to new highs this year, many investors felt their prices were justified by robust corporate earnings. They were only partly right. Other powerful forces were at work as well: corporate buybacks and mergers, both of which require access to E-Z credit. For instance, the Standard & Poor’s Index Services Group estimated that almost $118 billion was spent on stock buybacks during the first quarter of 2007, up 17.5 percent from the $100 billion registered during the first quarter of 2006.

In the first quarter, S.& P. said, 101 companies reduced their actual share count by at least 4 percent, while 72 cut their average diluted shares, used to determine earnings per share, by at least 4 percent. That means that at least 4 percent of the growth at those companies came from share count reductions, not operating earnings.

The S.& P. data also show that information technology companies were the biggest buyers of their own shares, accounting for almost 23 percent of the total buybacks and 15 percent of the market value of that stock during the first quarter. Consumer goods companies were another major player in the repurchase arena last quarter, accounting for almost 15 percent of stock buybacks and 10 percent of the market value.

Merger frenzy has also contributed mightily to the bull market. According to Thomson Financial, $3.1 trillion in deals have been announced so far this year, almost as much as the $3.6 trillion conducted during all of 2006. Many investment banks, including Lehman Brothers and Deutsche Bank, have already advised on more deals, on a dollar basis, than they did during all of last year.

Private equity investors played a major role in this mania. During July, United States private equity investors did $90 billion worth of deals, Thomson reported, the second-highest monthly number on record.

DIVERSIFICATION IS NOT A PANACEA Many investors who bought securities backed by prime mortgage loans made to creditworthy borrowers thought that they would be fine no matter how disastrous subprime loans turned out to be. But as officials at Countrywide Financial confirmed in their quarterly results last week, mortage problems are now firmly in “prime” territory.

“There is no diversification,” declared Steven Eisman, a portfolio manager at FrontPoint Partners, during a July 19 conference call the investment firm sponsored on the subprime mortgage debacle. “If there is a problem with underwriting, there will be problems everywhere. The entire capital structure from equity all the way to AAA can go to nothing.”

Not one to mince words, Mr. Eisman added: “It is going to be many months before this market clears. The freakathon is yet to come.”

EVERY CLOUD HAS A SILVER LINING There are still bright spots in what looks like a very dark market scenario. Shutting off the credit spigot means profit opportunities for investors who were awaiting a return to sanity in the debt markets, especially those looking to pick up damaged goods. And with fewer acquisitions being made, the insider trading that seems to occur ahead of almost every deal will no longer produce easy profits for chiselers.

Finally, the slowdown in the credit market may mean that we will be spared some of the gushing accounts of merger deals and the brilliant stars who make them. Financial engineering is fun and all, and so delightfully lucrative. But reporting on the people who actually run companies is surely of greater value to the world at large.

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