Friday, August 17, 2007

With Markets Moving Wildly, Insight Suffers

High & Low Finance
The New York Times
August 17, 2007

Twenty-first-century financial markets react with lightning speed to events halfway around the world. Investors in China can immediately see what happened in New York and make trades in London based on the news.

So why is the credit panic of 2007 being played out in slow motion?

One reason is that those involved have never seen anything like this before. Information may arrive instantly, but insight takes longer.

It seemed unlikely, if not absurd, that the American economy and credit system could be shaken because a few people with poor credit fell behind on their mortgages. Why should that slow consumer spending? Why should it affect companies that made mortgage loans only to people with good credit? Why should it bring a halt to the leveraged buyout boom?

Perhaps none of those things should happen. But fears that they may take place have sent the stock market on a wild ride over the last month, culminating yesterday with the Dow Jones industrial average falling more than 300 points before gaining nearly all of them back in the final hour of trading, amid speculation that the Federal Reserve would find a way to keep troubled financial companies from failing. Not long ago — four weeks, to be exact — Larry A. Goldstone, the president of Thornburg Mortgage, a real estate investment trust, was feeling good. He had seen the subprime mortgage disaster unfold, and believed it was good for his company.

“The current credit crisis is the market environment today,” he said in a conference call on July 20, as the stock rose above $27. “The liquidity issues in the marketplace are creating a very, very nice opportunity for us. This is not a big surprise to us.”

The way he saw it, the crisis was shaking out his competitors, the ones who had made those imprudent loans. With them gone, he could make more money.

Within days, he bought 10,000 shares. The chairman and chief executive, Garrett Thornburg, invested almost $13 million in company stock. Four other insiders, including the chief financial officer, were also buyers.

But last week, things got dicey. Thornburg Mortgage owned a lot of AAA-rated mortgage securities, and had borrowed up to 95 percent of their value. Now the lenders, suspecting the securities were worth less, wanted more cash. To get it, Thornburg had to sell securities, and few wanted to buy. Suddenly the commercial paper market, so willing to lend to Thornburg at small margins just weeks before, was not interested in lending even at much higher rates.

As for the share price, it went into a free fall on Tuesday, amid rumors that the company could not meet its obligation. Trading was halted with the stock under $8. On Tuesday night, it conceded it was having trouble raising money to finance mortgages. It said the dividend it had promised to pay on Wednesday would be delayed by a month.

But it insisted that it was not bankrupt. Even marking down the value of its assets to current market value, it said, it was worth $14.28 a share on Monday, down from $19.38 at the end of June.

That provided some reassurance, and since then the shares have climbed back above $12.

Thornburg has prospered until now with a fairly simple formula. Organized as a REIT, it paid big dividends representing all of its taxable income. It grew by issuing more shares, which it could sell at prices above its book value because individual investors valued the high yield. The shares wound up in a lot of retirement accounts, and the fact that people paid more than book value enabled the book value per share to grow.

The insiders profited hugely from that. The company gets away with not disclosing how much the bosses are paid because it is managed by a separate company owned by some of the bosses. That management company gets incentive fees based on the company’s total book value and profits, a formula that would seem familiar to a hedge fund manager. Effectively, the bosses get a cut every time the company sells new stock, and keep getting cuts from those sales every year.

Now Thornburg, like many other companies, needs a quick unfreezing of the credit markets. But even if they get it — if the Fed tells banks to rescue them with emergency loans — many may find that they cannot safely operate with such high leverage. And without the leverage, profits will be harder to make even if Thornburg can charge more for mortgage loans.

The unfortunate series of events that got us here — remember the proverb in which a kingdom is lost for want of a nail — began with a weakening housing market. That caused some mortgages to go into default, which raised questions about the value of mortgage securities and the credibility of the ratings that enabled the securities to be sold.

That led to the questioning of other types of loans that had been financed by selling packages of securities that were structures in similar ways to ones that had financed the mortgages. It became more difficult for companies to borrow. Now it seems to be spilling over to the real economy, with consumers getting nervous.

“We are going through a psychological event,” Mr. Goldstone said. “It has everybody in a panic. There is nothing fundamental here.”

He may be wrong about that last part. There may not have been a fundamental change in the health of his business, but such a change is taking place in the credit markets. There, buyers with available cash are few, and many of them are in no hurry to buy when so many need to sell.

It is sort of like a game of musical chairs in which the music stops and it turns out that all the chairs have vanished.


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