Twenty-Five Standard Deviations in a Blue Moon

What’s going wrong in the financial sector is not so unusual after all.

One of the funniest moments in the great credit crunch of 2007 came in the summer.

"We are seeing things that were 25-standard deviation events, several days in a row," said David Viniar, CFO of the smartest financial firm in the world, Goldman Sachs.

That Viniar. What a comic.

According to Goldman’s mathematical models…August, Year of Our Lord 2007, was a very special month. Things were happening then that were only supposed to happen about once in every 100,000 years.

Either that…or Goldman’s models were wrong.

We recall looking out our window. Outside, we saw a summer day much like any other. And inside, what we saw in the news was also rather typical – a credit crunch. No, credit crunches don’t come along every day…but nor do 100,000 years separate one from another. In the United States, recently, we have had the crash of the dotcoms, the crash of Long Term Capital in ’98 and the crash of ’87; outside of the United States, there have been a number of credit crunches, in Japan, Russia, Mexico and various Asian countries.

When you make loans to people who can’t pay the money back, trouble is only a couple standard deviations away. So far, during the first eight months of 2007, some 1.7 million houses have been caught up in foreclosure proceedings in the United States. That is just the beginning. According to Congressional estimates, up to 2 million families are expected to lose their homes over the next two years.

The individual amounts of money weren’t very large, not by Wall Street standards. But when the money didn’t show up, it had an alarming effect. Last week’s press brought estimates of total losses of over $13 billion at Citi. Morgan Stanley is said to be facing $8 billion in losses. Merrill Lynch set records with estimated losses of $18 billion. The cat still has Goldman Sachs’ tongue. But when the losses are toted up, they will probably be spectacular. Altogether, there is more than $1 trillion in subprime debt outstanding; much of it will go bad.

Already heads have begun to roll. First, Warren Spector of Bear Stearns got axed. Then, it was Peter Wuffli at UBS. He was followed by Stan O’Neal of Merrill Lynch. O’Neal made the headlines when he was pushed out of the corporate jet with a ‘golden parachute’ valued at $160 million. After O’Neal hit the ground, along came Chuck Prince of Citigroup – America’s largest bank. The firm is expected to write down $5 billion this quarter alone. Chuck was chucked out.

What went wrong? The business model seemed so pure and simple. You simply bought up subprime loans from the knaves who made them…then, you cut them up, slicing and dicing them into a kind of mortgage spam. You got the rating agencies to bless them…and then you sold them off to naïve investors. The idea was to earn huge fees upfront…while laying the risk onto the fools who bought the stuff.

When the going was good, it looked as though no business could be better. You were providing a valuable public service, helping people buy houses by redistributing the risk from the people who incurred it to people who had no idea it was there. And in the process, you earned such large fees you would get your picture in the paper, build a huge mansion in Greenwich and acquire some abominable paintings to put on the walls.

But wrong it did go. The Financial Times provides more detail on what happened at Citigroup:

"The bank reported that, at the end of September, it had around $2.7bn of unsold collateralised debt obligations – pools of debt securities that are repackaged and distributed to other investors.

"But it also had $4.2bn of subprime loans it had bought in the past six months, and about $4.8bn of loans to customers which were secured by subprime collateral. In addition, the bank had $43bn of exposure to the most highly rated tranches of CDOs based on subprime mortgage assets."

It turns out Citi was fool and knave at the same time. It sold dubious subprime debt to its customers. But it bought it too…and took it as collateral.

Gary Crittenden, Citi’s chief financial officer, claimed Monday that the firm was simply a victim of unforeseen events. The losses were, "driven by some events that have happened during the month of October," he said, referring to downgrades by rating agencies. No mention was made of the previous five years, when Citi was busily consolidating mortgage debt from people who weren’t going to repay…pronouncing it ‘investment grade’…mongering it to its clients…and stuffing it into its own portfolio…while paying itself billions in fees and bonuses. No, according to the masters of the universe, downgrades by Moody’s and Fitch’s were completely unexpected…like the eruption of Vesuvius; even the gods were caught off guard. Apparently, as of September 30th, Citigroup’s subprime portfolio was worth every penny of the $55 billion Citi’s models said it was worth. Then, whoa, in came one of those 25-sigma events. Citi was whacked by a once-in-a-blue moon fat tail.

Who could have seen that coming?

Regards,

Bill Bonner
The Daily Reckoning
October 24, 2008

Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis.

With Halloween just around the corner, it is fitting that today’s headline on CNN.com was "Stocks Headed for a Bloodbath." Not exactly what you want to see first thing in the morning, but at least it doesn’t keep you guessing.

Despite the fact that the Dow and S&P 500 were able to overcome yesterday’s unfortunate data, ending slightly up as the closing bell rang, this morning was a different story all together. Concerns over the what effect the weak economy will have on corporate profits hit the overseas markets hard. Japan’s Nikkei index tanked 9.6% and European shares plunged about 7% this morning.

The gloom over growth expectation is now worldwide…says one expert:

"Periods of panic punctuated by occasional calm appears to be the manner of the things for now."

The Dow, S&P and Nasdaq futures all fell so much that they set off the "circuit breaker rules". In other words, the exchanges reached pre-specified limits that can’t be broken until pit trading starts. However, once trading opens, all bets are off. Hence, the ‘bloodbath’.

You how the saying goes: America sneezes, and the rest of the world catches a cold. It might be time to stock up on tissues…we are looking at a case of walking pneumonia.

*** The FOMC is meeting next week and the general consensus is that they will indeed cut rates. Really, how could they not? But some speculate that they will go where no Fed has gone before: below 1%.

"Everyone at the Fed has pretty much told you they’re going to cut," said Rich Yamarone, director of economic research at Argus Research. "They’re in kitchen sink mode now. Rate cuts, fiscal stimulus, bailouts – they’re throwing in everything they can right now."

However, there’s a chance that lowering rates below 1% won’t even make a blip on the radar in the United States’ struggling economy…rate cuts just aren’t as important as they once were.

"It’s a window dressing, only a psychological weapon," said Sung Won Sohn, economics professor at Cal State University Channel Islands. "Right now, the problem isn’t the cost of the Fed’s money, it’s that the existing money supply isn’t circulating. The pipelines are clogged."

*** The price of oil fell below $65 a barrel today, even though OPEC decided to cut oil production by 1.5 million barrels a day starting next month. The black goo is selling for 50% less than it was just a few months ago due to a pretty major crimp in global demand.

In a statement released by OPEC they said: "Oil prices have witnessed a dramatic collapse – unprecedented in speed and magnitude. This slowdown in demand is serving to exacerbate the situation in a market which has been oversupplied with crude for some time."

The saving grace here could be the recent dollar strength. Today, the greenback rose against most major currencies – except for the yen. The yen rose to a 13-year high against the dollar overnight.

"The deleveraging and risk aversion continues to prompt the strengthening of the yen," writes Chris Gaffney in today’s issue of The Daily Pfennig .

"The Japanese currency also surged against the euro after Belarus, Ukraine, Hungary and Iceland joined Pakistan in requesting at least $20 billion of emergency loans from the IMF. Fear that pressures in Eastern Europe will have a negative effect on Euroland is another reason the euro continues to drift lower vs. the US$. European banks lending to emerging markets is about 21 percent of GDP and UK banks loans are around 24%, compared to 4% for the US and 5% for Japan. Eastern European currencies continue to be under speculative attack, and the currency markets are selling the Euro due to its close relationships to these emerging markets."

*** The signs of the difficult economic times the United States is facing is showing up everywhere…and most likely at your favorite restaurant as well. Chris Mayer explains:

"The convulsing U.S. economy is really the big topic of conversation everywhere. It’s affecting all kinds of businesses now. Anthony Bourdain, whose book Kitchen Confidential is one of my favorites, recently talked about how the economy is affecting the restaurant business. He was at Caesar’s Palace in Atlantic City doing some kind of cooking demonstration. Afterward, he offered some thoughts on what the recession will bring: ‘There are going to be a number of real sea changes in the business model of the fine-dining restaurants, and in basic menus. The proportions are going to change, the menu selections are going to change.’

"The upside to this? ‘Cooks will learn to how to cook shanks and shoulders and hooves and snouts well.’ In other words, they’ll learn to really cook using things previously discarded. It has long been a theme running through Bourdain’s books and his TV show that great cooks (and great food) emerge from essentially poorer cultures. Whether it is the budgetary constraints or shortages or lack of certain ingredients, these cooks must be more creative. They learn skills that cooks in richer circumstances never learn. Brilliant cooks and wonderful dishes are born in such environments.

"What does this have to do with investing? Well, besides simply noting the ripple effects of Wall Street’s self-immolation, I think that living through this environment will make you a better investor. Anybody can invest when things are going well – a lot of skills don’t matter when the markets are rising. But when things get dicey, it suddenly becomes important again to understand what you’re buying and to know how to value assets.

"Right now, there is still a tremendous amount of fear out there, which leads to valuations far removed from underlying business values. If you can’t get excited about some of the values on your screen now, I’m not sure what you’re hoping for."

*** Yesterday, everyone’s favorite former Fed chief testified in front of the House committee about the nation’s worsening credit crisis.

"We are in the midst of a once-in-a-century credit tsunami," he said to the House Oversight and Reform Committee.

That said, Big Al believes that the United States will emerge from this crisis with a "far sounder financial system." And that he was "shocked" that the financial system broke down.

However, some Committee members weren’t buying Ol’Bubbles song and dance (and neither were you, dear reader – but more on that below).

CNN reports that in his opening statement, Rep. Henry Waxman, D-Calif., committee chairman, opined that the current crisis could have been prevented "if regulators had paid more attention and intervened with responsible legislation. The list of regulatory mistakes and misjudgments is long and the cost to taxpayers and the economy is staggering."

By and far, you agree with this sentiment. We asked yesterday for our long-time DR sufferers to write in about your thoughts to Greenspan’s testimony…and here’s what you had to say:

"I think Big Al and the Federal Reserve’s lending practices are largely part of the blame," writes one DR reader.

"It was the Federal Reserves practice of lending money out for virtually free (1% for over a year) that I believe was the core problem that fueled all of the rest of the items that Big All mentioned. Guess he forgot to mention that item.

"Then Bernanke took over (realizing that the housing market was becoming way over valued) and raised the overnight lending rate 0.25 % every time they met till they finally ‘popped’ the housing bubble (which needed to be popped, but way to late). You can see it on the chart.

See this key interest rate chart at bankrate.com from 2001 to 2008:

http://www.bankrate.com/brm/news/fed/key-interest-rates.asp

"I guess it was fun while it lasted!"

Writes another:

"As always the case with Mr. Greenspan it is not what he says but what he is not saying.

"He is not telling that he supported (reckless) lending by offering money below inflation rate.

"He is not telling that people should not trust rating agencies because they are paid by the issuer.

"He is not telling that his oversight on the financial market was insufficient and lax.

"The mistakes he mentioned others made are surely lessons to learn from.

"But no doubt in my opinion; Mr. Greenspan is one of the main culprits originating this crisis."

And another: "Yes Greenspan is full of it but what a ‘maestro’. After whipping the morons on the hill over and over through the years (they were afraid to parse his babble for fear of looking uninformed or stupid) Greenspan mea culpas that his ‘free market’ philosophy let him down. Har har har har har har har!!! He feeds them gibberish in which he now supports more regulation after having virtually blown up the world through incompetence and self-serving water carrying for his masters. Now he lays it at the feet of the ‘free market’ in one of the most managed economies on the earth. The dopes on the hill are used to beating up on slow-witted baseball players so this was easy for Mr. Maestro. Out the door he went without a single mention of the guillotine as a fitting punishment."

We’ll leave you on that uplifting note…have a great weekend!

Short Fuse
The Daily Reckoning

P.S. Have you checked out Strategic Short Report’s Dan Amoss’ special 20-minute video on how to profit in the midst of this financial meltdown? It’s entirely free and available for download – but only until next Tuesday, October 28.

P.P.S. Addison and the director of I.O.U.S.A., Patrick Creadon will be attending a screening of the film at Columbia University from 5-7 on Sunday. We’ll be at Lerner Hall, in the Roone Arledge Cinema Room at the southeast corner of 115th and Broadway. There will be a short Q&A after. Come check it out if you’re in the neighborhood!