Is It Time to Don Hard Hats?

Four months after the subprime crisis broke out among big lenders in the United States, we learned that the problem is closer to home than we'd thought.

Four months after the subprime crisis broke out among big lenders in the United States, we learned that the problem is closer to home than we'd thought. Haim Israel, an equity analyst at Merrill Lynch, dropped a bomb. Bank Hapoalim's exposure to the risk involved in financial instruments involved in the subprime trouble is double the sum that the bank reported: it reaches $730 million, Israel said.

The man in the street might wonder how the biggest bank in Israel could claim that its exposure to risky securities is $365 million, while one of the biggest investment banks in the world thinks it's $730 million. The answer is simple: most of the sophisticated financial instruments that Wall Street developed in recent years aren't actually traded on any stock exchange.

Pros say they aren't marked to market, which means that because they aren't actually traded, the market isn't constantly setting and resetting their price. They're marked to model, which means that their value is calculated using statistical models. These models are, by definition, based on historic figures, and assume that the past is indicative of the future.

Reality has changed in the last six months, but many players won't admit it, and slog along hoping for the best.

Many players have no incentive to change the way they price the non-traded assets they hold: managers of mutual funds and hedge funds who charge their clients 20 percent of the profits they present, for instance. If they can delay recognizing potential losses from these financial instruments while continuing to claim their share of profits, why hurry anywhere?

But there's at least one serious player who did see and acknowledge the sea change, who realizes that what was, won't be again for the time being at least. It's the man who pioneered mortgage securitization 30 years ago, who has a star turn in the most famous book ever written about Wall Street - Michael Lewis' Liar's Poker, which tells about securities brokers at the legendary American investment bank Salomon Brothers back in the 1980s.

Last week this man said he's selling his real-estate financing company after the subprime crisis dried up its financing sources.

Perhaps the Bank Hapoalim people, who still think their risk in that same arena is limited, should take the hint. After all, the man is none other than Lew Ranieri, who had owned a controlling stake in Bank Hapoalim until a few years ago. And if Ranieri, who invented mortgage-backed bonds, feels he should get out, how much chance do less sophisticated players have?

The biggest mistake of the Greek Island affair is being repeated. Instead of dwelling on the behavioral norms one might expect of the prime minister or finance minister, instead of discussing the need for public personalities to behave ethically, the discussion of Ehud Olmert's involvement in Bank Leumi's privatization is focusing on whether he behaved criminally.

Attorney General Meni Mazuz said three and a half years ago that the evidence did not warrant pressing criminal charges against the prime minister at the time, Ariel Sharon, over the Greek Island affair. Focusing only on the criminal aspect, Mazuz ignored other issues and closed the case.

Olmert admits that he personally intervened to change the terms of selling Bank Leumi, without disclosing that he was affiliated with Frank Lowy, who was a contender to buy the bank. If his lawyers convince Mazuz that Olmert's behavior was not criminal, the case will be closed irrespective of questions regarding norms and ethics.

Worse, Olmert and his people will present the ruling as evidence that there was nothing amiss in his conduct and that he was being hounded on political grounds.

What is that buzz? Oh, it's people talking about the sky-high prices of penthouses these days. Israel's housing market is hotter than it's been in years.

How short memory is. People may be chattering excitedly about how much they're getting or paying for a rooftop apartment or land or office, but the truth is that in general, property prices haven't yet returned to their level of seven years ago. That was the last time the real estate sector was booming: the year 2000. In some cases, prices are lower than they were 12 years ago.

Most people don't realize just what the U.S. dollar has undergone in the last seven years, and that's the currency in which Israeli property prices are marked. In October 1999, the shekel-dollar rate was NIS 4.30. Today it's NIS 3.90 and meanwhile, the shekel has lost 12 percent of its buying power.

Israel's two biggest business barons flew off together last week. Yitzhak Tshuva and Nochi Dankner had their picture taken together, wearing hard hats and blowing the Frontier Hotel in Las Vegas to smithereens. The two men plan to build the biggest, grandest hotel-cum-casino-cum-living complex on the Strip at a vast investment of $8 billion.

Given the stunning success of Tshuva's venture in Manhattan with the Plaza Hotel, few doubt his intuition, talent and mainly, his luck, even given the enormous size and risk involved in his Vegas venture. But Tshuva and Dankner know perfectly well just how risky this long-term venture is.

They have less than a year to recycle the first loan, taken to buy the land on which the Frontier sat. That's when America's capital market has to decide whether it has faith in the two Israelis' mega-project, what interest rates it will charge them, and how much equity it will demand that they bring from home.

Tshuva and Dankner didn't actually need their pretty red hard hats last week, but they did make for a great photo op. Yet these helmets may well come in handy if America's real estate sector and capital market continue along the path blazed by the dollar in the last month.