Taking Stock / Six Impossible Things Before Breakfast

"Why, sometimes I've believed as many as six impossible things before breakfast." - The White Queen, "Alice in Wonderland," by Lewis Carroll.

"Why, sometimes I've believed as many as six impossible things before breakfast." - The White Queen, "Alice in Wonderland," by Lewis Carroll.

Like many economists, Warren Buffett loves to quote from Alice in Wonderland and last week, in his letter to shareholders, he chose that extract from one of the imaginary child's bizarre conversations, in this case with the White Queen, a vocal advocate of the impossible.

There are plenty of explanations for the financial slaughter on Wall Street, but at the heart of the matter is investor insistence on believing in the impossible well before their low-fat latte. The ones marketing the impossibilities are the brokers, the bankers, and the coupon-cutters. "Beware the glib helper who fills your head with fantasies while he fills his pockets with fees," Buffett warns in his letter this year.

1Laymen saw the word "subprime", shuddered and skipped to the next story. But the explanation is simple. Banks lent money to people who were likely to default on their loans, so they could buy homes. Central to the concept was what Buffett calls "HPA," or house-price appreciation. Tens of millions of Americans, bankers, brokers and government officials believed that housing prices would climb forever, solving all other economic and financial woes. The housing boom created a munificent circle that spurred consumption. But when the bust arrived, a vicious circle immediately developed, which devastated borrowers and lenders, too.

2 Most Americans now grasp that HPA is a figment of the imagination. Housing prices cannot increase all the time. They can collapse, in fact. But the leaders of some of the biggest companies in the U.S. and Europe refuse to acknowledge that the same is true of stocks. Buffet reminds investors of the ticking time bombs hidden in the balance sheets: pension schemes based on the assumption that stocks will return 8% a year forever. If the auditors of these companies were to force the management to lower that assumption, even just to 7%, vast deficits amounting to hundreds of billions of dollars would suddenly appear in corporate balance sheets.

3 Subprime loans were a mere niche in the U.S. economy, a tiny sector where high-risk loans were lavished on unworthy borrowers. That's what investors insist as they watch the prices of their stocks and homes implode and fears of recession in America spread. They're about to find out that the subprime swamp is just one facet of the credit spree on Wall Street over the last five years.

The next explosion in the bursting credit bubble will be loans for leveraged buyouts, which had been a major growth driver on Wall Street. Then we'll see a wave of insolvencies among commercial real estate companies.

Analysts and regulators have been arguing that the root of subprime evil actually lay in massive securitization. Which means, you take a pool of loans, slice and dice it and repackage them as securities sold to investors. But it's far from clear that securitization was the main cause. Securitization is actually a great way to diversify risk, if used properly.

What characterizes securitized assets is that their price adjusts to market fluctuations much more quickly than do regular loans, listed in bank books.

When the subprime bubble burst, it happened fast and hard, partly because 80% of the loans had been securitized. Goldman Sachs economists estimate that only 28% of the loans for commercial property, such as malls, offices and hotels, had been securitized, so the process of adapting to new reality is slower there. But given the speed of America's economic deterioration in recent weeks, we're likely to see gigantic writeoffs there too in the first quarter of 2008.

4 So bad banks that lent money to bad borrowers who bought housing they couldn't afford led to hundreds of billions of dollars in writeoffs. That's peanuts to an economy the size of the U.S.', say some analysts. They forget Ben Bernanke's term "financial catalyst."

For every dollar in equity, America's banks and financiers lend $10 to $25. So, for every dollar in losses on bad loans, they'll have to reduce their balance sheet by $10 to $25. A joint study published last week by Morgan Stanley, Goldman Sachs and Princeton shows that at least half of the bad loans were issued by leveraged lenders, the type that have to reduce their balance sheet by $10 for each dollar they lent.

Even if these financiers manage to halve their losses by raising fresh money, the economists believe they'll have to reduce their balance sheets by at least $2 trillion. That is not peanuts, even for America.

5 A bear market creates opportunity for the courageous, who scoop up the best merchandise on the cheap. So say the savvy, or at least the ones who think they're savvy. They are right: the wise investor should be pessimistic when everybody else is cheery, and vice versa. But when the markets are growling and the financial storm is raging, even the cleverest can crash on the rocks.

Just ask Ron Beller, co-manager of the Peloton hedge fund, which was ranked one of the best in its niche last year, with returns of 87%. Beller et al gambled against the subprime market. They sold the riskiest segments in that market short and went long on the safest segments. And to make real money on their gamble, they leveraged their equity times 30. Last year their strategy earned them money hand over fist, as the subprime market imploded while safer loans held firm.

But something went wrong. The prices of bad loans stopped dropping and the price of good loans started to fall. Because their bet had been so enormously leveraged, when it went wrong, their equity disappeared. Now Peloton is history, though Beller and his colleagues shared the pain, for once. Not only had they been personally invested, they returned bonuses they'd taken. They were wiped out.

6 All very interesting, but that's all in America, not here. We have no subprime mortgages market to speak of. We don't have a real estate bubble building and building over 10 years and the balance sheets of our banks are stronger than ever. So they say.

But when America catches a credit crunch, Israel's capital market won't continue to bathe in the same liquidity that characterized the market in the last three years. A lot of Israelis made it mega-big by expanding abroad, and now the risk in that reward is showing its fangs. Stay tuned: this is going to be an interesting year.