What's left in Wall Street?

Bear Stearns, Merril Lynch, Citicorp, UBS, Washington Mutual, Fannie May, Freddie Mac and now Lehman Bros. What’s left in Wall Street?

Waves of selling wiped out nearly half of Lehman’s value in the stock market on Tuesday, leaving the firm, one of the nation’s oldest and largest investment banks, in an all-out fight for survival.

“He [Richard S Fuld, Jr., CEO of Lehman Bros] is dealing as if he has a whole deck of cards, when as he has none” – NYT reporters quoting a banker who has had recent dealings with Lehman, representing a potential foreign buyer.

How long can they live in denial?

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Why does it linger?

The Economist brings out a brilliant analysis of why the liquidity crunch refuses to die down.

It’s a long article. Here is my synopsis –

The double shock of decline in house prices and the sudden slump in prices of ABS have come at a time when the global economy is also witnessing a surge in commodity prices. This limits the power of the central banks to cut interest rates as it could stoke inflation further up.

The double shock entails uncertain direction of monetary and regulatory policy. When inflation targets are revised upwards, central banks will crack down so hard on inflation pushing the economies into recession. Further the effect of investment bank rescues will let in a harsh new regulatory regime that will stifle credit and hence future growth.

Then it is the nature of the previous boom fueled by indiscriminate borrowing by people to buy houses that they couldn’t clearly afford hoping to cash in on capital gains and investors buying complex high yield debt products they hardly understood. Both the lenders and investors were beholden to banks and that former wellhead of finance has now run fairly dry. In turn, that explains the absence of bargain hunters, particularly in the debt markets.

Investment-grade debt might look attractive on a five-year view, if all you have to worry about is the risk of default. But most investors in that market have a three- or six-month view; they cannot afford for things to get worse before they get better, in case they are forced into a fire-sale of their assets.

"So the markets (and the developed economies) are waiting for a catalyst for recovery. Lower commodity prices helped for a while, and may help further if they encourage central banks to cut rates. Evidence of a bottom in the American housing market may also do the trick. But the crisis seems certain to linger into 2009, and could even make it into the following year. Successful horror movies tend, after all, to have several sequels."

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Losing sight of human context

Most things begin benign. They aim to serve a good cause. Take subprime mortgage as example. Wall Street bankers looked at the rising price of real estate and figured that it isn’t going to come down any time soon. Their net interest margins (interest collected from borrowers minus paid on deposits by banks) were so narrow and the housing market was so frothy, banks began making high-interest loans to shaky borrowers. That’s how families with annual income of $50,000 got to own million $ homes. Fairytale stuff? You bet!

Sometimes, things aren't as bad as they seem. They're worse.

But, if nothing else, this saga shows the great blind spot that still haunts many western banks. Even some Asian banks fell for it. Financiers have invented so many brilliant mathematical tools to repackage risk that the industry has slipped, almost unthinkingly, into an assumption that “credit” is a collection of abstract equations, stripped from any human context. They became so dazzled with their powers that they have ignored how they interact with the rest of society – or how the tribal aspects of their own institutions can create dangerous traps.

Meanwhile, the cult of models has become so extreme that banks have believed them even when this collides with common sense and popular social constructs like the real meaning of `credit’ - a synonym for worthiness, not wishful assumption. And bankers forget this human dimension to their cost – no matter how impressive the abstract numbers might seem.

Losing sight of human context always results in agony. Earlier we had empire building ambitions of monarchs and dictators that fueled wars and catastrophes. Now economic institutions take turn to wreak havoc. The common factor is human suffering, entirely avoidable.

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The quant blow up behind subprime fiasco

Was subprime fiasco the canary in the mine?

It is looking more and more like the answer is – well, yes. Many signs have suggested so, from job losses to a continuing credit drought to a weakening dollar, but that history has not yet been written.

And how the quants contributed to the blow up? MIT Review Part I and II, here and here.

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