Subprime Storm Mimics
Wall Street may have reason to worry about a financial hurricane poised to do the
same kind of damage Hurricane Katrina did — in terms of money and assets lost — in New Orleans in 2005. Given the latest storm warnings about subprime
mortgages and the Dow’s dive last week, it looks like "Subprime Katrina" might become the financial storm of the decade.
Wall Street investment
bankers who remember the devastation in New Orleans might want to start battening down the hatches. In fact, some of them
seem to understand their pending doom as they try to cajole the rest of the world into thinking that the subprime (otherwise
known as low-quality) mortgage contagion is contained. "Sure, sure, Bear Stearns got hit when its subprime hedge funds lost their value, but everyone else is O.K.," they say. "Let's all heave one collective sigh of relief that we dodged that
Does that attitude sound
familiar? It's exactly how the people of New Orleans felt for the 8-10 hours after Hurricane Katrina whipped up the Gulf Coast and dumped its rain. It was over; they had dodged the bullet. Their beautiful city that is built
below sea level and surrounded by sea walls and levees was safe.
That's where Wall Street
is right now – hoping the levees will hold as investment bankers try to sandbag the rest of us with lots of placating talk. Well, it turns out that New Orleans was about as safe as the subprime
bonds that are now below their own "C" level.
Although Wall Street bankers
have been doing one heckuva job, I think it's too soon to breathe easy, just as it was too soon then for those in the Big
Easy to breathe easy. Because right now, we're in that eerie quiet period when everyone thinks that the subprime storm has
blown over and headed east. We're all oblivious to the larger problems coming behind it. Just like when New Orleanians breathed
their collective sigh of relief, oblivious to what a few city engineers worried about and watched for: Would the levees hold, or would they be breached?
We shouldn't give into
that false sense of relief, and here's why: Wall Street was warned about the coming hurricane-force fall-out from subprime
mortgages, and it ignored the warnings, buying up all the securities backed by subprime mortgages that it could. Subprime
Katrina actually did hit hard and wiped out one of Bear Stearns' hedge funds invested in subprimes valued at $6 billion. It
left the other hedge fund at only 10% of its original value.
But now that this episode
is behind us, Wall Street is having trouble selling more debt. News came this week that the group of Wall Street banks that
is raising funds for GM had to postpone a $12 billion debt offering, because investors wanted better terms. It sounds like
it may be too late for many Wall Street denizens to get out of town – and their positions – before the floodwaters
Nor is everyone buying
the argument that now we're safe. The Economist magazine (June 21, 2007, issue) suggests that "perhaps the most worrying thing
for financial institutions holding mortgage-backed paper is not the subprime market itself, but the unnerving parallels with an even bigger
one to which they are also exposed: leveraged loans to companies." The story also quotes Daniel Arbess of Xerion Capital Partners
as saying that subprime might well be “a dress rehearsal for something bigger and scarier.”
Doug Casey, who writes
The International Speculator newsletter, agrees in his July 2007 issue. Referring to the $6 billion hedge fund wipeout, he
writes, "There could be hundreds of billions more in losses. And it's impossible to say which firms that are bankrupted by
the default may in turn default on debts to others, like a string of dominoes."
Remember, too, the finger-pointing
and blaming that started as soon as the rest of the nation realized that the U.S. government was not doing enough to help
New Orleans? The editors of The Elliott Wave Financial Forecast recognize a similar change in attitudes toward Wall Street:
"The unwinding process
will be sped along by a flood of revelations about illicit hedge fund and investment banking activities. Just as Enron, Tyco
and a host of other primary beneficiaries of the late 1990s bull market run became the focus of scandals, hedge funds and
the banks that enabled them are starting to become a focal point for scrutiny." (The Elliott Wave Financial Forecast, July
Then will come the final
installment. Just as the U.S. government was slow to come to grips with the disaster in New Orleans so that people were left
to fend for themselves, so too will investment bankers and investors have to fend for themselves. They may find themselves
clutching their worthless paper and wishing someone would bail them out from the rooftops of their now-worthless homes.
And if this analogy holds
true, Heckuva Job Brownie – now known as Helicopter Ben Bernanke and his Federal Reserve team – won't have any
more luck picking up the pieces on Wall Street than FEMA did in New Orleans. Neither the federal government nor the Federal
Reserve did the heavy lifting up front to avert these natural and financial disasters.
So telling us now that
the subprime problem is contained sounds too much like wishful thinking, the kind that the federal government indulged in
as the floodwaters started rising in New Orleans two summers ago.
Susan C. Walker writes
for Elliott Wave International, a market forecasting and technical analysis company. She has been an associate editor with Inc. magazine, a newspaper
writer and editor, an investor relations executive and a speechwriter for the Federal Reserve Bank of Atlanta. She is a graduate
of Stanford University.