Tough ’07 has lessons worth remembering
For a lot of people on Wall Street, this year can’t end soon enough.
But long after the calendar has turned, here are four memories of 2007 that will linger:
Most abused word of the year: “contained.” As in, “sub-prime mortgage losses will be contained.” Or “the housing market’s woes will be contained.”
Those were the mantras of many bank and brokerage executives and their federal regulators from January to July, as they sought to portray the mortgage and housing busts as limited in their effects on the economy and financial system.
Was it wishful thinking -- or were they lying outright? Or both?
By mid-August it was clear that containment had failed, if it ever was a realistic hope. Contagion, not containment, has been the buzzword since then.
Like a nasty virus, the debacle in U.S. mortgage-backed securities has infected banks and brokerages around the planet, money market mutual funds, state investment pools and the municipal bond market. It has required major central banks to pump hundreds of billions of dollars into the global banking system to keep it from seizing up.
U.S. Treasury Secretary Henry M. Paulson Jr. recently has taken to describing the housing and mortgage mess as unprecedented. Likewise, many bankers have said they’ve never witnessed the kind of fear and loathing that has gripped their business in recent months.
And so “contained” has been retired from the lexicon of modern finance. Too bad it wasn’t a much earlier retirement.
Enron revisited. At the heart of the massive accounting scandal at Enron Corp. in 2001-02 was the energy company’s use of so-called special purpose entities -- enterprises that were effectively controlled by Enron but weren’t consolidated on its balance sheet.
The SPEs allowed the company’s executives to hide debt and losses and thereby distort the firm’s true earnings picture. Until it all blew up.
SPE, meet SIV -- the structured investment vehicle. SIVs were created by major banks including Citigroup Inc. and HSBC Holdings Inc. to hold assets off their balance sheets.
The basic idea was to borrow with short-term funds to buy long-term assets, such as sub-prime mortgage-backed bonds. If all went well, the profit was the difference between the cost of short-term money and the returns earned on the long-term assets.
What happened beginning in August, as the credit crunch deepened, was that lenders and investors began to balk at providing the short-term money that funded the SIVs. Bank shareholders had a rude awakening: It became clear that the banks managing the SIVs were on the hook to ride to the cash-strapped funds’ rescue -- even though, technically, SIV assets weren’t the banks’ responsibility.
With the SIVs, nobody is alleging the kind of blatant fraud that went on with Enron’s SPEs. But SIVs smack of the same kind of obfuscation of liability.
Deception drains investor confidence, and confidence ultimately is the only thing that holds a banking system together. Why did the world’s financial geniuses need a refresher course on this point?
Cash equals power, Part I. Given the turmoil in the financial system this year, many stock investors may wonder if they’re living in an alternate universe. If you own shares of some of the biggest and best-known U.S. companies, you could be looking at hefty double-digit returns for 2007.
That may be because of the turmoil in the financial system, rather than despite it. Looking for relative safety, investors have piled into shares of U.S. multinational firms benefiting from robust business abroad and that aren’t dependent on skittish banks for money. In many cases these companies are sitting on huge cash hoards.
Farm machinery giant Deere & Co. held almost $4 billion in cash and marketable securities at the end of October, up from $3.5 billion a year earlier. With its sales booming thanks to foreign demand, Deere’s stock has rocketed 89% this year.
Other big-company stocks in the double-digit club include Honeywell International Inc., up 34% year to date; drug maker Merck & Co., up 36%; McDonald’s Corp., up 35%; and Exxon Mobil Corp., up 22%.
The blue-chip Dow Jones industrial average is up 7.9% this year. By contrast, the Russell 2,000 index of small-company stocks is down 0.3%.
For most of this decade stock investors have favored the up-and-comers over the giants. It may have taken a financial crisis, but that trend looks like it has finally reversed.
Cash equals power, Part II. In a credit crunch, it’s a good thing if you don’t need credit. It can be even better if you have wealth to lend or invest for the long term -- because you have the very thing in short supply.
Heavy losses on mortgages and mortgage bonds have depleted the capital of many commercial and investment banks. Anxious to bolster their balance sheets, some are turning to the people who control mountains of money: the managers of sovereign wealth funds, the investment arms of governments in Asia, the Middle East and elsewhere.
Hence, Citigroup lined up a $7.5-billion cash infusion from Abu Dhabi’s state investment fund in November. Morgan Stanley this week agreed to a $5-billion investment from China Investment Corp. And Friday, Merrill Lynch & Co. was reported to be in talks with Singapore’s state fund for a $5-billion investment.
As the financial clout of the developing world grows, sovereign funds are bound to become much more important players in markets. A recent Merrill Lynch study estimated that the funds’ assets would balloon from $1.9 trillion now to nearly $8 trillion by 2011.
That raises the question of who’s going to be working for whom down the road.
The Japanese in the 1980s chased after trophy properties in the U.S., like the Pebble Beach golf course. The sovereign funds today are taking stakes in the entities that provide the lifeblood of American capitalism.
Certainly, the funds are a long way from exerting control over the U.S. beneficiaries of their largesse. Still, the American housing and mortgage-market mess of 2007 may well be remembered as the tipping point of a monumental global power shift.
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