The Sticky Collapse

What went wrong? A short twelve months ago, everything financial was in a sweet spot; with the stock market back to its 2000 high (S&P500 at 1540). The sub-prime mortgage pool was leaking a little, but most people did not expect a flood.

Ninety years ago, on a non-descript industrial street in the north end of Boston, everything was quiet as well. The dominant structure was a huge tank, fifty feet tall and ninety feet in diameter, filled with two million gallons of molasses... The tank was made out of steel plates riveted together. It leaked a little bit, but that was fine with the locals, who collected the leaking molasses to take home. Then, on January 19, 1919, for causes never completely determined, the tank collapsed, and a tsunami of sticky, sweet molasses filled the neighborhood.

The cliché, “slow as molasses in January” didn’t apply. The sticky mess flowed at 35 miles per hour, knocking down buildings and breaking the columns of the Boston Elevated Railway. Twenty-one men and women were killed as well as many horses, and 150 people were injured. It took 87,000 man-hours to clean up the sticky, stinking mess.

When I entered MIT in the early 1950’s the first engineering formula I was taught was to calculate “hoop stress” – how much force was produced in the walls of a tank full of liquid. MIT was only a mile from the molasses tank, and the disaster was still an important memory. The unsound molasses tank had been designed and built by poorly-trained men, and one result of the tragedy was new regulation of construction, mandating engineers to design and inspect structures.

This is all a fine metaphor for the sub-prime mortgage mess, a gooey mess that overwhelmed Fannie Mae, Freddie Mac, WaMu, Indy Mac, Bear Stearns, Lehman Brothers, Wachovia... (At least this time no horses were drowned.) The investigations have already begun, and additional regulations will show up soon. After the Boston Molasses Disaster, the local residents filed one of the first class-action lawsuits, and after three years the United States Industrial Alcohol Company paid a large settlement. One should not rule out the possibility of litigation in regard to the SubPrime Disaster.

I am writing this on October 14, 2008. The government has just announced a massive program to support bank solvency, causing a welcome rally in the market after a week of terrifying declines. The government action is well thought out and seems to have bipartisan support. The European governments have announced a similar package, a fine example of international cooperation. The threat of a cascading flood of monetary molasses drowning the world banking system has likely been averted.

Thank is all to the good, but not completely satisfying. The jarring bear market, that has hurt housing, the debt markets, and stocks, has turned a lot of smart, confident money managers into panicky, helpless fools in the molasses, unable to either swim or float.

The Markets

There are three good things that have happened to the stock market.

1. The bank bailout is a big help.
2. The price of oil has dropped nearly in half from the high.
3. Stocks and bonds have already dropped as much as they do in an average bear market.

The future remains a sticky mess. The straight-down drop in the market may be over, but a lot of complex events lie ahead, and a balanced hedged portfolio seems like a good idea. The U.S. economy is not fixed yet. The real problems have been housing, and then the debt market. The stock market has really been only a residual.

Unleveraging

If a person, or company, or bank, has got too much debt, it has a problem. We will call the overextended entity Beefsteak Securities. When they built up debt, this is called using leverage. We can do a very easy bit of arithmetic to show how this works. This example will be oversimplified but perhaps helpful.

We will define leverage as debt divided by net worth:

Leverage = $19,500 / 500 = 39x.

Leverage of 39x is high, and so Mr. Beefsteak decides to reduce it. He sells 300 shares of Acme at $20 and pays down debt by $6000:

Leverage = 13,500/500 = 27x

Mr. Beefsteak has accomplished his goal. Leverage has been reduced from 39x to a more manageable 27x.

The deleveraging program succeeded because Beefsteak was able to sell assets at a price on the books. However, in the real world today, many asset holders are trying to reduce leverage, all at the same time. What happens? If everyone is trying to sell at the same time, the sale might be made at $19.75 instead of $20, so:

1. The sale of 300 shares of Acme raises only $5,925.
2. The assets must be “marked to market.” That means, the remaining shares in Acme Fireworks will be marked down from $20 per share to $19.75 per share. Marking an asset to market means recording its value at the most current available market price.

Leverage = $13,575 / 250 = 54.3

On one hand, by selling 300 shares at $19.75 instead of $20, Beefsteak only gave up $75 ($0.25 x 300 = $75) from the previous example. But because they had to mark down the remaining assets, their net worth was cut in half. The leverage did not go down, it went way up. When everyone tries to deleverage, no one can.

Bait and Switch

Now we can understand why Paulson and Bernanke persuaded Congress to pass a $700 billion package to buy investments from the banks, but now have changed the deal to buy preferred stock instead. If you look at the Beefsteak balance sheet it should make sense that increasing the net worth by selling stock reduces leverage much more effectively than by selling investments.

Ralph Wanger, CFA, is Senior Advisor to Wanger Investment Management, Inc.