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Ouzilly, France

The funniest moment of the ’07 credit crunch…so far,

A $40 billion subprime explosion on Wall Street,

Tracking financial fat tails, liftoff at the Dubai Air Show and more…

Joel Bowman, back on solid ground in Dubai, reports…

When you think about it, Wall Street bankers are a lot like expats in the desert: When presented with a wild, risky ride, both are likely to augment (or completely abandon) their risk models to justify their pursuit of a thrill.

Invariably, this is to their detriment.

“As an Aussie you should know better than to venture into the outback without 4-wheel drive,” wrote one caring Rude reader after we confessed to coming unstuck in the Omani desert over the weekend. “Even this old Texas grandmother knows that!”

The trouble is, like bankers on Wall Street, we’ll probably make the same mistake again. Maybe we won’t take exactly the same path, or even the same vehicle (4-cylinder is no replacement for 4WD), but if we’re entirely honest with ourselves, we’ll probably always take the road less traveled in one form or another.

Sometimes it pays off, like it did for the world’s smartest bankers all through the early part of this century. They lunched up and down Midtown Manhattan on the proceeds of their EZ-credit credit cards. Even when things started getting a little hairy they pushed and pushed. Time better spent worrying and scrambling to cover their EZ-asses was spent popping champagne corks and celebrating record stock market highs. All the while the tide was lapping at the fortifications around their subprime castle in the sand.

It’s not at all surprising that financial thrill seekers would behave in such a reckless manner…it’s only surprising that everyone was so surprised when they did.

The feeling you get when a risky move pays off - particularly when you know it shouldn’t have - is one of eerie elation. That strange feeling is caused by the stuff coursing through your veins: sweet, addictive adrenalin. Freshly hooked on your body’s own chemicals - caused by your brain’s own stupidity - people become a little more brazen the next time a risky choice comes along. All of a sudden it’s not so hard pushing the envelope/pitifully ill-equipped vehicle/rancid debt obligation just that little bit further.

Then comes an unforeseen (but ever-present) pothole in the road ahead and, “woops!” there goes the apple cart…

In the column below, Bill Bonner takes a look at exactly what happens when Wall Street’s hotshot bankers take their SIVs where only SUVs should go. Enjoy…

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Twenty-Five Standard Deviations in a Blue Moon
By Bill Bonner

What’s going wrong in the financial sector is not so unusual after all.

One of the funniest moments in the great credit crunch of 2007 came in the summer.

“We are seeing things that were 25-standard deviation events, several days in a row,” said David Viniar, CFO of the smartest financial firm in the world, Goldman Sachs.

That Viniar. What a comic.

According to Goldman’s mathematical models…August, Year of Our Lord 2007, was a very special month. Things were happening then that were only supposed to happen about once in every 100,000 years.

Either that…or Goldman’s models were wrong.

We recall looking out our window. Outside, we saw a summer day much like any other. And inside, what we saw in the news was also rather typical – a credit crunch. No, credit crunches don’t come along every day…but nor do 100,000 years separate one from another. In the United States, recently, we have had the crash of the dotcoms, the crash of Long Term Capital in ‘98 and the crash of ‘87; outside of the United States, there have been a number of credit crunches, in Japan, Russia, Mexico and various Asian countries.

When you make loans to people who can’t pay the money back, trouble is only a couple standard deviations away. So far, during the first eight months of 2007, some 1.7 million houses have been caught up in foreclosure proceedings in the United States. That is just the beginning. According to Congressional estimates, up to 2 million families are expected to lose their homes over the next two years.

The individual amounts of money weren’t very large, not by Wall Street standards. But when the money didn’t show up, it had an alarming effect. Last week’s press brought estimates of total losses of over $13 billion at Citi. Morgan Stanley is said to be facing $8 billion in losses. Merrill Lynch set records with estimated losses of $18 billion. The cat still has Goldman Sachs’ tongue. But when the losses are toted up, they will probably be spectacular. Altogether, there is more than $1 trillion in subprime debt outstanding; much of it will go bad.

Already heads have begun to roll. First, Warren Spector of Bear Stearns got axed. Then, it was Peter Wuffli at UBS. He was followed by Stan O’Neal of Merrill Lynch. O’Neal made the headlines when he was pushed out of the corporate jet with a ‘golden parachute’ valued at $160 million. After O’Neal hit the ground, along came Chuck Prince of Citigroup – America’s largest bank. The firm is expected to write down $5 billion this quarter alone. Chuck was chucked out.

What went wrong? The business model seemed so pure and simple. You simply bought up subprime loans from the knaves who made them…then, you cut them up, slicing and dicing them into a kind of mortgage spam. You got the rating agencies to bless them…and then you sold them off to naïve investors. The idea was to earn huge fees upfront…while laying the risk onto the fools who bought the stuff.

When the going was good, it looked as though no business could be better. You were providing a valuable public service, helping people buy houses by redistributing the risk from the people who incurred it to people who had no idea it was there. And in the process, you earned such large fees you would get your picture in the paper, build a huge mansion in Greenwich and acquire some abominable paintings to put on the walls.

But wrong it did go. The Financial Times provides more detail on what happened at Citigroup:

“The bank reported that, at the end of September, it had around $2.7bn of unsold collateralised debt obligations – pools of debt securities that are repackaged and distributed to other investors.

“But it also had $4.2bn of subprime loans it had bought in the past six months, and about $4.8bn of loans to customers which were secured by subprime collateral. In addition, the bank had $43bn of exposure to the most highly rated tranches of CDOs based on subprime mortgage assets.”

It turns out Citi was fool and knave at the same time. It sold dubious subprime debt to its customers. But it bought it too…and took it as collateral.

Gary Crittenden, Citi’s chief financial officer, claimed Monday that the firm was simply a victim of unforeseen events. The losses were, “driven by some events that have happened during the month of October,” he said, referring to downgrades by rating agencies. No mention was made of the previous five years, when Citi was busily consolidating mortgage debt from people who weren’t going to repay…pronouncing it ‘investment grade’…mongering it to its clients…and stuffing it into its own portfolio…while paying itself billions in fees and bonuses. No, according to the masters of the universe, downgrades by Moody’s and Fitch’s were completely unexpected…like the eruption of Vesuvius; even the gods were caught off guard. Apparently, as of September 30th, Citigroup’s subprime portfolio was worth every penny of the $55 billion Citi’s models said it was worth. Then, whoa, in came one of those 25-sigma events. Citi was whacked by a once-in-a-blue moon fat tail.

Who could have seen that coming?

Joel’s Note: Enjoy Mr. Bonner’s musings on fat tails and stupid bankers? Want to know where you can read more or, perhaps, if our fearless leader has written a New York Times Bestseller in the last few months? Well, lo and behold, both questions are answered by clicking this here link:

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Rude Endnote: This week your junior editor is hanging out at the Dubai Air Show, the third largest aviation exhibition in the world. Today Emirates and Qatar Airways inked some multi-billion dollar deals with GE, Airbus and Boeing Co. We sat inches away from CEOs as they fielded questions and posed for pictures.

Keep a look out for details during the week as we report from under the increasingly polluted skies overhead in the UAE.

In the meantime, the lads in Baltimore are busy crunching numbers and picking through guvmint stats from around the world for your enjoyment. Their 5-Minute Forecast will be along shortly.

Cheers,
Joel Bowman
Rude Awakening