Why the market’s going nuts

The great mortgage crisis of the summer of 2007 has slopped over into nearly every nook and cranny of the financial markets, laying low stocks that until a month ago had been on a great bull run. Even such Bay Area technology stalwarts as Apple have taken it on the chin. Apple, maker of the popular iPod digital music player, is down more than 21% from its peak, recorded late last month.

On Thursday, US stocks took off on a wild ride, the Dow Jones industrial average falling as much as 343 points in midday trading before recovering and finishing at 12,845.78, down just 15.69 for the day. At the day’s lowest price, major market averages were 10% below highs posted a few weeks ago, a fall that would qualify as a correction. Despite Thursday’s rebound, stocks remain vulnerable, analysts caution. The reverberations from the collapse of the subprime mortgage market have yet to fully play themselves out, they say. The global investment market is more tightly interlinked than ever before. Troubles in one corner, such as mortgages, have profound ripple effects on investments such as technology stocks, gold and oil, which seem far removed. “This is classic financial contagion,” said Russ Koesterich, a portfolio manager at Barclays Global Investors in San Francisco. “You’ve got people in multiple markets. Losses in one force them to capitulate in others.”

So far, the main actors in the stock market sell-off have been institutional investors and big money managers, many of whom specialize in risky and complicated investments. Retail investors have mostly sat out the selling spree of the last few weeks, market watchers say. Oakland resident Patrick Hollister, 42, and his wife have a 401(k), an IRA and a brokerage account filled with tech stocks. Hollister, who works in sales for a semiconductor startup, hasn’t done anything special in response to the market’s woes. “I’ve been through four downturns and two layoffs,” he said. “You’ve just got to ride it out.” While mom-and-pop investors are keeping their cool, some investment pros say the events of the past few weeks mark one of the greatest market dislocations of recent times -- one that could potentially shake credit, stocks and the economy for a long time to come. Any further market meltdowns could force the Federal Reserve and other central banks around the world to limit damage by cutting interest rates. The root of the problem lies in tectonic shifts in financial products in recent years.

Exotic financial products created from mortgages in the last decade or so are being tested for the first time in a market crisis, pushing investors into uncharted territory. No one knows the full extent of the losses caused by the failure of a mushrooming number of subprime mortgage borrowers to pay back their loans. A mortgage made in, say, San Jose gets sliced and diced - some of the interest payments are packaged as securities and sold to an investment fund in New York, and part of the principal is put into a security sold to a bank in Germany. When the borrower stops paying the monthly mortgage, the investors lose income. What’s more, they can’t sell those exotic mortgage securities because no one knows what they’re worth. “People have been moving into new territory,” said Zachary Karabell, a portfolio manager with Fred Alger Management in New York. “It’s a complex system that nobody fully grasps.” The mortgage investors suddenly face a desperate need for cash -- perhaps to pay back margin loans they took out to buy the securities in the first place or maybe to pay off big clients who are yanking their money as fast as they can. What makes this crisis so hard to measure is that trillions of dollars worth of US mortgage securities have been sold around the world, in many cases to hedge funds, those secretive, largely unregulated investment vehicles that don’t have to disclose their finances.

In recent years, institutional investors largely stopped paying attention to the risks of buying mortgages made to people with bad credit records. Suddenly, they have become allergic not only to subprime mortgages but to almost any kind of risk. That means all borrowers - from a consumer who wants a home equity loan to a hedge fund that wants to finance new investments - must pay more for money. That’s a key connection to the stock market. Hedge funds and other big institutions that need cash can’t borrow easily. Instead, they’ve been selling anything that isn’t nailed down, whether it’s crude oil or shares of hot technology companies. The process feeds on itself. Because exposure to bad mortgages is so hard to calculate, a wide array of lenders, financial institutions and banks fall under suspicion. Rumors fly.

“Talk about fear - this is a whites-of-their-eyes kind of fear,” Mark Lehmann, director of equities at JMP Securities in San Francisco, said about market sentiment early Thursday. Two star financial players of recent years - Countrywide Financial Corp. and E-Trade Financial Corp. - were pounded this way.
Shares of Countrywide, the nation’s largest mortgage lender, have fallen 22.5% since Tuesday, after a Merrill Lynch analyst warned that bankruptcy was a possibility. Countrywide said Thursday that it was tapping an $11 billion bank credit line to fund operations. E-Trade also was a victim of rumors that it couldn’t raise money and faced potential losses in its portfolio of tens of billions of dollars of mortgages and other home loans. Its shares fell as much as 29% Thursday before recouping most of the losses. The company said its financial position is sound.

Apple got caught in the downdraft, its shares falling more than 2% Thursday. It was hurt on one hand by investors who need to raise cash and on the other by those who don’t want a heavy load of high-priced, volatile technology stocks in their portfolios, analysts said. “The company’s fundamentals have not changed,” Barclay’s Koesterich said. Investment pros are loath to predict how long the current market trends will last. “I don’t see a meltdown scenario,” Lehmann said. “But I can’t predict a bottom.” (sfgate.com)