Fallling Knives

Slate has a nice article today about the dangers and rewards of trying to catch a falling knife:
One of the nice things about being a billionaire, or a private-equity magnate, or the CEO of a gigantic bank is that you don't fret about paying retail. If you see an object you desire—a plane, a mansion, a car, a suit—you don't wait for it to go on sale. You just buy it.
In their professional lives, however, such players are attracted to marked-down merchandise like post-Christmas shoppers are drawn to Macy's. Picking through the discard bin and sifting through marked-down inventory of formerly hot products is a highly respected investment strategy. But efforts to catch such falling knives depend on perfect timing. Stick your hand out too late, and you get nothing. Grab the handle at precisely the right moment, and you've got yourself a set of Wüsthofs on the cheap. Stick your hand out too early, and you're simply impeding the blade's fall to earth. Today, several savvy financial operators who tried to catch falling knives in the formerly hot housing and credit sectors are walking around with huge gashes in their hands.
On Aug. 22, Bank of America decided things couldn't get worse for Countrywide Financial, the massive mortgage firm whose stock had been halved since the beginning of the year. Bank of America boldly announced a $2 billion investment in the form of a security that pays a 7.25 percent annual interest payment and "can be converted into common stock at $18 per share." In the months since then, Countrywide, stung by a deteriorating housing market, has fallen another 50 percent. Today, its stock trades at about $9. Bank of America, which is already licking its wounds from an ill-timed plunge into investment banking, is already out several hundred million dollars on its investment in Countrywide.
In the fall, Bear Stearns, the mortgage-dependent Wall Street firm that soared to dizzying heights as the credit market boomed only to crash back to earth, attracted an international cast of falling-knife catchers. In September, Joseph Lewis, one of Britain's wealthiest men, spent $860 million on a 7 percent stake in Bear, paying an average of about $107 per share, according to the Wall Street Journal. In December, he boosted his stake twice. Today, with Bear's stock trading at close to $85, Lewis has turned his massive fortune into something slightly smaller. He's likely lost about 15 percent of his investment. In October, Bear agreed to a complicated deal with CITIC Securities, in which the Chinese firm would invest $1 billion in Bear Stearns for a stake worth at least 6 percent. Since then, Bear's stock has fallen about 20 percent.
Some investors have suffered deeper wounds. On Dec. 10, Warburg Pincus—a very sharp private-equity firm—agreed to invest up to $1 billion in struggling bond insurer MBIA, which had lost 55 percent of its value in the previous two months. Warburg bought 16.1 million shares at $31 a share and committed to fund another $500 million. (The deal also included warrants to buy several million shares of the company's stock at $40 per share.) Within days, as MBIA dealt with questions about its exposure to collateralized debt obligations and other exotica, the company's stock plummeted to $19. In less than two weeks, Warburg lost nearly 30 percent on its investment in the shares, or about $183 million. And that was before deep-pocketed investor Warren Buffett said he might start his own bond insurer to compete with MBIA.
Of course, it's early days, and these investments could well turn out to be genius moves. But the experience of these knife-catchers highlights a significant difference between the denouement of the dot-com bubble and the real-estate/credit bubble. In the former, the end came swiftly and violently. Since the bubble activity was concentrated in highly liquid, publicly traded stocks, investors—mutual funds, hedge funds, individuals—were all able to flee at the same time. The NASDAQ Composite—the epicenter of the bubble—fell 37 percent in two months in the spring of 2000, and nearly 75 percent between late March 2000 and April 2001. In some instances, this herdlike behavior created overreactions that set the stage for smart Dumpster-diving investors. In April 2003, Apple's stock traded for a split-adjusted $6.60; today it's at $198.
This time around, the bubble activity was concentrated in comparatively illiquid assets—like mortgage-backed securities, collateralized debt obligations, and houses. It may seem obvious now, but homes don't trade with the same speed and lack of friction that stocks do. And when housing prices fall, builders don't respond by slashing prices with alacrity; they respond by keeping prices the same and throwing in amenities, or, as the Wall Street Journal reported, by funneling cash back to buyers through third parties. The housing bubble popped, but between October 2006 and October 2007, according to the Case-Shiller index, housing prices fell only 6.1 percent. Housing prices may need to fall 30 percent or 40 percent before they bottom out, but it will take years—rather than months—for that process to play out. And as the market continues to slump, companies whose business models rest on making mortgages—and on buying, selling, and insuring securities based on mortgages—may face a string of losses.
Not all knife-catchers have been hurt, though. Goldman Sachs was one of the few Wall Street firms to prosper during the subprime tsunami, as it used its own cash to make bearish bets on subprime securities. By late December, First Marblehead, the student-loan company, had lost about 75 percent of its value over the course of 2007, as investors fretted over loan defaults and rising financing costs. On Dec. 21, Goldman's private-equity unit stepped in and agreed to buy up to 20 percent of the company for $260.5 million and offer a line of credit. With First Marblehead's stock having rallied from $11 to about $15 today, Goldman is solidly in the money on its investment. Many analysts already believe the sharp traders and risk analysts at Goldman have superhuman powers. Its ability to overcome the force of gravity and halt a plummeting financial-services stock may only add to the firm's legend.