The credit crunch spreads – from tapped-out holders of adjustable-rate mortgages, to specialty insurers desperate to preserve their ratings, to the leaders of Citigroup and Merrill Lynch on begging-bowl fundraisers in Asia and the Middle East, to a swell of big-number litigation enough to enrich the lawyers world-wide.
And as spring foretells the release of the finest French wines, my wine-collecting friend in Paris confronts a crunch of his own.
He prefers his tangible cellar of fine vintages over a portfolio of financial derivatives. But he has learned that – as with countless investors ranging from holders of the Bear Stearns subprime funds to pension funds and village treasurers and any number of other yield-chasing funds and institutions -- he has an uncomprehended and volatile commodities market exposure.
Like the small investors who clamored to share the sexy returns of the hedge funds, my friend ventured beyond his retail wine shop. Going to an internet wine vendor in 2006, he bought a quantity of a fine Bordeaux 2005, then being offered en primeur – that is, an advance sale just after the harvest but two years before the wine would be ready for retail sale.
In simpler times, the wine makers would sell perhaps half of their production en primeur – only to sophisticated professionals – in a direct form of forward contracting that both financed inventory and mitigated price volatility.
But the en primeur market then became open to individual players. Buyers of the 2005 vintage made the leap of faith that as this wine is even now being released for delivery, they will actually receive the specific wine contracted for, rather than some poorly made or inferior substitute.
Additionally, though, my friend faces a huge market exposure.
Namely, the vendor – who is said to have made some € 10 million of advance sales – is now exposed as were Bear Stearns or Merrill or Citi, who had sold highly-leveraged investments in hard-to-price slices of the subprime mortgage sector. Instead of locking in a contract with the vineyard for the necessary physical supply, at the time it took its customers’ deposits, the vendor reportedly chose to wait and play the fluctuating secondary market.
That is, like the bankers who sold the mortgage-based derivatives on the assumption that ever-rising housing prices would bail out all the dodgy mortgages, the wine-seller assumed an ability to cover its needs at delivery time, perhaps even hoping that a soft market might give it a windfall.
Here arises the problem of unexpected risk and uncontrollable price volatility in an underlying commodity. Holders of subprime paper were whacked by collapsing real estate values, unpredicted under their black-box pricing models. Just as with killing frost in the orange groves or warfare in the oil fields – serious re-pricing has hit the wines of 2005. With the publicists touting 2005 as a vintage for the century, the entire Bordeaux market took a major upward spike. Prices for my friend’s particular wine are up over 60%, and the very top wines have shot up 300% in less than a year.
Again as with the subprime sector, my friend has learned to his bewilderment that he is in an unraveling commodity hedging operation -- the vendor’s naked delivery problem being piled onto a whole structure of risks.
At a simple level, the vendor generated two years of float for itself, by immediately cashing its customers’ checks. And although dealing frequently with Anglo customers investing dollars and pounds, the vendor could easily hedge any currency fluctuation exposure.
But like Bear Stearns or New Century Financial or Northern Rock or UBS today – or others in recent memory such as Long Term Capital Management or Amaranth – the wine vendor is hostage to externally-delivered pricing shocks.
With the vendor facing a massive and expanding loss, my friend has the entirely legitimate anxiety that when the time comes, it may be unwilling or unable to deliver.
While he waits, it has been brought home – for both the bankers’ one-time valuation geniuses and their management who blithely assured that their controls were all in good Sarbanes/Oxley order -- that market reality has a stubborn unwillingness to behave according to unprovable mathematical models. And there is a lesson for central bankers: one-time bailouts have a terrible tendency to be under-calculated, insufficient, and fraught with unintended consequences.
Time will tell. Come this summer, while the Bordelaise prepare to press the grapes of 2008, my friend may be preparing to press his legal rights.
Meanwhile, shareholders and investors in subprime funds have enlisted their lawyers to assess whether their glasses are half-full, half-empty or only holding the bitter dregs.
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