A Few Thoughts on Market Dislocations
The events over the past few months have been fascinating, at least when taking a clinical view of things. It is like a slow-motion train wreck where the force of the collision spreads detritus all across the landscape. Is this like LTCM? No. Is this the emerging markets debt crisis redux? No. Did legacy government policies contribute to a real-estate bubble that has seemed poised to pop for years? Yes. The current crisis is, in fact, a contagion, where Wall Street and Main Street are inextricably linked in a complex web of relationships that only time and suffering will help untangle. And do we have Alan Greenspan sitting in his exalted perch pulling strings and lending confidence and authority behind the scenes? No. And this is part of what makes this story so compelling.
What are some of the factors that make this market meltdown so, well, intriguing?
Quasi-governmental agencies competing with the private sector: Long story short, it seems to me that Congress let FNMA and FHLMC get way, way too big, doing business well beyond their original charter. They used an implicit government guarantee to provide ready credit to too many homeowners, and fostered a competitive landscape that placed origination volume over loan quality, the problems of which we are dealing with today.
Rating agencies not imagining beyond their Monte Carlo simulations: Investors rely heavily on ratings. Issuers pay rating agencies lots of money to validate their securities, which, on its face is a conflict of interest. Well, let’s forget about that for the moment. Getting back to ratings quality, what is the purpose of having ratings if they are adjusted post-facto? Isn’t this kind of like Wall Street sell-side analysts putting a Sell rating on a stock after they whiff on earnings, when they previously had a Buy rating on it? And this happens every day. Boo.
Leverage, leverage everywhere: Homeowners. Securitized vehicles. Investors. With leverage comes reduced margin for error, and with error comes pain. The issue is that the pain incurred does not move linearly, it moves exponentially. Once the pain starts happening, its effects ripple outward, often swallowing everything in its path. With a leveraged portfolio, a normal drop hurts, but isn’t fatal. However, when the drop moves beyond normal, beyond the expected, the investor is asked for more collateral, which causes further downward pressure on portfolio value as liquidations are needed to make margin calls. But as more securities are sold in a rapidly declining market bids start to fall away, committing the leveraged investor to months in purgatory, working out a busted book. And what about homeowners? As adjustable rate mortgages get reset sharply upward and payments can’t be made, remember the value of that equity in a home? Poof. Now what if that happens 1,000, 100,000, a million times or more? All those real assets flooding the market? There is no bid. Which causes builders’ inventory to crater, which kills their stock prices, which hurts investors’ portfolios, consumer demand, etc. It just goes on and on.
A rookie running the Fed: I don’t envy Mr. Bernanke. Not for a minute. His wealth of deeply-felt, academically-grounded views and best of intentions by seeking to avoid the “moral hazard” of a Fed put all went out the window in less then a week. There is nothing more hazardous to one’s professional reputation than being at the helm of a true market Chernobyl, especially when you were just given the keys to the reactor, but this is what Ben is facing early in his tenure. He was (and still is) staring at a liquidity crunch right in the face, challenging it to a game of “who’ll blink first,” and he lost. And fast. Notwithstanding my leanings towards letting the chips fall where they may and letting those who made bad and irresponsible decisions get smoked, Mr. Bernanke made the only decision he really could make. Even if it went directly against statements he made earlier in the month concerning his focus on inflation pressures and, therefore, stable to higher - not lower - interest rates. Water under the bridge. He’s learning. Dust him off, wind him up and he’ll be ready for the next (read: inevitable) series of crises during his tenure.
A pro running the Treasury: As much as Mr. Bernanke is grounded in academia, Mr. Paulson is steeped in global financial realities. The academic vs. the pragmatist. They are really great foils for each other, especially at a time like this. While Mr. Bernanke is clearly the bell of the ball of the global financial markets, there can be little doubt that notwithstanding Treasury Secretary Paulson’s low profile during this crisis, he is having an influence on Fed thinking. He spent a career at one of the most successful and deft global financial powerhouses, leading part of the charge during its worldwide expansion. Let me tell you, it makes me a lot more comfortable knowing that Hank is back there providing his two cents to Ben and his Fed pals, because he knows the way it is, not the way it should be as depicted in Ph.D dissertations and textbooks. In another few years, Hank and Ben could be a virtual “dream team,” the princes of theory and practice side-by-side. Nice.
I think we are in the early innings of a global financial de-leveraging that will necessarily take place, and it will be the skill of those like Messrs. Bernanke and Paulson along with their EU and Asian colleagues that will dictate how the air is let out of the bubble. Moral hazard sucks, and we are right in the midst of some pretty morally hazardous stuff taking place from a policy perspective. Certain firms and investors will be bailed out though they shouldn’t be, but net net, the impact of letting them go may well be far worse then showing the financial community that the Bernanke Fed will not be issuing put options as the Greenspan Fed did. There are times and places for making points, grand, sweeping points, but this is not one of them. The next twelve months should be challenging for investors across many if not most asset classes, and it is largely due to the government messing things up and then trying to fix them post-facto. And this is the real hazard that should be driving the discussion.
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COMMENT:
AUTHOR: Los Angeles Lawyer
EMAIL: losangeleslegal@gmail.com
DATE: 08/22/2007 02:11:14 PM
Good real estate info. Thanks for the read!
As far as the real estate bubble goes, it looks worse in San Diego.
I came across a San Diego real estate broker’s blog post that is to be the only one I’ve seen that does not spout the ‘industry line: “It’s always a good time to buy real estate.” This broker calls it like it is. No it’s not PC, but it is amazingly informative and insightful.
Bob Schwartz, the San Diego real estate broker who publishes the blog, wrote a great article back in 2005 that predicted today’s huge home deprecation. You can read this article at: San Diego real estate the url is:
http://www.brokerforyou.com/brokerforyou/?p=11
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COMMENT:
AUTHOR: David Merkel
EMAIL: david.merkel@gmail.com
URL: http://alephblog.com
DATE: 08/22/2007 02:46:20 PM
There’s a difference between stock ratings and credit ratings. Stock ratings are directional; bond ratings are locational. Even if correct, bond ratings don’t tell you whether to buy or sell, they only give you a relative ranking of expected loss classes. Those evolve over time, and sophisticated bond buyers know that.
The rest of your piece made a lot of sense. Any reason why you omitted ABCP? The money markets and repo markets are having a tough sled.
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COMMENT:
AUTHOR: MT
EMAIL: mt57@aol.com
URL:
DATE: 08/22/2007 05:15:06 PM
I don’t get why everyone says “investors rely on rating agencies” so they must be at fault. The agencies’ procedures are transparent. The investor - in MBS it’s a highly sophisticated investor - can do its own diligence and its own evaluation. In MBS, it’s not prohibitively expensive given the deal size - takes only 1-2 days at a modest cost. If they choose not to, and they know the agencies don’t diligence the underlying assets, then how can they say it’s someone else’s fault? There is no a priori reason why a transaction cost should be placed on a third party rather than the investor who is putting money at risk.
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COMMENT:
AUTHOR: hps
EMAIL: page.starr@int.sc.mufg.jp
URL:
DATE: 08/23/2007 07:57:17 AM
It’s not just rating agencies, it’s the regulators. Banking regulations (including Basel II) are not equipped to regulate risky AAAs. So either the rating agencies need to improve their imagination (!), as suggested, and issue lots of downgrades, or else the regulators need to toughen up the capital requirements (hard to see how this can be done quickly).
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COMMENT:
AUTHOR: Yaser Anwar
EMAIL: yaser@yaseranwar.com
URL: http://www.yaseranwar.com
DATE: 08/23/2007 05:14:52 PM
MT & hps-
Very interesting comments.
MT: We all can agree that at the end of the day the onus is on the investors to do the appropriate due diligence and not rely on sell-side analysts and/or rating agencies (or any other third parties for that matter).
hps: As you know, the downgrades are already in play by the rating agencies (no point after the blow ups, as mentioned previously). I don’t think regulation can help either.
It’s all up to (90% anyway- IMO) the investment manager and his/her staff to allocate resources appropriately.
I had an interesting talk with a PM from Citadel who told me about how Citadel increased its exposure (by double digits- in %) to the subprime instrument alphabet soup AFTER the jitters and implosions (around May-June). Wait till the dust settles, then increase your exposure and buy 40-70 cents on the dollar.
Couldn’t Citadel make money prior to the blow ups? I’m sure they could and did. But, they (clearly a student of history) knew once blood was on the street they could buy up the assets at a discount.
This is exactly what you’d expect from a top-tier hedge fund like them.
Of course all this sounds easy to do in hindsight, but this shows that the market can almost never be rational, as we fail to learn from the past.
No amount of regulation or third-party assurances can make up for thorough due diligence (even then); the more layers added to protect investors, the more complex the system becomes, thus increase in “normal accidents” in the market.
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3 years ago
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