At the center of a storm...

The spread between 3 month libor and 3 month U.S. treasuries (see graph), a measure of market confidence is going through the roof.

One thing that is sorely absent from markets these days is indeed confidence. It seems that no matter the amount of assurances by government entities, (both verbally and in their actions), an acute degree of skepticism has taken hold of the market place. Although U.S. government bailouts are at record levels and there are signs of a spillover into Europe and Asia, the market (which is always forward looking) is under the impression that the final bill (which won't be known with any degree of certainty for a long time to come) will be significantly greater than the amounts that are being pledged today. This seems logical considering the growing distrust of financial institutions resulting from uncertainty with regards to their true exposure to toxic debt. The price of the opacity has been to exacerbate the crisis for the financial sector by making it more difficult for firms to gain access to funding, as lending has all but dried up. The result of all this is that we are now faced with a situation in which many firms that, under normal circumstances, would be considered healthy, can no longer get the necessary funding to function properly. Government bailouts are therefore likely to continue until the day that at least some confidence is restored. When and how it will occur are the two big unknowns of this conundrum.

Explicit and implicit bailouts...

Fed and Treasury action over the past two weeks, starting with the announcement that they would be placing the two GSE’s into conservatorship, followed by the decision to let Lehman and Merrill Lynch to their own fates, only to backtrack on a sputtering AIG (once it became all too clear that turning a blind eye in this particular case, with all the counterparty risk, could end up being very costly), and finally announcing a comprehensive bailout plan for the entire economy, has again revived the moral hazard debate.
Suddenly, the point where the line is drawn between what is considered too large to fail and what can be let go of became very blurry and more so with the decision of the Fed to convert the remaining investment banks (Morgan Stanley and Goldman Sachs) into traditional bank holding companies, marking the beginning of a new era.
What was probably not clear with the announcement was that Bank of America's and JP Morgan's purchase of Merrill Lynch and Bear Stearns respectively have pushed the liabilities of these two firms into the same league as that of AIG. So does that mean they are now considered too big to fail? If the markets think so, they could start enjoying lower borrowing costs like those that Fannie and Freddie did. So then the question should be, is the government, with their comprehensive bailout plans, sowing the seeds of future troubles? The answer will depend on how carefully they plan through this very delicate period of reorganization.

The great unwind Part 2...

On our blog of the first of May 2007 entitled "The Great Unwind", we mentioned how the process of globalization brought about a remarkable degree of innovation into the derivatives market, providing access to capital to segments of the market that use to traditionally be left out and providing an unprecedented amount of flexibility in tailoring risk to specific needs (or so it was believed). These instruments did have a dark side related mainly to the sheer complexity of their structures, forcing investors to rely on rating agencies (who, it turned out, themselves had no clue) for risk appraisals.
The problem stems from the systematic failure of the market to grasp the shifting nature of risk. PIMCO's Chief Strategist described it best with a piece entitled "the Paradox of Deleveraging". The current crisis stemming from the uncertainty regarding the true extent of leverage is forcing institutions to de-lever their balance sheet (as mentioned in our previous blog) by liquidating assets. That in itself is the right thing to do but becomes problematic if everyone is doing it at the same time! It is the famous "negative feedback loop" whereby as more and more assets are liquidated, their values drop at a faster pace, in the worst case leading to the perverse effect of greater leverage than what they started with.
It seems that markets fail to factor into their risk models the potential adverse effect of herding. In other words, the riskiness of a security is only considered in a vacuum. Correlations suffer from the exact same risk assessment flaws. We tend to think of correlations as a static notion (i.e. that does not change through time) when in fact, casual observation shows us that correlations are anything but static. Two variables that may have exhibited weak or even negative correlation in the past can suddenly move in the opposite direction. This is typically the case when systemic risk is involved. Today's financial crisis, for example, is having a negative impact on most of the other sectors mainly because of the threat it poses to the overall economy (see our September newsletter). That is why when it was announced over the weekend that Lehman would seek chapter 11 and Merrill Lynch would be bought by Bank of America, the entire stock market took a hit as money shifted out into safer assets such as Treasuries (the flight to quality move).
In the end, no one knows when this process will bottom out because no one known with any degree of certainty how much leverage has been effectively eliminated. Only time will tell.

Black holes and other worries...

The announcement over the weekend by the Treasury secretary and the director of the Federal Housing Finance Agency that two of the largest Government Sponsored Enterprises (representing roughly half of the total mortgage lendings in the U.S.) would effectively be placed into conservatorship was yet another attempt at stemming systemic risk. The market fanfare this time around lasted less than 24 hours as it was rapidly hijacked by news of a battered Lehman losing the little credibility it has left with investors.

The GSE bailout was, in our opinion, a necessary operation to try to stem the debt deflation that, like a black hole, is threatening to pull everything in its vicinity. Indeed, in an attempt to delever, firms are fire selling their assets but when everyone is doing the same, you get a perverse effect of rising debt to assets ratios as the value of existing assets shrink faster than the debt.
So what is the solution? I'm afraid there isn't much that can be done apart from attempting to reduce the severity of the downturn. The housing price deflation (resulting from a bubble) has to run its course and still has some distance to go before reaching bottom (see the Case-Shiller U.S. home price graph above) with some pundits suggesting that we are only half way there! All this is to say that the drag on the economy will continue at least until sometime later next year.

Recession or Stagflation?

The ECB and the Bank of England have joined the chorus of central banks that have opted to keep interest rates steady (or in observation mode) in what seems to be a bid to preserving price stability amidst clear signs of further economic deterioration.

With the sharp rise in the dollar and a steady decline in Euro rates, markets seem to be anticipating that ECB rate cuts are not far away. The same seems to apply for the Fed, observed by the steady erosion in treasury yields (in stark contrast with just a short while back when markets were adamant that the Fed would tighten before year end). The strengthening dollar, however, suggests that the European slowdown could be nastier than that of the U.S., which should come as no surprise considering that the U.S. is ahead of Europe in terms of the business cycle and the ECB target rate was and remains significantly above that of its U.S. counterpart (further choking an already sputtering economy).

So what sparked a change in monetary policy (switching from tightening to steady in Europe and from loosening to steady in the U.S.) and the shift in market expectations? The single largest factor seems to be the sharp reversal in commodities (most notably oil and gas). The drop seems to have subdued inflation worries and, combined with the now global economic slowdown, has shifted market concern from inflation back to the economy. Supply shocks tend to work with lags (as observed with the so far tepid rise in the core inflation rate) which means that even with the marked drop in oil prices, it will take time to impact core inflation. In the meantime we may observe a further rise in the core.
In terms of interest rate policy we believe that in the present context, there is far greater risk of a full blown recession than a risk of stagflation and therefore think that the Fed's strategy (maintaining a loose monetary policy) is way sounder than that of the ECB.