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.