The legend of Stan the Man

So is this the start of the W, or the lambda, or whatever other letter 85% of you expect to produce a dip in risk assets? Peut-etre. (Incidentally, thanks to everyone who voted.)

While the scope of yesterday's sell-off in US equities was surprising, in many ways it simply unwound last week's low-volume rally, so perhaps we are all square. While the Fed minutes failed to imply that they were on the verge of easing rates three weeks ago, Macro Man would humbly suggest that anyone who had expected that sort of outcome was being pretty unrealistic. They have been quite clear in tying future monetary easing to developments in the real economy, albeit while noting the potentially deleterious impact of a financial market implosion on "the real world." To date, however, evidence of such an impact has been pretty slim.

What is curious is that European markets are thus far pretty happy to shrug off yesterday's horrid late-session price action in the SPX and further news of distress in hedge fund-land. Sure, stocks have been marked lower, but they've trickled higher since the open. And risky currencies have actually performed quite well on the day, no doubt helped in part by strong yen selling from Mrs. Watanabe and co. One possible explanation is a rumoured Fed discount rate cut; such rumours now appear to be de rigeur following any day in which the S&P 500 falls more than 5 points. Now, it's an interesting question: should the Federal Reserve cut interest rates?

If money markets are freezing up, it's not hard to see that something should be done to help ensure that markets can clear. However, it could be argued that this should be done via the discount window, which banks (who are, ultimately, the private-sector facilitators of credit to markets and the real economy) can access, but other financial institutions cannot.

Why should other institutions get a bail-out? A mortgage company that couldn't be bothered to verify someone's income before cutting a loan check for several hundred thousand dollars probably doesn't deserve to remain in business. A hedge fund that used excessive leverage and poor risk management to purchase crappy assets at inflated prices also deserves to be an ex-hedge fund.

As Macro Man sees it, cutting the discount rate would help those institutions whose functioning is important to the health of the financial system. Cutting the Fed funds rate in the absence of broad-based signs of economic distress (which the Fed has suggested is currently the requirement) would help support the survival of institutions who, to put it bluntly, made stupid decisions with other people's money.


Now, Macro Man admittedly has an axe to grind here. Back in the mid 90's, when Macro Man was young and just starting to earn some decent wedge out of this game, some of his buddies in the market put him in contact with a "red hot" stockbroker who was making triple digit returns for them in the then-new internet and networking sectors. After speaking to this guy (let's call him "Stan the Man"), Macro Man sent him a check for what at the time was a fairly hefty sum.

The firm that Macro Man worked for at the time stipulated that this had to be a completely discretionary arrangement. In other words, MM gave Stan the money, and Stan had total discretion to place trades (at $200 a clip commission!) on his behalf. And over the next four years, despite a raging bull market in the sectors that were Stan's "specialty", he proceeded to lose it all. He bought crappy stocks on margin but never sold them out, and so lost 99% of Macro Man's money by the time the Nasdaq went to 5000.

Along the way, Macro Man called him periodically to inquire WTF was going on. Sadly, the more money that Stan lost, the more difficult it was to get ahold of him- Macro Man's account had dwindled to such a tiny value that he no longer registered on Stan's radar.

Let's be clear about two things here. First, it was Macro Man's fault that his account dwindled to zero. He should have pulled the plug on Stan while his account still had value, and when it was clear that Stan didn't have the same attitude towards preserving Macro Man's wealth that MM himself did.

Of course, the other conclusion to be reached is that Stan had no business running other people's money. He showed no desire to preserve some modicum of Macro Man's account value when his plan went awry and absolutely no remorse when he failed to do so.

So when Macro Man sees the strategies that some of these firms have pursued, sees the flash cars they drive, the big houses they live in, and the big drawdowns they have subsequently sustained, all through taking big risks with other people's money, he sees one thing and one thing only: the ghost of Stan the Man. And that's a ghost that he wouldn't mind seeing laid to rest for good.

Obviously, not all firms are run in such a cavalier style, and there are plenty of people in both the mortgage and hedge fund industries who've lost plenty of their own cash. But just as the third rate cut in 1998 set up the subsequent equity market explosion and exemplified the moral hazard engendered by the Greenspan Fed, a cut in the funds rate at this juncture would slow or even reverse the very normalization in risk premia that central bankers have been calling for over the past several years.

And that, in Macro Man's humble view, would be a mistake.