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.


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Anonymous
admin
August 29, 2007 at 12:15 PM ×

[Why should other institutions get a bail-out?]
But isn't this already being done?

"The Aug. 20 letters from the Fed to Citigroup and Bank of America state that the Fed, which regulates large parts of the U.S. financial system, has agreed to exempt both banks from rules that effectively limit the amount of lending that their federally-insured banks can do with their brokerage affiliates. The exemption, which is temporary, means, for example, that Citigroup's Citibank entity can substantially increase funding to Citigroup Global Markets, its brokerage subsidiary. Citigroup and Bank of America requested the exemptions, according to the letters, to provide liquidity to those holding mortgage loans, mortgage-backed securities, and other securities."

http://tinyurl.com/246r87

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Macro Fan
admin
August 29, 2007 at 12:43 PM ×

We love your third person voice Macro Man.

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Macro Man
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August 29, 2007 at 12:57 PM ×

I'd suggest that the Fed action, while unusual, does not necessarily constitute a bail-out per so. Giving C and BAC the right to lend to their subsidiaries does not entailan obligation to do so, just as those affiliates' having the right to lend to PB customers does not entail the obligation to do so. I certainly haven;t heard any suggestions, for example, that PB margin requirements had been relaxed....

MF, it was a stylistic device that I started using when I began this blog, and I've kept it up. It must be intensely annoying, and I apologize...

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prophets
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August 29, 2007 at 2:09 PM ×

Big Ben seems more prudent and patient than Greenspan. While I agree that every financial company across the board doesn't deserve a bailout, Joe Six Pack might need some help on his variable mortgage rate. A few small cuts through this minor US slowdown, would be OK with me. Just not the insanity of negative real rates and 1-2% fed funds...

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August 29, 2007 at 3:26 PM ×

One person I know would have it that the use of the third-person fiction (among others such as the subjunctive, were it to be employed) has the same truly magical effect on polemical discourse that the invention of sports might have had on relations between rival and adjacent villages, in some distant past, previously only governed by a half dozen neurons in the lizard brain. It focuses attention on the subject of the debate and away from the imagined undesirable personal habits and heretical religious beliefs of the debater. This not to mention his or her unacceptability as a spouse to one's offspring.

The disadvantage? A possibly inaccessible pompousness or frivolousness when read by the uninitiated or those not adept at the art of interpretation. On the other hand, the success of the endeavour is generally reflected in the comments section.

But annoying? Never!

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Macro Man
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August 29, 2007 at 3:56 PM ×

I suppose the annoying bit is in the writing- when I want to use a personal pronoun, it becomes a bit convoluted, per the Stan the Man story today...

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August 29, 2007 at 4:03 PM ×

You have to write it in Word and search for all instances of the words 'I' or 'me'. If you actually erase them from the dictionary, they'll show up underlined. We like to think of it as mystical.

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prophets
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August 29, 2007 at 6:26 PM ×

I kind of like the third person commentary. The format provides a more distinct form relative to the other blogs/editorials/news we read on a daily basis.

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Anonymous
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August 29, 2007 at 8:20 PM ×

A few comments:

I agree that cutting the Fed funds rate would be a mistake at this juncture. However, I think intervention, even discount, to clear frozen markets sends the wrong message to risk takers and pretend risk avoiders. If I park my fire proof vehicle next to a building that ends up catching fire and crushing my vehicle in the ensuing collapse, that is my mistake. Perhaps if I was going to park my car next to buildings that could collapse I should have bought different kinds of insurance, or designed my vehicle differently. The world gains nothing whatsoever by enshrining the belief that risk can be eliminated because governments will always intervene, save perhaps a pernicious complacency. Buying government issued or insured instruments or holding currency or precious metals in a bank vault entails risk, yet somehow far too many people act as if risk can be eliminated. Too many people want to equate safest with absolutely safe. Sometimes a lot of people need to get burned for humanity to remember that fire is hot, even the ones who didn’t think through, or weren’t smart enough to manage, possible exposure. There is no risk free action.

During this liquidity problem there has also been a far too often heard cry of “that’s not a fair bid!” If one is forced to accept, rather than just receive, a bid that is uncomfortably low it does not mean that the bid is unfair, but rather that one manages risk poorly.

I agree with anon 11:15 that the Fed’s exemption for Citigroup and Bank of America is a prima facie bail-out. Granting the request of these banks rather than letting them reap the market consequences of taking risks as rule bound institutions is not just a bail-out, but also a very poorly timed moral hazard play.

I am also a fan of the third person voice. Reading about the adventures and contemplating the ruminations of Macro Man is routine for me.

JS

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Anonymous
admin
August 30, 2007 at 11:05 AM ×

You're making a very convincing argument MM! Someone pointed out to me recently, that when the Fed cut rates twice in the past two bail outs of the financial markets (in '87 and '98) did so at a point in the economic cycle when spare capacity was low and as a result, had to hike agressively shortly afterwards (mar-88 and jun-99) in order to fight inflation. We know that those two episodes ended with recessions.

So the risk now, it seems, is that the Fed cuts to save the markets, and is forced into overtightening agressively in 2008.

Regards, FR

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