Monday, March 17, 2008

Financial market limbo

Limbo. It's a strangely apt word to describe financial markets at the moment. Limbo is a strange place, a sort of karmic holding pattern between heaven and hell. In today's financial world, it's a place inhabited by a myriad of institutions, all awaiting knowledge of their final fate: will they reach the Nirvana of solvency and survival, or become the latest victim of a Faustian bargain made long ago, and so enjoy a one-way ticket to the Inferno of oblivion?

One might reasonably question how Bear Stearns descended from Nirvana with only the briefest of stops in Limbo before evidently disappearing forever. Such is the perils of leverage! Sure, BSC appeared to have a book value of $10 billion, which is more than even the Kerviels of the world have managed to lose. But when savagely levered, that $10 billion of book value represents $400 billion of assets on the balance sheet.....and $390 billion worth of liabilities. It's the equivalent of putting down $10k, taking out a $390,000 mortgage, and buying a $400,000 house. (Dare we label this the subprime business model?) And as both Bear and subprime borrowers have learned to their chagrin, you don't need to take much of a haircut on your assets before you're completely wiped out.

While it appeared this morning that markets were set up for a doomsday scenario, the ultimate price action in equities was unsatisfying for just about everyone. We didn't get the climactic downdraft that often marks out a bottom, but nor did we get a strong bounce that might suggest a short-covering rally is in the offing. So equities, too, are in Limbo, having plowed most of the way towards the downside targets of the current move, but still lacking the appetite to start pressuring the shorts. Ugh.
And of course, Limbo is a word that conveys overtones other than the religious/philosophical. It's also a party game, found most often on cruise ships and Club 18-30 holidays. The game is about arching one's back and walkign under an increasingly low-level bar or rod; the one-sentence summary of the game is How Low Can You Go?

And that is a question confronting the Federal Reserve today. A few weeks ago, markets were lookign for a 0.50% cut at today's meeting. With equities lower and CPI defying logic to print lower, that was raised to 0.75%. And now Bear has pretty much cemented expectations of a full percent. Apologists might suggest that rate cuts of this magnitude are required to fix the problems with the financial system...but are they? Surely the scale of the issue now transcends monetary policy, and requires a toxic waste dump for people to use to clean up their balance sheets and reduce their leverage.

If the Fed cuts 1% today and things don't durably improve, how long before the market starts to fret that the Fed is "running out of bullets"? Macro Man doesn't know the asnwer, but presumably it won't be far off. We have exited the world of fact-based reality and entered a world of superstition, sentiment, and psychology. Or at least, those items are the new "facts." As foretold by Cassandra, counterparty risk is now at the tip of everyone's tongue; unlike 1998, and unlike 2001-02, we've seen a bank go under, with the potential for more in the pipeline. Whether that happends depends on sentiment and, dare it be said, a fiscal solution to clean up the financial system.

As Macro Man sees it, Helicopter Ben and his 1% rate cut won't make a damn bit of difference.


Macro Man said...

Bizarre! This was posted early this morning but didn't "take" for some reason. Hopefully everyone can see it now.

James said...

I think its a cosmetic move for Congress and to take pressure off the fed when things get much worse. There are a ton of institutions that levered up into a massive bubble and when it popped they got crushed. Get ready for the federal government to start assuming trillions in bad securities. If I was a foreign government I would be steering my economy away from the dollar and getting ready to break free from this system.

MP said...

MM, assuming that the FED manages to stabilize the financial system and avoid a meltdown in credit markets, we still will have to face a bunch of other problems (e.g. the insolvent US borrowers and consumers).

It seems that lots of people have the view that this whole exercise of unwinding the excesses of the past is an internal issue among the involved banks and it will be gone once all bad debt has been written off.

Any thoughts on this issue?

Macro Man said...

MP, the problem is that all those insolvent homeowners' and consumers' loans' are securitized and held by others (banks/hedge funds/asset managers/pension funds/foreigners).

As long as these loans don't perform, the value of these securities will not be terribly high...and the process of securitizing new loans will remain broken, at least partially.

As noted in the text of this post, the scale and sums involved are such that the Fed is, if not irrelevant, than probably only a minority piece of the solution.

Four or five months ago, perhaps the Fed could have saved the day (perhaps through making it look/sound like they knew what they were doing?), but it seems that that time is past, today's risk asset love-in notwithstanding.

But your ultimate point is, I think, that even if no one else blows up, the US economy looks like it's going into recession. And it's hard to see that being a wonderful environment for risky assets.

Anonymous said...

i think it is fair to say that bankers trust went under in 1998 (taken over by deutsche) and that ltcm could be seen as a quasi-dealer. but there certainly was not the systemic leverage across so many entities -- consumer, corp and govt -- that there is now. that all said, i cant decide whether we care going to see inflation, deflation or what magnitude of either or neither. it is as if we are on a super-conductor: the distribution of looks flat for all outcomes. the ultimate fat tail distribution.