Monday, March 17, 2008
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.