Wednesday, October 08, 2008
Is There a BID? Hello?
We have seen several consecutive days of hemorrhaging in the equity and credit markets as the great deleveraging proceeds apace. The problem, among others, at the moment seems to be the absence of any genuine long bid. There is no buying constituency. The only bid seems to be a short cover. And the Fed.
Today's global rate cut met an immediate selling wave which, as I write this, has reversed into a modest buy, increasing US equity markets by 2% or so. I don't believe it will last. Shorting becomes legal again soon, at which point we will unleash more selling pressure.
A couple of learnings - with the benefit of hindsight, the Fed and Treasury should have done an assisted deal on Lehman, and preserved the Fannie and Freddie preferred holders. The unintended consequences of a Lehman bankruptcy and wiping out the Fan / Fred prefs has been a deadly combination of a run on cash (money markets, bank deposits and commercial paper) and a significant reduction in the equity accounts of most US banks (which were nearly universal owners of Fan / Fred prefs). That has been deadly. Deadly. Within ten days of the those actions, WAMU lost 10% of its deposits. Goodbye WAMU. Shoes fell everywhere.
I guess moral hazard has some positive consequences people forgot about. It keeps financial institutions liability structures in place.
By the way, the hedge fund business as we have come to know it is dead. With quarterly redemptions exploding (another bank run), virtually every hedge fund must sell and raise cash. So in addition to a giant deleveraging of financial institutions unleashing a massive supply of securities, hedge funds are selling as well. It ain't pretty. If there's more than a handful of sub $500 million hedge fund that survive intact, I would be pretty surprised. The only survivors are those with locked up money. You can't redeem them. But I would guess 95% of hedge funds have no lockups. And people want their cash right now. Performance doesn't matter so much. It is access to cash that matters.
One other point that bears some discussion. There is going to be a massive amount of whining about an absence of regulation and oversight causing this problem. Because of the election, both candidates are competing to make this point. Let me suggest that is so wrong as to be stupid. Here's why. Over the past many years, we imposed Sarbanes Oxley, market to market accounting, high yield market transparency, decimalization and a host of new regulations. The object of those rules was to reduce the profit margin in client flow business for financial institutions, among other things. There was a perception that making money that way, without taking risk, was somehow wrong and required more regulation. But, by doing so, we forced financial institutions to seek profit from higher risk activities which involved using capital. And leverage. And in a low rate environment awash in liquidity, those financial institutions did it. And so, by the way did individuals.
Now, take away the liquidity, and the reversals are untenable. And it's going to take awhile before these institutions figure out how to make money again (besides lending to the government). And to get there, they have to shrink not just their balance sheets, but their headcounts. By a lot. More than they have already.
Yep. Wish they hadn't let Lehman go quite the way they did. That hurt a lot of people. It did teach a moral hazard lesson for sure. That lesson will last for at least a generation or more depending upon where this current panic ends. But that one left quite a mark. And we designed a regulatory system based on solvency, liquidity and excess financial system profits, not the reverse. And it's a long, long way down.
6 Comments:
By 
smitty1e, at
Wed Oct 08, 03:38:00 PM:
>It did teach a moral hazard lesson for sure.
Which would be: don't forget to buy sufficient Congressmen.
By 
, at
Wed Oct 08, 04:26:00 PM:
Apropos to your post--and reaching the same conclusion--the WSJ had a riveting article detailing the events leading up to Lehman's demise. But for the fact that we are living this white knuckle nightmare, it has all the drama of a John LeCarre page turner.
By Charlottesvillain, at
Wed Oct 08, 05:17:00 PM:
Wow, CP, I have been the reigning pessimist on this blog...until now. I think with the term "generation or more" you just stole the title. I have enormous respect for your experience and analytical ability, and so that scares the crap out of me.
By Cardinalpark, at
Wed Oct 08, 05:30:00 PM:
Villain - just to be clear, the lesson will last a generation, not the market setback. I'm not that pessimistic. But there will be a far greater reluctance to extend credit that will last because this is a crisis that will indelibly imprint so many market participants.
By Escort81, at
Wed Oct 08, 05:51:00 PM:
The object of those rules was to reduce the profit margin in client flow business for financial institutions, among other things. There was a perception that making money that way, without taking risk, was somehow wrong and required more regulation.
CP -- was reducing profit margin the object or the unintended consequence? And don't financial institutions understand that eventually every new money making approach gets imitated until competition reduces returns?
I would agree with you if what you are saying is that there are many on the left who consider "profit" a dirty word. They are bascially uncomfortable with capitalism because "exploitation" (at least as an economic term, i.e., the difference between marginal revenue product and wage rate is "exploitation") and unequal results are inherent in the system. But everyone within one standard deviation of the political center wants to have a set of rules in place that govern the activities of commerce for different businesses. Tigerhawk has to deal with FDA, but it's not as if he wishes FDA didn't exist at all (I think). The more complex the activity, and the more innovative the participants are, the more difficult it is to have an appropriate level of regualtion and for the regulators to keep pace with the business. Fair and appropriate rules and good referees are important in any competition. There is a fundamental difference in playing in a pick-up basketball game (as honest as the partipants may try to be in calling and acknowledging fouls) and playing in a game with clocks and referees. Obviously, everyone at the Cato Institute disagrees with this.
I can't lose too much sleep over hedge funds suffering from redemptions. Of course, there is a short term effect on the markets of the hedge funds dumping securities to raise cash, but eventually that should create buying opportunities for those with cash. Hedge fund operators chose to live in a relatively unregulated universe (domociled on paper offshore and not regulated as an investment company under the Securities Acts) and many had a high risk / high reward existence. No problem. Redemptions were always a part of that risk.
The market for credit default swaps was also largely unregulated, and the size and scope of that market was at the very least a contributing factor (if not the primary factor) in the fall of Lehman and AIG. There is nothing inherently wrong with a tradeable insurance policy (which is essentially what a CDS was, and in that sense not that different from other types of options), provided that everyone in the market has at least a vague understanding of the underlying risk of the insured. Otherwise, it is as if I am in Vegas at the roulette wheel betting on a couple of longshot numbers, and there are a bunch of people milling around behind me making bets as to how often I'll win, and then trading those bets over and over again.
I am with you on wishing Lehman did not have to go that way and that it hurt a lot of people. I have a classmate and clubmate who was very senior there when the crash came (his M&A advisory business had little to do with the problems at Lehman), and this can't be fun for him after many years at the firm. We'll see what Barclay's does with what is left.
I am also with you that we need a better regualtory system -- one that is better at allowing risk taking and segregating it in clearly defined market niches. You wanna play at the $10 tables, or in the back room with no limits? Know WTF you (not you personally) are getting into.
Look on the bright side -- it's not a bad time to be in private equity and be liquid. There will be excellent opportunities. Markets work in the long run (indeed, markets are inevitable), whatever the short term disruptions may be.
By , at
Wed Oct 08, 06:02:00 PM:
I do wish that investment banks had been regulated in one respect more like banks and, as the various wire houses like Merrill, Bear and Lehman began to pad their balance sheets with securities to be held to maturity (a polite way of saying there was no readily available bid), instead of using their balance sheets for the traditional purposes of inventorying of short term holdings, the banks should have had to run matched books on the funding side. I'm no expert, but it seems to me that over the years the OCC has been very good at assessing funding risk, and also that the Fed works hard to make sure holding company structures keep various portfolio risks compartmentalized. Lehman, and the critical role it played in the commercial paper market, might still be functioning today if the company's balance sheet had been properly monitored.
