Minnesota Futurists Takes No Position or Recommendation - Do Your Own DD

 

March 25, 2008

Black Swans Flock To Wall Street

 

July 26, 2007

It Never Was Just Subprime

So now the dissecting of today's market jitters begins, and there is no shortage of diagnoses. Today's data releases -- described here, here, and here, for example -- were certainly not great, but the most popular explanation seems to be that market players have developed a newly found sense that the world is a risky place.  Barry Ritholtz sums it up nicely:

The Dow is off 395 points as I type this. There will be some short covering shortly, and a rally attempt. But what I want to address is the change that has taken place:

What has changed? What is different today than yesterday? Are the prospects of the economy and/or corporate profits so different today than they were merely a week ago?

What has changed is Credit: Risk appetite for anything less than AAA -- and that includes the ABX stretched definition of AAA (see WTF is going on in the ABX Markets?) -- has waned considerably.

 

The tinder, if not the spark, for the flare-up of credit concerns was this week's revelation from the mortgage lender Countrywide Financial that loan problems extend well beyond the subprime borrower.  From the Wall Street Journal (page C1 of the July 25 print edition):

By laying the blame for its earnings shortfall on rising defaults of prime home-equity loans -- many taken out by people who were straining to afford a house and didn't fully document their income -- Countrywide undermined the popular notion that only subprime borrowers are falling behind. And that could have a broad, negative impact on lenders' stocks.

 

And from from Joanna Ossinger's column at the WSJ Online:

Credit-market woes are partially rooted in the subprime-mortgage sector, which has been a source of market angst for months. But recently the problems have become more acute, as hedge funds invested in mortgage-backed securities have struggled and as default rates have risen, even among prime borrowers. Banks have been hurt by having to take loans onto their balance sheets instead of passing them on to outside investors. And major private-equity acquisitions have struggled to find financing, possibly removing one long-standing support for the market.

It "all goes back to weakness in the mortgages," said Larry Peruzzi, equity trader at Boston Company Asset Management.

 

But a closer look at the Countrywide development is instructive, as it reveals that the source of the problem is, not surprisingly, non-conventional types of loans.  Again from the WSJ article:

Many of the home-equity loans that are going bad are "piggyback" loans to borrowers who took out a second mortgage because they couldn't afford a large down payment and didn't want to pay for mortgage insurance.

Now, with home prices falling in many areas, some borrowers owe more than their houses are worth. That is forcing Countrywide and others to increase provisions against losses.

Another concern is the $27.78 billion of pay option adjustable-rate mortgages held on the books of Countrywide's banking arm. These loans allow borrowers to pay no principal or less than full interest each month. If they choose that option, their loan balance grows. Payments are now overdue on 5.7% of these loans held by Countrywide, up from 1.6% a year earlier.

 

But here's the thing -- we surely have known for a while now that the building stress in mortgage markets is not a prime vs. subprime thing, but conventional-loan vs. non-conventional loan thing:

 

 

What seems like fresher news to me is the growing skittishness in credit markets that are not so clearly associated with the housing sector.  From the Financial Times:

Stock prices plunged on Thursday amid a flight from risky credits and fears about banks’ growing exposure to leveraged buy-out debts...

Concerns about the possibility of a credit contraction were exacerbated this week when banks gave up attempts to sell to investors $20bn of debt for the leveraged buy-outs of Chrysler and Alliance Boots, the UK retailer.

 

A Financial Times analysis shows that in recent weeks, bank balance sheets have absorbed more than $40bn of high-yield debt for buy-out deals that was meant to be sold to investors.

 

So you have your pick -- weak economic news, a broadening of housing market woes, a fading corporate debt market.  Or just choose all of the above and keep your fingers crossed that it's only a bad week and not a perfect storm.

 

March 10, 2007

Is Providing Liquidity A Problem?

see below:

http://macroblog.typepad.com/macroblog/2007/03/is_providing_li.html

 

Earlier this week Jim Hamilton had an informative post -- for my students, consider this a recommendation -- on financial crises and the role of the Fed:

 

 

 

At Economic Dreams - Economic Nightmares, Dave Iverson picks up on Professor Hamilton's closing thoughts:

 

 

 

The reference to the U.S. in 2001 refers to this...

 

 

 

... and the reference to Korea 1997 refers to this:

 

 

 

It might be worth noting that, in the aftermath of 9-11, the immediate actions of the Federal Reserve were concentrated in the area of discount window lending, or direct loans to financial institutions. This response was not so much about "flooding the market" with currency -- initially, the federal funds market was inoperative -- but about temporarily replacing funds that were in effect "locked up" because they could not be transferred from the affected financial institutions in New York City. (To provide some perspective on the magnitude of this operation, on a typical day discount window lending by the System might be on the order of $200-500 million. On September 12 the value was in the neighborhood of $45 billion. The total for the week was about $90 billion.)

 

As things progressed over the week of 9/11 and into the week after, standard open market operations once again took center stage, and "flooding the market" with liquidity is an apt description as the sharp decline in the effective federal funds rate indicates that more reserves were being supplied than demanded at the pre-9/11 price:

 

Federal_funds_rate

 

The key word in Jim Hamilton's description of this event -- evident in the picture -- is "temporary": Once markets stabilized, policy returned more or less to normal (or at least as normal as it could be under the circumstances).

 

With that in mind, I'll suggest that U.S. monetary policy in the fall of 1998 might provide a better contrast than Korea 1997. You'll recall that the Asian currency crisis of summer 1997 was followed by the devaluation of the Russian ruble and the subsequent fall of Long-Term Capital Management in August 1998. Those events were followed by this in September...

 

 

 

... and yet another rate cut following a special unscheduled conference call in October:

 

 

 

The Federal Open Market Committee would choose to move one more time, at their next meeting in November:

 

 

 

This series of rate cuts would not be so temporary. The federal funds rate target remained at 4-3/4 percent until June 1999, a fact that did not please everyone. From the minutes of the November meeting:

 

 

 

In fact, the rate of inflation accelerated through 1999 and into 2000, prompting a cumulative increase in the federal funds rate target of 175 basis points between June 1999 and May 2000. In retrospect, it is clear that the economy began to weaken in earnest soon after. One would, I think, be forgiven for entertaining the thought that the FOMC may have gone too far, and hung on too long, in its response to the very real liquidity strains in Autumn 1998. Consequently, some people might be tempted to rephrase the Hamilton question just slightly: In the event that "the Fed can and will prevent potential liquidity strains from cascading into broader liquidity problems," will the outcome be more like the U.S. in 2001 or the U.S. in 1998?

 

 

Comments Follow:

 

I agree, fall of '98 provides a wonderful comparison. IF we're at the very height of a bubble, aren't "potential liquidity strains" just what we need?

 

Posted by: bailey | March 10, 2007 at 12:07 PM

 

Hi bailey -- One would hope that any necessary corrections could occur without any extraordinary stress on financial markets, but history does suggest it doesn't always (usually?) work out that way.

 

Posted by: Dave Altig | March 10, 2007 at 06:29 PM

 

I have been on the receiving end of the liquidity flood since entering the trading business in 1986.

The fed has performed very well during these crisis.

 

I think in the case of a bubble, the markets have sorted it out pretty well. We had a dramatic crash in 2000 (Which I called on Bloomberg TV in January of 2000. I have the tape to prove it!) That crash was very dramatic. A lot of folks lost a lot of money. It was pretty bad. Friends of mine had invested fortunes in internet companies at high share prices, and now they were worthless. In 1999, you could not trade the expiring December treasury contracts or eurodollar contracts with any certainty or confidence. It began to put a strain on the March contracts. The fed stepped in at the end of that year to provide certain liquidity in case of a dramatic Y2K event. Fortunately, it did not occur.

 

In 1999, I was on the CME board of Directors. Gerry Corrigan sat next to me. He was the chair of the committee that looked into all that. He said that we were closer to world financial meltdown than any other time he had seen. It is shuddering to think what would have happened had the Fed taken the stance Hoover's govt did in 1931.

 

It is probably good to be cynical about markets when they fly high. There is a reason that things happen, and they almost always are not readily apparent.

 

This latest melt down was caused by what? Yen carry trade? Overvalued stocks? Stocks looking for a correction? The Chinese government rumoring that they might raise taxes?

 

There are so many variables to the market, that the Fed cannot react to each and every one of them. It can only pursue correct monetary policy given market conditions.

 

I do not agree that we need a melt down to rationalize the market. My opinion is that is happens rarely. We have had only two notable ones that happened quickly since 1987.

Oct 19, 1987, and August of 1998. All the other stuff was noise, and the Fed acted correctly to soothe the markets nerves. The Housing bubble, if there really is one, will be a market moving event, but not a cataclysmic one. The Chinese redeploying dollars and debt will be a market moving event, but not cataclysmic. These are normal, and not entirely unexpected.

 

Posted by: jeff | March 11, 2007 at 08:56 PM

 

dave, maybe the fed can supply free playboy girls to us during the next melt down! I think you would see M1 increase! ; )

 

Posted by: jeff | March 12, 2007 at 12:49 PM

 

Jeff: "There are so many variables to the market, that the Fed cannot react to each and every one of them. It can only pursue correct monetary policy given market conditions."

 

So what constitutes 'correct monetary policy'? I certainly don't know.

 

Jeff: "We have had only two notable financial meltdowns that happened quickly since 1987. Oct 19, 1987, and August of 1998. All the other stuff was noise, and the Fed acted correctly to soothe the markets nerves."

 

What I do know, or at least believe is what Charles Kindleberger argues in his history of financial crises:

 

"There were more asset price bubbles between 1980 and 2000 than in any other earlier period. Japan … Finland, Norway, … Sweden, … Thailand, Malaysia, Indonesia, and several nearby counties in Southeast Asia in the first half of the 1990s. US stock market wealth doubled in the late 1990s…."

 

Add in the current housing bubbles in many parts of the US and the world and we have what we have: bubbleland. Right, wrong or indifferent.

 

Kindleberger continues: "The failures of banks, the overshooting and the undershooting of exchange rates were systematically related and resulted from various shocks that led to large changes in the scope and direction of cross-border money flows. The failure of the banks -- which primarily occurred in three waves -- resulted from the sharp depreciations of the currencies or from the sharp declines in the values of real estate and of stocks during the crash phase of the financial cycle. These crashes were preceded by manias that led to large cross-border flows of money to individual countries whose economies were then performing well; the foreign exchange value of these currencies increased and prices of real estate and of stocks increased significantly."

 

Kindleberger is talking about feedback loops, of course: Success breeds success, then speculation. Success then breeds failure. Then, failure breeds failure, then desperation.

 

And it all happens very quickly in the hot-money environment of contemporary international finance cooperative and non-cooperative games. Usually the mania builds on itself for some period. The crash happens quickly. Then the aftermath may be protracted. It may well be protracted simply because no matter what 'helicopter money' is available in the wake of any big crash, the system is not willing to risk again for some time. Maybe I'm just being old fashioned on the latter point.

 

 

Dave A: "Will the outcome be more like the U.S. in 2001 or the U.S. in 1998?"

 

Or something more akin to the aftermath of the Japanese bubble that burst in 1990, or our earlier US bubble days that began to end in 1929? Or worse still, since the sea of American dis-savers is a noteworthy historical anomaly, at least from what I've read. And the derivatives/hedge fund novelties are in play too, or may be.

 

I hope you are right, Dave, and that I am proven to be nothing more than an over-zealous worry wart. I'd love to collect my piece of the entitlements that seem now to be over-promised in the US. But I'm not counting on collecting all of it. Even half would be nice. Although many of my contemporaries would be very displeased with only half.