Reading the Fed minutes – no warning signs

The minutes for the August 7^th Fed meeting came out yesterday. The reading suggests that the Fed had little anticipation of the coming storm over the next two weeks. There was a section on the illiquidity of sub-prime structures and the fact that investors were seeing a erosion of value, but there was no connecting of the dots to conclude that there would be a credit crunch problem or that Fed help may be needed. In fact, in an earlier section of the document there was a comment that in spite of the softness in the housing market household wealth was increasing. Without sounding like Mr. Edwards and his “two Americas” speech, there was little discussion of the bifurcation of the mortgage market between long-term home owners sitting on gains and new owners in the ARMs markets facing financial difficulties. There also was no discussion about speculative behavior in the housing market.

Of course, we may all sound brilliant in hindsight. We can finger-point to what should have been done and what we saw in the market tea leaves, but at the end of the day many investors were unable to properly anticipate or act on this credit crunch. We knew there were credit problems but we were missing the potential for contagion or the sensitivity of investors to valuations. From my perspective, it will require more vigilance of factors that are normally not included in macro models.

Consumer confidence does not reflected Wall Street woes

The Conference Board consumer confidence number came out this morning with a slight downturn. http://www.conference-board.org/economics/ConsumerConfidence.cfm

There are two major take-aways from this data. First, the confidence number does reflect the most recent information on consumer thoughts. Albeit a small delay, the information is collected through the 22^nd. This provided enough time to include the credit debacle in consumer views. Given the high level of uncertainty about the market, it may have been difficult for consumers to properly assess the impact on their situation, yet it is surprising that the decline was relatively mild. Confidence has been stable for most of 2007. The credit crunch has centered on the sub-prime market and real estate. This is an issue that should hit home to all consumers, yet the fall in the August numbers does not reflect the housing problems. There have been some much larger past declines which were not associated with recessions. This will give the Fed some reason to pause about taking serious action before their September meeting.

A classic Michael Lewis story –

There are certain characteristics of a Michael Lewis story. He loves the individualist who finds market inefficiencies. In fact, almost all of his best books are about exploiting market inefficiencies. This could be in the mortgage market through quant traders and securitization, the technology bubble, baseball general managers who have to find players or football player who have unique skills. All these stories find a visionary who is able to see something that other could not and how these entrepreneurs try and exploit these opportunities. His latest story in last Sunday’s New York Times looks at another inefficiency, catastrophic risks. http://www.nytimes.com/2007/08/26/magazine/26neworleans-t.html?ref=magazine The article discusses tail risk and how some may try and exploit the opportunity in catastrophe bonds.

Even for those who are not directly involved in the insurance industry CAT bonds, this is an interesting story. It provides some thoughtful insights on what it means to be diversified and what are the types of harm that investors may face when risks become correlated or not fully priced.

The current credit risk problem is another example of tail risk that was not fully examined. The credit markets became correlated and there was a limited amount of diversification. The full extent of the price impact was not properly examined. Perhaps we need to brush up our knowledge of tail risks. This is not a theoretical exercise but a real world problem.

Natural gas dive -

Growing inventories driven by a mild summer in many parts of the United States has driven natural gas prices to lows which have not seen in a year. Actually, the pattern is not that dissimilar to last year. There was a hurricane premium early in the season, but as we moved through the summer and saw an inventory build-up there was a seasonal decline in price. With reduced uncertainty, the actually changes in volatility has been surprisingly stable relative to the past. Last year saw much greater variation.

We are moving into the height of the hurricane season, so there is room for some large swings, but the time it takes to develop a hurricane and potentially see it hit natural gas producing areas suggest that we are safe for at least another 10 days. There are no storms on the horizon.

This was the 17^th consecutive week of increased inventories, which remain significantly ahead of last year’s record levels. If there is inventory build-up there is less likelihood for a hurricane premium to sustain prices at a high level. What is unusual for the natural gas is the price curve for back month futures. The seasonal high for this winter is markedly lower than what we are seeing for the next few winters. The combination of high inventories and some weather forecasts of a mild winter are keeping prices moderated. While the lows last year touched $4, there should be a leveling of price as we move closer to the heating season.

Sub-prime lenders as real estate firms

Countrywide and other sub-prime lenders made a big bet that was not directly related to the quality of the borrowers. The bet was on the continued rise of real estate and not on the quality of their lending standards. While they may not have stated that explicitly to their shareholders, the bet was that the increasing value of real estate would bail out any lender problems. This could happen three ways.

If the borrower sold the property at a higher price, the lender wins. There were prepayment penalties in the loan agreements, so the lender got some of the upside from a flip of the property. The lender would also get to finance another transaction.

If the borrower defaulted, the lender would take the collateral and gain from a flip in the real estate to another buyer. It did not matter if the quality of borrower was poor, you had the collateral. As long as the price appreciated by more than the cost of foreclosure, the lender would win.

Higher inflation that drives interest rates up would not be a problem. The collateral goes up. If you believed that inflation was going to make a comeback and you were writing adjustable rate mortgages, you would be ok. Real estate lending would be good business.

Only one problem, if the value of collateral goes down fast, the lenders lose. Holding collateral should be the last resort. Who would expect that? It is not like this is a “Black swan” problem. We have seen real estate decline. The combination of the S&L debacle with a recession led to a languishing real estate market. The worst case scenario would be a real estate decline without a recession, a fall in housing under the weight of too much building and affordability that got out of control. Lending is not supposed to be an investment in collateral, but these lender were will to play in the "secured lending" market knowing that they were going to make their profits base don the benefit of rising real estate. It is turning out to be just what was expected but at the wrong time.

The great bank bail-out – good policy

The only banks using the discount window have been four big money center banks – Bank of America, JPMorgan Chase, Citibank, and Wachovia. Each borrowed $500 mm. The additional policy twist is the fact that the Fed is willing to take ABS CP collateral and have changed the risk weightings for collateral. The Fed also exempted Citicorp, JP Morgan Chase and Bank of America from its limit on how much its banking unit could lend to its broker-dealer. The Fed provided the exemption because in its words, it was in “in the public’s interest”. This is an exemption of section 23a of the Federal Reserve Act.

The combination of actions has provided significant liquidity to the market and has been the key to the growing stabilization of the money markets. These large banks are some of the key players in the commercial paper market through their dealing and the providing of back-stop credit. Of course, there is the higher rate paid on the discount borrowing, but this is a small penalty relative to the overall benefit granted by the Fed.

Was this good policy? It clearly had the intended effect without forcing the Fed to lower overall interest rates. Theory states that lending standards and providing credit are more important than monetary policy for fixing a credit crunch. In the short-run, this was a deft course of action. The amount of risky loans exceeds the capital base of the banks, so support was needed, but this does not help the borrowers in the declining real estate market or the buyers of CDO. They will have to take their lumps. There are responsibilities but also privileges with being a bank.

Market improvement but still hidden credit IEDs

While there has been improvement in the credit markets, the problems are still not solved. Some positive improvement has been the more rational pricing in the Treasury market. The flight to quality has slowed so that the almost irrational Treasury yields of the last week have moved closer to normal. The relationships between Treasury bills and repo rates have also improved. The problem is still the high spread for commercial paper and the significant declines in financing. You can see the reduction in CP outstanding from the Fed. It may be an understatement to say that Investors have not returned to the CP market.

What is stopping the investors from picking up "attractive" yields? They are not attractive! There is too much uncertainty that cannot be quantified especially with what could be characterized as credit IEDs. There are a number of complex structures in the ABS CP market. For example, SIV-lite deals whereby the long-term sub-prime mortgages are financed through the CP market. This is the classic borrowing short and lending long problem. There is no financing available and the collateral has fallen into the tank. Should we have expected any different given a slowing economy and flattened yield curve?

The credit IED problem is made more difficult through the re-rating of deals by the rating agencies. It is not clear what the new rating standards will be, so all deals are at risk. You cannot avoid the price revaluation if the rating falls. There are few people who would be willing to stand in front of the rating truck that is adjusting their views on structured deals.

While not an expected scenario, one of the advantages of structured finance is the belief that there will be limited event risk. A deal is stress tested and the rating will be based on these tests. The expectations is that the rating agencies when they provide their rating would account for different economic and markets scenarios. Fitch has now stated they are re-rating their sub-prime structured deals. S&P and Moody’s have also started this process. Where will the next credit blow-up occur? Who knows? All we know is that the rating agencies, in an attempt to right past wrongs, will be contributing to the uncertainty and create the potential for more credit explosions. However, are there any alternatives?

A turn-around in the credit crisis?

Some events are often catalysts that change the direction of markets. At this time, three actions have lead to a reduction in the dangers from the credit crunch crisis. Each of these events is not large by itself but all serve to change the tide of credit panic in the debt markets. Their signaling effect has calmed the markets.

• Four large banks borrowed money from the discount window. The problem with using the discount window is that it may be perceived by the market as a weakness in the financial stability of the borrowing bank. Do you want to be the first institution to borrow large sums from the Fed? Four money center banks banded together and each borrowed $500 mm from the discount window and jointly announced their actions. There is less shame in this action and it sends a signal that the Fed is willing to provide liquidity. It can also lead to profitable business for the banks. Take the simple case of borrowing from the discount window and posting commercial paper as collateral which was bought at a discount. If the underlying collateral is good, then the banks can be virtually assured a profit on this transaction. Liquidity is restored and the Fed provides an avenue for funds to the market. The system is improved and the credit crunch is diminished.
• The ECB provided further liquidity in Europe to reduce continued concern about the banking environment in Europe. The further injection of funds into the market provides needed liquidity which will further stabilize the credit markets. The ECB has not stated that they will lower rates but they are willing to provide funds at the current levels. This short-term action has been helpful.
• Bank of America invested in Countrywide Financial. BofA buying into the largest originator of home mortgages sends a message that the home mortgage market is still a good business in the long-run even with the current rash of lay-offs in the industry. A savvy aggressive bank is stating that values for these companies are out of line with reality. Could other investors be far behind after this action?

None of these actions solve the credit crisis, but each provides some positive signal in an otherwise dismal market environment. The problem is not solved but there is now more breathing space for markets to achieve order.

“Black Swan” risk management at the extreme

The recent credit problem suggests that managers have to be better prepared for the unanticipated. The problem of the “Black Swan” Just because I have not counted or seen an event does not mean that it will not occur. Nevertheless, this can be taken to an extreme. The London story talks about race organizers taking out Loch Ness monster insurance. This could be the Black Swan of Scotland, but it also raises the point of what level of risk protection is necessary. Risk is everywhere, but should you pay someone to take all of those risks away?

LONDON (AFP) - Organisers of a duathlon in Scotland have taken out a one-million-pound (1.46-million-euro, 1.97-million-dollar) insurance policy against attack by or sighting of the fabled Loch Ness monster.

Transport operator FirstGroup said in a statement that its policy with insurers Royal and Sun Alliance would pay out should "Nessie" emerge from the murky depths of the vast watercourse and/or attack one of the competitors.

First Monster Duathlon race director Malcolm Sutherland said they were planning for all eventualities.

Jon Woodman, trading director at R and SA said: "This is one of our more unusual requests but it certainly gave our team something to get their teeth into."

Any "proven sighting" has to be independently verified, subject to policy terms and conditions, the insurer said

From relationship banking to merchants of debt -

Current arguments that we may see a slowdown in the economy caused by an old fashion credit crunch are right on the mark. But first we have to define terms. A credit crunch is caused by growing conservative lending policies during periods of financial duress and reduced profitability. If there are higher risks from lending, reduce the amount (quantity) of lending that is being done. If the changes in risks are swift, there is a crunch. A credit crunch may not be solved with lower interest rates. There is a distinction between a credit crunch and a liquidity crisis. Monetary policy may not be effective for a credit crunch. It will is more likley to be effective with a liquidity crisis.

The world has radically changed since the last credit crunch in the early 1990's, but it has not all been for the worst. First, the bad news on the credit market changes. One key finding of the credit cycle work is the value of relationship banking. When the bank knows its customers and can reduce moral hazard and adverse selection problems, there is an opportunity to avert some of the potential problems from changing credit quality. The relationship banking model allows the lender to understand the business of the borrower and hopefully make more nuanced decisions on how to extend credit. Credit will be shut for the marginal borrower and for the borrower that does not have a long history with the lender. When assets are securitized there is a break in the link or relationship between lender and borrower. Detailed information on the history of the borrower is not as readily available. There is greater likelihood that the lender will walk away from the borrowed in situations where there is not good information on the collateral or borrower and there is no long-term relationship.

Now, the good news since the last credit crunch. The advantage of securitization is that the pool of potential lenders or buyers of debt are much greater. At the appropriate price there can be found buyers where otherwise it would not be the case if the information on the borrower was limited and the relationship was with one institution. Lending information can be sold to a broader market than the local bank. Lending risks will not be localized. There can be significant gains from diversification. In a securitized world, there is a greater chance that new lender will step in at the right price. This expands the potential pool of credit.

Securitization is not without problems. Selling off loans to third parties divorces the initial lender from the risk of default. This environment creates disincentives to find only quality loans. If you get paid on the flow of loans and no the ultimate payment of loans, you will just write more loans without regard for high standards. You write to the lowest standards in the market. It is up to the buyer of the loans and rating agencies to set the standards, yet they may not have the expertise in this area. (When I was in banking back in the early 1990’s, it was informative going on a trip with bank loan underwriters. Seeing collateral makes a big impact on lending standards.) Securitization changes the incentives for bankers. They are not holding debt but become as quoted by Minsky, ‘merchants of debt”.

Going back to the old relationship banking may be difficult, but it will clearly happen through market forces. Securitization will be more difficult and rates will rise. This will make holding loans more profitable. The market will adapt, but currently, we do not have a historical precedent for this credit crunch.

You cannot avoid ABS commercial paper – so let's stop financial profiling

The size of the ABS commercial paper market is big. Very big. And its very size is a problem in the market. Money managers are declaring they don’t own the stuff, never had it in their portfolios, don’t understand it, and if they did they would not have bought it. Yet, this cannot be true for the market as a whole. Just like all Boston’s baseball fans could not have been in Fenway Park when the Red Sox beat the Yankees in 2004, everyone could not have avoided the ABS market. It is just too large. The chart shows that the ABS market is larger than non-financial CP debt outstanding. In fact, it has surpassed the total debt in both the financial and non-financial sectors. Who is holding this paper? How is it going to roll?

To say that all ABS CP is bad is the height of financial profiling. It is just not the right thing to do, but in situations of high uncertainty this type of profiling is done. The key public policy issue right now is to have the government help stop this profiling. The Fed and other government services should help banks and rating agencies provide distinctions in this paper. If the Fed is willing to take CP collateral it should help distinguish haircuts. This will relieve the market uncertainty. Of course, some CP issuers of poor quality programs may not want the market to distinguish between good and bad credits. This is an information problem which needs to be solved not by regulation but through cooperation. Note that this is like all asymmetric information problems. I am thinking about the classic “lemons” and cars problem. The prices across all used cars are affected if the quality cannot be distinguished. Better information allows for a better functioning market.

Flight to quality continues –

The flight to quality continues with further declines in Treasury bill rates. It is interesting to note that the very short-end of the yield curve has seen the biggest declines. There is significant steepening of the yield curve between one month and six months. This suggests that the flight to quality is focused on money fund investors. If it was a general flight to quality from holders of corporate bonds and equities, there would be a less steep decline in short-term yields. Non-money fund investors would be willing to take some maturity risk while looking for a cash asset.

This yield decline will continue until there is enough interest rate difference between credit products and Treasuries to induce investors to move out on out curve or out to the commercial paper market. At this time, the risks of a funding problem are still too large to induce a shift in funds to the CP market. Window dressing by money funds is paramount. Cash managers are being told to increase quality regardless of yields. Until investment committees are willing to take on more risk, we will see a CP funding crunch.

Expect to see some movement out of the very short-end of the curve as investors find longer maturity Treasuries more appealing, but the commercial paper crisis is far from over. The funding roll risk is real and will not go away with just a Fed announcement or one good day in the stock market.

Minsky craze over done –

The strategist world is now captivated by Hyman Minsky. Some pundits are calling this credit crisis a Minsky moment. The Wall Street journal had a long story concerning the now dead economist on Saturday. http://online.wsj.com/article/SB118736585456901047.html The FT had a story on who discussed Minsky first in 2007. http://ftalphaville.ft.com/blog/2007/08/20/6687/economist-idol-minskys-new-found-fame/ We all seem to have a good explanation for what is happening now, but there are problems with the whole premise of declaring a Minsky moment. Minsky noted that long periods of stability will lead to complacency in markets so that any problem or shock will cause a higher level of instability. How can you prove this hypothesis? If there is no instability, the Minskyites could argue that it has not yet occurred. If we move to a state of higher volatility or instability, it would be argued that the moment has arrived. This to some degree represents the worst type of forecasting. Argue for some calamity. It may eventually occur. There have been blog writers warning about Minsky moments since 2001. Are they right because they have been arguing for the fall for over 5 years? I am not arguing that Minsky is not useful. I am suggesting that more care has to be taken in trying to understand this crisis.

While this may be an over simplification, we have to look at the root causes of problems and trace through the structure of the economy the potential problems. The writings of Minsky are extensive, but hard to obtain. In general, the key focus is that that during periods of long-term stability there will be a movement from traditional hedge funding to Ponzi financing where more money has to be borrowed or assets sold at a higher price to pay-off existing debt. Borrow money to buy a home under the hope that it will appreciate and the profits will be able to pay-off the loan. The scheme only works if the price increase is faster than the loan rate. This Ponzi financing environment will lead to instability if there is a decline in asset price or the inability to find new financing. Why does this occur? Minsky would argue that bankers are actually “Merchants of Debt” who need to find new ways of making a profit and that will often lead to financing of riskier projects because the profit margin in traditional lending are driven down to low levels. This process can continue for a relatively long-time while we wait for the event that will slow asset price increases. Even then, there will be a lag before the markets are affected.

This is a good story and the current crisis fits the facts, but Minsky does not tell us when a crisis will occur or how to solve the problem. That book has not been written.

Money funds are where the risks are greatest –

A good portion of the subprime market was financed through the structuring of CDO which were in turn financed through the commercial paper market. This represents the classic borrowing short and lending long story under a steep yield curve environment. There is a parallel with the S&L crisis of the 1980’s. When the curve flattened and rates rose, the profitability of CDOs were adversely affected.

More importantly, if there is a closing of the commercial paper window, these CDOs have one of two choices, sell assets to delever or find other financing. The selling of assets to delever is not possible because the pricing of assets has fallen. Alternatively, if the financing cannot be gained because money funds will avoid this type of commercial paper, we are left with a credit crunch. The sale of assets will still have to occur at even more distressed levels. There are no good alternatives to this story. Losses will have to be incurred. The issue is who will take the losses. The managers may be out of business but their capital losses are limited.

Now the problem is focused on the commercial paper that is on the books of the money funds which cannot break the buck. This paper has to be rolled. Banks may have provided credit lines as back-stops but these are usually limited in time. The funding problem may be pushed out into the future, like 30-60 days but the game is coming to a conclusion. The Fed may help with taking collateral and lending at the discount window, but this may not help some of the money funds. The contagion is that nothing associated with ABS CP will be safe even if it has good collateral. Funds are moving to safe havens and this problem is bigger than a stock market correction.

Discount rate cut - good news

The Fed cut the discount rate to banks from 6.25% to 5.75 or 50 bps. This action was done because there was the perception that the downside risks to the economy have increased appreciably. This has caused a significant turn around in the markets. Additionally, their statement states that they will provide term financing for all type of collateral. This is a rare intra-meeting move by the Fed which further increases the announcement effect. This move will allow the markets to gain some time to review portfolios and let liquidity back into the market. Allowing the banks to borrow at the discount rate should help with the liquidity issues of commercial paper and back-up credit line from banks.

This was a deft move by the Fed because the Fed funds target rate was left unchanged. The discount rate has usually not been used as an active policy tool separate from the Fed funds rate. Of course, there is talk of this move continuing the perception of the "Greenspan put". nevertheless, the contagion effects across markets and the closing of liquidity in the money markets reached a level that some action was necessary.

Volatility in the currency markets

The volatility in some currency markets have moved beyond anything normally expected. The RBA intervened in the Aus currency markets to stabilize the market yesterday. This is all due to the unwinding of carry trades. In markets where carry has not be as active such as the Eur, the currency volatility increased but is still down relative to the longer-term levels of the last few years.

In those markets where carry was dominant, there has been a multiple increase in the level of volatility. In case of Aus and NZD, the short-term volatility has reached high teens which is greater than normal by a factor of 3. In non-carry markets, the increase is only 50-100%.

There will be a number of strong opportunities in these markets. The country fundamentals have not changed so the reasons for high interest rates are still present; consequently, the potential value from these trades still exists. Unfortunately, one of the new wild cards is the consumption beta story. The demand for low-yielders actually increases if there is greater threat of a recession. The higher volatility also requires a strong risk appetite. The return to risk from these trades have fallen significantly.

Until there is less uncertainty, there will not be a demand for these high yielders.

Explaining quant fund performance as illiquidity risk

There has been a growing amount of grave dancing on quant funds by traditional stock pickers. These quant funds have performed well over the last five years but have seen significant declines in performance over the last month. It may take some time before we fully understand the return declines of these funds. Some would suggest that herd behavior was the cause. Too many managers were using the same factors to squeeze out extra returns. Once some tried to get out of their trades, there was a liquidity problem. Certainly that could be a contributing factor to the decline in performance, but there are other explanations which are similar but provide a better framework for discussion.

There is a growing body of research on illquidity as another factor that can be used to describe the return behavior of stocks. Liquidity risk, as a missing factor, can explain the conditional behavior of stocks and can also provide a prescription for when this type of factor will contribute to performance. This story is well presented in the research work of Dimitri Vayanos in his paper, "Flight to Quality, Flight to Liquidity, and the Pricing of Risk". See http://papers.ssrn.com/sol3/papers.cfm?abstract_id=509858. Vayanos is one of the rising stars in finance. His work is a thoughtful presentation on the liquidity issue that provides a good explanation for the under-performance of some quant funds.

The framework is not dissimilar to work on bank runs. There is a need for liquidity by money managers because clients will demand redemptions during times of financial stress. This will often be associated with higher volatility or uncertainty. It will also be periods of transition in asset returns. These will also be times when there is increasing risk aversion or a reduction in risk appetite. Assets will become more negatively correlated with volatility as compensation is required for holding these assets. If this is happening across all assets, there will also be an increase in the correlation of stocks. We have seen this increase in correlation whenever there has been a downturn in the equity market.

If there was not a threat of redemptions, there would be no need for immediate liquidity and this effect will be less. These redemptions can, of course, come at any time but there is a higher probability during those periods of financial stress.The conclusion from this work is that unconditional analysis will not capture this type of risk, so when this type of event occurs, there will be a breakdown of the relationships that usually occur in the market. The problem for a quant shop is that this type of conditional factor does not occur very often, so it is hard to capture. We are thankful that the threat of redemption runs occur infrequently, but the very fact that these events are rare means that it can have a important impact during concentrated periods.

Carry trade unwind - flight to quality

If there is a flight to quality in domestic markets, you should expect to see a a similar flight to quality for currency markets. What does it mean to have a currency flight to quality? There are two major flight factors which can be considered.

One, there will a flight to higher rated sovereign countries. This a relative value trade to less risky countries. Emerging market countries will be hit no different than corporate bonds. This is consistent with what we are seeing in domestic markets.

Second, there will a flight to quality based on the home bias. Investors want a premium when they invest outside of their home country for the currency risk and the uncertainty associated with distant cross-cultural investing. In this case, those countries which are net lenders will see a huge flight back to their currencies. There will also be a flight to quality to reserve currencies such as the dollar.

Enclosed is our risk appetite index which is similar to what banks have used with their research. It shows that risk avoidance has reached all time highs. The flight to currency quality this week is just a further manifestation of this behavior.

Flight to quality thoughts from Bernanke

The above abstract is from a 1994 paper by Ben Bernanke, Mark Getler, and Simon Gilchrist called "The Financial Accelerator and the Flight to Quality" They argue that there is a financial accelerator from problems with agency costs at the outset of a recession. If lenders cannot distinguish the credit quality of the borrower when there is a reduction in the credit available, there will be a flight to quality and a credit crunch for those who are of lesser quality or who cannot advertise their credit quality effectively. The authors focused on the credit crunch between small and large firms, bu the framework for analysis can easily be applied to today's market.

The paper is worth a read to better understand how Bernanke thinks. he was a leading researcher on adverse selection and bank lending, so he understands the process and has a mental framework for viewing the current problems.

Fed signals and credit crunches

What will the Fed do during a credit crunch? This is the forecast that many are focusing on, yet we have little information to guide us. The personalities at central banks change and they do not want to signal their intentions too early. Yet, the comments by St Louis Fed president is a perfect example of how central bank comments could be taken out of context. Poole has been a thoughtful economist and a strong leader at the St Louis Fed, but snippets of comments published in news articles can cause more uncertainty than necessary.

He states that only a "calamity" would cause an interest rate cut. So what is a "calamity"? There was no definition given. For many, this crisis has reached close to the calamity stage. He also stated that "no one has called up to say the sky is falling". Perhaps those people have been too busy saving their business.

Clearly, it would be wrong to signal your intentions through the news service, so the cryptic messages do not help the market. of course, there are probably behind the scenes discussions and comments, but clarity from the central bank is necessary right now. Bernanke has been a strong advocate for transparency from the central banks, so this is a great time to put this policy into practice.

Liquidity crisis continues with demand for Treasuries

There are often three levels of flight to quality based on the amount of market uncertainty. We may be at the highest level of uncertainty based on the current movement in cash yields.

Level one is when funds flow from higher risk assets to lower risk assets within the same asset class. This would be a shifting of funds from low grade to high grade bonds. This could be caused by relative pricing and views on the merits of subclasses with different credit quality. This could be a movement from high to lower beta stocks.

Level two flight to quality is a movement to Treasuries along the yield curve. Again this is a relative asset class allocation change. Duration risk is kept constant. It could mean an allocation from stocks to bonds. There is still a desire to hold risky assets but in a another form or another asset class.

Level three flight to quality is a dramatic movement to cash. Investors get rid of all risk and hold only the risk free asset. Yield curves especially for very short maturities become very steep. This will occur if there is maximum uncertainty or when there is the belief that no asset class is safe.

We are in a level three flight to quality. The movement is out of all risky assets and into the risk free asset. The change in rates for short-term instruments has been dramatic. Treasury bill rates have fallen off a cliff with little desire by investors to hold risk. We have little experience with these types of dramatic flows to quality but when markets move to extremes there is a greater chance that others will find level compelling.

Liquidity crisis further hits short-rates

The liquidity crisis is taking on a new dimension with funding problems in the commercial paper market. The graph of CP rates shows how there is greater differentiation across issuer types. ABS CP market spreads has blown out to levels not seen in years.

The CP crisis is taking on a scary tone in Canada when 17 Canadian issuers failed to sell short-term debt and sought alternative financing from banks, according to Dominion Bond Rating Services, the Canadian rating agency.

The options for short-term cash managers are becoming limited. Spreads have grown for some CP names. You cannot sell this short-term paper and you may have to mark it down. If there are fund redemptions and the paper cannot be sold to raise cash, the concentration levels for some names actually increase. If the CP reaches maturity, investors may not be willing to roll the paper forward which exacerbates a companies funding problems.

More than central bank liquidity may be needed, but options are limited.

Surprisingly optimistic?

What do we have to look forward to in the coming months? Tighter credit. Falling housing prices. Declines in equity. Election boredom. Slower growth. Economic struggles. Geopolitical risks. Continued war.

Don't worry, be happy. Or, that is what the latest survey data suggests. While the numbers are below 50 which is the point of optimism, the survey results show that most investors are not pessimistic about the future. A closer look suggests there is pessimism about the economy but there is a good feeling about personal finances. Isn't that the definition of recession, when we are employed but the other guy is out of work?

It is hard to interpret these types of numbers. Are we waiting for individual investors to catch up withe bad news? Should we take away from this that things are not as bad as reported? It does suggest that the problems of hedge funds are a high net worth issue and not an issue for the average consumer at this time. Individual investors may eventually feel the pain of the credit crunch in their wealth portfolio, but we may still be in the early stages of this crisis.

Analogies and the current crisis

The current crisis is like:

• LTCM and the Asian crisis in 1998;
• the S&L crisis;the Scandinavian crisis of the early 1990’s;
• the 1907 credit crunch;
• the Latin American crisis;
• none of the above.
  

This credit crunch is like all of these crises and it is also like none of them. Nevertheless, we like to extrapolate from the past and form analogies to past events especially if we had some experience with them. It is part of our human nature to think through analogies. While there are similarities with all of these crises, our power of explanation is tied to our ability to find both commonality and uniqueness in these cases. This represents our creativity. The wrong analogy could be more costly than no analogy because we may extrapolate the wrong answer. The correct analogy will allow us to capitalize on the opportunities that will present themselves.

One of the key issues is determining the type of problem that exists. Here are some generalizations concerning credit crunch / liquidity crises which seem to be apparent from all analogies to the past. However, explaining the past is a lot different from forecasting the future and this is where poor analogies often breakdown.

Discovery consists of seeing what everybody has seen and thinking what nobody has thought.
– Albert Szent-Gyorgi

First, the commonality:

• Decline in asset prices from a change in economic conditions. In this case a slowdown in the housing market and rising interest rates.
  
• Credit crisis are usually preceded by rising interest rates, a slowdown in credit expansion. Tighter liquidity leads to tighter credit conditions.
  
• Herding behavior by one or more groups is present. Everyone is hit by greed through buying securities that are believed to be cheap on a relative basis or gaining access to credit which would not be given during other times. deviations from fair value are rationalized away as the old paradigm.
  
• One-sided markets exist when prices decline. Change in expectations or risk create a lack of buyers in the market. The herd changes direction and prices have to fall to induce new buyers.
  
• Significant decline in price from fair value. These deviations are deep and may last for a long time. There is a risk premium for providing liquidity.
  
• Change in lending practices either through the market or through regulatory process. The structure of lending changes. The old ways of lending are gone.
  
• Significant increase in defaults often in places not usually expected. The defaults move beyond the problems of the initial declining asst class. Contagion will occur.
  
• Leverage increases the size of the problem through increasing the sensitivity to price changes. Leverage is affected by the cost of borrowing.
• The extent of the problem is associated with the behavior of central banks. Continued tight credit leads to a more severe problem. The Great Depression was more severe because of a lack of liquidity and tight central bank policies.
  
• The work-out period could be years.
  

There are also unique risks which we have not seen in other crisis which have to be addressed.

• Securitization of risk. Risk is dispersed across a wider group of investors. This increases the surprise factor in the market.
  
• Risks held in securities thought to be liquid. Sub=rime loans were usually considered a special area of bank lending and not something that could be structured in liquid instruments. The pricing of securities is very different in a securitization versus a bank which may hold loans at book value.
  
• Greater decoupling between lender and borrower. Less regional risk, but risk can appear around the world from a local problem. The lender does not know the borrower and is less likely to be able to conduct a work-out. There is less incentives for a work-out given the disperse nature of the security holders. Who will run the process of a work-out?
  
• Greater reliance on rating agencies. Due diligence was given to the rating agency and not the buyer.
  
• This crisis is not yet associated with a business downturn. This crisis has not be preceded by strong business decline. A recession could be the ultimate stress test.
  

What is the right analogy? While every crisis has been unique, securitization makes this time different from other crises. Extrapolating into the future, not just reporting about the past, is perilous.

The “Peso problem” in hedge fund land

One of the long-lasting explanations for the risk premium in some forward exchange rate markets is called the "Peso Problem" answer. With this argument, there is a premium with holding an asset with a low probability of a large negative event. This event could have occurred in the distant past or it may not have occurred at all and is a perception by the market. In the case of the currency markets, it is a large devaluation.

A peso problem is now affecting credit markets and the hedge funds with credit exposure. Investors want to be compensated for the chance of a large negative event in these markets and would like a premium even if the data may not suggest the risk exists. This problem can also be placed in terms of the language of Nassim Taleb, investors want compensation for "Black Swan" risk. Investors believe such an animal exists even without observing it.

What type of credit time bomb could exist that has "peso" or "black swan" characteristics? We already know that defaults of sub-prime loans will go up. No doubt managers are reviewing portfolios to understand their holdings. The issue could be a large failure or it could be a something which could be more far-reaching. While doubtful, one scenario could be a downgrade of structured products by rating agencies. Ratings for CBO/CDO are based on the structure of the deal and stress-testing. There is not the expectation for a credit event such as a systematic change in the characteristics of the collateral.

The whole idea of a black swan problem is that surprises do occur and by their very nature they are unanticipated. While we do not readily foresee one of these events, the nature of the peso problem is that it is expected and discounted in the price of securities.

Temporary versus permanent liquidity infusions - an addiction to credit

News reports yesterday suggested that the liquidity crisis had dissipated. We had seen the worst and that liquidity from central banks was not needed as much as required last week. While every central bank has commented that liquidity is available, the net injection of money has declined from the major infusions of last week. The big problem with liquidity infusion during a crisis is that we do not know how long a crisis will last.

There has been much talk about when liquidity should be added, yet there has been less discussion about when liquidity should be reversed. These liquidity investments have a way of hanging around as extra money for longer than is often necessary. The fed funds future sis now expecting Fed ease by the end of September. How do you now signal that funds will be taken out of the system?

and there are new private buyers, the Liquidity can be taken out of the system if the size of the credit problem has been fully revealed to the suppliers of funds. Nevertheless, problems are now popping up all over the place. For example, Sentinel money management is asking regulators if they could halt withdrawals. Sentinel provides cash management services. If there are no lenders or residual buyers of these debt instruments, central banks may be providing funds for some time. If there is a tightening of financial institution regulation or if standards for hedge funds are tightened, the need for alternative funds from central banks may actually grow.
The crisis is not over and the actions of central barks as a player in this financial drama are just beginning. The addiction to easy credit is hard to break.

Why isn't gold a safe haven?

Uncertainty is high. The dollar has declined. Stocks are off their highs. Volatility is up. Gold is down.

This does not make sense for those who have played the gold bull story. Gold is believed to be a safe asset during times of turmoil, but it has failed the market this time. Gold has moved down from its high of around $688/oz to the just under $670. The price actually hit a low over the last thirty days of just under $654. While it is still early in this credit crunch, gold has not been the place where funds have moved. It could be the lower inflationary expectations is driving the price down, but that type of thinking is just trying to fit the events with the specialized facts. This should have been a period of new highs for gold. While we do not have information on central bank gold sales which can move the market, the barbaric metal is just not serving the purpose of a safe asset.

So what is a safe asset during the current times? Cash is expected to decline in yield and it is not clear which currency will maintain its store of value, so it still seems like there is a place for gold if only some investors thought so.

I thought commodities were uncorrelated with equities?

The sell-off in equities has also seen a sell-off in a number of commodity markets. This performance is not surprising when you look at the specific markets which have moved with equities. These moves should not be associated with contagion from the credit crisis or at least not directly. There is spillover between equities and commodities associated with changes in economic growth expectations.

Commodities are uncorrelated with equities over the long-run as measured by daily or monthly returns. The correlation for major commodity is close to zero, but the performance of the index is not the same as individual markets, so any comments concerning commodities have to be tempered by the specific market discussed. The correlation between these asset classes also have to be compared at different times in the business cycle to fully understand their relationship.

Crude oil has sold off with equity markets; however, over the long-run the correlation with equities is low. Over the long-run, crude oil price increases have usually preceded a recession. Hence, the oil price rise without a recession over the last few years is what has been unusual. Currently, the decline in growth prospects has hit the equity markets and has also caused sell-off in oil. The high correlation is coincident with a business cycle downturn. Base metals are also pro-cyclical, higher growth expectations lead to rising prices. Again, the lower expectations for US growth has reversed prices in industrial metals like copper. Nevertheless, the relationship across the business cycle is not the same for commodities and equities. Commodities will see their price rise closer to the end of the cycle.

However, many commodity markets are not correlated with equity returns. Specifically, the grain and soft markets have moved in different directions. Soybeans and wheat are hitting multi-year highs. These are all markets which have higher short-term correlation with weather behavior.

Commodities are uncorrelated, but there are common factors which can make them correlated during specific periods. A common business cycle shock is one of those factors. This common factor has been driving short-term behavior.

Credit crunch continues

We don't have a lot of history concerning credit crunches so it may be hard to make generalization on how this event will spread and how it will stop. The current crisis has now moved way beyond a simple liquidity problem within the sub-prime market. The continued turmoil suggests that my earlier comments about limiting the Trichet put were misplaced. This event is having more contagion than what may have been the case just a week ago. The surprise closing of funds in France because of sub-prime debt suggests that the US housing debt crisis has a strong international dimension.

We do know that while providing more short-term liquidity is helpful, it is like emergency room triage. It may stem the bleeding and temporarily stabilize the system but it will not solve the problem. The solution to a credit crunch is for a willingness for banks and investors to supply credit because they believe they are being compensated for risks. If the perceived probability of a default is so high that the yield compensation is not there, credit will not be extended. These are simple concepts.

The current problem is that if you do not know what is in the portfolio of some of these funds, you will sell your holding. This is like a primal response to danger. The is some noise in the bushes. You do not wait to see what it is. You in the opposite direction. It may be nothing but the cost of being wrong is too high.

This primal response causes a liquidity crisis if there are no buyers of the paper that is being sold. The liquidity crisis in one area then has carry-over to other markets. If you cannot sell the illiquid investments get rid of what you can that is liquid. Raise cash and await more information.

Credit crunches - no credit for nobody

We Don't Want Nobody Nobody Sent, Milton J. Rakove Chicago, June 1979. Title of a book about Chicago ward politics, but may be the new standard of credit officers for lending.

The current arguments that we may see a slowdown in the economy caused by an old fashion credit crunch may be right on the mark. But first we have to define terms. A credit crunch is caused by growing conservative lending policies during periods of financial stress and reduced profitability. If there are higher risks from lending, reduce the amount (quantity) that is being done. There is the crunch.

It has been found that monetary policy is largely ineffective in alleviating a true credit crunch, while changes in loan standards and regulation can erase it. This is one of the problems in the current environment of rising short-rates in Europe. While the ECB has provided an unprecedented amount of funds which has brought rates down from their highs, changing credit standard will close the borrowing window for some institutions. If credit lines are pulled, then funds are not available at any price. The less credit-worthy institutions will have to search for those banks which may be willing to lend on a short-term basis and those institutions will want to be compensated for the risk.

In the current environment, liquidity is still available as measured by the money in the financial system. The problem is that those who have liquidity and funds are not willing to part with the money at almost any price. In an uncertain market, this is very rational. One of the ways that the credit markets can be stabilized is through information on the problems. Who has sub-prime exposure? What are the sizes of those exposures? What are the credit protections in place for those risks? Unfortunately those who have the risks would like the markets to remain opaque. Disclosure of information may actually cause the markets to adjust faster. This may be good for the economy as a whole but it will not be good for those with bad loans.

Trichet "put" in practice

The large flow of funds from the ECB to stem the rise in overnight funding rates has been unprecedented. Formally, there has been a strong shift in money demand in response to a change in risk appetite. The strong shift in demand caused overnight rates to soar. Money supply had to increase to bring rates down to their target.

The rise in rates and ECB action has been in response to the halting of withdrawals from three investment funds offered by BNP. While these are investment funds, the trickle-down effect is that there to be a liquidity crisis in Europe from a bank closing funds. We are seeing what may be called the Trichet put in action. This could be similar to the Greenspan put which protected the US stock market in the 1990's.

A key role of the central bank is to provide liquidity in a crisis. The harm to economies when this action has not been taken is well-documented. The issue is whether this represents a crisis and whether a short-term spike in rates should be dampened immediately by the central bank. Nevertheless, the greatest fear may come from the law of unintended consequences. Yes, the major European equity markets are down over 2 percent for the day, but what will be the longer term impact of this response to this short-term funding shock? If the market believes that the ECB will help out when there are bad investment decisions from securitization problems, it gets the wrong signal.

The central bank response may have been too quick. A period is needed for the market to find its appropriate level and not have a central bank provide a level of protection from these short-run shocks. There is no sub-prime problem in Europe although it has some major real estate problems in a number of countries. The investors in these funds are relatively sophisticated and high net worth. Short-term shocks should be monitored but it may have been early for central bank action and a signal that the ECB will try and make everything normal.

End of the world trade?

In spite of the current upturn in the market today, there is a lot of doom and gloom out in the speculative community. A friend and reader of our sight sent the commitment of traders speculative net open positions for the eurodollar and stock indices through the current reporting period. It looks ugly.

We are at the all time highs in long spec positions and the largest short positions in stock indices in the last three years. The speculative community is betting on lower rates and lower stock prices in a big way.

However, we should be careful with how to interpret these numbers. Generally, commitment of traders positions have been used as a signal at the extremes, but it usually suggests a reversal and not something that should be followed with the rest of the herd. What is very interesting about the eurodollar positions is that they have grown at such a fast rate. Just looking at the chart shows how quickly sentiment in the interest rate markets has changed. we have seen a 25 bp change in less than a month. The stock index spec positions have also changed quickly. Given the size of this change in both market sectors, there is a greater chance for a reversal and a moderation of these extreme positions. Nevertheless, it is hard to say who will be the lucky winners in this trade.

Real rates are moving higher together in G-10

While much of the story has been focused on carry trades and nominal interest rates, a focus on real rates should not be missed. The inflation adjusted or real rate is the returns that bond investors should have the most interest. We took the simple approach of using 2-year nominal rates and subtracting the yoy CPI inflation rate. This simple approach, albeit backward looking provides a good estimate of the current real rate. If inflation is more volatile a forward-looking measure would be appropriate.

While there are no surprises in the relative ranking of the real rates relative to nominal rates. The differences between countries tells a story that flows should be starting to change. First, there has been a general rise in real rates around the G10. Second, there has started to be a compression of spreads across countries. With less real spread differentials across the countries, flows will be more sensitive to risk considerations. The signal from higher carry returns may be diminished. Third, the US has improved its relative return position versus a number of countries. While this may not drive the currency in the short-run, dollar declines will have to be associated with other reasons. Granted there are many reasons for a dollar decline, but the real rate may not be a strong contributor. Risk considerations at this juncture may be paramount.

EMBI+ good measure of emerging market carry risk

A good measure of emerging market carry risk is the JP Morgan EMBI+ bond market index. When it is compared against a long-term moving average, it provides a good measure of price declines and reduction of momentum in these bond markets. The downturn in these markets has occurred in tandem with the increase in credit spreads in developed countries. While we expected that global credit spreads would increase around the world, the fact that it has fallen below its long-term trend is meaningful. The last time this happened was a year ago at the same time as the hiccup in carry. A closer inspection of the index will show that it has a strong co-movement with specific carry declines. I would not use the word correlation because there are a limited set of cases, but conditionally reducing exposure in emerging market carry trades when this index declines is a easy risk management tool.

Carry trades – two-sided equation

There has been much talk about carry trades with the increase in credit risk spreads. Wider credit spreads suggest that there is a less risk appetite around the world and there will be less flow into high yielding currencies. There is also the other side of the equation, the funding currencies.

With the reduction in risk appetite we have seen a significant rally in the funding currencies for carry. The yen is off by 4.5% from its high in late June. Capital is coming back home, or there is a new conservatism by Japanese investors to keep cash at home. The same effect is happening with CHF which has appreciated by 4.5% over the same period. The short-term rate in Switzerland is at 2.5% which is 275 basis points less than the US and 150 and 325 bps less than Europe and Great Britain respectively.

It may not be surprising to see the funding currencies have greater changes in price. With many of the emerging market high yielding currencies in better financial shape than we have seen in the past, there will be less pressure to sell those positions. The credit risk story is significantly less for these high yielders. It is the lending currencies that may be hit harder for the simple reason that less flows will be drawn out of these currencies.

Carry trades and credit trades – the completion is heating up

Carry trades have caused vast sums of money to pour into the FX markets. Why have all of these flows come in the last few years? There have been other times when the interest rate spread differential has actually been greater, so the gains from these trades would have been better. What makes this time unique and what could cause a change back to another environment.

A closer look across markets may suggest that the investors in these trades have a very broad perspective of their investment alternatives. They look for the best interest rate opportunities around the globe, although they may have a home or domestic bias. The reason for moving into FX carry trades over the last few years may be due to the tight spreads in corporate debt markets. Spreads have been tight in traditional debt markets, so these investors have gravitated to other debt alternatives. The same can be said for yield curves. As the curves flattened in home markets, there was search for better alternative across foreign markets.

One of the basic principals for the foreign exchange markets is that if you hedge your foreign bond exposure you will get the same returns as a domestic bond which as the same rating as the sovereign debt of the country you invested in. You buy double-A country risk and hedge the currency exposure, you will get a double-A corporate spread. You are able to get further gains if you take on the currency risk component. Of course, you take on the currency risk which don't have in the domestic bond market. You can also look for a cheap funding source, bu you then take on more currency risk and the interest rate risk of the funding currency. Nevertheless, at some point the currency and funding risk may be viewed as manageable relative to the domestic corporate spread alternative.

Similar to the corporate spread story, if the domestic yield curve is relatively flat, financing will take on a geographic dimension. Find the lowest funding source in another country. You can borrow in the low yielding currency and buy the high-yielder of fund a purchase of a longer-term asset. The choice of making a carry trade will be based on the relative opportunities in other markets. If corporate spreads increase and there is not a corresponding increase in the relative yields across countries, then the opportunity to receive gains in domestic markets increase and the money is less likely to flow to off-shore markets. There is not a repricing of risk but a shifting in the relative gains in trading domestic versus foreign assets.

This comparison of alternatives becomes clear when you look at the risks of each trade. In the FX market you have three levels of risk to worry about. There is the interest rate risk in the high yielding currency, the interest rate in the funding or low-yielding currency and the exchange rate. In the corporate spread market, there is the spread itself and the movement in the underlying Treasuries. The dimensions of risk is lower.

With higher yields in domestic credit markets, there will be a flow of funds out of the carry market and into the domestic credit markets. It is not a function of something happening to the currency markets other than there are better alternatives with fewer dimensions of risk in the domestic markets.

What are the components of risk?

Reviewing the components of risk is important when there are uncertain market situations in order to separate reality from the panic of the herd mentality. There is no question that the market is repricing risk, bu the issue is whether this is overdone. Market commentaries will discuss risk in broad terms when in reality it differs for each person.

In the simplest case, look at two investors with different portfolios. One may have 100% stocks while the other has 100% in bonds. There is risk in the stock market, but for the bond investor there is no risk from a market downturn. Of course, there are spillover effects from stocks to bonds as measured by their correlation but the direct impact of an equity downturn will not be felt by the bond investor. Going back to basics, risk can be broken up into four parts:

The hazard- What is the problem associated with this trade or situation? How can the potential problem be described? the description of the hazard may actually be very complex. Sub-prime loses by itself may not be a hazard for many investors until those loses reach a threshold.

The exposure - What is the dollar amount of exposure to this strategy or asset? Clearly, if the exposure is small, then the potential risk is also small.

The consequences - What are the potential results that can occur from this hazard? Could you lose all of your money or just a portion of the investment? The consequence for a CBO will be different than the a equity holding in builders.

The probability - What are the chances of this hazard actually occurring? Is it a low probability event with a high potential lose or a high probability event with a potential for a limited lose? The probability will change with time. We already have a a credit problem. The probability is now whether the problem will get worse.

To understand risk, requires an understanding of each of these parts because the ultimate cost from a risk is the combination of these parts. Classifying risks based on these four criteria are not easy but the issue is still manageable. However, risks are often viewed as independent or discrete events. The problem of risk management increases when these events are interrelated or correlated. More pressing is when a risk in one area will create greater or new risks in another. A simple medical analogy works here. Assume that you get one sickness, it may not be fatal, but it may make you more susceptible to other illnesses which could prove fatal. This is the problem of contagion and may be what we are now facing in credit markets.

We now have a sub-prime problem, but you may not be holding any sub-prime debt. The hazard may be present, but your exposure is zero; nevertheless, if there is a spill-over to other markets, there could be significant risks to your portfolio. For example, you may be holding a high grade credit portfolio but an increase in credit risk across the board can mean a extremely high exposure to a low probability event. The contagion is much harder to measure and model because it may not be obvious that there is a connection between markets and strategies. The key connection may be the need for liquidity which can spill-over to other markets. It is the liquidity crisis which may be the most frightening risk.

The coming doom from hedge funds?

Richard Bookstaber is a quant who has been a financial Zelig. He has been present at many of the major developments of the financial derivatives markets and has had the special quality of being able to reinvent himself with the changes in the markets. I first met him at a Chicago Board of Trade research seminar when he was a finance professor at Brigham Young University. He was a very good researcher and writer who made option pricing theory more accessible to investors. In his new book “A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation”, he makes the inside working of trading firms accessible to the average finance reader.

In his book, , Bookstaber presents a rich history of the major financial trading problems of the 1980’s and 1990’s. His perspectives on innovative trading strategies are the main focus of the book. He lived this work and writes with a confidence of someone who knows the markets. Nevertheless, the book's key focus concerns the power of liquidity. Liquidity trumps all other risks in a crisis and is the focal point for potential contagion across markets. In that sense, the title of the book is a misnomer. This not about the demons of derivatives and hedge funds, but the simple issue that when liquidity is not present, the best laid plans in trading will be thrown asunder. This can happen with simple relative value trades across the Treasury market or through complex options structures. Without liquidity during times of stress, Wall Street can be brought to its knees.

Innovations are not bad. They often times serve a specific purpose or hedging need. It is the excess use from an innovation and the unattended consequences when an innovation needs liquidity to work that is the main problem. The combination of high volume with a specific strategy and a sudden loss of liquidity is a toxic cocktail of risk. Herding behavior whatever the cause leads to the potential for liquidity crises and herds will stampede when risks all start to move in the same direction and are concentrated in a specific financial structure. Do derivative products make these problems worse? Anytime there is leverage, risks will increase. Th ability of a trader to sustain loses is rescued when leverage is increased. Leverage can be a demon when it is put in the wrong hands, but it also serves the purpose of proving trading liquidity. Leverage allows those with trading skill to provide capital when it is needed. There are two sides to this argument.

In some of Bookstaber’s Wall Street tales, it is not the innovation which is the root problem but old fashioned leverage which is the issue. Leverage causes time to speed up. Risks are greater and decisions have to be made faster. the margin for error is reduced. Positions which may have long-term gains will have to be sold to meet margin calls. This demand for added funds to meet margin requirements is what drives the market to liquidity crises. The demand of cash is great and the time necessary to find or access cash is limited.

The ultimate problem is whether there are firms willing to provide liquidity in a crisis. In fact, one theme of this book is the lament of the author for firms that can be risk-takers and provide liquidity during times of dislocation. In the “good old days”, the trading partnerships were willing to provide liquidity. They understood the risks and were willing to fill the gap when liquidity was in short supply.

In the current corporate environment, there are those who have the capital but they often do not have the willingness to bear risk during a liquidity crisis. A strong argument that comes out from this work is that firms that can understand fair value during a liquidity crisis are needed. These are firms willing to add capital even to losing trades because they believe that they will be paid for adding liquidity in the long-run. This type of risk taking requires experience, clear understating of markets, and a focused management structure that is willing to subject itself to loses in the short-run in order to see long-term profits. The poster boy for this risk-taking was Salomon brothers when they were a trading leader. It is unlikely we will see that behavior from banks today. Risk-taking during liquidity crises is unlikely to be made by organization men, but only by firms whose sole purpose is to trade. These firms may not exist, or they may only exist in another form, hedge funds.

This book actually argues that some types of hedge funds could be the firms that have the ability to provide liquidity in a crises and serve the purpose of old trading firms. Of course, it takes a special type of firm to do this work and there are many hedge funds who actually would be contributors to a liquidity crisis. Nevertheless, it is the focused behavior of hedge funds who may be angels not demons. Look at the firm Citadel who has provided liquidity during the recent sub-prime crises and has bought the energy book of Amaranth when it had a liquidity crisis. Of course, it was motivated by profits but it had the vision and structure to be willing to commit funds during a crisis. Citadel bought at a discount but it is willing to hold for a long-term gain if necessary.

While one example does make the argument, hedge funds may be the marginal providers of liquidity in a crisis. The issue is whether they are able to obtain the necessary liquidity from banks and investors when a crisis hits. Liquidity providing requires the ability to obtain capital in a crisis. The current system of risk management such as VAR may not allow for this to happen. Perhaps lock-up term terms by hedge funds is actually a positive for the market as a whole during a crisis. The biggest problem with a liquidity crisis is that if funds are not available in one markets, they will have to be raised in a more liquid market even if there is a not a direct link between these markets. Correlations will collapse to one as money is raised for margin.

The other key argument that is not as fleshed out by the author is the problem of complexity. Greater innovation increases the complexity of the business which means that risk management becomes more difficult.If it is more difficult to see the risks and determine whether you will be compensated for providing liquidity, you will not do it. Complexity will also add to contagion. If you do not understand the extent of risks, you will reduce exposures across the board.

"A Demon" is a well-written and interesting book, but the focus should have been different. The demons we are facing are the same as in years past, liquidity. The potential threat to the markets form innovations may be greater but it is the lack of market players to accept risk which may be the biggest risk we are facing.

Canadian dollar getting loonie

The rally in the Canadian dollar has been one of the best in the G10 currency markets over the last few years. In fact, all of the Anglo currencies have done well but a simple model of purchasing power parity may suggest that it is time to call it quits. We ran purchasing power parity calculations since 1981 and placed a five percent range around the PPP exchange rate. The Canadian dollar has come off its tremendous undervaluation, but it has now turned to being rich for the first time in almost fifteen years. This makes it a good time to reassess the Canadian dollar. Now the PPP model has fallen in and out of favor over the course of time, but the latest research still suggest that this model is effective for long-term valuations. There are more complex models which are more effective but PPP is a good workhorse for long-term valuation discussions.

We use it in a very simple manner. If the exchange rate deviates from fair value, we flag it for observation. These misvaluations may last for a long period so this by itself may not be an indication for strong action. There may be a reason to reduce long positions, but we are very interested when the exchange rate is away from fair value and starts to move back to equilibrium. These are the points for greatest opportunity. By this criteria, we have flagged the Canadian dollar as moving outside the fair value range. We will see if there is a move back to fair value which is a good opportunity, in this case, for selling the currency.