Thursday, August 30, 2007

The Financial Markets' Confidence Game

All investing is a confidence game. You give your money to someone else who invests it. You hope the investment prospers, and you further hope that you are rewarded with interest, dividends and capital gains. You trust that the person to whom you give your savings will use it diligently, and account for it honestly. This was true at the end of the Middle Ages, when rudimentary forms of the partnership were used in northern Italy to finance merchants' journeys to the Low Countries to trade in wool products and other goods. It's also true today, when European banks create off-balance sheet vehicles and raise money from investors to purchase interests in American subprime mortgages. It you don't have the necessary trust, you won't have investment.

Without this dynamic, businesses could not obtain the vast amounts of financing needed to conduct commerce on a national and international scale. In 1607, the Virginia colony was financed by a company chartered by King James I, which raised its money from investors. In the 1800s, much of the financing for America's railroads came from British investors. America in those days was a relatively poor country, and Britain, with its global empire, was fabulously wealthy. There was lots of capital in Britain, and the economic potential of the North American continent couldn't be overlooked.

That remains true today. America is still seen as a good place to invest. This, even though we have an enormous balance of trade deficit with the rest of the world. Americans buy huge amounts of manufactured goods from other countries, which accept dollars in return. Foreigners have to do something with those dollars. While the dollar is the international currency, and large quantities of dollars are exchanged between foreigners (such as when China buys oil from Middle Eastern nations), trillions of dollars come back here to be invested in the U.S. financial markets. As we discussed in our preceding blog (, the international connectedness of the financial markets means that when a fast-talking mortgage broker convinces an unsophisticated borrower to sign up for an adjustable rate mortgage that the borrower can't repay (but which generates a large commission for the broker), a German bank that set up an Irish affiliate to invest in U.S. asset-backed securities may take a loss.

The fact that so much of the impact of the subprime mortgage mess has been felt overseas greatly complicates the Federal Reserve's job. A reduction of the target fed funds rate, now ardently sought by many in the financial markets, would likely cause the dollar to drop in value. That could lead investors to withdraw capital from dollar denominated investments, which would put downward pressure on the financial markets. Of course, many would cheer if the Fed lowered its target for the fed funds rate, and their good cheer would have upward impact on the financial markets. What would result from these countervailing forces? No one knows.

On the other hand, holding the line on the fed funds rate would likely keep many in the financial markets morose. People in bad moods can be unpredictable, and a loss of confidence could lead to more credit crunches and stock market drops. Foreign investors who lose confidence in the U.S. markets could withdraw their money. That, too, would put downward pressure on market prices. And--get this--many U.S. hedge funds might abandon their dollar-denominated investments and turn to foreign markets because they might make more money that way. (Please don't bring up patriotism; we're talking about money, here.)

One thing that seems clear is that the central banks of the industrialized nations have been in close communication with each other. Events indicate that they basically agree on a strategy. The strategy apparently is to maintain interest rates at current levels until the lay of the land becomes clearer. A month or two ago, the central banks of some nations may have been considering interest rate increases. Today, those moves are on hold. The central banks have also agreed to diffuse credit market panics. Note that they've moved swiftly to provide liquidity when needed.

Yet, at the same time, they have not lowered interest rates generally, because they want to dispel the notion that they will bail out people who make bad investment decisions. The hedge fund operators, bankers and other folks who were at the forefront of investing in CDOs are smart, well-educated people. They'd love to dump the cost of their mistakes on their governments (and the taxpayers that support those governments). Needless to say, they wouldn't have shared their profits had those investments turned out well (except, perhaps, for whatever paltry taxes they might be required to pay). Lowering interest rates could give the smart money exactly what it wants, at everyone else's expense. The perpetuation of the Federal Reserve put might create even larger long term problems as increasingly large asset bubbles pop up with greater frequency. The Federal Reserve wants to combat this perception and make the markets healthier by forcing people to bear, of all things, risks as well as rewards.

The financial markets' confidence game has now become a government confidence game. The central banks of the world, and especially America's Federal Reserve, have to convince investors that they are on the ball, and will do the right thing. A lot of people would be pleased to see Maserati-driving, $1,000 a bottle champagne drinking hedge fund operators bear the risks that they created with their voracious appetites for mortgages that couldn't be repaid. And many would cheer the central banks if they made these fair-weather risk takers experience adulthood and suffer losses of their own creation. But the rub is that if the explosions set off by the fast-money boys are so great that they do major collateral damage to civilians, then ordinary folks would expect the central banks to step in and prevent panic.

The financial markets, on a systemic level, are now a confidence game played by governments. Forget the notion that markets are best left undisturbed by government intervention. The financial system as it now exists is a creature of government policy. The question isn't whether there will or will not be government involvement. That question was resolved when the Federal Reserve was created in 1913. The only question now is what the government involvement will be.

The central banks, and the rest of us, are in a quandary because so little is known about the derivatives market and the hedge funds. The belief that derivatives and hedge funds shouldn't be regulated has resulted in the creation of a monster. The Fed's current obsession with monetary policy, while appropriate and necessary, only treats the symptoms. The Fed struggles because it still doesn't know how big the monster is or where all of its tentacles extend. With the lack of regulatory mechanisms in place, the Fed and other financial regulators can't even take an x-ray, let alone do a CT scan or an ultrasound. All they can do is keep the patient on life support and hope that the immune system revives itself.

The panic among investors stems from the same lack of information. They don't know how bad the damage from the subprime mortgage mess is. This lack of information creates panic, which, in turn, fosters an irresistible urge to sell. It's one thing if a public company announces it has a problem. Hypothetically, let's say a pharmaceutical company announces the failure of crucial clinical trials of a much touted product in development. That doesn't mean the company's stock is a sell. Maybe you should buy more after the stock price drops because you think the company's long term potential remains positive. On the other hand, if you hear through the rumor mill that the company is in trouble but you can't get any details, then selling may be a sensible thing to do. And that's what many hedge fund investors are doing. In an environment where they can't get much information, it makes sense to sell.

Will the subprime mortgage mess eventually lead to regulation of derivatives and of hedge funds and similar investment vehicles? Only time will tell. For posterity, though, let's remember the confusion and uncertainty of these times, when the lack of regulation and information forced the world's central banks to play the biggest confidence game of all.

Celebrity News: Helmsley dog gets $12 million, but two grandkids get zip. Did the house plants get anything?

Tuesday, August 28, 2007

Were Subprime Mortgage Risks Hidden?

Yesterday's news included a story that a German bank called SachsenLB was forced by subprime mortgage losses to sell itself to another German bank. This marks the second time in the subprime mortgage mess that a German bank has needed a bailout because of mortgage losses. In both instances, it appears that the banks' losses came from affiliated hedge funds or other affiliated entities that invested in subprime mortgages.

The German banks have hardly been alone in having subprime problems emanate from an affiliate. Bear Stearns and Goldman Sachs had similar problems. So, too, did a major French bank, BNP Paribas. An Australian bank, Macquarie, also fell victim to losses in an affiliated fund. A French insurance company, AXA, encountered problems with an affiliated hedge fund.

The Fed and other central banks have been quietly bailing out the major players in the financial system. See our previous blog, Since significant amounts of the losses evidently came from affiliates of regulated financial institutions, it may be a good idea to a look at how financial institutions use affiliates.

First, let's review how financial regulation works. The regulators of the banking system provide benefits--deposit insurance and funding when the banks have trouble finding other financing. In turn, the regulators control and limit the risks that the banks take, so that the government's facilities and resources are not exploited by the banks to profit from every loony and harebrained risk out there. Otherwise, the banks might take extreme risks in the hope of gaining extreme profits (called "heads, we win"). And if the extreme risks blow things up, the government steps in and provides a bailout (called "tails, the government and taxpayers lose"). The key to effective financial regulation--the maintenance of stability of the financial system--is to control and limit the risks that can clobber regulated financial institutions.

It appears that at least some of the affiliated hedge funds were "off-balance sheet vehicles." This is an accounting term for entities that a sponsoring corporation (i.e., the financial institution in this case) is associated with, but whose assets, liabilities, earnings and losses are not included in the sponsoring corporation's financial statements. Depending on context, their structure and where they are established, these entities might be known as special purpose entities, special purpose vehicles, structured investment vehicles, variable interest entities, or special purpose companies. In general, they are created to serve a narrow purpose that benefits the sponsoring corporation that creates them. The narrow purpose could be investment in high risk assets that the sponsoring corporation could not or does not want to directly invest in. The sponsoring corporation may hold some sort of equity interest in the off-balance sheet entity (not common stock, but perhaps preferred stock), so that it can profit if its little brother does well. It is likely to provide the affiliate with asset management and other services, which provide fee income to the sponsoring financial institution. And it will often provide financing, since leverage is the key to making big bucks investing. Until recently. But that's another story.

Thus, the affiliates become a way for the sponsoring financial institution to derive income and profit, without formally recognizing the risks and losses that the affiliate incurs. At least that's the theory. But things seem to be turning out differently. The two German banks needed government bailouts. The other financial institutions have closed their funds, in some cases with losses to themselves as well as to investors. We'll know more as they start to announce third quarter results in the next month or two. See In reality, the financial institutions haven't been insulated from the risks of the off-balance sheet vehicles.

Because they've created losses for the regulated financial institutions, these vehicles and their use raise questions for regulators. To what extent were the regulated financial institutions truly insulated from losses and liabilities of these entities? If the financial institutions in reality had exposure, did they disclose it clearly and completely to regulators and investors? Did they maintain adequate reserves and capital against the possibility of loss? Did they properly account for their exposures on their financial statements? Did they suitably manage their risks? (Apparently not, in some cases, so hard questions should be asked.)

The use of off-balance sheet entities extends well beyond hedge funds and similar investment vehicles. Essentially all of the CDOs, CMOs, CLOs and the like that have proven so risky are off-balance sheet vehicles created by banks that packaged debt obligations into them. Because the banks packaged these deals, it's possible that they could have contractual liability for some of the losses, either because of obligations to buy back defaulting mortgages or failures to make appropriate disclosures in offering documents they prepared as underwriters of the securities. There are trillions of dollars of asset-backed securities drifting around the financial netherworld, and the potential liabilities from the off-balance sheet entities that issued these securities could dwarf the losses to banks from affiliated hedge funds. If it turns out that the banks have liabilities emanating from their creation and underwriting of asset-backed securities, the same questions about disclosure, capital adequacy, accounting, and risk management should be asked.

Off-balance sheet vehicles have largely stayed hidden in the shadows of the financial world, of interest only to the cognoscenti. They made a brief appearance under the klieg lights during the Enron scandal, where we learned that Enron executives used off-balance sheet entities they controlled to play accounting shell games that applied an impermissibly large amount of makeup to Enron's financial statements.

Now, it turns out that a shipload of risk and losses to the world financial system were lurking in off-balance sheet vehicles used in the world of hedge funds and asset-backed securities. And its unclear that these risks and losses were known to regulators or investors. These losses have necessitated government bailouts around the globe. Understanding and limiting the exposure of regulated financial institutions to such losses is essential to effective regulation. Granted, the issues here are highly technical (take a look at the Financial Accounting Standards Board's FIN 46R, if you're in the mood for brain death). Nevertheless, it would do taxpayers, depositors and investors a good turn indeed if regulators were to focus their magnifying glasses on the use of off-balance sheet vehicles.

Crime News: robbery in moderation.

Sunday, August 26, 2007

The Federal Reserve's Quiet Bailout of the Credit Crunched

Amidst the hew and cry of the credit crunch, the Fed has, by all appearances, firmly resisted calls to lower the fed funds rate. The financial press attributes this reluctance to fear that lowering the fed funds rate would appear to bail out Wall Streeters and other wealthy folks who knew or should have known what they were getting into. In a time when median household incomes have largely stagnated and middle to lower income homeowners struggle to pay adjustable rate mortgages they may not have understood, the Fed cannot afford to project the image of a government of the people, by the people, and for the wealthy.

Nevertheless, the Fed has quietly implemented a bailout of the credit crunched players in the financial markets. Let's dive down the rabbit hole and see what happened.

1. Discount Rate Cut Plus. The Fed's recent discount rate cut wasn't just a reduction of the lending rate it charged member banks. It also agreed to take asset-backed securities as collateral. Normally, its requirements for collateral are more stringent. And it agreed to extend 30-day loans against this collateral. The Fed more typically lends on an overnight basis. What does this accomplish? It allows member banks to lend to distressed hedge funds, taking asset-backed securities that these days can't draw a better cash bid than an order of fries, and re-collateralize them with the Fed. In turn, the Fed provides the cash that the member bank re-lends to the hedge fund. The hedge fund can get a 30-day loan, a long enough time that values of asset-back securities may recover a bit. In effect, the hedge fund is able to get federal financing that might stave off bankruptcy. While hedge funds are not members of the Federal Reserve System, they apparently can get . . . shall we call them "guest memberships"?

2. Liquidity Injections. The Fed and other central banks have injected hundreds of billions of dollars of liquidity into the world financial system in the last few weeks. While much of it was quickly withdrawn, the willingness of the central banks to furnish liquidity has held down actual fed funds rates. Remember that fed funds are lent between banks, usually for the purposes of meeting reserve requirements. The actual interest rate on these fed funds loans fluctuates throughout the day, and can be higher or lower than the Fed's target rate. In fact, in recent days, the actual fed funds rate has often been lower. There is no shortage of liquidity for banks, and the Fed has effectively lowered fed funds rates.

3. Regulatory Ease. As reported on on Friday (8/24/07), Fortune magazine reports that the Fed eased regulatory restrictions for Citigroup and Bank of America that would ordinarily limit the extent to which their commercial bank subsidiaries can fund their brokerage firm subsidiaries. Usually, a bank such as Citibank or Bank of America, NA can fund a brokerage firm affiliate in an amount not exceeding 10% of its capital. The purpose of the limitation is to control the exposure of the commercial bank, with its federally insured deposits, to the risks of nonbanking businesses that the bank holding company is also engaged in. However, the Fed lifted these restrictions, effectively allowing these banks to fund their brokerage firm affiliates to a greater extent--reported as much as 30% of its capital in the case of Citibank. This special dispensation in effect makes it easier for brokerage firm subsidiaries of bank holding companies to tap into the liquidity and discount window borrowing power that the Fed has made available to its commercial bank members. Brokerage firms are not members of the Federal Reserve System. But it looks like some of them, too, may now be able to get guest memberships. Reportedly, the Fed said this is a temporary relaxation of the rules. However, there's no indication when the normal limits will resume.

In the financial markets, as elsewhere, if it walks like a duck, quacks like a duck and looks like a duck, there's a strong likelihood it's a duck. This walks, quacks and looks like a bailout. Although the Fed's initial announcement of a discount rate cut appeared to be essentially symbolic--a bit of talk therapy--we now seem to have a strong likelihood of a bailout.

Perhaps that shouldn't be so surprising. With the growth of the asset-backed securities and derivatives markets to mammoth proportions in the last 20 years, the commercial banks are largely no longer banks in the Jimmy-Stewart-It's-a-Wonderful-Life sense. Banks today originate loans, but sell them off to brokerage firms who package them into CDOs, CMOs, CLOs and other alphabet soup entities, and sell derivative interests in them to hedge funds and other investors. The hedge funds and other investors have effectively become the true lenders. As such, they are an integral part of the banking system, albeit unregulated. Deluged by withdrawal requests from nervous investors who have a problem losing money at the hands of those 2%-20% guys, the hedge funds are experiencing an old-fashioned depositor run. Granted they aren't regulated as banks and these deposits aren't federally insured (or are they with the bailout?). But they, the brokerage firms, and the commercial banks are locked into a thicket of intertwined liabilities and exposures that might potentially lead to an avalanche of failures if one or a few big players go under. Thus, the Fed has to be concerned when the unregulated banks (read, hedge funds) are plastered by the outsized risks they foolishly took.

In a sense, the Fed is quietly doing what a central bank is supposed to do. It is providing liquidity to the banking system when the banking system faces a credit crunch. The disturbing part of the picture is how much of the real banking system has slipped outside the federal government's regulatory authority. The true lenders are the hedge funds and similar investment vehicles. And they've been able to take investor monies, make investments, create and embrace risks, and incur massive exposures and liabilities, all without any regulatory oversight. The government didn't have the authority to prevent their misjudgments, recklessness, greed, irrational exuberance, mathematical model mistakes, and sheer boneheadedness. Yet it has been forced to step in and quietly bail them out.

Once the government slips into the bailout swamp, it tends to get stuck there. The problems at hand create enormous suction and it's difficult to extract oneself from the muck. When the S&Ls blew up in the mid-1980s, the federal government eventually undertook a massive bailout, one that may have cost the taxpayers as much as $3,000 each. You can buy a lot of fried calamari for 3K.

All of the Fed's measures taken to date have been temporary, and theoretically can be easily undone. And maybe they will turn out to be the better part of valor. But, then again, it's often very difficult to get welfare recipients off the dole. Federal farm subsidies and flood plain insurance have proven more durable than Plymouth and Oldsmobile. If the federally insured banking system is to be put at risk by the unregulated recklessness of hedge funds and others of their ilk, who are then bailed out by the federal government, it behooves us to require legally mandated responsibilities of the unregulated banks. Lincoln got it right. The government should be of the people, by the people and for the people.

Strange News: hugging your way into the record books.

Thursday, August 23, 2007

When the Credit Crunch Losses Will Become Known

Much of the difficulty with the current financial markets credit crunch is that we don't know how bad the fallout may be, and where and how large the losses are. Known losses, no matter how bad they might be, would provide a degree of certainty. Asset prices could adjust and volatility would lessen. Of course, those that realized losses would be disappointed, and those that realized a lot of losses would be more than disappointed. Losses--and disappointment- are coming, though. It's only a matter of time. Here are some dates to keep in mind.

LATE AUGUST 2007: this is the end of the third fiscal quarter for many brokerage firms. These firms often have fiscal years ending in late November, so that they can close out their books before the end of the calendar year and pay employees bonuses by the end of December. (Bonuses are a crucial part of brokerage firm compensation, but may be less than glorious this year.) With the close of the third fiscal quarter, the publicly traded brokerage firms will likely announce their financial results in early September. These announcements will give us an early look at the situation. We will get only part of the picture. But the brokerage firms are crucial intermediaries in the mortgage markets, and may have exposure to much of the fallout from the problem. Their problems could include not only CDOs and other such instruments, but also losses from bridge loan obligations for private equity deals that have been unable to find bond market financing. The firms might also have losses from credit derivatives contracts and other derivatives market exposure that is essentially impossible for an outsider to predict. The hits the brokerage firms disclose will give us some idea of the magnitude of the problem.

SEPTEMBER 30, 2007: this is the end of the third quarter for many banks and other public companies that are involved in the mortgage mess. They will probably announce their financial results for the third quarter in early October. Banks, thrift institutions, mortgage companies, and homebuilders may be among the public companies reporting losses. Much will become clearer at this point, although this, too, will be only part of the picture.

HEDGE FUNDS: hedge funds are not public companies and will generally not make public announcements. However, there is news from time-to-time about a hedge fund going under. Pay attention, because the hedge fund sector is in the belly of the beast, where some of the greatest losses likely were taken. When a hedge fund collapses, banks that loaned money to the hedge fund probably feel pain, and the hedge fund's investors probably feel a lot of pain. If you see news of a hedge fund freezing its assets and refusing withdrawal requests, count that as a situation where losses are likely. Some of the freezers try to characterize their problems as a lack of liquidity and make comments about how their assets are undervalued. Both statements may be accurate to some degree. But there is a major repricing of risk taking place, and the CDOs and other asset-backed securities that these hedge funds hold--whose risks have become clearer and larger--may never recover the values they had before July 2007. That means, ultimately, losses are likely. In today's economy, the hedge funds, which serve as the actual lenders for many credit transactions, are effectively a form of bank, albeit unregulated. And we now have a run on this sector of the banking system. The more hedge fund closures and freeze-ups there are, the worse things will be.

COUNTRYWIDE: the largest mortgage mortgage company in America is Countrywide Financial Corp. Early in the mortgage market crisis, it put on a confident face, hiring mortgage brokers laid off by failed competitors and predicting that the problems of others would give it opportunities to expand. Since then, the waters have proven rough indeed. Last week, Countrywide borrowed $11.5 billion from a syndicate of banks. On Wednesday (8/22/07), Countrywide announced that it had obtained an additional $2 billion from Bank of America through a sale of convertible preferred stock. The preferred stock is convertible into Countrywide common stock at $18 a share, which was trading around $21 when the preferred stock sale was announced. The discounted conversion price caused some speculation that things at Countrywide might be rather gloomy, although the common stock which Bank of America would get in a conversion would be subject to restrictions on its sale for 18 months. Those restrictions could explain the discounted conversion price. Nevertheless, the infusion of $13.5 billion into Countrywide in the last couple of weeks is a sign that things there aren't entirely copacetic. If Countrywide goes under, hold onto your hat.

LATE NOVEMBER 2007 and DECEMBER 31, 2007: these will be the ends of the fiscal year for brokerage firms, and many other public companies, respectively. More information will be revealed at these times.

LATE FEBRUARY 2008, MARCH 31, 2008, LATE MAY 2008, JUNE 30, 2008, etc., etc., so on and so forth: The losses are likely to continue for years, as adjustable rate mortgages reset their rates. A fair number of adjustable rate mortgage loans made last year have rate resets scheduled for as late as 2011. Depending on where interest rates are by then, and how strong or weak the real estate market is, that could be a time of discontent. Recall the real estate bust of the early 1990s. Four or five years into the bust, prices in some of the formerly hot markets (like southern California and eastern Massachusetts) had not recovered their losses. Many homeowners were under water on their mortgages and refinancing was difficult.

If the losses are big (and that's what's often rumored), the regulators will no doubt face pressure to allow deferrals of loss recognition. Dispensation is not in order. While reports of large losses can lead to investor and depositor concern, not recognizing losses leaves capital misallocated and hinders recovery. This was--and continues to be--Japan's experience. Concurrent with the 1989-1990 crash of its stock market, Japan also suffered a real estate market crash. Its economy went into recession. The Japanese banking system's losses were staggering. A number of major Japanese banks were probably insolvent. However, the Japanese authorities allowed (and indeed encouraged) the banks to defer recognizing many of their losses. The result was that loans to failed businesses continued to be funded (with a little help from the taxpayers), and Japan's economy stagnated. Japan's banks did not fully recognize their losses until perhaps fifteen years later. One could say that Japan's unique social contract explains these events, and perhaps the Japanese people consider this their best alternative. Nevertheless, during that 15-year period, Japan had a number of years of recession or minimal growth. Capital that could have been devoted to new investment was instead misallocated for a decade or more. Japan continues to pay the price today.

Whatever the social contract in Japan may be, 15 years of stagnation would be unacceptable in America. The regulators should hold the line when asked for variances from the accounting rules. The plus side of losses is that realizing loss is where recovery begins. Asset prices can be firmed up (even if at lower levels). End-of-the-world market hysteria, such as when yields on 3-month Treasury bills went from around 4.8% to 2.5% in a matter of a few weeks, will hopefully subside. Rational evalution of risk can be restored, and the flow of investor funds into repriced riskier investments may resume. Enthusiasm for asset-backed securities will probably be damped for years to come. But that would be a good thing. Like perhaps some highway bridges, these instruments have been too finely engineered. A little more ruggedness and stability are in order. For at least the next few years, investments that can run reliably for 300,000 miles on little more than oil changes and tune ups are likely to be favored.

Fashion News: luxury lederhosen. Expect to see them at the Oscars.

Wednesday, August 22, 2007

Financial Engineering: Money Maker and Credit Cruncher

In these times of market turmoil, it's natural to obsess over the market's daily bungee jump and wonder whether or not the rope will hold. With things momentarily calmer the last two days, we should take a brief step back to think about how we got here, and what we might learn from the events of the last few months.

Financial engineering--the design and construction of new financial contracts--has been a part of the financial system since, metaphorically speaking, the days of Romeo and Juliet, when bankers in northern Italy developed the notion of the check as means of financing trade in wool and other products made in northwestern Europe. Over the centuries, financiers have continuously developed new ways of attracting capital and investing it. The corporation, with its innovative limitation of the liability of shareholders to the amount of their investments, was much less risky than a general partnership, which placed unlimited personal liability on partners, or traditional insurance syndicates (such as Lloyds of London as it existed in the 1980s), which placed unlimited personal liability on the persons assuming the insurance risk (called the "names"). Consequently, the corporate form of business facilitated the aggregation of the enormous amounts of capital needed for an industrialized society and came to predominate.

Financial innovation can be highly remunerative. Forty years ago, mutual funds were a small sector of the financial services sector. However, with the bear market of the 1970s, the advantages of providing small investors a highly diversified and liquid investment that might be less volatile than individual stocks made mutual funds--and especially the index fund--a winner. The shareholders of mutual fund management companies such as Fidelity and Vanguard profited greatly.

Another innovation that has enjoyed increasing popularity is the Exchange Traded Fund (or ETF). Fifteen years ago, the ETF was a tiny blip on investors' screens. Today, it is a commonplace investment. There are advantages and disadvantages to investing in ETFs, as we discuss in Whatever they mean for the individual investors, they mean big bucks for the firms that developed them.

And then, there are derivatives. While some kinds of derivatives have existed for centuries (such as the commodities futures contract), today's financial markets are distinguished by the proliferation of financial derivatives. The credit markets--including commercial lending, the bond market, the mortgage market, and the consumer credit market--have to a large degree been transformed into derivatives markets. Banks are no longer the ultimate lenders much of the time. Investors who purchase derivatives of these extensions of credit are often the true lenders. The stock markets are shadowed, and perhaps overshadowed, by the derivatives contracts that institutional investors can purchase as proxies for equity investments. One can fairly debate whether price movements in the S&P 500 stocks drive market activity in the S&P 500 futures contracts or vice versa.

Gargantuan amounts of money have been made on Wall Street by firms offering and trading in financial derivatives contracts. Because these financial products are mostly traded by telephone or by appointment (in much the same way that over-the-counter stocks were traded in the 1920s), the firms that deal in them can charge large markups on sales and large discounts on purchases. There is usually no exchange or electronic trading system that displays prices of these contracts, even though such a system would promote competition. The dealers have the upper hand.

The enormous profit potential of financial derivatives has fueled innovation. The CDO, a financial instrument which will live in infamy, has been around in its current iteration for only a few years. The rate of innovation in financial engineering has accelerated to such a degree that simple processes like recordkeeping for transactions hasn't kept pace. See In plain English, what this means is that some derivatives contracts may be based on nothing more than a phone call. There isn't even a handshake to seal the deal. In cases like this, if one side of the contract goes into a tailspin, do we think the losing party might deny any recollection of the phone call?

Notwithstanding the current market mess, financial innovation will surely continue apace. As new financial instruments proliferate, the ability of everyone in the traditional financial sector--bankers, investors, and regulators--to keep track of what's going on is greatly diminished. Derivatives trade in largely unregulated markets, that have no central repositories for market data. As the derivatives markets grow larger and larger, and the exposures they create spread farther and farther, no one can figure out where all the tentacles go. And when the yogurt hits the fan, it splatters all over and no one has a good idea of how to clean it up.

It would be one thing if the only victims of the current mortgage market mess were rich people who were forced to bypass the Bentley dealer and crawl into a Lexus dealership with their tails between their legs. However, the credit crunch has cut a much wider swath of victims--uninformed adjustable rate, no doc mortgage borrowers, laid-off mortgage company employees, everyone who owns stocks or bonds, and overextended home equity borrowers who thought their equity was real, among others.

Most of the discussion today of governmental action revolves around the question of a Federal Reserve cut in the target fed funds rate. That, however, is debating whether we administer CPR or use a defibrillator. Perhaps we should also think about diet, exercise, stress control and other preventative measures. Here are a few points to consider.

1. Hedge Fund Registration. It's important to know who is out there, and which individuals are in charge. Little things like the hedge fund's address, telephone number and e-mail address may make a lot of difference in an emergency. Basic information about structure and investment philosophies could be valuable.

2. Recordkeeping Requirements. Uniform recordkeeping requirements would greatly facilitate the task of figuring out where the bodies are buried when hurricanes reach the shoreline. Markets can become pretty dysfunctional when the only record of a trade is one witness' recollection that is contradicted by another witness.

3. Settlement and Clearance. Trades should be settled and cleared by a third party. This is what happens in the stock and bond markets, where trades are reconciled by independent corporations that seek to confirm what the buyer and seller claim. With major losses accumulating in the derivatives markets today, we will surely see a lot of market players try to walk away from trades where they hold the short end of the stick. If the trade hasn't clearly been settled, they may succeed. Many lawyers will cover their children's college expenses and then some from the litigation that is in the offing. But these windfalls for lawyers could be avoided with a good third party settlement and clearance process.

4. Margin Authority. As we have discussed before, derivatives contracts were usually developed as ways to hedge or lay off risk, but can easily be turned into instruments for speculation. See The recent easy availability of credit to transact in derivatives greatly increased the potential for speculation. That's what about 3,000 hedge funds founded in the last 4 years did. They used mountains of credit to invest in CDOs composed of subprime mortgages. They didn't buy CDO tranches to transfer risk or hedge exposures. They were speculating.

Most of the collateral damage from the mortgage market mess resulted from the credit gluttony of hedge funds and other speculators. If these players had invested only their paid-in capital and not deployed borrowed money, they would have bought much less risk. And when losses occurred, they would have fallen on the hedge funds' investors, but not a lot of other people who never agreed to speculate with them in subprime mortgages.

Because the use of leverage has caused so much collateral damage, it's fairly nominated a candidate for regulation. An appropriate independent agency--most likely the Fed--should have the authority to impose limitations on the use of credit to transact in derivatives contracts. This authority should cover not only hedge funds, but all financial market participants who want to play with these matches. The Fed got the authority to regulate margin used to buy stocks after the 1929 stock market crash (much of which resulted from leveraged speculation in common stocks). It's logical to extend that authority now to derivatives.

5. Examination Authority. The feds--SEC and Federal Reserve--need to be able to find out what the heck those hedge funds are up to. Both regulatory agencies should have the authority to demand information from the hedge funds, and to have staff go on site to look at their records. Right now, the Fed is struggling to figure out who's got exposure to whom for what, when and for how much. It has no systematic way of getting this information, and what it's getting may or may not be comprehensive. Information is crucial to effective government action in a crisis. We have a crisis now, but the availability of information is not up to snuff.

Banks and brokerage firms face regulation regimes that are much more stringent than these few measures. Yet they've managed to thrive. Perhaps many in the hedge fund community react viscerally against the idea of regulation. They should consider the visceral reactions of their investors who are now seeking to withdraw their funds asap. Having the confidence of one's investors is crucial to success in the financial markets, and confidence in hedge funds is receding. The SEC recently attempted to adopt a regulation calling for hedge fund registration, but was shot down a federal appeals court. Perhaps Congress needs to take action to make clear the SEC's authority in this area. Whatever the legal issues, the economic case for hedge fund regulation increases with every point lost in the Dow.

Food News: some people really like chicken wings.

Sunday, August 19, 2007

The Federal Reserve's Discount Rate Monetary Policy

On Friday, August 17, 2007, the Federal Reserve Board announced that it had cut its discount rate from 6.25% to 5.75%. The Dow Jones Industrial Average closed up 233 points. Many commentators described the Fed's action as "symbolic." But there's nothing symbolic about a day where the Dow closes up 1.8%. Or is there?

The discount rate is the interest rate that the Federal Reserve charges to member banks when they borrow from the Fed. Banks often borrow to meet reserve requirements. Members of the Federal Reserve System are required to maintain certain minimum reserves of money in accounts with the Federal Reserve Banks or in vault cash. These reserves are meant to strengthen the banking system, by setting aside some money that is available if needed. The funds used to meet reserve requirements are called "federal funds," which is where the term "fed funds rate" comes from. Banks needing reserves typically take out loans from other banks, and the interest rate they pay is the fed funds rate.

The Federal Reserve System member banks can also borrow from the Fed. The interest rate they pay for direct loans from the Fed is the discount rate. Banks generally avoid borrowing from the Fed. In part, this is because they think borrowing from the Fed signals weakness--that they cannot borrow from the marketplace and must turn to the government. Also, the discount rate has been higher than the fed funds rate, so borrowing from the Fed costs more.

Because banks usually borrow very little from the Fed, a lower discount rate contributes little or nothing to their short term profitability. When it announced the lowering of the discount rate, the Fed encouraged member banks to borrow from the Fed and stated that doing so would be seen as a sign of strength, not weakness. Thus, the Fed wanted to make clear that it stood ready to make loans to member banks.

It's unclear how many member banks took up the Fed's offer. The fed funds rate has been running lower than the new, lowered discount rate much of the time. This is a consequence of the liquidity infusions that the Fed and other central banks have been making during the last couple of weeks. The fact that the fed funds rate is often running lower than the discount rate suggests that there isn't a systemic liquidity crisis. Moreover, the new discount rate of 5.75% is still a half a point higher than the Fed's targeted fed funds rate of 5.25%. This leaves member banks with little reason to borrow from the Fed.

It's possible that smaller banks, which have fewer resources than the big banks, might line up at the discount window. However, there isn't much indication that many smaller banks are in distress. They generally aren't big enough to be major players in the derivatives market/hedge fund sand lot. Nowadays, they might see that as a good thing..

The news headlines point toward hedge funds and mortgage companies as the big losers. But they can't borrow from the Fed. And the banks aren't enthusiastically lending to them any more, unlike three months ago. So the discount rate cut isn't likely to help the folks who are hurting the most.

Then, why did the Dow pop 233 points skyward?

The answer probably stems from the fact that markets are based on differences of opinion. One person may think an asset is worth more than the current market price, and buy it. Another may think the asset is worth less than the current market price, and sell it. If we didn't have differences of opinion, we wouldn't have markets. You can see this with respect to CDOs today. Everyone who owns one wants to sell, and no one wants to buy. You can't get a cash bid for the little buggers, so they don't trade. Because there's no difference of opinion, there's no functioning market.

In the stock markets, however, there is a pool of optimists and a pool of pessimists. The optimists tend to see the sunny side of the news and buy. The pessimists tend to see clouds and sell. The dual-sided nature of the market isn't necessarily evenly balanced. From about July 2006 to July 2007, the optimists had the upper hand, and the Dow topped 14,000. This, even though the rapidly ballooning pool of adjustable rate, no doc, no income, no job, no assets, head-in-the-sand mortgage loans was well-known to Wall Street and the real estate industry. Then, in late July, the accumulated evidence of financial rot suddenly precipitated a market retreat. Since then, the pessimists have held sway.

But the optimists remained, waiting on the sunny side of the Street for an excuse to buy. And the Fed's discount rate cut gave them that excuse. Choosing to see empathy and sympathy from the central bank, they plunged back into the melee, pushing back the forces of doom and gloom 233 points.

The Fed's discount rate took advantage of the dual-sided nature of the market. It was an ambiguous step--enough to give hope to those that feed on hope, but not so generous that it looked like a bailout of the professional speculators who created the subprime mess. Friday's rally helped to stabilize things, at very little real cost to the Fed. The Fed, in effect, implemented monetary policy at a discount rate.

The ambiguity of the discount rate cut is reminiscent of Chairman Greenspan's oft indecipherable ramblings, which could be interpreted to fit your mood, whatever it might be. His ambiguity allowed listeners of all stripes and varieties to hear what they wanted to hear--so much so that market volatility fell, risk aversion went the way of the dodo, and all asset classes prospered. Unfortunately, we know how that story ended.

When Chairman Bernanke took office, he promised to provide more clarity about the Fed's intentions. All else being equal, clarity is a good idea. Yet, here he is, 18 months later, perhaps a little Greenspanian himself. Why the reversion?

Because the Fed doesn't know what the best course of action is. The unregulated nature of the derivatives market has left the Fed with a paucity of information. It doesn't know what risks and losses have come to rest where. It doesn't know, amidst the intertwined, overlapping, laid off, and offsetting thicket of derivatives exposures in today's financial markets, who's holding the hot tamales. The Fed is flying on instruments, and the instruments can't detect everything that's out there.

Ambiguity may work for a while. And if it works well enough, the markets may stabilize and asset classes unrelated to the mortgage mess may recover. But uncertainty and lack of information will continue to plague the Fed and other central banks. They may feel compelled to cut interest rates at some point. The darndest thing, though, is that they probably won't have a very clear idea whether or not their interest rate policy will work.

Crime News: you know it's time for rehab when you try to buy meth from a man wearing a badge.

Thursday, August 16, 2007

How Computer Models In the Financial Markets Missed the Mark

Some of the more recent victims of the subprime mortgage mess are hedge funds called "quant funds." They use computer models to trade, and apparently their models never anticipated that the markets would do what they are now doing. Prominent among these quant funds are three Goldman Sachs sponsored funds. The people who get jobs at Goldman are often in the top 0.1% of their B-school classes, so this is a little disturbing, to say the least.

The details of how the quant fund computer models work are generally kept confidential, for commercial reasons. So we don't know what happened at any particular quant fund. But some overarching problems have emerged. First, the models didn't account for the kind of risks that we have today. Models are based on statistical analyses, which by definition use past data. If something hasn't been seen in the past, the analysis won't pick it up. Today's market conditions are unprecedented. Never before have we had such enormous derivatives markets, with exposures reaching all over the globe. Never before have we had a lending process that favored the creation of huge amounts of risky loans. But that's exactly what the mortgage backed securities market did by encouraging mortgage lenders to make no doc, adjustable rate loans to people who hadn't a prayer of repaying them. We discussed this problem in our blog at

Furthermore, never before have we had a situation where large numbers of illiquid CDOs were being offered for sale simultaneously. While the people that created these computer models try to anticipate potential market messes (through a process called "stress testing"), they can't imagine everything that might happen.

Second, the models didn't account for the kind of volatility we have today. A fundamental premise of the computer models is that there are mathematical relationships between various asset classes that can be discovered by the power of the computer and exploited for investment purposes. If this isn't true, one can forget about computer modeling and go back to picking stocks by throwing darts at pages of the business section of the newspaper or reading 10-Ks. Anyone who believes in the reliability of computer models has to assume, explicitly or implicity, that there is a limit to volatility. If the potential for volatility is infinite, then the model cannot ultimately be said to be reliable.

The problem is that the potential for volatility is infinite--or at least beyond the imaginings of the folks that created Wall Street's computer models. Volatility today is coming at us from many different directions, but two of the most important causes are: (a) the enormous amount of risk created by the plethora of really dumb subprime and other adjustable rate mortgage loans made in the last few years, (b) the inability to sell the CDOs in which those mortgages are packaged, which has forced hedge funds to sell other assets. The models apparently didn't have a way to deal with a world where incentives existed to create massive amounts of unusually risky assets. They also didn't anticipate that hedge fund investors would respond to the unanticipated crisis with an old-fashioned run on the bank, making large numbers of withdrawal requests. These requests would force asset sales that would drive down the prices of stocks, corporate bonds, commercial paper, municipal bonds and who knows what else.

Third, the models were part of a herd. Many of the quant funds use similar models. So they took similar risks. When those risks proved to be imprudent, they all got caught in the same vortex of asset liquidations. Herd animals can be easily stampeded, and now that crocodiles have appeared at the river crossing, the wildebeest are scrambling for any foothold on dry land.

Much of the problem is a result of the index fund. The index fund was one of the most revolutionary concepts in personal finance in the last century. It gave the individual investor a shot at earning the market average without needing a lot of capital or knowing much about finance. You could spend all your spare time gardening or playing canasta, and still earn respectable returns. In order to justify their increasingly infamous 2% and 20% fees, the hedge funds had to find a way to beat the index fund. Using the massive amounts of RAM and memory capacity of modern computers, they could scour enormous financial databases for any anomaly, inefficiency or squirm in asset values that could be exploited to obtain above average returns. Then, they'd employ linear and nonlinear regression analyses, and other statistical methodologies, to show that when salmon begin to clear the lowest set of fish ladders on the Columbia River, gold prices per ounce would be at least 100 times silver prices per ounce.

The ubiquity of the computer can blind us to its weaknesses. It does marvelous things, like operate 4-liter automobile engines to generate twice the horsepower the same sized engine could provide 40 years ago, fly commercial airliners (Airbus jets are almost entirely flown by computer), send space probes to distant planets, and provide a worldwide communications mechanism through which you are accessing this blog. But the computer also creates an illusion of certainty and authority. It's so capable that we begin to believe it can't be wrong. In that respect, the computer makes us stupid. People who rely a great deal on computers often lose the willingness to think for themselves.

There's an old saying among computer programmers: garbage in, garbage out. It recognizes that a computer is just a machine and will only do what it's told. If the computer is told to do something incomplete or incorrect, it will do something incomplete or incorrect. If a computerized trading model doesn't recognize all the potential anomalies that can occur in the financial markets, the computer may well eventually direct trading in the wrong direction.

Some people predicted the subprime mortgage mess before it happened. To have picked up on the budding crisis, a computer would have had to take in information about human nature, such as the reasons for increased market demand for higher risk CDOs (the desire of institutional investors for higher yielding debt securities than Treasuries that nevertheless were supposedly safe), and the resulting appetite among investment bankers and mortgage brokers for loans whose only realistic expectation for repayment was a continually rising real estate market. But these things can't be reduced to numbers. They have to be intuited from knowledge of incentives and desires.

A computer has no intuition. While its massive analytical power can crunch through tons of historical trading data, it has no ability to read the unprecedented tea leaves in the current market and intuit a new and different future. The backwards looking nature of computer modeling won't anticipate unexpected conditions like we have today. And that's the ultimate problem with computer models. Life inevitably is unprecedented. No one day is quite like any other. Sure, computer models can generate profits a lot of the time, just as one Big Mac tastes pretty much like any other Big Mac. But you can't eat Big Macs for every meal.

Markets are a process of human interaction. Like people, they will do unprecedented things. There's no computer model for mortgage and financial market professionals greedily following short term incentives while recklessly disregarding the interests of borrowers and investors. There's no computer model for how to handle the investor panic that now fuels the withdrawal requests that are forcing large-scale liquidations of any hedge fund asset that gets a bid. Even as we see the benefits of computers, we should also recognize their limitations.

We've been here before, with the Long Term Capital Management bailout in 1998. As now, unprecedented conditions in the financial markets led to the collapse of a hedge fund that was in the process of going down and taking the financial system with it. Have we learned from that experience? Or do computers continue to mesmerize us?

The Boeing 777 has computerized flight controls. But it allows the pilot to override the computer and fly the plane manually in emergency situations. If you're going to invest in a hedge fund that uses a computer model to trade, make sure it has a manual override, and a pilot with the experience, judgment, wisdom and guts to take control when the markets become turbulent.

Crime news: here's a new fraud--glass eating.

Wednesday, August 15, 2007

How the Current Stock Market Crisis Grew in the Tulip Garden

Another day, another 207 point drop in the Dow. When you're feeling pain, it's hard to think about anything else. But it might help to step back and think about why we have this pain.

The current market turmoil is a consequence of the loose credit policies of the Greenspan era at the Federal Reserve. We've discussed how repeated loosening of credit in response to market instability created expectations that the Fed would always step in to protect asset values. See Low interest rates facilitated the boom in the stock markets. A years-long policy of very low interest rates after the terrorist attacks of 9/11/01, supposedly intended to prevent price deflation, triggered a massive inflation of real estate values. Apparently the Fed, and in particular Chairman Greenspan, thought that a vibrant real estate sector would stimulate the economy and keep things humming. A busy real estate market would employ a lot of people: construction workers, real estate agents, mortgage brokers, title company personnel, bank loan staff, investment bankers packaging CDOs, hedge fund managers, and even an occasional home inspector (although not at the height of the lunacy).

Even more importantly, home values rose. That gave homeowners greater equity, even if they had done nothing to earn it. Simply holding title to real estate meant greater wealth. And you know what they say about easy money: easy come, easy go. The banks made it even easier, offering home equity loans and lines of credit to anyone with a home and a pulse. People eagerly converted their no-sweat equity into cars, big-screen TVs, overseas vacations, backyard grills large enough to roast an ox, bathrooms that cost more than a year at a private college, kitchens that cost more than a full-size luxury sedan, and diverse and sundry other indicia of prosperity.

Given that you could buy a home with no money down and no proof of your income, and then get access to rising home equity that would finance a lifestyle that your earnings, if any, couldn't begin to cover, who wouldn't buy a house? Come up enough eye-hand coordination to sign some paperwork, and you'd be driving the car of your dreams to the home of your dreams for the backyard barbecue of your dreams. And your guests would be too busy sticking their faces in two-inch thick steaks to notice that you hadn't gotten any smarter, worked any harder, earned any more, or saved a penny.

The asset boom had a wonderful quality of rotating from a faltering market to a fresh market ripe for exuberance. When the real estate market peaked in 2006, the stock market took off. Much of its rise was fueled by speculation in the stocks of companies thought to be good candidates for going private transactions. Hedge funds, as well as individual investors, used leverage to buy stocks of companies they hoped the private equity firms would use leverage to acquire.

The loose credit policies of the Greenspan era rewarded asset speculation. Further, as asset prices rose, speculation on a leveraged basis was rewarded even more highly. The financial services industry, ever eager to pounce on a profitable trend, developed ways for every Tom, Dick and Harry, however indigent, to engage in leveraged speculation.

On the other hand, those dull, boring and unimaginative people who worked hard, lived within their means, paid their debts, and saved were duly punished. The ultralow interest rates of 2001 to 2005 drove interest rates paid on bank deposits and money market funds below 1%, not enough to begin to offset inflation. Why save a downpayment when: (a) you would lose value from inflation on your short term investments, and (b) you could buy a house without a downpayment--or any other verifiable financial resources? Old-fashioned virtues such as moderation, thrift and long term planning had sand kicked in their faces by the luxury car leasing, credit card wielding, minimum monthly payment making swells of the leverage loving classes.

Now, however, the chickens have come home to roost; and the home is in foreclosure with hardly a hot dog to throw on the grill. Here's the problem: you can't build true economic wealth by speculating in asset values. No asset will increase in value indefinitely. The Dutch learned that lesson from their little spending spree on tulip bulbs. While the commodities markets provide valuable grease to keep the wheels of the economy turning, you can't have an entire society trying to get rich from speculative investing. That would lead to a cycle of asset sales at ever escalating prices, where recklessness and, ultimately, stupidity are the only things keeping the lemmings going. However, since no asset can rise in value indefinitely, when the lemmings reach a cliff, Newton's law of gravitation becomes operative.

True economic wealth comes from productive activity (meaning work). Okay, work stinks, but it's better than losing your house to foreclosure. True personal wealth means having a positive net worth, not a lot of debts. True national wealth comes from production of goods and services, not asset speculation, and requires having a positive savings rate that provides capital to finance investment.

The loose credit policies of the Greenspan Fed penalized work and saving, which would generate income taxable at ordinary income rates. The same policies rewarded speculation in assets, which would generate capital gains taxable at lower rates, or real estate gains that wouldn't be taxed at all. Interest paid on mortgage debt would be deductible, while interest received for savings would be taxed as ordinary income. Granted, the Fed didn't create the tax code. But it knows how the tax code works and doesn't have to misallocate resources worse than the tax code already misallocates them. A rational, thrifty and hardworking person would think the entire world had fallen down a rabbit hole.

The Greenspan Fed's loose credit policies were a form of pump priming, deficit spending that is leaving a lot of people with individual real estate or stock holding deficits. While these policies temporarily provided some stimulus, the piper meticulously kept a ledger and now has come around to be paid.

Norman Rockwell wouldn't recognize today's America. McMansions consume the entire lot, even the edge where the white picket fence once stood, and soda fountains now charge $5 for a cup of coffee. The current Fed's kabuki dance to maintain confidence by infusing liquidity, while keeping interest rates stable in order to discourage the speculative use of credit, may be the right medicine. The Fed seems intent on not administering narcotics this time, so we will probably continue to feel some pain. Addictions are hard to break, but being sober and healthy would be worth the pain.

Legal News: no CSI for jurors. Is it any wonder people don't like jury duty?

Sunday, August 12, 2007

Banks Dancing with Hedge Funds

On August 9 and 10, 2007, the last two business days of the previous week, European and U.S. bank regulators injected billions of dollars worth of liquidity into the financial system because of fallout from the subprime mortgage mess. They also expressed sympathy for those that have money invested in the financial markets. But they didn't lower interest rates, and some European regulators even made some noise about raising interest rates. What's with the good cop, bad cop routine?

The regulators are struggling with the dual nature of the world financial system. Part of the system is heavily regulated. These would be the commercial and investment banks. The other part of the system is essentially unregulated. These would be the hedge funds. Both parts of the system operate side by side, doing business with each other in ways that have made them become financially intertwined.

Banks, being heavily regulated, are usually pretty transparent. They have to report their financial condition, and reveal their activities. Examination staff from the federal bank regulators, and inspection staff from the SEC, from time to time visit the banks within their respective jurisdictions to sniff them over. Indeed, federal examiners are continuously on site at the largest commercial banks.

Hedge funds, on the other hand, are virtually unregulated. An attempt to require them to register with the SEC and provide some information about what they were up to was given the thumbs down by the U.S. court of appeals in Washington, D.C. The SEC has been trying to figure out where to go next. But the reality for now is that no one knows what the hedge funds have been doing, where their financial exposures and liabilities are, and how much of a threat to the world financial system they present.

Banks and hedge funds interact in a number of ways. Banks loan money to hedge funds. They sell investments to hedge funds, making commissions and perhaps trading profits, and buy investments from hedge funds, making more commissions and perhaps more trading profits. Banks and hedge funds enter into derivatives contracts, which adds to their liabilities to each other. Some banks may sponsor hedge funds, so they can earn even more money from asset management contracts (that 2% and 20% formula would not have escaped the bankers' attention), and their own proprietary investments in the hedge funds.

All this is hunky dory in a rising market. After all, there is hardly any risk that isn't worth taking in a rising market. Hedge funds proved to be extremely successful. (Then again, who isn't successful in a rising market?) So they grew--and grew and grew. As they grew, so did the amount of intertwined liabilities they had with the regulated part of the financial system, the banks.

However--and in the financial markets, there will always be a however--the market stopped rising. In this case, it was the real estate market. And when the real estate party ran out of booze, mouths dried out and heads started to pound.

At this point, the intertwined liabilities of the banks and hedge funds became, well, liabilities. There wasn't a rising market to smooth them over. Some of them--like margin loans--actually became due and payable. Others, like derivatives contracts, may be partially or entirely uncollectible from hedge funds that have collapsed or shut down. The fee income from ailing hedges is likely to be much lower than it is from the healthy ones. (The ailing ones don't buy as many investments, and the 2%/20% formula is a lot less rewarding when the fund's assets are shrinking like a falling souffle.)

Banks live on a cushion of credit. That may sound strange for institutions that hold so much money. But both investment and commercial banks avidly borrow money every business day for a number of different purposes, and couldn't survive without credit. Ordinarily, banks have an easy time borrowing, since much is known about their activities and financial condition, and because they are heavily regulated (which fosters confidence among customers and creditors).

But with the subprime mess, things have changed. The banks' exposures to hedge funds are largely indeterminate right now. And creditors hate uncertainty. Word on the Street has it that a shipload of losses (well, you know what we mean) from the subprime mess lurks somewhere in the financial system. But there ain't too many folks owning up to those losses.

In such a shadowy environment, lenders pull back. Banks that may or are rumored to have subprime exposure suddenly find it hard to borrow. Without credit, they cannot operate, and are at risk of collapse. Credit for banks is like air for humans--without air, humans expire quickly. Without credit, banks go under and very quickly.

That's why the bank regulators infused liquidity into the financial system last week. Banks that couldn't otherwise breath needed emergency oxygen. However, this is just treating the symptoms. The patient is still breathing, but we can't tell if his condition is stabilized. The root causes of the problem--outsized and reckless risk taking by hedge funds and their bank lenders--remain to rear their ugly heads another day.

One could argue that surely the financial services industry will learn from this experience and be more prudent in the future. After all, a co-president of Bear Stearns and senior executives at a German bank lost their jobs because of subprime stumbles. Hedge funds have collapsed and tastelessly opulent apartments on Fifth Avenue remain unbought.

Let's remember, though, that we've been here before. In 1998, Long Term Capital Management did the love-that-leverage dance, only to end up with a beyond-the-stress-testing-of-our-computer-model mess. The Federal Reserve had to deputize a posse of large banks to ride to the rescue. Perhaps we smell a faint whiff of moral hazard here. The financial services industry's learning curve was apparently warped by the 1998 bailout. Instead of focusing on finding effective ways to identify and manage risk, the industry leaped into the next rising market (this time, real estate) and exuberantly took up where it had left off.

The regulated bank-unregulated hedge fund relationship is like a couple on the dance floor, where one person is doing the tango and the other the waltz. Sooner or later, they will trip over each other. But even with the couple now sprawled on the floor, regulation of hedge funds remains political anathema. Leading politicians can hardly bring themselves to speak of it. So, instead of discussing that whose name shall not be spoken, let's call it broccoli.

Broccoli is quite common. The banking industry has been eating broccoli since 1913, with the creation of the Federal Reserve System. It ate more broccoli in 1933, with the creation of the Federal Deposit Insurance Corporation. Today, both the Fed and FDIC are part of the bedrock of the financial system. The securities industry has been eating broccoli since 1934, and the SEC, too, has become part of the bedrock of the financial system.

Broccoli proved to be very good for banking. It restored depositor confidence, and has prevented the widespread bank failures that plagued the United States before 1933. Broccoli also did much to restore investor confidence in the stock markets. The mutual fund industry, which eats a lot of broccoli, has been one of the fastest growing segments of the securities industry in the last 30 years.

Hedge funds may account for 20% or more of the trading in the stock markets. They engage in untold amounts of derivatives trading and other investment activities. Intertwined as they are with the regulated part of the financial system, their losses create systemic financial risk, and ultimately become our losses. Yet, without any broccoli, there is no way to ascertain the scope or extent of the dangers they pose. When hedge funds first emerged 50 to 60 years ago, they were small and posed no danger to the general public or the taxpayer. Today, neither is true.

Many hedge fund managers have recently been having a new and unpleasant experience. They've received withdrawal requests. 2% and 20% of zero is zero. In the past, they knew what it was like to have investor confidence. Now, they are finding out what it's like to lose investor confidence. Investors are only doing what's rational. They don't know squat about what's going on, and pulling out their money is the one thing they understand.

With hedge funds being such a large part of the financial system, they can now subject the U.S.--and the world--to the types of financial panics that plagued the 19th and early 20th centuries. A historical footnote: some of the men who couldn't find jobs as a result of the financial panic of 1873 joined the Army and rode under George Custer's command into the Little Bighorn valley in 1876. There, they learned that financial panics have all sorts of undesirable consequences.

The current financial panic is driven by fear. Remember that when FDR said that we have nothing to fear except fear itself, he didn't merely offer words. He also offered a serving of broccoli. It proved to be good. The issue of whether hedge funds should eat some broccoli deserves reconsideration. It need not be an enormous serving. Probably moderate amounts would have significant health benefits. The patient is ailing today. And if broccoli helps, the hedge funds may find they like the stuff.

Crime news: some people aren't cut out to be bank robbers.

Thursday, August 9, 2007

The Federal Reserve Walks the Line by Holding the Line

Today, Thursday (August 9, 2007) was another day, and another 387 points lost by the Dow Jones Industrial Average. Things got started across the pond when a French bank, BNP Paribas, announced that it had frozen the money in certain investment funds that it managed, evidently because of subprime problems, and would not honor withdrawal requests. The investment funds, it seems, could not figure out what some of their U.S. assets were worth, because the U.S. markets were illiquid. And if a fund can't figure out what its assets are worth, it can't determine how much money to let investors withdraw.

Things pretty much went downhill from there. Reports of liquidity problems came from all over Europe. Another fund froze up. A Dutch bank decided not to go public, apparently not wanting to find out how the markets view financial institutions these days. Banks in the Old World scrambled for cash, and had a hard time borrowing. It was like they bellied up to the bar and couldn't even get a sarsaparilla.

Things in the U.S. weren't much better. Some kinds of commercial paper--the asset backed variety, which constitutes more than half the commercial paper market--found themselves swimming against the tide when they tried to roll over. (To make things worse, the Wall Street Journal reported today on p. C1 that some money market funds hold this asset-backed commercial paper--is nothing safe?) Two hedge funds sponsored by Goldman Sachs reportedly have suffered big losses, evidently because they invested in accordance with computer models that didn't predict the current mess. (Remember what they say about computers: garbage in, garbage out.) AIG, the world's largest insurance company, reported that it had been roughed up by defaulting mortgages. Some mortgage bankers are losing access to money to lend. Rates for jumbo mortgages (those above $417,000) have jumped from below 7% to around 8%, because they can't be re-sold (meaning, investors don't want those tamales any more).

The European Central Bank injected $130.6 billion in the money markets today in order to ease the drought. The Federal Reserve added $24 billion in the U.S. and the Canadian central bank, Bank of Canada, added another $1.5 billion. That's a total of $155.1 billion in cash, injected into the money markets in one day. In its fiscal 2006 (i.e., the year ended Sept. 30, 2006), the U.S. government had a deficit of about $248 billion. So, in a single day, cash equal to about 60% of last year's federal deficit was injected into the European and North American money markets. This isn't meant to be a strict comparison; it's just gives you a sense of magnitude. We could have said that today's cash infusions were equivalent to about 30 billion grande cups of premium coffee, but that's probably harder to get your arms around.

It seems we have an old-fashioned financial panic, like the panics of the late 1800's and early 1900's. In those days, banks were less regulated than they are today, and often made loans that would be considered unduly risky today. When these loans defaulted, they sometimes triggered runs on the banks by depositors fearing that loan losses would render the banks insolvent. The depositors sought to get their money out before the bank collapsed. Of course, the run would often cause the bank to collapse.

These panics had a plague-like way of spreading quickly and remorselessly, and a run at one bank could easily lead to runs at other banks. Things got so bad in a financial panic in 1907 that the U.S. Treasury deposited around $35 million in New York banks to try to stem depositor runs. $35 million was considered real money in those days, but it wasn't enough to stop the runs. So, J.P. Morgan had to personally take the lead in lining up healthy U.S. and European banks to provide lines of credit to ailing banks to keep them on their feet. Had he not stepped in, a number of banks might have failed and the entire financial system could have taken a walloping.

The panic of 1907 was so bad it convinced the New York banking chieftains that private interests couldn't effectively prop up the financial system. They supported the creation of the Federal Reserve System in 1913, which today plays the role that J.P. Morgan played in 1907 of providing liquidity when the tap runs dry.

Let's step back and look at the structure of today's financial system. Lending isn't done that much by banks any more. Banks are just intermediaries that find the borrowers and make the initial credit decisions. But the banks often sell the loans to investors. Many of these loans are packaged into pools of debt, liked CDOs and their first cousins, CLOs. Then derivatives contracts are created from the various "tranches" of these packages and sold to investors such as hedge funds, pension funds, university endowments, etc. These investors are the actual lenders today, since it is ultimately their cash that funds the loans and their butts that bear the risk of defaults.

If the hedge funds and other institutional investors stop lending, then the cash spigot dries up fast. We've seen that in the CDO markets, where some contracts simply don't get cash bids when put up for auction. It's not that they don't necessarily have value (although some tranches may have no value). But there's so little information available about the risks of these puppies that no one is prepared to put anything on a barrel head for them. Notice that the banks haven't stepped forward to buy CDOs, when the hedge funds have stepped back. Banks don't do this .. . uh, stuff. And the Fed doesn't make loans to hedge funds. It's the banker of last resort for banks, not other financial institutions.

Some hedge funds facing withdrawal requests have either refused to honor them and closed the door, or have shut down and proceeded toward liquidation. Neither choice builds investor confidence, and it may be reasonable to expect that investors, if anything, are moving with greater alacrity to retrieve whatever they can from hedge funds. Today's news from Europe certainly indicates that.

So the Fed is confronted by a run on many of today's de facto banks, the hedge funds. It can't directly prop them up. And there's no J.P. Morgan in New York finance today to organize a private sector bailout. (Gosh, did we ever think we'd yearn for the old robber baron?) Yet, hordes of people are screaming at Chairman Bernanke and the other members of the Fed to do something. So what did they do?

They walked the line--the line between giving booze to a substance abuser and causing greater financial panic.

This week's Fed Open Market Committee meeting concluded with a statement that held the Fed's target for the fed funds rate at 5.25%, where it's been for a year. The Fed also acknowledged the problems in the credit and real estate markets and indicated that it would monitor those developments with heightened sensitivity. This balancing act was apparently meant to stem the cross-currents now flowing every which way in the financial markets:

1. Holding rates steady is important to tamp down the flood of easy credit that created the mountains of risk in the debt markets that have been cascading downwards in recent weeks. As we discussed in, the Fed's all too liberal use in the last 20 years of low and lower interest rates to medicate the economy through rough spots has created an enormous pool of easy money that has bubbled up the values of first one class of assets, then another class of assets, and yet another class of assets. All these asset bubbles have popped, which is what bubbles do when they get too big. And we have all suffered the consequences. Lowering interest rates now would only fuel the Brogdingnagian "moral hazard" problem that seems to have made too many investors believe that they shouldn't be held responsible for their decisions.

2. Some acknowledgement of the credit and real estate problems was necessary to assure shaky hedge fund and other investors that the Fed feels their pain. If investors think the government is indifferent, they might redouble their efforts to withdraw their money from the hedge funds, which would only exacerbate the credit crunch. Chairman Bernanke is doing his best portrayal of Jimmy Stewart. If he succeeds, an Oscar would be in order.

3. A large part of the money invested in the U.S. financial markets today comes from overseas. We discussed one aspect of it--the yen carry trade--in the previous blog ( There are many other sources of foreign investment. If the Fed lowers interest rates, the dollar's value will drop in relation to other currencies, and foreign investors will take losses. They then might withdraw their money, which would only push U.S. stock, credit and real estate markets down even more. Much of the foreign money invested here is held by foreign central banks, who won't act precipitously because they understand that the U.S. is the market into which their economies import a lot of goods. But there are plenty of private foreign investors who may not have such a long term perspective. The result could be a run on the U.S. that would make the run on the hedge funds look like peanuts.

Remember the Asian financial crises of 1997, when foreign investors fled the so-called "Tigers" of East Asia--South Korea, Taiwan, Malaysia, Thailand and Indonesia? This capital flight wreaked havoc on the Tigers, tossing large numbers of formerly middle class people literally into the streets or back to third world agricultural lives. Capital flight from the U.S. might not be quite so destructive. But no one wants to find out what it would be like.

So the Fed held the line and offered talk therapy in order to walk the line. Given the speed at which things are happening now, we may find out as soon as tomorrow whether its approach will work.

Crime News: in New Mexico, Billy the Kid's home state, a man's home is his castle, and they aren't kidding.

Tuesday, August 7, 2007

Stock Market Volatility and How It Bailed Out the Fed (This Time)

Anyone with even a passing interest in the stock markets has noticed the surge in volatility in recent months. The Dow Jones Industrial Average seems clinically manic-depressive, flying in the stratosphere one day and bungee jumping with a frayed rope the next day. Daily movements of 200 or even 300 points have become commonplace. Antacid manufacturers and therapists are celebrating.

Where does the volatility come from? There's no way of knowing all of the reasons. As discussed in an earlier blog, there are unknown factors that probably will never be known. But not everything is unknown. Here are a few thoughts to chew on.

1. The Managed Money Problem. The greatest threat to professional money managers is the index fund. Most money managers can't beat the S&P 500, and many don't even do as well. If a money manager can't beat the S&P 500, why would his or her clients not simply move their money to an index fund? Many index funds have low fees and expenses, and are relatively tax efficient. Money managers feel the pressure to step away from traditional stock picking and try out other strategies in order to get even a tiny increment ahead of the overall market. For example, one can trade futures contracts for the S&P 500. This is a game for bigtime money managers and institutional investors. Individual investors should not try this at home. If a money manager senses that the stock market is likely to fall, he could sell S&P 500 futures contracts in an effort to hedge his stock holdings, or simply to bet on the price drop. Alternatively, he could buy S&P 500 put options, which would hedge his losses if the S&P 500 drops.

If the market begins to sink after the money manager has sold S&P 500 futures contracts or bought S&P 500 put options, the counterparty to that transaction will begin to sell the S&P 500 stocks to hedge its exposure (or do some sort of derivatives trade with another counterparty, who will start to sell stock). Either way, sell pressure is added to the market at a time when it is teetering. Financial history buffs will recall that portfolio insurance had a similar effect in the 1987 market crash.

2. Yen carry trade. Interest rates in Japan have been extremely low ever since the Tokyo stock markets rose in the 1980's and then crashed in 1989. The Nikkei 225 fell from an all-time high around 38,900 to the 7,000 to 8,000 level and has risen to around 17,000 today. The Japanese stock market bubble was accompanied by a real estate bubble so extreme that the Japanese imperial palace was said to be worth more than the entire value of all the real estate in America. Some Japanese home buyers took out 100-year mortgages (that's some inheritance for your kids). Needless to say, the Japanese real estate bubble also popped. Between the stock market crash and the real estate bubble popping, Japan's banks were saddled with such enormous loan losses that they very possibly were insolvent. In order to bail out the banks, the Japanese central bank lowered interest rates to virtually zero (which meant the banks could take deposits and otherwise borrow money for almost no cost). These rates have been kept more or less around zero until recently.

The extraordinarily low interest rates in Japan gave rise to a trading strategy called the "yen carry trade." You borrowed yen at the very low rates available in Japan, converted it into dollars, and invested in the U.S. Because U.S. interest rates and other returns were quite a bit higher than your borrowing costs, you made some easy money fairly quickly. There's nothing like easy money. Many Japanese have been using this strategy. So have many other investors, from places like the U.S., U.K., Australia and New Zealand. Anyone who can borrow yen--and in today's globalized financial system, that means almost anyone who can borrow--can do the yen carry trade.

The catch--remember, in all investment schemes, there's a catch--is that currency exchange rates fluctuate. If the dollar drops in value against the yen, the dollar denominated investment gains you get will be reduced by your losses in the dollar. In the last year or so, the dollar has been dropping against the yen. While the drop has been fairly gradual, it's been enough to make yen carry traders nervous.

Then, the stock market fell, sometimes abruptly, in the last two and a half weeks. That's been enough to make a lot of yen carry traders throw in the towel. They've ditched their U.S. investments, and reconverted their money into yen.

3. Hedge Funds. You knew hedge funds would be mentioned sooner or later, and here they are. Hedge funds that invested in subprime and other mortgages (another thing you knew would come up) have been receiving many withdrawal requests from nervous investors who believe too much of what they read in the newspapers. In the case of one Bear Stearns sponsored hedge fund, the fund simply ceased honoring withdrawal requests. But many other hedge funds have been trying to accommodate these nervous Nellies who have a complex about retiring with only Social Security.

The hedge funds have a minor problem, though. There aren't many people paying cash for CDOs these days. Some CDOs, when put up for auction, apparently aren't getting any bids at all. You can't honor a withdrawal request with zero. So, hedge funds have been liquidating other investments, like other debt securities. The private equity debt and junk bond markets have been particularly hard hit by these liquidations, and spreads between these securities and Treasuries have widened sharply. It's also likely that some of the selling in the stock markets has also been hedge funds raising cash to meet withdrawal requests, or just hoping to avoid losses.

4. Short Sellers. Short sellers are viewed by many as a scourge. They are disliked for profiting from misfortune and scorned for scavenging. However, they may assist the pricing function of the market, pushing the price toward its true equilibrium.

Some short sellers have no doubt been shorting the market (through derivatives that allow them to trade the equivalent of the S&P 500 or other broad market indexes). This probably has added to the downward pressure on the market. However, the shorts can also fuel some of the upward pops in the market. When the market begins to rise, the shorts start to take losses on their positions. As their losses increase, the counterparties with whom they traded (in order to assume their short positions) will often ask for cash collateral. If the shorts don't or can't provide cash collateral, or simply want to cut their losses, they'll buy stock to cover their shorts. This "short covering" is fast and intense, and may account for the laughing gas quality of some of the recent upswings in the market.

5. Derivatives Market? The increasingly tattered state of the derivatives market may account for some of the increased market volatility. There's no way to know for sure, since the derivatives market is unregulated and seriously opaque. But many players that might write derivatives contracts to protect holders of stocks from downswings could be inclined to demure these days. They may have taken losses in the subprime and corporate debt markets, and be unable to take on additional equity risk. They may simply be skittish, not knowing how bad things are, and prefer a quiet game of croquet.

Derivatives are said to moderate volatility by shifting risk to parties willing to take it. There's some truth to that. The problem is one of success--they proved so good at risk shifting that more players began investing in risky contracts, with expectation that they'd shift the risk to someone else. That was a clever strategy until it created such a large amount of risk that the mortgage market belly flopped. We discussed these unintended consequences in

If some of the participants in the derivatives market have stopped playing in that particular sandbox, others seeking to hedge their stockholdings may be unable to lay off their downside equity risk. In that case, they'd have to take old fashioned action to protect themselves--like sell. As the derivatives market pulls back, it won't damp volatility as much.

There may be many other causes of market volatility, although these are probably enough for anyone who owns stock. The past few years have been unusually calm ones for the markets. But an unduly large amount of risk may have been heedlessly created because of the Panglossian perception fostered by that calm. The concern now is that this change in financial climate may have created the conditions for larger and more frequent hurricanes. Let's hope the levees hold.

A Fed Bailout: in the vein of cat-saves-people-from-fire stories, we noted in the preceding blog ( that the stock market was hoping the Fed would give the market a little boost at its meeting today. In anticipation of some dispensation, the Dow rose 287 points on Monday (8/6/07), the day before the meeting. With a handicap like that, it was easy for the Fed not to indulge the market, hold interest rates steady and maintain that its primary concern is controlling inflation. The Fed gave the market a bit of a doggy treat by noting the problems in the credit and real estate markets, and the stock market's volatility. But it gave no real indication that an interest rate cut would be forthcoming at any predictable time in the foreseeable future. The Dow closed up 35, apparently satisfied with the crunchy chicken and beef flavor of its treat.

Animal News: you can't take hardly any liquids on board a plane, but if it's a monkey . . .