Unless one is actually involved in the credit markets in an institutional way, one is unlikely to appreciate quite how much of the "L" thing, or leverage, is at work in the system. There seems to be a lack of appreciation on this point, particularly among those who inform or decide policy.
Recent characterizations of the credit markets as panicking "irrationally", or needing a "face-slap" moment to break the hold of a fearful mindset strike m* as uninformed about the dynamics of leverage. This is not a panic. To the contrary, the accelerating sell-offs in credit indicies and spreads reflect the most rational and serious behavior: de-leveraging.
Prior to last fall, institutional money was typically levered in loan markets at 10x, levered in asset-backed debt 20x, and brokerage firms doing the lending levered at 30x. By way of contrast, a typical equity hedge fund is levered only 2-3x. As holders of many no down payment to very low down payment sub-prime mortgages have found out, it takes only a hiccup in asset values to create negative equity (for a buy and hold investor) or technical insolvency (for a mark-to-market investor), whether one runs a loan fund, a mortgage fund, a brokerage house, or even a government chartered home mortgage lender (50x in case you were wondering).
Lulled into a false sense of security and extrapolating the trend, the Street gorged at the credit banquet. And it's Risk Management function, more a portfolio optimization scheme for maximizing profits at VaR-ious levels of statistical risk, proved its worth in last summer's quant meltdown - which is to say, not much.
In these conditions then, with asset values having more than hiccup'd, the need for cash and the resultant pressure on the prices of assets most held by the levered players is quite simple. Whether today's rumors of trouble at Bear Stearns "bear out" or not, the potential for a liquidity crisis at a well known name has never been higher. It is likely that this cycle sees major broker failures, or last ditch acquisitions of them on the brink (see BoA/Countrywide). Those who said the problem would be "contained" to the home mortgage sector may have been confused about how far that sector stretched - all the way to Wall Street.
Monday, March 10, 2008
Wednesday, February 20, 2008
Six Point Eight
From the minutes of the Fed's Jan 30th meeting released today:
"The higher-than-expected rates of overall and core inflation since October, which were driven in part by the steep run-up in oil prices, had caused participants to revise up somewhat their projections for inflation in the near term. The central tendency of participants’ projections for core PCE inflation in 2008 was 2.0 to 2.2 percent, up from the 1.7 to 1.9 percent central tendency in October. However, core inflation was expected to moderate over the next two years, reflecting muted pressures on resources and fairly well-anchored inflation expectations. Overall PCE inflation was projected to decline from its current elevated rate over the coming year, largely reflecting the assumption that energy and food prices would flatten out. Thereafter, overall PCE inflation was projected to move largely in step with core PCE inflation."
Also today the BLS released it's CPI report showing inflation running at 4.3% over the last twelve months. Over the last three months, the all items index increased at a 6.8% annual rate. Yesterday, China reported it's CPI has also increased over the last three months at a 6.8% annual rate. It should be clear now, if it has not been for some time, that resource competition among the world's economies is fierce, and inflation pressures globally, especially in the case of food and energy, are approaching levels where inflation expectations become rather less "well-anchored."
Yesterday, the value of fiat money globally was reduced by 5% against the price of just about any commodity traded on organized markets. Crude breached $100, and items from palladium and platinum, to wheat and gold made all time highs anew. And yet in the foggy corridors of the Fed, where "muted pressures on resources" are "expected" and softer food and energy prices are "assumed" it seems the future course of monetary policy depends on the Fed's ability to pick the top in commodity prices, a decidedly naive and costly strategy.
The Fed is depending on a slowdown in domestic consumption from the over-levered consumer to relieve resource pressure globally and soon, while aggressively lowering rates in a desperate attempt to keep that same consumer's spending habit alive. The contradiction is clear. The question is then how many more six-point-eights can you stand? The chart below says not many.
Bloomberg: Spot Gold
"The higher-than-expected rates of overall and core inflation since October, which were driven in part by the steep run-up in oil prices, had caused participants to revise up somewhat their projections for inflation in the near term. The central tendency of participants’ projections for core PCE inflation in 2008 was 2.0 to 2.2 percent, up from the 1.7 to 1.9 percent central tendency in October. However, core inflation was expected to moderate over the next two years, reflecting muted pressures on resources and fairly well-anchored inflation expectations. Overall PCE inflation was projected to decline from its current elevated rate over the coming year, largely reflecting the assumption that energy and food prices would flatten out. Thereafter, overall PCE inflation was projected to move largely in step with core PCE inflation."
Also today the BLS released it's CPI report showing inflation running at 4.3% over the last twelve months. Over the last three months, the all items index increased at a 6.8% annual rate. Yesterday, China reported it's CPI has also increased over the last three months at a 6.8% annual rate. It should be clear now, if it has not been for some time, that resource competition among the world's economies is fierce, and inflation pressures globally, especially in the case of food and energy, are approaching levels where inflation expectations become rather less "well-anchored."
Yesterday, the value of fiat money globally was reduced by 5% against the price of just about any commodity traded on organized markets. Crude breached $100, and items from palladium and platinum, to wheat and gold made all time highs anew. And yet in the foggy corridors of the Fed, where "muted pressures on resources" are "expected" and softer food and energy prices are "assumed" it seems the future course of monetary policy depends on the Fed's ability to pick the top in commodity prices, a decidedly naive and costly strategy.
The Fed is depending on a slowdown in domestic consumption from the over-levered consumer to relieve resource pressure globally and soon, while aggressively lowering rates in a desperate attempt to keep that same consumer's spending habit alive. The contradiction is clear. The question is then how many more six-point-eights can you stand? The chart below says not many.
Bloomberg: Spot Gold
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