Risky Business

Since I have retired from "real" life, apart from taking care of the kids in the evenings, one of my main interests has become keeping up with what is going on in the financial markets and the economy. Nathalie got me subscriptions to the "Financial Times" every day and "Barron's" on the weekends. It is kind of my homework.

So right now, guys in the financial world are complaining about an "information overload". Yup, that is right, our friends in the financial markets are looking forward to a week of vacation, after a very tumultuous month of August, to "make sense of it all and catch up on reading" as one journalist put it. Basically no one seems to really know what the fuck is going on and where it will all end up.

So where it beging is the implosion of the sub-prime debt markets. Turns out $250B of $10T is at risk in subprime mortgage loans or 2.5% of the total amount. So a fraction of people cannot pay their mortgage. They don't have any money, they can't count and they should never have had a loan in the first place. It would be ok if they just defaulted since the property is a collateral. Problem is that the real-estate prices are going down, so the assets that back the mortgages are rotten, meaning the property was over-valued to begin with. No one wants that debt anymore as its price does not reflect its value.

How did we get there? Cheap credit. The feds have fueled the real-estate boom with cheap credit (no money? no problem!) Who is left holding the bag? not the banks that made the loans it turns out. That debt got repackaged as part of layered instruments with a mix of high-quality debt. Rating agencies got caught off-guard somehow and AAA rating were bestowed on instruments that were really more risky. These instruments were sold to investors all around the world.

Distribution of the risk is a good thing at a macro-level as everyone takes a bit of the risk. The risk is spread thoughout the whole financial system. That is also the problem as it is everywhere. The sytem has to stomach $250B of bad debt with a 20% value decrease (assuming a 20 drop in real estate prices) for a grand total of $50B of evaporated cash. That is about 50bp of the mortgage market, in other words, it is nothing.

On the surface of it, it looks like a simple problem of "repricing" this subprime risk then. However no one wants to move first. No one knows really how to reprice the risk and there is effectively no market to do it. Much like a constipated real estate market where sellers are holding onto their property and buyers are waiting, no one moves first in a game of chicken where liquidity goes to zilch. There is no market, nothing is changing hands, no volume, no liquidity. What is your debt asset worth? we don't know as there is no market.

As a double whammy, when credit pulls back, liquidity pulls backs with a compounding effect. For every dollar that I put in the bank, that is a dollar I have and a dollar that the bank is lending to someone else, so really that is $2 in circulation. Stuff gets bought, deals get made, we have liquidity. Take a dollar back out and the liquidity goes down.

Two weeks ago, in mid-august, the credit markets had all but shut-down. This prompted BNP over in France and another fund here in the US to basically "freeze" accounts so clients could not withdraw their money. Officially they claim this is to protect their customers since a forced sale of assets would net prices that would be marked to market and would by definition suck, since there is no market to the disadvantage of the client or, alternatively, "marked to model" in which case the bank would then carry the risk of then recouping its money in a illiquid market.

Basically the boys over in Paris were saying "neither we nor our customers want to be left holding the bag for the greedy US real estate market, fuck you guys". It is bad enough that they hold the sub-prime paper, no need to fire-sale it back to the US on top of it.

Apparently BNP has reopened its funds for withdrawal as of yesterday, partially yielding to political pressure in France and partially because the markets have gone back to working almost normally.

Normalcy momentarily came back when the central banks in both the EU and the US injected close to $300B of credit into the financial system. Again, credit increases liquidity and the markets have recovered some of their colors, or at least are not completely stuck in the mud as they were a couple of weeks ago.

While the feds support the central banks, they could not care less about the fate of individual hedge funds, who are usually very leveraged, and are feeling the heat these days. In order to respond to demands of liquidity, or margin calls, they find themselves having to dump highly valuable assets, that are still liquid, to meet their cash needs. This is an upside down world that has led to a bloodbath in the hedge fund industry. Many are going belly up.

In turn, hedge funds are blaming "Quant" guys, street-speak for math and computer wizards, for their woes. When all else fails, blame the IT department. All the model guys were doing roughly the same 200 variable economic models (! that cracks me up) to craft their stock picking strategies. But the risk has been so sliced and diced that it is everywhere and no one knows where it is or what it is worth. So it is back to "dealing with the feeling" and the markets live in fear, every participant expecting the next gaping hole to appear at any moment under its feet.

While it means that our Quant friends on Wall Street will pull their hair out retooling all their applications to account for the new economic environment and reality, for a newbie, it is such a great time to learn about these markets. There is something mildly amusing about the puzzled faces everyone seems to sport these days when probed about the markets. I love it.


marcf