Saturday, August 11, 2007


Liquidity injections can smooth out the wrinkles in financial markets, but the effects are both mildly disfiguring and very temporary.

In less than 48 hours this week, the central banks of the US, Europe, Canada, Japan, Switzerland, Australia, Singapore, Malaysia, the Philippines and Indonesia injected over $326.3 billion of liquidity into the global financial markets. A whopping 65% of this infusion -- $213 billion -- occurred not in the US system, but in Europe.

This was the largest global liquidity injection in history, and it's ironic that the US pump was a paltry $62 billion, one-fourth the size of Europe's.

There was also a jargon injection, with "statistical arbitration" and "quantitative funds" added to a growing list of arcane credit terminology popping up in the mainstream press.

The market also saw a volume injection, as this marked the heaviest week of trading in US stock market history. The kicker is that even though volatility reached record highs, the stock market paradoxically edged higher as well.

What's going on here?

Hard to say for sure, but below are eight observations:

1. The Stock Market
The financial markets have become more irrational than they've been in years. The source of the problem is that mortgage-backed securities -- a huge asset class -- have become difficult to value. Wall Street hates uncertainty anyway, and when it extends to the value of an entire asset class, it's a big problem. Massive positions are being liquidated for reasons other than fundamentals or technicals, making this an unusually risky time to own stocks. Because so little has been resolved, it's going to get worse before it gets better, probably much worse.

2. Statistical Arbitration and Quantitative Funds
Stat-arb is the latest variation of black box strategies in use for decades (LTCM was brought down by a variation of these). Really smart guys with computers exploit tiny, statistical abnormalities in the relationships between various securities. The spreads are so small that enormous leverage -- up to 10 times -- is used to make them profitable. The problem is that in an emergency, it can take 10 times as long to exit a position. When the emergency is in an illiquid asset class -- like mortgage securities -- it can really get out of hand. Perfectly good stocks get sold en masse to raise cash, which in turn triggers stops at other firms, and so on. The irrationality can accelerate rapidly.

3. Liquidity Injections vs. Rate Cuts
Because the FOMC didn't cut rates on Tuesday, Fed critics feel vindicated by this week's liquidity pump. However, liquidity injections and rate cuts are very different tools. Liquidity can be highly targeted (the Fed bought high-quality mortgage paper this week) and is very short-lived. Rate cuts are a blunt instrument capable of producing unintended consequences. The effects are also much more long-lasting.

4. Bail-Outs
There's widespread disgust at the thought that the peddlers of shameless credit products are getting "bailed out" in some way. The truth is that the peddlers are paying dearly for the Fed's help. The Fed is holding the market's best mortgage paper for just 3 days. After 3 days, the peddlers have to buy the paper back plus a Soprano-style vig that's roughly 5-19% higher than on the open market. The bad news? This caper doesn't solve the original problem of the subprime toilet paper they still can't sell.

5. Greenspan vs. Bernanke
Thanks to the bias of Greenspan's 20-year reign, an entire generation of Wall Street pros believes that the main function of the Federal Reserve is to be "accommodative". This isn't true of course, and Bernanke's data-driven approach has proved a genuine shock to the system. Despite consistent policy language and behavior, Wall Street refuses to take Bernanke at his word. You can see this refusal in the Fed fund futures and the bond market. After 1 1/2-years, they still resemble more of a Greenspan handicap than an acknowledgment of Bernanke's approach. Bernanke will continue to provide liquidity, but will be slow to cut rates. If things really fall apart, he will of course. But short of that, he'll continue adjusting policy to the incoming data.

6. Frozen Markets
The biggest reason Bernanke will be slow to cut rates is because in the end, lower rates won't solve the problem. Illiquidity has hit the mortgage market because the value of the assets is unclear. In absolute terms, rates are low, and making them lower (a) isn't going to create valuation epiphanies, and (b) will open a can of worms in other asset classes and global economies. Transparency, not cheap rates, is the only true solution.

7. "Malt Liquor Mortgages"
The unspoken secret about the subprime mess is that these products were designed for and marketed to low-income minorities, mostly African-Americans and Hispanics. Comedian Jon Stewart had a great subprime bit on The Daily Show this week. Fellow comedian Larry Wilmore called subprime the "menthol cigarettes of loans", adding "we knew these loans were unfair, that's why we stopped paying them back!" In a cheeky twist on Black Power, Wilmore contends that Blacks are getting back at The Man by using $100 billion in leverage to strip him of power, status and wealth. Protests, voting and riots are dead ends -- using Wall Street against itself is the ultimate diss.

8. The Silver Lining
When the stat-arb boys are forced to raise cash, they sell the market's best companies, and cover shorts on the worst. This crushes hedging strategies in both directions. It's also why the best stocks fell and the worst stocks climbed this week, and a troubled, heavily-shorted market closed higher. The silver lining is that this irrational behavior is creating a large value inefficiency in the market. The economy is in decent shape, yet some of the most best stocks in America are being dramatically mis-priced. There's a bundle to be made when this is over.

Keep some powder dry.




Anonymous said...

"There's a bundle to be made when this is over"

in your opinion, what kind of timeframe are we looking at ? What are some specifics that you are looking for to indicate a turn around ?

Student_Of_The_Trade said...

Hey DK.....good points, all. Item #6 was especially well said and inspired me to post this note of appreciation for your commentary.

Thanks, man. :-)



dk said...

Hi anon...thanks for the question. I have no timeframe in mind for this nightmare to play itself out, although history suggests that it could take weeks and months. Bottoms are hard to determine as well, as they're all slightly different. They're a process, not a destination, and are often so ambiguous that I'm rarely one to jump in early.

Hi student...thanks for stopping by, and I appreciate the comment.

beingpossibility said...

Great post! Could not agree with you more.

Anonymous said...

a good read