Why the Panic?

As readers doubtless know, a nasty day in the markets yesterday was followed by distress overnight as the Japanese central bank injected funds into the marketplace and the European Central Bank added liquidity a second day, following an unprecedented, unlimited injection Thursday. The Dow opened down over 100 points, and due to a spike up in the Fed funds rate to 6%, even the reluctant Fed has stepped in and injected $19 billion, an amount a commentator in a Bloomberg story, Tony Crescenzi, chief bond market strategist at Miller Tabak & Co., deemed “large but not extraordinary.”

This injection of liquidity is not only large (collectively) by any standard, but it is very unusual for a credit crunch to occur this early in a credit contraction. The drumbeat of bad news, specifically bank and/or other financial institution failure, historically has had to be evident for panic like this to set in.

And the particularly troubling thing about his set of developments is that the bad news is far from over. More on that later.

So what is different now? Quite a few things (note that this list isn’t mutually exclusive and collectively exhaustive, since many of the factors are interlinked, but it hits most of the major issues):

1. Reluctance by investment professionals to exit too early. The pressure on institutional investors to maintain competitive performance levels has gotten worse with every passing year. This has driven many to do things that in the cold light of day they knew weren’t too smart, like invest in risky assets (and worse, in many cases, ones they didn’t understand very well) for inadequate risk compensation to boost returns.

2. Misplaced faith liquidity would always be there. Due to 1. above, people again who should have known better told themselves they could get out when they needed to. This has led to the inevitable rush for the exits just as the exits are getting impossibly crowded. Witness the sure to be a classic market peak comments by Citigroup’s Chuck Prince that Cit would “keep dancing” as long as liquidity held up.

In particular, the specter of funds halting redemptions is a big psychological blow. That sort of behavior says crisis. For that to be happening not at a single fund, but at multiple funds, combined with the near-certainty that even more hedge funds are certain to freeze investments, is not something the vast majority of investors had ever contemplated.

3. Lack of transparency. This is a new and substantial cause of fear. In the bad old days (S&L crisis, LBO crisis, emerging markets crisis, LTCM, the old sovereign debt crisis) everyone knew where the dead bodies were; the uncertainty was around exactly how bad the damage was (and that depended on an uncertain workout/crisis resolution process). We’ve long said that the LTCM crisis was misunderstood as reassuring because the Fed was able to orchestrate an orderly wind-down. In LTCM, the danger to the system was fortunately housed in one unregulated player so it could be made visible (LTCM had to sit down and go through its positions with all its counterparties). The downside of the current risk dispersion is that in a crisis, there are too many weak hands with unknown holdings for anyone to have even a dim sense of how bad things are systemically. Remember, even the prime brokers don’t know because hedge funds deliberately spread their trades across multiple PBs allegedly so that the PBs’ proprietary trading desks don’t trade against them.

4. Significant investment in “Ponzi units”. Hyman Minsky, an economist who studied speculative behavior in the wake of the 1929 crash, observed that creditors become more lax about lending standards during times of stability. He divided borrowers into three types: the upstanding sort that can pay principal and interest; speculative borrowers (or “units”), who can pay interest but have to keep rolling the principal into new loans; and “Ponzi units” which can’t even cover the interest, but keep things going by selling assets and/or borrowing more and using the proceeds to pay the initial lender. Minsky’s comment:

Over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight of units engaged in speculative and Ponzi finance.

What happens? As growth continues, central banks become more concerned about inflation and start to tighten monetary policy,

….speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently units with cash flow shortfalls will be forced to try to make positions by selling out positions. That is likely to lead to a collapse of asset values.

While subprimes are the most obvious “Ponzi unit,” the lower rated tranches of CDOs and CLOs have some of their characteristics.

Because this crisis is outside historical norms, the unexpected collateral damage is further spooking investors. For example, blue chip stocks took a beating yesterday. Most observers believe this is because hedge funds were raising cash in anticipation of redemptions and were selling high quality assets first. But blue chips are supposed to be a relatively safe haven.

Those sort of anomalies are leading to further upheaval at quantitatively-oriented hedge funds, which are very large and active traders. From Bloomberg:

The turmoil in the equity and credit markets has created a “perfect storm” that led to losses for hedge funds employing mathematical strategies, according to a Citigroup Inc. strategist.

Most quantitative strategies, such as investing solely on the basis of share value or changes in analysts’ earnings estimates, are resulting in declines, Manolis Liodakis, a London-based strategist at Citigroup, wrote in a report dated yesterday. The event is rare in an environment where volatility has increased.

“Nothing seems to be working,” Liodakis wrote. “Previously uncorrelated factors have recently been falling with the same pace, leaving investors with very few places to hide.”

Now as we observed earlier, the bad news is far from over. Many observers expect a considerable number of hedge funds to announce significant losses. Wall Street is choking on LBO related debt and is facing the possibility of losses in their prime brokerage units if any of their hedge fund clients run into serious trouble.

And we have yet to see the impact on the real economy. The housing market is far from its bottom. There has been similar frothy lending in the commercial real estate market. And there is the potential for a deflationary crisis. From FT’s Alphaville:

The first sign of weakness in commodities this week is evidence that markets have begun to think about economic weakness as a potential consequence of the escalating distress in the world of credit, says CLSA’s Christopher Wood in a particularly sweeping issue of his client newsletter, Greed & Fear. “It would be extraordinary if the credit universe continued to deteriorate and there was no ensuing growth scare.”A commodity correction would be a “natural symptom of such a growth scare”, and is likely to happen in coming months, says Wood. Such a commodity correction is also likely to put upward pressure on emerging-market debt spreads, which show signs of becoming more correlated to the rising credit spreads seen elsewhere.

“None of the above is to deny the strength of the long-term commodity story, based on the demand stemming from the emerging world”, he says. “Still it is also the case that the world has not completely decoupled from the US economy. A sudden sharp decline in the US current account deficit would represent a deflationary shock for the global economy even if it would be bullish for the beleaguered US dollar.”

It’s not clear that the injection of funds will do much to help these problems. If the issue is that investors have put too much capital into fundamentally worthless paper and unduly high risk strategies, no amount of cheap capital will induce them to go back once they have sobered up. Yes, it will (hopefully) staunch the dumping of worthwhile assets. But as we said, this level of injection of capital in a process that has some ways to run is not a good sign at all. What happens if and when the real economy starts to feel the effects?

One bit of good news: credit default swaps prices in Europe were stable this morning.

Addendum: Just saw a very good (as usual) post, “Worse than LTCM,” by Nouriel Roubini, who makes the observation that what we are witnessing isn’t simply a credit crunch but, more seriously, a solvency crisis:

Economists distinguish between liquidity crises and insolvency/debt crises. An agent (household, firm, financial corporation, country) can experience distress either because it is illiquid or because it is insolvent; of course insolvent agents are – in most cases – also illiquid, i.e. they cannot roll over their debts. Illiquidity occurs when the agent is solvent – i.e. it could pay its debts over time as long as such debts can be refinanced or rolled over – but he/she experiences a sudden liquidity crisis, i.e. its creditors are unwilling to roll over or refinance its claims. An insolvent debtor does not only face a liquidity problem (large amounts of debts coming to maturity, little stock of liquid reserves and no ability to refinance). It is also insolvent as it could not pay its claim over time even if there was no liquidity problem; thus, debt crises are more severe than illiquidity crises as they imply that the debtor is insolvent, i.e. bankrupt, and its debt claims will be defaulted and reduced…..

Today we do not have only a liquidity crisis like in 1998; we also have a insolvency/debt crisis among a variety of borrowers that overborrowed excessively during the boom phase of the latest Minsky credit bubble.

First, you have hundreds of thousands of US households who are insolvent on their mortgages. And this is not just a subprime problem: the same reckless lending practices used in subprime – no downpayment, no verification of income and assets, interest rate only loans, negative amortization, teaser rates – were used for near prime, Alt-A loans, hybrid prime ARMs, home equity loans, piggyback loans. More than 50% of all mortgage originations in 2005 and 2006 had this toxic waste characteristics. That is why you will have hundreds of thousands – perhaps over a million – of subprime, near prime and prime borrowers who will end up in delinquency, default and foreclosure. Lots of insolvent borrowers.

You also have lots of insolvent mortgage lenders – not just the 60 plus subprime ones who have already gone out of business – but also plenty of near prime and prime ones. AHM – that went bankrupt last week – was not exposed mostly to subprime; it was exposed to near prime and prime. Countrywide has reported sharp losses not only on subprime lending but also on prime ones. So on top of insolvent households/mortgage borrowers you have plenty of insolvent mortgage lenders, subprime and – soon enough – near prime and prime.

You will also have – soon enough – plenty of insolvent home builders. Many small ones have gone out of business; now it is likely that some of the larger ones will follow in the next few months. Beazer Homes – a major home builder – last week had to refute rumors of its impending insolvency; but so did AHM a few weeks before its insolvency. With orders for home builders falling 30-40% and cancellation rates above 30% more than a few home builders will become insolvent over the next year or so.

We also have insolvent hedge funds and other funds exposed to subprime and other mortgages. A few – at Bear Stearns, in Australia, in Germany, in France – have already gone bankrupt or are near bankrupt. You can be sure that with at least of $100 billion of subprime alone losses – and most losses are still hidden given the reckless practice of mark-to-model rather than mark-to-market – many more will go belly up. In the meanwhile the CDO, CLO and LBO market have completed closed down – a “constipated owl” where “absolutely nothing moves” the way Bill Gross of Pimco put it. This is for now a liquidity crisis in these credit markets; but credit events will occur given that the underlying problem was not of of liquidity but rather one of insolvency: if you take a bunch of to-be-defaulted subprime and near prime mortgages and you repackage them into RMBS and then these RMBS are repackaged into various tranches of CDOs, the rating agencies may be using magic voodoo to turn those junk BBB- mortgages into AAA tranches of CDOs; but this is only voodoo as the underlying assets are going to be defaulted on…..

His post continues here