I thought I would give a summary of some of the discussions we have been having about the future of the markets. Some have suggested that the fallout from the subprime mess will lead to the doom of the financial system. Let's revisit what a subprime asset is: banks make loans to people with a shaky credit history. Since the loans are risky, the banks want to offload some of that risk. So they pool the risky mortgages together into a package. They then sell parts of the package to investors. When an investor (often a hedge fund) buys part of the package (often called a "mortgage backed security") he inherits parts of many loans-- he gets the money that the borrowers would have paid the bank, as well as the risk that the borrowers will never repay him. Problem is that investors thought they were safer than they actually were. Since they were so diversified (they had many parts of many different loans) they thought it was unlikely that all the borrowers would stop paying at the same time. But the problem is that this is happening. Since the housing bubble burst, borrowers who thought they could resell their house for a profit--and thus didn't need to worry about making payments for the loan (ie "I can always sell if I run into hard times and can't pay off the mortgage)--can't sell for a profit, and are stuck -- their loan is worth more than the current price of the house, and they couldn't pay off the mortgage even if they sold the house. As investors realize that the assets they bought are riskier than they thought, they become worth less, and their prices fall.
The way hedge funds work is that they borrow a lot of money to make investments--that way they can amplify their return. They pay back the loan and get to keep the profit they made with the money from the loan. However if the market for certain assets (like mortgage backed securities) goes sour, the people who lent the money will want their money back, as they are worried that those invested in rapidly devaluing assets will not be able to pay their loans back (the hedge fund "should" keep the losses it made with borrowed money as well as the gains, they can lose more than they have, go bankrupt, and be unable to pay back their creditors). The lenders will therefore force the hedge funds to pay them back right away, rather than risk that they will lose more money and be able to pay back their loan. The theory is that hedge-funds and other investors who borrowed money to buy mortgage back securities and other risky securities will not be able to sell them, because no one wants to buy them. Therefore they will be forced to sell their good investments in order to pay the borrowers back. The only problem is that with so many massive hedge funds forced into this situation, there will be so much forced-selling going on that all assets, no matter how risky, will be forced down (think supply and demand). As prices fall, lenders will become more worried, force more investors to sell, which will send prices even lower.
Thus, or so the theory goes, the financial markets are facing impending doom.
However, I think there is still hope. China, and the oil rich countries have a ton of dollars because of their trade surplus (sell goods, get dollars). They want to put those dollars to good use. In addition, there are a ton of pensions and endowments which are trying to juice their returns by investing in hedge funds and other alternative investments. Therefore, there is a ton of capital looking to make investments worldwide.
Enter Superfund. The Superfund, which we have discussed below on this blog and in our meetings, is a super big fund created by a bunch of major banks. The idea is that they will buy the good assets that investors who are forced to sell will be selling. This might be able to prevent the panicked selling created by margin calls (the name given to situations where banks force investors to sell their investments in order to pay them back). It might be able to contain the crash to the risky subprime assets, which were priced incorrectly and should fall.
If the assets can be repriced fairly quickly (read: if the Fed or Treasury doesn't step in and the Superfund doesn't start buying bad assets at artificially high prices in an attempt to hide losses), and investor confidence can be regained, the market will move on fairly quickly-- there is a ton of capital seeking to be deployed. The Superfund might be exactly what we need to prevent a panicked sale and the impeding doom. It is very possible, however, that, despite its best efforts to stop a firesale, the Superfund will do too little, too late. Unfortunately, with the recent turmoil at the banks which were going to set up the fund, it looks as though the fund might never be created.
So dark days might be ahead after all....
Just some thoughts from someone who knows very little about these things. What do you all think? Respond by clicking on the "Comment" button below.
2 comments:
Pat,
The idea that there are large volumes of capital "waiting" to be deployed by pension funds and developing and oil-rich nations is comforting in the sense that these entities may see a repricing of risk as a buying opportunity; their activity would help to soften some of the collateral damage caused by an Asset-Backed Securities "fire sale" by buoying some of the "good assets" that have nothing to do with subprime mortgages (but were sold off due to massive margin calls to the hedge funds). So if we are to believe that this capital is "waiting," then I would agree that the financial markets might recover quite quickly in the aftermath of a crisis, much like they did in 1987. But I don't think that these investors have the ability to stop or slow a crisis that has the potential to be very damaging.
One lesson we learned in 1987 has to do with the idea of "time disintermediation" in financial markets (which means that investors respond differently to stimuli, or, more simply, that some investors are "more active" than others...your average futures pit trader is much quicker on the trigger than your average portfolio manager). In the case of the subprime mess, if some type of catalyst caused the hedge funds to rapidly unwind their positions in order to meet margin calls, I do not think that China, CALPERs, etc. would step in quickly enough as "bargain hunters" to slow the fire-sales.
In 1987, portfolio managers tried to hedge themselves by shorting the futures of the S&P 500. The belief was that, as stock prices fell, the short positions in the S&P futures would become more favorable and would therefore "hedge" their losses in equities. This strategy grew extremely popular, and the managers constantly had to adjust their positions in stocks and futures in order to keep properly hedged. On Monday, October 19, 1987, stocks continued a sharp decline they had began on Friday, so portfolio managers began to sell futures rapidly. The traders in the futures pit noticed that the S&P futures were trading at a discount to the stocks that make up the S&P (due to the selling pressure on the futures), so they bought the futures from the portfolio mangers and sold the stocks that made up the S&P. Because the futures traders were quick on the trigger, the price of the futures did not decline quickly. However, their activity put more selling pressure back on the stocks!! This was the portfolio manager's worst nightmare. Before anyone could notice that this "negative feedback" was occurring, stocks went into freefall. This is because the portfolio managers who seek "bargains" (and would normally offset selling pressure) generally make more "calculated" decisions and, in this case, could not keep up with the very rapid sell-off in equities. Eventually, asset prices were dropping so fast that all of the "bargain hunters" were scared away. There were no buyers, and the markets tanked. They recovered over the next few days, but not before the S&P 500 dropped 22%, and nearly a trillion dollars of US wealth was wiped out in a single day.
While we shouldn't ever see the same type of "negative feedback" in markets ever again, we are still susceptible to the same type of "time disintermediation" in the event of a liquidity shock. If we do enter "freefall" due to massive liquidations from the hedge funds, I am not sure that the big "waiting" investors will be there to catch us. Rather, I think they will pick us up after we've already hit the ground.
So while I do agree that the idea of "waiting" capital is comforting, for me it's "comforting" to the extent that we know that our wounds would heal eventually. The real question, at this point, is how deep those wounds would be.
-Tyler
You have a very good point, Tyler. I guess it comes down to the Superfund, which if it gets off the ground, will be created for the express purpose of stepping in quickly, within the timeframe of the forced sellers. It might, in this way, prevent a panic. Possible, but unfortunately, unlikely...
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