No Chairs Left When the Music Stopped

By The Curmudgeon

The across the board decline in all asset classes has been a surprising and shocking result of the credit market lockup and liquidity crisis.  It is almost impossible to believe that less than one month ago the Wall Street cognesetti were ranting about the oceans of liquidity that was available for buyout deals and low quality credit markets.  In the last few weeks, there had been a mad scramble for liquidity which has completely vanished.  That has necessitated the sale of many assets at fire sale prices.  No asset class other than Treasuries were immune from the selloff, which rocked and socked global asset allocators.  Such "conservative" investments as ultra short bond funds, multi-sector bond funds, municipal bonds, market neutral funds, and bank loan funds were hard hit.

This is a direct result of there being more leverage in the system then most anyone (including this author) believed.  As a result of complex derivatives, and Yen carry trades, we were not able to accurately measure the amount of borrowed money that was put to work.  For many months now, we have opined that we did not have abundance of "liquidity," but a credit bubble-the difference is huge. In a June 23rd Forbes blog posting we said that the liquidity was the result of leverage and could disappear at any time- a huge accident was waiting to happen.  And indeed it has.  The sub-prime mortgage market has shut down and high yield bond financing is at a standstill.  None of the leveraged buyouts in the pipeline can get financing they require.  There is even a crisis in commercial paper issuance.  Not only has the liquidity disappeared, but for practical purposes the (non Treasury) credit markets have shut down!

So what is "the great unwind?"  When the leveraged trades needed to be unwound, in order to mitigate additional losses, there was still not enough money to be put up to cover the loan.  Therefore, any asset which can fetch a bid is sold to close out the leveraged position (long or short).  This is probably what caused the "Quant Quake," where so many quantitative based hedge funds and institutions had to liquidate both sides of relative value trades.  It made for huge losses and extremely volatile trading in equity market neutral and long short funds.

We can infer by watching the big move in Yen/Dollar (from 123 to 113) that there was a tremendous amount of Yen carry trades that were used to speculate in other markets.  That is an undocumented form of leverage, as no one knows how much money was placed in carry trades - by hedge funds or Japanese housewives.

The price we are all paying now is due to the reckless institutional "dancing and prancing" that went on for years.  Institutions, including banks, would lend money to would be renters without requiring any money down or any proof of income or net worth.  According to Bloomberg, HSBC Holdings Plc, the world's third largest bank, lent $47 billion into the U.S. housing market. But the annual net income of the HSBC is only $15.8 billion.  Hedge funds would use leverage to pursue momentum strategies to buy assets that were rising in price. Private equity funds thought nothing about paying 50% premiums for companies to be acquired (as long as cheap financing was available).  Companies were floating bonds and warrants to buy back there own shares four years into a bull market.   In short, there was no concern for risk.  It was roll the dice baby!

If the hedge funds were the smart money, why weren't they net short before or immediately after the initial break?  When the music stopped, portfolio managers thought they would find a chair, but none were vacant.  Meaning, they believed they would have plenty of time to sell assets before the big plunge.  Why?  Because they thought that "bull market tops take a long time to form"  and they would heed the warning flags to sell near the top.  They were dead wrong.

Just as so many pundits were wrong when they said the sub prime problem would not spread to other financial markets and that the initial decline off the July 19th highs was NOT the start of a major correction or bear market.  As of August 1st, the top 10 timers tracked by Hulbert Financial Digest were still bullish on stocks.

Top market timers still bullish on stocks

There were four + years of gains for every asset class - global equities, bonds of all stripes and colors, real estate, and gold.  That was unprecedented.  So now that the liquidity has disappeared and money is scarce, is asset allocation still valid?   If all asset classes except Treasuries go down, what good is diversification and what if all risk metrics are blown out by hedge funds unwinding of relative value trades?  Asset classes that were supposed to be totally non correlated to global equities, were smashed and there was no place to hide (not even gold or commodities).  What about the risk - return profile of the "efficient frontier?"  Too early to tell if that academic work is still valid.  Clearly, asset allocation and selection of 'non- correlated" investments has not worked in the short run.  We hope that it will still be a sound strategy for the long term.

Finally, we reiterate that a full fledged bear market will not occur as long as the sub prime and mortgage problems do not materially effect consumer spending and cause a recession.  The Bank Credit Analyst recently addressed this issue:  "The sub-prime and related mortgage debacle will not manifest into a serious, widespread credit crunch that threatens the major banks or sparks a recession."  Let's wait and see if they are correct.

The decline in Treasury bonds, notes and bills indicates to us that weaker economic growth and much lower inflation is expected in the future.  Otherwise, how could one justify such low real returns that are approaching zero or are negative?  They key question for investors is how much downside does the lower rates imply for future corporate earnings?  Only time will tell.

The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartrered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.