Two readers wrote to me concerning phenomena we’ve mentioned upon occasion in the expanding credit crunch, and it seemed a good opportunity to discuss them longer form.
There are two separate, but related threads: we are now seeing a lot of “every man for himself” behavior (liquidity hoarding is one of many examples) that seem rational (or at least defensible) on an individual basis, but are destructive to the financial system as a whole. The second is that, per Richard Bookstaber, our financial system is “tightly coupled” and in tightly coupled systems, risk reduction measures (which too often look at risks in isolation) will typically have the perverse effect of increasing risks. As he explained:
Tight coupling is a term I have borrowed from systems engineering. A tightly coupled process progresses from one stage to the next with no opportunity to intervene. If things are moving out of control, you can’t pull an emergency lever and stop the process while a committee convenes to analyze the situation. Examples of tightly coupled processes include a space shuttle launch, a nuclear power plant moving toward criticality and even something as prosaic as bread baking.
In financial markets tight coupling comes from the feedback between mechanistic trading, price changes and subsequent trading based on the price changes. The mechanistic trading can result from a computer-based program or contractual requirements to reduce leverage when things turn bad.
Eugene Linden, who has written extensively on animal behavior as well as markets, gave this observation:
The problem facing the credit markets right now is yet another iteration of the “prisoner’s dilemma” from game theory, at least in the sense that participants know that if everybody takes the stance of “every man for himself” the markets will crater, but they also know that if they rush for the exits there’s a chance that they will get out the door relatively unscathed. Studies of the problem suggest that the more anonymous the context, the more likely that players will adopt “every man for himself,” and, of course there’s nothing more anonymous than markets. Nature has a long time to work out solutions for problems, and it turns out that a number of animals have converged on the same optimal solution that game theorists have worked out. It’s called “tit for tat,” and it simply means that if someone extends trust to you reciprocate that trust, and if not, not. The best example comes from vampire bats. When a bat is short on blood it will call on a copain for a sip, and if its bat buddy does the right thing, then the thirsty bat will reciprocate at some point in the future when the tables are turned.
It is wonderfully perverse that vampire bats are more community-minded than Wall Street.
The problem now is, save perhaps within the dealer community itself, many players deal with each other on an anonymous, one-off, or transactional basis. So the opportunity to discipline bad behavior is diminished considerably (but ironically, one of the big factors behind Bears’ demise was anger in the community that it had behaved badly both in the LTCM crisis by being the only firm called by the Fed who refused to participate, and its reluctance to shore up its failed hedge funds last June).
Now consider how this conspires with the second element, the perverse outcomes that result from trying to reduce risk in a tightly coupled system. We had written about these examples of efforts to fix the housing/credit crunch backfiring. I’ll start with the first, which is that aggressive cuts at the short end of the yield curve initially did nothing to lower long-term rates, which are the basis for pricing most mortgages; the later cuts have steepened the curve, making matters worse.
Reader Lune came to similar observations independently and put them together well, so we’ll continue with her list:
We’ve already seen the law of unintended consequences so far:
1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.
2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.
Now we have 3) Fed opens TSLF to broker-dealers. Given the track record of our esteemed Fed so far, I shudder to think what the unintended consequences of this one will be, and I’m disturbed that it’s very likely that no one has thought about that while running around in a panic shooting from the hip at any shadow that comes up. Anyway, here’s my speculation…
The Fed is already close to tapping its full balance sheet. The trigger for the collapse of the past few weeks has been the rise of agency spreads, which is the cause not the effect of all the implosions we’ve seen so far. So to stop the panic, the Fed would have to intervene in the agency market. But it’s remaining reserves of ~$400bil is tiny compared to the amount of debt out there. Furthermore, even a full faith govt. guarantee is unlikely to stop the rise in premiums (witness Ginnie Mae debt, where spreads are increasing even with a govt. guarantee). This is partially because of panic, and partially because agency debt will have fundamentally different behavior when it includes all the extra debt Congress is talking about stuffing it with. So with that uncertainty and unpredictability, it’s no wonder spreads are increasing.
As the spreads continue to claim more casualties, more firms will line up for funding (when do hedge funds get to drink directly from the punch bowl? At this rate, probably in a week or two), and the Fed, unable to say no, will have to start issuing treasuries to expand its balance sheet. Within a matter of a month or two, the Fed will find itself with a trillion or so dollars of impaired debt in a “repo” that can’t ever be recalled (some because the counterparty’s balance sheet is still too weak, others because the counterparty has gone BK). The ultimate casualty? The Fed itself, unable to lower interest rates below 0%, facing default on collateral on its hands, and counterparties (central banks) unwilling to trust the Fed to manage the dollar any longer.
Oh yeah, and mortgage markets will still be frozen.
And she continued later with another possible unintended result:
I’m wondering: if the demise of Carlyle and BSC was hastened because they were firms that couldn’t access Fed money and thus were foreclosed by firms that could, what will happen Monday? I’m thinking hedge funds, unable to access the Fed directly, will be eaten alive by the IBs.
Why? Because I’m figuring they’ll find it safer to shut down hedge funds, take their collateral and convert it into Treasuries, even at the usual Fed haircut, rather than deal with the prolonged uncertainty and volatility of working with their hedge fund clients for an orderly unwind of their positions.
When there was no choice but to choose option #2, plenty of IBs bent over backward to try to keep the hedgies afloat, lest the market collapse. But now, better to shut them down, stuff the Fed with the remaining crap, and sleep better at night knowing your collateral is now in Treasuries rather than illiquid and opaque hedge fund positions. Which IB out there wouldn’t be willing to convert their whole CDS position into treasuries even at a 50% discount (especially since with a repo, if the CDSes don’t default, you’ll get them back at par when the storm has settled)?
Altogether plausible. Let’s hope this is not what come to pass.