Tonight I am initiating summer reruns, a replay of posts I particularly liked from 2007, 2008, and early 2009 (the blog started in late December 2006). This selection represents roughly the top 1% of the pieces written then. I picked this window because it overlaps with the crisis (although the replays of posts from the acute phase of the crisis, Sept-Oct 2008, will be thin, much of it was market reporting that is of limited interest now) and is aged enough that many blog readers now probably did not see them the first time around and even those who did have almost certainly forgotten them. Note also that some of the early posts, like this first one, may not necessarily feature much in the way of my own commentary, but instead highlight an issue, via citing another writer’s work, that proved to be of critical importance.
They will appear daily starting today through July 29, intermittently in August through August 29, then daily again through the Saturday after Labor Day.
This post first appeared on January 27, 2007
Somehow we missed this Financial Times story when it came out on January 19, but it is still germane. Titled “The unease bubbling in today’s brave new financial world,” it’s Gillian Tett’s follow up to a story she wrote on the raging growth of structured finance (covered in our January 16 post, “The Rising Tide of Liquidity.”)
This article illustrates how rampant self interest, both individual and institutional, can keep Ponzi schemes, whoops, bubbles, going far longer that believers in the virtue of market prices would think possible. As long as you can keep the paper moving, and the faithful invested, participants not only stay in despite the risks, but are actually leery of pulling out, lest they lose out to peers who remained in the game and extracted a bit more.
Last week I received an e-mail that made chilling reading. The author claimed to be a senior banker with strong feelings about a column I wrote last week, suggesting that the explosion in structured finance could be exacerbating the current exuberance of the credit markets, by creating additional leverage.
“Hi Gillian,” the message went. “I have been working in the leveraged credit and distressed debt sector for 20 years . . . and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past.
“I don’t think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions . . . with very limited capacity to withstand adverse credit events and market downturns.
“I am not sure what is worse, talking to market players who generally believe that ‘this time it’s different’, or to more seasoned players who . . . privately acknowledge that there is a bubble waiting to burst but . . . hope problems will not arise until after the next bonus round.”
He then relates the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds’ money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. “Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors’ capital – a 2% price decline in the CDO paper wipes out the capital supporting it.
“The degree of leverage at work . . . is quite frankly frightening,” he concludes. “Very few hedge funds I talk to have got a prayer in the next downturn. Even more worryingly, most of them don’t even expect one.”
Since this message arrived via an anonymous e-mail account, it might be a prank. But I doubt it….since I have recently had numerous e-mails echoing the above points. And most of these come from named individuals, albeit ones who need to stay anonymous, since they work for institutions reaping profits from modern finance.
There is, for example, a credit analyst at a bulge-bracket bank who worries that rating agencies are stoking up the structured credit boom, with dangerously little oversight. “[If you] take away the three anointed interpreters of ‘investment grade’, that market folds up shop. I wonder if your readers understand that . . . and the non-trivial conflict of interest that these agencies sit on top of as publicly listed, for-profit companies?”
Then there is the (senior) asset manager who thinks leverage is proliferating because investors believe risk has been dispersed so well there will never be a crisis, though this proposition remains far from proven. “I have been involved in [these] markets since the early days,” he writes. “[But] I wonder if those who are newer to the game truly understand the impact of a down cycle?”
Another Wall Street banker fears that leverage is proliferating so fast, via new instruments, that it leaves policy officials powerless. “I hope that rational investors and asset prices cool off instead of collapse, like they did in Japan in the 1990s,” he writes. “But if they do, monetary policy will be useless.”
To be fair, amid this wave of anxiety I also received a couple of “soothing” comments…But if there is any moral from my inbox, it is how much unease – and leverage – is bubbling, largely unseen, in today’s Brave New financial world. That is definitely worth shouting about, even amid the records now being set in the derivatives sector.