Remembering Fingers of Instability
08/15/07
The markets finally washed out last week. Relentless selling through the first half of August came to an end in a crescendo last Thursday. Waves of panic had washed over Wall Street for two long weeks with rumors of bankruptcies and hedge funds going belly up appearing every hour. Wave after wave of liquidations forced by margin clerks around the country finally ended when the Dow Jones Industrials had lost 360 points on Thursday morning, reaching intraday a 12% correction 20 trading days after its peak in July, touching its 200 day moving average in the process and then mounting a snapback rally of 700 points between Thursday afternoon and Friday morning. Volatility indeed is king and alive. In theory, this volatility should be a dream for traders and hedge funds, but it turned for most of them into a nightmare. The Wall Street Journal had a great article about the way, the hedge fund community had to say "Sorry!" Remember those fingers of instability? We had talked about the origins of catastrophes in November last year. In that same month, Risk Magazine had published an article about the uncertainties, which surrounded the new financial credit risk products and their lack of liquidity. The article was aptly named: Credit Model Meltdown. Let me quickly quote one paragraph from it, because it said it all:
Liquidity concerns
Industry concerns are exacerbated by the risk premium in many standard trades currently being close to zero. While many market participants expected the low spread environment to reverse in 2003 and 2004 - and so bought protection and have suffered losses as a result - any potential widening of spreads has yet to take place. Indeed, some participants believe that although there will inevitably be a turn in the credit cycle, there has been a long-term secular and permanent shift in average levels of credit spreads. Effectively, people now know the real cost of counterparty credit risk is considerably lower than they previously believed. But the continued tight spread environment has led to an increasing number of market participants selling credit protection, or going long credit risk. This has raised concern about the leverage involved in many tranche trades and whether hedging techniques are adequate given the imprecisions in correlation modelling.
The more things change, the more they stay the same.
The yen carry trade went awry last week. Hedge funds all over the world were forced to reduce leverage and to exit every crowded trade. Yen which they previously had borrowed at a cost of 1-2% interest to be invested at higher yields in different currencies, had to be bought back. Everybody wanted through the same door at once and the yen's value increased by over 3.5% within a week. This is a monstrous move for any currency.
The yen strengthened to trade at $0.0088 (or 113.8 yen per dollar) to the dollar Friday afternoon. It is now at a five-month high. New Zealand's "kiwi," the currency most heavily favored in the yen carry trade, was hit the hardest: a free fall of more than 15% since it fetched a valuation of 0.811 U.S. dollars, a 22-year high, last month. On Friday it plunged below the 0.70 barrier closing at 0.68848 U.S. dollars. Even the relatively insulated Australian dollar plunged close to a five-month low Friday to trade at 0.78881 U.S. dollars, about 12% less than its 18-year high on July 25, when it was trading at 0.8871 U.S. dollars. Another favorite currency vehicle for betting against the yen, the Korean won, also declined to a five-month low, trading at 939.9 won to the U.S. dollar, much to the evident satisfaction of the South Korean central bank, which has been calling for global action against the carry trade. The effects of the carry trade have hurt the export competitiveness of the nation's small and medium-sized businesses. The drying up of interbank liquidity has promoted the Bank of Japan, Tokyo's central bank, to pump another 400 billion yen ($3.45 billion) into the domestic banking system Friday morning to tide over the market. The carry trade affects many currencies and coupled with the risk aversion that has taken hold in trading rooms around the world is forcing central banks around the globe to inject $ Billions into their economies.
The global deleveraging has begun. It had started in May 2006 when the Icelandic Krona got whacked. But then it all seemed just a bad dream and the leveraging up began again. Then at the end of 2006, the first difficulties in the credit markets began to surface. Sub prime credit caused initial ripples in February, then in May and now in August again. The question that everybody is not daring to ask is this: Will this "liquidity crisis" that seemingly affects only certain sub-prime borrowers - be they individual home owners or corporate borrowers with a flawed business model – turn into a "solvency crisis" of national (or international) proportions. Nouriel Roubini thinks that the latter will be the case.
The Federal Reserve took highly unusual steps Friday to open up the supply of cash to the nation's banks and signaled a willingness to cut interest rates if necessary. Clearly Bernanke has to be concerned that this liquidity crisis of some might turn into a solvency crisis of many and drag down the economy into a recession. The step on Friday was a signal to creditors that he is watching and ready to act should it become necessary. The invitation to financial institutions to borrow at the discount window of the Federal Reserve was mainly a trick to divert the child's attention from its temper tantrum and enable it to relax. Every mother knows this trick and it works often enough. I believe it could work with the credit markets, too. Collateral that will be accepted include those pesky mortgage backed securities that are at this time very difficult to sell. The Fed is willing to accept them as collateral, enabling banks in return to accept them from their prime brokers and their hedge fund customers. This is a creative way to resuscitate the patient and to get the oxygen where it is needed. The stock markets loved it all the way, at least on Friday. The higher quality parts of the credit markets also improved. Now the markets at least should get a reprieve for a couple of weeks. The retest of last weeks low, however, seems certain to occur sometime before Christmas. The headline risk is simply too great. But again, this means opportunity for those who are ready and liquid.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
