The Impact of Greater Uncertainty

From 2003 to 2007, we went through a period where the balance sheets of financial entities went through a systemic downgrade.  They became:

• More leveraged
• Less transparent via derivatives
• More reliant of floating rate finance
• Reliant on debt structures with shorter maturities
• More sensitive to calls on cash via ratings-sensitive collateral agreements

That is what has set us up for the problems that we have today.  In the bond markets, those conditions have led to the failures of many large market makers, straining the remaining system.  The remaining market makers in bonds are offering little liquidity amid the panic.  It doesn’t matter what sub-segment of the bond market I point at, every part faces a lack of risk-bearing capacity as parties hoard cash.

Part of this is the fault of the Treasury and Fed, as they proffered their TARP and pullled it back.  The greater the uncertainty from large parties, the more that small parties run and hide.

Away from that, many parties with capital have decided (seemingly) as a group to seek safety all at once, leading to a general malaise in all things risky.  Part of that could be related to the original TARP, as many parties decided to wait on selling until the TARP came along.  With no TARP (as originally conceived), those inclined to sell made offers, and the markets balked.

What can I say? Compared to 2002, there are fewer entities willing to bear credit risk during the crisis, even for short amounts of time.  This allows for arbitrage situations that don’t immediately get resolved, because no one has the balance sheet necessary to do it.

Eventually we wil get to a point where those with unencumbered cash will make an effort to close those arbitrage gaps, and lend to worthy businesses at exorbitant rates, but it may take some time.  Until then, the market will flounder in the volatile way that it does.

Comments

[Smarty_Pants:]

By far the largest uncertainty facing market participants is trying to determine what the changes in gub'mint policies will be tomorrow.

When everyone relies on the gub'mint to "save" the system, every gub'mint feint or sneeze produces knee-jerk reactions writ large on the economic landscape.

Until the 'rules' are stable uncertainty will abound.

2008 Nov 20 02:39 PM

[Steven Hansen:]

smarty_pants is right. the government is broadcasting the economy is out of control and there is nothing they can do. changing their mind on the use of the tarp is no big deal - except for those who were standing in line to benefit.

i love all the analysts explaining the reasons for what is happening, and what must happen for it to get better. for me, the market got out of balance with leverage and greed - and is simply correcting to levels which properly correspond to their real worth. just do not stand in front of the bus.

2008 Nov 20 11:35 PM

[Thomas J. G...:]

David has an interesting theory, that we have too much debt (gov't+businees+consum... and that until debt levels reach more normal levels we will have problems. The Economist magazine did an article on this and it was quite striking. Just prior to the Great Depression was the last time we had debt to gdp ratio's as high as as we had in September of this year (I don't personally think we are going to have another depression). Given how striking this is I think I do fault the Fed and Treasury for not noticing debt levels were high and battening down the hatches (using bank regulation to make sure member banks had sufficient capital, other actions). Any of you Merkel fans, do you know where a retail investor can see these debt levels simply and quickly. David published them a few articles back but where does he get that information?

2008 Nov 21 12:38 PM