Early Innings Of A Global Financial De-Leveraging

by: Roger Ehrenberg

The events over the past few months have been fascinating, at least when taking a clinical view of things. It is like a slow-motion train wreck where the force of the collision spreads detritus all across the landscape.

Is this like LTCM? No. Is this the emerging markets debt crisis redux? No. Did legacy government policies contribute to a real-estate bubble that has seemed poised to pop for years? Yes. The current crisis is, in fact, a contagion, where Wall Street and Main Street are inextricably linked in a complex web of relationships that only time and suffering will help untangle. And do we have Alan Greenspan sitting in his exalted perch pulling strings and lending confidence and authority behind the scenes? No. And this is part of what makes this story so compelling.

What are some of the factors that make this market meltdown so, well, intriguing?

Quasi-governmental agencies competing with the private sector: Long story short, it seems to me that Congress let FNMA and FHLMC get way, way too big, doing business well beyond their original charter. They used an implicit government guarantee to provide ready credit to too many homeowners, and fostered a competitive landscape that placed origination volume over loan quality, the problems of which we are dealing with today.

Rating agencies not imagining beyond their Monte Carlo simulations: Investors rely heavily on ratings. Issuers pay rating agencies lots of money to validate their securities, which, on its face is a conflict of interest. Well, let's forget about that for the moment. Getting back to ratings quality, what is the purpose of having ratings if they are adjusted post-facto? Isn't this kind of like Wall Street sell-side analysts putting a Sell rating on a stock after they whiff on earnings, when they previously had a Buy rating on it? And this happens every day. Boo.

Leverage, leverage everywhere: Homeowners. Securitized vehicles. Investors. With leverage comes reduced margin for error, and with error comes pain. The issue is that the pain incurred does not move linearly, it moves exponentially. Once the pain starts happening, its effects ripple outward, often swallowing everything in its path. With a leveraged portfolio, a normal drop hurts, but isn't fatal. However, when the drop moves beyond normal, beyond the expected, the investor is asked for more collateral, which causes further downward pressure on portfolio value as liquidations are needed to make margin calls. But as more securities are sold in a rapidly declining market bids start to fall away, committing the leveraged investor to months in purgatory, working out a busted book. And what about homeowners? As adjustable rate mortgages get reset sharply upward and payments can't be made, remember the value of that equity in a home? Poof. Now what if that happens 1,000, 100,000, a million times or more? All those real assets flooding the market? There is no bid. Which causes builders' inventory to crater, which kills their stock prices, which hurts investors' portfolios, consumer demand, etc. It just goes on and on.

A rookie running the Fed: I don't envy Mr. Bernanke. Not for a minute. His wealth of deeply-felt, academically-grounded views and best of intentions by seeking to avoid the "moral hazard" of a Fed put all went out the window in less then a week. There is nothing more hazardous to one's professional reputation than being at the helm of a true market Chernobyl, especially when you were just given the keys to the reactor, but this is what Ben is facing early in his tenure. He was (and still is) staring at a liquidity crunch right in the face, challenging it to a game of "who'll blink first," and he lost. And fast. Notwithstanding my leanings towards letting the chips fall where they may and letting those who made bad and irresponsible decisions get smoked, Mr. Bernanke made the only decision he really could make. Even if it went directly against statements he made earlier in the month concerning his focus on inflation pressures and, therefore, stable to higher - not lower - interest rates. Water under the bridge. He's learning. Dust him off, wind him up and he'll be ready for the next (read: inevitable) series of crises during his tenure.

A pro running the Treasury: As much as Mr. Bernanke is grounded in academia, Mr. Paulson is steeped in global financial realities. The academic vs. the pragmatist. They are really great foils for each other, especially at a time like this. While Mr. Bernanke is clearly the bell of the ball of the global financial markets, there can be little doubt that notwithstanding Treasury Secretary Paulson's low profile during this crisis, he is having an influence on Fed thinking. He spent a career at one of the most successful and deft global financial powerhouses, leading part of the charge during its worldwide expansion. Let me tell you, it makes me a lot more comfortable knowing that Hank is back there providing his two cents to Ben and his Fed pals, because he knows the way it is, not the way it should be as depicted in Ph.D dissertations and textbooks. In another few years, Hank and Ben could be a virtual "dream team," the princes of theory and practice side-by-side. Nice.

I think we are in the early innings of a global financial de-leveraging that will necessarily take place, and it will be the skill of those like Messrs. Bernanke and Paulson along with their EU and Asian colleagues that will dictate how the air is let out of the bubble. Moral hazard sucks, and we are right in the midst of some pretty morally hazardous stuff taking place from a policy perspective.

Certain firms and investors will be bailed out though they shouldn't be, but net net, the impact of letting them go may well be far worse then showing the financial community that the Bernanke Fed will not be issuing put options as the Greenspan Fed did. There are times and places for making points, grand, sweeping points, but this is not one of them. The next twelve months should be challenging for investors across many if not most asset classes, and it is largely due to the government messing things up and then trying to fix them post-facto. And this is the real hazard that should be driving the discussion.