Reflexivity Driving Risk and Reality

How does the market for a floating rate note with virtually no risk of default turn into an illiquid roach motel of a bond virtually overnight? Why did Bear Stearns (BSC) claim to have no liquidity problem and then less than 36 hours later need a bailout from JP Morgan (JPM) and the New York Fed? Are subprime loan default rates really going to be as poor as the ABX index suggests? The answer lies in Reflexivity, a term coined by Goerge Soros to describe financial markets price action.

The concept in simple English states that prices are a function of future expectations and therefore merely changing those expectations can change the price. A large enough change in the price can actually change the fundamentals of a company or an entire economy. Perception will drive reality, especially when markets are at their extremes.

This occurred in Auction Rate Preferred shares. The yields on these floating rate notes implied only a small liquidity premium in most of 2007 until there was a perception of liquidity evaporating which caused there to be a flood of sellers turning the perception of a problem into a real problem.

The is true for Bear Stearns. Two weeks ago, Bear was likely making good money on its trading desk as most many firms do when markets get volatile. A trading house like Bear thrives when bid/offer spreads are wider than normal.

However, rumors of problems surfaced and a few large accounts transferred assets. A few counterparties in the repo market likely demanded a larger haircut on collateral when the underlying value only modestly changed. Quickly, this perception transferred to a reality over the course of just days. As the CDS market indicates, Bear Stearns was no longer a quality rated credit and quickly was moving towards the junk spreads. These problems are not because of a trade gone bad like SocGen (SGSOY.PK) had in January or Morgan Stanley (MS) had in November. It is merely because the reflexive nature of markets.

Reflexivity works in the opposite direction as well. The perception of ever increasing wealth clearly drove house prices beyond normal economic levels. At this point in the ongoing crisis, reflexivity needs to take place for the contagion of declining asset prices to end. How can this be done? Remember, the perception is that no mortgage is safe and all financials companies are suspect for unknown losses.

The Fed can manage this and it doesn’t come from today’s 0.75% rate cut. It comes from the Fed changing the perception in the financial markets. Fear is driving decisions from homebuyers to lenders to investors in equity and mortgage markets. The global appetite for leverage and risk has declined to 1970s recession levels. The Fed can start by bidding on the highest quality agency mortgages. They can intervene in the currency markets although today’s journal clearly speaks against it, intervention could change the perception that the dollar is dead. Bush could release a portion of the Strategic Petroleum Reserve to relieve the speculation in Crude. There is cash waiting to be invested as is evidenced by the Blackstone conference call last week and the sharp short covering rallies.

It is necessary for somebody to change the perception that nothing is safe to the perception that most Americans are paying their mortgages on time with plenty of cash leftover to eat at McDonald's (MCD) as the comp sales suggested last week. The perception is that no risk is worth taking when the reality is that quite the opposite a zero risk 5 year treasury bond is a negative yield when you account for expected inflation. It is the best time for policy makers to push the perception that there are many risks worth taking. In the reflexive nature of things, the risk holders will likely be handsomely rewarded.

Comments

[Alex Wallen...:]

The truth is that lowr-than-normal Fed interest rates after 2001 have caused investors to starve for risk, driving their risk tolerance ever higher, causing an unprecedented amount of leverageing throughout the markets. It's only natural and healthy that this should unwind now. Any more Fed interventions, and we will go through the same cycle again and again, each time at higher risk to the overall system.

2008 Mar 19 09:07 AM

[Alex Wallen...:]

Low yields mean low returns, which can then only be raised by climbing up the risk ladder.

2008 Mar 19 09:10 AM

[jardine:]

The trick is for an investor or the Fed for that matter to recognize the extremes in risk tolerance and work opposite the reflexive forces. The reason that we had a housing bubble was the reflexive nature of prices. This is now playing out in reverse. The reason that we have a credit crisis is the reflexive nature of investors fear of collapse.

2008 Mar 19 01:15 PM