The Beginning of the End of the Credit Crisis?

David Gaffen is watching the VIX decline to levels well off its March highs, and back towards its lowest point of the year to date. Meanwhile, Alea is watching financial-institution credit default swap spreads decline to levels well off their March highs, and back towards the lowest point of the year to date. Could it be that we really are at the beginning of the end of the credit crisis? Has Ben Bernanke been successful in averting disaster?

"For the most part, investors appear to view the credit crisis as having passed over," says Gaffen - and this of course is one of the areas where investor sentiment has a tendency to become self-fulfilling. Of course, it helps that the Fed has turned the faucets wide open and is likely to keep them that way for the foreseeable future: if Ben wasn't dropping money from helicopters, things would surely be very different.

Still, if Nassim Taleb is to be believed, the time to worry is not when volatility is high, but rather when volatility is low.

Also, he says, people do not understand the link with the concept of volatility. In a market, if returns do not follow a "normal" bell curve distribution (as appears to be the case), volatility will actually be less than the bell curve would predict. For much more than the predicted two-thirds of the time, returns will be very close to the average. Such low volatility, counter-intuitively, is a danger sign that there is a greater risk of true "black swan" events, when returns do deviate from the norm, because it shows that returns do not follow a normal bell curve.
His geopolitical analogy is with Italy and Saudi Arabia. Italy has had many different governments since the war, while the same family has retained power in Saudi Arabia. This means that Italy is the more volatile but, he says, that Saudi Arabia is more risky, because if something does change in the political situation there, it will have much greater consequences.

On the other hand, if Saudi Arabia goes volatile and then settles down again, it's likely to be in a more sustainable place than it was originally. The people who mistrusted the Great Moderation were right. But if the world is really de-risking right now, rather than just mispricing risk, then this time around volatility might be falling for all the right reasons.

Comments

[Lilguy:]

Volume plays an important role in volatility and right now there is next to none in the markets. Volumes this year have been highest when (a) there was a dramatic drop in the indices (January and March) and (b) when volatility was highest.

Right now, most people (& institutions) are just sitting skeptically or fearfully on the sidelines. This has enabled the modest rally of the last month on very low volume. Then, every once in awhile, the bears step in (like last week) and the price goes down.

I don't think serious investors are willing to take a substantial risk right now. They are waiting on the sidelines for the smoke to clear on the credit crisis, the housing crisis, the inflation run-up, and the (ongoing) recession.

With the summer being a normally dull time in the market, I don't see much prospect of it going up further in the absence of some systemically positive news, an unlikely event in the extreme.

2008 May 14 08:40 PM

[Rafael Grillo:]

I think the worst panics of the credit crisis are behind us as there is slightly better visibility of the level of exposure and vulnerabilities of the financial sector. Yet, the sector is still fragile. Add to that an oil-driven inflationary recession with no end in sight (with the consumers' disposible income shipped overseas to pay for oil) , and Lilguy is spot on. Skepticism and caution prevail in these conditions. I am optimistic though: the US economy has proven extraordinarily resilient. One would think the kind of run up in oil we've had would be enough to take it to its knees, and yet, it's chugging along. But it will take a burst in the oil bubble to see consumers optimistic and spending again. And that is unlikely to happen, since by all accounts, this increase in oil prices is truly demand-driven. Too many people having cars and electricity in too many countries. How ironic, isn't it? The premise of globalization was that by promoting the economic development of the world, everyone would be better off: more developed countries would mean more consumption and more production, raising everyone's quality of life. What nobody seemed to have taken into account is that the basic resources for production are limited, and that more thriving economies mean higher demand for those limited resources and therefore escalation of prices. Time for some serious disruptive innovation in the energy sector.

2008 May 14 09:56 PM

[Dwane:]

I agree low volume rises seem worrisome. Another worry is the thought that financials raising lots of money .... only to pay it out in dividends. Its got the vision of a ponzi scheme. The banks are too scared to slash dividends, so they raise billions to water down their stock and keep up the dividends ? I still believe that the markets will close with a gain this year, but not a buyer in the next two months.

2008 May 14 10:01 PM

[Mike Stathis:]

The credit crisis is taking a rest, but is by no means over and most likely has not even bottomed.

2008 May 14 10:11 PM

[Nick Gogerty:]

eye of the hurricane. To use the over used metaphor, prepare for more headwinds. The fed isn't pumping in liquidity so actively becuase it feels happy about the situation.

2008 May 15 09:27 AM

[spragus:]

Yes, the market is probably just taking a rest awaiting the next shoe to drop. Will the banks suffer real loan write-offs? And what about the increase in ABX prices; will they hold and inspire mark-to-market write-ups. What an unnerving spectacle that would be.

2008 May 15 09:51 AM

[sivere:]

How about the END OF THE FED?

TakeBackTheFed.com

2008 May 15 10:27 AM

[Manifestor:]

Another simple way to put it IMO, is that low volatility periods encourage build-up of asset bubbles that eventually have to burst.

2008 May 15 02:58 PM

[Tom Lindmark:]

Perhaps the more important question is what happens now. Yes the worst of the crisis may be over but what sort of credit market will we have. Is it one that shuns risk and relies on bank financing or will we see the good parts of securitization return?

2008 May 15 04:56 PM