A Critical Market Juncture (Again)

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."(Charles MacKay)

Considering that hell is the impossibility of reason, these have been a reassuring couple weeks, with a couple of days finally showing large drops in the US equity indexes and with the market mood sobering up to more realistic perspectives, namely:  

1. That credit crunch is not over and continues to work its way in waves through the system,
2. That the taunted second semester recovery is not happening,  
3. That oil prices and inflationary pressures remain high.

As a result, the market expectation of earnings is being revised downwards.

At this juncture in the coming weeks, a market recovery does not seem likely; instead, it seems to me that we are looking at two possible scenarios: 

1. A base case (70 pct. chance) where receding earnings growth expectations and persistently high oil prices bring the market down in an orderly fashion to find support perhaps in the low 10,000s,
2. There is also a material chance (30 pct.) that an increase in severity of the credit crunch could impair the derivatives market, resulting in an explosion of counter-party defaults. This off-course even with a Fed intervention to prevent contagion would likely bring complete pandemonium to the equity markets, in which case the herd would take over and it is anyone's guess where it could stop perhaps at the 10 years ago level reached during the LTCM/ Russia default crisis in the 7,000s? 

A number of events could bring this unfortunate downside scenario into fruition:

1. A melting of Lehman Bros (LEH) (even with the discount window) 
2. A last minute palace coup at BofA (BAC) seeking to save it from a potentially disastrous merger with Countrywide Financial (CFC).
3. A couple of large regional bank blowups 
4. A big hedge fund blow-up.
5. A failure of a visible capital raise by any of the banks  

The fact that the Fed has been zealous in saving banks at any cost (with complete disregard for moral hazard) and the existence of the discount window lifeline, makes1) and 3) unlikely: they will play out more in death by a thousand cuts fashion than in a spectacular blow-up. At some point, the Fed may decide to make an example out of someone, but we are not there yet.

Number 2) also seems quite unlikely at this point. The higher likelihood is number 4) or number 5). The good news is that it seems the Fed is keenly aware of the counterparty risks embedded in the over the counter derivatives market, particullarly the 60 trillion CDS market (about 5 times the US GDP). This is probably what is keeping Bernanke awake at night.

I understand that a clearing house mechanism may soon be put in place to mitigate the systemic risk in counterparty exposure (i.e. a sort of CDS exchange).  So it seems that provided we can survive the next couple of months, systemic risk may be well more under control then. And Bernanke may yet be well remembered by the remarkable way he handled this crisis.

Comments

[SW Richmond:]

How can a "clearinghouse mechanism" serve to mitigate counterparty risk? Unless it mitigates counterparty risk by excusing it? Is someone going to do a review to see who wins and who loses if swaps are all defaulted, and then pick the winner via regulation?

2008 Jun 29 11:05 AM

[icandoitdon:]

yes, what's this nonsense about a clearinghouse mechanism to mitigate counterparty risk of derivative contracts? sounds to me like it's more of the same BS....socialization of losses and privatization of gains.

as for a palace coup at BAC...get real. that merger closes within days. and in any event, who would conduct the coup?

in grad school it was widely known that banks are among the dumbest organizations in a capitalist economic system. they've proven it.

2008 Jun 29 02:23 PM

[secmaven:]

Stocks are not bought and sold through a specialist system anymore. It is all computer matching of orders. If the specialist's had control LeBranch stock would not be in the toilet.

2008 Jun 29 03:23 PM

[Gerry Sullivan:]

Years ago, at the peak of their power, the NYSE Specialists might have been able to move a stock intra day. More often they profited by taking large blocks of stock when a stock halted and reopened lower and then feeding it out at higher prices.

They also made money from the spread, usually 1/8 or 1/4.

Those days are long gone. Most NYSE listed stocks also trade in 8-10 other places. There are much tighter spreads and much less opportunity for the Specialists. Their last big payday was when the NYSE went public.

2008 Jun 29 04:52 PM

[1worldcurrency:]

Again, how the hell would a clearinghouse get us out of this crisis?

2008 Jun 29 06:59 PM

[Ishortyou:]

CDS need to be regulated like a common stock with a common market to have an idea of what the hell they are worth for before hand, this regulation or basis for it will come slowly but surely.

2008 Jun 29 10:07 PM

[Fish Gone Bad:]

The McClellan Summation Index is still headed down. Money is still moving out of the market, and as such, as the tide of money moves out, all stocks fall (at least to some extent).
Now on to the Specialists. Specialists have been allowed to sell stock short and NOT replace the sold shares in a timely matter (3 days). This creates counterfeit stock. Now the scary part. Since the SEC has been downsized, it does not have the man power to enforce stock counterfeiting by the specialists, there is nothing to stop them from selling as much stock short as they want.

2008 Jun 29 10:35 PM

[moderator:]

I think these points you mention have for the most part been factored into the market. At least for now, barring any unexpected event, the markets look to be ready to settle and maybe rally.

2008 Jun 29 11:28 PM

[Charlie Bottle:]

The introduction of a clearinghouse in the "middle" of all CDS contracts means that each contract would have as counterparty the clearing house (just like in a derivatives exchange) rather than another participant.

For example, a contract where LEH sold JPM CDS on a name, becomes effectivelly two transactions: LEH sells to the clearing house; the clearing house sells to JPM. This way JPM is not exposed to LEH counterparty risk (or vice-versa).

By creating this hub structure, this sytem effectivelly diversifies counterparty riks and allows the system to better absorb the default of any individual counterparty. The problem with the existing over the counter structure is that it coexists with concentrations of exposure to a limitied number of counterparties by any given participant which creates the potential risk for a domino effect of counterparty defaults. This is why JPM had little choice but to buy bear strearns, and why the Fed is very focused on this.

2008 Jul 01 12:51 AM