Monday, March 17, 2008

Market Turmoil: Is the Fed Seeding Inflation?

The markets are in some turmoil this morning. Imagine: Bear Stearns, a truly unique investment bank, was trading for $30 per share on Friday and will be sold to JP Morgan (to the rescue!) for $2 (assuming Bear's shareholders approve it, which I expect they will do given the alternatives).

How could this happen? Bear was hit by two things: Leverage, and the nature of a trading business. Suppose you have $3 of equity supporting $100 of assets. Then if the assets fall in value by 3% the equity is wiped out. This is the same "gearing" effect that many subprime investors had to (re-)discover. Second thing hitting Bear is what Enron discovered as it was approaching bankruptcy: Counterparties quickly stop doing business with trading partners who become risky, particularly when the true risk is unknown.

At this point, counterparty risk seems to be a dominant factor in affecting credit markets. Banks are unwilling to lend to one another. This kind of liquidity crisis is precisely what central banks are supposed to fight. The Fed, in my humble opinion, is doing an admirable job so far. There are a fair number of critics out there who fear that the Fed is simply pumping money into the economy, thereby feeding future inflation.

At least for this latest set of moves, the bond markets do not seem to agree with the inflation arguments. Nominal yields on all maturity Treasury bonds and bills moved lower today, with the 5-year down 14 basis points and the 30-year down 5 basis points. The inflation-indexed Treasuries saw HIGHER yields, although the yield on the 10 year inflation indexed Treasury is still only 1.05%. My reading would be that the bond markets saw the Fed move as not increasing inflation, but as being somewhat beneficial to economic activity (hence the higher real rate).

Lots of interesting things to think about in these crazy times. For instance: Isn't it ironic that traders are so attuned to risk today -- their risk aversion brought down Bear Stearns -- but that they were so asleep at the wheel when everyone was buying subprime mortgage-backed securities at close to par the last several years?

1 comment:

Anonymous said...

Bear stearns was not brought down by a decline in value of the the assets. Their book value per share after the mark to market was $80 per share according to the company.

It was brought down by the second reason, a crisis of confidence. The problem is that investment banks (most financial institutions)including Bear Stearns finance themselves through liabilities (debt, repos etc.) that have a much shorter duration than that of the assets. The inherent assumption is that there will always be enough liquidity to be able to refinance or sell assets at what is believed to be fair prices. While that is true most of the time, it is not true all of the time.

The Fed is seeding inflation but do they have a choice? The low interest rate and continuing weak dollar is only ensuring higher inflation. The Fed may not believe it has much of a choice as restoring confidence in a liquid capital markets environment is viewed as key before. I do believe, however, that the markets self adjust quite well on their own. It may require more pain than people like. Continuous growth and boom times without much of a correction is not something that I believe yet in. Human nature and behavior leads to excesses that eventually correct. Unfortunatlely the correction often is too harsh but it is the excesses and the correction that contribute to the mean. Can we curb the excesses and the correction so that the amplitude of the two is flatter? Unless we can tame human emotions, I doubt that we will be able to do that.