An Absolute Mess

By on August 12, 2007

Below is an excerpt of the August 10th commentary by Doug Noland available at:

“It is popular to explain market gyrations as a “re-pricing” of risk. Other comments suggest that this is only a “short-term Credit crunch” and that “this is a liquidity issue not a solvency issue.” This is much, much more serious. Key facets of “contemporary finance” are on the line. The entire process of Wall Street Credit and Risk Intermediation is today in jeopardy.

There are literally Trillions of dollars of impaired debt instruments – previously “top-rated” securities that will never live up to their (fallacious) billing. And after a spectacular multi-year issuance boom, they are everywhere – especially in places appropriate for only the most “money-like” instruments. The perceived safest and most liquid securities found homes in various types of “money market” funds and other perceived low-risk investment vehicles. The perceived safest and most liquid instruments were fodder for the greatest abuses of leverage. The bottom line is that these securities were misconceived as “money-like” from day one, and the marketplace has shifted to the recognition that they are instead highly risky and inappropriate for most investment vehicles, as well as for leveraged strategies. This radical change in market perceptions is wreaking bloody havoc on the untested Credit derivatives marketplace.

Global central banks can somewhat cushion the de-leveraging process, but I doubt they can do much more than slow the flight from risky Credit instruments and “investment” vehicles. Importantly, perilous market misperceptions with respect to risk and liquidity have been exposed. Speculative de-leveraging is unmasking serious flaws in various assumptions (including liquidity and market correlations) used by “black box” models in leveraged strategies across various securities markets. Risk management strategies are failing. The bloom is off the rose and a tidal wave of hedge fund withdrawals – and further de-leveraging – cannot be ruled out.

The major international banks have been key players in U.S. structured finance, especially in money market “conduits,” “funding corps,” and “special purpose vehicles.” This might very well be the epicenter of the current liquidity crisis, and they will surely vow to avoid such exposure to U.S. Credit risk going forward. The highly leveraged Wall Street firms will struggle to rein in risk on myriad fronts and likely be forced to fight mightily for survival. And for how long the American public can hold its nerve is a major question. They have been conditioned to believe that their holdings in the stock, bond, and “money” market are safe and secure. And the longer central bank interventions sustain unsustainably inflated asset markets, the greater the opportunity for the speculator community to “distribute” their holdings to the unsuspecting public.

As much as I recognize the traditional role of central banks as liquidity providers of last resort, I just sense that being forced to move this early – with global stock markets at near record highs – provides confirmation of the Acute Fragility of the global Credit system. Such moves would appear to risk further destabilizing already highly unstable global markets, especially currency markets. This does look to me as a Run on Wall Street Finance – and an absolute mess.”

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