Tag Archives: justice

The Credit Crunch and the Market

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The past month has been a roller-coaster in the financial markets.

At the first hints of falling prices in the mortgage backed securities markets, Bear Sterns announced the bankruptcy of two large hedge funds, and 90% losses in a third fund which had $850 million invested in highly rated mortgage-backed securities. In the following weeks, other major funds also announced losses. Goldman Sachs’ Global Alpha hedge fund fell 27% this year through Aug. 13, prompting clients to ask for $1.6 billion in redemptions, investors told Bloomberg. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard in August. DE Shaw’s Valence fund is down more than 20% through August 24th, according to a fund of hedge fund manager.

These high-profile losses are prompting redemptions, and as cash flows out of hedge funds, managers must sell. Around the world, leveraged funds anticipate redemptions and are deleveraging (selling).

“When you can’t sell what you want, you sell what you can.”

Because the markets for mortgage-backed securities dried up so completely and so quickly, managers began selling positions that remained liquid and well-priced. In a sense, they had to sell good investments because they couldn’t sell the bad ones. What started as a series of collapsing mortgage strategies has spread into just about every other market that hedge funds touch. Prices fell in investments ranging from emerging market bonds to the price of hogs. In all, more than $1 trillion in value has been lost in US stock markets, alone. Many foreign markets and alternative asset classes suffered worse declines.

The trigger event is a credit tightening: mortgage issuers extended too much credit, were too loose with their lending standards, and may not have adequately communicated their loan terms. In response, lending standards have been increased and credit is tighter. US consumers might slow their spending, which might trigger a broader slowdown in the US economy, which might have implications for global growth. Uncertainty and fear prevail.

We view this fear as primarily psychological, wildly overestimated, and only loosely related to market fundamentals (See Figure 1). But that may not matter.


The pricing of risk is driven by psychology. Investors require compensation for the possibility of loss and also for the inconvenience of uncertainty. So rising risk can cause capital to become scarce, lending rates to go up, and spending to slow. In this sense, the psychology can impact the fundamentals in what is sometimes called a “contagion”.

The “Greenspan put” was like a safety net, providing the comfort that credit would be made available on those occasions when it was needed. Bernanke has reiterated this strategy, but it remains to be seen if he has the same appreciation for what Keynes called the “animal spirits” of the market. Contagion is a real phenomenon, generally starting with a crisis in one market or a large fund, then spreading to other asset classes as volatility rises and investors require higher premiums for risky investments.

In our view, the excessive lending in the mortgage industry could trigger a contagion in a variety of ways, such as:

  • Rising rates and tightening lending standards leads to a contraction in home prices, reducing consumer spending and slowing economic growth.
  • A new awareness for the risk of debt investments causes borrowing costs for corporations and governments to rise, reducing investment and slowing economic growth.

These risks can be self-reinforcing, and could change the fundamental characteristics of the economy. These are the type of events that could change our investment strategies if they appear to develop out of control.

So far, these contagions have not caused a significant slowdown in economic activity. Volatility triggered by major hedge fund failures is different; it generally causes sharp declines in recently popular asset classes followed by recovery. These declines can proceed in unexpected ways, and can continue for some time because each price shock runs the risk of triggering another failure. It is surprising how many hedge funds use leverage sufficient to make them incompatible with price shocks. As months pass, however, these shocks can be a blessing because they offer rare value opportunities.

We should all hope that a full-fledged contagion does not develop, and be thankful that the world’s central banks are standing guard.

The Federal Reserve

It is important for the government to intervene if a contagion might damage the economy in fundamental ways, but also important for the government to avoid interfering otherwise. The Federal Reserve and foreign central banks play an important role in managing the stability of economic growth by changing the availability of capital at money-center banks, but interventions can also cause distortions in currency exchange rates, changes in the money supply affect inflation expectations, and reliance upon government intervention can lead investors take excessive risks.

On the 17th, the Federal Reserve followed several foreign central banks (European Central Bank, Australia, Japan, and others) by pumping capital into their nations’ banking systems in response to the recent volatility. This intervention increases the monetary supply, but the psychology of selling is still driving down many market prices as global investors reduce their exposure to risk and shift their portfolios to hold more cash and US Treasury Bonds.

Credit tightening is a reasonable response to excessive lending, but the signal from global central banks is that they are ready to smooth the volatility, even if it means increasing the money supply. This indicates that they may intend to inflate their way out of potential economic pain. As a result, we are less concerned about a recession, but our long-term expectations for inflation have risen. This combination makes stocks and real assets more attractive because they are better hedges against inflation, and reduces the value of fixed income instruments (such as US Treasury Bonds). Meanwhile, the global investor crowd has been doing the opposite. If higher inflation will be the ultimate outcome of this recent roller coaster, then the massive global shift toward cash and fixed income may ultimately be reversed.

Veterans Healthcare

In this country, the burden of healthcare is placed on the employer.

In any other industry, paying for the treatment of work-related injuries is the responsibility of the employer. If soldiers were civilians working for a construction company, for example, they would be given health insurance and likely a token amount of life insurance. Companies who refuse to compensate large numbers of employees for work-related injuries are often sued under class action. The same standard should apply to the military.

Finally, it is the moral responsibility of the nation to treat the injured soldiers that fight for our safety, sovereignty, and freedom. Soldiers are asked to make the ultimate commitment, risking life for country; the country should at least commit to treating the injuries that result.

Healthcare for young Americans

If you take away one’s right to support themselves, you have an obligation to support them.

If children could work, they could presumably receive health care. For the sake of argument, let’s ignore the pay check, work experience, and other benefits – and focus on the healthcare. In many cases, parents can not or do not choose to pay for appropriate healthcare for a child. In these cases, the child might be better off quitting school and working to afford the medicines or treatments she desperately needs. But that child is restricted by law from doing so. The government, by placing this restriction, is morally responsible for providing at least that which the child could have achieved on her own. The government should provide health coverage for any persons restricted by law from the work force.

Retirement savings reform

Company sponsored retirement programs are costly to administer, and provide employment benefits in the form of tax reduction. By providing employment benefits in this manner, government is subsidizing the businesses that submit to the administrative costs. Large companies can more easily afford this administrative cost. The intention to reward workers becomes a reward for working in a larger organization. When workers change or lose their jobs, they must transfer their 401(k)s and in some cases (when they are hired by a small firm or are not immediately re-hired) are no longer eligible for tax advantaged retirement savings. This compounds the pain of unemployment by effectively increasing the person’s tax rate. Finally, 401(k) rollovers have created an entire bureaucratic industry, tapping the productive force of many bright and hard-working people.

There is a simple solution: Replace 401(k) plans by increasing the amount all individuals can contribute to their traditional IRAs. And if a company chooses to administer it, a percentage of every check could be directly deposited. This change would help to level the economic playing field for small American businesses, eliminate the harsh tax penalty upon unemployment, and simplify the financial accounts of most working Americans. 401(k) plans can already be rolled into IRAs, so conversion from legacy policies would be painless.

What about the government’s intention to reward workers? The financial incentive of a pay check is designed to be just that, but additional reward might include a federal income tax holiday for the first $50k in earned income, for example.

Special cases of inconvenience and frustration are many, I’m sure, but consider the case of a married couple, both of whom work. One employer provides a 401(k) plan and the other does not. Saving equally, the person with a 401(k) takes home more money. This means that in order to save equally, one person is structurally required to subsidize the other. Adding structural financial conflict into marriage should be avoided as a matter of policy.

Informatics Used to Manipulate Politics

The Economist is publishing an article describing how information about demographics is leading to an algorythmic method of “redistricting” to enable very meaningful manipulation of state-wide votes.

The article provides examples, and even claims “Weirdly shaped districts… are signs that a crime has been committed. Again, start with Florida. This year, the Republican-controlled legislature has proposed a map with 18 Republican-leaning seats and seven Democratic ones. But as the 2000 presidential vote showed, Florida’s electorate is split perfectly down the middle. The map has been rigged outrageously to favour the Republicans. ”

The Article also discusses the cases of Michigan, Texas, and California.