Derivative Markets Jitters Again

The May 19 Financial Times notes [$]:

The recent sharp falls in stock markets appear to have been exacerbated by an unusual wave of derivatives activity on the part of hedge funds and big banks, traders yesterday indicated.

In particular, some banks and big investors appear to have been forced into selling large amounts of equity futures because they have been acting as counter-parties to large, leveraged bets on the direction of stock market volatility in recent months - and these bets are now unravelling because volatility has increased sharply.

As I begin, once again, to get nervous about derivatives, hedge funds, and risk concentration, Doug Noland chimes in to reinforce my nervousness with his latest Credit Bubble Bulletin. Somebody please provide help me understand why my nervousness is misplaced! Until then, here's a bit of Noland's thought:

...From the 1987 stock market crash, the Fed understood that it may very well be necessary to intervene in the marketplace to cushion the influence of some of the new financial "innovations." This certainly included interventions to forestall marketplace bouts of trend-following derivative-related selling and other forced liquidations. This policy insight served them well during the LTCM crisis. When the disintegration of a highly leveraged portfolio of international bond bets risked precipitating a global financial market dislocation, Greenspan hastily intervened. The Fed shielded the insolvent LTCM from liquidation, aggressively cut rates, added liquidity and, importantly, assured the markets that the U.S. government – the Greenspan, Rubin and Summers "Committee to Save the World" –– were ready and willing to employ unprecedented measures to guarantee liquid and continuous markets. I have in the past written extensively regarding the momentous moral hazard implications of this endeavor and will not delve further into this issue this evening.

With regard to policy implications, the Greenspan Fed emerged from the LTCM crisis resolution with an intrepid appreciation for the unparalleled power and control they now exercised over marketplace liquidity. Virtually on demand, Greenspan could incite risk-taking and leveraged speculation, both activities that would immediately add to marketplace liquidity, stimulate borrowing and risk-taking, boost asset prices, and only somewhat later stimulate economic activity.

The instantaneous actions of today's leveraged speculators can be compared to the influence adding reserves and tinkering with interest-rates – the Fed's old toolkit - previously had nudging along bank loan officers and businesspersons. I have always believed that the primary impetus for Greenspan's championing of derivatives, hedge funds and Wall Street finance was that they afforded him the most powerful policy device in the history of central banking. Besides, in post-LTCM analysis, the Fed could rationalize their intervention with the notion that their encroachment stemmed the forced liquidation of high-quality debt instruments held by Credit-worthy borrowers.

The next major financial crisis will be of much broader scope than 1998, just as LTCM was to 1987. I believe the probability for such a crisis during the next year is high, and I wouldn’t be surprised if recent market turbulence is a precursor to trouble ahead. With this in mind, I will briefly share some thoughts I have as to why the next crisis will be significantly more problematic for the Fed.

First of all, I cannot write enough times that the key to the so-called "resiliency" of the U.S. markets and economy has been due to the capacity for uninterrupted Credit growth and marketplace liquidity creation. While there have been a few instances where the flow of new finance was at risk, in each case the Credit wheels were greased with lower rates and assurances of a hospitable environment for risk-taking. The Fed enjoyed great flexibility during the LTCM crisis. The global backdrop (post-Mexico, SE Asia and Russian collapses) was quite disinflationary, especially in the energy and commodities markets. Oil was heading to $10, gold to $250, and the CRB index to multi-decade lows. And, importantly, while the dollar did weaken around the time of the worst of the LTCM scare, it had rallied 25% over the preceding three-year period (on its way to King Dollar highs). The Fed enjoyed the incredible luxury of inciting massive Credit inflation with confidence that dollar liquidity would readily find a home in U.S. securities markets (where the nature of its inflationary impact was largely contained).

The genesis of the problem for the market during 1998 was one of illiquidity and the forced unwind of various Credit spreads, derivatives, and interest-rate arbitrages. The potential collapse and liquidation of LTCM (and copycats) was hanging over the marketplace; players were either hastily liquidating positions or completely backing away from the market in anticipation of a marketplace dislocation. But this predicament was certainly amenable to lower rates, additional liquidity, and concerted Fed and Treasury assurances that a marketplace disruption would be avoided at all costs.

The next financial crisis will be much less agreeable. For one, I believe the general nature of leveraged speculating is different today. The type of the underlying assets being financed (distorted and inflating global assets) is altogether different, and the general inflationary/liquidity backdrop is unrecognizable from 1998. Whereas LTCM speculations were primarily Credit spreads and various rate-arbitrages, I fear the prominent trades today are more of the global carry trade variety. These involve borrowing in low-yielding currencies to finance speculations in instruments of higher-yielding currencies. This recalls SE Asia, Russia and Argentina.

Objectively surveying the global environment, one can surmise that today's leveraged speculations are financing gross and unsustainable distortions (including U.S. over-consumption and global asset inflation). This implies especially weak underlying Credit instrument fundamentals, basically a non-issue back in 1998. To what degree leveraged speculations have been financing our Current Account Deficit is unknown, but this could prove to be a huge issue in the event of a currency market disruption. One can envisage a scenario where the Fed's best intention of supporting the marketplace in providing Credit to "worthy borrowers," is undermined by the deteriorating view of U.S. creditworthiness. There is a huge risk associated with financing serial current account deficits and asset inflation with market-based leveraged speculations. To be sure, U.S. imbalances and policymaking are certainly held in much less regard these days.

I will suggest this evening that acute dollar vulnerability is poised to significantly curtail the Bernanke Fed’s flexibility. The ramifications for a policy approach that pushes the Credit system into overdrive to counter financial disruption are different going forward - perhaps much different. The greatest problem for the global financial system currently is enormous and relentless dollar liquidity excess. Inciting Credit growth and risk-taking may very well prove counter-productive, and it is likely that aggressive (1998-style) Fed actions would exacerbate a flight out of dollar securities. A flight from the dollar would only then worsen the deteriorating inflation backdrop. Not only is it possible that the Fed loses the luxury of lowering rates during the next crisis, it may very well be forced at some point to do what other countries are forced to do - raise rates to mitigate a run on its currency.

Perhaps we've already been somewhat privy to the backdrop for the next crisis: a sinking dollar, spiking metals prices, surging crude, and rising global bond yields. A scenario where marketplace dislocation manifests first in the currency markets (with a faltering dollar) is as reasonable as it would be problematic. Here, one would assume that the Fed’s proven modus operandi of adding liquidity, cutting rates, and inciting more Credit and liquidity would be only counter-productive. And, as we have witnessed, the nature and consequence of current leveraged speculation are more unsettling than those preceding 1998. Today's inflationary backdrop nurtures destabilizing speculative leveraging in all the "un-dollar" markets – certainly including the emerging markets and commodities. This creates a highly unstable situation prone to myriad and recurring Bubbles, volatility and busts. Accordingly, the characteristics of the underlying debt instruments are problematic and increasingly susceptible to wild price gyrations.

I read a lot about Bubbles these days: The "energy Bubble", the "metals Bubble", the "commodities Bubble", the "emerging market Bubble", the "hedge fund Bubble", and so on. But most of the analysis misses the more salient points. What we’re dealing with – the overriding issue is - The Dollar Liquidity Bubble. The combination of massive Current Account Deficits and outbound (investor and speculator) finance is inundating the financial world, and there is no way short of a major U.S. crisis to rein it in. This liquidity is fueling myriad dramatic global marketplace price inflations – as well as the occasional hiccup - along the way. I don’t view recent pull-backs in these markets as bursting Bubbles because I don’t yet see any change to the nature of underlying dollar liquidity excess. ...

Early this week, Stephen Roach also warned investors to be afraid of riding commodity bubbles, hedging his warning carefully, however, as to when such bubbles might burst:

…Price increases are begetting more price increases. Yes, it can go on for longer than we think -- speculative blow-outs usually do. But history tells us how it will end. Play the commodity bubble of 2006 at your own peril..

I still believe concentration of risk in derivatives markets remains a big danger to our financial system. I agree with many that the ability to hedge bets is useful, and that ultimately more and better derivative instruments, hedge funds etc. will make our system better, not worse. But I fear that our current regulatory system is not yet up to the task. We are still vulnerable. Maybe we live in one of those times when basic problems will not be fixed this side of severe crisis, just as John Kenneth Galbraith argued was the case in the Roaring Twenties. Or maybe some of us worry too much.

Two books that seem important, at least to me, are: Peter L. Bernstein's Against the Gods: The Remarkable Story of Risk, and Roger Lowenstein's When Genius Failed: The Rise and Fall of Long Term Capital Management. Neither of these books help to calm my nerves, but both give insight into our current plight. If others want to serve up other books (blog posts or whatever) to help calm my nerves, please do.

I heard early this week that more than eight in 10 US citizens are optimistic about their future, despite recent and continuing political messes, wars, etc. I wonder what drugs they've been taking. It all reminds me of Soma from Aldous Huxley's Brave New World, or better still Huxley's nonfiction follow-up Brave New World Revisited.