Speculative Finance and Liquidity Bulges
Credit Bubble Bulletin, by Doug Noland
August 20, 2004
<snip>
Pondering Nuances of Contemporary Speculative Finance:
August 18 - Dow Jones (Michael Mackenzie): “The desire to chase better returns in a low yield environment is driving already strong demand for structured credit derivative deals. Not surprisingly, hedge funds, who usually stand to reap 20% of the profits they make for clients, are leading the way. Underperforming hedge funds are looking to load up on credit risk via collateralized debt obligations or the fast maturing high yield debt market, say credit derivative traders. Whether the strategy backfires or pays off depends on how risky corporate borrowers fare over the coming quarters as the Federal Reserve hikes interest rates into what appears to be a decelerating economy… So for hedge funds not faring well, a choice looms between making bigger sized bets or increasing their appetite for high yield, or riskier corporate credit, said a credit derivatives trader at an investment bank in New York. ‘The underperforming guys face having to take a swing at the market.’ As a result, demand for higher exposure to such debt via collateralized debt obligations - built upon credit default swaps - has been buoyant in recent months.”
The New York Times this morning reported that Barton Biggs’ Traxis Partners has posted losses this year (down 7% through July), “partly because of a bearish bet on the price of oil…” There seems to be little doubt that some speculators and derivative players have faced a painful squeeze as energy prices have surged higher. Some analysts had argued that commodity prices were being pushed upward by speculative buying. That said, there have as well been significant bearish bets placed – oil and gold, for example – whose unwind supports higher prices. Welcome to the Unstable World of Speculative Finance.
I would conjecture that Mr. Biggs succumbed to placing a wager on lower crude prices because he lacked conviction as to how stellar returns could be achieved elsewhere for his $2 billion hedge fund. Coming into the year, the bond market offered an unattractive risk/return profile, and prospects for equities were dicey at best. Commodities had already made a major move, with the near-term outlook especially uncertain. And for many speculators that have been stung by bad bets (i.e. technology stocks and interest-rates), there is now the inclination to reach for stronger returns (and risk) wherever they can be garnered. The CDO (collateralized-debt obligations) and Credit default swap markets (see the excerpt from the Dow Jones story above) fit the bill, augmenting already ultra-easy Credit Availability.
Similar to writing catastrophic risk insurance policies, Contemporary Finance does empower a speculator with the opportunity to enjoy the fruits of receiving large risk premiums, all the while hoping that inevitable losses are delayed for at least a few years (earning 20% of “profits” along the way). However, the problem with a boom in writing Credit insurance (or “flood” protection) is that the resulting Credit boom ensures both financial and economic distortions, along with eventual busts.
I find the nature of speculative finance absolutely fascinating. I have done battle and studied speculative dynamics on the short-side now for almost 15 years. In the process I have witnessed innumerable spectacular squeezes (including the historic technology and Internet melt-ups during 1999/early 2000) followed generally by rather abrupt and often only more spectacular collapses. Speculative Bubbles do create their own liquidity, although long periods of liquidity over-abundance can end quite suddenly. And now - as shorting myriad securities, instruments, commodities, and markets has become such a prominent aspect of contemporary, securities-based finance - I do ponder the ramifications with respect to systemic stability.
Examining the mechanics of an equity short position will hopefully provide some basic insight. To short a stock, we must first call the stock loan department at our prime broker. Shares are borrowed from a pool of available securities (from institutions seeking extra remuneration, or perhaps holders that purchased their shares on margin). These borrowed shares are then sold into the marketplace. A couple of additional facets of this simple example are worth noting. First, additional shares circulating in the marketplace (“float”) are created by selling borrowed securities, and a heavily shorted stock could experience a significant increase in outstanding “float.” Second, proceeds from the short-sale are segregated into a restricted account at the brokerage (to be invested in money market-type instruments). The sale of borrowed securities creates (after settlement) immediately available funds at the brokerage.
Conceptually, it would seem that shorting stock – because of the selling pressure and the creation of an additional supply of shares - would weigh on the stock price. At the same time, selling additional shares would seem to impinge marketplace liquidity. But, as is often the case in life, things are generally not as simple as they appear.
First of all, despite an increase in the supply of shares, market dynamics often dictate upward pressure on shorted stocks. Markets are, after all, truly an ongoing battle between fear and greed. If a heavily shorted stock continues to rise, the longs will be emboldened while the shorts will fear escalating losses. The actual supply/float may play a less than important role in determining short-term prices. Rising asset prices generally create their own speculative demand, often irrespective of supply. And when a heavily shorted stock surges higher there are greater quantities of inflating shares and a larger amount of perceived wealth creation.
As for system-wide liquidity, shorting can have divergent and unexpected impacts. First of all, proceeds from the short-sale are placed in restricted accounts and these funds are then used to purchase short-term liquid instruments, including asset-backed securities and “repos”. As such, funds from short-sales provide a source of additional finance elsewhere, including for speculative purposes. In addition, unfolding “short squeezes” will commonly attract keen speculative interest. Aggressive long positions will be taken, often with leverage (augmenting system liquidity).
Contemporary finance and derivatives also provide a (too) convenient mechanism with which to handily satisfy the impulses of either greed or fear. Options and derivatives certainly were a major factor in fueling the technology “blow-off.” On the one hand, they provided highly leveraged instruments whereby one could easily participate in the parabolic rise on the long side (and, at the time, who wasn’t hankering to do that!). On the other hand, options and derivatives were also used (sometimes in desperation) to mitigate disastrous bearish short positions that were being squeezed to the moon. In either case, rising prices forced the writers of these instruments to implement leveraged long positions to hedge escalating risk. And, all the while, liquidity flush technology companies were buying back their stock and often dabbling in the derivatives market.
The upshot was a self-reinforcing speculation and liquidity melee that propelled a period of acute Monetary Disorder. Securities market dynamics had come to marshal a massive liquidity bulge that was both destabilizing and unsustainable. From stratospheric “blow-off” over-valuation, prices and speculative dynamics eventually reversed. And with the bursting of the Bubble, inflated quantities of shares trading in the marketplace, huge leveraged speculative long positions, and massive derivative-related leverage provided a powerful confluence of forces that assured collapse. As it was, it took only a few short months for a manic and historic Bubble to give way to a devastating marketplace illiquidity and an industry bust.
A strong argument can be made today that shorting, derivatives, leveraging and speculative dynamics have taken firm hold throughout the largest market in the world - the U.S. Credit market. And while I certainly cannot profess to understand and appreciate the various facets of this most opaque and complex marketplace, I do strongly believe that market dynamics have once again fostered a massive destabilizing liquidity bulge – a bulge that is over-liquefying various markets and keeping global market rates at artificially low levels (and in the process, accommodating and exacerbating dangerous imbalances).
According to most recent Fed data, primary dealer “repo agreements” have almost reached $3.0 Trillion. These financing arrangements are up an astonishing $446 billion over the past year, an 18% increase. The only comparable growth throughout the world of finance is the approximate $690 billion, or 27%, y-o-y increase in global central bank currency reserve positions. And I certainly do not view these two Bubbles as unrelated coincidences. Massive Credit market leveraging (of which the “repo” market is surely the most significant) is the instrumental source of excess domestic and global liquidity that is then (buyer of last resort) “monetized” and “recycled” right back into U.S. securities markets.
I have little doubt that the “repo” market and ballooning central bank balance sheets are at the epicenter of today’s unwieldy liquidity creation, yet the specifics are not easily comprehended. There are, after all, many extraordinary facets to the analysis of contemporary liquidity, including the predominance of the securities markets (as opposed to traditional banking and “money” supply).
Let’s ponder a couple of examples. For example #1, the Bank of Japan purchases newly issued notes from the U.S. Treasury. Treasury uses this liquidity to pay government employees year-end bonuses. Government employees then use these bonuses to fund their pensions and buy imports. The liquidity is then quickly directed right back to U.S. securities markets, perhaps completely bypassing the monetary aggregates while providing the impetus for additional credit creation and securitization.
For example #2, a hedge fund borrows and shorts Treasuries and then uses sales proceeds to take a leveraged position in mortgage-backed securities (MBS). Here, unlike when proceeds from equity short positions were segregated into restricted accounts, a good hedge fund client can use the funds generated from Treasury shorts to acquire higher-yielding securities (MBS, agencies, corporates, CDOs, junk, emerging market debt, etc.) And in this example, the Bank of Japan purchases the Treasuries (using dollar balances exchanged for yen with Toyota’s Japanese bank). Having bought new MBS from the proceeds of the Treasury short sale, the hedge fund transaction provided liquidity to Countrywide to make additional mortgage loans. These additional mortgage loans provided the finance for consumers to sustain consumption, including the acquisition of more Toyota and Lexus vehicles. And the liquidity goes round and round…
Note that central bank Treasury purchases create liquidity for the risk-taking hedge fund (and, more generally, the Leveraged Speculating Community) and then the MBS marketplace, thus creating new Credit/purchasing power for the household sector. This liquidity could then flow right back to Toyota, the Bank of Japan, the hedge fund community, the MBS marketplace and/or the American consumer. Liquidity expands unrestrained right along with the increase in marketable debt (increasing quantities of MBS and Treasuries “float”). And with rapid mortgage Credit growth fueling the economy and home prices (keeping Credit losses minimal), the attractiveness of the spread trade – shorting Treasuries and buying MBS – only increases over time. The Great Mortgage Spread trade balloons over the years.
Let’s ponder a more complex example: Here, a hedge fund uses “repo” financing to take a $1 million leveraged position in mortgage-backeds. In this example, there are six players: the hedge fund, the securities dealer, a pension fund, an MBS trust, Bank of Japan, and household sector. First, the securities dealer borrows $1 million of bonds from the pension fund. The dealer then shorts these Treasuries, selling them to the Bank of Japan. The dealer then uses this liquidity to finance the hedge fund’s MBS “repo.” The hedge fund then purchases mortgage-backeds held by the pension fund. The pension fund, now with $1 million of immediately available funds, chooses to invest these funds temporarily in money market instruments. In this example, these funds are borrowed by the securities dealer, and immediately lent to the hedge fund as it acquires $1 million of new MBS from MBS Trust. This purchase provides liquidity for the Trust to acquire additional mortgages from mortgage brokers across the country, providing the liquidity to finance additional household borrowing and spending (and more trade deficits and foreign central bank securities purchases). And as long as speculative leveraging expands, the economy grows, interest-rates remain low, and foreign demand for U.S. securities is sustained, liquidity will be abundant throughout the entire Credit system.
In a world of debit and Credit journal entry Contemporary Finance, securities finance – whether it is through shorting Treasuries or borrowing in the “repo” market – creates seemingly endless system liquidity. Liquidity and Credit excess work to seductively underpin the value of the underlying securities. Liquidity empowers the issuance of additional marketable securities, and securities leveraging exacerbates liquidity excess. And that is why they are called Bubbles. And, in similar dynamics to the short squeeze example examined above, the increasing supply of securities and leverage in the marketplace remains seemingly benign, at least as long as the price of these securities is not declining.
Today, massive trade deficits foster unprecedented foreign Treasury buying. Domestically, a steep yield curve and heightened systemic risk boost demand for Treasuries. Indeed, there is today a virtually insatiable appetite for Treasury securities. This dynamic is quite accommodative for speculator funding of higher-yielding risky securities through government bond short-sales. And these transactions then create abundant liquidity that is dispersed throughout the Credit system, in the process sustaining the Credit and economic Bubbles.
But acute demand for Treasuries in the face of a massive and growing short position does create a rather volatile mix of unpredictable market dynamics - including inherent volatility and acute short squeeze vulnerability. And contemplating my experience with short squeezes, it is fascinating how they often go “parabolic” right when it should be apparent that fundamental deterioration is accelerating. This was conspicuously the case in early 2000 for the Internet, telecom and technology sectors. Indeed, negative fundamental developments encourage short sales and hedging, although market dynamics often dictate that the bulls and “greed” inertia maintain the upper hand in the marketplace well beyond the point when fundamentals have turned south.
Understandably, with the dollar sinking, energy prices surging, inflation rising, market rates extraordinarily low and demand for mortgage Credit exceptionally strong, many hedges were implemented to protect against higher rates (especially in the mortgage arena). And, wouldn’t you know, the imbalanced U.S. Credit system and economy have proved incapable of generating robust job creation and expected (balanced) economic performance. The hyper-sensitive Treasury market (over-liquefied markets and insatiable demand for govt. debt) have rallied, and it would appear a major short squeeze has developed. It is again worth noting that the terminal “blow-off” technology squeeze and resulting final liquidity bulge sealed the fate for much of the industry. Similar dynamics are now in play throughout mortgage finance.
prudentbear.com |
