Saut: “The Big W?!”

From Jeff Saut of Raymond James: Paraphrasing comments by Ken Dupre a particularly bright portfolio manager at the Muhlenkamp organization:

The two most important market trends I see today:

1) Banks and brokerages are being forced to de-lever as they bring their SPE (Special Purpose Entities) on to the B/S (balance sheet):

• Increased margin requirements are forcing hedge funds to de-lever.
• De-leveraging will lead to a decrease in consumer, corporate and commercial real estate credit.

This will cause decreased spending for consumers, poor credit businesses and commercial real estate.

2) Legislation:

• CNBC talked about legislation adding margin requirements to CDSs (Credit Default Swaps, a $45 trillion world market). Many in the commodities market have been using some form of CDS instead of commodities futures because there currently are little to no margin requirements. If rules for CDSs are changed, it would force a lot of selling of commodity CDSs.
• There are also possible legislative limitations on commodity trading, which would produce similar or add to CDS requirements.
• It is clear to me that the increase in asset allocation (money flow) to commodities by pensions and the public has been a major contributor to the driving of higher oil and other commodity prices. And if commodity buying dries up (prices looking awfully high), there should be one strong down draft.

Note: The Big W in the title refers to an earlier part of Mr. Saut's article discussing potential shapes of the economic decline and recovery.

Treasury Market Volatility explodes on Black Box Retreat

Elizabeth Stanton and Daniel Kruger for Bloomberg on Black box quant traders pulling out of the treasury market:

Treasury Market Volatility Increases to Highest in Three Years

The retreat by so-called black-box traders and hedge funds caused orders for Treasuries to drop as much as 80 percent

During my lifetime of trading I have traded in and through many crisis events, Hunt silver collapse, 87 stock market crash, 98 LTCM blowout, 911 market shutdown, and the current subprime money market debacle. The one thing they all have in common is the evaporation of liquidity. I always hear stupid remarks like this one:

“We were seeing things that were 25-standard deviation moves, several days in a row,” said David Viniar, Goldman’s chief financial officer

The same kinds of idiocy were spouted by the Nobel winners at Long Term Capital Management. The flaw in these statements is the unstated assumption that the "model" is complete. The model is not complete because these models invariably make the implicit assumption that market liquidity is a constant. Nothing could be further from the truth. The one characteristic of big market panics is the shift from analysis of fundamentals like interest rates or earnings to a focus on preservation of capital and deleveraging. We all become Will Rogers who is reputed to have said "I am not so concerned about the return on my capital but the return of my capital." From return on to return of is a very significant change when the entire market place makes the switch.
If we take the distribution of prices only from periods of collapsed liquidity Mr. Viniar's 25 standard deviations become more like 1.7.
Every quant should tatoo on the back of his/her hand " the market is right not the model".

PS. there is a nice Wiki on the LTCM event.

Volume drop due to vacations or wounded quant funds?

Ticker Sense posts a chart showing the sharp decline in volume on the NYSE recently. They wonder if this is due to extensive August vacations does it mean we could see some bargain hunters back in the market after Labor Day.
Vacations are surely part of the reason for lower volumes but, I think the carnage in quantitative hedge fund results is also a big factor. I know in the fixed income sectors of the market liquidity has diminished significantly. Arbitrage strategies between futures contracts and cash securities are usually traded heavily by automated electronic systems based on statistical correlations. We have seen bid ask sizes drop by 80% in some markets as many of the arbitrage funds have pulled out of the market. Some will be back as the markets normalize again but some have blown up and will not return.
The equity markets too, have many of these types of funds operating in normal times. I believe more than 30% of NYSE volume is usually program trading which is nothing more than statistical arb driven by computer algorithms. I have no numbers on how many of these players have been hurt by recent market action but I am sure the drop in volume is partially caused by a shrunken level of mean reversion strategies.

who is swimming naked

The title is the ending of one of Warren Buffett's favorite sayings " It is not until the tide goes out that you find out who is swimming naked." The tide has gone out in the short term money arena and a few folks are looking redfaced. The Wall Street Journal discusses the SEC looking at irregularities at Sentinel Management Group. This is likely to be only the first not the last instance of suitless swimmers. Thanks to Between The Hedges for pointing out this article.

The Fed to the Rescue!

Accrued Interest writes a good article about Bernanke, the Fed, and how they are reacting to the subprime led liquidity crisis.
I know wall streeters and Cramer were all panicking and crying for mommy to do something. Well the Fed did do something friday. They injected huge cash reserves in to the banking system by accepting various types of mortgage securities as collateral for short term loans. This effectively put a value on securities that banks were refusing to use as collateral because there was no viable quote to use as a valuation method. Billions of dollars of collateral ( fewer billions than a few weeks ago ) were temporarily rendered valueless because the participants in that market had withdrawn. The fed properly stepped in to restore some normalcy and prevent further contagion so that a general credit crisis would be averted.
I am not normally a fan of government intervention in markets, but this is precisely the proper role of the Fed in a market spasm. Bernanke and friends took a very targeted approach and addressed the exact problem rather than cutting rates. The liquidity crisis was not because of rates being too high it was due to lending not being available. What difference does the interest rate make if I cannot get a loan in the first place?
I applaud the Fed's action and am reassured some about Ben Bernanke's abilities to take the heat and perform.
Restoring normal credit conditions to the market is the right move. Bailing out a bunch of over leveraged hedge fund managers is not the job of the Federal Reserve.

stock market looking troubled tonight

A distinct change to the negative in tone tonight in Bloomberg headlines:

July 31 (Bloomberg) -- Bear Stearns Cos., manager of two hedge funds that collapsed last month, halted redemptions from a third fund after investors demanded their money back.

Aug. 1 (Bloomberg) -- The yen gained, after posting its biggest monthly advance in more than a year against the euro, on concern that losses from U.S. subprime mortgages will push investors to pare riskier investments funded by loans in Japan.

July 31 (Bloomberg) -- On Wall Street, Bear Stearns Cos., Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Goldman Sachs Group Inc., are as good as junk.

July 31 (Bloomberg) -- Jeremy Grantham, the money manager who oversees $150 billion as chairman of Grantham, Mayo, Van Otterloo & Co. LLC, said credit-market declines may force as many as half of all hedge funds to close in the next five years.

These are just some of the lead paragraphs of negative news stories much of it appearing late this afternoon. Markets are already showing nervousness in the thin overnight trade.

Whoops!

Bear Stearns Tells Fund Investors `No Value Left' (Update1)

By Yalman Onaran

July 18 (Bloomberg) -- Bear Stearns Cos. told investors in its two failed hedge funds that they will get little if any money back after ``unprecedented declines'' in the value of AAA rated securities used to bet on subprime mortgages.