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Liquidity Not There When it's Needed Most

Fri, Aug 10 2007, 06:34 GMT
by Comstock Partners Team

Comstock Partners Inc.

Whatever happened to liquidity? Although the major argument of the bulls was the abundance of global liquidity, the ECB was suddenly forced to inject $130 billion into the European banking system followed by a Fed injection of $24 billion into the U.S. banking system. The immediate cause was the suspension of redemptions by three funds run by PNB Paribas, France’s biggest bank. The problem was that the funds held positions tied to U.S. subprime mortgages and couldn’t value its holdings. We have been saying for some time that the subprime problem would spread due to the fact that were hundreds of billions of dollars of related securities in portfolios that had not marked them to market. What we and others did not know is where these securities were after being sliced and diced and resold numerous times as part of CDOs, most of which ended up being rated Triple-A. As Art Cashin of UBS said, the problem is that "We don’t know what we don’t know, and we don’t know anyone who knows what we don’t know."

It’s not that there weren’t any warnings. Two years ago an IMF report pointed out the dangerous combination of massive amounts of debt, global imbalances and huge amounts of outstanding derivatives. Former Federal Reserve Chairman Paul Volcker issued similar blunt warnings. New York Federal Reserve President Timothy Geithner also expressed as much concern as he could in his official position. Even Treasury Secretary Paulson, soon after taking office, told a well-known political columnist that he was worried about a long over financial incident. All of these were noted in comments we made at the time that are in our archives.

More specifically, six months ago on February 8 HSBC announced $1.76 billion in write-offs due to losses on subprime mortgages. Around the same time New Century Financial (remember them?) announced that they lost money in the 4th quarter and would have to restate earnings for all of 2006. Those two announcements were the canaries in the coal mine, but were moistly ignored by the vast majority of the investment community. Over the last six months there has been a series of announcements by various financial companies including outright shutdowns, big write-offs, employee layoffs and other pronouncements from various company executives indicating how bad the mortgage situation was getting. Through it all most economists and strategists were vigorously denying that would be any contagion throughout the financial industry or the real economy, and many are still in denial as we write.

In our view the facts are still leaking day by day and the carnage is far from over. Even the quant-oriented hedge funds that are supposedly market neutral are apparently not immune from the chaotic conditions in the credit markets. In a letter to shareholders sent on Wednesday, Black Mesa Capital, a Sante Fe-based hedge fund that uses quantitative techniques, said that at least one large hedge fund is liquidating massive trading positions. The warning is said to be causing disruptions and triggering big losses among other market neutral hedge funds. The letter stated that "Clearly something is amiss in the market that few in our strategy, if anyone, have experienced before." This follows reports that Global Alpha, a Goldman Sachs $9 billion hedge fund had suffered steep losses and is selling positions. This is a potentially ominous development as many hedge funds have similar positions and use a lot of leverage. As some funds liquidate positions and knock prices down, others may be forced to do so as well, setting in motion major negative feedback In addition many now allow monthly withdrawals, meaning that other funds may have to suspend redemptions.

All in all the credit crisis appears to be snowballing with no end in sight, and a bailout by the GSEs or the Fed will be extremely difficult to achieve. Even if the portfolio restraints on the GSEs are lifted they must follow the new restrictive guidelines just recently issued by the regulators. As for the Fed, even easier money would be no panacea now as the problem was too much debt in the first place, the housing situation is still worsening and the risks in the financial area so widely spread. In our view the risks to the stock market remain extremely high and far lower levels are likely.

Published on  Fri, Aug 10 2007, 06:32 GMT