Manhattan Apartment Sales Drop Furthest in 18 Years

The 1990-1991 recession hit New York City particularly hard, with deep cuts in Wall Street jobs. The city has become even more dependent on financial services, so a similar or deeper contraction in percentage terms would have an even greater impact. We're getting a first whiff via the fall-off in apartment closings.

One assumption have been that foreign buyers would hold up the market. However, as non-residents, they would add much less to the tax base, and if government services are cut back, Manhattan may not look like such a desirable place to live.

From Bloomberg:

Manhattan apartment sales plunged the most in 18 years in the first quarter as buyers faced the prospect of a recession and job cuts at Wall Street securities firms.

Sales fell 34 percent from a year earlier and inventory rose 4.6 percent to 6,194 units, New York-based real estate appraiser Miller Samuel Inc. and broker Prudential Douglas Elliman Real Estate said in a report today. The median price of a Manhattan co-operative apartment or condominium increased 13.2 percent to a record $945,000.

``If it continues along this pattern, we're in a period of transition to a weaker market,'' Miller Samuel President Jonathan Miller said in an interview. ``You typically see a slowdown in sales activity precede a slowdown in pricing.''

Financial companies have cut at least 34,000 jobs in the past nine months as losses and writedowns related to mortgage- backed securities climbed to at least $230 billion. Wall Street drives Manhattan real estate, with the median apartment price roughly tracking bonuses paid by investment banks since 1997, Miller said.

``There are a lot of buyers out there,'' said Prudential Douglas Elliman Chief Executive Officer Dottie Herman.

``It's not that they're not looking, but there is no sense of urgency,'' she said. ``If you continue to see inventory rise, that would be a sign that you are going to see a price dip.''

Until now, Manhattan has avoided the national housing slump. Last year, the U.S. saw the first drop in existing home prices since the Great Depression, while Manhattan apartment prices rose 3.6 percent, according to Miller Samuel.

Gains continued in the first quarter, according to today's broker reports. The Corcoran Group said the median for condos and co-ops rose 9 percent to $917,000. Terra Holdings LLC, which owns brokers Brown Harris Stevens and Halstead Property LLC, said the median climbed 13 percent to $855,000. The numbers vary in part because each broker includes some of its own sales that have yet to show up in the city's public records database.

About 30 percent of all first-quarter closings were for apartments in new developments that went into contract before turmoil hit the credit market, said Gregory Heym, chief economist for Terra Holdings.

``They are pre-credit crisis, pre-Wall Street worries, pre- new mortgage standards,'' he said in an interview. ``You see a delay in impact in these numbers.''....

Apartments are already taking longer to sell. The average time spent on the market rose 12 percent to 146 days, according to Miller Samuel....

The average price per square foot of a Manhattan co-op rose 16 percent to $1,128 for the quarter, Miller said. For condos, the price per square foot gained 21 percent to $1,416. Co-ops make up more than two-thirds of Manhattan apartments. Residents of them buy shares in a corporation that owns the building, rather than having a deed to the property itself.

On the East Side, the greatest price appreciation was in apartments with at least four bedrooms, with the average rising 53 percent to $13.6 million, according to Brown Harris Stevens. On the West Side, three-bedroom apartments gained 90 percent to an average of just under $5 million.

Prices on Fifth Avenue jumped 63 percent in the quarter to a median of $6.5 million, and on Park Avenue the median jumped 23 percent to $3.3 million. The median price of lofts fell 12 percent to almost $1.45 million, Corcoran said.

The luxury market also saw big increases, largely due to multimillion dollar condominium sales at the recently converted Plaza, and at architect Robert A.M. Stern's 15 Central Park West.

The median price of a luxury apartment rose 46 percent to almost $5 million, Miller Samuel said. Corcoran's estimate was an increase of 18 percent to $4.4 million. Both companies consider apartments of more than $2.8 million as luxury.

``There is no question 2007 was the record year for real estate in New York City,'' Liebman said. ``I don't think any of us will be surprised if 2008 doesn't hold up in comparison.''

IMF Cuts World Growth Forecast

Bloomberg tells us that the IMF has lowered its global growth outlook due to the severity of the financial crisis, yet for those of us living in advanced economies, the discounted level of 3.7% still sounds pretty robust. I did go to the IMF website to see how the forecasts changed for the first versus the third world, but found no link (the latest news releases is April 1). I assume that will be remedied shortly.

From Bloomberg:

The International Monetary Fund cut its forecast for global growth this year, citing the worst financial crisis in the U.S. since the 1930s Great Depression.

The world economy will expand 3.7 percent in 2008, according to a document titled ``IMF Background Paper on the Update of the Global and Regional Outlook'' obtained by Bloomberg News at a meeting of Southeast Asian deputy finance ministers and central bank officials in Da Nang, Vietnam. In January the fund projected world growth of 4.1 percent.

``The financial shock that originated in the U.S. subprime mortgage market in August 2007 has spread quickly, and in unanticipated ways, to inflict extensive damage on markets and institutions at the core of the financial system,'' the statement said.

``The global expansion is losing momentum in the face of what has become the largest financial crisis in the United States since the Great Depression,'' it said.

The IMF gave a 25 percent chance that global growth will drop to 3 percent or less in 2008 and 2009, a pace the fund described as equivalent to a global recession.

``The greatest risk comes from the still unfolding events in financial markets, particularly the potential that big losses related to the U.S. subprime mortgage market and others sectors would seriously impair financial system capital and initiate a global de-leveraging that would turn the current credit squeeze into a full-blown credit crunch,'' the statement said.

The IMF lowered its forecast for U.S. economic growth to 0.5 percent this year, according to the document, below a 1.5 percent prediction made in January. The world's biggest economy will expand 0.6 percent in 2009, it said.

The euro region will expand 1.3 percent in 2008, the document said, down from the fund's 1.6 percent projection in January.

Although this is largely anecdotal, a story in today's New York Times on the 45% fall in the Shanghai stock market illustrates how precarious prosperity can be in emerging economies, Keep in mind that the fall was induced primarily by increases in interest rates, rather than a marked slowing of the economy. Nevertheless, short-sighted banking policy virtually guaranteed a stock market bubble, since deposits pay interest at a rate of 1% when inflation is 7-8%. Savers thus need to put their holdings at risk to avoid losing out in real terms.

From the New York Times:

A year ago, investors like Guan Ling were ebullient. Chinese share prices had climbed over 500 percent in the span of two years, setting off a nationwide stock buying frenzy....

That was last year. The Shanghai composite index has plunged 45 percent from its high, reached last October. The first quarter of this year, which ended Monday with a huge sell-off, was the worst ever for the market.

Suddenly, millions of small investors who were crowding into brokerage houses, spending the entire day there playing cards, trading stocks, eating noodles and cheering on the markets with other day traders and retirees, are feeling depressed and angry.

"These days my family quarrels a lot," says Zhang Liying, 55, a retired hotel waitress who with her husband invested all their savings in the stock market. "My husband asked me to sell; I wanted to hold for a while. Now my husband condemns me as so stupid that we lost our family's savings."

Si Dansu, 68, and a retired engineer, is even more distraught, but she blames the government.

"I devoted my whole life to the country. I went to the countryside after graduation, and worked as an engineer in a Shanghai factory until retirement. I invested almost all my savings and retirement fund in the market 10 years ago. But now I'm totally penniless. All my stocks went down."

Other parts of Asia are as bad, or worse. In India, stock prices have plunged 31 percent in Mumbai; they are off 31 percent in Japan and a whopping 53 percent in Vietnam, another booming economy. Angry investors have burned a securities regulator in effigy in Mumbai, and some are in tears in Ho Chi Minh City, Vietnam.

"Some of them have cried," says Nguyen Quang Tri, 74, a retired cement company manager who was visiting a Ho Chi Minh City brokerage house this week. "I have my own equity, but most of the people here borrowed money from the bank."....

Few experts say the stock plunge is a major threat to growth in the real economy here. But there are worries that a prolonged downturn could reverberate through China's financial markets — especially since a large number of corporations had aggressively shifted money, sometimes secretly, to play the market.

By some estimates, 15 to 20 percent of the profits reported last year by publicly listed companies in Shanghai that are not involved in banking or finance (which usually invest in stocks) came from stock trading gains.

Companies with primary businesses like selling electricity, or even sports jackets, were moonlighting by trading stocks, hoping to bolster their earnings....

But the big companies were following the small investor. JPMorgan estimates that 150 million people in China were invested in the Chinese stock market as of the end of last year. That may still be a small slice of China's 1.3 billion people, but it is a huge new constituency, and it has led to the birth of both a new source of potential popular discontent and a new lifestyle: the diehard investor...

Shopkeepers, real estate brokers, even maids and watermelon hawkers are said to have become day traders.

A new version of the national anthem made its way around the country last year, beginning, "Arise! Ye who haven't opened an account! Pour your gold and silver into the hot market!"

The anthem went on: "The Chinese nation faces its craziest time. The passionate roar of our peoples will be heard!"...

In some brokerage houses, entire floors are divided into small and midsize rooms that investors camp out in, from opening to closing bell, with their lunch bags, knitting gear, playing cards and newspapers to help them feel at home.

Only now, many investors cannot bear to look at their screens.

"I'm getting out of the game," said Yuan Yuan, 23, a researcher at a fund company in Shenzhen who also invests on his own. "The game is over. Big institutions pulled out first, only leaving the small investors."

In China, the government fears that angry investors can be a social problem. And so while the state-run media report on the ups and downs of the market, and even warn investors of the risks and pitfalls of investing, the press does not usually report on investors' anger....

"It's a deformed market, an unhealthy market," Mr. Guan says. "We've always had long bear markets and short bull markets."

"Look," he said, "it took two years to go from 1,000 to 6,000 but two months to go from 6,000 to 3,500."

Congress Plans to Move Fast on Homeowner Relief

According to the New York Times, Congress is suddenly keen to get a homeowner bailout program in place, and made a rare bipartisan show of a joint news conference, with the hope of tabling the bill as soon as noon Wednesday.

Key elements:

At a minimum, the bipartisan package was expected to include up to $200 million to expand counseling programs for homeowners at risk of foreclosure, $10 billion in tax-exempt bonds for local housing authorities to refinance subprime loans, $4 billion in grants for local governments to buy foreclosed properties and a $15,000 tax credit for purchasers of foreclosed homes or newly built homes that have been sitting vacant.....

Both the Senate Banking Committee and the House Financial Services Committee have been working on bills that would allow the Federal Housing Administration to insure $300 billion to $400 billion in additional mortgages, with an upfront cost of $10 billion.

As the Times notes, despite the big numbers being thrown about, it isn't at all clear how many will be helped. First, any plan would have tough approval requirements and require borrowers to demonstrate the ability to repay. Second, the servicers would have to write down mortgage balances voluntarily and then the loan could be refinanced through the FHA (although the Democrats are trying to revive proposed changes to the bankruptcy laws that would allow judges to write down mortgages to the value of the collateral).

Moreover, even die-hard liberals are voicing reservations:

Critics warn that taxpayers could get stuck with a huge bill if large numbers of borrowers defaulted yet again.

That risk is especially great in places like Las Vegas and Phoenix, where home prices are falling fast, said Dean Baker, the co-director at the Center for Economic Policy Research.

"In the bubble-inflated markets, you still have a long way to go down. That's one of the things that I don't think people have fully appreciated," he said.

What got us in this mess in the first place is that America has the most heavily subsidized housing market in the world. Is more of the same a wise solution?

Desperate Measures to Tackle Credit Crisis Discussed

A Financial Times story reports that the Financial Stability Forum, which is tasked with finding remedies to our credit crisis, is circulating a paper which suggests some radical possible solutions. The fact that these measures are under consideration says that the authorities do not expect a resolution any time soon.

One paragraph caught my eye:

Among the ideas floated was getting a large group of the most important banks simultaneously to disclose their financial positions based on a "common template" including information on the prices attributed to different securities and the methodologies used to derive them.

This would include standardised disclosure of exposures to collateralised debt obligations, residential and commercial mortgage-backed securities, leveraged finance, exposure to off-balance sheet entities and capital and liquidity resources. One party present said there was widespread interest in this idea.

This is a stunning request. The banking authorities don't already posses this information? What were they doing in their regulatory reviews, drinking sherry while listening to PowerPoint presentations? Regulated entities should be reporting on a periodic basis, in formats dictated by the regulators, and that ought to include their pricing methodologies. Otherwise, any data gathering is a garbage-in, garbage-out exercise.

This development confirms my worst suspicions. The regulators weren't merely out-maneuvered by bankers skilled in deception financial wizardry; they enabled it by taking a "see no evil, hear no evil, speak no evil" stance.

The only thing that might make this need defensible is if various national regulators have widely differing frameworks for data compilation, and a one-shot probe is needed to calibrate them. But the FT article did not give that impression. If anything, it implied that the FSF was having to pressure recalcitrant central bankers and financial regulators.

From the Financial Times:

Radical strategies to fight the credit crisis including temporary suspension of capital requirements, taxpayer-funded recapitalisation of banks and outright public purchase of mortgage-backed securities are being actively discussed by governments and central banks.

These were among possible next steps discussed in Rome on Friday at a meeting of the Financial Stability Forum, the body co-ordinating the global response to the market turmoil....

The steps are set out in an options paper prepared for governments, banks and regulators by the FSF, led by Mario Draghi, the governor of the Bank of Italy, a copy of which has been obtained by the Financial Times....

The FSF floated temporarily suspending capital and reporting rules that tie prudential requirements to market values of securities.

Regulators could temporarily change capital rules under Basel II to allow trading assets to be treated as available-for-sale, reducing their impact on capital calculations.

Alternatively, regulators could temporarily relax regulatory capital minimums wholesale, the FSF said. It noted that an alternative approach would be to suspend accounting rules for some assets, but said this could "damage market confidence."

Authorities could organise a consortium of long-term private investors to buy mortgage assets from banks, possibly with state "co-investment" or governments could buy assets outright.....

The FSF raised the possibility that governments might want to "announce a coordinated operation to boost capital simultaneously in a number of institutions" with the help of public funds, to avoid stigma problems.

Central banks could further expand their liquidity support operations, including expanding the eligible collateral and providing emergency liquidity support to troubled institutions.

Many of the FSF's ideas are likely to encounter resistance from governments and central banks, but the fact they are being mooted points to policymakers' concern about the outlook and willingness to explore unorthodox solutions.

Stock Hedge Funds Hold Record Cash Positions

Bloomberg reports that stock hedge funds carried unprecedented levels of cash in the first quarter, which is usually considered to be a highly bullish sign. However, note that their cash levels fell by 28% from January to February due to deleveraging (which may not have been entirely voluntary given new tough-mindedness on behalf of prime brokers).

Some observers anticipate that there will be a large number of hedge fund closures this year, so high cash levels in hedge funds may not be a conclusive a bull market indicator as high cash balances in more conservatively managed mutual funds is.

From Bloomberg:

Stock hedge funds, unsure about which direction the markets would move, sat on a record amount of cash as the industry headed for its biggest quarterly decline in almost six years.

Equity managers, who oversee about one-third of the $1.9 trillion in hedge funds, held an estimated $90 billion of cash in January, a hoard that dropped to $64.8 billion the next month, according to data compiled by Merrill Lynch & Co. analyst Mary Ann Bartels. The last time equity funds held cash outside of their trading accounts was in 2004, according to Merrill. At that time, market direction was also unclear, with the Standard & Poor's 500 Index up less than 2 percent through October.

``The data indicates to us the equity hedge funds have de- leveraged and have record cash balances,'' she wrote in a report last week. ``Margin debt has declined sharply in recent months as investors have grown more cautious on the U.S. equity market.''

Hedge funds dropped an average of 2.83 percent this year through March 28, according to Chicago-based Hedge Fund Research Inc.'s Global Hedge Fund Index, which is updated daily with a two-day delay. If the decline holds, it would be the biggest in a quarter since a 3.85 percent drop in the second quarter of 2002 for HFR's Weighted Composite Index...

``Hedge funds have not covered themselves in any form of glory in this quarter,'' said Paul Ross, chief executive officer of London-based Iveagh Ltd., the investment arm for the Guinness family brewing fortune. ``They've been extremely difficult markets for hedge funds in general.''....

Strategies that should profit as stocks and bonds decline have also been hurt because of short-term rallies as the U.S. Federal Reserve takes steps to restore confidence after the decline in the U.S. subprime-mortgage market....

``Even if the view has been correct and negative, it's been very difficult in these markets to make money because the moves are violent and the rallies sharp,'' said Ross, who invests a large portion of Iveagh's $800 million in assets with hedge funds.

Update 4/2/08. 12:00 AM: A reader e-mailed us:

Corporate buybacks have been the single biggest support to the market for some time now, and they didn't slow in the last quarter of the year, when over $1.1 trillion at an annual rate was plunged into the market by non-financial corporations. In doing that, they bought back 9.6% of their year-end market cap. Over the course of 2007, non-financials spent 150% of their net income on the combination of buybacks and dividends. With those profits falling, with debt on balance sheets rising, and with credit tightening, that is not going to continue. Just look at the financials. TMA's money raising adventure on Monday, the "success" of which gave its stock a nice 20% boost today, took their shares outstanding from 172 million to 4 billion. Them's serious dilution. Lots more of those coming.

And speaking as a hedge fund that's holding a ton of cash, I'm nowhere near the point where I'd deploy it, and in fact when I get close to that point, I strongly suspect that I'm going to be looking at Japan and Thailand and Brazil, and not at the United States.

Private Equity: "Nothing More than a Clumsy Trick"

It's remarkable how otherwise sophisticated individuals want to believe in magic bullets. If they get a horrific illness, surely there must be a treatment somewhere that will restore them to health. Similarly, some investors know how to tease superior returns on a consistent basis out of highly efficient markets.

Now I am willing to accept that markets are not perfectly efficient, that there are individuals who can do very well year in, year out. But they probably are 1/10000th the number of the pretenders to the throne. And it's much easier to be really good if you are obsessive (which usually means anti-social) and manage comparatively small amounts of money. Yet the economics of money management is that profits are a function of the size of the fund. So the industry's return objectives will every and always conflict with superior results.

Michael Gordon, global head of institutional investment at Fidelity, argues in the Financial Times that private equity, more properly called its original name, leveraged buyouts, is a scam that used leverage to produce the illusion of winning performance (a recent post carried a similar argument about hedge funds).

I'll give the LBO crowd some credit it may not deserve. In theory, its business model could work, particularly now that the public market have gotten so short-term oriented as to impede the pursuit of prudent strategies. But the popularity of private equity (or one might say its aggressiveness in launching new funds) guaranteed that the economic benefits its professionals might add would be paid to the seller. Many academic studies have concluded that the big reason most corporate acquisitions fail (the estimates range from 60% to over 75%) is that the the value of any synergies winds up being paid to the sellers, With hypercompetitivenes in LBO land (mid-market deals routinely would attract 40 bids), it's easy to imagine a similar, or even more extreme, process taking place.

From the Financial Times:

So now we know. The boom in private equity, which was promoted as the superior business model, based on patient capital, superior management and an alignment of interests, was nothing more than a trick of financial engineering – and a clumsy one at that. The magic of leverage works both ways, as we are discovering.

Henry Kravis of Kohlberg Kravis Roberts is asking his investors to be patient after a bout of negative returns and writedowns, echoing the cries of Alan Bond and other entrepreneurs of earlier credit cycles. Hamilton James, Blackstone's president, said at the Super Returns private equity conference on February 26: "We're a proxy for the credit markets." David Rubenstein, co-founder of Carlyle Group, recently asked whether "modest return" was a more apt name for private equity. He thinks it's funny. It's not.

As investors are increasingly bruised by the recognition that reality has once again triumphed over hope, the private equity barons are having to confess that the benefits of superior management, alignment of interest and, of course, the superior reward structure counted for very little.

Many of the private equity deals look no different from Yell and other highly leveraged public companies. As Warren Buffett notes, when the tide is going out, we find out who has been swimming without their shorts.

Sometimes a simple observation can prove an important point. In November 2006 Citibank published a research report that highlighted how private equity returns could be achieved by just leveraging basic stock market indices. It is a seminal note. "How do they do that?" asked the report, and then went on to provide the answer.

By leveraging the basic stock market indices by three to one, Citibank pointed out, returns could exceed even the best historical private equity returns. Never mind that as they were spellchecking the final version of the note, leverage on that season's deals was reaching four to one and even five or six to one.

As Citibank pointed out, the private equity barons would always emphasise alpha over beta – their ability to outperform a market rather than merely ride the market wave – but it showed clearly that leveraged beta was where the returns were being generated.

Interestingly, a similar lesson could be being learnt in other asset classes.

Shaken but not stirred, the private equity barons are looking to move on. Dismayed and disillusioned western investors will not play ball. In the leveraged loan markets, assets have been marked down by a fifth, so 80 cents in the dollar is the new par. Thus the financial alchemists have turned to the huge pools of money available in the Middle East and Asia.

Guy Hands of Terra Firma believes they will enable the disintermediation of Wall Street and the City of London. Perhaps, but in what shape and form?

Does he really assume that these new investors will be as naive as many of the investors in some of the five- and six-times-levered private equity deals of the past three years? I would be surprised. Commentators have suggested that many state-backed funds are still in their infancy and thus do not have the experience and organisation to cope with "big debt investments". That gives the private equity guys something of a problem.

Private equity as we have come to know it is all about debt – lock, stock and sinking barrel. There may have been better management and better incentive structures in the deals of recent years. But they really contribute nothing to the overall return when compared with the impact of the leverage in the capital structure.

So let us be candid. The deals of recent years are leveraged buy-outs. Let us give them their proper name. It is a shame that private equity has been degraded by misused financial engineering that was permitted by easy monetary policy and lax credit conditions. Moreover, the fact that these structures generated enormous management fees bears further questioning. These LBO deals and their business models were held up as superior in structure and therefore in worth. Massive fees were thus justified. That the market was happy to pay these for a simple leveraged structure that could have been assembled in a DIY fashion seems remarkable now.

In reality, private equity should not be about debt. Pure, properly capitalised private equity remains a wonderful business model. It should be able to prosper without recourse to cheap and easy finance.

Were Risk Models and Bank Regulation Destined to Fail?

Avinash D. Persaud gave a speech to the Committee of European Securities Regulators (posted at Willem Buiter's blog) that argues that banks' risk models and regulation based on market based pricing were bound to fail. That's a very bold claim, yet Persaud appears to have the goods.

If any of you have worked with models, one of basic yet regularly-ignored rules is to understand and respect their assumptions, because they usually constitute a major limitation on their usefulness (the best remedy is to rely on multiple metrics and tools and apply good old fashioned human judgement, but many people prefer to default to the answer that pops out of a spreadsheeet).

Persaud tells us that an underlying assumption of "market sensitive risk models" is that the user is the only party taking that approach. Now instead of going to Zurich or the Caymans to coin money based on their findings, Harry Markovitz and George Dantzig instead made them public, which should have made them merely interesting. However, the practical implication was that they could be used successfully on a relatively small scale, but once they became common, their success became more and more erratic, as many quants and risk managers have learned to their dismay.

Persaud then launches another fundamental attack. He argues that the logic of regulation is circular. The purpose of regulation is to prevent market seize-ups (actually, I thought it was to prevent institutional collapse and damage to innocent and/or unsophisticated bystanders, but let's go with his interpretation, since many have come to view well functioning markets as automagically producing those other results). But (and here Persaud is not as explicit as he might be) making market sensitive risk tools part of how financial institutions are regulated insures they will be widely, nay almost universally used, guaranteeing their failure. Eeek.

I would be curious to get the reaction of those skilled in the art. I've also included the reference to a paper by Persaud in 2000 which goes into his theory in more depth.

From Persaud:

Sir Alan Greenspan, and others have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today's financial turmoil. There are two answers to this, one technical and the other philosophical. Neither is complex, but many regulators and central bankers chose to ignore them both.

The technical explanation is that market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them. This was not a bad approximation in 1952, when the intellectual underpinnings of these models were being developed at the Rand Corporation by Harry Markovitz and George Dantzig. This was a time of capital controls between countries, the segmentation of domestic financial markets and to get the historical frame right, it was the time of the Morris Minor with its top speed of 59mph.

In today's flat world, market participants from Argentina to New Zealand have the same data on the risk, returns and correlation of financial instruments and use standard optimization models, which throw up the same portfolios to be favoured and those not to be. Market participants don't stare helplessly at these results. They move into the favoured markets and out of the unfavoured. Enormous cross-border capital flows are unleashed. But under the weight of the herd, favoured instruments cannot remain undervalued, uncorrelated and low risk. They are transformed into the precise opposite.

When a market participant's risk model detects a rise in risk in his portfolio, perhaps because of some random rise in volatility, and he tries to reduce his exposure, many others are trying to do the same thing at the same time with the same assets. A vicious cycle ensues of vertical price falls prompting further selling. Liquidity vanishes down a black hole. The degree to which this occurs is less to do with the precise financial instruments, but more with the depth of diversity of investor behaviour. Paradoxically, the observation of areas of safety in risk models, creates risks and the observation of risk, creates safety.

Quantum physicists will note a parallel with Heisenberg's uncertainty principle.

Policy makers cannot claim to be surprised by all of this. The observation that market-sensitive risk models, increasingly integrated into financial supervision in a prescriptive manner, was going to send the herd off the cliff edge was made soon after the last round of crises*. Many policy officials in charge today, responded then that these warnings were too extreme to be considered realistic.

This brings us to the philosophical problem of the reliance of supervisors on bank risk models. The reason we regulate markets over and above normal corporate law is that from time to time markets fail and these failings have devastating consequences. If the purpose of regulation is to avoid market failures, we cannot use as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator.

My purpose is to explain why the reliance on risk models to protect us from crisis was always foolhardy. In terms of solutions, there is only space to observe that if we rely on market prices in our risk models and in value accounting, we must do so on the understanding that in rowdy times central banks will have to become buyers of last resort of distressed assets to avoid systemic collapse. This is the approach we have stumbled upon. Central bankers now consider mortgage-backed securities as collateral for their loans to banks. But the asymmetry of being a buyer of last resort without also being a seller of last resort during the unsustainable boom will only condemn us to cycles of instability.

The alternative is to try and avoid booms and crashes through regulatory and fiscal mechanisms designed to work against the incentives, fed through risk models, bonus payments and the like, for traders and investors to double up or more into something that the markets currently believe is a sure bet. This sounds fraught and policy makers are not as ambitious as they once were. We no longer walk on the moon. Of course, President Kennedy's 1961 ambition to get to the moon within the decade was partly driven by a fear of the Soviets getting there first.

Regulatory ambition should be set now, while the fear of the current crisis is fresh and not when the crisis is over and the seat belts are working again.

*Sending the herd off the cliff edge: the disturbing interaction between herding and market-sensitive risk management models, A. Persaud, Jacques de Larosiere Prize Essay, Institute of International Finance, Washington, 2000.

UBS 1Q Losses to Equal 1/3 of Equity

The word was out earlier today that UBS was going to take a stunning first quarter writedown of $18 billion (the total turned out to be $19 billion), far and away the largest credit crunch writedown to date.

But for my money, the attention-getting number is the quarter's net loss in relation to equity: $12 billion, in comparison to a book value of SFr 35.6 billion as of year end (the dollar and Swiss Franc are more or less at parity these days). That's 1/3 of the big bank's equity. No wonder my trader buddies put UBS high on the list of Firms at Risk of Serious Trouble.

Bloomberg noted:

The bank will raise 15 billion francs ($15.1 billion) in fresh funds from shareholders to replenish capital, Zurich-based UBS said in an e-mailed statement today.

Now if you were a shareholder, would you be so keen to give more equity to a business that lost a third of its net worth in a mere three months? UBS got a capital injection of Sfr 19 billion last year, much of it from friendly sovereign wealth funds. I'm sure they'll be delighted to stump up more cash.

Bear Conspiracy Theories and Carry Trade Unwind

A reader sent me the link to this week's Institutional Risk Analystics, and I am posting despite the fact that at points it undermines its own credibility.

Most of the article, "Novated Bears & the Education of Ben Bernanke," is a combination of trader gossip about the fall of Bear Stearns, some of it quite informative, such as Goldman CFO David Viniar maintaining "we have 100 percent confidence in Lehman Brothers," when the firm was refusing to trade with Lehman and take clients out of Lehman exposures.

But the piece takes some interesting tidbits and goes overboard, muttering darkly that the government allowed Bear to fail and not Lehman and Goldman.

Simple explanations are usually best. Bear hit the wall first, therefore it went under. The government made the mistake of announcing a new liquidity facility for primary dealers a good, what, ten days or two weeks before the facility was effective. The Fed's announcement made it sound as if the delay in implementation was due to the need to work out technical details. But Bear's liquidity crisis hit before the lending program was in place. The Fed felt could not allow two sizeable dealers to fail (it may be hard to recall the panic of two weeks ago). As an aside, I'm not of the school that Bear should have been salvaged, but that's a separate issue.

Moreover, Bear did not put up much of a fight. Alan Schwartz was reported to given a presentation on the firm's liquidity that if anything heightened worries. And as we noted, Bear had substantial bank credit lines that it did not use. By contrast, Lehman has gone on the offensive (one investor called the conference call March 17 "Orwellian," but hey, those techniques have proven effective).

What is most surprising is that the newsletter puts its most important bit of information at the very end, as almost an afterthought:

Many people inside and outside the Federal Reserve System don't seem to appreciate that the US Treasury is dependent upon the primary dealers. Dealers like BSC, LEH and GS are the main outlet for funding all of the great ideas that emanate from Washington. We hear from several Fed insiders that Geithner, at least, understands this nuance, but it seems incredible to us that the Fed staff in Washington were not able to construct a rationale for invoking Section 13 (3) of the FRA [the "unusual and exigent circumstances" provisions] long before March 16.

"People were not novating with Bear and the CDS market was careening out of control, like a collapsing Ponzi scheme" the head of asset allocation at one of the largest corporate pension funds in the world tells The IRA. "The Fed finally stepped in very late to save the Treasury's ability to issue debt, but this clumsy effort is not without cost. The credit standing of the United States has started to be perceived as being impaired because foreign investors think our government officials don't know what the hell they are doing. Even though asset quality problems inside many European banks are far worse than in the US, for example, you don't hear any noise coming from the EU."

The pension mogul continues: "Now add to this perception problem the fact that Bernanke has pushed interest rates on US government debt down to Japanese levels. At Japanese levels, the yen-dollar carry trade unwinds and we are going to see a massive contraction of liquidity coming out of Japan. The yen crashes through 100 and is most likely going to 80 per dollar as liquidity is sucked back into that market like an imploding black hole. People are looking at the US for the deflationary problem. No, the deflationary problem is coming from the collapse of the carry trade and the liquidity created by the Bank of Japan."

As the yen has rallied from below 120 to under 100, talk of the carry trade unwind has receded. It may well be that a fair number of foreign borrowers were able to make timely exits and reestablish positions at higher yen/dollar levels. But a fair bit of the pain and losses emanating from hedge fund land no doubt come from carry-trade-related losses.

Despite the negative that a higher yen has on Japanese exports, our contacts in Japan tell us that the officialdom regards the yen as still cheap and the dollar's fall as the result of developments internal to the US. That means they will not be terribly inclined to intervene, at least for a while. Thus the yen going to 80 is far from implausible, and the consequences would be, to use a Japanese turn of phrase, severe.

Now to the gossipy parts of the newsletter:

First, we all of us need to understand that the bailout was not of BSC, but rather of Lehman Brothers (NYSE:LEH), Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM), and the rest of the primary dealer community. BSC was the sacrifice, the Easter Pascal lamb put to the knife while the Fed belatedly bailed out the rest of the Street.

The actions taken by the Federal Reserve Bank of New York during the week of March 10, culminating with the March 16 announcement of the acquisition of BSC by JPM and the creation of an emergency loan facility for broker dealers, was not to rescue BSC but instead everyone else on Wall Street, particularly LEH, GS and JPM. In the case of JPM, a BSC bankruptcy filing could have started a chain reaction in the credit default swaps ("CDS") market that might have seriously damaged this huge derivatives dealer.

Some BSC partisans tell The IRA that the firm was the victim of a concerted "bear raid" by a number of hedge funds, which actively worked to undermine the BSC's liquidity while shorting the firm's stock and debt. Hedge funds reportedly were buying counterparty risk positions with BSC from other parties, and then demanding immediate payment or the return of collateral, deliberately accelerating the firm's collapse. Note: It is illegal to take such actions against a commercial bank, but not against a broker dealer.

On Wednesday March 12, BSC CEO Alan Schwartz told investors that the firm remained liquid and solvent, but by the market close on the following day BSC's fate was sealed by the hedge fund mafia, at least according to this version of events. Strange, is it not, that the managers of BCS's mortgage and repo desks did not give Schwartz a friendly heads up on the Wednesday.

Other observers, however, tell The IRA a different story, whereby the dealer community, and not vicious hedge funds, actually caused BSC to fail by refusing to face the struggling bank in the interdealer market. As all manner of clients tried to trade out of or novate counterparty positions with BSC to other firms, dealers began to refuse to take further exposure with BSC.

By the close of business on Thursday, March 13, BSC effectively lost access to the repo and interdealer markets, the death knell for any investment bank. As one BSC official told The IRA on a not-for-attribution basis, had the Fed acted a week earlier, there would have been no liquidity crisis....

As BSC was being shut out of the interdealer market, LEH was also being shunned by other dealers and attacked by the hedge fund hordes in the same fashion as BSC. Several veteran traders in the CDS market say that LEH was essentially in danger of failing as well.

One hedge fund veteran, who was and is short LEH, complains to The IRA that LEH was essentially dead in the water on Monday, March 17, but the Fed intervened. When the markets opened after the Easter holiday, clients and other dealers were backing away from LEH and the shorts were swarming in for the kill, he claims....

Indeed, the only reason that LEH did not fail as well, claims this well-connected trader, was a conference call on that Monday with the top ten dealers organized by the Fed of New York. During that call, the Fed of New York reportedly told the other dealers that it would lend LEH "whatever is necessary" to keep that leading mortgage-backed security underwriter and CDS house afloat. That open-ended promise, not the Fed's new lending facility, reportedly saved LEH from collapse - for now....

Chairman Dodd and his SBC colleagues should understand that the real beneficiaries of the "BSC Bailout" are neither that firm nor its shareholders, who have paid a very steep price for not being part of the "Too Big to Fail" club. Rather, in our view, it is GS, LEH, JPM who benefited indirectly from the Fed's tardy largesse. When Chairman Dodd convenes his hearing, hopefully he will ask the witnesses from the Fed several key questions:

** What logic drove the Fed to pick LEH et al to survive and BSC to die? As and when any other of the major dealers become insolvent, will the Fed allow a market resolution? Is there an objective standard used by the Fed in picking winners and losers? If so, what is that standard?

** What role has Secretary Paulson played in the Fed's bailout of LEH, GS and the other major dealers? Do Fed officials have any concerns about the existence of a real or apparent conflict of interest in having the former CEO of GS involved in these deliberations? Despite the fact that Paulson is in almost constant contact with Chairman Ben Bernanke, are we really expected to believe that the Fed went into that week unaware that the primary dealer community was about to collapse?

** Secretary Paulson has proposed giving the Fed additional oversight responsibility for dealers, funds and other non-bank institutions. In view of the Fed's failure to anticipate this crisis and the fact that no other industrialized nation in the world gives its central bank primary responsibility for safety and soundness of financial institutions, why should Congress not instead strip the Fed of its regulatory role and limit its responsibility to monetary policy and providing market liquidity?