A few days ago, a handful of nervous physicists feared that CERN’s Large Hadron Collider (the world’s largest and most powerful particle accelerator with a $9 billion price tag, unassumingly lying under the Franco-Swiss border near the serene foothills of the Alps) could lead to the inadvertent creation of a black hole that could potentially swallow the entire planet – as an appetiser. Well, the experiments are underway and we’re still here so those nervous nuclear nellies must have got it all wrong, right? Well not exactly. Ask any trader on Wall Street, Tokyo or London and he’ll tell you the black hole is here – and it’s swallowing up value, jobs and confidence in the postmodern financial system faster than the near-lightspeed particle experiments at CERN. At least that’s what it feels like when a few trillion dollars of value is vaporised and hundreds of thousands of jobs are threatened in a matter of days, anyway.
The events on Wall Street over the last few days are, to refer to a clichéd geologic analogy, similar to the 2004 Indian Ocean Tsunami triggered by a 9.3 magnitude earthquake – the second largest on record. A series of waves are crashing on-shore, the first set of waves clearing debris to allow the next wave to move faster and further. What will go down in history as the Great Financial Panic of 2008, is being driven by a handful of primary drivers: (1) unwinding of failed financial innovations, namely leveraged securitised US residential mortgages, (2) IFRS fair-value accounting that forces corporations to mark to illiquid market prices, (3) asymmetric incentives for traders to take risk on behalf of their employers (and the providers of debt and equity capital) and (4) magnified counterparty risk thanks to the opaque $62 trillion Credit Default Swap market.
The virtual collapse of uber financial giant AIG, a day after the bankruptcy of Lehman and absorption of Merrill Lynch – just a few months after the bailout/sale of Bear Stearns, has resulted in a situation technically known as “I Just Shat My Pants” syndrome. This syndrome is driven by powerful fight-or-flight psychological cues that have been hardwired into human brains over millennia and should not be underestimated. It doesn’t matter that AIG was “rescued” by the Fed at the last minute (more on that later). The Fed’s flip-flop on its criteria on intervention and ambiguous rationale behind watching Lehman burn to death and yanking AIG out of the burning building at the last minute has only intensified the confusion in the market regarding who’s going to be saved or left to “private market solutions” like a panicked run-on-a-really-good-but-not-systemic-risk-investment-bank.
Here’s an example of the state of mind of the syndrome ‘I Just Shat My Pants’ because I realised that there was a reasonable chance that the global financial system could collapse, my money market account could break the buck, I could lose my job, the surviving independent broker dealers could blow up, the last counterparty I traded with could be holding a gazillion dollars of toxic shitbonds collateralised by who knows what marked at par. Perception of reality has changed. Nothing, no one can be trusted – except, maybe my mom. Even the Fed screwed me on my short-dated Lehman bonds – you think they’ll throw a line to Morgan Stanley while its CDS trades 22 points up-front? I want to break free – like that Queen song – I want to be free of RISK. But how can I buy risk-free assets if I can’t assess risk anymore? I drive 3-month T-Bills yields to 6 decade lows, buy oil, bid gold to its stongest rally in 26 years, anything but fixed-income because I know there’s nothing fixed about that ^%&*$$ income.
So what does this mean for the markets going forward? Fundamentals you ask? Valuations? Irrelevant over the next few days – fear rules the day so don’t try and step in front of this adrenaline fueled stampede. The Fed can print dollars like candy wrappers all day long and pump liquidity, but if overnight LIBOR stays at double digits and banks are scared to lend to each other it doesn’t make much difference in the short term – you can have plenty of blood to transfuse but if the drip doesn’t work the patient still stays sick. Ultimately, fundamentals are going to have to come back into the picture. The toxic Freddy Kruger bonds may need to be exorcised from the system once and for all – either through a global “bad bank” fund or via a morally hazardous Central Bank purchase. Also, banks need to be able to hold illiquid assets for longer than three months without the fear of analyst fits each time they mark their book for the quarter. Finally, there is plenty of cash sitting on the sidelines: Private Equity, Sovereign Wealth Funds and Hedge Funds are sitting on unprecedented hoards of cash as a result of aggressive fundraising in the boom pre-crunch years. Also, a portion of the approx. $400 billion of mark-to-market credit losses have been replenished with cash injections as part of recent bank recapitalisations. At some point, the Central Banking system has to make it too damn painful for banks to hoard cash (globally coordinated interest rate cuts) and less scary to extend credit (strip out toxic securities). And, stocks of handy wipes and spare underwear will be very helpful as well.