Friday, February 25, 2005

The shadow of LTCM

WSJ: "The watchmen are back. And they're watching the hedge funds again, among other points of concern.

The group, which wields the weighty title Counterparty Risk Management Policy Group II, was established to monitor risks to the world-wide financial system in the wake of the 1998 implosion of hedge fund Long-Term Capital Management.

E. Gerald Corrigan, past president of the Federal Reserve Bank of New York and now a managing director at Goldman Sachs Group Inc., is serving as chairman of the revived 15-member group, which includes representatives from major brokerage firms, banks and one insurer as well as the hedge funds with which they often trade. It will hold its first formal meeting next month.

The group's revival comes with the quiet backing of the New York Fed, which appears to have grown more concerned about potential market disruptions. For example, in a speech in November, New York Fed President Timothy Geithner noted "hedge funds -- and financial leverage more generally -- still present a source of potential risk to the financial system" and went on to cite a relaxation in credit terms and other risks."

Sounds like a good idea to me. But will they really be able to do anything about systemic risk? Someday this global liquidity bubble will come to an end. Hopefully in an orderly manner, but if not, look for a lot of hedge funds to blow up. LTCM would be a medium-sized fund these days, although the amount of leverage they used would still be considered high.
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13 comments:

Anonymous said...

How are we to know if there is a global liquidity bubble?

Anne

10:39 AM
Steve Hsu said...

I think the evidence is pretty convincing. In an earlier post, Liquidity Feedback, I linked to an Economist article on the subject.

Yields are down all over the world, and I think it is because there is a glut of liquidity. The only thing that keeps inflation at bay is that Asian economic integration keeps a lid on pricing power. (This doesn't apply to commodities like oil, though.)

The process of integrating >1 billion underemployed Chinese or Indian workers into the global economy will keep manufacturing and (increasingly) service costs low, despite the Fed's easy money policies (some say the real interest rate is still negative today).

The consequences are massive current account imbalances and investment bubbles driven by easy money. It may all equilibrate in an orderly way, but there is also the chance for systemic disruption.

I guess Steve Roach at Morgan Stanley is the most outspoken backer of this point of view...

Wise man Warren Buffet says he can find very few attractive investments in the US, and has bets in place against the dollar.

4:12 PM
Anonymous said...

"How are we to know if there is a global liquidity bubble?"

we will know after it bursts.

As steve notes, at this point we can but surmise there is one, based on close study of the available information. But much info is not available, not the least being what leverage is being used by the $1 Trillion in the hedge funds, as well as the Zillions of derivative positions (of which "only" $84 Trillion is held by US banks - the rest is ????)

anne: as you know from my comments elsewhere, my view is that the tale (and tail) of the bubble will be in the unwinding of the unknown (as to size) counter-party risk. And that - per LTCM - we will not know until too late. (not that LTCM itself was done in by counter-party risk; those who dealt on the other end of LTCM positions were left holding the counter-party risk, which was LTCM - and no one thought that LTCM would be a credit risk)

The question therefore becomes what should the prudent person do.....

fatbear

4:23 PM
Anonymous said...

Fine responses :) There is little general inflation in America, less in Europe and of course deflation in Japan. The price earning ratio for the S&P was 18.4 as February began. Real estate prices are selectively high from Melbourne to Paris, but there is an 8% vacancy rate for commercial property in Manhattan. Materials prices are high, surely. Labor costs in America are not keeping up with productivity increases. Labor costs in Europe are rising moderately, and falling in Japan. Long term bonds? There the price is awfully high. I rather tend to agree, and yet and yet...

Anne

5:57 PM
Anonymous said...

Dear Fatbear

A. A. Milne was the perfect stylist, as E. B. White, and I once would use Winnie the Poor in particular to set up logic problems. Always did like bears :)

Anne

6:05 PM
Anonymous said...

What is needed is to get Steve to notice birds :)

Anne

6:05 PM
Anonymous said...

Steve -- Am interested in your last line: LTCM = a small fund these days, though its level of leverage would still be on the high end. LTCM had something like $5 billion in capital before it headed south -- I guess that is now considered small? They geared up 30 to 1, I think (need to read lowenstein and the reports put out by the US gov afterwords), but that may exlude some derivative positions. That apparently is still considered high? What is your estimate of a typical level of leverage these days, and how much does it vary across hedge funds who pursue different investment strategies?

LTCM's strategy was that of a typical fixed income prop desk at the time, so they geared way, way up on their relative value trades (on the run v. off the run treasuries) but those trades got crowded so they got involved in lots of directional trades too -- long Russian GKOs with the ruble hedge from russian banks for example, was basically a pure long bet on Russian credit risk. Any sense of what formerly profitable trades are not getting crowded, pushing people into riskier bets? (curve flattening strikes me as one possibility)

p.s. feel free to email me if you prefer -- my email is pretty easy to find on my blog.

8:45 PM
Anonymous said...

"Any sense of what formerly profitable trades are now getting crowded, pushing people into riskier bets? (curve flattening strikes me as one possibility)."

When you mention curve flattening, are you referring to a gradual limiting of the carry tade? To what extent would you guess the carry trade is using Japanese credit?

Please extend these interesting remarks.

Anne

10:54 AM
Anonymous said...

By the way, the solution to what the Economist holds is excess liquidity appears to be recession by the logic they use. We do not need to sacrifice the domestic economy for a money supply abstraction when there is no problem with general inflation. Whether there is asset inflation is questionable, still the health of millions of households should be considered and there is little general inflation. Besides short term interest rates are slowly rising.

Anne

11:05 AM
Steve Hsu said...

Re: LTCM and funds today, I wouldn't say $5B is small, but there are many funds of that size today, and of course some that are much larger.

One important point to make is that most hedge funds are not using a lot of leverage, and many are trading (mostly) plain vanilla securities like equities, bonds or commodities without using a lot of derivatives. Just having the ability to short occasionally or move quickly on M&A rumors gives them more flexibility than a typical mutual fund.

The number that are using very sophisticated techniques or have large exposure to derivatives or use large amounts of leverage is relatively small.

12:47 PM
Steve Hsu said...

PS I couldn't email the poster directly because the comment wasn't signed - although I have a feeling I know who it is :-)

12:47 PM
Anonymous said...

steve -- apologies. I thought I had signed my previous post. try

brad underscore setser at msn dot com

I had forgotten about the dunbar book.

brad

anne -- i don't think too many US investors are funding themselves in yen these days. The borrow in yen invest in dollars trade was real popular in the mid-90s, but it also blew up in a big way in late 98, after Russia. there were a couple of huge moves in the yen-dollar then linked to the forced unwinding of positions. and with US short-term rates so low, I doubt it was worth the yen-dollar risk just to get slightly cheaper yen funding. I suspect some private japanese investors are buying dollar assets for the carry, but that is a slightly different thing (I would not be surprised if some folks don't fund in euros/ buy dollars -- if you believe Stephen Jen, it is a two-fer, cheaper money and capital appreciation from a rising dollar). As for curve flattening -- all i am saying it that with rising short-term rates and constant long-rates, the curve has flattened, and as it flattens more, the probability of further curve flattening arguably falls ... plus, i get a sense that everyone was doing this, to a degree, which means the market moves quickly in the expected direction and future gains are compressed

6:02 PM
Anonymous said...

Anne-
Bubbles seem so easily spotted in hind sight, do they not?

1:45 PM

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