1. One feature of the credit crunch is that the worst of the distress has been felt not so much by hedge funds but by Fannie and Freddie, some insurers, and the quoted investment banks; three of Wall Street’s “big five” have now disappeared.
This is not what the chattering class expected: 2-3 years ago, lots of experts claimed that hedge funds were a big source of systemic risk. They seem to have been wrong (so far!)
Could this vindicate my point that this is a crisis of ownership, not markets? Big sprawling investment banks were unable to overcome principal-agent problems, whereas in hedge funds the division between ownership and control is less sharp, so these have (generally speaking, touch wood) been less vulnerable to disaster. (Not that their returns have been great, but that’s another tale.)
2. There’s a contrast between the dramatic collapse of Lehmans and the undramatic stock market reaction. Although Lehmans' troubles are a roughly once-in-a-century event, the FTSE 100, as of now, is down a mere 2.7 per cent. This is only a 2.2 standard deviation event (assuming 20% volatility) - the sort of thing that happens 3-4 days a year.
One reason for this muted reaction is that markets believe the Fed and US Treasury will do anything necessary to stop a wider crisis - a belief corroborated by the nationalization of Fannie and Freddie.
This in turn suggests we should regard stock prices not so much as the discounted value of future cash flows, but rather as the probability-weighted price of a bundle of state-contingent securities. The reason for the market’s muted reaction is that traders believe the probability of a catastrophe - thanks to state intervention - hasn’t increased much.
3. What impact does financial distress have upon economic growth? Anatole Kaletsky is moderately optimistic. My instinct is to agree; what we’re seeing is a destruction of “insider assets” (banks’ bets with each other) rather than of the assets that drive economic growth outside the financial sector.
However, this new paper from Fed economists suggests we might be wrong: financial distress can have big economic effects.
This is not what the chattering class expected: 2-3 years ago, lots of experts claimed that hedge funds were a big source of systemic risk. They seem to have been wrong (so far!)
Could this vindicate my point that this is a crisis of ownership, not markets? Big sprawling investment banks were unable to overcome principal-agent problems, whereas in hedge funds the division between ownership and control is less sharp, so these have (generally speaking, touch wood) been less vulnerable to disaster. (Not that their returns have been great, but that’s another tale.)
2. There’s a contrast between the dramatic collapse of Lehmans and the undramatic stock market reaction. Although Lehmans' troubles are a roughly once-in-a-century event, the FTSE 100, as of now, is down a mere 2.7 per cent. This is only a 2.2 standard deviation event (assuming 20% volatility) - the sort of thing that happens 3-4 days a year.
One reason for this muted reaction is that markets believe the Fed and US Treasury will do anything necessary to stop a wider crisis - a belief corroborated by the nationalization of Fannie and Freddie.
This in turn suggests we should regard stock prices not so much as the discounted value of future cash flows, but rather as the probability-weighted price of a bundle of state-contingent securities. The reason for the market’s muted reaction is that traders believe the probability of a catastrophe - thanks to state intervention - hasn’t increased much.
3. What impact does financial distress have upon economic growth? Anatole Kaletsky is moderately optimistic. My instinct is to agree; what we’re seeing is a destruction of “insider assets” (banks’ bets with each other) rather than of the assets that drive economic growth outside the financial sector.
However, this new paper from Fed economists suggests we might be wrong: financial distress can have big economic effects.
crisis of ownership and principal agent risk is exactly correct Chris. The shareholders failed to exercise proper control over the senior management.
Posted by: Dipper | September 15, 2008 at 11:26 AM
«2-3 years ago, lots of experts claimed that hedge funds were a big source of systemic risk. They seem to have been wrong (so far!)»
One of the differences is that hedge funds are not quoted, and anyhow have mostly a long lockin period. Until another fund as big as Amaranth etc. blows up, who knows what's happening inside those privately held, closed-end funds?
«stock prices not so much as the discounted value of future cash flows, but rather as the probability-weighted price of a bundle of state-contingent securities»
That's one of the most obvious explanations for the so called stock risk premium.
Along with my favourite one: that talking of expected value of discounted cash flows makes no sense because of the lower zero boundary. Once a company has run out of cash, it closes, so survivorship bias.
Posted by: Blissex | September 15, 2008 at 01:22 PM
My question would be how would Lehman's collapse and an apparent US financial services meltdown affect the UK, considering how much of the British economy is tied into the financial/banking sector?
A supplimentary thought: I have long believed that one of the main (if not, the main reasonings behind the widescale deregulations of the 1980s was to force the British economy to become reliant on the whims and wishes of multinational corporations and the banks and effectively give them the power to financially undermine any 'unfriendly' Government to a greater degree than was previously possible (after all, every Labour government prior to 1997 came up against some form of financial crisis after gaining power). Is this the case, even partially? Would this explain (in part) New Labour's craven supinity when it comes to big business?
Posted by: Cheesy Monkey | September 15, 2008 at 02:21 PM
This is also a huge failure of regulation.
If a financial institution is small enough to be allowed to fail then this is, indeed, only a matter for shareholders and management.
But many banks are too big to fail - as that would pose severe systemic risk. (Imagine the Halifax going under!).
Where governments have even an implicit obligation to step in in the event of insolvency or illiquidity then I for one feel that governements have rights over the way such institutions work.
I used to work for a failed investment bank (Barings). The key problem is that traders can make fortunes by gambling massively with their employers capital. SO they have a giant upside. If they screw up (legally but just incompetently) then the worst they face is the sack. So no giant downside.
Management cannot and will not control this as they are the chief beneficiaries. If I was Chancellor I'd impose tight regulations on profit driven bonuses that did were not specifically adjusted for risk (beta) inherent in the underlying trades. This would, of course, kill the trading floor risky behaviour, much profitability and make trading only a service for clients. NO bad thing.
I work now in the finance function of Shell. Shell treasury policy basically says that treasury only transacts for the needs of its operating companies - no 'for profit' purely financial trades at all and almost no use of derivatives. Very sound!
Posted by: Patrick | September 15, 2008 at 02:38 PM
I would be less sanguine about the prospects of hedge funds. Ownership might be less divorced from control, but they're still gambling with other people's money for short-term gain. They are also less constrained by the accounting procedures and reporting restrictions applicable to the banks -and can 'lock' their investors in when things start to go pear-shaped.
Looking back at the collapse of Long Term Capital Management, it's quite a nostalgia trip to remember who bailed them out:
Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, J.P.Morgan, Morgan Stanley, Salomon Smith Barney, UBS, Société Générale, Paribus and ... er ... Lehman Brothers.
Posted by: anotherplanet | September 15, 2008 at 03:16 PM
But Lehmans was 30% employee owned - quite a high proportion for a large corporation.
Many of those who made the decisions that killed the bank were people that owned a stake in it.
So much for ownership and control.
Posted by: Rick | September 15, 2008 at 03:16 PM
What fraction of their personal assets was tied up in the bank?
"a once-in-a-century type of financial crisis"
Is it my imagination, or do we have one of these every decade or so?
Posted by: ad | September 15, 2008 at 06:45 PM
To be fair, Lehman has been on its last legs for months. The collapse yesterday was only because a potential buyer pulled out - the bank was in trouble well before yesterday.
Posted by: Letters From A Tory | September 16, 2008 at 09:41 AM
Barclays pulling out? What happened to the other two buyers, and could they not wait another couple of days before pulling the plug completely...?
Posted by: Think Money | September 16, 2008 at 12:16 PM
What is the difference between believing the probability of a catastrophe hasn’t increased much, and believing that the present value of expected earnings hasn't decreased much? Earnings expectations are state contingent aren't they?
What do you make of the argument, being made here and there, that these failures show that the market did spread risks like it oughta, and the failures are happening to those who could best bear the risk?
What decides the question? How do we tell the difference between risks being spread as the ought, and risks being magnified and pooled in the wrong places? What pattern of failures in the crisis ought we expect in each case?
Posted by: Luis Enrique | September 16, 2008 at 12:28 PM
Kaletsky is now quite pessimistic.
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