Monday, August 20, 2007

From Excess Liquidity to Credit Crunch.. Gone in 2 weeks

The last week I was on vacation in France and Switzerland. I found a nice castle to get married in France next year, of which I have forgotten the name. I will post the link as soon as I remember.

A lot of drama happened in the markets when I was away, especially last week. Please read WSJ to get more details. And the Fed cut its bank lending rate by 50bps on Friday, because of which all the markets are up today.

A lot of pain of recent days has been on the quant funds. Some of them seem to have become even for the year (esp. AQR, Renaissance) after the jump in the last 2 days. They have all been delevering for sure. But overall in the long run, quant funds will make money, unless they are so overleveraged that they go under when markets make 5 std deviation moves against them. Goldman will make money on the $2billion it put in its quant fund for sure.

I think the next issues would be these -

(a) Are all the hedge funds and money market fund blowups over? It is the money market fund blowups (which were holding AAA rated sub-prime paper) that has shaken investors, who are now questioning the very credibility of AAA rating. And if investors ask higher returns to hold the AAA paper, it implies credit spreads have widened. All this credit crunch is more of a ratings credibility issue than anything else.

(b) What happens to the $300 bn+ LBO financing coming up in the next few months? In some cases, offers will be revised down, like with Home Depot supply chain sale. In others, PE and I-banks will take a hit.

(c) What are the quarterly results for I-banks? Note that some of them operate on Aug-end quarter, and almost half of the quarter would have virtually no I-banking/debt market activity. The big question would be - how did the prop trading desks of the banks do? This is where the Mogans and Goldmans of the world have been minting money over the years. Were their traders smart to make money even this time?

(d) And the most important of all - will the Fed really cut rates on or before Sep 18. And how much will it cut? The Fed has not cut rates on Friday - it has lowered the rates at which banks can borrow directly from it (which is now 50bps higher than its fed funds rates, in normal times nobody borrows from the Fed as it is considered a sign of weak credit). So homeowners are still squeezed in US - their rates are determined by the Fed Funds rates.

(e) If the Fed has to cut a lot to stabilize the markets, dollar would depreciate sharply because capital will flow out of a low interest bearing currency. Or it could appreciate if investors seek safety of US treasuries. Or it can remain stable because both these effects offset. And how does this impact other currencies (Yen, Euro) - I have no idea. This could turn into a currency crises, or it may not. Note that Australian Dollar and NZ currency had their biggest declines last week as investors unwound carry trades.

I still think that there will be a lot of volatility in the markets, and a better time to invest would come probably next month. As somebody said, people have lost more money catching the first 5% move than they made in next 95% move. I will wait and not invest in the first 5%.

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