Thursday, February 26, 2009

Last bid in size: Anatomy of market meltdowns

Major market meltdowns share one critical factor: a liquidity vacuum. Liquidity vacuums occur when information is not available or is not trusted. Confidence deteriorates and markets go “no bid”. “No bid” means there is no participant willing to pay any price at that moment for any amount of a particular asset.
As investment professionals, these are surreal moments because we have come to believe in the market as the clearing house for all information, both good and bad. If a company disappoints, expectations adjust to a lower reality by reducing its quoted price. Participants rely on the market to reflect the discounted present value of “reality” and reality is the “last bid in size”. But when the market for an asset goes “no bid” as is the case for so-called toxic assets underpinned by sub-prime mortgages of unknown or questionable origin and solvency, it is theoretically saying that the asset is “worth” nothing.Even in the case of catastrophic events, there is usually some market participant willing to pay a deep discount, during an information black hole, to arbitrage the time between not knowing or trusting the facts and some future point when reality reconstitutes a value.
The current financial crisis is simply more complex than previous crises and it is so because the terms of arbitrage have been disrupted. Let’s start with an example.
If you list your house for sale and receive no offers for several months is it worth zero? Does it mean that the value of your property is zero until it was sold? The issue for some assets that are not liquid is that time is required before a market value can be established. If you bought another house before selling this one, there may be a cost to carrying or arbitraging the time until it can be sold. The same principle holds for most banks today. They must find a way to arbitrage their toxic assets to shore up their capital in the short run until the problem assets can be worked out or finally written off.
When Bear Stearns was forced to mark down the value of their mortgage portfolios to “market” was the “market” value realistic? Most market participants would say yes, because if nobody was willing to buy it at any higher price, that “marked down” price was its real “value”.If some mechanism existed to allow Bear to arbitrage the time until a work out were established, they would not be the historical footnote that they are today.
Today, bank and government officials from U.S. Treasury and the Federal Reserve Board are struggling to restore interbank confidence in the value of assets in a critical attempt to unblock the constipation in the banking system over unknown capital adequacy issues.
If banks take an immediate write down and amortize the notional loss over a reasonable period of time (say five years), there should be adequate time to restructure and/or establish better valuations in the absence of a liquidity freeze. They need a reliable mechanism to arbitrage time.Homeowners who have been caught in the crossfire of declining housing values may also need a mechanism to arbitrage time. This may be a reduction in monthly payments in exchange for longer amortization periods. It is difficult to have any sympathy for consumers who have "maxed out" their credit cards who will be seeking relief sometime later this year and perhaps only empathy for the sub-prime borrowers who were partly duped by unscrupulous mortgage originators particularly in the case of falsified mortgage applications. Nevertheless an arbitrage can be structured that creates realistic choices for those folks who feel they are "in over their heads". Losing a house is disruptive and disheartening but if the choices are food, clothing, shelter and education for the kids, vs. a 100 year mortgage (a la Japan pre-bust), perhaps more rational choices can be made.

The idea of closing ones eyes to the problems and hoping that they vanish when one awakes is obviously unsatisfactory. But in this case, arbitraging time while addressing systemic problems can buy valuable time for the banking and credit markets to do what needs to be done. What those things may be will be in a future post.