Thursday, August 30, 2007

Reading the Fed minutes – no warning signs

The minutes for the August 7th Fed meeting came out yesterday. The reading suggests that the Fed had little anticipation of the coming storm over the next two weeks. There was a section on the illiquidity of sub-prime structures and the fact that investors were seeing a erosion of value, but there was no connecting of the dots to conclude that there would be a credit crunch problem or that Fed help may be needed. In fact, in an earlier section of the document there was a comment that in spite of the softness in the housing market household wealth was increasing. Without sounding like Mr. Edwards and his “two Americas” speech, there was little discussion of the bifurcation of the mortgage market between long-term home owners sitting on gains and new owners in the ARMs markets facing financial difficulties. There also was no discussion about speculative behavior in the housing market.

Of course, we may all sound brilliant in hindsight. We can finger-point to what should have been done and what we saw in the market tea leaves, but at the end of the day many investors were unable to properly anticipate or act on this credit crunch. We knew there were credit problems but we were missing the potential for contagion or the sensitivity of investors to valuations. From my perspective, it will require more vigilance of factors that are normally not included in macro models.

Tuesday, August 28, 2007

Consumer confidence does not reflected Wall Street woes

The Conference Board consumer confidence number came out this morning with a slight downturn.

There are two major take-aways from this data. First, the confidence number does reflect the most recent information on consumer thoughts. Albeit a small delay, the information is collected through the 22nd. This provided enough time to include the credit debacle in consumer views. Given the high level of uncertainty about the market, it may have been difficult for consumers to properly assess the impact on their situation, yet it is surprising that the decline was relatively mild. Confidence has been stable for most of 2007. The credit crunch has centered on the sub-prime market and real estate. This is an issue that should hit home to all consumers, yet the fall in the August numbers does not reflect the housing problems. There have been some much larger past declines which were not associated with recessions. This will give the Fed some reason to pause about taking serious action before their September meeting.

A classic Michael Lewis story –

There are certain characteristics of a Michael Lewis story. He loves the individualist who finds market inefficiencies. In fact, almost all of his best books are about exploiting market inefficiencies. This could be in the mortgage market through quant traders and securitization, the technology bubble, baseball general managers who have to find players or football player who have unique skills. All these stories find a visionary who is able to see something that other could not and how these entrepreneurs try and exploit these opportunities. His latest story in last Sunday’s New York Times looks at another inefficiency, catastrophic risks. The article discusses tail risk and how some may try and exploit the opportunity in catastrophe bonds.

Even for those who are not directly involved in the insurance industry CAT bonds, this is an interesting story. It provides some thoughtful insights on what it means to be diversified and what are the types of harm that investors may face when risks become correlated or not fully priced.
The current credit risk problem is another example of tail risk that was not fully examined. The credit markets became correlated and there was a limited amount of diversification. The full extent of the price impact was not properly examined. Perhaps we need to brush up our knowledge of tail risks. This is not a theoretical exercise but a real world problem.