Pisani's Trader Talk: Taking Lessons from Former Crises
CNBC's Bob Pisani reports on what traders are telling him:
I've been with CNBC since 1990, and have lived through and reported several financial crises. Each time, the economy recovered, but each one was a little different.
A brief synopsis of three of these crises and what we learned.
The real estate collapse of 1989-1990
In 1989, billions of dollars in assets held by savings and loan associations were declared insolvent. Nearly 1,000 S&Ls failed, and it was a major factor in the 1990-91 recession. The causes are complex, but the S&Ls were under severe regulatory constraints, and some fraud was clearly involved.
The Resolution Trust Corporation (RTC) was created to dispose of these assets. They held a series of auctions and created limited partnerships that, over a period of several years, effectively disposed of most of the properties.
I was the Real Estate Correspondent for CNBC during this time, and covered the real estate collapse and recovery.
The lessons learned:
1) the partial "bailout" worked. Aggressive, unorthodox action by the Congress and the President helped heal a disaster that could have taken far longer to recover. The U.S. government essentially stepped in to help support the thrift and banking industry at a critical moment.
This action, which seemed extreme at the time, greatly accelerated the real estate recovery. Many were predicting the damage was so bad that real estate would not recover for a decade; but the market began recovering in the mid-1990s.
2) Contrast this with what happened in Japan, where real estate also collapsed in the late 1980s; but rather than mark down the damaged goods and dispose of them, Japanese banks held them on their books. The result was a painfully slow recovery in the Japanese real estate market.
The 1997 Asian crisis
Southeast Asian economies maintained very high interest rates to bring in foreign investors in the mid-1990s. As a result, growth rates increased dramatically in countries such as the Phillipines, Thailand, and Malaysia.
In the early part of 1997, interest rates in the U.S. began rising, and the dollar strengthened. This made U.S. investments more attractive investment relative to SE Asia. Many SE Asian countries had their currencies pegged to the U.S. dollar, so when the dollar strengthened, it made their exports more expensive and less competitive.
In July, 1997, the Thai government, after massive speculative attack, devalued the Thai baht; it quickly lost about half its value. The huge money that had gone into Asian stocks and real estate began to reverse, and quickly turned into a route. The Thai stock market dropped more than 50 percent that year; all other Asian markets were also hurt.
What we learned:
--Like the present crisis, the Asian crisis provoked a "flight to quality," but it was a flight into "safer" U.S. stocks and bonds. That year, the S&P 500 was up 31%.
--Investing in emerging market stocks was a relatively new trading strategy in 1997; because there wasn't a large global base of investors (many investors were U.S. hedge funds), many attempted to get out all at once.
1998 Russian-LTCM crisis
In August 1998, Russia devalued the ruble and declared a moratorium on its Treasury debt. Like today, there was a "flight to quality," but this time investors fled emerging markets in particular and into government bonds. Specifically, many traders sold Japanese and European bonds and bought U.S. bonds.
This dramatically impacted a hedge fund called Long Term Capital Management (LTCM). The fund specialized in finding securities around the world (mostly bonds) that were mispriced relative to each other. Simply put, they went long cheap securities and shorted those believed to be expensive. Like many hedge funds today, they also used an enormous amount of leverage in order to make significant profits.
LTCM believed that their long and short positions were highly correlated and so the risk was small. This turned out to be wrong, as the Russian crisis (among other factors) dealt a severe blow to the portfolio. As traders sold foreign bonds and bought U.S. bonds, the value of the bonds diverged; the long and short positions were not correlated. Like quant funds today, expectations occurred outside the parameters of the model developed.
What we learned:
--A bailout worked. Ultimately, the Federal Reserve organized a bailout by the major creditors. Like the creation of the Resolution Trust Corporation, a government bailout--particularly of a hedge fund--was controversial, but the fear was that once the company started liquidating its portfolio to cover its debt, it would lead to a vicious cycle that would force other companies to liquidate.
This fear of a "vicious cycle" is also what is behind many of the calls for the Fed--or Congress--to intervene in the current crisis. We have still not answered the question: when is it appropriate for the government to take extraordinary action?
The Stock Market: (posted earlier today)
The sector to watch is the U.S. banks. Big commercial banks like Citi, JP Morgan and Bank of America have extensive retail banking operations and are far more diversified and better at laying off risk (often to foreign banks) than investment banks like Goldman, Merrill, Bear Stearns, and Lehman.
No one has even remotely raised the possibility that a major bank might be in big trouble. At the same time, no one on the Street I have talked to today said they would be shocked if a brokerage firm got bought out somewhere in the next couple months.
That's why banks are outperforming brokers. Today the Bank Index is up fractionally, brokers are down 1.8% again. The bank index is down about 6% in the last month, the broker index is down 18%.
The Credit Crunch:
1) Although stock traders would prefer the Fed lower rates to provide a psychological boost to the market, those with a "broader" view agree that it would do little to get liquidity to the players who need it most--mortgage lenders.
2) Calls for the Congress to get involved in the mortgage market are being met with dread on the Street. Proposals that have been floated include:
a) mandate forebearance for borrowers
b) allow losses to pass through to buyers of mortgage backed securities
c) raise the conforming loan limits above $417,000 to allow Fannie Mae and Freddie Mac to expand their mortgage portfolio
d) allow Fannie and Freddie to simply hold more mortgages in their portfolio below $417,000
The Fannie and Freddie proposals are likely nonstarters; their regulators are already opposed to it. First, most subprime loans are below $417,000, so raising the conforming loan limit is no help. Allowing them to hold more mortgages? Fannie and Freddie are working through accounting problems already, and may have unrecognized losses. This morning Fannie said higher risk mortgage loans in their portfolios that were originated in the market between 2003 and 2006 increased significantly through 2006.
Yen Rallies; Countrywide Tumbles (posted earlier today)
The rally in the yen we saw at the end of yesterday continued today--not just against the dollar (one year high against the dollar)--but against many other currencies where there was a notable carry trade, particularly the Australian dollar; New Zealand as well.
Another down morning for Countrywide as it announced it was drawing on all its $11.5 billion credit facility.
Traders are disappointed with Bill Poole's comments in a Bloomberg interview that it is unlikely there would be an interim rate cut from the Fed unless there was a "calamity."
Most traders agree that this is not a liquidity problem, it is a credit problem. There is plenty of money around--it is just not getting to the players who need it, like the mortgage companies.