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Small Ripple, Big Waves

Bad news has been roiling financial markets for some time.  It’s hard to stay on top of what has spooked investors recently and how important it might be.  A sense of fear and at time panic drives much of the news.  But last week a few things happened that might just be the worst news we have seen since the meltdown of Lehman in 2008, the event that plunged the financial world into crisis.

Two things have happened that have investment houses running for the exits very rapidly.  The first is that Spain appears to be in need of a bailout, the largest European economy to hit a key threshold yet.  The second is that a weak US jobs report has bid up demand for safe US treasuries to a dangerously high level.

Bonds are securities that pay out constantly, making them an apparently safe investment.  The published rate of a bond is based on what those bonds are selling for.   If you have a $100 bond that pays $5 a year, the interest rate is 5% – simple enough.  Bonds deemed to be a good investment might start trading for $120, or 4.2% on the same regular payout. Similarly, the same bond might be deemed bad and sell for $80, making the rate 6.3%.

Spanish bonds have hit 6.5% net interest lately, meaning investors are fleeing them rather rapidly.  That is the big ripple working through the system.

As riskier bonds are sold, bonds that seem secure are being bought.  The 10yr US Treasury hit 1.5% interest on Friday, and short-term bonds in Germany, Denmark, and Switzerland went slightly negative.  Negative rates are worth it to investment houses with “virtual” money to park, and in this case represent some insurance in case the Euro does break up – any new German currency would be worth quite a bit more than the current Euro, the theory goes, making a tidy gain to offset losses elsewhere.  But the US 10yr Treasury is more worrisome.

Lower interest rates mean that anyone who can borrow money here will pay less for it.  That’s the good news.  But as recently as a few months ago that same bond was paying around 2%, briefly spiking near 2.4%.  Goldman Sachs was advising a “short” at that rate, a bet that the bonds would fall.  They made big bets that the rates would rise.  Did they clear all those out recently?

Bond rate watching shows how small changes in markets are amplified into bigger payouts, the secret of modern finance.  Markets have come to crave complexity because low interest rates mean lower income from investing – the more those small payouts can be amplified the bigger the take.   The keys are “leverage”, or making your bet bigger with other people’s money, and “hedging”, or bets that will pay off in case you are wrong and the market goes the other way.

Big changes like we saw on Friday, up or down, are always tricky.  The tremendous complexity of the markets means that some people made money and others lost.  Through the complexity of modern finance the full effects have to work their way through.  Rapid change is very hard to hedge and the effects magnify.  This is what happened to LTCM, Enron, and Lehman – a small ripple was amplified into a tsunami.

What the markets need to make their complex systems work is stability, which is why so much money was poured into big investment houses in 2008.  It did not bring stability.  Instead, it was put into the same complex system and has made the situation even more tenuous.  Add in bad news and huge changes start to take place that make all of the bets placed in the market dangerous.  It’s impossible to properly hedge when a reasonably small event is amplified into something much larger.

That brings us to last week.  An exit from Spain and US stocks caused big changes in government bonds all over the world.  Anyone who bet the wrong way will spend this week scrambling to cover their losses, meaning that something else is likely to rise or fall in ways that reflect the needs of investment houses, not the underlying economy that supposedly backs that particular security.  Suddenly, things that seemed safe and stable come unglued for what seems like no particular reason.

The secrets remain leverage and hedging.  But without new money to leverage and a roiling market where it is impossible to assess risk, these two fail.  The complex system falls over and collapses at some point because it has no foundation left.

This is why banking needs to be boring.  Right now, however, it is far too exciting to be useful – or even reflect reality.

8 thoughts on “Small Ripple, Big Waves

  1. Something has to be done about this but I have no idea what. Do we just wait for it to fail? Seems like it has to eventually.

  2. It is way more complex than it needs to be and more money just seems to make it more complicated. The financial markets have become their own thing and are not doing their job of providing capital to companies that need it. It is all so broken in so many ways. I would like to hear what you think should be done about this if you can.

    • All I can think of is new regulation based on better disclosure. If a bank is selling a new product, they should have to provide some kind of simple risk assessment that they can stand behind. If it turns out to be far riskier than advertised, they should be forced to pay in a fairly automatic way (ie, let’s not wait for the courts to work it out). That’s about all I can think of at this time.
      It’s not much, but regulations written around existing securities will only be worked around. Something more comprehensive has to be done, and disclosure still feels like the best thing for both the markets and the public.
      Anyone else have a better idea?

  3. This is why banking needs to be boring.
    Or at least not control so much of ppl’s live’s.

  4. Pingback: Bad News is Good News | Barataria – The work of Erik Hare

  5. Pingback: The Reset Button | Barataria – The work of Erik Hare

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