Architecture

Most architects must have a fulfilling life. You design, you build, and you and others admire for years to come. With respect to the financial system, loud calls are being made for a new architecture. How did we get here and where do we go?

Alan Greenspan has been referred to as the "intellectual architect" of current policy and financial structure. That makes him "similar in profession" to his mentor Ayn Rand's most famous character, Howard Roark. Maybe not in the completely uncompromising, unconventional way, but no doubt Rand/Roark's influence made its way into Greenspan's laissez-faire, free market philosophy.

The other name to invoke here is Adam Smith. Greenspan is again a long-time admirer of the 18th century economist/philosopher. Trust the invisible hand, and society will maximize its potential.

A key distinction must be made, however, between free market commerce and free market finance. When Greenspan was mastering his craft, pouring over thousands and thousands of pieces of data, figuring out mathematical relationships and dissecting economic indicators, he was engrossed in the real economy. When he became Fed Chairman though, he inherited power and persuasion over financial markets. Quotes from the late 90's show that he was clearly in favor of extending the invisible hand throughout the financial system and limiting the reach of regulation.

By now it is clear that the financial architecture is going to undergo change. Speculation and leverage have different systemic implications in the financial markets than they do in commerce, and steps are being taken to prevent the current crisis from reoccurring once we have all conveniently forgotten the missteps of the recent past. I sincerely hope though that the current architects keep the spirit of Greenspan's philosophy alive, albeit with a humble acknowledgment that trust and transparency are key characteristics of a sustainable financial system.

Bernanke's Put-etto

In Ben Bernanke's much anticipated speech today in Jackson Hole, he essentially absolved the Fed of responsibility for protecting market participants from bad financial decisions, emphasizing vigilance yet patience and allowing others to make policy decisions that should relieve pressure on the economy's best friend: the US consumer.

Equity markets liked the speech, even though the market expectation for Fed rate cuts this year has been tempered. Unlike his predecessor, who was famous for swiftly cutting rates to ensure liquidity, Bernanke seems to be content biding his time despite some implicit pleading by others.

Of course this positive market action could just be month-end (and quarter-end for some broker-dealers) window dressing....

Taking It In the Shorts

Recent volatility and uncertainty is part of the market's unending pendulum swing between fear and greed, but the specifics around this summer's high drama deserve special mention. Let's lay out the backdrop:

1) New Fed Chairman

Ben (not Benjamin) Shalom Bernanke was sworn in as Fed Chairman on February 1, 2006, but it took the greater part of eighteen months for him to meet a true challenge. Oh, and by the way, good luck following the legendary Alan Greenspan and establishing your own credibility.

2) Single source of market disruption: Credit

The economy seems fine, inflation is relatively contained, and global issues are benign. Far and away the main reason for this disruption is lenders have been doing silly things in the credit markets.

3) "Alpha" dogs

The proliferation of hedge funds and accompanying strategies has led to money flow into some rather strange places. Universa Investments is an example of a fund that seems to pin its investment strategy on short-selling and extreme levels of volatility. Just the latest in the never-ending quest for "alpha".

So what did this cocktail produce? Well the only further background information needed is the characteristics of a credit instrument. Being long credit means that you are short optionality, and therefore volatility. In a steady state world, everyone gets their loans paid back (or doesn't have to pay Par for a defaulted security as a result of a credit derivative contract settlement). But in a more volatile environment, the best case for a creditor is still return of principal, but the likelihood of loss is much greater. Therefore it is not surprising to learn that credit spreads and market-based volatility measures (such as the VIX) are highly correlated.

Fast-forward to the credit contagion that started with the Bear Stearns Asset Management announcement. Soon all the aggressive credit deals that had been originated in the past several months (mortgages, LBOs, CDOs, etc...) were under pressure and liquidity became an issue across the globe. Markets began moving (up and down) in whipsaw fashion and volatility spiked.

Enter the Fed. The Federal Reserve Act states:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

But everyone knows that financial market stability is an "unlegislated" mandate of the Fed as well. The ingenious aspect of the Fed's response to panic in the market was in the timing. To wit:

1) On the third Saturday of every month, index options expire. Those options stop trading at the end of business on Thursday, and the index settlements are determined based off the opening prices on Friday.

2) The equity market hit new lows on the afternoon of August 16th (Thursday), which also coincided with a spike in the VIX to 37.5.

3) The Fed's policy response was released after the index options stopped trading but before the index settlements were determined.

4) The most leveraged way to play any market is through options, and one would imagine that short-sellers (long puts, short calls) and "long vol" plays were very instrumental in driving the market lower and vol higher.

5) By acting between the end of trading and settlement, the Fed "hung the shorts out to dry" as equities rallied over 5% and vol dropped about 30% as a result of the announcement.

The response can therefore be seen as a warning shot to short-sellers, assuming that the Fed believes that "unfettered" short selling drives up volatility and therefore damages the credit market even more.

In addition, the Fed didn't even use the most famous tool in their monetary policy tool chest: the official Fed Funds target. They get to save that for when economic, not just market, conditions warrant it. And it also gives Mr. Bernanke a another notch in his credibility belt, which never hurts.