Monday, October 13th, 2008
a nasty habit

The Beatles taught us that “love has a nasty habit of disappearing overnight.”“I’m Looking Through You” was on the classic album Rubber Soul.  Indeed, “I’m looking through you, you’re not the same” could be the motto of the analyst examining derivative positions in the light of a new day. So too liquidity.  Not so long ago, there were great oceans of it, fed by rivers that never seemed to run dry.  Like love, most market participants took that liquidity for granted, only to have its sudden absence leave them disoriented and unable to function as they had previously.

In reflecting on such losses, it is easy to focus on the proximate cause of the change — or the signs that weren’t recognized — and somehow fantasize that it could all be put back together again.  Such forlorn longing is particularly out of place now, given the bleak landscape of parched financial markets.  The unavoidable message of the recent CFA Institute conference on fixed incomethe research puzzle | This is the second in a series of postings about the conference, the first being “rethink everything.” is that the carcasses of many exotic creatures now rotting in the sun represent endpoints in the process of natural selection.

The word of the day is “deleveraging,” and, so far, there’s nothing of it to like and every reason to expect that it has a long way to go.  As such, while price, time, and the coordinated actions of every governmental entity on the planet might get a trickle of water flowing again, there’s little hope for “business as usual” (at least as it was defined not that long ago) to visit any time soon.

If we knew that liquidity would return, there are a lot of trades we should do, according to the analytical tools on the desks of tens of thousands of investment managers around the world.  Some possibilities with oddball names and byzantine structures were displayed for those gathered at the conference, and the broad outline of the debate of the hour was soon clear:  Some said, “These things are cheap, and deserve to be bought,” while others counseled caution, spotting “more sellers than buyers for as far as the eye can see.”

As it is, money managers are burdened by some of the choices that linger from a relationship gone bad.  First of all, what are they going to do with all of this stuff?  There are many suspect structures still on the books.  Unfortunately, at the very time that they can make the argument that the holdings are too cheap to sell, some of their clients want (what’s left of) their money back.  So, the managers are now where they should have been before, actively accessing the liquidity risk of various structures and trying to make the difficult decisions on what to keep and what to throw (assuming that they can actually trade anything).

As for covenants and promises of all types made in the heat of passion, many are asking, “What were we thinking?”  You would have thought that they would have learned from that last little foray a few years ago (or the one before that) that misplaced trust and blind faith don’t always work out.  There, too, firms are faced with the task of assigning increments (or, more typically, decrements) of value in a way that they failed to do upon purchase.

And who to believe now and to rely on for good information?  Some of the enablers of old are gone (along with their firms).  The assumed web of facts, opinions, and ideas has been disrupted and discredited, and must be rebuilt.

Presenters at investment conferences rarely talk about the details of how to do such things, and that was the case in this instance as well.  Outside of that normal tendency, a contributing factor may have been some sense of the futility of the exercise, given that there was a general feeling that large parts of structured finance (that now-bitter sort of leveraged love, if you will) were simply going to evaporate, leading to fewer jobs, lower fees, and orphaned positions that would be hard to value for years to come.

Certainly those with cash to spend (plus analytical acumen and staying power) may find some bargains that will deliver nice returns.  Distressed debt funds are expanding, new ones are being created, and the detritus of the whole sad affair will provide a nice living for those who can pick up off of the street once-cherished keepsakes that are tossed from the window in despair.

It is tempting to ask whether the hearts of professional investors are broken for good, or whether all will be forgotten when a “come hither” look draws their attention.  The nature of the next infatuation will depend in part on what is allowed by the regulatory chaperones standing about with prying eyes.  Of greater importance, though, is the parental example set by the leaders of investment organizations — will they promote a love for the ages, or a fling that ends in tears?