Wednesday, October 6th, 2010
vectors of contagion

Two years ago today, I was at a CFA conference on fixed income, which happened to take place at a time when much of the fixed income market was effectively closed for business.  We were in the throes of the great crisis, trying to make sense of it all.the research puzzle | I did three postings related to the conference and the implications of the events of the time. (It was to get worse before it got better.)

During a presentation by Francis Longstaff of UCLA, I jotted down the phrase, “vectors of contagion.”  Looking back on my notes now and presuming that I didn’t dream it up and not sure if Longstaff had, I did a search, and the earliest financial usages I found were by Martin Mayer.  One place he used it was in an August 1999 interview with that’s remarkable for a number of reasons and is required reading.Derivatives Strategy | The magazine has been defunct since 2001, but the site says it’s “still the largest online source of derivatives information.” In it, he laid out his three laws of derivatives and postulated a fourth:

When the whole is valued at less than the sum of the prices of its parts, some of the parts are overpriced.

When you segment value, you also segment liquidity.

Risk-shifting instruments will tend over time to shift risks to those less able to bear them.

The more abstract the instrument, the less it depends on real developments in real economies, and the more likely it is to be a vector of contagion.

The interview touches on Long-Term Capital Management and some other less famous incidents that should have been heeded, with interesting thoughts about the fickle nature of liquidity, the inanity of relying on the rating agencies, and the need for regulation and exchange trading of OTC derivatives.  Nassim Taleb even makes a pre-fame appearance.

What is remarkable is that after attending the CFA conference, I wrote pieces about liquidity (adapting a Beatles lyric to say that it “has a nasty habit of disappearing overnight”) and the ratings agencies, and that all of the things that Mayer worried about were finally on the radar screen of the big market players that had been in attendance.  Nine years later.

There are always themes and memes to examine and there is always contagion in the realm of investment ideas.  That’s the sociological nature of the markets to begin with, and there are investment vehicles and market structure changes and performance pressures that amplify and redirect them.  The impacts are felt by market participants of all types.  For example, a trader who relies on technical patterns may find that the emergence of high frequency trading has inhibited his strategy (or benefited from it, although it’s easy to ignore that possibility for a long time and claim victory for yourself).  Or a fixed income manager feels forced to play along — just two years after nothing was trading — when others buy at tight spreads or without the protection of good covenants.

Of late, the contagion has been in the direction of “risk on,” but the tricky part is always figuring out how far it has gone and whether it has “gone too far.”  Interest rates, gold, stocks of various kinds, the list goes on and on.

One phrase that has started popping up a great deal is “currency war.”  It is a very real economic issue of course, but when a phrase spikes in popularity and it happens to support the marquee trade of the times — gold, in this case — it’s time to be on high alert.  Remember the prior lessons about disappearing liquidity.

And know that the effects of such a war could be unpredictable.  For reference, see another Mayer quote, this one from 1998, in testimony to the Senate Agriculture Committee:  “On the international scene, custom-made derivatives that rely on analyses of covariance among different currencies and interest rates in different countries become the vectors of contagion in time of trouble.”Senate Agriculture Committee | This appears to be a statement before his testimony, but I have not seen the rest of the transcript.

The more things change the more they remain the same.  If only the vectors of finance had some of the predictability of those of physics.