Quote of the day: Kasriel on Leverage

From the ever readable Paul Kasriel:

"Fund managers and investors have been puzzled why prices across a wide spectrum of assets moved together last week – namely, down. I think it has everything to do with delevering. What is bringing about delevering? When a fund owns assets that are going down in value for some fundamental reason, say mortgage-backed securities whose underlying collateral are defaulting subprime mortgages, and the fund is levered, its creditors start to make margin calls. The fund, then, has to sell assets to raise cash. The fund might end up selling relatively high-quality and liquid assets [Ed: i.e., Gold, Oil] in order to raise the maximum amount of cash quickly to meet its margin call. This puts downward pressure on the prices of assets not tainted by credit risk.

Now price volatility increases in asset classes unrelated to the originally troubled asset class. Many hedge funds engage in seemingly low-risk strategies that have commensurately low returns. In order to boost investor returns, these low-risk funds incur leverage. Many of these funds measure risk by the price volatility of their asset holdings. When there has been an extended period of low price volatility, risk is considered to be low. Therefore, more leverage can be incurred. But when asset-price volatility starts to increase due to the sale of assets to meet margin calls by funds with tainted assets, funds with seemingly “good” assets are forced to delever because of the increased risk these hitherto low-risk funds now face. So, the low-risk funds end up selling “safe” assets in the process of delevering, thereby putting downward pressure on the prices of these “safe” assets.

Leverage is wonderful when asset prices are rising. It is a bear when asset prices start to retreat. It creates a vicious cycle. Both the sinners and the sacred get got in the undertow."
(emphasis added)

That last paragraph us especially sharp . . .

Diverse Asset Class Correlation and Leverage
Northern Trust Global Economic Research, August 13, 2007

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What's been said:

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  1. Jason R commented on Aug 17

    OMG!!! AMEN brotha! Can I hear an Amen from the crowd?!

    LEVERAGE. Bad! FIRE. Bad!- as Phil Hartman would’ve spoken it…

    This is why such a *small* part of the debt economy can have such a huge impact. Man, it took four freakin’ weeks for someone to actually write about this… People just do not get how interconnected it all is. There is no isolation. If you are in the pool with the rest of us folks, you will notice that quite a few people have urinated.

  2. David Pearson commented on Aug 17


    According to the London Telegraph’s sources, the Fed was repo’ing ABCP yesterday. Looks like Larry Kudlow got his wish. The ulitmate in manipulation. Liquidity injection not flowing to the right assets? Just repo the assets!

    Now, if only the Fed had repo’d bank holdings of those nasty, levered Trust shares in 1929…I bet you Larry would have been all for that.

  3. peggy commented on Aug 17

    a repo is just a short term loan. The fed buys nothing. the securities are collateral only.

  4. jake commented on Aug 17

    its 1929 all over again……

  5. Philippe commented on Aug 17

    « Play it again Sam »
    Leverage and collusion among markets participants are the stories of these assets markets; corporations in Europe have made profitable round trips trading their own shares, fund management companies have leveraged their positions through derivative purchases and « hedge funds » and Banks have been doing the same. It is fine, companies acquired assets at these high prices benchmarks, and it was fine.
    Regulators were passively looking at ebullient markets until the real economy started to be hurt bonds markets, CDO, CLO, corporate bonds are and will be hurt. The assets prices benchmarks of the consumers are going through attrition and it is no longer fine, and now?
    EC commission is asking for an assessment of the credit ratings agencies
    Few members of the European community are asking a G8 meeting to address the financial markets pervasive downturn.
    May be few others will wonder why Yen and Swiss currencies have depreciated in quantum which are far away from their « theoretical » values.

  6. jake commented on Aug 17

    god bless you mr bernanke…god bless you……were saved!!!!!!!!!

  7. pj commented on Aug 17

    Fed Cuts Discount Rate to 5.75 Percent to Ease Credit Crunch

    Aug. 17 (Bloomberg) — The Federal Reserve, in an unscheduled announcement, cut its discount rate and said it’s prepared to take further actions to “mitigate” damage to the economy from the rout in global credit markets.

    “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward,” the central bank’s Federal Open Market Committee said in a statement released in Washington. “The downside risks have increased appreciably.”

    In the statement, the committee said it is “prepared to act as needed to mitigate the adverse effects on the economy arising from disruptions in financial markets.”

    So the Q is whether the Fed Funds rate is next on the line??,,, Bernanke put, anyone.

  8. Steve C commented on Aug 17

    The Fed cut the rate at the Discount window 1/2%.
    Suge, who comments on this blog has often claimed the bottom will be 12,500 on the DJIA. It got within 1 point of that yesterday. Is he the winner?

  9. Ross commented on Aug 17

    Back in the OLD days….. Bet you’ve heard that one a few times. But back then, the FED could and did disintermediate the markets by driving rates above the max rates offered by S&L,s thereby causing a ‘run’ on deposits and hurting especially the homebuilders. This in turn would slow an overheated economy. Much different today. The markets esentially disintermediated themselves. It took a lot of leverage, idiot loans and liquidity but it is now upon us.
    IMAHO (in my authoritative humble opinion) we give the FED way too much credit, no pun intended. The Brothers are there as a salve. The markets are bigger and more powerful than any and probably all CB’s. Their primary mission the the slow debasement of currencies, hence debt. But we know this. Just play their game.
    Discount rate cut? So what. The markets will for a time cuddle up to the FEDDIE bear, but it will make no difference. Unwinding is a process.

  10. Woodshedder commented on Aug 17

    Therein lies the problem. Periods of low volatility are MORE risky, not less. When volatility declines, and the consolidates, things are only going to get MORE volatile.

  11. Werner Merthens commented on Aug 17

    Oh, money lords at the FED hear Cramer’s prayer…

    Hey, they just did!

  12. michael schumacher commented on Aug 17

    So really what the fed is saying is that free markets are fine….as long as it’s going up. Who put kudlow and/or cramer in charge

    Total crap. This only elongates the pain.


  13. mrkcbill commented on Aug 17

    Is there going to be a ticker tape parade in NYC today? CNBC acts like they just won the Super Bowl.. Seems like the rate cut was yesterdays news.
    Does anybody feel bullish about stocks short term.. I have not heard of one merger in a month.

    My BS radar is pretty good and it’s telling me there were way to many funny deals being done across the board– I believe all the financials still have NEWS for us the public and shareholders.

  14. Nattering Nabob commented on Aug 17

    The Fed cut the discount rate, so it’s much worse than I imagined. Time to sell my long positions into this rally.

  15. j commented on Aug 17

    Finally someone talking intelligently about what happened. Low spreads (either in debt or equities) coupled with low volatility lead people to think they can take more on more leverage. The event last week was a 1 in 3 year event on average. But it hasn’t happened form 8 years. The quant models have always broken down over time. But many of them have been extremely successful. It’s just that no one with half a brain uses leverage and quant models.

  16. Stuart commented on Aug 17

    This is the symbolic Discount Rate, not the Federal Funds rate. But that will happen in September, if not sooner.
    “The Federal Reserve, reacting to concerns about the subprime lending crisis and the volatility in the financial markets that have resulted from it, announced Friday that it is cutting its so-called discount rate temporarily by a half percentage point, to 5.75 percent.

    The discount rate is the rate the Federal Reserve banks across the country charge qualified lenders – mainly banks – for temporary loans. It is largely symbolic.

    The central bank did not change its more closely watched federal funds rate, which affects rates that consumers pay on various types of loans. That rate remains at 5.25 percent.

    The Fed added that “although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably” and that the Fed was prepared to take more action if necessary.

  17. Stuart commented on Aug 17

    A snippit from another blog site. Useful.

    “We can only speculate about this, but the decision to move the primary discount rate rather than the Fed funds rate may indicate that the Fed anticipates some institutional failure as soon as today, probably not a bank, but rather an institution that has substantial bank liabilities that may not be able to clear. Markets should not be calmed by this tactic. Unlike the Fed funds rate — which affects all banks’ cost of funds — a discount rate cut only lowers the cost of emergency borrowing by institutions in distress. This move is not going to provide any relief to the overall economy. However, we believe that the Fed’s action and statement today raise the odds of a reduction in the Fed funds rate at the September FOMC meeting, or perhaps even before.”

  18. Lord commented on Aug 17

    I presume they sell their long positions and let their short positions ride while deleveraging becoming more market neutral.

  19. DB commented on Aug 18

    Don’t fall for the 1998 Fed rate cut scenario and aftermath BS….this is best case, January of 2001 (Fed surprise cut to prevent tech bust recession), where the market proceed to fall another 30% into the October low….OR…more than likely, because of the similarities….

    Japan, 1990..the world’s last “credit/debt/real estate/banking” bust where markets fell 65% from the top in less than a year.

    Buckle up folks.

  20. Bob Bernardo commented on Aug 19

    After the shorts are done covering on Monday, it’ll be just like Art Hogan said last week: “We’re going down like free beer.”
    Did Cramer rant like this in 2000?

  21. flyingtree commented on Aug 21

    I heard Paul say basically the same thing on a radio show last week. Fortunately, he got it out before the host went nuts and hung up on him. Really helped to solidify my opinion on the movement of some assets I was increasing ownership in. In particular, some research revealed that my little microcap had a significant holding by a Bear Stearns hedge fund. Thank you, Mr. Market, for small favors. Us little people need all the help we can get.

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