Can We Use Reflexivity to Analyze the Current Crisis?

After giving a brief introduction to the concept of reflexivity last post, I will try to use the "theory" to analyze the current credit crisis. I will make several generalizations during this discussion, but bear with me.

First off we should define the crisis we are discussing. Since the summer of 2007 the credit markets segment of the capital markets has been locked up. Liquidity has evaporated in many previously highly liquid debt markets - auction rate securities, collateralized debt obligations, student loans, etc. The key here is how we define the underlying trend. I define it as a tightening of credit across the board. This is not a subprime crisis, or a mortgage crisis, it is a credit market crisis and it has painted a broad brush across most debt markets.

This underlying trend of credit contraction, unchecked, has several negative implications. Mainly, as credit contracts to certain asset markets, the value of the assets in those markets falls. Let's use a house for example. A house may be worth $1,000,000 if credit is widely available for anyone to borrow 100% of the house's value in order to purchase the home, however when credit is withdrawn and is only available up to 80% of the value and the borrowers are constrained by additional income requirements, etc. the value of the home may fall to $500,000. The price decline may be assymetrically greater than the decline in credit availability but I assume the prices ARE a function of the credit availability.

That is a great micro example of the phenomenon of credit contraction, but you can imagine how it is affecting the banking sector (the creators of credit). The banks have extended massive amounts of credit and then hold that credit as assets on their balance sheet, either in the form of a retained loan portfolio or possibly securitized loan products. Ironically enough, the value of these "assets" are impaired on a macro level just as credit contracts on micro level. Why is this bad? The banks are forced to write down the bad loans on their balance sheet, but their liabilities do not necessarily decrease by the same percentage. Assets - Liability = EQUITY. Banks make NEW loans based on the equity they have available to lend. Banks which have declining equity also tend to reign in the amount of loans they are making and the try harder to control the quality of loans they are making. This in turn subtracts credit from the market. What does this give us? A vicious cycle of credit contraction and asset price declines along with many bank failures.

Now lets tie this back into the reflexivity analysis. The above layout is my personal (UNBIASED - ;) j/k) analysis of the underlying trend - this reflects the "cognitive function." This however is not the end of the story.

The next segment of the reflexivity analysis is the participating function or manipulative function. This is where human interaction with the underlying fundamentals either vis a vis market participants or regulatory action affect how the process unfolds and at what speed. The current bias of market participants is that the economy will recover in the second half of 2008 and the credit crisis will be over soon. Regulators are encouraging this perception by explaining the credit market issues as a crisis of confidence. (Aren't they all crises of confidence.... ;) j/k)

Anyways - let's call the regulators the following: the Federal Reserve, the US Treasury, SEC, and Congress. They are trying to arrest the fall in asset prices and thereby restore confidence to the credit markets. How are they doing this? They are exchanging very liquid securities (i.e. US treasuries) for securities of dubious value (i.e. mortgage backed securities, etc.) The banks who participate in these loan agreements then become more liquid and trade treasuries for cash as need be, whereas previously the mortgage securities may have only traded for $0.85 on the $1.00 that was instead received from the FED as the government participant.

The FED has also dropped the fed funds rate precipitously to encourage credit expansion. Unfortunately for the FED they have as of yet been unable to arrest the underlying trend underway as of yet. Some of the banks have written assets down more aggressively than others, but it has become readily apparent to the astute observer that we would have had multiple bank failures by now if not for the bailouts of Countrywide, Bear Stearns, and now WAMU. It is also clear that the FED is willing to backstop and favor certain banks to attempt to keep some strong ones in the market (i.e. JP Morgan.)

How can we reconcile these two countervailing forces? What is stronger? I think the underlying trend is more important and will triumph. I think it is too early to buy US financials and investors should stay short the US market as thing will get worse before they get better.

The analysis of course would not be complete without discussion of the unintended consequences of the participant's bias. The massive government backstopping and intervention in the market has resulted in continued pressure on the US dollar with it hitting new lows every day. Commodity prices hit new highs with oil around $120 per barrel. Perhaps more importantly the US government is threatening the integrity of our currency and public debt situation in the long term in order to apply a short term bandaid. Let's hope that there are still resources left over as the crisis continues to accelerate.

Regards,

BG