Saturday, March 22, 2008

Another bubble in the making

The sub-prime mortgage crisis and the resultant loosening of monetary policy, so as to ease the credit squeeze, may actually end up blowing a new bubble. Commodities trading is the new boom sector. In an ironic twist to the tale, the leaner, lighter, and knowledge and internet-based economy is being now propped up by the clunky and mundane commodities economy of copper, wheat, and oil. The recent small drop in commodity prices, is seen as only a temporary blip, since the factors repsonsible for the higher prices continue to be active.

A NYT article describes the commodities market thus,"The heart of commodities markets is the so-called cash market, a “professionals only” setting where producers sell boatloads of iron ore, tanker ships full of oil and silos full of wheat for immediate use. Wrapped around that core are the commodities futures markets. Here, hedgers and speculators trade various versions of a derivative called a futures contract, which calls for the delivery of a specific quantity of a commodity at a fixed price on a particular date."

"Futures contracts trade both on regulated exchanges and in the immensely larger but less regulated over-the-counter market, where banks and brokers privately negotiate futures contracts with hedgers and speculators around the world. The prices at which all these contracts trade indicate the potential strength of demand and supply for commodities still in the ground or in the fields. That makes them important to everyone who produces, buys and uses those goods — wheat farmers, baking companies, grocery shoppers, oil companies, electric utilities and homeowners. Prices here can also influence the values of the increasingly popular exchange-traded funds, or E.T.F.’s, that focus on commodity investments."

Investors perceive that commodities like oil and gold offer a safe hedge against inflation. They are seen as one of the few remaining sources of double-digit gains that have fast been disappearing from the markets for stocks, bonds and real estate. Small investors are plunging in, too, using dozens of new retail commodity funds to participate in markets that by one measure have jumped almost 20 percent in the last six months and doubled in six years.

As NYT reports, "the biggest speculators and lenders in the commodities markets are some of the same giant hedge funds, commercial banks and brokerage houses that are caught in the stormy weather of the equity, housing and credit markets. As in those markets, an evaporation of credit could force some large investors — especially hedge funds speculating with lots of borrowed money — to sell off their holdings, creating price swings that could affect a host of marketplace prices and wipe out small investors in just a few moments of trading."

Margin calls and volatility can be managed as long as the prices of commodities continue to rise, as they are now. Credit will continue to flow uninterrupted, further raising the prices of commodities based financial instruments. But commodity prices can record daily percentage changes that dwarf typical movements in stocks, thereby adding considerable volatility to the market. And when the time of reckoning comes, as it should, the same sub-prime mortgage backed securities story will get enacted.

Wall Street and the global financial markets need to face up to the reality that there is a deep solvency problem. There are whole classes of asset backed securities, traded and re-traded many times over, insured and reinsured, which are now valued at a fraction of the original value of the asset. In some cases, the original asset itself has been liquidated or has spiralled into oblivion. The repayment of these liabilities can be postponed for some days or months. They can even be transferred or shifted to some others. All this financial engineering will only be at great cost to the long term health of the financial system, as it will release moral hazard and information asymmetry problems aplenty into the system.

The bottomline is that somebody has to bear these liabilities. The sooner we realise it the better. The breathing time that the Fed is giving by its rates cuts, liquidity injections and the extraordinary relaxations in credit standards has to be utilized effectively to wring out these losses in a slow and phased out manner.

Instead it would appear that the financial and mathematics wizards and Nobel laureates occupying the backrooms of the Wall Street firms and hedge funds, are using this breather to spin out new asset categories that would seek to shift or transfer away (or even conceal) their liabilites and risks to other unsuspecting investors and lenders (of which there appears to be plentiful in supply, even after the very recent, bitter lessons of the sub-prime mess). The game will go on and the agony will be postponed for a few more days or months.

The technology stocks led equity market boom (remember Dow 36,000!) of the nineties and the real estate market bubble of this decade generated huge Ponzi schemes, with deferred judgement days, that spread wealth around a wide base of consumers and investors. A whole generation of investors have grown up used to double digit returns, that has been the distinctive mark of the last two decades of financial market innovations and booms. It is no surprise that this era is now coming to an end. It had to end, for those boom era returns were built on fickle foundations and thereby not sustainable.

One of the most eternal and profound lessons from the financial market is simple - that which goes up has to come down, and that which goes up furthest has to go down the deepest! Investors will be all the more wiser to pay heed to this basic lesson.

1 comment:

salmanspeaks said...

Really an eye opener!!!
Wonder where you all these days!!!!!