• Until Friday, I thought the medium term economic problem would be the negative impact tighter credit conditions might have on domestic US demand. Bernanke's decisive lowering of the discount rate and the liquidity that central banks have pumped into the system has led me to think the real challenge will be what happens as the liquidity starts to search for a home.  It will have to find a home somewhere. The problem that has emerged in the last 5 years is what can happen when excess money supply chases a shortage of reasonably priced assets.  Money managers resort to investing in unsound, poor quality and overpriced assets.   The sub-prime debt blow out is a manifestation of such conditions.  As brilliant as the maestros that packaged these wonderful structures (CDO's etc) might have been, it looks like the only thing they really did was find a clever way to disguise that they really did not have any answer other than to get lousy assets and tart the assets up with smoke and mirrors so that they could justify their fees and get innocent people to invest.
  
• The real sleeper is what will happen with the excess liquidity once the contagion settles.
  • Will it lead to a resurgence in asset price inflation and if so, in which asset classes?  An adjustment has taken place in credit related instruments and equity markets. 
  • But will there be a big bounce back that will be fuelled by this last round of liquidity injections?
  • Will such a bounce back lead to a much bigger bust in 12-24 months time? 
  • Where can the money go?   
    A new US administration might develop a sound mechanism that will enable the funds to filter into productive uses such as the upgrading of US infrastructure.  Who knows, but one hopes the unusually incompetent management of this administration will not be repeated.  The US has the propensity for entrepreneurial brilliance and its people deserve a hell of a lot more.
• A further sleeper remains the US/China trade imbalance and the growing power of sovereign investment organisations - China , Russia and Abu Dhabi Investment Authority.  How will they act and wield their power?
• A third big factor is the next US election. Post the internet bubble collapse and September 11, Greenspan flooded the market with liquidity in accordance with his mandate to maintain the functioning of the financial system and avoid a US recession.  A finger could be pointed at Greenspan for allowing interest rates to remain to low for far to long, but we all know exactly when was too long after the fact. The real culprit is the Bush administration's economic mismanagement. The Bush administration did not create an environment that would lead to a suitable increase in productivity and investment that was capable of soaking up the liquidity in a sustainable manner.  Instead, uninspired and unimaginative economic policy was coupled with an ill managed military venture in Iraq . Not only did the misadventure serve to highlight the limitations of US military might but it made every US individual far more exposed and vulnerable to foreign economic forces. The US is now far more exposed to the decisions of economic institutions and sovereign fund managers (eg: ADIA) that have funded the US budget deficit by buying US bonds.
• The result:
  • [1] A spurt in consumption demand fuelling China's trade surplus and the US trade deficit, all compounded by a poorly managed military initiative in Iraq.
  • [2] A burgeoning hedge fund industry and other asset/fund managers who garnered the liquidity and used it as an opportunity to charge larger than normal management fees by packaging assets at inflated prices and selling them to unsuspecting investors and pension funds.  The market correction has been spurred by hedge funds packing the equity portion of housing loans to non-credit worthy US citizens.  Such loans would not have been possible in the past because such individuals would not have been able to save for the minimum 10% deposit required for a bank loan.  But the hedge funds took other peoples money and used the money to fund the equity portion that would normally be provided  by an individual borrower (the borrowers hurt money and also some basic evidence that they can manage money).  So suddenly, individuals without a savings track record, and low income could obtain a loan to purchase a house.  All good while rates are low.  Cleverly, the hedge funds packaged the equity portion into various opaque, supposedly sophisticated, bond structures and added gearing (ie: further risk) to boost returns.  The higher returns enabled the fund managers to justify higher fees.  .  S&P and other rating agencies were complicit. The result  - mucho fees for the funds and the sharing of upside.  But, not sharing of downside.
    
    A nice arrangement when you can get it. There was disproportionate upside for the fund managers since the investors were putting their money at risk, not the fund manager.  The opaque nature of the product marketing must have left many investors unaware of the risk they were assuming.  After all - the name hedge, implies safety.  An improved risk position.  But when these structures are reduced to their essence, they are nothing more than highly geared junk bonds.  The same sort of thing as LTCM except the packaging was a lot cleverer. 
    
    

    

    
    
    Deep down the markets know that this type of trickery might have taken place with other assets. So how far can it really go? How will the newly empowered sovereign fund managers act? New less predictable players have emerged such as China and Russia .  Who knows how they will react?  Power has been dispersed to many lesser known participants. 

   

 Australian Markets

• The wider credit spreads, at more realistic levels, will allow the banks to regain market share from mortgage managers whose higher funding costs will soon force them to increase their lending rates. Banks have many sources of funding, many of which are not as sensitive to wholesale market rates.  Mortgage managers rely entirely on wholesale securitized markets for their funding and it will not be long before mortgage managers are forced to pass their higher borrowing costs on in higher lending rates to preserve their margins.  The events of the past two weeks almost reverses the position of a decade ago when mortgage managers were able to gain substantial mortgage market share from banks because they could offer lower rates.  The rate advantage has disappeared in the last few years but many mortgage managers were able to retain their position in the market by using good sales and marketing techniques. Plus their ability to capitalize on the brands they were able to establish with their flexible, commission driven, loan broker distribution networks.  The position has now reversed and banks might for a time be able to reclaim share from mortgage managers by delaying rate increases.  Banks will be able to do so for far longer than can mortgage managers.  Once markets settle, mortgage managers might still not be able to offer rates as competitive as banks.  

• Babcock and Brown might be a good buy.  B&B's share price might have been impacted more than is justified by the market correction because it has positioned itself as the next Macquarie Bank.  So markets might have confused this to mean that they are likely to have hedge fund exposure.  Truth is, Babcock & Brown is a highly focused on global property and infrastructure manager.

With no clear evidence that hedge funds are generating Alpha to justify their high fees is it time to rethink fund management strategies in these uncertain times.  Perhaps some form of portfolio insurance as recommended by Taleb and Shiller.  Using either options or a derivation of the CPPI technique.  [to be developed further and linked into fund management strategy].