"Honey, get a doctor. I've got the confidence virus" Friday, March 14, 2008
Confidence underpins business. Whenever you transact with someone, you demonstrate confidence that they can satisfy their end of the deal e.g. Amazon will deliver the book you ordered online and for which you gave your card details; the butcher is selling you fresh meat.
When confidence is lost, you stop doing business with that person/company and usually share that news with others.
In financial markets, loss of confidence about firms solvency is a primary contributor to the current paralysis - will this firm be able to pay me back or settle any trade I do with them? This is exacerbated by the viral nature of confidence. The demise of Carlyle Capital is now causing worries about the solvency of Bear Stearns, understood to be one of its prime brokers. Amplified by rumours and fears, this knock-on effect [systemic loss of confidence] is unconstrained.
In Bear Stearns case, solvency concerns exist because it is believed they will have seized collateral in the form of mortgage backed securities. Since this have become highly illiquid, so they cannot be easily converted to cash and will sit as idle assets. This is precisely why the Fed moved to offer the asset exchange facility, albeit I doubt they will publish which firms used it and in what size given the potential impact on confidence this may have - the use of such a facility may imply desperation and was the reason the run on Northern Rock began.
Elsewhere the move by the Chicago Mercantile Exchange ["CME"] to raise the margin limits for transacting five- and 10-year Treasury futures and currencies will have risk teams and dealers speculating on who will be hit by this drain on cash. Hence, CME will ask its' members for more margin, who in turn will demand higher margin from their customers. If clients can't meet these calls, they will either have to forcibly close positions and/or sell collateral, hoping that this will cover potential losses. Consequently, brokers like MF Global will be closely scrutinised/monitored in case any of their clients appears to be struggling that may have potential knock-on effects.
At the same time, the "generous" credit lines some hedge funds will have enjoyed will have been slashed by their brokers, reducing their trading capacity and requiring them to adjust portfolios i.e. trade, in smaller increments within the lower headroom they have. Combined with counterparty concerns, this has an effect on the depth of the market and the ability to trade in size [reference to the quantity of shares/units]. Trading in size matters, because if you can't trade in large quantities, then it becomes even harder to sell blocks assets at all or at least without triggering sizeable price falls.
Loss of confidence happens far faster than gains occur, so expect recovery to take a long time.
UPDATE: Just hours after writing this post, Bear Stearns shares collapsed by over 50% and it was forced to arranged emergency funding via JP Morgan with the New York Fed. Alan Schwartz, Bear Stearns CEO said in a statement that the bank’s liquidity had ”significantly deteriorated” in the last 24 hours as counterparties and clients rushed to close positions with the bank and withdraw funds. JP Morgan is provide back-to-back finance as an intermediary between the Fed and Bear Stearns, because technically Bear does not have access to the discount window. JP Morgan, notably, stressed it was just facilitating the deal and providing lending on identical terms to those of the Fed - it wouldn't wish to catch the confidence virus by association! It is hard to see a stand-alone future for Bear Stearns given the market-wide fear of trading with the Bank given its' evident insolvency.