Will The EU Emergency Fund Work?
Readying for reality after a historic week
The stock market crashed last week.
While calmer heads are quick to put the panic into perspective -- the S&P was off 9% on Friday's close since ticking at fresh, 18-month highs two weeks earlier-- the capital markets stopped functioning on Thursday, albeit only for a short time. That, by definition, is a crash.
As I wrote Friday morning, there are a few ways to view what happened, ranging from the obvious to the conspiratorial to the nonsensical. At the end of the day -- and from this day forward -- the takeaway has little to do with the “why” and everything to do with the “what.” (See: The 1000-Point Plunge: Reasons and Results from the historic collapse.)
Politicians were quick to declare war on perceived culprits; German Chancellor Angela Merkel lashed out last week, saying “speculators are our adversaries” and she’s “resolved to win the battle against markets.” Senator Chris Dodd, Chairman of the Senate Banking Committee, said yesterday that high-frequency trading created a “casino environment” where “finance is getting detached from the real economy.”
To be sure, there is plenty of blame to go around. As we’ve long posited in Minyanville, the spectrum of culpability extends from over-extended consumers to institutions that financially engineered the markets to policymakers complicit by acceptance. While the system collapsed during the first phase of the financial crisis and cracked anew last week, those were not the cause -- they were simply the effect.
Old school Minyans understand the causal elements of cumulative imbalances and the societal ramifications of percolating class wars, as well as the potential pitfalls inherent in a finance-based, derivative-laced global economy. Those are among the reasons why we warned of “a prolonged period of socioeconomic malaise entirely more depressing than a recession” in the summer of 2006. (See: Keynote Address from Vail.)
We’ve long drawn the distinction between drugs that mask the symptoms and medicine that cures the disease, as well as the difference between a legitimate economic recovery and debt-induced largess.
We’ll see fresh measures implemented on a global basis with hopes of containing the contagion, including but not limited to the staggering $962 billion European Union emergency loan package crafted over the weekend. While these numbers are obscene—by some accounts, ten-fold the size of what was expected—the reality is that this has been the grand plan for nearly a decade. The more things change the more they stay the same and the more they stay the same, the greater the inherent forward risk. (See: Anatomy of a Recession)
Entering September 2008, with $871 billion in corporate debt coming due in the financial complex, we warned that one of two things would happen. Either markets would experience a cancer that spread through industry sectors one at a time or the system would experience a cataclysmic car crash. (See: Pirate’s Booty.)
The US government took a wait-and-see approach before attempting to “buy the cancer” and “sell the car crash.” (See Shock & Awe.)
Last Wednesday, when the specter of proactive measures by the ECB kept a tentative bid under a very nervous market, we openly asked if the European Union would take the necessary steps to snuff out the fuse of contagion. (See: Will Europe Order a Code Red?)
The next morning, after ECB President Jean-Claude Trichet effectively blew off percolating market concerns, it felt as if he stole a page from the initial US response which set the stage for the market rage. (See ECB Tries to Avoid a Sovereign Debt Contagion.)
It remains to be seen if this new structural backstop will achieve the desired results, particularly given the European crisis is but one of many global concerns. Let’s not forget that US states are in a similarly dire financial condition, as are many of its citizens. And there’s the matter of the crash itself.
The question we must wrestle with is one of psychology, which is “why” the events last Thursday pales in comparison to “what” actually transpired.
Faith in the system and the credibility of our leaders has long been fingered as the issue at hand for markets at large. (See: The Credit Card.)
Decisions made in a state of panic often have serious repercussions. We witnessed this dynamic evolve during the last eighteen months as the unintended consequences of the government intervention manifested. From moral hazard to record profits -- and bonuses -- at financial institutions to the attendant class war and shifting social mood, risk wasn’t destroyed -- it simply changed shape.
What if high-frequency trading actually provides liquidity in the marketplace? It’s conceivable that Thursday’s 1000-point swoon was triggered by computerized models “pulling bids” at precisely the same time. If that’s the case -- I’m not saying it was, I’m simply posing the possibility -- banning the robots would lead to more, not less, market volatility.
What if “naked CDS” are banned, as we’ve long suspected might happen? The knee-jerk reaction would likely be a melt-up in the equity space, but we could then see “counter-party contagion” given the $500 trillion dollars of notional derivatives tying the world together. If you think there was confusion Friday when mom & pop couldn’t get a handle on their exposure, imagine the domino effect if JP Morgan (JPM), Goldman Sachs (GS), Bank of America (BAC), Citigroup (C), and Morgan Stanley (MS) suddenly have billions of dollars of unidentified risk. (See: Regulatory Risk Abounds!)
And what if the reaction to last week’s crash causes investors -- many of whom have been burned multiple times during the last decade -- to lose faith in the system, if only for a spell? While psychology can be manipulated for extended periods of time, free will, as discussed Friday, can never be caged. In that regard, the reaction to the EU Emergency Fund, not only today but in the weeks ahead, is entirely more important than the Fund itself.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at email@example.com.
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