Monday, July 7, 2008


Came across some earlier notes today which hold up remarkably well.

The GS report from Credit Suisse talks about a liquidity crisis with lots of liquidity. Where did all of this liquity come from and where is it going to? Certainly, to know that there is lots of cash sitting in hedge funds and private equity funds makes you wonder just how bad this can all really get. The stock market at least, hardly seems overvalued, and the bargain hunting has already begun. I wonder, however, whether there aren't two time-scales to this particular cycle. First, a rapid one defined by hedge funds finding bargains in companies that have written off debt and putting their cash to work. Second, a slow time-scale based on the actual economic fall-out of the bad housing debts. Bad mortgages can be marked to market in an instant but people don't stop paying on them for years. In addition, you can mark to market (especially an illiquid market) with all kinds of assumptions, but who knows what the economic reality of these instruments will be -- i.e. how far housing will fall. This gap in time scales, assuming the worst for the economic consequences of housing dropping (say, 50% in real terms according to Shiller's index) may lead to a quick apparent recovery as people's fear's ease and they go back into the market, and then a much longer and more grinding slide down as the real economic consequences become gradually apparent. Which is to say, look for a big bounce within a few months followed by a long, slow unwinding.
The next question is where does all this liquidity in the middle of a liquidity crisis come from? I think the relatively simple answer to this is foreign central banks supporting the dollar and thus pumping money into our credit markets. There's no way to bet on how long they will go on doing this, because it's a political rather than an explicitly economic calculation. This sort of "reverse bailout" phenomenon does seem perverse and unsustainable though.

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