The "D" Word

The "D" word, in case you aren't aware, is deleveraging. It is a fancy buzzword for something that has been discussed here many times, risk reduction. The risk in this case is borrowed money. Entities borrowed a lot in the market run up to "leverage" their equity, hence the term deleveraging as those loans are being called out, paid off, or otherwise being removed from the market. The sad part about this (from my standpoint) is that over the past few years, there were a few of us out there that saw what was happening to the market, particularly in cash bonds, couldn't do much about for a variety of reasons, got frustrated with the situation, and left the active participation of the market.

There have been many vocal critics of the Fed over the past eight months (you know who they are), saying they haven't done enough and/or were too late to respond. In retrospect, they were too late, by about three years. If, in the waning years of the Greenspan Fed/early days of the Bernanke Fed, the Fed had taken some action to stop the "leveraging" from ramping up so rapidly in the first place, maybe the current mess could have been avoided. However, I can just imagine what the criticism of such action would have been, ranging from "you are hobbling business", to "you are killing economic growth", to finally " you are accelerating the decline of New York as the financial capital of the world" (A note of this criticism: For all of you out there that are big proponents of principle-based regulations, as is the norm in London, over rules-based regulation, as exists in the US, most of these opaque CDO and the like entities set up to issue these difficult to value securities, were set up and issued offshore, outside everyone's purview in the US).

The LTCM crisis in 1998 is an excellent example of rapid deleveraging. At the time, the market seized up as no one could figure out, or was willing to tell, what their exposure to LTCM was. The Fed stepped in, got all of the relevant people involved, and set up a facility to oversee the orderly liquidation of the fund. While it would have been thought, certainly by me, the LTCM's method were discredited after their debacle, in fact, their methods were duplicated and replicated by everyone and everybody over the past decade. The LTCM "crisis" was a drop in the bucket compared to today's problems (This should also shut up the Fed naysayers who simultaneously hold up the Greenspan Fed's action in that situation as why Bernanke isn't up to snuff. As I said , today is much worse.).

Art Cashin this morning called what is happening now potentially a death spiral for the markets. He is correct. The more this uncertainty goes on with respect to asset holdings and valuation, the less likely anyone is going to lend to anybody for any reason. The deleveraging going on now is necessary and healthy, but it needs to be done in a systematic way so that the baby isn't thrown out with the bathwater. We've seen the spillover into markets where there really shouldn't be any meaningful spillover. Full and complete disclosure of holdings is needed now. The Fed's action today to increase the TAF helps, but they need to open it to all financial institutions, not just banks, so the banks just don't sit on the money to improve their own positions. We're rapidly approaching a situation where the only way out is to establish a RTC-like facility for crappy assets in order to establish a clearing price for them. Using that type of facility, those that have cash will do quite well cherry picking good assets. Current participants will not do well in that scenario, which is why they need to (again) come clean.