"They found that the financial markets are always vulnerable to what they called a liquidity shock"

Another interesting NY Times post:

"Yes, History Has Much to Say About This Market

By MARK HULBERT

IN bull markets, it’s wise to guard against thinking that “this time is different ”( THIS IS WHEN YOU SHOULD BE THE MOST FRIGHTENED AND CAREFUL ) — that stocks will keep rising forever. Sooner or later, the laws of economics reassert themselves. And it’s wise to remember that major market declines follow some common patterns, too.

Right now, it’s tempting to think that this bear market is so unusual that history’s lessons are of little use( THEY ARE ), and that the types of investments that are weakest now will keep dropping indefinitely. No two market environments are identical, of course, but there is plenty of precedent for the credit crisis of the last 18 months — and for its profound effects on the stock and bond markets.

In fact, you can view the markets’ behavior since mid-2007 as a textbook illustration of a statistical pattern uncovered years ago by two finance professors, Lubos Pastor of the University of Chicago and Robert F. Stambaugh of the Wharton School of the University of Pennsylvania. They found that the financial markets are always vulnerable to what they called a liquidity shock — a sudden tightening of credit( HERE CAUSED BY A CALLING RUN ). Aside from the current crisis, two recent examples are the market conditions during the market crash of October 1987 and the wake of the near-collapse of Long-Term Capital Management in the fall of 1998.

Some types of securities — high-yield, or junk, bonds, for example — are usually more vulnerable than others in such an event. The most immune from liquidity problems are those for which there is always robust demand, so they can be sold anytime( LIQUID ) without pushing down their prices. As has become abundantly clear over the last 18 months, Treasury securities are a good illustration. At the other extreme are those securities that, without an abundant supply of available credit, become difficult if not impossible to sell at any price( TRUE ).

The professors’ research was the focus of this column in August 2001, and their study appeared in the June 2003 issue of The Journal of Political Economy. According to Google Scholar, no fewer than 623 academic articles and studies now cite their study.

This research provides a good template for understanding the last 18 months, according to Lasse Pedersen, a finance professor at New York University who has conducted a half-dozen studies in recent years into the market’s reaction to liquidity crises.

In the current crisis, Professor Pedersen said in an e-mail message, “securities with high liquidity risk have done very poorly,” just as we should have expected. A good example is convertible bonds, which previous research found to be particularly vulnerable to liquidity shock.

“They have gotten killed,” he wrote.

Though the large body of research into liquidity shocks may offer little comfort to investors who’ve lost so much in the last 18 months, it is an antidote to the argument that history has nothing to teach about the current crisis. The research has found that when liquidity shocks occur, they are so intense that the securities most vulnerable to them predictably provide higher longer-term returns. This happens, Professor Pastor said in an interview, because these securities must compensate investors for the risk of big losses during those shocks.

This doesn’t mean that anyone can predict such shocks with certainty. Instead, according to Professor Pastor, there is a small but significant risk that one could happen at any time — and that investors are deluding themselves if they don’t take that risk into account( VERY GOOD ).

Investors who despair that this credit crisis may never end may therefore be guilty of the mirror opposite of a mistake made earlier in this decade( THAT'S WHAT I BELIEVE ), when liquidity was plentiful. Just as many investors forgot several years ago that another liquidity crisis was destined to happen someday, many may now be forgetting that liquidity shocks don’t last forever.

WHICH securities will perform best after the current credit crisis, and which will fare worst?

According to the research, once a liquidity crisis passes, other factors come to the fore, and securities that have risen in price, like Treasury bonds, are then likely to perform poorly. By contrast, the best performers will be those securities that have lost the most during past credit crises — not just during the current one. Convertible bonds and junk bonds are two obvious categories that should do particularly well, but others, including stocks, should also benefit( I AGREE ).

If you can tolerate short-term volatility, you should consider such securities for the long term, Professor Pastor said, even if you’re worried that the credit crisis has longer to run. That’s because it is impossible to predict the exact end of the bear market( TRUE ), and because these investments should provide high-enough returns over the long term to make the risk worth taking.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com."

A Liquidity Shock ends up in a run. In this case, a Calling Run, in which financial concerns were forced to quickly increase their capital. In order to do this, they must quickly sell some assets. If this can't be done, a ripple effect occurs throughout the system as people flee to the safety of liquid and guaranteed assets, since many of the assets, which are not guaranteed, will probably have to be sold at fire sale prices.

History does provide some help here, but it is nothing more really than being prudent when you invest.

"So ends he who evil did. The death of a sinner always reflects his life"

In my continuing search to blame actual human beings for our current difficulties, I might have to add an addiction to opera and skiing:

"Canada’s Carney Says Some Bankers Focused on Opera, Not Lending

By Greg Quinn

Nov. 22 (Bloomberg) -- Bank of Canada Governor Mark Carney said the global financial crisis was caused in part by banking executives who thought about opera and ski trips instead of risks in their loan portfolios.

Regulators and executives were “seduced” by the idea that risk was “spread thinly around the world” by packages of loans, Carney told the British Broadcasting Corp. in a radio interview broadcast today.

Carney, 43 and a former Goldman Sachs Group Inc. investment banker, also said he was troubled by talks he had with bank executives during the past five years.

“If you were having a conversation with a central banker like myself, and the chief executive drifted into opera or the ski slopes of Davos or some type of social setting, that’s an issue,” Carney told the London-based network."

A bit off topic, I'd say.

“There is vicious natural selection going on right now in the financial services industry, and it’s appropriate,” Carney said in the interview. “Those who weren’t on top of things are gone or going.”

He sounds delighted. A kind of ebullient Herbert Spencer. I agree, but don't want to dance on their graves.

"The credit crisis might have been prevented if other countries had regulations like Canada’s, Carney said. The country’s banks were rated the strongest by the World Economic Forum last month. "

Could be.

“It’s like many things -- it’s excess,” Carney said in the radio interview. “Fundamentally, the ideas were sound, but they got applied too widely and ultimately by people who had forgotten about the fundamentals, or never knew the fundamentals of what they were doing.”

I agree. Maimonides. The Golden Mean. They're still forgetting the fundamentals.

"Carney spoke in London on Nov. 19, saying regulators should avoid worsening a worldwide recession by forcing lenders to stockpile more capital while economies are slowing."

I think that's what I'm saying.

"He also said countries need to bolster domestic regulations to improve the “transparency” of new types of securities, and should strengthen international bodies to better monitor emerging strains in financial markets."

I agree here as well.

"I am no expert on swaps (to put it mildly) but it sure seems like the current move is driven by something other than fundamentals."

Brad Setser hits the Trifecta:

"Treasury yields aren’t hard to calculate. But they are still my favorite indicators of the scale of the current crisis. The fact that so many are willing to lend so much to the US Treasury for so little is a clear indicator of a lack of confidence in other financial asset. Dr. Krugman is right. Market analysts are more or less saying the same thing: ““Where the credit markets are trading, it’s all but implying a 1929 scenario,” said Joe Balestrino, fixed income strategist at Federated Investors”

That's right. Investors are buying bonds with basically no interest in order to avoid risk, and hedge against deflation. Make sense?

"Suffice to say that surge in Treasuries — and rise in credit spreads — isn’t a good sign. Investors (including central banks) aren’t willing to accept anything that just has an implicit government guarantee — let alone debt with real risk. Right now they want nothing less than the full faith and credit of the US government."

That's right, they won't lend money to corporations ( Buy bonds ), slowing the economy, by reducing lending and causing the interest rates that these corporations need to offer to get a loan to skyrocket.

"I am no expert on swaps (to put it mildly) but it sure seems like the current move is driven by something other than fundamentals. A negative swap spread — according to the FT – implies that “investors are somehow reckoning that they are more likely to be paid back by a private counterparty than by the government.” That doesn’t seem consistent with what the rest of the market is telling us …"

I agree. There's a total disregard for fundamentals because of the Fear and Aversion to Risk. It's a downward bubble, if you will.

Now we need to figure out how to combat it. One way, according to Buiter, is to force banks to lend, however fearful they are. Rebecca Wilder and I favor cutting taxes. We'll see.

"nervous investors sought sanctuary from the turbulence in equities and other asset classes."

Here's more evidence of the Flight From Risk going on in the FT:

"The spectre of looming deflation drove government bond yields on both sides of the Atlantic to historic lows on Thursday as nervous investors sought sanctuary from the turbulence in equities and other asset classes.

Some US Treasury bills were quoted at 0 per cent, while the two-year note and the 30-year bond recorded their lowest yields since they were first regularly issued in the 1970s. The five-year note was at its lowest since 1954, based on historical data from the Federal Reserve. In the UK, the two-year gilt yield dropped to its lowest level since since the second world war."

So, people are buying bonds with no interest in order to buy a government guarantee that their money is safe. Does this even make sense?

"Buying government bonds as a safe haven investment has dominated flows in recent months. The latest moves come as increasingly worrying economic data point to rising unemployment and plunging inflation.

“Given the recent deflationary data, not just in the US but globally, the world is starting to build in a Japan-style deflationary scenario,” said Jim Caron, head of interest rate strategy at Morgan Stanley."

It can make sense in a time of Deflation, since your money is essentially appreciating in value because you can now buy more with it at cheaper prices. Is Deflation even realistic given the Fed?

"Recently, the Federal Reserve’s effective Fed funds rate has traded at around the 0.25 percentage point level, well below the target rate of 1 per cent. Meanwhile, Treasury inflation securities have moved to price in deflation for the next nine years.

Bill O’Donnell, strategist at UBS, said the bond market was reacting to the very low effective Fed funds rate and the possible start of a deflationary period. “The mood is ‘give me Treasuries at the expense of all other asset classes’ as spreads blow out and stocks slump,” said Mr O’Donnell.

Tom di Galoma, head of Treasury trading at Jefferies & Co said: “There is no place to hide but in US Treasuries. You cannot hide in corporate or mortgage bonds.”

So, investors are buying US Treasuries because they're the safest bet, and are willing to get almost nothing for that. It's hurting investment because investors are avoiding corporate and mortgage bonds, read loans. TIPS see deflation for 9 nine years. Is this even realistic?

"Deflation fears drove the 30-year swap rate to more than 50bp below that of the 30-year bond yield. Some investors are using swaps rather than buying bonds to keep their cash reserves intact as they seek greater exposure to long-term rates.

“If you already have a portfolio, using swaps allows you to increase duration without liquidating cash bonds,” said Jay Mueller, portfolio manager at Wells Capital Management."

So there's a rush into Swaps to maintain liquidity to be able to purchase long term rates, read more interest.

"The demand for long-term debt pushed the 30-year bond yield to a new record low of 3.71 per cent on Thursday; the two-year note traded as low as 0.96 per cent."

That shift to government backed long term bonds have driven their interest rate down. Supply and Demand. There's a large supply of fear, and a demand for less risk. But is this rational?

“This is about the collapse of inflation from official numbers this week and the very real spectre of disinflation in the UK,” said Moyeen Islam, fixed income strategist at Barclays Capital. “We expect yields will go lower as inflation is likely to be negative between May and October next year.”

The yields on the two-year German Schatz fell to levels not seen since September 2005. Yield spreads between Germany, the most liquid and deepest bond market in Europe, and other eurozone countries, also widened as it continued to outperform."

Since I don't fear deflation, as opposed to a drop in prices for a short period of time, and always fear inflation, I consider this behavior to basically panic behavior, based on the more unlikely scenarios going forward. Time will tell if I'm being foolish. But, given my beliefs, you can see why I believe that the Fear and Aversion to Risk at the expense of ignoring fundamentals and the most likely outcomes is our main problem now, and we need to attack these fears with incentives and moves to encourage risk.

Were Going There, But Will It Work Now?

From the NY Times story "Panic Strangles Asia Stocks, Yen Jumps":

"No one is buying. Fundamentals don't matter any more and there's no explanation for such a plunge," said Yoshinori Nagano, chief strategist at Daiwa Asset Management in Tokyo, of the selloff in Japanese stocks."

That's not good news.

Here's more:

"The iTRAXX Asia ex-Japan high-yield index, a key measure of risk aversion for the region's "junk"-rated credit, soared about 90 basis points to a record 890/940 bps, a Singapore-based fund manager said. But traders warned of little activity in the credit markets, which tends to magnify price differences.

Extreme market volatility stoked talk that the major central banks would have to reduce interest rates again, just days after a concerted round of cuts led by the Federal Reserve and European Central Bank. There were also reports the U.S. Treasury was under intense pressure to inject funds directly into commercial banks.

"It highlights the enormity of the issue and the problem faced by the G7," said Adam Carr, a senior economist at broker ICAP. "Given the muted response in markets, certainly I think more rate cuts are to come, as ineffective as they are proving. Lets hope the G7 propose a good dose of fiscal medicine to the real economy as well."

Whether or not global policymakers have anything more planned, time was running thin.

The spread of 3-month London interbank offered rates over the 3-month U.S. Treasury bill yield widened to 426 bps, increasing more than 300 bps in the last month, with cash being hoarded and practically no lending between banks."

What's a good dose of fiscal medicine? We could sure use it.