Sand Piles, Chaos Theory, Subprime and The Yen Carry Trade

[LA_Renter]

I found this to be a great read this morning with that first and second cup of coffee. It’s written by John Mauldin, he will be having a strategic investment conference April 19-21 in La Jolla. This article makes the case that the contagion of the subprime meltdown will spread into other areas of the economy. Here is a snippet

“Bubbles have consequences far beyond their causes when they burst. That is because they encourage irrational behavior and expectations not just in the asset that is rising in price, but in surrounding areas. As an example, remember the internet bubble? There were 350 internet stocks at the end of 1999, comprising a mere 6% of the market cap of total US equities. But the NASDAQ dropped by over 70%. The damage was not confined to just internet stocks.”

http://www.marketoracle.co.uk/Article541.html

[jztz]

I was surprised to read this sober account on Union Tribute:

http://www.signonsandiego.com/uniontrib/20070318/news_lz1b18calbrea.html

It is interesting to ponder this: subprime is going down in a free spiral, we know there are more to come, yet data from the field says that activity is picking up and people are buying again…

[LA_Renter]

Wow, that is a sober account from the UT. This subprime meltdown is only two weeks old. I don’t think you will really see it in the numbers until later this Spring. Regarding a pick up in activity I anticipate many of these transactions to fall out of escrow. I like this quote from the John Mauldin article;

“Last week I highlighted the excellent piece by Paul McCully of Pimco. His thesis is that subprime buyers are the plankton of the housing ocean. Without a healthy supply of plankton, the rest of the ocean’s denizens do not live well. (You can read the essay, and you should, at http://www.pimco.com ).”

[ucodegen]

Last week I highlighted the excellent piece by Paul McCully of Pimco. His thesis is that subprime buyers are the plankton of the housing ocean.

I don’t know if I agree with the sub-prime plankton idea. What I do know, is that PIMCO is exposed to dollar devaluation (most of their foreign funds are dollar hedged, so they do not benefit from dollar decline), and has a large securitized mortgage holdings. I think there may be a bit of a slant on this one. (I’ll see if I can get some time to read these through).

[Anonymous]

The comparison to the NASDAQ in 2000 may be inappropriate.

Firstly, those 350 “internet stocks” may have comprised a significatn fraction of the market capitalization.

And other not completely “internet stocks” were at very rich valuations: e.g. Cisco, AOL, even Microsoft.

Many of the internet stocks went down 99%.

By the way, the description of the “self organized criticality” of the sandpile system doesn’t exactly mean (as the article states) “It was indeed completely chaotic in its unpredictability.” That’s not really meaningful scientifically.

But the description of the sandpiles is reasonably apropos as to financial markets.

The best “take home message” in nerdspeak is that second moments (variance) can be unbounded, and assurances that anything is “contained” or “will blow up” aren’t to be trusted.

For policy makers it means that taking smaller hits sooner is better. If one were a nonlinear-dynamics informed physicist running the Fed, then a reasonable policy to pursue might be to intentionally have capricious, but small, policy changes at random intervals. (This is “stochastic resonance” or noise-induced stability). Maybe dynamically justified but politically impossible.

The Fed is going of course to “transparency” and “predictability” which is probably the worst thing in this setting since outside participants can predict its ‘control function’ and will themselves attempt to maximize profits and probably thereby go into a state where the catastrophic outcome is more likely.

[ucodegen]

For policy makers it means that taking smaller hits sooner is better.

That is kind of what I took out of it, when reading through the Market Oracle article (http://www.marketoracle.co.uk/Article541.html). It would also tend to match what we already know. If the lending standards were not loosened to allow easier financing in an already tight environment (close to critical slope), we would not be looking at this kind of meltdown in the future.

Going back to the sand, it would be like changing the grains to be grains that were slightly ‘stickier’ when a significant amount of the slopes are approaching critical. This may help hold these new grains to the surface, but the underlying sand is still weak. The resulting ‘cascades’ end up being much larger (because they will also involve more of the underlying sand).

[Author]

Posts