Divergence and Convergence

August 18, 2007 Copyright © 2007, Greenwich Financial Management Inc., a registered investment advisor.

I would bring your attention to a perceptive piece by Floyd Norris in the New York Times, “With Markets Moving Wildly, Insight Suffers.” He asks the question of why the current credit crunch is “being played out in slow motion.” And how could it be that the troubles of some homeowners having trouble paying their mortgages could have such wide-ranging effects? See http://select.nytimes.com/2007/08/17/business/17norris.html

Norris recalls the old adage about how, for want of a nail, the horse was lost, and ultimately the kingdom was lost.

Historians sometimes refers to such a phenomenon as divergence. A single event, seemingly small in magnitude, affects others in such a way as to bring about a crucial turning point.

In the case of the credit markets, participants were aware that the market was in an unusual state of hyper-activity. Commercial bankers knew that the “covenant lite” loans they were making were riskier than usual, investment bankers knew the bridge loans they were issuing were dicey, and mortgage bankers knew that subprime borrowers were skating on the edge. None of these participants were stupid, though it’s easy to think so in retrospect. Rather, all had positions of responsibility in institutions that gave them a mandate: join loan syndicates, write bridge loans, underwrite mortgages. Most had pay packages in which a significant element of pay depended on carrying out their mandate. All wanted to get high five for beating out the competition. All hoped to get paid their bonuses before the market changed course. As the old saying from the private placement world goes, “I’ll be out of here before this thing blows up!” And most of these individuals may also have hoped that there would be a second (or third) chance at some similar job if the investment did blow up in their hands. This is the essence of the “trader’s option,” the incentive to spin the wheel, to go for the double zero.

As a result of small percentage changes in borrower default rates, the magic of leverage can create huge effects on the bottom tranche of a collateralized debt obligation (CDO). When this detonates, some hedge fund in Australia gets blown to smithereens. That leads a commercial bank in Germany not to want to lend to the Cerberus buyout of Chrysler, which in turn could affect autoworkers in Detroit. This hurts business confidence, which leads a Brazilian executive not to invest in more equipment for the steel mill. This is the divergence.

The opposite effect, convergence, is where very different phenomena take on the same appearance. This is also happening in the current market. For example, the seemingly very different situation of workers in Japan, Netherlands, South Africa and France could all be affected similarly by the worldwide credit crunch.

It is the nature of highly convergent phenomena that they are difficult to reverse. Beneath the Fed’s decision to take massive and symbolically potent stimulative action recognizes this fact. It will take even much more to restore confidence, and (for salutary reasons) we will not go back to the place where we started.


Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 203-531-2877 or e-mail Szabo@GreenwichFinancial.com).

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