As I mentioned in my last post, from an Australian perspective I feel the market reaction to the whole US sub-prime thing to be somewhat overblown. The total quantum of the losses is simply not large enough to warrant the market drops we saw last week and Friday’s adjustments in the US and today’s in Australia have restored some sense into the pricing of the underlying assets.

While I am normally a believer in semi-strong market efficiency there are times when sentiment can get ahead of sense and I feel that happened last week.

The reasons behind it I feel are clear – while there were some large losses where individual firms the market generally was not informed of where those losses were and, worse, some firms had previously issued wrong information to the market on their exposure. The result was that liquidity dried up as no-one really wanted to get into anything they could not really be sure of – which, with a fully integrated financial system, was not very much.

I feel there are several lessons from this:

  1. Firms trading in the riskier end of the market need good (or very good) internal information on the positions they are running. If you are running riskier positions that is fine – but you need to be able to get accurate and timely information out to the market in the event that the market turns down. Macquarie announcing they had no real issues and then later correcting this is a good example of the violation of this principle.
  2. Even for firms with safe assets you need to have robust treasury operations – Ram’s problems are particularly pertinent here. Borrowing with short term debt at floating rates to lend long and fixed is OK – provided the risks are managed well and you have enough capital to see you through the inevitable gaps. Good risk management here is to ensure that you have a wide variety of funding sources and that very little of your funding matures on any one day. As Rams found out it may just be the wrong day.
  3. As discussed elsewhere, relying on the Greenspan (or now Bernanke) put is a perilous thing. The US Fed could just as easily decided that this was a good correction, moving asset prices and credit spreads closer to sensible levels.
  4. If you keep sufficient liquidity hanging around for a rainy day you can make a pretty handsome buck doing some bottom feeding when things like this happen. Buying at the pit of the market (the ASX at least) on Thursday to sell today would have made a good trading profit for a few days’ tension.

Back to my favourite topic. If you are going to run risks you need to know what they are. Information

is everything.