Short Term:

· The consensus expectation is for recession and a hard landing particularly in US and Europe with a protracted trough before recovery. There is some disagreement over the outlook for emerging markets but sentiment is beginning to deteriorate. The short term, however, is a poor guide for the medium to long term.

· All markets are trading on liquidity and not on fundamentals. Opportunities abound for the unlevered investor.

· Market attention was focused on the proposed Troubled Asset Relief Program, a 700 billion USD bailout of the US banking system. The substance and material impact of the Program is limited and the majority of its utility was in shoring up confidence in the financial system. Debating the Program and delaying it has blunted its signaling value.

· The hedge fund industry is facing large scale redemptions starting first from investors exiting funds of funds, and funds of funds redeeming from their hedge funds to meet their redemption needs. Most funds have calendar quarter redemption dates and the September redemptions have been known for some time. Aggregating the outflows from the annual redemption funds with those that are quarterly and monthly, implies that December will be a highly risky month for hedge funds and the markets in which they invest, as gross exposures are reduced in large scale. It is expected that a significant number of hedge funds may not survive.

· A large number of hedge funds will be suspending redemptions. A Prisoner’s Dilemma situation now exists where strong holders need to redeem ahead of weak holders. Hedge funds will not have the liquidity to meet the expected volume of redemptions.

Medium Term:

· Falling stock prices and house prices will have knock on effects on consumer confidence and thus consumption plans.

· Increased credit spreads have raised the cost of debt and will impact corporate profitability going forward. Availability of credit from cash strapped banks will also be reduced. Demand for credit will be impacted by expectations of consumer confidence and exports which will be dampened by slowing economic growth elsewhere.

· Economic data from around the world are indicative of a severe economic slowdown. Inflation is unlikely to be a problem at least in the developed world.

· The influence of liquidity will remain for a time. However, as the velocity of capital outflow slows, asset prices will come to be driven more by fundamentals than by momentum.

· Regulatory changes almost always follow large dislocations in financial markets and recessions. One can expect the financial sector to be regulated as a public good. There is much uncertainty here as regulators do not have the best access to information, can make errors in policy, are often driven by politics before economic efficiency, and plan over different time horizons.

· The CDS markets, and more generally the OTC markets, are likely to be regulated and moved on exchange.

· Investors will take some time to regain their risk appetite. As they do, they are likely to realize the risks in liquidity mismatches inherent in various investment vehicles from hedge funds, to structured products, to banks. Many hedge fund strategies which are sound and logical, fail because of liquidity mismatches. The closed ended fixed term fund, the investor vehicle of choice in private equity, is well suited to many hedge fund strategies. One could argue that with greater certainty of outcome than private equity, and with greater certainty of maturity in arbitrage, such investor vehicles are even more appropriate for hedge fund strategies. Examples of such structures arose in 2005 in the structured credit markets, triggered by the credit ratings downgrades in the US auto sector.

· Investors are likely to be wary of highly leveraged investments and will scrutinize more closely the magnitude and structure of levered investments. Many credit hedge fund strategies are levered implicit providers of capital to the economy. Leveraged provision of credit is a strategy that has most visibly failed not only in hedge funds, but banks as well. Here lies a two fold opportunity. For the Asset Based Lender, a beleaguered banking industry provides them the opportunity to take market share and to grow in scale. For businesses, Asset Based Lenders are an efficient source of credit, providing more responsive client service, bespoke financing solutions and thus more flexible pricing. For the investor, Asset Based Lending Funds provide the opportunity to participate in the new banks, lending institutions without the excessive leverage, complex and opaque proprietary trading books, sprawling organizations and overall operational and financial complexity.

· The face of hedge fund investing will change. Before Aug 2007, hedge fund analysis focused on the skill, talent and integrity of the manager, the operational infrastructure and mostly investment issues. While the astute investor scrutinized the investor base, the importance of this consideration in the greater scheme of things was not as high as it will be going forward. Henceforth, the stability of the equity base and of funding will be a major consideration. For established funds with a long list of legacy investors, this analysis is complicated, more so than for a small or medium sized fund with an anchor seeder that has stable capital and can offer marketing support to strategically build the asset base. Risk management will include policies, limits and guidelines for funding as well as for the investor base. Transparency to the structure, if not the identities, of the investor base will be important.

The credit crisis that first broke in August 2007 deteriorated very quickly in September 2008. The month was dominated by bank failures and bailouts, a dysfunctional LIBOR market, free falling equity markets, failing credit markets and a general crisis of liquidity. Equities, bonds and commodities all sold off simultaneously as investors sought to reduce risk in any way shape or form. Below is a quick time line of the key events in September as the US financial system lurched precariously to the edge, where at the time of this writing, it remains.

• September 7: Federal takeover of Fannie Mae and Freddie Mac.
• September 14: Bank of America takeover of Merrill Lynch over fears of a liquidity crisis.
• September 15: Lehman Brothers files for Chapter 11 bankruptcy protection.
• September 17: Federal Reserve rescue finance of 85 billion USD extended to support AIG.
• September 19: Treasury Secretary Paulson announced the proposed “Troubled Asset Relief Program.”
• September 19: The US SEC leads a number of regulators around the world in establishing a ban on short selling.
• September 25: Washington Mutual is placed under receivership of the FDIC and its assets sold to JP Morgan.
• September 28: Fortis NV partially nationalized.
• September 29: Congress votes down the “Troubled Asset Relief Program.”

Money market stress increased to unprecedented levels with the TED spread widening from 1.09% at the end of August to 3.42% at the end of September. 3 month US T bills traded briefly with negative yield.

Currency markets gyrated significantly, with the EUR starting September at 1.463, weakening to 1.399, rebounding to 1.4866 and closing the month at 1.409. Similar trading patterns were seen in GBP and CHF. JPY traded from 109 to 104 then to 106.

· Equity markets were broadly weaker, the US markets losing between -6 to -10% depending on your benchmark. Small caps were more resilient as the sell off was driven by capital flows. European markets saw greater damage with European indices losing between -6 to -20%. Asia experienced even heavier losses, with Japan losing -14%, HK -19%, and various markets losing of the order of mid teens. Similar losses were recorded in Lat Am.

· In fixed income, the Lehman Aggregate lost -2% in the month. Credit spreads widened sharply in the final weeks of September, US AAA’s widening 1.6% on average, AA’s 1.9%, A’s 2.4%, Baa’s 3.2% and High Yield an alarming 9.5%.

· Commodities also fell as pricing started to reflect recession expectations. Crude futures fell -16%, driving the whole energy complex down by similar amounts. Base metals, softs and ags were all sharply weaker. Only gold was higher at +4.8% over August purely reflecting the degree of risk aversion in the markets.

The Fed and Treasury are putting their heads together to find a solution. They need to figure out first what the problem is beyond the symptoms we see. It is, however, a first step. Managing expectations at a time like this is as important as material policy.

It looks like they propose a system wide solution since their ad hoc measures are not working and the fairness of their process or lack of it has been called into question. It doesn’t mean that ad hoc solutions won’t be found for Goldman Sachs and Morgan Stanley. It certainly buys them time for a more orderly solution.

On the subject of bailouts, the US cried foul when Malaysia established currency controls, when HK spent 15 billion USD (1997 prices, in a much smaller market than it is today), to fend of the speculators, when Malaysia’s Khazanah bailed out the banks by buying their assets.

Academic purity reacts to all this by pointing out that:

Singapore did nothing during the 1997 crisis but emerged from recession ahead of Malaysia.

Bailouts sew the seeds of the next crisis.

The Greenspan put which was responsible in great part for the current crisis is now replaced by the Paulson put.

The intentions of the current plan look highly domestically focused and internationally myopic.

The intentions of the current plan look highly market focused and economically myopic.

The reality is that:

-Singapore was a sound economy and Malaysia wasn’t. Malaysia emerged stronger than Thailand which took the IMF’s prescribed hard medicine.

-Bailouts sew the seeds of the next crisis if lessons aren’t learnt. Bailouts are necessary so that there is enough residual industry to face the next crisis.

-The Paulson put has higher theta and omicron compared to the Greenspan put.

-It is likely that any bailout plan will be negative for the USD which would be positive for terms of trade

-It is likely that any bailout plan will be inflationary.

On the subject of banning shortselling, it will have the effect of:

-Impairing market efficiency by limiting the feasible set, this is mostly an academic objection.

-Forcing investors to sell long positions to scale risk instead of hedging whenever they want to reduce market exposure. This will have practical consequences.

-Making it hard for option holders and writers to hedge positions. The uncertainty that the restrictions introduce to derivative markets is significant.

-Lowering liquidity in the markets at a time when market liquidity is an important factor in the crisis.

Some conjecture:

The creation of some agency to purchase distressed assets from financial institutions has to be paid for. It will have to be paid for by the government. The government will have to raise cash. They will have to issue debt. Who will buy this debt? They could just auction new debt and see what the free market thinks of US sovereign risk. Given that the faith of the US government in the free market is not all that strong these days, its likely that they will need a backstop. Foreign investors may not be willing to take USD risk. US investors whether healthier corporates or individuals through asset management companies may not be willing to take that risk either. The financial institutions in receipt of aid may be asked to be that backstop resulting in a de facto swap of US Treasuries for risky assets. System wide, this would only defer the liabilities, not crystallize them. It would, however, reflate the financial institutions, providing them income bearing risk free assets in exchange for toxic waste, without relying on external price discovery.