What Others Have To Say III.

No escape, aka “Roach motels”

The asset backed commercial paper market is basically frozen currently as no one will trust these securitized vehicles because of the potential bombs they contain. This crisis in confidence is the direct result of the structure of these products in which they offer the investor “NO OPTIONS” to exit the trade. Until a way to exit is devised, global liquidity can be expected to continue crash. Let me thank John Taylor of www.fx-concepts.com for the excellent insights below. As a long time investment manager, his handle on history is extraordinary and his clients are undoubtedly well served by his experience.

What is a roach motel? As John explains,

“a box that lured the omni-present house hold pest, the roach, with tantalizing odors into its sticky interior, where it was entrapped, unable to move. Each box would catch hundreds of roaches that died slow deaths, stuck to the very stuff they desired. The catch line of the campaign was “roaches check in but they don’t check out” For us, as money mangers the name roach motel soon became attached to an attractive but complex trade that was easy to enter but was illiquid- i.e. there was no market price except when the trade reached maturity or when (and if) the bank that created the product decided to buy it back. If the investment situation changed and the trade was no longer the one you wanted, you were stuck- or at the very least the hedge of the position would be very expensive and imperfect, often drastically so depending on the circumstances”.

This is the perfect description for the current CDO/CMO/CLO markets as they offered the potential of higher returns than usually available on quality AAA and AA paper. The buyers jumped at them just as the roaches pile into the roach motels. John goes on to say that in the forex markets liquidity is assured. To have an illiquid currency market is to have a huge financial impact on a country’s citizens.

He then says: “It is completely different when dealing with structured products. There is no expectation of liquidity as the institution that created the product has no responsibility for it and is not directly impacted if the price collapses – or more likely is unknown. It is not their complexity that is the primary problem – IBM is complex but it is valued thousands of times each day – it is the total lack of liquidity in all these structures. However, if you add the extreme level of model uncertainty – i.e. it is impossible to value these structures as their have been no previous transactions – together with the lack of liquidity, you end up with assets that might be worth anywhere between 5% and 95% of their original value, it’s anyone’s guess.

“Roach motels or totally illiquid investments only appear when investors are so confident about the future that it never crosses their minds that things might change for the worse. Why else would someone totally ignore the value of his capital and only worry about the spread over the short term funding cost. Considering that there are far more that 100,000 instances of this capital uncertainty, from hedge funds to SIV’s to money market funds to banks to pension funds, there are a lot of problems still ahead. Global liquidity will crash until the day that these assets can be traded and values established. Now while liquidity is shrinking faster than the Fed is pumping it out, the dollar will be strong.”

Thanks again John (www.fx-concepts.com).

This about sums is up doesn’t it? Think of all the institutions, pension funds, banks, mutual funds, money market funds, SIV’s (short term investment vehicles), hedge funds, etc. who have checked in and can’t check out. The biggest money in the world and they didn’t ever raise a question of controlling the risk in the trade or how to exit the investment. Now it’s time to pay the piper as there is NO WAY OUT! Due to unbelievable amounts of overconfidence and hubris, the investors who placed their futures in their hands will be forced to pay the price. This finger of instability has a long way to run. However, you can expect it to be front and center in the headlines over the next several months until a market has been developed to discover the price they should have and a real marketplace for them to be exchanged.

This is an excerpt from TedBits – Copyright © 2007 Ty Andros — Portions of this document may be reproduced ONLY with full credit and contact information to Ty Andros at tedbits@TraderView.com and www.traderview.com

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Administrator note: I like this Roach Motel comparison very much. We are subscribed to this view since times immemorial (We trade forex since 1997). We are producing more than 100% annualised returns on the most liquid market: Forex Majors. Our performance is verified by The Trading Systems Authority.