The Shanghai shock: financial lessons from the late-February 2007 hiccup.

• Author: Malmgren, Harald

At the start of 2007 an eerie calm had settled in across world financial markets. Global economic growth seemed to be spreading outward to encompass virtually every economy in the world. The U.S. and world economies seemed to be in a "Goldilocks" mode--not too hot, not too cold, but just right.

National markets and major asset classes all seemed to move in unison across world markets. Market volatility had all but disappeared. With less and less volatility, and copious liquidity, market risks seemed to fade away.

In this seemingly benign environment, hedge funds and proprietary trading desks continued to increase leverage, buying into virtually every tradable asset in relentless pursuit of higher yields. Accelerating financial innovation seemed to disperse risk ever more widely, providing a feeling that individual institutions and their portfolios were invulnerable to significant hits from any conceivable negative development. Emerging market debt, subprime loans, junk bonds, and other assets traditionally classified as "risky" were eagerly bought, driving down their yields to the point that spreads over high-quality government debt became paper-thin.

However, central bankers were not complacent. While investors seemed unafraid of potential negative surprises, central bank officials increasingly fretted that the markets had priced every asset "to perfection." Central bankers worried that risks were no longer being adequately priced to account for any negative shocks that might lie ahead.

On February 27, the Shanghai composite index abruptly fell almost 9 percent. Without knowing exactly what had taken place and why, sleepily complacent investors were abruptly awakened. They started to cut back holdings of their most liquid assets in a frantic effort to build cash shock absorbers. Like an unanticipated earthquake far away, the Shanghai shock sent a wave of selloffs across world markets throughout the remaining hours of the day. News and media commentators rang alarms. Panic spread among big and small investors in Asia, Europe, and North America. By the time the wave hit Wall Street, the Dow Jones fell by more than four hundred points, with more selling halted by the close of the market.

The White House responded by describing the worldwide selloff as "an anomaly." When selling on the New York Stock Exchange reached its peak at 3:00 p.m., trading volume overwhelmed the NYSE's computers. Transactions were left in limbo for precious minutes, followed by an abrupt and inexplicable drop of two hundred points in the Dow. An NYSE spokesman described the computer disruption as a "glitch." In the next few days, various U.S. and European central bank officials pronounced that world markets had proven "resilient." Was this really a one-off event, or was it a warning of something more fundamental?

Volatility had returned to markets, and not just for a day or two. After the Shanghai shock, financial markets throughout the world remained jittery.

Although the global wave of selling was unanticipated by most traders, the fact that a shock in one national market should spread to the entire global financial market should not have been surprising. Moreover, the big correction in the Shanghai composite index should not have surprised anyone paying attention to Chinese government spokesmen. For months, individual investors in China had been piling into the Chinese market for stocks and real estate. Millions upon millions of investors frantically increased borrowing against everything they owned in a frenzy of speculation. The domestic markets were bubbling faster and faster. This posed a financial management problem for Chinese authorities. But more than that, it posed a monstrous political problem. Officials warned of the dangers of growing bubbles, but investors seem undeterred. What would happen if large parts of the population were caught up in a financial meltdown, having already borrowed against every asset they had managed to scrape together in recent years? Would the public unrest be containable?

Chinese political leaders recognized that bold action was needed. At that moment, near the end of February, former Federal Reserve Chairman Alan Greenspan happened to express to investors and news commentators in Hong Kong his judgment that a recession was "possible" in the U.S. economy by the end of 2007. Coincidentally, other negative news also came out of the U.S. market, especially deterioration in the mortgage market and signs of weakening in capital spending. Since most Chinese investors still believe that the U.S. economy is the engine that propels China's growth, government officials decided the timing was just right to prick the bubble. Rumors were spread that the government intended to sell into the market large quantities of shares of some of China's biggest companies. A capital gains tax was said to be imminent.

The bubble was pricked, and heavily leveraged Chinese investors had to scramble to sell. Some analysts said the China shock was a big event for China's market, but hardly big relative to the scale of global financial markets. However, the convergence of the Shanghai shock with disappointing news about the U.S. growth outlook--and the apparent confirmation by the Maestro, Alan Greenspan, that change for the worse might lie ahead--all heightened apprehension among investors worldwide.

February 27 and subsequent days revealed that there was underlying uneasiness and even apprehension among investors below the seemingly placid surface of world markets. Some traders suffered severe hits when they were caught by surprise by the tsunami which swept across the world. On the other hand, many big traders were apparently poised with hair-trigger readiness to liquidate positions. The China shock set in motion a sharp increase in market volatility, and the return of volatility brought with it an elaborate process of global market "corrections."

With the return of volatility, most investment managers have had to rethink their trading strategies. Many hedge funds and proprietary trading desks also busied themselves assessing the damage to their positions, but because of the opaqueness of their trading activities, that fallout would not become visible until months later.

CHALLENGES FOR INVESTMENT STRATEGIES

Analysts are now arguing heatedly with one another whether this storm out of China was a one-time event, or evidence of long-term "climate change" in world financial markets. Was this just an ordinary, overdue market correction, or did it represent a tipping point?

To seek an answer to this fundamental question it is necessary to step back and reflect on how global financial markets have changed in recent times, and where the risks may lay as we look ahead.

First, the return of volatility suggests a need for reassessing risks and investment strategies. With low volatility, risk spreads had become unusually thin. Now that volatility has returned, risk spreads have started widening. Initially, the main impact was on subprime debt, but eventually many asset classes will experience "repricing." Even in the weeks following the Shanghai shock, volatility still remained well below historical averages. More volatility lies ahead. Relatively weaker market segments will likely experience the biggest repricing consequences. Most vulnerable to repricing are emerging market debt and lesser-quality debt in the industrialized countries.

A repricing of a significant part of the debt market had already been set in motion before the Shanghai shock. The rapid deterioration in the subprime U.S. mortgage market had begun a substantial repricing of mortgage debt and the valuations of mortgage generators. A couple of dozen subprime mortgage originators shut down or went bankrupt. In February and March, cracks even began to appear in the prime borrower market segment. A large share of the entire mortgage market and the inextricably linked residential mortgage-backed securities (RMBS) market came into question. (Even a behemoth like General Motors came under reexamination, because of its exposure to GMAC's mortgage business.)

Second, the markets for almost all asset classes had become "correlated." It has become commonplace for market analysts to point to the increasing globalization of financial markets as a defining phase in the evolution of the world economy. Markets in New York, London, Frankfurt, and Tokyo all tended to move in the same direction at the same time. But globalization means more than increasingly close interaction among national markets. Flush with liquidity and with diminished fear of risk, investors throughout the world poured capital into almost every asset class, and in every sub-segment within each class, driving investment returns from disparate market segments into global convergence.

This emerging convergence, or "correlation" of most asset classes, has not been the focus of much attention from market commentators, but it has major implications for risk management strategies of institutional investors and hedge funds. In 1979-80, U.S. laws and regulations regarding the management of pension funds were altered to allow investment in "non-registered securities." What this did was open the doors for pension funds to invest in venture capital and private equity partnerships. These "alternative investments" were said to be "uncorrelated" with equities, bonds, and other tradable...