What Brings Maturity to a Market
Some housekeeping before I start. My post yesterday was meant to be a “when the credit/liquidity cycle turns” post, not a “the sky is falling” post. Picking up on point number 4 from what could go wrong, I would refer you to today’s Wall Street Journal for two articles on LBOs that are not going so well, and the sustainability of private equity in the current changing environment. Please put on your peril-sensitive sunglasses before reviewing the credit metrics.
In the early 90s, as 401(k)s came onto the scene, savings options were the hot sellers to an unsophisticated marketplace. Because of the accounting rules, insurance contracts could be valued at book, not market, and so Guaranteed Investment Contracts [GICs] were sold to 401(k) and other DC plans.
The difficulty came when companies that issued contracts failed, like Executive Life, Mutual Benefit, Confederation, and The Equitable (well, almost). A market that treated all contracts equally was now exposed to the concept that there is such a thing as credit risk, and that the highest yielding contract is not necessarily the one that should be bought.
In the mid-90s, that was my first example of market maturation, and it was painful for me. I was running the Guaranteed Investment Contract desk at Provident Mutual, and making good money for the firm. We survived as other insurance companies went under or exited the business, but as more companies failed, the credit quality bar kept getting raised higher, until we were marginal to the market. Confederation’s failure was the last nail in my coffin. I asked my bosses whether I could synthetically enhance my GICs by giving a priority interest to the GIC-holders in an insolvency, but they turned me down, and I closed down an otherwise profitable line of business.
Failure brings maturity to markets, and market mechanisms. When a concept is new, the riskiness of it is not apparent until a series of defaults occurs, showing a difference between more risky and less risk ways of doing business. Let me give some more examples:
Stock Market Leverage: How much margin debt is too much, that it helps create systemic risk? In the 20s leverage could be 10x, and the volatility that that policy induced helped magnify the boom in the 20s, and the bust 1929-1932. Today the ability to lever up 2x (with some exceptions) is deemed reasonable. If it is not reasonable, another failure will teach us.
Dynamic Hedging: In the mid-80s, shorting stock futures to dynamically hedge stock portfolios was the rage. After all, wasn’t it a free way to replicate a costly put option?
When it was first thought up, it probably was cheap, but as it became more common the trading costs became visible. For small price changes, it worked well. Who could predict the magnitude of price changes it would be forced to try and unsuccessfully hedge? After Black Monday, the cost of a put option as an insurance policy was better appreciated.
Lending to Hedge Funds: I’m not convinced that this lesson has been learned, but if it has been learned, the crisis from LTCM started that process. After LTCM failed, counterparties insisted more closely on understanding the creditworthiness of those that they expected future payments from.
Negative Convexity: Through late 1993, structurers of residential mortgage securities were very creative, making tranches in mortgage securitizations that bore a disproportionate amount of risk, particularly compared to the yield received. In 1994 to early 1995, that illusion was destroyed as the bond market was dragged to higher yields by the Fed plus mortgage bond managers who tried to limit their interest rate risks individually, leading to a more general crisis. That created the worst bond market since 1926.
There are other examples, and if I had more time, I would list them all. What I want to finish with are a few areas today that have not experienced failure yet:
- the credit default swap market.
- the synthetic CDO market (related to #1, I know)
- nonprime commercial paper
- covenant-lite commercial loans, particularly to LBOs.
There is nothing new under the sun. Human behavior, including fear and greed, do not change. In order to stay safe in one’s investments, one must understand where undue risk is being taken, and avoid those investments. You will make more money in the long run avoiding foolish risks, than through cleverness in taking obscure risks ordinarily. Risk control triumphs over cleverness in the long run.
June 8th, 20077:05 am at
Hello David,
I wonder if you are under characterizing the leverage currently present in the system – particularly stocks. Yes margin requirements exist when they did not in 1929, but futures trading is massive at present and leverage there can be 20+ to 1. Also, as you indicate, hedge funds and fund of funds are so dominate now. We have fund of funds that are leveraged several times investing in hedge funds that are leveraged several times investing in a lot of OTC options and derivatives contracts which have not been stress tested at 3+ standard deviations to see if they’ll perform as all of the pricing models forecast (paint me VERY skeptical they will). Also, with commercial banks up to their eyeballs in commercial real estate and derivatives, the financial system is massively leveraged with a fairly risky asset profile.
June 8th, 200712:48 pm at
Hello James,
The $64 billion dollar question is who holds the risk in a crisis? How well capitalized are the ones who who be asked to deliver liquidity when it is demanded. Derivatives are tricky because they net to zero in aggregate, but the counterparties may have decidedly different abilities to make payment in a crisis.
Some exposures can’t be hedged. There is no natural counterparty for them. A financial entity can only do the following for risk control in that case: 1. Cross-hedge (might provide some relief)2. Keep spare capital around (how quaint!)
3. Have enough seemingly uncorrelated exposures that diversification keeps any problem to a reasonable size. Trouble is, the world is more correlated during a crisis. If I were at one of the major investment banks and in charge of risk control, I would push as hard as I could to analyze the strength of the counterparties, and see which contingencies have the weakest counterparties behind them. Some managing directors would start to scream because it would hurt a very profitable business, but an exercise like that could save the investment bank in a crisis.
June 8th, 20071:50 pm at
Thanks for the reply and education. My primary point was questioning your comparison of leverage in the 20’s to today. I believe that actual leverage is higher than 2x’s in mass due to all the factors we have sited.
As for derivatives, I remain extremely skeptical that the large banks have it under control. One need only to read the last 10 years of Berkshire letters from Buffet and his dismay with unwinding General Re’s book. There is no way in **** that JPM or C or UBS have a better handle on counterparty risk or correlations of their “assets”….in my opinion anyway!
June 8th, 200711:55 pm at
There are definitely some places where leverage exceeds that of the 20s. I know about the use of derivatives to achieve that, as well as outright borrowing schemes that create double leverage. My hesitation is over how widespread it is on average at present. We need a good downdraft that sticks to show who is hyper-levered. We haven’t had a 10% decline in a long time… perhaps some are relying ion that not happening again; after all, a 10% decline would wipe out anyone with 10x leverage.
June 9th, 20071:32 pm at
David,
I would agree that pure-play stock leverage is probably not at “insane” levels, but there is a massive amount of money that is being run in multi-discipline strategy with the assumption that correlations will not be high between strategies. I am by no means an expert in the area, but from what I have gathered from some who are, there is immense leverage based on this assumption. In fact, the new portfolio margin levels which reduced “regular” requirements are based on this assumption. I would venture that we won’t know until we get an across the board decline like we did on Thursday, where most risk assets declined AND treasuries as well. Of course it would likely have to stick for a while as you mention…..