Speculation Away From Subprime, Compendium

Subprime lending is grabbing a lot of attention, but it is only a tiny portion of what goes on in our capital markets.  Tonight I want to talk about speculation in our markets, while largely ignoring subprime.

  1. I have grown to like the blog Accrued Interest.  There aren’t many blogs dealing with fixed income issues; it fills a real void.  This article deals with bridge loans; increasingly, as investors have grown more skittish over LBO debt, investment banks have had to retain the bridge loans, rather than selling off the loans to other investors.  Google “Ohio Mattress,” and you can see the danger here.  Deals where the debt interests don’t get sold off can become toxic to the investment banks extending the bridge loans.  (And being a Milwaukee native, I can appreciate the concept of a “bridge to nowhere.”  Maybe the investment bankers should visit Milwaukee, because the “bridge to nowhere” eventually completed, and made it to South Milwaukee.  Quite an improvement over nowhere, right? Right?!  Sigh.)
  2. Also from Accrued Interest, the credit markets have some sand in the gears.  I remember fondly the pit in my stomach when my brokers called me on July 27th and October 9th, 2002, and said, “The markets are offered without bid.  We’ve never seen it this bad.  What do you want to do?”  I had cash on hand for bargains both times, but when the credit markets are dislocated, nothing much happens for a little while.  This was true after LTCM and 9/11 as well.
  3. I’ve seen a number of reviews of Dr. Bookstaber’s new book.  It looks like a good one. As in the last point, when the markets get spooked, spreads widen dramatically,and trading slows until confidence returns.  More bad things are feared to happen than actually do happen.
  4. I’m not a fan of shorting, particularly in this environment.  Too many players are short without a real edge.  High valuations are not enough, you need to have an uncommon edge.  When I short, that typically means an accounting anomaly.  That said, there is more demand for short ideas with the advent of 130/30 and 120/20 funds.  Personally, I think they are asking for more than the system can deliver.  Obvious shorts are full up, and inobvious shorts are inobvious for a reason; they aren’t easy money.
  5. From the “Too Many Vultures” file, Goldman announces a $12.5 billion mezzanine fund.  With so much money chasing failures, the prices paid to failures will rise in the short run, until the vultures get scared.
  6. Finally, and investment bank that understands the risk behind CPDOs.  I have been a bear on these for some time; perhaps the rapidly rising spread environment might cause a CPDO to unwind?
  7. Passive futures as a diversifier made a lot of sense before so many pension plans and endowments invested in it.  Recent returns have been disappointing, leading some passive investors to leave their investments in crude oil (and other commodities).  With less pressure on the roll in crude oil, the contango has lessened, which makes a passive investment in commodities, particularly crude oil, more attractive.
  8. Becoming more proactive on ratings?  I’m not holding my breath but Fitch may be heading that way on CMBS.  Don’t hold your breath, though.
  9. When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.
  10. We lost our NYSE feed on Bloomberg for the last 25 minutes of the trading day. Anyone else have a similar outage? I know Cramer is outraged over the break in the tape around 3PM, and how the lack of specialists exacerbated the move. Can’t say that I disagree; it may cost a little more to have an intermediated market, but if the specialist does his job (and many don’t), volatility is reduced, and panics are more slow to occur.
  11. Perhaps Babak at Trader’s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
  12. The bond market on the whole responded rationally last week. There was a flight to quality. High yield spreads continued to move wider, and the more junky, the more widening. Less noticed: the yields on safe debt, high quality governments, agencies, mortgages, industrials and utilities fell, as the flight to quality benefitted high quality borrowers. Here’s another summary of the action on Thursday, though it should be noted that Treasury yields fell more than investment grade debt spreads rose.
  13. Shhhhh. I’m not sure I should say this, but maybe the investment banks are cheap here. I’ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.
  14. Comparisons to October 1987? My friend Aaron Pressman makes a bold effort, but I have to give the most serious difference between then and now. At the beginning of October 1987, BBB bonds yielded 7.05% more than the S&P 500 earnings yield. Today, that figure is closer to 0.40%. In October 1987, bonds were cheap to stocks; today it is the reverse.
  15. Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
  16. Now, a trailing indicator is mutual fund flows. Selling equities and high yield? No surprise. Most retail investors shut the barn door after the cow has run off.
  17. Deals get scrapped, at least for now, and the overall risk tenor of the market shifts because player come to their senses, realizing that the risk is higher than the reward. El-Erian of Harvard may suggest that we have hit upon a regime change, but I would argue that such a judgment is premature. We have too many bright people looking for turning points, which may make a turning point less likely.
  18. Are we really going to have credit difficulties with prime loans? I have suggested as much at RealMoney over the past two years, to much disbelief. Falling house prices will have negative impacts everywhere in housing. Still, it more likely that Alt-A loans get negative results, given the lower underwriting standards involved.
  19. How much risk do hedge funds pose to the financial system?  My view is that the most severe risks of the financial system are being taken on by hedge funds.  If these hedge funds are fully capitalized by equity (not borrowing money or other assets), then there is little risk to the financial system.  The problem is that many do finance their positions, as has been seen in the Bear Stearns hedge funds, magnifying the loss, and wiping out most if not all of the equity.
  20. There is a tendency with hedge funds to hedge away “vanilla risks” (my phrase), while retaining the concentrated risks that have a greater tendency to be mispriced.  I want to get a copy of Richard Bookstaber’s new book that makes this point.  Let’s face it.  Most hedging is done through liquid instruments to hedge less liquid instruments with greater return potential.  Most hedge funds are fundamentally short liquidity, and are subject to trouble when liquidity gets scarce (which ususally means, credit spreads rise dramatically).
  21. Every investment strategy has a limit as to how much cash it can employ, no matter how smart the people are running the strategy.  Inefficiencies are finite.  Now Renaissance Institutional is feeling the pain.  My greater question here is whether they have pushed up the prices of assets that they own to levels not generally supportable in their absence, simply due to their growth in assets?  Big firms often create their own mini-bubbles when they pass the limit of how much money they can run in a strategy.  Asset growth is self-reinforcing to performance, until you pass the limit.
  22. I have seen the statistic criticized, but it is still true that we are at a high for short interest.  When short interest gets too high, it is difficult but not impossible for prices to fall a great deal.  The degree of short interest can affect the short-term price path of a security, but cannot affect the long term business outcome.  Shorts are “side bets” that do not affect the ultimate outcome (leaving aside toxic converts, etc.).
  23. I’ve said it before, and I’ll say it again, there are too many vulture investors in the present environment.  It is difficult for distressed assets to fall too far in such an environment, barring overleveraged assets like the Bear Funds.  That said, Sowood benefits from the liquidity of Citadel.
  24. Doug Kass takes a swipe at easy credit conditions that facilitated the aggressive nature of many hedge funds.  This is one to lay at the feet of foreign banks and US banks interested in keeping their earnings growing, without care for risk.
  25. Should you be worried if you have an interest in the equity of CDOs?  (Your defined benefit pension plan, should you have one, may own some of those…)  At present the key factors are these… does the CDO have exposure to subprime or Alt-A lending, home equity lending, or Single-B or lower high yield debt?  If so, you have reason to worry.  Those with investment grade debt, or non-housing related Asset-backed securities have less reason to worry.
  26. There have been a lot of bits and bytes spilled over mark-to-model.  I want to raise a slightly different issue: mark-to-models.  There isn’t just one model, and human nature being what it is, there is a tendency for economic actors to choose models that are more favorable to themselves.  This raises the problem that one long an illiquid asset, and one short an illiquid asset might choose different values for the asset, leading to a deadweight loss in aggregate, because when the position matures, on net, a loss will be taken between the two parties.  For a one-sided example of this you can review Berky’s attempts to close out Gen Re’s swap book; they lost a lot more than they anticipated, because their model marks were too favorable.
  27. If you need more proof of that point, review this article on how hedge funds are smoothing their returns through marks on illiquid securities.  Though the article doesn’t state that thereis any aggregate mis-marking, I personally would find that difficult to believe.
  28. If you need still more proof, consider this article.  The problem for hedge fund managers gets worse when illiquid assets are financed by debt.  At that point, variations in the marked prices become severe in their impacts, particularly if debt covenants are threatened.
  29. Regarding 130/30 funds, particularly in an era of record shorting, I don’t see how they can add a lot of value.  For the few that have good alpha generation from your longs, levering them up 30% is a help, but only if your shorting discipline doesn’t eat away as much alpha as the long strategy generates.  Few managers are good at both going long and short.  Few are good at going short, period.  One more thing, is it any surprise that after a long run in the market, we see 130/30 funds marketed, rather than the market-neutral funds that show up near the end of bear markets?
  30. Investors like yield.  This is true of institutional investors as well as retail investors.  Yield by its nature is a promise, offering certainty, whereas capital gains and losses are ephemeral.  This is one reason why I prefer high quality investments most of the time in fixed income investing.  I will happily make money by avoiding capital losses, while accepting less income in speculative environments.  Most investors aren’t this way, so they take undue risk in search of yield.  There is an actionable investment idea here!  Create the White Swan bond fund, where one invests in T-bills, and write out of the money options on a variety of fixed income risks that are directly underpriced in the fixed income markets, but fairly priced in the options markets.  Better, run an arb fund that attempts to extract the difference.
  31. Most of the time, I like corporate floating rate loan funds.  They provide a decent yield that floats of short rates, with low-ish credit risk.  But in this environment, where LBO financing is shaky, I would avoid the closed end funds unless the discount to NAV got above 8%, and I would not put on a full position, unless the discount exceeded 12%.  From the article, the fund with the ticker JGT intrigues me.
  32. This article from Information Arbitrage is dead on.  No regulator is ever as decisive as a margin desk.  The moment that a margin desk has a hint that it might lose money, it moves to liquidate collateral.
  33. As I have said before, there are many vultures and little carrion.  I am waiting for the vultures to get glutted.  At that point I could then say that the liquidity effect is spent. Then I would really be worried.
  34. Retail money trails.  No surprise here.  People who don’t follow the markets constantly get surprised by losses, and move to cut the posses, usually too late.
  35. One more for Information Arbitrage.  Hedge funds with real risk controls can survive environments like this, and make money on the other side of the cycle.  Where I differ with his opinion is how credit instruments should be priced.  Liquidation value is too severe in most environments, and does not give adequate value to those who exit, and gives too much value to those who enter.  Proper valuation considers both the likelihood of being a going concern, and being in liquidation.

That’s all in this series.  I’ll take up other issues tomorrow, DV.  Until then, be aware of the games people play when there are illiquid assets and leverage… definitely a toxic mix.  In this cycle, might simplicity will come into vogue again?  Could balanced funds become the new orthodoxy?  I’m not holding my breath.