Quantitative Methods – Page 43

Cruising Across Our Speculative Markets

Posted on 29 August 2007 by David Merkel

Quants have it tough.? Few in the investment world really understand what you do, and even fewer outside that world.? To many investment managers, quants are the guys nipping at their heels, clipping their returns, and questioning the need for fundamental analysis.? There comes a kind of schadenfreude when their models blow up, where qualitative mangers get to say, “See, I knew it was too good to be true,” and in the newspapers, a kind of bewilderment at eggheads whose models failed them.

I write this as a hybrid.? I am a qualitative investor that uses quantitative models to aid my processes.? As such, I was hurt, but not badly, but recent market troubles.? Any class of models can be overused, and the factors common to most quant models indeed became overused recently.? Truth is, the models don’t vary that much from quant shop to quant shop, because the market anomalies are well known.? Many of these funds held the same stocks, as seen in hindsight.? Should it surprise us that their results were correlated?

In a situation like this, success tends to breed more success, for a time, as more money gets applied to these strategies.? The statisticians should noticed the positive autocorrelation in excess returns, rather than randomness, which should have tipped them off to to much money entering the trade.? But no.? There was another calculation that could have been done as well, estimating the prospective return from new trades, which was declining as the trades got more popular.? My view is that a quant should estimate the riskiness of his strategy, and compare the returns to those available on junk bonds.? When the return is less than that available from a single-B bond, it’s time to start collapsing the trade.? (What, they won’t pay you to hold cash?? No wonder….)

On a different topic, consider mark-to-model.? I’ve said it before, but Accrued Interest said it better when it said that mark-to-model is unavoidable.? Most bonds in the market do not have a bid at any given time.? Most bonds are bought and held; beyond that, there are multiple bonds for a given company, versus one class of common stock.? The common stock will be liquid, and the bonds merely fungible.? It is even more true for structured securities, where the classes under AAA are very thin.? The AAAs may trade, classes with lower credit ratings rarely do.

Now the same argument is true when looking at a whole investment bank.? How do you mark positions that never trade, and here there is no readily indentifiable bid or ask?? You use a model that is built from things that do trade.? Sad thing is, there isn’t just one model, and there isn’t just one set of assumptions.? It is likely that the investment banks of our world, together with those they deal with, have marked illiquid securities to their own advantage.? Assets marked high, liabilities low.? Aggregate it across all parties, and the whole is worth more than the parts, due to mismarking.

Now for a tour of unrelated items:

There is something about a spike in volume that reveals weaknesses in back offices.? For derivative trading, where there is still a lot of paper changing hands, that is no surprise.
Prime brokerage is an interesting concept.? They bring a wide variety of services to hedge funds, but also compete in a number of ways.? At my last firm, I never felt that we got much out of our prime brokerage relationships for what we paid.? They provided liquidity at times, but not often enough.? Executions were poor as well.
The market sneezes, and we worry about jobs on Wall Street.? Par for the course.? What is unusual here is that few bodies were cut 2001-2003, so pruning may be overdue.? It may be worse because the structured product markets are under stress.
Catastrophe bonds are opaque to most, and Michael Lewis did us a favor by writing this.? That said, though this article begins by suggesting that 2007 will be an above average hurricane season, I ask, “What if it is not?”? It is rare for the hurricane season to shift halfway through the season.? It may be time to buy RNR, FSR, MRH and IPCR.? But regarding cat bonds, they are issued by knowledgeable insurers.? After issue, there are dedicated hedge funds that trade them, taking advantage of less knowledgeable holder, who only originally showed up for the extra yield.
A break in the market affects obscure asset classes as well.? If wealthy hedge fund managers are the marginal buyers of art, and they are getting pinched now, the art market should follow.
Message to Mish: If Bill Gross is shilling for a PIMCO bailout, we are all in trouble.? If the prime mortgage market and the agencies are in trouble, then I can’t think of anyone in the US that will not feel the pain.? I think Bill Gross is speaking his mind here, much as I think that Fed funds rate cuts are not needed, though I also think that they will happen, and soon.
Many emerging debt markets are in better shape than the US, because their current accounts are in better order.? Now, as for this article, Brazil might be okay, but Turkey is not in a stable place here because of their current account deficits, and I would be careful.
Finally we are getting real volatility.? I like that.? It helps keep us honest, and shakes out weak holders and shorts.

See you tomorrow, DV.

Tickers mentioned: IPCR, MRH, FSR, RNR

The State of the Markets, Part 2

Posted on 13 August 2007 by David Merkel

There are several ways I would like to go from here in my short-term plan for this blog.? One is to focus on the stress in credit markets.? Second is to post on the macroeconomics surrounding these changes.? Third is to point at the oddball stuff that I am seeing away from points one and two.? Last would be portfolio strategy at this point in time.? From a conversation with my friend Cody Willard today, where we went over many of these topics and more, what I believe every investor should do right now is look at every asset in his portfolio, and ask two questions:? What happens if this asset can’t get financing on attractive terms, and would this asset benefit from any reflationary moves by the global central banks.? That’s the direction that I am heading.? Tonight, I hope to go through stress in the credit markets, and maybe macroeconomics.? I haven’t been feeling so well, so I’ll see what I can do.

Let’s start with Rick Bookstaber, who recently started his own blog, after writing a well-regarded new book that I haven’t read yet.? He sees the risks with the quant funds: leverage, similar strategies, and the carrying capacity of the strategies.? Very similar to my ecological view of the markets.? Move over to the CASTrader blog, a nifty blog that I cited on my Kelly Criterion pieces.? He also subscribes to the Adaptive Markets Hypothesis, as I do.? He also makes a carrying capacity-type argument, that the quants got too big for the markets that they were trying to extract excess profits from.? Any strategy can be overdone.? Then go to Zero Beta.? The hidden variable that the quants perhaps ignored was leverage, which affects the ability of holders to control an asset under all conditions.? Leverage creates weak holders, or in the case of shorts, weak shorts.? Visit Paul Kedrosky next.? I sometimes talk about “fat tails,” and yes, looking at distributions of asset returns, they can seem to be fat tailed, but regime shifting is another way to look at it.? Assets shift between two modes:? Normal and Crisis.? In normal, the going concern aspect gets valued more highly.? In crisis, the liquidation aspect gets valued more highly.

Looking at this article, quant funds were precariously over-levered, and now are paying the price.? Goldman Sachs may understand that now, as its Global Alpha fund moves to a lower leverage posture.? This NYT article points out how fund strategy similarities helped exacerbate the crisis, as does this article in the Telegraph.

We have continuing admissions of trouble.? AQR, and this summary from FT Alphaville.? Tighter credit is inhibiting deals, which is to be expected.? Some mutual fund managers are underperforming, including a few that I like, for example Wally Weitz, and Ron Muhlenkamp.? Problems from our residential real estate markets will get bigger, until the level of unsold inventories begins a credible decline.

Is 1998 the right analogy for the markets?? FT Alphaville gets it right; the main difference is that the funding positions of the US and emerging Asia are swapped.? We need capital from the emerging markets now; in 1998, it was flipped. Is 1970 the right analogy?? I hope not.? ABCP in credit affected areas should be small enough that the overall commerical paper market should not be affected, and money markets should be okay.? But it troubles me to even wonder about this.? Finally, CDS counterparty risk — it is somewhat shadowy, so questions are unavoidable.? The question becomes how well the investment banks enforce their margin agreements.? My suspicion is that they will enforce them well, particularly in this environment.? But what that means (coming full circle) is that speculators on the wrong side of trades will get liquidated, adding to current market volatility.

The State of the Markets

Posted on 11 August 2007 by David Merkel

I’m going to try to put in two posts this evening — this one on recent activity, and one on the Fed, to try to address the commentary that my last post generated.

Central Banking in the Forefront?

Let’s start with the state of monetary policy.? Is it easy or tight?? It’s in-between.? The monetary base is growing at maybe a 3% rate yoy.? The Fed has not done a permanent injection of liquidity in over 3 months.? MZM and M2 are around 5%, and my M3 proxy is around 8%.? But FOMC policy is compromised by the willingness of foreigners to finance the US Current account deficit, and cheaply too.? The increase in foreign holdings of US debt is roughly equal to the increase in M2.? That provides a lot of additional stimulus that the Fed can’t undo.

So what have the Central Banks done lately? Barry does a good job of summarizing the actions, all of which are temporary injections of liquidity, together with statements of support for the markets.? So why did short-term lending rates to banks spike?? My guess is that there were a few institutions that felt the need to shore up their balance sheets by getting some short-term liquidity.? I’m a little skeptical of the breadth of this crisis, but if anything begins to make me more concerned, it is that some banks in the Federal Reserve System needed liquidity fast.? Also, some banks needed quick liquidity from the unregulated eurodollar markets.? But who?? Inquiring minds want to know… 😉

So, over at FT Alphaville they wonder, but in a different way.? What do central bankers know that we don’t?? My usual answer is not much, but I am wondering too.? Panicked calls from investment bank CEOs?? Timothy Geithner worrying about systemic risk?? Maybe, but not showing up in swap spreads, yet.? Calls from commercial bankers asking for a little help?? Maybe.? I don’t know.? I wonder whether we’ve really felt enough pain in order to deserve a FOMC cut.? We haven’t even had a 10% correction in the market yet.? Obviously, But some think we’ve had enough pain.? But inflation is higher than the statistics would indicate, and is slowly getting driven higher by higher inflation abroad, some of which is getting transmitted here.? Not a fun time to be a central banker, but hey, that’s why they pay them the big money, right? 🙂

Speculation Gone Awry, Models Gone Awry

We can start with a related topic: money market funds. Some hold paper backed by subprime mortgages.? With asset backed commercial paper, some conduits are extending the dates that they will repay their obligations.? Not good, though ABCP is only a small part of the money markets.? Ordinary CP should be okay, even with the current market upset, though I wonder about the hedge funds that were doing leveraged non-prime CP.

In an environment like this, there will be rumors.? And more rumors.? But many admit to losing a lot of money.? Tykhe. Renaissance Technologies. The DWS ABS fund.? There are some common threads here.? I believe that most hedged strategies (market-neutral) embed both a short volatility bet, and a short liquidity bet, which? add up to a short credit spreads bet.? In a situation like this, deal arbitrage underperforms.? The Merger Fund has lost most of its gains for the year.? Part of the reason for losses is deals blowing up, and the rest is a loss of confidence.? Could other deals blow up, like ABN Amro?? If you want to step up now, spreads are wider than at any point in the last four years, and you can put money to work in size.

More notable, perhaps, are the extreme swings in stock prices. Many market-neutral strategies are underperforming here.? (Stock market-neutral does not mean credit market-neutral.)? Statistical arbitrage strategies were crowded trades.? Truth is, to a first approximation, even though almost all of the quant models were proprietary, they were all pretty similar.? Academic research on anomalies is almost freely available to all.? Two good quants can bioth start fresh, but they will end up in about the same place.

Last week, I commented how my own stocks were bouncing all over the place.? Some up a lot, and some down a lot on no news.? Many blame an unwind in statistical arbitrage.? Was this a once in every 10,000 years event?? I think not.? The tails in investing are fat, and when a trade gets crowded, weird things happen.? It is possible to over-arbitrage, even as it is possible to overpay for risky debt.? As the trade depopulates, prices tend to over-adjust.? Are we near the end of the adjustment?? I don’t think so, but I can’t prove it.? There is too much implicit leverage, and it can’t be unwound in two weeks.

Odds and Ends

Two banking notes: S&P has some concerns about risk in the banking sector, despite risk transfer methods.? A problem yes, but limited in size.? Second, ARM resets are going to peak over the next year.? The pain will get worse in the real estate markets, regardless of what the Fed does.

Insider buying is growing in financial stocks, after the market declines.? I like it.? My next major investment direction is likely overweighting high quality financials, but the timing and direction are uncertain.

Finally, from the Epicurean Dealmaker (neat blog. cool name too.), how do catastrophic changes occur?? I love nonlinear dynamics, i.e., “chaos theory.”? I predicted much of what has been happening two years ago at RealMoney, but I stated the the timing was uncertain.? It could be next month, it could be a decade at most.? The thing is, you can’t tell which straw will break the camel’s back.? I like being sharp rather than fuzzy, but I hate making sharp predictions if I know that the probability of my being wrong is high.? In those cases, I would rather give a weak signal, than one that could likely be wrong.

The Current Market Morass

Posted on 9 August 200710 August 2007 by David Merkel

Over at RealMoney, toward the end of the day, I commented:

		David Merkel
		Many Hedge Funds are Systematically Short Liquidity
		8/9/2007 5:43 PM EDT

You can look at Cramer’s two pieces here and here that deal with the logjam in the bond markets. Now, there are problems that are severe, as in the exotic portions of the market. There are problems in investment grade corporate bonds in the cash market, but spreads haven’t moved anywhere nearly as much as they did in 2002. The synthetic (default swap) portion of the market is having greater problems. Oddly, though high yield cash spreads have moved out, they still aren’t that wide yet either compared to 2002. The problems there are in the CDS, and hung bridge loans.

Most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. If these funds are blowing up, like LTCM in 1998, then liquidity will be tight in the derivative markets, but the regular cash bond markets won’t be hurt so bad.

I agree with Michael Comeau with a twist… this may end up being good for the equity markets eventually, but in the short run, it is a negative.

Let me try to expand a little more here. A good place to start is Cramer’s last piece of the day. Part of what he said was:

But first you have to recognize that I am not talking about opportunity. We need the Fed simply to issue a statement like it did in 1987, that it would provide all of the liquidity necessary to get things moving in the credit markets.

All of those who think the Fed is helpless are as clueless as the Fed. A statement like that would eliminate the fear all over town that committing capital is going to wipe your firm out.

The European action seemed desperate today, but it’s a bit of a desperate time, and they did what is right.

If we had made the right call on Tuesday at the Fed, we would have maneuverability over the next month to help.

Now we can’t. Not for another couple of months, [sic]

Unfortunately, Cramer is wrong here. The ECB only did a temporary injection of funds, which will disappear. The Fed also did a similar temporary injection of funds today, which brought down where Fed funds were trading. It will disappear as well, but both the ECB and Fed can make adjustments as they see fit. There isn’t any significant difference between the actions.
There have been notable failures and impairments, for sure. Let’s run through the list: the funds at BNP Paribas, funds at AXA, Oddo, Sowood and IKB, Goldman Sachs, Tykhe Capital, and Highbridge (and more). With this help from DealBreaker (most of the comments are worth reading also), I would repeat that most hedge funds that try to generate smooth returns are systemically short liquidity and volatility. Another way of saying it is that they have a hidden short in credit quality, and this short is biting bigtime.

Okay, I’ve listed a lot of the practical failures, but what classes of hedge fund investments are getting hurt? Primarily statistical arbitrage and event-driven. (Oh, and credit-based as well, but I don’t have any articles there.) The computer programs at many stat arb shops have not done well amid the volatility, and there have have been significant M&A deals that have come into question, like MGIC-Radian. Merger arbitrage had a bad July, and looking at the Merger Fund, August looks to be as bad. (Worrisome, because merger arb correlates highly with total market confidence.) As for statistical arb, I know a few people at Campbell & Company. They’re bright people. Unfortunately, when regimes shift, often statistical models are bad at turning points. Higher volatility, bad credit, and the illiquidity that they engender doom many statistical models of the market.
So, how bad is credit now? If you are talking about securitized products and derivatives, the answer is extremely bad. If you are talking about high yield loans to fund LBOs, very bad, and my won’t some the investment banks take some losses there (but they won’t get killed). High yield bonds, merely bad — spreads have widened, but not nearly as much as in 2002. Same for investment grade corporates, except less so. Now the future, like say out to 2010, may prove to be even worse in terms of aggregate default rates of corporates, because more of the total issuance is high yield. This is just something to watch, because it may imply a stretched-out scenario for corporate credit losses.

The Dreaded Subprime

Subprime mortgage lending has had poor results. I would even argue that early 2007 originations could be worse than the 2006 vintage. This has spilled over into many places, but who would have expected money market funds? The asset-backed commercial paper [ABCP] market is a small slice of the total commercial paper market, and those financing subprime mortgage receivables are smaller still. The conduits that do this financing have a number of structural protections, so it should not be a big issue. The only thing that might emerge is if some money market fund overdosed on subprime ABCP. I’m not expecting any fund to “break the buck,” but it’s not impossible.

I generally like the writings of Dan Gross. He is partially right when he says that the effects of subprime lending are not contained. Many different institutions are getting nipped by the problem. But I think what government officials mean by contained is different. They are saying that they see no systemic risk from the problem, which may be correct, so long as the aggregate reduction in housing prices does not cause a cascade of failure in the mortgage market, which I view as unlikely.

Perhaps we should look at a bull on subprime lending? Not a big bull, though. Wilbur Ross has lent $50 million to American Home Mortgage on the most senior level possible. That’s not a very big risk, but he does see a future for subprime lending, if one is patient, and can survive the present slump.

A note on Alt-A lending. There’s going to be a bifurcation here; not all Alt-A lending is the same. As S&P and the other rating agencies evaluate loan performance, they will downgrade the deals with bad performance, and leave the good ones alone. The troubles here will likely be as big as those in subprime. Perhaps the lack of information on lending is the crucial issue. Colloquially, never buy a blind pool, or a pig in a poke. Information is supremely valuable in lending, and often incremental yield can’t compensate.

Summary Thoughts

I think 1998 is the most comparable period to 2007. There are some things better and worse now, than in 1998. In aggregate it’s about the same in my opinion. Now with hedge funds, the leverage in aggregate is higher, but could that be that safer instruments are being levered up? That might be part of it, but I agree, aggregate leverage is higher.

In a situation like this, simplicity is rewarded. Complexity is always punished in a liquidity crisis. Bidders have better thing sto do in a crisis than to figure out fair value for complex instruments when simpler ones are under question.
Another aspect of liquidity is the investment banks. As prime brokers, their own risk control mechanisms cause them to liquidate marginal borrowers whose margin has gotten thin. This protects them at the risk of making the crisis worse for everyone else as the prices of risky asset declines after liquidations. Other investors might then face their own margin calls. The cycle eventually burns out, but only after many insolvencies. My guess: none of the investment banks go under.

Finally, let’s end on an optimistic note, and who to do that better than Jim Griffin? As I said before, simplicity is valued in a situation like this, and stocks in aggregate are simple. As he asks at the end of his piece, “What are you going to buy if you sell stocks?” I agree; there will be continued problems in the synthetic and securitized debt markets, but if you want to be rewarded for risk here, equities offer reasonable compensation for the risks taken. Just avoid the areas in financials and hombuilders/etc, that are being taken apart here. The world is a much larger place than the US & European synthetic and securitized debt markets, and there are places to invest today. Just insist on a strong balance sheet.

Eight Great Straight Points on Real Estate

Posted on 7 August 20078 August 2007 by David Merkel

So Moody’s tries to clean up its act, and finds itself shut out of rating most Commercial Mortgage-backed Securities [CMBS] deals? That’s not too surprising, and sheds light on the value of ratings to issuers and buyers. With issuers, it’s easy: Give me good ratings so that I can sell my bonds at low yields. With buyers, it is more complex: We do our own due diligence — we don’t fully trust the ratings, but they play into the risk management and capital frameworks that we use. We like the bonds to be highly rated, and misrated high even better, because we get to hold less capital against the bonds than if they were correctly rated, which raises our return on capital. Moody’s was always in third place behind S&P and Fitch in this market, so it’s not that big of a deal, but I bet Moody’s quietly drops the change.
The yields on loans are not only going up for LBOs like Archstone, leading to further deal delays, but yields are also rising on commercial real estate loans generally. Here is an example from one of the big deals. The risk appetite has shifted. Is it any surprise that equity REITs are off so much since early March? The deals just can’t get done at those high cap rates anymore.
An old boss of mine used to say, “Liquidity is a ‘fraidy cat.” It’s never there when you really need it, and with residential mortgage finance now, the ability to refinance is being withdrawn at the very time it is needed most. What types of mortgages are now harder to get? No money down, Jumbo loans, Alt-A, more Alt-A, and you don’t have to mention subprime here, the pullback is pretty general, with the exception of conforming loans that are bought by Fannie and Freddie. For (perverse) fun, you can see how detailed the guidance to lenders can become.
Should it then surprise us if some buyers of mortgage loans have gotten skittish? No, they forced the change on the originators. A buyers strike. But maybe that’s not the right move now. Let me tell you a story. When I came to Provident Mutual in 1992, the commercial mortgage market was in a panic. The main lines of business of Provident Mutual, hungry for yield, had accepted low-ish spreads from commercial mortgages from 1989-1991, because it improved their yield incrementally. The Pension Division avoided commercial mortgages then, because they felt the risks were not being fairly compensated. In 1992, the head of the commercial mortgage area came to the chief actuary of the pension division, and told him that unless the Pension Division bought their mortgage flow, they would have to shut down, because the main lines couldn’t take any. The chief actuary asked what spreads he would get, and the spreads were high — 3% over Treasuries, much better than before. He asked about loan quality, and was told that they had never had such high quality loans; only the best deals were getting done because of the panic in the market. The chief actuary, the best actuarial businessman I have ever known grabbed the opportunity, and took the entire mortgage flow for the next two years, then stopped. (Saving the Mortgage Division was icing on the cake.) Spreads normalized; credit quality was only average, and the main lines of the company now wanted mortgages. The point of the story is this: the firms that will do best now are not the ones that refuse to lend, but the ones who lend to high quality borrowers at appropriate rates. It’s good to lend selectively in a panic.
Eventually the ARM mortgage reset surge will be gone. Really. We just have to slog through the next two years or so. This will lead to additional mortgage delinquencies and defaults. We’re not done yet. There is a lot of mis-financed housing out there, and unless the borrowers can refinance before the fixed rate period ends to a cheap-ish conventional loan, I don’t see how the defaults will be avoided. Remember houses are long-term assets. Long term assets require long-term financing. Floating rates don’t make it. Non-amortizing loans don’t make it.
Should it then surprise us that the downturn in housing prices is large? No. With all of the excess supply, from home sellers and homebuilders, current prices are not clearing most of the local real estate markets, and prices need to fall further. (Maybe we should offer citizenship to foreigners who buy US residential real estate worth more than $500,000. A win-win-win. Excess supply goes away. Current account deficit reduced. Wealthy foreigners get a safe place to flee, should they need it. 😉 )
As a result, the homebuilders are doing badly. They aren’t making money on the hgomes they build and the value of the land (and land options, JVs, etc.) that they bought during the frenzy is worth a lot less. Sunk costs are sunk, and though you lose money on an accounting basis, in the short run, it is optimal to builders to finish developments that they started.
Could I get John Hussman to like this Fed Model? It’s from the eminent Paul Kasriel, and it compares the earnings yield of residential real estate and Treasury yields, and he suggested in early June that residential real estate was overvalued. There are limitations here; no consideration of inflation and capital gains, no consideration of the spread of mortgage yields over Treasuries. The result is clear enough, though. Don’t own residential real estate when you can earn more in Treasuries than you can in rents. (I know real estate is local, frictional costs, etc., but it does give guidance at the margins.)

The Great Substitution of Equity for Debt, Formerly Led by Private Equity

Posted on 7 August 2007 by David Merkel

When I do a review of links, I try not to do a linkfest, as much try to share my ideas, while annotating places where you can get more data.? I keep topical clipping folders.? Today’s review is on the Great Substitution of Equity for Debt, Formerly Led by Private Equity.? Usually I organize by subtopic when I write, but tonight I will do it by time, because it took me seven weeks to get back to this, and a lot has happened over those weeks.

Go back to mid-June.? 10-year Treasury rates were challenging 5.25%.? Rates all over the world had risen, and some predicted they would go higher, and choke off the private equity boom.? In hindsight, not a good argument, not because Treasury yields fell, but because junk credit spreads are more critical to private equity than treasury and high-grade yields.? In the short run, junk debt yields don’t react much to Treasury yields.? So most didn’t worry at the time.

Give Andy Kessler credit for timing. He expresses skepticism for private equity before Blackstone comes public, suggesting that all they do is borrow money against the assets of the target companies, and then foist them on the retail public later.? Well, that’s not all of what private equity does, but to a first approximation, that’s 90% of the deal.? He takes both sides of the issue, suggesting that conditions are stretched from a valuation standpoint, but suggesting that the insanity could go on for a while longer.

Failed deals often represent turning points, and by the end of June, both Thomson Learning and US Foodservice pulled their debt deals. The appetite for yield had diminished considerably, versus the need to protect capital.

In the short run though, the market is bouncy, and more deals piled up into early July, even as junk spreads began to widen.? I love the closing quote in this WSJ article: “It’s all worth keeping in mind as the market hits its rough spots. Roger Altman, chairman of Evercore Partners points out, for instance, that by any historical measure, the interest rates for junk bonds remain very cheap.? Barring a very steep climb in rates, Mr. Altman says, private equity ‘is a permanent feature of the capital markets. Nothing foreseeable can change that.'”? Mr. Altman is a bright man, no doubt, but turning points are only clear in hindsight.

Now, 2007 had already surpassed 2006 for private equity deals. Maybe completed deals are another issue.? Going to something more mundane, Mark Hulbert points out some research showing that companies that buyback their stock outperform the market.

By mid-July sentiment was definitely shifting in the debt markets, even as the equity markets rose.? More deals were having trouble getting done.? The willingness of lenders to take risk was declining, particularly on PIK bonds and Toggle notes.? Personally, I find it amazing that high yield investors buy instruments that may not pay interest in cash, given the dismal credit experience of such structures.? What would you expect from a company that doesn’t have enough money to make interest payments in cash?

The next article is a vision of the future. Five or so years from now, who will buy all of the new IPOs generated from today’s flood of private equity?? Then again, with the over-borrowing to make deals work, maybe not so many will come to market in the future, at least, not at the size that they left.

Take a look at the seven bad times to buy equities from John Hussman.? The last five of them came at times when the “Fed Model” would have told you to be in bonds.? The first two were close, but in the long haul, one was better off holding common stock through the declines.

By mid-July, we are a little past the recent peak, and buybacks are taking the place of LBOs in the market for shrinkage of the supply of equity.? With investment grade bond yields falling from mid-June, it seems like a reasonable thing to do.

I would never want to be a dedicated short investor.? Shorts are perpetually short the capital structure option, which the equity holders can exercise to lever up, when it is to their advantage to do so.? In this article, the difficulties of being short are explained, with the risks of private equity buyouts, and getting crowded out by naive shorts running 130/30 funds.? Jim Griffin at RealMoney takes an allied approach, suggesting that with equity getting replaced by debt, that equities are possibly a good deal here.

With rising junk spreads in the credit markets, by late July the buyer of choice for takeovers had become investment grade corporations because they could finance the purchase cheaply.? Private equity had gone quiet.? Things were bad enough, that investment banking bridge lenders wondered whether it wouldn’t be cheaper to drop out and pay the breakup fee on Texas Utilities rather than fund the deal personally.? The potential losses from many deals were mounting at the investment banks.? 46 deals had been pulled, versus zero in 2006.

So private equity is dead now, right?? I see it more as a sorting process.? Deals that make economic sense at higher lending rates will get done, and those that don’t make sense will be funded by the investment banks, or shelved for now, depending on the bridge lending deal terms.? It won’t be as big of a force in the market, but buybacks among investment grade corporations will continue to shrink the overall equity supply of the market for now.? I am still a moderate bull on the equity market.

Speculation Away From Subprime, Compendium

Posted on 3 August 2007 by David Merkel

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.

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.)
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.
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.
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.
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.
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?
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.
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.
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.
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.
Perhaps Babak at Trader?s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
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.
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.
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.
Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
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.
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.
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.
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.
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).
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.
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.).
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.
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.
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.
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.
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.
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.
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?
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.
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.
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.
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.
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.
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.

Deerfield: A Difficult Rebalancing Trade

Posted on 2 August 2007 by David Merkel

The following things that I write are more risky than normal, and may be wrong.? If you decide to imitate what I have done, you are doing so at your own risk.? Please do your own due diligence.

I have bought more Deerfield Triarc [DFR] today @ $9.76.? A sharp-eyed reader noted (see the first comment) that DFR must have been past my rebalance point, and wondered why I hadn’t bought more.?? Truth is, I had been working on the issue for two weeks.? Whenever a security falls dramatically (it was close to a second rebalancing sell for me at one point), I do a review.? I don’t automatically do rebalancing buys when a company is under stress.

Okay, what gave me confidence to buy? DFR is levered; the main risk here is that they cannot continue to finance the positions that they hold.? Point one that gives me comfort is that the financing is likely secure.

Most of it is repo funding on prime mortgage collateral, most of which is floating rate.? Though there is a high degree of leverage there, the hedging inherent in managing such funding is a common skill.? You could contrast Deerfield and Annaly.? The collateral and leverage are similar; the main difference is that Deerfield uses swaps and floors to manage interest rate risk, and Annaly uses longer repo terms (1-3 years) than Deerfield (0-3 months).

The trust preferreds are not putable, and they lever up their alternative assets through CDO structures, which are not callable.? The risk there is that the equity and subordinate bonds that they hold could be worthless.? Unlikely, but a possible loss somewhere north of $50 million.? They also have warehouse lines, where assets are held prior to securitization.? I don’t know what might be in their warehouse lines now, but they did recently complete a securitization which freed up $230 million of those lines.? (Note: they couldn’t sell the BBB securities.)? The lines are capable of financing $375 million, and extend to April of 2008 at minimum.

Point two is that very little of the assets inside DFR’s CDOs are subprime.? The total risk to DFR is from the Pinetree CDO, which if they end up writing off the CDO equity, will reduce net worth by $12 million.? Not huge.

Point three is that they might not be able to consummate the merger with Deerfield? Capital Management [DCM], since DFR has to pony up $145 million.? I find it unlikely that they could not get the financing for what is a profitable asset where Debt/Operating Income is around 6.? But even if they can’t do the deal, that does not affect DFR, except that they don’t get to purchase an asset manager at a bargain price, which is even more of? bargain now, given that the stock price has fallen, and the deal terms (half stock, half cash) don’t adjust.

Point four is might the deal terms adjust?? Couldn’t DCM allege a material adverse change, and try to get the terms changed?? It’s a little late for that.? The DFR shareholders meeting is one week from today.? Besides, many of the same problems facing DFR are facing DCM.

Point five is that much of what DCM manages are ABS CDOs.? Much of the ABS collateral is subprime residential mortgages.? (For more details, here is an S&P report from last year.) Now, aside from about $20 million of investments in the CDOs that they manage, they don’t have any more risk exposure.? There is the outside possibility that they could be removed as manager on some of the deals that they manage, but that doesn’t happen often.? The current market environment could have a negative impact on their ability to issue more ABS CDOs and other CDOs, but once things clear up, those that? are still in the game of issuing CDOs will make much better interest spreads than they made in the last two years.

In summary, why did I buy more?

The losses look limited, if they occur at all
The financing seems secure
Exposure to subprime losses are small, and
I think the deal goes through.

Could I be wrong on some of these points and lose badly?? Yes.

Full disclosure: Long DFR

More Slick VIX Tricks

Posted on 1 August 20072 August 2007 by David Merkel

Tonight’s article will be less mathematical, and more qualitative than last night’s article. Last night I did say:

The relationship of the VIX to the S&P 500 is an interesting one, one that I have studied for the past nine years. Over that time, I have used the relationships to:

Design investment strategies for insurance companies selling Equity Indexed Annuities.
Estimate the betas of common stocks. (Not that I believe in MPT?)
Trade corporate bonds.
Gauge the overall risk cycle, in concert with other indicators.

Investing to Back Equity Indexed Annuities

Let me talk about these applications. Equity indexed annuities [EIAs] are tricky to design an investment strategy for. Typically they contain long guarantees, say ten years or so, where the minimum payoff must be guaranteed. That payoff is typically 90% of the initial premium plus 3% compound interest. The optimal strategy invests 80% or so of the money to immunize that guarantee, while using the other 20% to invest short to pay for option premiums that match the payoff pattern promised in the EIA.

But here’s the problem. The forward market for 1-year implied volatility doesn’t exist in any deep way, so the insurance company decides that it will have to take its chances, and assume that volatility will mean revert over longer periods of time. Also, they try to build in enough policy flexibility that they can less favorable option terms to policyholders during times of high volatility (at the risk of higher lapsation). Certain bits of actuarial smoothing in the reserves can also be useful in assuming mean reversion. But what happens if volatility rises high and stays there a while? Unfortunately, that tends to be the same time when credit spreads are wide, because option implied volatility is positively correlated with credit spreads. So, at the time that the strategy needs the most help, option costs are high (or payouts are chintzy and lapse rates go up), and corporate bond prcies sag due to wider spreads.
If the insurance company can handle the lack of incremental income, investing in higher credit quality instruments in tight spread low implied volatility environments can mitigate the risks. The benefit to such a strategy is that in a higher spread and implied volatility environment, you can do a down-in-credit trade (lower credit quality) at the time that it is being rewarded. This takes real courage and foresight on the part of the insurance management team to manage this way, but it pays off in the long run. (Which is why the strategy doesn’t usually get used…)

Corporate Bonds Generally

On my monitor screens, I keep three things front and center: the S&P 500, the long bond, and the VIX. This served me well in 2001-2003 when I was a corporate bond manager. After 9/11, we did a massive down-in-credit trade, buying all of the industries that were out of favor because of fears of terrorism. This is the only time I can remember when our client, who never said “no” to incremental yield, told us to hold back. We were almost done anyway, but in the depths of November 2001, we questioned our own sanity. Then, as implied volatility fell, credit spreads did as well, and the prices of our bonds rose, so in the spring of 2002, we reversed the trade and then some. We were in great position for the double bottoms that happened in July and October of 2002. We played the risk cycle well. Following equity volatility aided structural management of the corporate bonds.
When implied volatility was so high, and volatile, I would use the S&P 500 and the VIX to aid the timing of my trades. When the S&P was falling, and the VIX rising, and the long (Treasury) bond rising in price and falling in yield, I would wait until the S&P 500 would level off, and the VIX begin to fall a little. Then I would buy the corporates that I had been targeting. I would get good executions because of the dourness of the day, but more often than not, the market would turn an hour after I bought as corporate spreads would begin to tighten in response to the better tone from the equity markets and implied volatility.Though we were a qualitative credit analysis shop, I would have analysts review companies when their stock price had fallen by more than 30% since the purchase of the bond, and where the equity’s implied volatility had risen by more than 30%. This test flagged Enron, and others, before they collapsed. Not everything that fits those parameters is a sell, but they are all to be reviewed.

One aspect of the bond market that outsiders don’t know about is that when it gets frothy, deals come and go rapidly. Some get announced and close in as little as seven minutes. Speed is critical at such times, but so is judgment on how fairly the deal is priced. When the market is that hot, a corporate bond manager does not have time to ask the credit analyst what he thinks about a given company. I developed what I called the one-minute drill, which when I explained it to my analysts, fascinated them. Using a Bloomberg terminal, I would check the equity price movement over the last twelve months (red flag — down a lot), equity implied volatility (red flag — up a lot), balance sheet (how much leverage, and what is the trend?), income statement (red flag — losing money), cash flow statement (red flag — negative cash flow from operations), and the credit ratings and their outlooks. I can do that in 30 seconds to a minute at most, giving me ample time to place an order, even if the deal closes seven minutes from its announcement. I told my analysts that I trusted their opinions, but in the few weeks that we might hold the bonds while they were working out their opinion, if I didn’t have any red flags, it was safe to hold the bonds for a month off of the one minute drill. If the analyst didn’t like the bonds, typically I would kick them out for a small gain.
For those with access to RealMoney, I recommend my articles on bonds and implied volatility. Changes in Corporate Bonds, Part 1 , and Changes in Corporate Bonds, Part 2.

Estimating Beta

You can estimate beta using the VIX. Here’s how: start with the Capital Asset Pricing Model (ugh), and apply a variance operator to each side. After simplification, the eventual result will be (math available on request):
What this means is that the actual volatility of the individual stock is equal to the square of its beta times the actual volatility of the market portfolio, plus the firm-specific variance. Now, one can estimate this relationship using a non-linear optimizer (Solver in Excel can do it), regressing actual market volatility on the volatility of the individual firm, allowing for no intercept term, and constraining the errors to be positive, because firm specific variance can’t be negative. In place of actual volatility, implied volatility can be used, because the two are closely related.
I played around with this relationship and found that it yielded estimates of beta that I thought were reasonable. It’s a lot more work than the ordinary calculation, though. The estimate might be more stable than that from using returns.

Gauging the Overall Risk Cycle

When I look at systemic risk, the VIX plays a big role. Other option volatilities are valuable as well, bond volatilities, swaption volatilities, currency volatilities, etc. Also playing a role are credit spreads in the fixed income markets. Together, these help me analyze how much risk is being perceived in the market as a whole. I don’t have a single summary measure at present; different variables are important at different points in the cycle.

Profitable Trading Rules

I think that there are no lack of profitable trading rules for the S&P 500 from the VIX. But you have to choose your poison. Absolute rules tend to have few signals, and require holding for some time, but are quite profitable. Here’s an example: Buy the S&P 500 when the VIX goes over 40, and sell when it drops below 15. Relative rules tend to have more signals, and don’t require long holding periods, but are modestly profitable on average, with more losing trades. Example: buy when the VIX is over its 50-day moving average by 50%, and sell when it is less than the 50-day moving average.

I don’t use any of those rules for my investing, but I do watch the VIX out of the corner of my eye to help me decide when conditions are are more or less favorable to put on more risk. Along with my other variables for tracking the risk cycle, it can aid your investment performance as well.

For Wonks Only — The Math of Volatility Mean-Reversion

Posted on 1 August 20071 August 2007 by David Merkel

I’ve estimated a number of mean-reverting models in my time. I had one of the best dynamic full yield curve models around in the mid-90s. The investment department at Provident Mutual said it was the first model that was not artificially constrained that behaved like the yield curve that they knew.

In yesterday’s article, I mentioned that I could give math behind estimating mean-reversion of volatility. In order to do the regression to estimate mean-reversion, we use a lognormal process, because volatility can’t be negative.

Taking the logs of both sides:

Alpha is the drift term, that will help us calculate the mean reversion level, beta is the daily mean reversion speed, and epsilon is a standard normal disturbance term. Assume that there are no more random shocks, so that the volatility returns to its equilibrium level, which implies:

Substituting into the log-transformed equation, we get:

where V-bar is the mean reversion level for volatility. From there, the solution is straightforward:

From my regression, alpha equals 0.046000, and beta is 0.98436. That implies a mean reversion target of 18.937, and that volatility moves 1.564% toward the mean reversion target. One last note: the standard deviation of the error term was 6.3383%, which helps show that in the short run, the volatility of implied volatility is a larger effect than mean-reversion. But in the long-run, mean-reversion is more powerful, because with the law of large numbers, the average of all the disturbances gets closer to zero.