Category: Real Estate and Mortgages

Speculation Away From Subprime, Part 3

Speculation Away From Subprime, Part 3

Posted on by David Merkel

More on speculation, while avoiding subprime which is still over-reported.

  1. 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.
  2. 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).
  3. 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.
  4. 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.).
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. 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.
  10. 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.

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.

Speculation Away From Subprime, Part 2

Speculation Away From Subprime, Part 2

Posted on by David Merkel

What a week, huh? Even with all of my cash on hand, I did a little worse than the S&P 500. One house keeping note before I get started, the file problem from my last insurance post is fixed. On to speculation:

  1. 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.
  2. 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.
  3. Perhaps Babak at Trader’s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
  4. 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.
  5. 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.
  6. 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.
  7. Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
  8. 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.
  9. 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.
  10. 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.

We’re going to have to end it here. Part 3 will come Monday evening.

Investors’ Markets versus Gamblers’ Markets

Investors’ Markets versus Gamblers’ Markets

Posted on by David Merkel

Before I get started on tonight’s piece, I thought I might apologize for a wrong prediction, lest I be confused with a famous guy that I sometimes get associated with.? I was wrong that ABX.HE 07-2 would not get created.? A number of the tranches priced significantly above a 500 bp yield, and so those lower rated tranches got sold at a dsicount to the par value of the securities.? In the unlikely event that those securities get paid off at par, the buyers will be most happy indeed.

But onto tonight’s topic.? Regarding credit default swaps, and their new cousins, ABX, CDX, LCDX, CMBX, etc… there are often more swaps trading than there are underlying cash obligations.? What this implies is that most of the activity going on is not hedging and speculation facilitating hedging, but merely speculation/betting.

What this means is that in the short run, until the cash obligations underlying the default swap mature, there is little to keep the cash and derivative markets together.? The swap spread could be a lot higher than the cash market spread, indicating fear, and a lot of players being willing to bet on partial or total default occurring.? That’s where we are now.? So, when I hear new lows on ABX.HE indexes, and some authoritative voice says that means many defaults are occurring in subprime mortgages, I take a breath and remind myself that it means that more players are betting on increased defaults and loss severity on subprime mortgages.

The opposite can happen too.? Back in 2002, when I was a corporate bond manager, and default swaps were pretty new, I would not buy bonds where the cash spread was smaller then the swap spread, because that indicated a lot of players betting against the bonds in question. If someone holding a bond would sell and replace it with offering protection on a default swap, they would improve their yield, so when the swap spread was wider, it would often lead the bond spread wider as well.? I would wait until the swap spread fell beneath the cash bond spread, and then I would pile in.? Worked really well, and my brokers at the time thought I had this great sense of timing.? Well, maybe I did, but it was analytical, not intuitive.

My main point for my readers: take the prices and yields from swap markets with a grain of salt, particularly on anything they imply to the real economy.? For that, look at the spreads in the cash bond markets.? Limited arbitrage aside, those spreads are more free from raw speculative frenzy.

One last note: almost all users of the bundled credit default swaps are speculators.? They never hold the exact exposure as the swaps, and so the best of them cross-hedges his positions.? So why did these get created?? Wall Street saw a need to allow speculators to express bets that correspond to larger liquid composites in the cash bond markets.? Individual tranches in structured bond deals below AAA are all very thin, and the ability to put a lot of money to work rapidly is limited as a result.? But what if you could pair up additional shorts and longs to take on opposing risks, without them directly investing in the cash bonds?? You would then have a swap market, and the spreads there would differ from the cash market depending on which side of the trade was more motivated: the side needing yield, or the side betting on default.? It’s a big side bet, and hopefully both sides are well-capitalized, but who can really tell?

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