Structured Products and Derivatives – Page 12

Against Risk Parity

Posted on 4 February 20125 February 2012 by David Merkel

Many investment ideas are promising so long as few do them.? Yes, there is an opportunity, but it is limited.? “Shh, don’t tell everyone about it.”

Thus, the concept of “risk parity.”? Lever every asset class up until it has the same volatility as common stocks. Under theoretical conditions, one could make extra money doing this, and with less risk than just a common stock portfolio.

That makes sense when few are doing it, but not when many are doing it.? When I worked for Hovde Capital Advisors, I highlighted to the group how hedge funds were forcing every asset class to the same level of riskiness.? A Grants Interest Rate Observer article on Leveraged Non-prime Commercial Paper is etched on my mind as emblematic of that era.

Risk parity can work so long as the total riskiness of the system does not get too high, as it did in 2007-8.? But if it does get too high, the assets that are levered face disadvantages versus volatile unlevered assets.? Failures of leverage feed on themselves, and lead to a real washout.? Failures of growth stocks don’t do that to the economy.

Risk parity turns managers into bankers, or worse yet, asset managers that specialize in non-AAA investment grade portions of structured securities deals.? Most asset managers are not used to thinking like bankers, largely because they think in terms of total return, and because they don’t have a balance sheet.? Their capital can run at will, unlike banks that have deposit stickiness, savings accounts, CDs, ability to borrow from the FHLBs, etc.? The banks can hold the assets to maturity, they have a buffer against losses in their capital, and don’t have to mark to market in an assiduous manner (though they *should* have to do so).

Think of the mortgage REITs in the most recent crisis — the ones that did the best were the least levered and had the longest terms for their repo lines.? In the short run, that costs more than the vain idea that one can roll over their repo lines every night, and that repo haircuts won’t rise.? Crises lead to a failure of both ideas, together with a set of forced sellers driving down the price of assets being repo-ed, which sometimes leads to a cascade where repo terms get progressively tighter, and only those that were the most conservative at the start of the crisis survive.

There is a Wall Street aphorism, “The fool does at the end of a bull market what the wise man does at its beginning.”? Risk parity falls into that bucket.? Early adopters of new asset classes and liability structures typically do well, but when they become mainstream, the dynamics can be ugly, as we learned in 2007-present.

So ignore the idea of risk parity.? Risk managers are not bankers, they don’t have the capacity to play leveraged spread games to maturity.? Risk parity if practiced on a large scale will produce wipeouts akin to the recent crisis.

Get a Piece of the Schlock

Posted on 2 December 2011 by David Merkel

There is a benefit to reading books on marketing for those that will never be marketers: it will immunize you to sales pitches.? Think of it as studying the strategies of the enemy.? When you talk to salesmen, you can flip their words back at them, or tell them “no,” to the questions that have a guaranteed “yes” attached to them.? Better, if you want, you can tell them, “Stop. I know your tactics.? Cease the sales language and answer these questions I have…” Maybe they will cease.? If not, leave.? There are many places to buy, and some people that will listen to you elsewhere.

Some weeks ago, I was traveling, and heard an ad for a “financial seminar.”? This one sounded better than most, and featured the teachings of a well-known writer.? For fun, I signed up for the free seminar, just to see what would happen.

In reading what little I had before the seminar, I concluded that the only way of doing what they claimed was private ownership of high cash flow properties or businesses.? When I went to the seminar, I was not disappointed — that was the main idea.? Secondarily, they said you could get non-recourse financing easily, or equity limited partnerships to finance you.? (Money grows on trees…)

The first problem is this: mispriced properties are few and far between, and there is competition to buy them, generally.? Second, financing for property investment is scarce, especially for anything where the lender has no recourse to the borrower.

Passive Income

Passive income is an idol in these shows.? It seems like free money, but in practice it is difficult for investors to buy properties cheaply, finance them, and get rents that are far higher.

If it were that easy, they would create a REIT and do it themselves.? I asked the presenter at the end of the presentation: “If there are that many high cash flow properties available, why doesn’t a REIT buy them?? After all, they can finance more cheaply than you.”? Response: “What’s a REIT?”

That’s more than the wrong answer; it means you don’t know what you are doing.

Tactics

There was a lot of framing going on.? The package was worth $5000, but we have a special offer for $600.? Today for you?? $200.? After some people leave — “Yes, $200, but your spouse can some too.”? Oh and if you buy today, we’ll throw in these extras…

I suspect there were shills in the audience, who went back to buy.? I looked back several times, and estimated that 50-60 out of 200 went back to buy.? At the end, only 30 remained to hear the ending advice.

Regardless, the gross revenue of the day was around $6000, which supposedly covered only the cost of the presenter and the hotel room.? I have my doubts.

Other? Notes

Twice the presenter mentioned that the company that the author worked with was publicly traded.? Well, sort of, it deregistered in Spring 2011, and the company is worth less than $10 million today as it trades on the pinks.? What can you say for a company with a negative net worth, normally negative income, and very low trading volume?? (Leave aside the lawsuits…)

The presenter appealed to Buffett on not diversifying, but Buffett tells average investor that they are best invested in mutual funds.? Being undiversified carries with it the idea hat one is incredibly smart, and able to do far better then the averages.

The reason that they put forth a private market strategy is that it can’t be falsified.? That is the great thing about selling people on investing in real estate.? There is no way to put forth an audited track record.? You can tell anecdotes, and people buy your educational materials.

Summary

Be skeptical.? Nothing good is easy.? Anything advertised in investing can’t be that good.? I knew this, and my experience proved it as I reviewed the charlatans.

Book Review: Manias, Panics, and Crashes (Sixth Edition)

Posted on 12 November 201113 November 2011 by David Merkel

This is the first book that I have reviewed twice.? I reviewed the third edition of the book previously, but I am reviewing the sixth edition now.

Kindleberger places the manias, panics, and crashes on a common grid, to see their similarities,? In it he draws on a number of common factors:

Loose monetary policy
People chase the performance of the speculative asset
Speculators make fixed commitments buying the speculative asset
The speculative asset?s price gets bid up to the point where it costs money to hold the positions
A shock hits the system, a default occurs, or monetary policy starts contracting
The system unwinds, and the price of the speculative asset falls leading to
Insolvencies with those that borrowed to finance the assets
A lender of last resort appears to end the cycle

The advantage over the third edition is that you get to hear about the Asian crisis LTCM, the tech bubble, Madoff, and the present crisis (banking & housing, soon to be sovereigns).

The main point for readers is to beware when monetary policy is easy, banking regulation is lax, and many seem to favor buying the asset du jour, often with leverage.? What is self-reinforcing on the way up will be self-reinforcing on the way down, but with greater speed and ferocity, as bad debts have to be liquidated.

Quibbles

Hindsight is 20-20.? If the US Government had rescued Lehman, something else might have proven to be “too big to rescue,” that the government might allow to fail, but miss the connectedness of the institution.? I do think the US Government should have been a DIP lender to troubled firms, but not a buyer of equity.

Who would benefit from this book: Most investors would benefit from this book.? It will make you more skeptical of assets that seems to be doing unnaturally well; it will also make you more skeptical about catching falling knives in the market.? If you want to, you can buy it here: Manias, Panics and Crashes: A History of Financial Crises.

Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it to me.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Bubbles are Easy to Spot, well almost…

Posted on 5 November 20116 November 2011 by David Merkel

Bubbles are easy to spot.? Wait, don’t most people say that bubbles are impossible to spot?

I’ll say that again: bubbles are easy to spot.? Why?? People have the wrong theory on bubbles.? They listen to those that don’t understand the efficient markets hypothesis, and think, “Prices are always fair predictors of the future.? I don’t have to think about the future as a result.” (It would be better to say that current prices are the short-term neutral line against which bets are placed.)

Don’t listen to academics on bubbles.? There have been booms and busts as far back as we can see.? If markets tend toward equilibrium, that is very well hidden — please require economists to take courses in history.? I mean this; I am not joking.? Neoclassical economics is not? a science; it is a religion, and with much less historical evidence to support it than Christianity has to support the historicity of the resurrection.

Why do I write on this? Partly because of Jason Zweig’s piece in the WSJ.? I ordinarily like what Jason writes; this is a rare exception.

Spotting bubbles gets easier when you don’t simply look at rising prices.? It is better to look at what is driving the rising prices.? How are players financing the purchase of assets is more important to view than even price trends.

It is hard to get a bubble without having an increase in debt-finance.? Financing with debt is cheaper, and riskier than financing with equity.? Financing long-term assets with short-term debt is even cheaper and riskier than financing with debt that matches the term of the asset.? Most bubbles end with some sort of financing time-mismatch, where the inability to renew short-term indebtedness in order to hold the asset leads to a panic, which leads some to say, “This is a liquidity crisis, not a solvency crisis.”? When you hear that leaden phrase, ordinarily, it is a solvency crisis, with long-dated assets of uncertain worth, and near-term liabilities requiring cash.

This is why the simplest way of looking for bubbles is to look for where debt is increasing most rapidily, and where the terms and conditions of lending have deteriorated.

But where do we have these issues today?? Let me offer a few areas:

We have a chain of financing arrangements in the Eurozone where many banks might have a hard time surviving the failure of Greece, Italy, Portugal, and perhaps some other nations as well.? Failure of those banks might lead to bailouts by national governments and/or a significant recession.? Anytime financial firms as a group would have a hard time with the failure of a company, industry, government, etc., that is a sign of a lending bubble.
There is a major imbalance in the world.? China trades goods to the US in exchange for promises to pay later.? Creditor-debtor relationships are meant to be temporary, not permanent as far as governments are concerned.? There may never be a panic here, but so long as the US retains control of its own currency, it is safe to say that they will never get paid back in equivalent purchasing power terms as when they exported the goods.
China itself, though opaque, has a great deal of lending going on internally through its banks, pseudo-banks, and municipalities, a decent amount of which seems to be for dubious purpose at the behest of party members.? The government of China has always been able in the past to socialize those credit losses.? The question is whether covering those losses could be so large that the government follows an inflationary policy to eliminate the debts amid public discomfort.
AAA and near-AAA government debt has been the most rapidly growing class of debt of late.? Maybe AAA governments that are unwilling to cut spending or raise taxes are a bubble all their own.? Remember, when you are AAA, the rating agencies let you make tons of financial promises — think of MBIA, Ambac, FGIC, AIG, etc.? Only when its is dreadfully obvious do the rating agencies cut a AAA rating, but once they do, it is often followed by many more cuts as the leverage collapses.

Now, my view here is both qualitative and quantitative.? To find bubbles there are indicators to watch, such as:

Low credit spreads and equity volatility
Low TED spreads
High explicit/implicit leverage at the banks
High levels of short term lending/borrowing (asset/liability term mismatches)
Credit complexity and interconnectedness
Poor Credit Underwriting
Carry trades are common (many seek free money through seemingly riskless abritrages)
Accommodative monetary/credit policy

All manner of things showing that caution has been thrown to the winds and lending is done on an expedited/casual basis is a sign that a bubble may be present.? Kick the tires, look around, analyze the psychology to see if you can find a self-reinforcing cycle of debt? that is forcing the prices of a group of assets above where they would normally be priced without such favorable terms.

Not that this analysis is perfect, but it follows the broad outlines of Kindleberger and Chancellor.? Speculative manias are normal to capitalism; don’t be surprised that they show up.? Rather, be of sane mind, and learn to avoid participating in manias, long before they become panics or crashes.

Book Review: The Greatest Trades of All Time

Posted on 5 November 2011 by David Merkel

This book grew on me. Think of it as “How I hit a home run in investing.”? Who are the sluggers that earned outsized returns?

But, there is a problem here, and the book would have been better if it had recognized the problem.? In a few cases, the “greatest” made one (or a few) good decisions.? In more cases, they made many good decisions that compounded over time.

Was the first group lucky? Maybe, but when things work out for the reasons that you specify in advance, I think not.? The problem of the first group is repeatability, which for John Paulson, is proving to be an issue for his asset management shop at present.

The investment markets are cruel.? No matter what you have done in the past, the question comes, “What have you done for me lately?” The pressure is high, so no wonder that one of the investors that the book mentioned has gone into hiding.

There are two more dimensions here.? Imagine an investor that made some amazing gains , but then craters.? There are some brilliant investors for which that has been true: Livermore, Niederhoffer, Keynes, and more… how much credit should we give to the gains, if the price is flameouts?

Second, imagine someone who is the best in class at a low-return area of the asset markets, like Jim Chanos in short-selling, or Bill Gross at Pimco.? They may not earn that much, but the skill level is really high.? But is the skill level so high when they chose areas of the market to work in that are low -return?

Maybe the book should have featured private equity players, or real estate investors, or those that have managed university endowments well… there are other investors that would be comparable or better to the returns of some in this book.

Or ask, where is Buffett?? He would deserve a spot here, not for any one trade, but for the multitude of clever trades and mergers he has done over the years.

Quibbles

The book needed a better editor.? Information on Templeton is repeated.? Beyond that, most of the ideas on how an average investor could try to replicate the strategies of the great investors are akin to drinking near-beer.? They are too weak, but on the other hand, without the brilliance of the investors, an average person would not know when to but and sell.

With those caveats, I recommend the book highly.? It is well-written, and it will fill out knowledge gaps in amateur investors.

Who would benefit from this book: Most investors would benefit from this book.? If you want to, you can buy it here: The Greatest Trades of All Time: Top Traders Making Big Profits from the Crash of 1929 to Today (Wiley Trading).

Full disclosure: The publisher asked if I wanted the book.? I said ?yes? and he sent it to me.

Dominoes

Posted on 11 October 201111 October 2011 by David Merkel

When I was a kid, I liked to set up large arrays of dominoes so that I could watch them fall.? Early on, I realized the errors in setup were frequent enough that I left gaps such that if I accidentally knocked down a domino, it wouldn’t destroy all of the work.? I usually put in a number of gaps close to the square root of the dominoes.? Once complete, I would fill in the gaps, and after that would come the show.

When the dominoes are set up, there is an unstable equilibrium.? Any jolt to the system will topple most or all of them.? Now, some would say the jolt causes the toppling of the dominoes, but the dominoes were arranged in order to make them all fall at once.? Whether the designer topples the first domino, or a marble from a kid brother rolls into the room, or there is a small earthquake, the array of dominoes was designed to fall.

So it was for the financial crisis.? These thoughts are my own, though others have uttered them as well.?? In order for there to be a panic that destroys a large portion of the financial system, there has to be:

High levels of leverage.
Leverage that is layered, where many parties are lending, and carry trades are common.? Parties borrow to lend more aggressively.
Collateralized lending — financial entities lend far more when lending is collateralized.? Most of the time, the existence of collateral prevents defaults.? But when things get really bad there is no protection with most collateral.
Problems with highly rated debt.? When debts are highly rated, in order to get high returns out of them, there must be a high degree of leverage applied.
There must also be general confidence that it is highly unlikely that there would be significant losses associated with the asset class.
Regulators must be similarly blind, and assume that risks are low in that set of assets.

So when the crisis struck it started in real estate lending, moving from Subprime, to Alt-A, to Prime, each one in turn more leveraged, and less likely to be prone to a crisis.? That’s why the crisis was so large.

The system had been optimized across many asset subclasses where many borrowers were trying to achieve equity-like returns through borrowing.? Thus when the overlevered previously safe asset classes began to fail, the failure was large, and had second-order effects that extended to lenders.

No one should say the current financial crisis was an accident; yes, no one aimed for it, but no, it was preventable.? It occurred from human activity that was left unchecked, building up leverage in safe asset classes, and pushing up the trading value of those assets to unsustainable levels.? Regulators had the power to bring it all to a halt, but they were complicit with the bankers.

That’s what you need to have a real crisis, and that ‘s why we still suffer from it.? The crisis will continue until enough of the safe debts have been rationalized, and the total level of debt gets paid down enough for the average borrower to borrow once again on a basis that has significant provision against adverse deviations.? Maybe we’ll get there in another 2-3 years.

Financial Complexity, Part 1

Posted on 2 September 20112 September 2011 by David Merkel

FT Alphaville had an article recently where they featured an academic paper Complexity, Innovation and the Regulation of Modern Financial Markets by Dan Awrey.? It?s not a mathematically complex paper, though it deals with complex financial instruments and it is quite relevant to our present troubles.

Let me start by quoting the beginning of the abstract:

The intellectual origins of the global financial crisis (GFC) can be traced back to blind spots emanating from within conventional financial theory. These blind spots are distorted reflections of the perfect market assumptions underpinning the canonical theories of financial economics: modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model and, perhaps most importantly, the efficient market hypothesis. In the decades leading up to the GFC, these assumptions were transformed from empirically (con)testable propositions into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society?s resources. This ideology, in turn, exerted a profound influence on how we regulate financial markets and institutions.

I have consistently been a critic of modern portfolio theory, the Modigliani and Miller capital structure irrelevancy principle, the capital asset pricing model and, the efficient market hypothesis.? I have also criticized the idea that incomplete markets are a problem, and that derivatives are needed to complete markets.? Trying to make liquid markets out of assets that are naturally illiquid is a fool?s bargain.? I have also argued that derivatives should be regulated as insurance contracts, and subject to the doctrine of insurable interest.

Why don?t academic finance theories work?? Quoting again from the paper:

These theories share a common and highly stylized view of financial markets, one characterized by, inter alia, perfect information, the absence of transaction costs and rational market participants. Yet in reality financial markets ? and market participants ? rarely (if ever) strictly conform to these assumptions.? Information is costly and unevenly distributed; transaction costs are pervasive and often determinative, and market participants frequently exhibit cognitive biases and bounded rationality.

In short, men are not hyper-rational calculators, like the Vulcans of Star Trek.? Markets for goods and services might be efficient, but not those for assets, where values are not as easily estimated.

Asset markets are frequently reflexive.? As an intelligent former boss once said to me, ?When does a company look its best?? Immediately after receiving a loan.? That?s why we wait a few years before shorting a bad company that has just received a significant loan.?

The paper encourages study to understand how markets work in practice, rather than how they work ideally to neoclassical economists.? I heartily agree; I think that the more one studies the structure of asset markets, the more they will understand that there are many approaches to the market, and the popularity of strategies depends a lot on past success.

Quoting again:

Nevertheless, taking a broad look across the financial system, it is possible to identify at least six ? in many respects intertwined and overlapping ? sources of complexity: technology, opacity, interconnectedness, fragmentation, regulation and reflexivity.

Technology ? things move faster, but can people keep up with it.? More data can be gathered by connected players.? It is one reason that I am a low turnover investor.? There are too many playing the short duration game in the market.

Opacity ? few can truly understand the economics of most securitizations, or whether the subordination levels are right or not.? Investing in ?dark pools? is rarely wise.? And as for the credit guarantors that I have criticized, they could not understand the risks they were taking, because they assumed the credit boom was normal and perpetual.

Interconnectedness ? What could be more interconnected than the financial guarantors?? Or the banks who lent to one another, directly and indirectly?

Fragmentation ? Securitization makes it tough for owner to understand what is happening several links down the chain.? Guess what?? It?s a lot easier to have your own mortgage loan department, and watch over your own loans.

Regulation ? Financial regulation is fragmented, and often co-opted by those regulated.?? Because the US government does not get this, market players arbitrage regulators.? Another aspect of it was the moral hazard engendered by the Fed and other regulators, giving the impression that there would be rescues available in any real crisis.

Reflexivity ? I have talked about this above.

I would add a seventh source of complexity ? leverage.? People underestimate the effects of leverage on managements in managing assets.? When the possibility of bankruptcy arrives, the effects are discontinuous, violent.? This is especially true when debts are layered, where A owes B, who owes C, who owes D, on thin equity bases.? A?s failure to pay has ripple effects, leading to a cascading failure.

An eighth source of complexity is use of short-term debt to finance long term assets.? An early precursor to the crisis was the failure of off-balance sheet subsidiaries that were financed with short-term loans.? Similarly, firms that relied on repo funding to finance their inventory of assets had a rough time of it as repo haircuts rose rapidly, and in tandem.

A ninth source of complexity was similar: margin requirements in derivative agreements, where a credit downgrade could lead to a call on capital at the worst possible moment.? This happened with AIG.

A tenth source of complexity which enabled much of the above nine is one that many writers don?t want to talk about, because it exposes many of ?victims? to be enablers: yield-seeking.? Why be a lender to complex investment vehicles?? You get more yield.? None of them have blown up.? They are highly rated.? Why not go for the higher yield?? As I have said before, it takes failure to mature an asset class.? All new asset classes look pristine; nothing starts with failure.? Typically the best deals get done first ? best quality, best incremental yields.? Then competition drives down quality and yield spreads, but raises quantity.

Without the yield-seeking, many complex financial instruments would never get issued.? Someone had to buy the ?safe? tranches of CDOs, CDO-squareds, ABS CDOs, etc., in order to sell the deals.? Many European banks bought them because they didn?t have to put much capital against them for risk purposes, and the added yield helped them meet earnings targets, at a cost of greater illiquidity.

An eleventh source of complexity was the failure of accounting to properly account for these new instruments with volatile fair values.? Fair Value accounting, using market values and their approximations was a step in the right direction, and bitterly opposed by those who were financing illiquid, opaque, financial instruments, while their funding was short-dated with too little equity.

More will come in part 2, soon.? Still without power — a hard providence, be we are surviving it.

FT Alphaville had an article recently where they featured an academic paper Complexity, Innovation and the Regulation of Modern Financial Markets by Dan Awrey. It?s not a mathematically complex paper, though it deals with complex financial instruments and it is quite relevant to our present troubles.

Let me start by quoting the beginning of the abstract:

The intellectual origins of the global financial crisis (GFC) can be traced back to blind spots emanating from within conventional financial theory. These blind spots are distorted reflections of the perfect market assumptions underpinning the canonical theories of financial economics: modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model and, perhaps most importantly, the efficient market hypothesis. In the decades leading up to the GFC, these assumptions were transformed from empirically (con)testable propositions into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society?s resources. This ideology, in turn, exerted a profound influence on how we regulate financial markets and

institutions.

I have consistently been a critic of modern portfolio theory, the Modigliani and Miller capital structure irrelevancy principle, the capital asset pricing model and, the efficient market hypothesis. I have also criticized the idea that incomplete markets are a problem, and that derivatives are needed to complete markets. Trying to make liquid markets out of assets that are naturally illiquid is a fool?s bargain. I have also argued that derivatives should be regulated as insurance contracts, and subject to the doctrine of insurable interest.

Why don?t academic finance theories work? Quoting again from the paper:

These theories share a common and highly stylized view of financial markets, one characterized by, inter alia, perfect information, the absence of transaction costs and rational market participants. Yet in reality financial markets ? and market participants ? rarely (if ever) strictly conform to these assumptions. Information is costly and unevenly distributed; transaction costs are pervasive and often determinative, and market participants frequently exhibit cognitive biases and bounded rationality.

In short, men are not hyper-rational calculators, like Vulcans. Markets for goods and services might be efficient, but not those for assets, where values are not as easily estimated.

Asset markets are frequently reflexive. As an intelligent former boss once said to me, ?When does a company look its best? Immediately after receiving a loan. That?s why we wait a few years before shorting a bad company that has just received a significant loan.?

The paper encourages study to understand how markets work in practice, rather than how they work ideally to neoclassical economists. I heartily agree; I think that the more one studies the structure of asset markets, the more they will understand that there are many approaches to the market, and the popularity of strategies depends a lot on past success.

Quoting again:

Nevertheless, taking a broad look across the financial system, it is possible to identify at least six ? in many respects intertwined and overlapping ? sources of complexity: technology, opacity, interconnectedness, fragmentation, regulation and reflexivity.

Technology ? things move faster, but can people keep up with it. More data can be gathered by connected players. It is one reason that I am a low turnover investor. There are too many playing the short duration game in the market.

Opacity ? few can truly understand the economics of most securitizations, or whether the subordination levels are right or not. Investing in ?dark pools? is rarely wise. And as for the credit guarantors that I have criticized, they could not understand the risks they were taking, because they assumed the credit boom was normal and perpetual.

Interconnectedness ? What could be more interconnected than the financial guarantors?

Fragmentation ? Securitization makes it tough for owner to understand what is happening several links down the chain. Guess what? It?s a lot easier to have your own mortgage loan department, and watch over your own loans.

Regulation ? Financial regulation is fragmented, and often co-opted by those regulated. Because the US government does not get this, market players arbitrage regulators.

Reflexivity ? I have talked about this above.

I would add a seventh source of complexity ? leverage. People underestimate the effects of leverage on managements in managing assets. When the possibility of bankruptcy arrives, the effects are discontinuous, violent. This is especially true when debts are layered, where A owes B, who owes C, who owes D, on thin equity bases. A?s failure to pay has ripple effects, leading to a cascading failure.

An eighth source of complexity is use of short-term debt to finance long term assets. An early precursor to the crisis was the failure of off-balance sheet subsidiaries that were financed with short-term loans. Similarly, firms that relied on repo funding to finance their inventory of assets had a rough time of it as repo haircuts rose rapidly, and in tandem.

A ninth source of complexity was similar: margin requirements in derivative agreements, where a credit downgrade could lead to a call on capital at the worst possible moment. This happened with AIG.

A tenth source of complexity which enabled much of the above nine is one that many writers don?t want to talk about, because it exposes many of ?victims? to be enablers: yield-seeking. Why be a lender to complex investment vehicles? You get more yield. None of them have blown up. They are highly rated. Why not go for the higher yield? As I have said before, it takes failure to mature an asset class. All new asset classes look pristine; nothing starts with failure. Typically the best deals get done first ? best quality, best incremental yields. Then competition drives down quality and yield spreads, but raises quantity.

Without the yield-seeking, many complex financial instruments would never get issued. Someone had to buy the ?safe? tranches of CDOs, CDO-squareds, ABS CDOs, etc., in order to sell the deals. Many European banks bought them because they didn?t have to put much capital against them for risk purposes, and the added yield helped them meet earnings targets, at a cost of greater illiquidity.

More will come in part 2, soon.

How Would You Run a Rating Agency?

Posted on 6 August 20117 August 2011 by David Merkel

Rating agencies grew up rating corporate credit risk.? The nice thing about corporate credit risk is the failures happen at least every seven years.? There was a sideline on municipal credit risk, but since munis rarely defaulted, it was not very relevant.

Guess what?? Moody’s, S&P, and Fitch are very good at predicting corporate default.? Some new players are better still, but their ratings change more rapidly, which has pluses and minuses.? They are faster to identify failing entities, but they also have more “false positives” where they signal failure, and it does not happen.

GICs

Go back to the late ’80s.? The rating agencies were trying to evaluate the newly popular 401(k) investment Guaranteed Investment Contracts [GICs].? Guess what?? No GICs had ever failed.? What’s the right rating for all the companies offering them?? If the history is so positive shouldn’t everyone be AAA?

Though some of the larger companies had corporate debt that traded, GICs were not obligations of the holding company, but of the insurance subsidiary.? Not only that, unlike bonds, GICs (in most states) were policyholder obligations, not debt per se.? GICs were often super-senior obligations of subsidiaries of the company.

So, how to rate them?? Since there were few historical losses, and the rating agencies lacked a forward-looking view of what might happen, they rated most GICs AAA or AA.

After a few GIC-issuing companies went into insolvency, those ratings changed rapidly over the next seven years, leading to many exits by marginal players who did not default, a few defaults (with almost no losses), and a much smaller GIC industry dominated by synthetic GICs that relied upon insurance company derivatives.

Securitization

Because the regulators required ratings, the rating agencies were willingly drawn in to rating structured products.? With the GSEs it was easy — there is no credit risk, so they are AAA.? With the non-guaranteed whole loans, it was tougher — no GSE guarantee.? How to rate?? This was a new product, a new risk, and so the rating agencies looked at resident mortgage default rates in the past.

Very much like the error of health insurers in the ’60s, where they tried to calculate utilization of healthcare services from the non-insured and apply that to the insured, mortgages retained by originators defaulted less frequently than those that were sold to third parties.

The rating agencies could get the math right on securitization, but could not get the parameters right.? All of their loss data came from an era where lenders held onto their loans.? Selling loans, and having servicing as a separable function was totally unknown to the past.

Much as those who implemented securitization were relatively farsighted, they did not take into account the agency problems involved in “selling to securitize.”

The rating agencies did the best that they could in a competitive environment, with little relevant loss data to guide them.

I suspect that they will do better before the next cycle of failures transpires.

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In short, my point is this: the rating agencies, blundered with ratings on securitization.? They will be better in the future, because they finally have real data to work with.? They are trying to be more forward looking on sovereign issuers, with some degree of pushback.? My view is that those that object more should be downgraded further, within reason.? I differ from the rating agencies, because I am more skeptical, and imaginative.

“Figures don’t lie, but liars will figure.” Issuers are not objective with respect to their own debts.? Rating agencies should ignore the issuers, and work off? of publicly available data, lest they be subverted by the issuers, as has happened.

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I don’t fault the rating agencies much with respect to sovereign ratings.? They seem mostly rational to me, though? there is little real default data to guide them.

That’s the crux of the issue here — they don’t have many sovereign fiat currency defaults to guide them.? Does that mean the odds are low?? By no means.? A larger model, including political motivations, and using game theory would indicate that there are possibilities where no coalition governs that debts will be paid.

I hate the simplistic models of the Keynesians and their bastard progeny.? One has to think more broadly, and consider the wide range of what might happen, because (surprise!) people/institutions aren’t always rational as economists view them.

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I leave you with this: imagine that you run a rating agency, and your clients ask you to rate debts that you don’t have a good model to use.? You have competitors, and they are seeking advantage as well.? Add into the mix that the issuers can choose who they want.? How do you react to a new class of credit?? The question is a hard one.

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And thus, to those who trash the rating agencies because of bad past decisions, I say, “Could you have done better, you have the benefit of hindsight?”

The rating agencies are flawed but are mostly honest dealers who used bad models on structured credit, because no one knew better.? They took the risk and put forth some bad ratings.

For this reason I say to the fools who argue against the S&P downgrade of the US, “How do you know?”? For once a rating agency is trying to be proactive, and they get a lot of abuse.? Watch the trading in the market, it will tell you a lot more than the downgrade.

Book Review: Bond Math

Posted on 29 July 201129 July 2011 by David Merkel

This book is the opposite of the book Interest Rate Markets, where bond markets were described, but there was no math.? This book was written by an academic who has done many seminars for bond professionals so that they could understand the math behind bonds.

The math rarely transcends algebra, except where he used calculus to briefly explain duration and convexity.? Perhaps he could have consulted with actuaries who use discrete approximations.

One more virtue of the book is that if you use Bloomberg, which is common for bond professionals, the book explains the nuances of how Bloomberg does many of its detailed bond calculations.? It even explains why you have to interpret some of what you get from Bloomberg with caution, because it may use different assumptions than you would expect.

So if you want to learn the bond math, this book is a congenial way to do so.? I recommend it highly.

Quibbles

Now, the writer is an academic who has never managed bonds.? As such, he can’t help a great deal with bond selection or portfolio management issues.? But that’s not the main goal of the book… he’s here to teach us the math, and nothing more.

Who would benefit from this book:

Anyone who wants to learn the bond math would benefit from this book.? Go learn and conquer.

If you want to, you can buy it here: Bond Math: The Theory Behind the Formulas (Wiley Finance).

Full disclosure: I asked the publisher for the book and he sent me a copy.

US vs Moody’s, S&P and Fitch

Posted on 16 July 201117 July 2011 by David Merkel

The rating agencies are the whipping boys of the market.? Like princes who had a whipping boy to take the hit for their transgressions, so the rating agencies take the hit that should go to the regulators, which delegated their? credit-risk responsibility to the rating agencies.? That works out well for all, in one sense: the rating agencies make money, and the regulators escape blame.? What could be better?

But now we face another situation with the rating agencies, where they will finally downgrade the US Government from AAA.? Long overdue, particularly when one looks at the entitlement promises.

But people put up all manner of objections to the rating agencies doing what they should have done ten years ago.? Here is the big one:

The rating agencies never get it right

Not true.? On corporate credit, their ratings are highly predictive, and even yield insights into the movement of stock prices.? Now, if you are talking about securitized credit, you have to understand one thing: no one gets a debt market right until it has been through a failure cycle.? The rating agencies use what little data exists, usually from loans that are held on-balance-sheet, and apply them to loans that are originated and sold.? Doesn’t work that well, but who had better data, because it was a new practice?? Everyone failed on securitization, and only a few of us questioned it in advance.

With government credit, the rating agencies have been right for the most part.? Why?? For the most part, rating agencies are honest dealers when it comes to credit.? To be otherwise would damage their reputation.

Other Objections

Others talk about what the US or the EU could do to muzzle the rating agencies, because the downgrades complicate their actions.? I would say that the Rating Agencies are late if anything — the agencies don’t have much impact on their own.? The big impact is that not enough cash will flow to service debt and other demands on cash at the right time.

If the rating Agencies were muzzled, it would not change the cash flows one whit, except that there would be greater distrust from lenders, because the referees were forcibly silenced.

So what happens if the US gets downgraded?

Not much.? As I have said before, the ratings don’t mean much, except to regulators.? Yields shouldn’t move much, and if there is a sovereign ceiling at Aa2/AA, that will be the benchmark for all US yields, and corporate/municipal/securitized yields won’t shift much, because the economic reality hasn’t changed much.

What will change are investment guidelines that require Aaa/AAA investments.? They will reflect the lower top category, and not force investors to buy foreign AAA dollar-denominated bonds.

What happens if the debt ceiling isn’t raised?

Not sure.? There are lots of things that can happen:

Prioritizing payments
Not paying principal or interest on bonds (not likely)
Issuing scrip (haven’t heard it yet, but who can tell, states have done it)
Martial law is declared, and the Constitution is null and void (again, not likely)

A genuine full default by the US Government would have many ugly consequences, and should be avoided.? Prioritizing payments would be ugly, but could force our government to do the hard questioning that it has avoided for a long time — what are the priorities of our government?? What would we spend money on if we were deciding on priorities today, rather than the dead ideas of the past?

What, Me Worry?

I have concern over a lot of things, but the debt ceiling does not make it for me.? The bigger entitlement issues have been ignored for 40 years, and I have covered them for 20 years.? This is not the end, but the beginning of debates over where the resources of the US go, and how much is extracted from the populace.? The real test will come when Medicare is reduced, and how well the voters accept that.