Sunday, December 13, 2009

Au revoir...

Dear Sober Look readers and friends,

Due to some rapidly changing personal circumstances, I have decided to put Sober Look on hold for the foreseeable future. It has been an amazingly rewarding experience and a privilege to be involved in this project. From the bottom of my heart I would like to thank all the readers for your support. I’ve learned a tremendous amount from your thought-provoking comments and e-mails.

Technology such as Blogger has allowed thousands of people to express their views and bring out concepts and information that the mass media often fails to do. Just because financial media reporters sometimes don’t understand concepts, doesn’t mean that the public shouldn’t understand them either. Just because the media sometimes wants to incite anger to improve ratings, doesn’t mean the anger is properly directed or even warranted. My goal with Sober Look has been to bring out alternate ways of viewing this crisis and it's sources, the economy, and the financial system.

A Bloomberg commentator Caroline Baum once said that if you want to know where the next financial crisis will come from, just look to the most popular current trends. Whether the tech IPOs and emerging markets in the 90s or the housing boom and securitization during this decade, this saying has proven to be correct again and again. These trends can persist for years until their invulnerability is no longer questioned. And then arrives an abrupt, painful, but never a fully anticipated conclusion.

The key is that the seeds of the next crisis are usually sown while the current one is still being played out. And it is often the reaction to the current crisis that sets us up for the next one. This concept is of course not limited to finance or economics, but is evident in the geopolitical arena as well. For example the Soviet occupation of Afghanistan and their ultimate defeat was a crisis that saw the birth of Al Qaeda, leading to the next geopolitical crisis.

As we look to the next decade, what are the signs of popular financial trends now emerging to haunt us in years to come? What about favorites such as China’s rapidly growing markets, commodities (particularly gold), and the ever popular US Treasuries? Economists and financial forecasters have never been so divided about the future. With rapidly growing global liquidity, continuously evolving markets, and accelerating capital flows, one thing we can be sure of - the next decade will see yet another crisis, possibly more than one.

But that doesn’t mean we should all be buying guns and store canned food in order to be prepared. With each crisis will come tremendous opportunities – from investments, to new businesses, and new jobs. The goal is to keep an open mind, keep learning, and keep questioning. And for my fellow bloggers who want to clear up misinformation, look through the hype, let others know of alternate ways of thinking, and point to the next crisis... keep on blogging. I’ll be reading.

Monday, December 7, 2009

Barney Frank's House bill H.R. 3996 - impact on secured lending

Bloomberg: [FDIC chair Sheila] Bair, in a letter to lawmakers released today, endorsed a proposal that was added last week to the regulatory overhaul legislation making its way through the House Financial Services Committee. It would require secured creditors, like repurchase agreement lenders and the Federal Home Loan Bank system, to bear losses of as much as 20 percent to cover the costs of a systemically significant bank failure.

In addition to finding a supposed way to cover costs of winding down a too-big-to-fail institution (and possibly all banks), this portion of the financial overhaul legislation will have some other consequences:

1. It will make it significantly more expensive for these institutions to borrow funds even if they post treasuries as collateral.

2. Any negative news about a specific institution or the financial system as a whole will get lenders running for the fences forcing rapid unwinds. This will make Lehman look like a gradual process.

3. It may destroy the repo market. Repo is used by money market funds, corporations, pensions, etc. to place funds on a secured basis (taking in collateral). As an institution if you have short-term cash and you don't want to deposit it with a bank (unsecured), your only option is to lend it to a bank on a secured basis via repo (taking in treasuries as collateral for example). If this option is taken away, institutions will need an alternative such as the ability to deposit cash with the Fed.

4. This will give foreign banks an unfair advantage by funneling repo lending (secured deposits) to non-US banks, making it cheaper for those banks to fund themselves.

5. US banks will try to get around these laws by creating off-shore financing vehicles that are not subject to US banking legislation, making banking supervision that much more difficult.

As we discussed before, knee-jerk reaction regulation is not always the answer, but in this case could spell an absolute disaster for the US financial system. It behooves the US legislators to slow down their political posturing and try to understand how the finacial system actually works in practice.

Nakheel - the assets behind the bonds

Nakheel property development company that is part of troubled Dubai World is about to hand over a big chunk of land to it's bondholders. Behind door number three would be some great waterfront properties, right? Not exactly.

Bloomberg: Nakheel PJSC creditors may win the right to seize a strip of barren waterfront land the size of Manhattan if the company defaults on the $3.5 billion bond backing the development.
This is what the bondholders are getting - with all the construction now abandoned.

source: Nakheel

And the bonds have traded to reflect the great recovery value.

source: Bloomberg

Sunday, December 6, 2009

The Hype Award goes to FT's Henny Sender

Here is a good example of the hype style financial reporting, amazingly enough coming from the FT. In an article called Reckless banks still to pay Henny Sender writes:

Two recent judicial opinions rebuking the banks offer a window into the lending practices that fuelled the boom and the tactics that banks resorted to in a belated attempt to cut their losses. These cases highlight just how reckless the banks have been and how that recklessness may come back to haunt them – and their bottom lines.

She discusses two cases, one of which has to do with Tousa, a Florida homebuilder. Citi indeed was reckless in its lending practices with this firm. Tousa’s business was on the brink when Citi extended it a loan that allowed it to refinance an earlier loan used for some highly leveraged acquisitions.

But as financial reporters often do, she starts with a valid point, but then moves on to a case that is actually unrelated (bunching it all into one anti-banking rant). Her second example deals with Charter Communications and JPMorgan. And that’s where the logic completely breaks down.

The second case involves Charter Communications, the fourth largest cable company in the US, and one of the most hotly contested battles to confirm an operational plan in the wake of a Chapter 11 filing. The judge rejected the banks’ claim that their loans were impaired, and said the banks were holding up the company’s emergence from bankruptcy protection just to change the terms of their loans and earn more interest. The adverse ruling could deprive the banks of $1bn in tax savings, a lawyer for the banks said. The banks in this case were led by JPMorgan whose spokesman declined to comment.

What Ms. Sender either doesn’t want to discuss or is simply clueless about is that Charter loan was always solid. There was absolutely nothing reckless about lending to Charter – there has been and still is plenty of asset coverage for the senior loan. The Charter case involves an intercreditor dispute. When a company files for bankruptcy, senior lenders generally have a say in the restructuring of the firm. In Charter’s case the management sought to file and restructure without involving the senior lenders. The firm then restructured the subordinated debt and simply reinstated its existing senior loans. These loans will remain in place as they have been prior to filing. There is going to be no principal loss for lenders.

What the lenders wanted was to restructure the senior loans in order to raise the coupon. As generally happens with covenant violations or other credit agreement “triggers”, the lenders can push the company to renegotiate the terms. For some reason the judge in the case sided with the company, refusing to allow the senior lenders to the negotiating table. That means they are stuck with the original low coupon.

But the Charter case has nothing to do with “reckless” lending. Charter, in spite of being quite leveraged was (and still remains) a prudent exposure for the lenders. Attempting to increase the interest rate on this loan in a bankruptcy scenario is exactly what banks are supposed to do. The fact that JPMorgan was unsuccessful in doing so speaks more to the changing nature of Chapter 11 than to any recklessness on behalf of lenders. Just to round things off, Ms. Sender ends the story by bringing up the Enron case from way back without any clarity on how it relates to "reckless lending".

In the environment where it is fashionable to bash banks, rather than focus on unbiased journalism and independent research, nobody seems to question or contradict Ms. Sender’s story. Misinformation that stokes anger continues to sell papers after all. FT’s Henny Sender will therefore receive the Sober Look hype award. Congratulations.

Wednesday, December 2, 2009

Debt 50c on the dollar - good luck finding any

The chart below shows the amount of corporate debt that trades at a price below 50 cents on the dollar. This is simply how JPMorgan defines "distressed debt". What's impressive is how demand for fixed income product nearly eliminated this spike in a matter of months. A year ago over $200 MM of corporate debt traded at discounts of 50% or more. Now there is almost none left.

Part of this exuberance in credit stems from falling default rates:

It's a bit of a self-fulfilling prophecy. Demand for fixed income product provides opportunities for refinancing, generating liquidity, extending maturites, and reducing default rates. Falling default rates generate more interest in credit/fixed income. Of course this process can work in reverse as well.

A better way to identify recessions

In an era of rampant conspiracy theories and mistrust of institutions, many have been sceptical of the National Bureau of Economic Research decision process with respect to identifying the start and end of recessions. Not only is the pronouncement on a significant lag, but some think the timing may have a political or some other bias.

To address this issue, James Hamilton from UC San Diego developed an index that uses the GDP data to "measure" the probability of the economy being in recession at a particular time. The strength of the approach is that it uses GDP trends (as opposed to just the latest number) over recent quarters to determine the probability. It's a mechanical approach that doesn't require judgement that is embedded in the NBER's decision process, therefore taking out any real or perceived bias. The measure is also much more current and does not require one to wait several quarters before confirming the beginning on the end to a recession.

Here is how the index compares to the NBER's pronouncements:

source: Atlanta Fed

Equity vol getting cheaper vs. credit

Equity volatility continues to trade cheap to credit. The chart below compares VIX to the investment grade CDX spread.

Except for the Dubai driven spike, equity vol may be disconnecting from credit and will continue to drift lower. At some point a spread trade will become interesting - shorting investment grade credit against long equity options (or VIX futures).

Tuesday, December 1, 2009

Japan facing harsh realities of deflation

It may sound like a wonderful concept - you wake up every morning and things are a bit cheaper than before. Your money is worth just a bit more. And that is (sort of) the situation in Japan currently. The chart below shows Japan's negative inflation rate.

But then you ask yourself, if things are getting a bit cheaper, why buy now, why not wait. And some of that type of thinking is a good thing. But when everyone thinks that, then nobody is buying and the economy stagnates bringing prices further down. This is deflation and it's quite dangerous, because once you are in it, it's hard for the central bank to do anything to get the nation out of it (unlike fighting inflation where central banks have numerous tools).

Japan is now facing this dilemma:

Bloomberg: Prime Minister Yukio Hatoyama’s government stepped up calls on the Bank of Japan to prop up growth after declaring on Nov. 20 the economy was in deflation. Shirakawa, who yesterday pledged to act “promptly and decisively,” has few options given that the key overnight lending rate is at 0.1 percent and the bank is already purchasing government and corporate debt.

The broad money supply isn't growing enough as bank lending continues to be constrained.

But the real killer is the yen strength. For an economy that is export focused and has a relatively weak domestic demand growth, this is bad news.

At this rate Japan will move more manufacturing out of Japan - possibly even to the US (as the US becomes the "high end" outsourcing center). They will also be investing more abroad - all of which is not too helpful for the domestic economy.

The central bank response has been "muted" so far:

Bloomberg: The central bank yesterday said it will offer three-month loans to commercial banks at 0.1 percent under the new facility. Governor Masaaki Shirakawa stopped short of boosting the monthly target for government-bond purchases from 1.8 trillion yen, a step analysts said may be taken within months.

It's not clear commercial banks will want to borrow from BOJ at all because their ability to fund themselves is not the issue. BOJ will need to get far more aggressive to prevent an accelerating deflation (which the nation has not fully come out of for decades).

If the current trend persist, expect BOJ to take more aggressive actions to try to deflate it's currency and pump yen liquidity into the system. Quantitative easing or even direct currency intervention are quite possible.

Monday, November 30, 2009

The secured bond market - a new trend?

As the corporate loans approach maturities, companies have been refinancing them by issuing bonds (some $60 billion of HY issuance has been used to pay down loans this year). With demand for fixed income continuing to surprise on the upside, new bond issuance has been quite strong.

However some weaker, more leveraged, or less known names, had to use a trick to entice investors. As the collateral pledged for loans got freed up (with loans getting repaid), the companies pledged it to the new bond holders. These are the so-called secured bonds, and unlike standard corporate bonds which are general obligations of the company, these bonds have specific collateral pledged against them. Nearly 40% of recent bond issuance has been in secured bonds.

The chart below shows that such bonds were generally used as a refinancing tool (instead of capital investments or acquisitions.)

source: Thomson Reuters

The question still remains whether this is a long-term trend. It would mean that the leveraged loan market at least in part is getting replaced with secured bonds. But demand for leveraged loans also continues to be high, especially as some existing inventory is getting paid down. If the loan syndication market recovers, secured bonds may become a temporary phenomenon.

Sunday, November 29, 2009

Ready for more state IOUs?

Remember California IOUs? Other states are starting to face budget realities as well. Reliance on easy credit and credit related tax revenue created a spending momentum (bordering on criminal) that's about to hit a wall. Debt maturities are looming.

NY Times: Without a budget deal, New York will be left with just $36 million in the bank by the end of December, according to current projections.

The state muni CDS markets are starting to widen, as reality sets in. In the chart below we exclude California and Michigan, as their problems have already been well publicized.

State financing is relatively simple. Many states can not run deficits by law, and even those who can will end up paying increasingly wider spreads. The two remaining choices are raising taxes or cutting budgets. Raising taxes only works on the so-called "wealthy" (as NY did in April), otherwise there will be a revolt in this environment. The "wealthy" in states like NY have enough mobility to simply move to other states, reducing tax receipts to the state further. And even if they don't, the impact of such tax hikes is generally insufficient to move the needle. Tax hikes also damage businesses and reduce hiring.

That leaves spending cuts. But employees of many states have significant influence over state politics, including influence over governors and state legislators. Those politicians who cut budgets - particularly if they cut state jobs - will simply not see another term. New York's Paterson for example knows he will not get reelected, so he has the guts to do the right thing and implement the cuts. The legislators however will fight him on this to the last minute. Other states will hit this wall soon as well, and more state IOUs (instead of cash) are sure to follow.

Wednesday, November 25, 2009

Above-target inflation expectations

The latest JPMorgan survey of institutional clients continues to show elevated inflation expectations. The majority of those responding believe inflation in the US and the UK will run above targets.

source: JPMorgan

Curiously, more than the central bank policies, it is the fiscal policy that is viewed as the largest contributor to inflation risk. Apparently institutions view government spending driving inflation more than low rates and quantitative easing by central banks.

source: JPMorgan

The CLO market may be making a comeback

Amazingly, the primary CLO market, which has been shut down since late 2007, may be making a comeback in 2010. The volumes will be a fraction of the peak, the capital structure will be simple, and the equity structures will be thicker, but the deals will get done. Unlike other securitization markets such as ABS and CMBS, it seems that the vast majority of the original AAA tranches will get their principal back in spite of record levels of corporate loan defaults. The AAA subordination of 25-30% has been sufficient to cushion the senior tranches from principal losses. In addition, deals that have had a relatively large portion of their collateral default or get downgraded have been forced to start using income to down the AAA principal, amortizing/deleveraging the transactions early. These facts may bring institutional investors back into the market.

The secondary CLO market spreads have come in dramatically as the chart from Citi/Reuters shows.

In order for the primary CLO market to work, the spread between the leveraged loan yields and the AAA tranche rate has to reach a level that will make the "excess return" attractive. As an analogy, consider what happens if you were to buy a rental property. If the monthly payments on the loan you take out is higher than the rent you collect on the property, you would never buy the property. In fact the differential between the rent collected and the interest expense on the loan has to be attractive enough to make you want to put down a downpayment on the property. In this analogy the CLO equity tranche is the "downpayment", the AAA tranche is the mortgage on the property (with lower rated tranches being "second mortgages"), and the collateral portfolio of corporate loans paying interest representing the property paying rent.

To make the equity returns work, one needs a relatively low financing spread ("mortgage rate") and a sufficiently narrow equity tranche (the "downpayment"). The chart below illustrates the expected return levels (roughly) as a function of the financing spread (blended spread of all the tranches above the equity).

The three lines represent the different equity tranche thickness ("downpayment"). As the AAA tranches continue to tighten in the secondary market, at some point the return on equity starts to make sense for some investors and the new transactions would get done. This may be the first securitization market that comes back (even as a shadow of what it used to be) without government (TALF) assistance.

Tuesday, November 24, 2009

Lower fees for longer lock-ups

2009 was the year for major structural changes at hedge funds. According to the latest E&Y survey of hedge funds, lowering the management fees has been one such key change. Apparently the majority (87%) of managers has lowered their fees or plans to do so shortly. For those who are fans of Venn diagrams, the chart below is a good illustration of the structural changes taking place.

source: E&Y survey

Coincident with the fees dropping are the increasing lock-up periods. As existing lock-ups end and redemptions loom, managers are trying to extend the lock-ups in exchange for fee reductions to attract/retain investors.

Monday, November 23, 2009

The world according to Fed: resolving large financial institutions

In order to address the "too large to fail" issue the Fed has begun a campaign to promote their solution: some form of a resolution regime for systemically significant financial firms. The Fed's goal is to broaden their regulatory reach and to prevent the US Congress (filled with populist fervor) from trimming the Fed's power. What the Fed is proposing is actually a complex piece of legislation that will span beyond the banking industry. It has the potential to engulf large insurance firms, financial advisory and securities firms, and even asset management firms.

Dan Tarullo's speech (included below) provides a good outline of such legislation. Other Fed governors are starting to carry the same message as part of their campaign to vastly boost the Fed's powers. You can see it gently inserted on slide 26 in James Bullard's recent speech for example (see included). Here are the three pillars of this special resolution process:

1. When the Fed determines that a institution that is on their too large to fail list is about to fail (or take some other action that threatens the financial system), the central bank would invoke the "special regime" to take control of the institution. The Fed would then have a broad authority to dissolve or restructure this company, including liquidating assets and businesses, as well as the ability the ability to set up a temporary firm to purchase and "warehouse" certain assets. Note that this is similar to the authority the FDIC holds in dissolving banks they regulate.

2. The shareholders and some creditors of the failing firm would bear the losses associated with this process. It's not clear to what extent the creditors would be hurt by this, because The Fed would clearly have to step in and guarantee some of the liabilities of the organization (for example institutional bank deposits or repo financing). Otherwise such liquidation may be no different than what the courts would do in a bankruptcy scenario. The model may become similar to that used in restructuring the US auto firms - some form of direct negotiations with creditors. Depending on the level of Fed's independence, the process may even become politicized.

3. The Fed would set up an "insurance fund" similar to the FDIC's fund to be used in orderly liquidation operations. The "too big to fail" organizations (again not just banks) would be assessed ongoing fees to capitalize the fund. Over time the fund would be significant enough to support a failing institution through the restructuring/liquidation process.

Developing such legislation is a massive undertaking with numerous key unanswered questions such as which organizations would be deemed too big to fail, how will the creditors be dealt with, how would the regulation of these institutions be different, will this make the Fed too powerful, etc. The model of course is the FDIC's bank takeover process - but on steroids, as these institutions are infinitely more complex. Of course no matter what form this process takes, it does create a form of moral hazard by backstopping certain risks in the financial system.



Sunday, November 22, 2009

China waiting for the US consumer

Each year the meetings of the China's Communist Party heads concludes with the same number - the number 8. Culturally it's an important number in China. In Chinese mythology for example it represents the Eight Immortals.

It is also consistently the target for China's GDP growth - year after year. The Party leaders have been convinced for years that 8% is the growth rate needed to prevent any major social unrest. As long as such growth is maintained, the people will not demand democracy the way they did in 1989.

And it looks like China is on target to get to (or exceed) 8% again this year. In the past the growth was driven by exports. As the chart below shows, this year however exports are not keeping up with the GDP.

So you start hearing stories about the domestic consumer demand all of a sudden picking up the slack. Hardly. The differential between GDP growth and slow export growth is picked up up by the government stimulus programs and tremendous domestic liquidity. As an example, take a look at this post/video on the Merrill Over Matter blog. This is what happens when central planning and corrupt politicians direct capital flows (as the asset bubble continues to build). Easy come, easy go.

The goal is simple: maintain this growth rate by all means possible until the US consumer is back. That's why any concern about China refusing to roll their US treasuries positions is overblown. PRC needs the US consumer back in spending mood, in order to return to that export-driven growth (at least in the near-term). Keeping the funding flowing to the US and dollar rates low is key to get the export growth back to historical trend. Whether and when this will actually happen is another story.

Friday, November 20, 2009

The inverted T-bill curve - an anomaly or a signal for another downturn?

The 3-month T-bill yield has collapsed to new lows, yielding half a basis point.

That means if you plow a million dollars into 3-month bills right now, in 3 months you will walk away with your million plus about 13 dollars. After inflation is taken into account, you are down about $3,000 (depending on the assumptions). Why would anybody do this?

Trading desks everywhere are told - we are done for the year. We've made out money for the year; let's bring it home. Unwind as much risk as you can before year-end. And all that cash is flowing into T-bills. Except that people don't want the 1-month bill because it will mature before year-end. There is much less liquidity at the 2-month point. That means the 3-month bills are the only game in town for short-term liquid riskless paper, even if the yield is zero (negative real rates).

That bid for the 3-month paper has created an inverted T-bill yield curve.

It's a strange phenomena because this curve implies negative forward rates (so much for the so-called "arbitrage-free" interest rate models). This means the market sees short term yields going negative before the end of the year (this happened in Japan a few years ago). One way to interpret this is the market is anticipating the economy to get worse before it gets better - possibly weak holiday sales. Another is simply a sudden drop in risk appetite through year-end.

Wednesday, November 18, 2009

The exciting new world of ETFs

The ETF world is becoming more crowded and competitive every day. ETFs have become an extremely popular product with both the individual investors as well as various institutional players. The reasons are plentiful - from instant access to index exposure, to an easy way to enter markets such as China, to a simple way to take a macro view (for example in commodities), or to simply obtain leverage. One of the key reasons institutions love ETFs is liquidity. SPY (S&P DEP RECEIPTS) for example has a trading volume of 100-300 million shares a day, making it one of the most liquid exchange traded instruments in the world. In contrast for example, IBM volume is under 10 million shares a day.

With all this demand, institutions are cranking out new ETF at what seems to be a weekly basis. And each tries to add their bells an whistles to get traction in this competitive landscape. Schwab for example just created a bunch of new equity index ETFs (such as the Schwab U.S. Large-Cap, Small-Cap, etc.), and looking at the ETf universe, one might say zzzzzzzz.... But the spice here is that if you have a Schwab trading account, you can trade these things comission-free -supposedly forever. So if someone allocates a few hundred bucks a month to this strategy, this zero comission offer definitely helps.

But how far are fund companies going to push these products? Well, here is the latest ETF form iShares: ticker symbol ALT. "ALT" stands for alternative investments. That's right, this ETF is a hedge fund. Don't have a few mil to plow into a hedge fund, here is what you can get with the exchange traded ALT:

The objective of the Trust is to maximize absolute returns from investments with historically low correlation to traditional asset classes while seeking to control the risks and volatility inherent in futures and forward contracts by taking long and short positions in historically correlated assets.

Feels, sounds, and might behave like a hedge fund. Here are the 3 strategies ALT manager will trade:

The Trust utilizes investment strategies relating to relative value. Relative value strategies seek to profit from the mispricing of financial instruments, capturing spreads between assets and asset categories that deviate from the fair value or historical norms. The following three general strategies are considered as sources of return:

1. Yield and Futures Curve Arbitrage Strategies
Seek to take advantage of interest rate and futures contract price differentials by simultaneously entering into long and short positions in various bond futures contracts, interest rates futures contracts, commodity futures contracts and/or currency forward contracts that the Trust determines to be mispriced relative to one another. The Trust will enter into long positions in contracts whose underlying assets are deemed relatively inexpensive and will enter into short positions on contracts whose underlying assets are deemed relatively expensive.

2. Technical Strategies — Momentum/Reversal
Seek to take advantage of a comparison between assets' historical returns and their recent performance. Technical strategies are based on the theory that past price history may be predictive of asset value, and so technical strategies may be used to capture returns arising from price changes over time. For example, if recent performance of an asset exceeds historical performance, then a long "momentum" trade opportunity to buy may arise. If the historical performance of an asset exceeds recent performance, then a short "reversal" trade opportunity may arise.

3. Fundamental Relative Value Strategies
Seek returns by attempting to identify instances where there are discrepancies between the market and fundamental values of an asset. Comparing current price to fundamental value may provide a measure of mispricing, or opportunity, which can be compared across markets to provide a metric of relative misevaluation. The Trust's relative value strategies tend to buy in markets that appear inexpensive on a relative basis, and sell in markets that appear expensive, trading long or short positions in the relevant assets.

So if you get bored with US equity index ETFs, or BRIC ETFs, or gold ETFs, of even 3x leverage ETFs, ALT is here to add some hedge fund excitement. But don't bet on this ETF as always being uncorrelated to the equity markets. As we discussed before, correlation can show up in a stressed market with little warning.

Tuesday, November 17, 2009

Reflections on the crisis

Here is an interesting take on the financial crisis - a paper from William Sahlman called Management and the Financial Crisis (We have met the enemy and he is us …). It's a broad overview with some unique perspectives. It points out for example how everyone is a "Monday morning quarterback" when it comes to the financial crisis (apologies to our non-US readers for this US style jargon - it just fits).

There have been fabulous new articles about why, for example, ratings on mortgage‐backed securities were flawed. These articles might have been more useful before the crisis rather than after. Academics have also poked holes in various widely accepted measures like Value‐at‐Risk. Again, a little foresight would have been helpful.

This of course is not entirely true, as there were some who sounded the warning bells. This article from the WSJ pointed out how correlation models broke down in 2005 when GM got downgraded. This brought out the dangers in the widespread reliance on models, particular when it comes to structured credit. A publication by Ed Grebeck in Euromoney in 2006 called "Why should Institutions Invest in CDOs at all?" was another warning sign. But the rest - both academia and practitioners alike - were just along for a ride.

William Sahlman points to the fact that regulatory proposals, even sensible ones are not necessarily going to solve the problem in the long run.

Take a simple example of a positive improvement in regulatory policy that would involve imposing higher permanent capital minimums on systemically important financial firms. Those requirements might even be contra‐cyclical – higher reserves required when asset prices are high and lower when times are tough. Increasing the buffer between an implicit Federal guarantee and private responsibility is a good idea – it may lower the likelihood of a panic and of forcing the government to step in. History reveals, however, that increasing the buffer will not stop clever people from figuring out ways to bypass regulated structures and, in the end, put the system back at risk. The rules and regulations become a point of departure for finding unfettered ways to make money and use leverage.

A number of other interesting observations are in this working paper - some a bit controversial. Enjoy.


Hat tip Ed, Bill

Longer term discount window financing not needed

Bloomberg: The Federal Reserve said it will reduce the maximum maturity on discount-window loans to 28 days from 90 days as it moves to unwind some of the emergency measures introduced to fight the credit crisis.

The Fed Board cited “continued improvement in financial market conditions” in today’s announcement and said the change will take effect Jan. 14.

The term discount window had been extended in 2007 to specifically address term funding issues (funding beyond overnight) banks were experiencing as a result of the collapse in the ABCP market. As banks like Citi and RBS started taking CP conduit and SIV assets onto their balance sheet, their funding needs spiked and the Fed stepped in. The funding proved to be insufficient, as investment banks like Bear didn't have access to the discount window. For a reminder of the escalation of events in the summer of 2007, see this now famous Cramer freak-out:

We've come a long way since then as demonstrated by the LIBOR term structure. In particular the 3-month LIBOR drop is unprecedented, demonstrating availability of interbank term lending.

Term interbank funding is now functioning well enough for the Fed to reduce the discount window as well as other lending programs.

Saturday, November 14, 2009

When correlation strikes

Here is a great example of the flaw in risk models that rely on historical correlations. Using data from Credit Suisse on leveraged loans and distressed leveraged loans, we compute the correlation of the loan markets to the S&P500 since 1997.

Correlation of this portion of the credit markets to the equity markets has generally been unstable, registering both positive and negative measures over the past decade. But in a real financial crisis we know that correlations rise, as evidenced by the loan markets. The spike in 2008 was significant, reaching correlation of 0.8 between markets that traditionally have been loosely correlated or even anti-correlated. This was in fact the case with other credit markets as well, including corporate bonds and ABS.

Now consider capital and risk models (such as the Basle Accord) that are based on the ability to "diversify" across exposures. Supported by academicians, regulators, rating agencies, and practicing risk managers alike, these models are intellectually elegant and have proved profitable by conveniently reducing "expected" losses. This spawned what amounts to a whole industry of these participants, all with a vested interest in maintaining support for correlation based capital models.

One notorious example of such approach has been the assumption that pools of residential mortgages spread geographically across the US are sufficiently "diversified". Property values under this model (and based on some historical data) would therefore not be expected to drop simultaneously across the country. The beauty of this approach is that it makes the pools significantly "safer", even as individual loans remain risky, lowering expected loss of such pools, and allowing a large senior component to be rated AAA. As we now know, these misguided correlation assumptions have created a clear path to under-capitalization, which is where the financial system found itself in the midst of 2008.

Thursday, November 12, 2009

Asset managers get reprieve from FAS167

As we discussed earlier, FAS 167 would become a nightmare for asset managers. Instead of providing more transparency, the FAS167 reporting would actually end up with less.

E&Y: As written, Statement 167 may result in asset managers consolidating many hedge funds, private equity funds and other investment funds that they manage. Some financial statement preparers and users have indicated that consolidation of funds by asset managers will result in less meaningful financial statements

FASB recently decided to defer hitting asset managers with 167 until these consolidation issues are addressed.

E&Y: At the 11 November meeting, the FASB voted to expose for comment an amendment that would defer the application of Statement 167 for a limited number of entities (principally mutual funds, private equity funds and hedge funds) until the completion of the joint FASB/IASB project on consolidation accounting.

It's good to know that when it comes to the post-crisis regulation (including accounting/transparency regulation)at least some folks are being rational about it.

Update: Looks like CLO/CDO managers are not on the list of entities that would get the FAS167 deferral. That means they would need to consolidate billions in CLOs they manage onto their management company financials.

FAS167 for Asset Managers

Implied Real Rate tells a story of loose monetary policy and asset bubbles

There are numerous ways to measure how easy the monetary policy is at any particular time. Quantitative easing aside, one can look at the overnight rates as the simplest measure of stimulus levels. The Fed Funds rate fluctuating between 12 and 25 basis points feels sort of accommodative.

Of course a better measure is the real rate, which is the nominal overnight rate less inflation. The lower the real rate the more stimulus is being provided. Unfortunately inflation in the form of CPI releases is a backwards looking indicator. Any monetary policy is meant to set the stage for the next few years and should be more reliant on forward looking indicators of inflation. One such indicator is the inflation rate implied from TIPS. There are clearly issues with both TIPS and the CPI measure itself, but the implied inflation measure gives a decent forward looking indicator implied by the markets.

Many economists view low real rates that exist today as restrictive because of tighter credit in the current environment. However the market implied inflation rate already takes into account the current and the expected credit conditions. Therefore the Implied Real Rate is in fact a more holistic indicator of how loose the monetary policy really is as viewed by the markets.

Let's define the Implied Real Rate as follows:

Implied Real Rate = (Fed Funds Effective rate) - (inflation rate implied by the 10-year TIPS).

The Implied Real Rate is now at about -2%, the lowest level since TIPS have been first issued. That certainly feels quite accommodative, but let's compare the situation to the last cycle. In particular, let's look at how accommodative policy impacted asset levels - here we use S&P500. The last big drop in the Implied Real Rate was back in the 2002 - 2004 period, which launched the famous liquidity driven asset bubble.

Here is what the measure looks like right now.

Given the similarities, is the accommodative monetary policy that is currently in place setting us up for another crisis? Is the Fed behind the curve? Many argue that there will be time to take the liquidity out. By then however it may be too late:

From HSBC:
The remarkable thing about such liquidity-driven asset bubbles is their long-cycles, underlining the eventual potency of loose monetary policy. Also, successive monetary tightening over the course of the bubble has apparently little impact: once the financial accelerator goes into full throttle, it takes aggressive tightening to pop the bubble – and, more often than not, policy-makers are reluctant to step up for fear of bringing down the house.

To illustrate that effect, in 2004 the monetary policy did in fact begin to gradually get tighter, as the Implied Real Rate began to rise. But as HSBC points out above, this gradual tightening is (and in fact was) ineffective, and asset prices continued to rise unabated.

Mr. Bernanke, maybe it's time for action.

Wednesday, November 11, 2009

Corporate lending ready to take off - just need the borrowers

Banks are ready to increase lending to corporations and will attempt to ramp their lending significantly in 2010. Here are the reasons:

1. Since the beginning of the year, bank commercial and industrial loan exposure has dropped by 14%, while real estate loan exposure has decreased by only 2%. To the extent they can, banks will rotate out of real estate loans and into corporate loans.

2. At this stage, real estate linked loans constitute some 32% of the balance sheet, while corporate loans are under 12%.

3. As the chart below shows, commercial and industrial loans as percentage of the total assets have dropped quickly. Bankers have demonstrated to their credit departments that corporate loan exposure can in fact be reduced when need be (large corporate loans can trade fairly actively).

4. The following chart from the Fed shows the end to tightening of lending standards to companies.

5. As capital markets stabilize, the bid-ask spreads become tighter, reducing profitability of market making activities. 2010 budgets will need to shift more into lending.

What is less certain is how much demand will exist for corporate loans. So far the demand for corporate loans has been weak.

The stronger companies have been able to tap the bond markets, avoiding some of the loan covenants. Other firms either have cash or simply have no major expansion plans. Given the level of unemployment, corporations continue to be cautious on expansion plans or capital projects. To the extent possible (with 08 fresh on their minds) firms will avoid increasing their leverage. The one key area where banks will be able to help is in inventory financing as corporations try to rebuild depleted inventories (see chart below).

It's not at all clear however how soon the inventory rebuilding will begin. Corporate lending will be ready for business, but will there be takers?

Tuesday, November 10, 2009

Hedge fund liquidity may prove fleeting

This chart from Hedgebay shows the full history of secondary hedge fund transactions (that Hedgebay has in their database). The discount, which seems to be permanent for now indicates the liquidity premium one would demand to go into a fund that is presumably locked (via a lock-up, a gate, or a general redemption suspension).

Some of the discount may be valuation uncertainties, but with all the scrutiny on hedge funds these days, most valuation uncertainties would have been vetted with third parties. If they haven't been, no one would buy such fund even at a 10-15% discount.

Such liquidity premium means that funds who provide the best liquidity terms (within their strategy category) will be able to raise more capital than those who have long lock-ups and sidepockets.

It's somewhat of a dangerous game because this may create an asset-liability mismatch. That is funds will offer unrealistic liquidity terms just to get the capital in the door. As assets become fully priced and rates continue to stay low, hedge funds will be pressured to seek out less liquid strategies to squeeze out incremental returns. They may deploy leverage, making less liquid investments even more illiquid. The liquidity of the portfolio will become "mismatched" with the liquidity terms for redemptions (the liability side).

And when redemptions increase, funds will put up gates and we are back where we started. As much as institutions, particularly funds of funds seek the liquidity holy grail, these investments are not mutual funds, and the most "investor-friendly" liquidity terms may not provide the investor protection these institutions expect.

IASB proposal for amortized cost and impairment

Currently if you are a bank, a loan you originated will be held at par on the books and accrue interest. The loan makes you one day's worth of interest less the funding cost - every day. No volatility. That is until one morning you walk in and find out that the coupon you've been accruing never came. Now you not only have to reverse out the amount accrued on that last coupon, but also have to take a provision against principal loss. This provision reverses the life-to-date interest income on the loan and then some. This "oops" approach to loan accounting is called the "incurred loss impairment method", and is standard under current accounting rules. As a bank you could be holding a bunch of option arms, and as long as they make the minimum payments you would keep them at par (in fact you would keep them above par to account for the "negative amortization"). That's how many smaller banks that were fine a couple of years ago, all of a sudden became undercapitalized/insolvent.

To address this issue, the International Accounting Standards Board (IASB) has proposed an alternative (see attached document). It's a portfolio approach that requires the lender to continuously project total expected losses. The expected losses are then amortized over the life of the portfolio and netted against interest income. For example if you project a 20% total principal loss on the portfolio over the next 5 years, you would be deducting 4% of the initial portfolio face value from the interest income going forward. It's a constant dollar amount taken out of interest income every year. That means if loans default at some constant rate, interest income will drop off, while the provision will stay constant, creating a possibility of net interest loss.

Here is a comparison of the current method with the "expected loss model":

IASB: Interest revenue that is recognised will reflect the allocation of expected credit losses over the life of the instrument. This is a better reflection of the ‘economic’ interest that the lender expects to earn from an asset over its life than today’s approach. Hence, it avoids inappropriate front-loading of interest revenue.

This approach becomes more problematic when the expectations for credit losses suddenly change. That may mean that the reserve has been "under-accrued", and IASB would say that you have to take that difference into P&L immediately. And this concept makes it the trickiest portion of the proposal.

IASB: Using the proposed impairment method, credit loss expectations are updated each period. Any changes to initial expectations of credit losses will be recognised immediately in P&L. This change could be an increase in expected losses, or a reduction (reversal) of past expected losses (including the initial expected loss estimate).

If one uses CDS spreads for example to imply credit loss expectations, this method amounts to a form of mark to market. It effectively means that rather than holding "banking book" loans at par (current methodology), banks would be required to take a mark to market hit amortized over the expected life of the portfolio. And that could be bad news for banks that are thinly capitalized - these reserve requirements may make them insolvent.

Expect a massive industry (and political) backlash against this accounting methodology going into effect. In addition, if IASB adopts this proposal, it may impact the convergence of the US GAAP and the IAS standards, which has been the ultimate industry goal in recent years.


Monday, November 9, 2009

Lend more, but don't increase your leverage

How many times have you heard that banks have taken on way too much leverage. And that ended up causing the current crisis. Right? But no more. The US Congress is trying to put this into action. Under the "too big to fail" proposals, the largest banks should be prepared for higher capital requirements (thus lower leverage). The smaller banks are already significantly undercapitalized because of their real estate exposure and are trying to improve their capital standing before the FDIC shuts them down. They need to de-lever more by rebuilding their capital base.

So that's what banks have effectively done - they've deleveraged. The chart below shows the ratio of total loans and leases (commercial, industrial, real estate, consumer) to book equity for all the US chartered banks.

source: FRB

Banks have reduced that ratio since 08, keeping it fairly constant in the last 6 months. The overall bank leverage is now down, though maybe not as much as the regulators would like to see. Much of it was done through equity raises, retained earnings, loan sales, and reductions in lending. Looks like we are moving in the right direction, right?

But wait! Mr. Geithner now says banks have to lend more!
Bloomberg: U.S. Treasury Secretary Timothy Geithner is echoing billionaire investor Warren Buffett in telling banks “to take a chance again on the American economy.”

So far, his appeal is falling flat.

Banks are not listening because... maybe... they were told for the last 2 years to reduce leverage.

And Mr. Stiglitz, Columbia University economist adds that if the banks were taken over by the government, we could simply force them to increase their leverage by telling them to lend more.
“Bloomberg: If we had done the right thing, we would be able to have more influence over the banks,” Stiglitz told reporters at an economic conference in Shanghai Oct 31. “They would be lending and the economy would be stronger.”

Lend more, but be prepared for higher capital requirements. Take more risk, but don't increase your leverage. Extend more credit, but no "excessive lending". Which is it?

As the credit addicted US economy goes through it's withdrawal symptoms, is the answer really more credit? Certainly the US government thinks so and has shown an enormous commitment to credit expansion. But now it wants banks to follow along.

A sociopath at the gate - Westgate that is

When one thinks of the word “sociopath”, a killer of some sort generally comes to mind. It’s someone who is completely devoid of emotion or empathy for others. Someone completely focused on his/her own needs with absolutely no regard for those around them. The definition in Wikipedia states that sociopath is often used as an alternative word for a psychopath to avoid confusion with the word “psychosis” (which is unrelated). The description is divided into two factors: “aggressive narcissism” and “socially deviant lifestyle”:

Factor1: Personality "Aggressive narcissism"

Glibness/superficial charm
Grandiose sense of self-worth
Pathological lying
Lack of remorse or guilt
Shallow affect
Callous/lack of empathy
Failure to accept responsibility for own actions

Factor2: Case history "Socially deviant lifestyle"

Need for stimulation/proneness to boredom
Parasitic lifestyle
Poor behavioral control
Promiscuous sexual behavior
Lack of realistic, long-term goals
Juvenile delinquency
Early behavior problems
Revocation of conditional release

Why are we discussing this in a financial blog you may ask? Well, it is estimated that about 1% of the population has this disorder. And the area of finance is particularly attractive for people with these special “talents”. Bernie Madoff is one of them, Marc Dreier is another. There are numerous others, and not all have such a high profile. One of them lived in a peaceful suburban community in Saddle River, NJ. His name was Jim Nicholson. Jim, in his early 40s, a father of 3 young boys, was married to Donna - his high school sweetheart. Jim coached the local little league team and was the pillar of his community. He also managed money in a hedge fund he created called Westgate Capital. He didn’t like to take in institutional money – instead he managed funds for his friends, his neighbors, and his family. His returns were rock solid and new funds just kept coming in (particularly from people closest to him).

These returns would be the envy of most money managers - steady and consistent. But it was all a fraud. It’s not clear when it became fraud, maybe 2003, maybe earlier. Investors figured this guy is not going anywhere, he's got 3 kids and is happily married. But after the Madoff news hit, many tried to redeem their money and Jim's ponzi scheme began to unravel. The check he sent to redeeming clients bounced. And the thing with the "perfect family" turned out to be, well, not so perfect after all. From

James M. Nicholson, accused of running a fraudulent hedge fund, cheated on his wife with another woman for more than a year as he continued to bilk investors out of tens of millions of dollars, according to his wife's divorce papers. Donna A. Nicholson's divorce papers, a copy of which was obtained yesterday, provided details into her husband's extramarital affair and the effects of the criminal case on her and their three children.
He's accused of stealing an estimated $163 million from his clients since 2004 through his hedge fund business, Westgate Capital Management LLC in Pearl River and Manhattan.Donna Hostomsky and James Nicholson grew up in Haverstraw and were high school sweethearts. They married on Sept. 26, 1992, and lived in Stony Point before moving to Saddle River, N.J.
Donna Nicholson's divorce papers accuse her husband of adultery with Toronto investment trader Linda Boville, starting on Feb. 1, 2008. Donna Nicholson's papers state that her husband admitted having sexual relations with Boville in New York City, New Jersey, Florida, Las Vegas, Canada and "in other locations and at other times and places too numerous to account."
Donna Nicholson accuses her husband of extreme cruelty with the adultery and alleged crimes. She also says they have irreconcilable differences. She claims his arrest "led to the seizure of all our marital assets, leaving myself and my children penniless and without any means of support."
Nicholson came under scrutiny by Rockland investigators a few months ago after nearly $5 million in redemption checks to clients bounced, county District Attorney Thomas Zugibe has said.

Unlike Madoff however, Jim didn't feel like having an accountant, even an incompetent one that Madoff had. Why bother? Just come up with a fake name, get a PO box and an answering machine - and you got yourself an "accountant". He also has been accused of doctoring financial statements and setting up a phony Manhattan accounting firm that sent out fictitious statements telling investors they were making money. He is accused of using money obtained through new investors to pay off suspicious longtime investors. Nicholson is being held on $10 million bail in the Metropolitan Detention Center in Brooklyn.

As a true sociopath, Jim had to indulge himself any way he could: Documents show he bought an interest in a multimillion-dollar private jet and a $27 million oceanfront estate in Southampton. He also bought a condo at the Time-Warner Building in Manhattan valued at $8.5 million. He also owned a $4.75 million condo in Palm Beach, Fla.

For those who are interested in more gory detail on this sociopath (which is not covered well by the media), see the full complaint below. But the moral of the story is that sociopaths like Jim make it that much tougher for honest money managers to make it. That's right, there really are honest money managers out there.

As an investor, follow the 3 simple rules:
1. Watch those returns to make sure they are realistic (they have some semblance to what markets are doing and the strategy makes sense)
2. Make sure there is a real accountant there who does the audits and knows what she is doing.
3. And watch for signs of the sociopath

Comp 20911
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