Tuesday, February 23, 2010

The systemic risk of the repo system

Original posted on Reuters by Felix Salmon:

Tyler Cowen has a copy of Gary Gorton’s new paper, and likes it. The excerpt he gives us raises a serious point about fragilities in the banking system: banks fund themselves in the repo market so much that they need about $12 trillion of collateral just to keep ticking over. So if you implement a 20% haircut on repos, banks would need to raise $2 trillion, which is impossible.

The first thing to note here is that no one is proposing a 20% haircut on repos. There’s a school of thought which says that the Miller-Moore amendment does that, but it doesn’t. And in any case, the Miller-Moore amendment only comes into effect after a bank has failed — it’s entirely a question of who takes the associated losses, and has nothing to do with the amount of capital that banks need to hold against their repo-funding operations.

More generally, Gorton suggests that banks’ reliance on the repo market constitutes a systemic fragility which renders the entire banking system prone to runs: “Gorton predicts the crisis was not a one-off event and it could happen again”, writes Cowen. I suspect this is true, but I also hope that Gorton doesn’t go on to advocate some kind of government backstop of the repo market. He wanted the government to start insuring securitizations in an earlier paper, and that was a very bad idea; regulating and insuring the repo market would be equally misguided.

The real underlying problem here is the treacherous state of denial in which the bond market generally finds itself 99% of the time. Participants in the repo markets know that there are risks there, but they ignore them, because ignoring the risks creates a smooth funding mechanism and allows credit to flow much more easily. Then, when there’s a credit panic and everybody becomes alive to the risks, everything grinds to a chaotic halt.

When the government started insuring deposits, it did so to protect both to protect depositors and to protect banks from runs: if depositors are insured, they don’t engage in runs on banks. Nowadays, as banks have moved away from deposits and towards repos as a funding source, deposit insurance still protects depositors; it just doesn’t prevent bank runs as well as it used to. And yes, that’s a systemic risk, which any systemic-risk regulator needs to be alive to. Whether anything can be done about it, on the other hand, is another question entirely.

Friday, February 19, 2010

The (2001) illustrated sovereign currency swap

Ta-dah — a theoretical sovereign currency swap purportedly presented to European officials in the early years of the new millennium. The diagram was drawn up in 2001 by Gustavo Piga, an Italian academic specialising in public debt and monetary policy issues. It’s part of a 150-page International Securities Market Association-commissioned report on derivatives and “public debt management.”

In the report, the author talks about the possible use of derivatives as window-dressing tools to help conceal public debt levels, at a time when Eurostat, the body charged with collating eurozone statistics, was drawing up its European System of Accounts (ESA 95).

Here’s what Piga says happened:

When the author, during a meeting, pointed out the transaction shown in Figure 4.2 to a European official who is supposed to monitor such transactions, the reaction the author received was indicative of the absence of firm national accounting principles over the use of derivatives by governments. The first thing this official said about this transaction was that “it is all right…We would not oppose it.” When the author explained his concern to the official, the latter recognized the problem but dismissed the need for action by saying that “for the time being we would not challenge such a transaction.” Shortly afterwards in this meeting he admitted that the problem was more serious than he first thought. He acknowledged that “we don’t have anything in ESA 95 to oppose it,” underlining the absence of a firm national accounting framework to deal with these window-dressing transactions. He concluded by opening the door to corrections in the system of national accounts by stating: “Today, it’s true. The door is open to such deals. It is worth examining whether ESA 95 should have a sentence to forbid this.”

Risk Magazine, first to report on the Greek swap issue, points out that Eurostat responded with “not, perhaps, the reaction Piga had expected.” Instead of forbidding the deals, the organisation decided to allow the swaps in ESA 95, even providing a theoretical example of how a swap-induced decline in a government’s debt could be worked out in official statistics, according to Risk.

It wasn’t until 2008, when Eurostat published updated guidance on the use of derivatives, that such window-dressing currency swaps became “impossible”, Risk says. Previous Eurostat guidance, as reported by the Wall Street Journal, had suggested that Eurostat had decided to value outstanding foreign currency-denominated debt using market exchange rates — not at swap-agreed rates.

The point, though, is that Eurostat had ample opportunity to catch these things.

It wasn’t until Greek debt became a `problem,’ that currency swap arrangements concealing debt levels, really became a problem for Eurostat.

Wednesday, February 17, 2010

Doomsday regulation scenario laid out

Original posted in the Financial Times by Patrick Jenkins:

The biggest banks will see their profitability fall by nearly two-thirds next year under a doomsday scenario to be outlined in research published on Wednesday .

Analysts at JPMorgan have calculated that if the full burden of regulatory and political initiatives to crack down on banks’ risks is implemented, it would cut the average return on equity from a projected 13.3 per cent to 5.4 per cent.

The conclusion is a stark illustration of what might happen if all of the proposals mooted by governments in the US, UK and France were put into effect globally at the same time as the overhaul of capital and liquidity standards being engineered by regulators on the Basel Committee on Banking Supervision.

The authors concede that such an extreme scenario, which would also entail the world’s 16 leading banks (excluding JPMorgan itself) having to raise an estimated $221bn, or $14bn apiece on average, is unlikely to occur in practice.

But there are growing concerns in the banking industry that a large number of the proposals will become reality in the coming years.

Up until the UK bonus tax was announced in December, there was an assumption that Basel and the Group of 20 leaders were working in a co-ordinated way.

But over the past month or two, governments’ interventions have complicated the regulatory approach.

In a trio of reports on the future of banks, JPMorgan identifies seven areas in which they are vulnerable to change: a political push to separate retail and investment banking activities; rising capital requirements; the need to hold higher levels of liquid assets; caps on size; accounting changes; potential levies on systemically important institutions; and contingency planning for failure, which could necessitate groups to be structured in a more costly way as strings of local subsidiaries.

Nick O’Donohoe, head of global research at JPMorgan, is convinced that whatever the burden of regulatory change, banks will not absorb the hit, instead passing the cost on to customers in the form of far higher prices.

“In order to return to similar levels of profitability as per current forecasts,” JPMorgan’s report concludes, “we estimate that pricing on all products (retail banking, commercial banking and investment banking) would have to go up by 33 per cent.”

European banks, such as Credit Suisse, Deutsche Bank, Royal Bank of Scotland and Lloyds, will be worst affected, JPMorgan calculates.

Tuesday, February 16, 2010

Fed carries losses from Bear portfolio

Original posted in the Financial Times by Henny Sender:

The US Federal Reserve is sitting on significant paper losses on the real estate assets it acquired in the Bear Stearns rescue, with much of the red ink coming from debt used to back some of the most high-profile buy-out deals of the bubble years.

Among the debts weighing on the central bank’s portfolio are those used in financing the acquisitions of Hilton Hotels, which is being restructured, and hotel operator Extended Stay, which is in bankruptcy, people familiar with the matter say.

The Fed holds these and other real estate assets in a vehicle known as Maiden Lane I, which was set up to pave the way for JPMorgan Chase’s purchase of Bear. At the time the deal was struck in March 2008, JPMorgan feared that if it bought all of Bear’s assets it would be left with too much exposure to the real estate market. Bear, for example, originally had $5.4bn of Hilton debt, a huge concentration

The assets in Maiden Lane I – all of which came from Bear’s mortgage desk – were originally valued at $30bn when a final agreement on the portfolio was reached in June 2008 by the New York Fed, its advisers at asset managers BlackRock and JPMorgan. At the end of 2009 the Fed said the assets were worth $27.1bn (€20bn, £17.4bn).

People familiar with the portfolio said Maiden Lane I’s losses were concentrated in commercial real estate assets, which had a face value of $8.4bn and an estimated worth of $7.7bn when they were acquired by the Fed.

As of September they had been marked down to $4bn, filings show.

About two-thirds of the Maiden Lane I portfolio involved mortgage debt backed by government-created entities, people familiar with the matter said. Those people describe the debt as highly illiquid, a factor that has resulted in its failure to rally strongly as credit markets recovered and interest rates fell.

“It was the scrapings off the slaughterhouse floor,” said one person. “It started with the things that were not good enough to get securitised.”

The Fed has disclosed little detail on these or other assets in the Maiden Lane I portfolio, fearing such revelations could hurt sales efforts, a person familiar with the matter said. JPMorgan and the New York Fed declined to ­comment.

Maiden Lane I was funded with $28.8bn from the New York Fed and $1.15bn from JPMorgan, which agreed to absorb the first $1bn of any losses.

The struggles of the portfolio could stir the debate on Wall Street over whether the New York Fed, then run by Tim Geithner, who is now Treasury secretary, struck a particularly good deal for taxpayers in the Bear rescue.

In a typical restructuring, creditors are made whole before shareholders are paid. In the Bear case, shareholders received $10 a share while creditors – in this case, the Fed – may lose money.

Mr Geithner told Congress in 2008 that the central bank had three “risk mitigants” to protect its interests in the Bear deal: JPMorgan’s agreement to take the first $1bn in any losses; the Fed’s long-time horizon as an investor; and the fact that the central bank’s $28.8bn loan was backed by “a pool of professionally managed collateral”.

Testifying before Congress last month, Jamie Dimon, JPMorgan’s chief executive, said the New York Fed received “the less risky mortgage assets” on Bear’s books. He added: “It would have been irresponsible for us to take on the full risk of all those assets at the time.”

Fed carries losses from Bear portfolio

y Henny Sender in New York

Published: February 15 2010 23:45 | Last updated: February 15 2010 23:45

The US Federal Reserve is sitting on significant paper losses on the real estate assets it acquired in the Bear Stearns rescue, with much of the red ink coming from debt used to back some of the most high-profile buy-out deals of the bubble years.

Among the debts weighing on the central bank’s portfolio are those used in financing the acquisitions of Hilton Hotels, which is being restructured, and hotel operator Extended Stay, which is in bankruptcy, people familiar with the matter say.

The Fed holds these and other real estate assets in a vehicle known as Maiden Lane I, which was set up to pave the way for JPMorgan Chase’s purchase of Bear. At the time the deal was struck in March 2008, JPMorgan feared that if it bought all of Bear’s assets it would be left with too much exposure to the real estate market. Bear, for example, originally had $5.4bn of Hilton debt, a huge concentration

The assets in Maiden Lane I – all of which came from Bear’s mortgage desk – were originally valued at $30bn when a final agreement on the portfolio was reached in June 2008 by the New York Fed, its advisers at asset managers BlackRock and JPMorgan. At the end of 2009 the Fed said the assets were worth $27.1bn (€20bn, £17.4bn).

People familiar with the portfolio said Maiden Lane I’s losses were concentrated in commercial real estate assets, which had a face value of $8.4bn and an estimated worth of $7.7bn when they were acquired by the Fed.

As of September they had been marked down to $4bn, filings show.

About two-thirds of the Maiden Lane I portfolio involved mortgage debt backed by government-created entities, people familiar with the matter said. Those people describe the debt as highly illiquid, a factor that has resulted in its failure to rally strongly as credit markets recovered and interest rates fell.

“It was the scrapings off the slaughterhouse floor,” said one person. “It started with the things that were not good enough to get securitised.”

The Fed has disclosed little detail on these or other assets in the Maiden Lane I portfolio, fearing such revelations could hurt sales efforts, a person familiar with the matter said. JPMorgan and the New York Fed declined to ­comment.

Maiden Lane I was funded with $28.8bn from the New York Fed and $1.15bn from JPMorgan, which agreed to absorb the first $1bn of any losses.

The struggles of the portfolio could stir the debate on Wall Street over whether the New York Fed, then run by Tim Geithner, who is now Treasury secretary, struck a particularly good deal for taxpayers in the Bear rescue.

In a typical restructuring, creditors are made whole before shareholders are paid. In the Bear case, shareholders received $10 a share while creditors – in this case, the Fed – may lose money.

Mr Geithner told Congress in 2008 that the central bank had three “risk mitigants” to protect its interests in the Bear deal: JPMorgan’s agreement to take the first $1bn in any losses; the Fed’s long-time horizon as an investor; and the fact that the central bank’s $28.8bn loan was backed by “a pool of professionally managed collateral”.

Testifying before Congress last month, Jamie Dimon, JPMorgan’s chief executive, said the New York Fed received “the less risky mortgage assets” on Bear’s books. He added: “It would have been irresponsible for us to take on the full risk of all those assets at the time.”

Why Are 86% of the NY Fed's MBS Purchases Occurring During Option Expiration Weeks?

Posted on Jesse's Café Américain:

My friends at ContraryInvestor have published some remarkable data this evening in their twice weekly (subscription) analysis of the economy and the markets. This is one of the best analysis sites we follow, and highly recommend that you at least take advantage of their complimentary monthly newsletter.

This data suggests that the Fed's purchases of Market Backed Securities serves not only to artificially depress mortgage rates and the longer end of the yield curves. The purchases occur, with a remarkably high correlation of 86%, during monthly stock market options expiration weeks in the US.

"...since July, there has only been one options expiration week whereby the Fed did not buy at least $60 billion of MBS during the options expiration week itself, providing instant and meaningful liquidity during options expiration weeks that have historically had an upward bias anyway! Talk about timing of liquidity injections to get maximum effect in the equities market."
The data is intriguing to say the least. As you may recall, option expiration in the US stock indices occurs on the third Friday of every month. We have pointed out in the past that this monthly event is often the occasion of some not so subtle racketeering by the funds and prop trading desks of the banks in separating the option players from their positions, and pushing prices around to maximize the pain.

Why would the Fed wish to provide extra liquidity, to the tune of $60 billion or so, for the banks during that week? There must surely be other ways to support the equity markets. Such as buying the SP futures in the thinly traded overnight session. I am not aware of a strong correlation for stock selloffs or extraordinary weakness in option expiry weeks per se.

It might not be a coincidence, but there could be some unrelated event in the mortgage markets that also occurs on the third Friday or Thursday of each month. We are not aware of it, but that does not mean it does not exist. They might also be making the purchases more randomly, but reporting them on some schedule as the Fed does its H.41 reports, for example. Anyone who might know of such a cross correlation would be kind to let us know of it.
Addendum 22 Jan: Several readers have written to suggest that the Fed is buying in the TBA markets, new issues, and that they have fixed settlement dates that roughly coincide with stock options expiration. That does not remove the potential material effect of providing liquidity in options expiry week, but it certainly does nullify the imputation of deliberation. I think the front running as noted in the blog today in Treasuries is more obvious and plausible.

See Also About Those MBS Purchases in Option Expiry
But otherwise, it would be a good question to ask of the Fed. Are they in fact supplying extra liquidity to the banks at certain intervals to support a manipulation of the market to boost their prop trading results?

Perhaps at the next occasion of Ben's visit to Congress. Or maybe the SEC can pick up the phone and call NY Fed CEO Bill Dudley, formerly of Goldman Sachs. Federal Reserve Bank of New York Tel: (212) 720-5000.

ContraryInvestor is one of the more 'squared away' analysts we follow, and they do go to some pains to stress their reluctance to ever take the conspiratorial route. There may be a perfectly innocent reason why the Fed buys the MBS when it does. Some correlation based on the calendar.

Inquiring minds would like to hear all about it, Revelations-wise.

"...in trying to follow the money we know the bulk of Fed money printing has gone to support the mortgage markets with the Fed buying up a huge swath of MBS since March of last year. From the summer of 2008 until the present, the Fed has been a huge help in getting conventional 30 year mortgage paper costs from the mid-6% range to the high 4% range. Quite the accomplishment.

But if you take a very careful look at the character of the Fed balance sheet since the big time money printing effort started in March of 2009, you'll see that their buying of MBS has been a bit of a multi-use exercise. Without trying to sound conspiratorial, we believe they have also used the MBS buying program to help "support" equity prices by essentially providing liquidity to the aggregate financial market at quite the opportune times...

You may have seen that recently Charley Biderman at MarketTrimTabs has been suggesting that he cannot account in aggregate for just who has been buying equities since March of last year. He suggests that although he cannot prove it, the Fed may indeed be a key buyer. MarketTrimTabs is the keeper of the records of the kingdom when looking at equity mutual fund flows, etc. We even did a bit of this ourselves in a discussion a while back by documenting that traditional equity buyers that have been households and corporations (buybacks) were essentially nowhere to be found in 2009.

In fact, households were selling and on a net basis corporations were issuing equity, not buying it back. That leaves institutions, banking sector prop desks, the hedge community, etc. as the key provocateurs of equity price movements in the rally to date. No wonder Charley is scratching his head a bit and wondering just how we could have scaled the largest 10 month rally in market history without households and corporations playing along. But like Charley, we can prove nothing about the Fed actually acting to buy equities or futures, etc.

But there just happens to be one thing we can prove when we “follow the money” that the Fed has been doing. And it ties right back to their purchasing of MBS in the marketplace. Remember, when the Fed buys a mortgage backed security from the financial sector, it provides liquidity that can 1) be lent out, 2) reinvested in other mortgage backed securities (not a chance), 3) used to buy bonds, or 4) used in prop desk trading. We already know the lending is not happening, MBS purchases have been the province of the Fed with few other buyers, banks have bought bonds, but in moderation, and finally banks are announcing “record trading profits” as per their prop desk activities. Get it? Of course you do. The prop desk destination has been a liquidity magnet.

So here’s the important issue regarding the Fed's MBS purchases relative to equity market outcomes. It’s the timing of the Fed’s MBS purchases that has been the key support to equity prices. And we see it that way when we analytically follow the money. Ok, the chart below chronicles ALL Fed purchases of MBS by the week since March of last year. The blue line is the ongoing level of Fed ownership of MBS as this position has been accumulated over the last 10 months. It’s an almost perfect stair step higher pattern. Although it may seem random, the dates we input into the chart happen to be the weeks ending on a Friday. Friday's of options expiration weeks. Notice a pattern here?



Of course you do. It’s blatantly obvious. To the bottom line, the Fed has been very significantly goosing its purchases of MBS during equity options expiration weeks. In fact, since July, there has only been one options expiration week whereby the Fed did not buy at least $60 billion of MBS during the options expiration week itself, providing instant and meaningful liquidity during options expiration weeks that have historically had an upward bias anyway! Talk about timing of liquidity injections to get maximum effect in the equities market.

Folks, this is right out in the open. No mysteries and fully disclosed on the Fed’s own balance sheet. And guess what? It gets better. The second largest weekly period for Fed purchases of MBS outside of the expiration week itself? You guessed it - month end week. Another maximum effect week where we usually see institutions engage in a bit of window dressing. Nothing like providing a few extra chips "on the house", no?



To put a little summation sign around this section of commentary, the chart below breaks down the timing of Fed purchasing of MBS since June of last year. Yes, 86% of all Fed purchases of MBS since that time occurred directly in equity options expirations weeks. Another 7.8% of total MBS purchases occurred in final weeks of each month. And an overwhelming 5.8% of total Fed purchases of MBS occurred at other times.

In following the money, this is the only thing we can prove in terms of actual Fed actions relative to the equity market itself. A mere coincidence? Not a chance. As we see it, the Fed printing of dough to buy back MBS has had a dual purpose. The ultimate new age definition of cross-marketing? Yeah, something like that.

Now that we have covered this data, the question of "what happens when the Fed stops printing money in March?" takes on much broader meaning and significance. Of course the Fed has not directly been buying equities with their clever and clearly very selective timing of MBS purchases, but they sure as heck were providing the immediate and sizable liquidity for "some one else" to do so during equity periods where they could achieve "maximum effect".

Wildly enough, at least as of last week's option-ex, the Fed was still purchasing $60B in MBS. So, as we stand here today, there are now two more options expirations weeks prior to us theoretically reaching the end of the game for Fed printing and MBS buying. You already know we'll be watching, errr.. following the money that is.

When/if the Fed stops printing to buy MBS, do we also lose an options expiration week and month end equity liquidity sponsor? Something we suggest you think about as we move forward. See why we suggest following the money is a key theme?

Monday, February 15, 2010

A fox, a hound and other market tales

Originally posted in the Washington Post by Daniel Greenberg

These traditional Tales from The Market have been handed down and treasured for generations. Each story has outstanding analytics and has been rated AAA ("a super-good read") by Shotzy's Tale Rating Service.

One of the wise elders from the town of Greenwich tells this first tale, introducing us to the magic of The Market.

A fox and a hound waited in a copse outside of a farmer's henhouse.

"Ooh, I can hear those chickens clucking from here," said the hound. "Let's go in there and snatch them all!"

"Not so fast," said the fox. "If we take them all at once we can't ever return. But if we take just one, then perhaps the farmer won't notice and we can keep coming back night after night to get more."

"That's a good idea," said the hound.

The two entered and went to work quickly. The fox grabbed as many chickens as he could, emptying the henhouse.

"Hey," said the hound. "I thought you said we were going to take only one chicken."

"That is what I did," said the fox. "I limited myself to one chicken."

"Forgive me, my friend," said the hound, "but that is not accurate. I saw you take at least seven chickens."

"The one chicken was my limit," said the fox.

"And the other six?"

"Ah," said the fox with a smile. "The other six were the bonus I gave myself for staying within my limit. And a very nice bonus it was indeed."

The moral of this story? In The Market, a bonus doesn't count. That's why they call it a bonus.

* * *

The mouse king needed a ride to the other side of the river, so he called on a large alligator for help.

"Can you take me to the other side of the river?" the king asked. "I will pay you $20 billion from my coffers."

"That's a lot of money, even if it is in mouse dollars," said the alligator. "I'll take your offer."

So they set out on the river, which was very shallow, allowing the alligator to crawl more than halfway across. Then they hit a deep spot and started to sink.

"Help!" cried the king. "I can't swim."

"Neither can I," said the alligator.

"But you're an alligator," said the king. "Surely all alligators can swim."

The alligator explained that he had once been able to swim. But the river was so shallow and so rich with fish to eat that he had grown plump and lost the skill.

"What do we do now?" cried the king.

At this point the subjects of the king who were watching from the river bank recognized what was happening. Many began paddling furiously to the sinking alligator. They used their little mouse legs to prop him up and propel him to the other side. Most did not survive the task.

When he was safe on the other side, the mouse king asked, "Why did you accept my offer if you couldn't swim?"

The alligator said, "I will be honest. I did it for the money. I figured we would somehow make it to the other side. And sure enough, we did make it. You see, I was right."

"But what about all of my subjects who drowned in the river?" asked the mouse king.

The alligator shrugged. "Hey, risk is a part of every transaction," he said.

With that, they went to dinner at the restaurant on the other side of the river and shared a very nice bottle of wine. And forgot about the whole thing.

Tuesday, February 9, 2010

Flipping Coins Proven To Beat Professional Buy And Hold Investing

Original posted on the CXO Advisory Group web page:

Did the poor returns and high volatility of the U.S. stock market during 2000-2009 represent a tailwind for market timers? To check, we measure the performances of various simple market timing approaches (equal weighting with cash, 10-month simple moving average signals, momentum, and coin-flipping) over the decade. Using monthly closes for S&P Depository Receipts (SPY), a short-term interest rate composite and the S&P 500 index from December 1999 through December 2009 (and earlier for S&P 500 Index signal calculations), we find that:

For perspective, consider the monthly statistics for the S&P 500 Index in the following table. The mean monthly return is much lower, and the standard deviation of monthly returns higher, during the 2000s than during the prior half-century.

Next, consider a fly-off of the following simple long-only market timing strategies during the 2000s:

  1. Buy and Hold: Buy and hold SPY (as a benchmark).
  2. EW SPY-Cash: Hold equal amounts of SPY and cash, rebalancing monthly.
  3. 10-Month SMA: Hold SPY (cash) when the monthly close of the S&P 500 Index is above (below) its 10-month simple moving average (SMA).
  4. 6-1 Momentum: Hold SPY (cash) when the past 6-month return for the S&P 500 Index is positive (negative).
  5. 6-1-1 Momentum: Hold SPY (cash) when the past 6-month return, with a skip-month, for the S&P 500 Index is positive (negative).
  6. 100 Monthly Coin Flippers: Hold SPY (cash) when the coin comes up heads (tails).

For this fly-off, we make the following assumptions:

  • Use adjusted returns for SPY to incorporate dividends.
  • The return on cash is the short-term interest rate composite.
  • There are no trading frictions (biased in favor of all timing strategies). The effects of actual trading frictions depend on strategy trading frequency, bid-ask spreads, specific broker fees and account size.
  • For the 10-Month SMA and 6-1 Momentum strategies, signals derive from data just before monthly closes, allowing executions at monthly closes. Note that these strategies may be very fragile with respect to this assumption (see the blog entries of 2/3/10 and 12/18/09), such that shifting execution by small intervals may materially reduce returns.
  • Ignore any tax implications of trading.

The following chart compares the cumulative performances of the above strategies during 2000-2009. Some notable findings are:

  • 85% of Monthly Coin Flippers beat Buy and Hold, and the average Monthly Coin Flipper beat the market by 29% on a cumulative return basis. In other words, the sample period presents a tailwind for long-only market timers.
  • The best (worst) Monthly Coin Flipper outperformed (underperformed) Buy and Hold by 122% (32%).
  • The 10-Month SMA and 6-1 Momentum strategies perform similarly and beat all 100 Monthly Coin Flippers on a cumulative return basis.
  • The EW SPY-Cash strategy beats Buy and Hold but loses slightly to the average Monthly Coin Flipper.

Imposing trading frictions would depress results for all timing strategies (by differing amounts according to trading frequency). For example:

  • Monthly Coin Flipper #64 has a cumulative return 29% higher than that for Buy and Hold (same as the average Monthly Coin Flipper). Imposing a trading friction of 0.2% per change in position reduces #64's cumulative return outperformance from 29% to 13%.
  • Applying the same level of trading friction to the 6-1 Momentum strategy reduces its cumulative return outperformance from 145% to 138% (the 6-1 Momentum strategy does not trade as frequently as the typical Monthly Coin Flipper).

For a different view, we look at average (arithmetic mean) monthly returns for all tested strategies.

The next chart compares the average monthly returns for the above strategies during the 2000-2009 decade and during each year over the decade. Some notable findings are:

  • The average monthly return for Buy and Hold over the decade is approximately zero. 55% of adjusted monthly returns for SPY are positive.
  • The EW SPY-Cash, 10-Month SMA, 6-1 Momentum and 6-1-1 Momentum strategies have similarly low standard deviations of monthly returns.
  • Standard deviations of monthly returns for the Monthly Coin Flippers are lower than those for Buy and Hold.

In summary, any long-only timer of the U.S. stock market who did not beat the market during 2000-2009 has some explaining to do.

How Greece hid its borrowing in the swaps market

Original posted on Reuters by Felix Salmon:

Beat Balzli has an intriguing story at Spiegel saying that Greece has been hiding the true nature of its deficits and its debt using clever derivatives dreamed up by Goldman Sachs. I believe it, although the details are sparse:

Greece’s debt managers agreed a huge deal with the savvy bankers of US investment bank Goldman Sachs at the start of 2002. The deal involved so-called cross-currency swaps in which government debt issued in dollars and yen was swapped for euro debt for a certain period — to be exchanged back into the original currencies at a later date.

Such transactions are part of normal government refinancing. Europe’s governments obtain funds from investors around the world by issuing bonds in yen, dollar or Swiss francs. But they need euros to pay their daily bills. Years later the bonds are repaid in the original foreign denominations.

But in the Greek case the US bankers devised a special kind of swap with fictional exchange rates. That enabled Greece to receive a far higher sum than the actual euro market value of 10 billion dollars or yen. In that way Goldman Sachs secretly arranged additional credit of up to $1 billion for the Greeks.

This credit disguised as a swap didn’t show up in the Greek debt statistics. Eurostat’s reporting rules don’t comprehensively record transactions involving financial derivatives. “The Maastricht rules can be circumvented quite legally through swaps,” says a German derivatives dealer.

According to Balzli, Goldman has no risk on this deal, after selling the swap to a Greek bank in 2005.

How might a deal like this work? Let’s say that Greece issues a bond for $10 billion, which it would then normally swap into euros at the prevailing interest rate, getting $10 billion worth of euros up front. In this case, it seems, the swap was tweaked so that Greece got $11 billion worth of euros up front — and, of course, has to pay just as many euros back when the bond matures. Essentially, it has borrowed $11 billion rather than $10 billion. But for the purposes of Greece’s official debt statistics, it has borrowed only $10 billion: the extra $1 billion is hidden in the swap.

This wouldn’t be the first time that Goldman came up with a clever capital-markets deal to help a European country get around the Maastricht rules: as far back as 2004, Goldman put together something called Aries Vermoegensverwaltungs for Germany, in which Germany essentially borrowed money at much higher than market rates just so that the borrowing wouldn’t show up in the official statistics. And according to Balzli, Italy has been doing something almost identical to the Greek swap operation, using a different, unnamed, bank.

It’s a bit depressing that EU member states are behaving in this silly way, refusing to come clean on their real finances. But so long as they’re providing the demand for clever capital-markets operations like these, you can be sure that the investment bankers at Goldman and many other investment banks will be lining up to show them ways of hiding reality from Eurostat in Luxembourg.

Quants’ Risk-Free Ideas Sink Market, Cause Ruin

Posted on Business Week by Susan Antilla:

To become a potentially market- destroying “it” group on Wall Street, you need some arrogance, enough brains to justify making huge financial bets, utter cluelessness about lessons learned from finance’s booms and busts, and a sincere belief that your unique contributions to Wall Street will mean, ahem, that that this time it really is different, so old truths can be ignored.

Such is the profile of Wall Street’s nerdy quants, the most recent contingent to reach stardom and then keel over on its pocket protectors when boom turned bust. I learned much about this geek gaggle by reading “The Quants,” a new book by Wall Street Journal reporter Scott Patterson.

Most of all, I learned that the brainy brigade -- they are mostly poker-junkie Ph.D.s with physics, cryptology and game- theory backgrounds -- was no different from any of the groups that, from time to time, take their turns as Wall Street luminaries. True, they can do long division in their heads, and the computer models they stuff with can’t-lose trading instructions may even garner a Nobel Prize.

But just like investment bankers, junk-bond kings and other finance superstars who came before them, the quants reached a pinnacle where they figured they alone had The Answer (and the profits) and that no one should question their methods.


History of Meltdowns


Take, for example, a market-meltdown scene Patterson describes, when a quant guru is trying to sell. A trader has to inform the guy that he can’t sell because “the market’s frozen.” It’s a real Say What? Moment, because the quants had promised that a financial collapse was really, really, really unlikely -- a 27-standard-deviation event, in quant-speak.

Problem is, this little anecdote dates from the stock market crash of 1987, when geek-designed portfolio insurance helped send the market on a roller-coaster ride. A flurry of they-blew-it books were published in the wake of that meltdown, and a Newsweek cover asked, “Is The Party Over? A Jolt for Wall Street’s Whiz Kids.” So the nerds proved to be not too swift at the learning-curve thing -- mandatory for true Wall Street heroes -- when you consider it happened all over again at Long Term Capital Management in 1998. And yet again at all the quant- run hedge funds in 2007.

They were, though, fantastic at understanding their role as newly anointed Wall Street celebrities. The manager of one quant fund got married at the Palace of Versailles, hired acrobats from Cirque du Soleil to perform and dropped $80 million on a Jasper Johns painting. Another trashed plans to live in a 12,500-square-foot mansion in Greenwich, Connecticut, in favor of a larger place.


Can’t-Lose Formula


They excelled at persuading their bosses, regulators and the media that some of them were market neutral, meaning that they couldn’t lose money because every bet was offset by a counter-bet that would go up if the other went down.

Genius-designed or not, somehow, starting Aug. 6, 2007, the models “were operating in reverse,” Patterson writes, depicting a scene at the hedge fund AQR Capital Management LLC with the in-house brainiacs watching in a daze as losses mounted. “You know what’s going on?” one would ask, only to hear the response, “No. You?” At another hedge fund, which had placed bets on small-cap stocks, the reality suddenly hit that selling illiquid stocks in a downturn would be time-consuming and expensive.

In the meantime, Patterson writes, the ultimate horror was that the financial regulators didn’t have a clue about what was happening -- perhaps the book’s least-surprising revelation.


Computer Models Surprised


As it turns out, the collapse in the subprime mortgage market set off margin calls on funds heavily invested in subprime, and that triggered the need to sell stocks, which are relatively liquid, to meet the call. Selling pressure that the computer models hadn’t anticipated? Who knew?

Proving that they deserved their esteemed positions nonetheless, quants got moving at rationalizing the mess and warding off regulation so they could get back to business.

Hedge funds shouldn’t be forced to publicly disclose all their positions, said Citadel Investment Group LLC’s Ken Griffin in testimony to the House Committee on Oversight and Government Reform in November 2008. That would be like “asking Coca-Cola to disclose their secret formula,” Griffin told the committee. A nice try, but I’m stuck on figuring out how Coke’s secret formula has the potential to bring down the global financial system.


Some Success


Best of all: Patterson says AQR Capital Management founder Cliff Asness wrote a letter to investors on Aug. 10, 2007, noting that his was a “long-term winning strategy” despite the recent bad performance. So what was the glitch that sent the markets into a tailspin? “The very success of the strategy over time has drawn in too many investors.” In other words: We were so darned good at this that everybody tried to copy us, and that messed things up.

OK, you say, so quants can finger-point and dodge responsibility like the best of them. Everybody knows, though, that to really be part of Wall Street’s elite, you’ve got to have contempt for the little people.

Patterson assures us that the quants make that cut. As the crisis was unfolding in the summer of 2007, a group at Deutsche Bank made a big win by betting against subprime mortgages. To celebrate, the author says, traders at the bank sported gray T- shirts that read, in bold black letters, “I Shorted Your House.”

Monday, February 8, 2010

Citi reinvents end-of-the-world insurance

Original posted on Reuters by Felix Salmon:

In hindsight, one of the silliest and most dangerous excesses of the Great Moderation was the large number of companies — foremost among them AIG, although there were lots of monoline insurers in the same trade — basically selling insurance on the world coming to an end. It’s a great trade: either the world doesn’t come to an end, and you make lots of money, or the world does come to an end, and it doesn’t matter ‘cos you’re bust anyway.

Now, however, after seeing how that trade worked out, we’re wiser, and no large and leveraged financial institution would have the chutzpah to start selling world-coming-to-an-end insurance. Would they?

Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis…

“The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don’t worry about interest-rate exposures any more – they just pay a fee to hedge it,” [says Citi's Terry Benzschawel].

Like a swap, the contracts envisaged by Citi would be entered into without an up-front premium, with money changing hands according to the index’s movements around a fair strike value.

I’d forgive you if your eyes started rolling after just the first four words: the phrase “credit specialists at Citi” is not exactly the kind of thing which instills enormous confidence in analysts and investors these days. After all, it was credit specialists at Citi who ended up losing the bank billions of dollars on trades which were meant to be too safe to fail. And this trade is in many ways even worse than the one put on by AIG, because Citi doesn’t even get any insurance premiums up front, but still needs to pay out enormously in the event of a crisis.

We learned in the crash of 1987 that when financial markets start selling products which insure a portfolio against catastrophic loss, the very existence of those products can destabilize the market and make it more prone to crashing. And, of course, we learned that such insurance has a tendency not to get paid out on exactly when it’s most needed. But heaven forfend that the market should ever learn from its mistakes.

It’s crucial, in financial markets, that investors walk into risky asset classes with their eyes open, rather than kidding themselves that they can simply hedge those risks away by buying a fancy financial product from Citigroup. But the only people who can stop this from happening are the technocrats at the systemic-risk regulator we desperately need to step in and get sensible about these things. And those people, unfortunately, don’t yet exist.

And as originally posted on Clusterstock by Vincent Fernando:

It's easy to sink into knee-jerk cynicism towards any new financial product these days, but it isn't very productive.

The concept of creating insurance against risk is sound. Huge risks exist without insurance, insurance just attempts to match people with opposite risk exposures, thus hedging away some of the world's risk.

In fact companies already hedge against moderate changes in funding costs every day using interest rate swaps, which are one of the most common and well established derivatives out there. Swaps can frequently be hedged between different companies who have opposite risk exposures, thus eliminating risk for both. Vast amounts of derivatives transactions happen daily allowing companies to hedge themselves from the vagaries of markets and focus on their core operations.

Risk.net: However, there is concern from academic circles that the counterparty risks involved in such a product could create moral hazard. Chris Rogers, chair of statistical science at Cambridge University, said the only participants able to sell CLX-based products would probably be those who are too big to fail.

Thus there are concerns for these new Citi derivatives similar to those for credit default swaps that insure against bond defaults.

Yet we'd point out that credit default swaps are inherently risk-reducing products. They just got a bad wrap due to some stupid exposure accumulated pre-crisis by AIG. Even if credit default swaps didn't exist, bond defaults would still happen during a crisis, causing hideous losses to certain investors. CDSs are badly needed, and this will be shown over time as demand for the insurance protection they provide explodes over the next decade.

To address the concern above, given that we unfortunately now live in the age of too big to fail, perhaps the sale of 'financial crisis swaps' would need to be regulated in order to make sure the government doesn't have to step in and cover their losses one day, just as is happening right now with CDSs.

But let's not fear innovation just for the sake of being cynical, especially when it comes to hedging risk. It's too easy to forget all the financial advances we benefit from.

RIsk.net: "The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don't worry about interest-rate exposures any more – they just pay a fee to hedge it,"

The old 'uh oh, financial innovation, here we ago again line' is pretty tired and backwards looking.

Sunday, February 7, 2010

Housing Rebound in Canada Spurs Talk of a New Bubble

Original posted in the Wall Street Journal by Phred Dvorak:

Dominic Carrasco first tried to sell his studio apartment here in January 2009. The only offers the 42-year-old massage therapist got were well below the 166,900 Canadian dollars he'd paid for it five years earlier.

Last month, Mr. Carrasco tried again. The condominium was snapped up by the woman in charge of posting the information to the real-estate listing site, for C$209,900, or US$196,003, 40% more than the highest bid last year.

"I couldn't believe it," says Mr. Carrasco, who says he's both relieved and unsettled by his change in fortune. "If my condo can go up that much in one year, it doesn't make sense."

As the U.S. struggles to get out of its housing slump, its neighbor to the north faces a different challenge: Canada's housing recovery has been so rapid that some here are worrying about a bubble.

Last Wednesday, a housing-price index for Canada's six biggest cities posted its seventh straight monthly gain, showing home prices in November are now back to their prerecession peak. Another broader measure shows the average home price in 2009 hitting a record. Home building has picked up too, with housing starts in December jumping to their highest level since October 2008.

Canada's finance officials say they're watching home prices carefully. The finance minister in December outlined steps he can take to cool things down, if needed. The central bank last month said it is watching the booming market with "vigilance, but not alarm."

Some observers foresee trouble. "It's a mania. It's going to end badly," says Garth Turner, a former Cabinet member who just published a book predicting that prices of real estate and other assets will fall.

Several other nations have taken action over concerns that their real-estate markets are heating up too quickly. In China, a housing boom has been lifting property prices at a 20% annual rate, helping fuel economic expansion of more than 8% in 2009. As evidence of a Chinese real-estate bubble mounts, the government there has tightened controls on bank lending. In South Korea, record-low interest rates led to frenzied home buying, and the government last year lowered the maximum amount that would-be homeowners can borrow.

In Canada, nearly 40% of gross domestic product historically is generated by exports, mainly to the U.S., where economic weakness persists. To stimulate its economy, the government has focused on the domestic slice. In an effort to boost internal consumption, it has kept a key interest rate near zero—resulting in exceptionally low mortgages rates—and has offered various financial incentives and tax credits.

Consumers have responded. Average home prices in Canada have risen 23% from their trough in January 2009. Home-sales volumes are up 70% over the same period.

Canada never had the kind of bubble created by risky "subprime" home loans that the U.S. had, thanks in part to conservative lending practices. The S&P Case-Shiller index—a U.S. index of home prices in 20 cities—more than doubled between January 2000 and late 2006, then fell 33% during the economic slump. In Canada, a similar home-price index of six major cities rose 90% between 2000 and mid-2008, but fell only 9% during the slump.

Real-estate agent Heather Holmes, third from left, at a preview event for a new condominium development project in Toronto. After seeing real-estate sales drop off in 2008, Ms. Holmes says bidding wars for condominiums were back by the middle of last year.

Not everyone agrees that Canada's recent price increases are cause for concern. Bubble skeptics say they aren't yet seeing other symptoms of froth such as speculative buying, looser lending standards or a run-up in land prices. Canada's central bank and finance ministry say there isn't currently any reason for alarm.

But some economists who are concerned point out that home prices are rising far faster than other measures of economic health. The 2009 price increase of more than 20% came as personal income in Canada fell nearly 1% and total employment was 1.4% lower than the year earlier. In a December report, the Bank of Canada warned that household debt—largely mortgages—was 1.42 times disposable income during the second quarter of 2009, a record high.

Another possible danger: Because Canadian banks typically reset adjustable-rate mortgages every few years, those who are buying now at low rates will likely see increases soon. Toronto-Dominion Bank forecasts suggest that the rate to which many Canadian mortgages are pegged, the prime rate, could nearly double by the end of 2011. The Bank of Canada warned in its December report that if interest rates increase as expected, by mid-2012 about 9% of Canadian households could have so much debt that they'd be "financially vulnerable."

"This is exactly what happened in the U.S., when affordability had moved way out of whack with prices," says David Rosenberg, an economist who witnessed America's housing bubble at Merrill Lynch in New York, and now sees similar trends up north from his post at Toronto-based wealth-management firm Gluskin Sheff.

The Canadian housing market's roller-coaster ride began in September 2008 with the collapse of Lehman Brothers in the U.S. and the freeze in global credit markets.

Brad Lamb says his Toronto real-estate firm noticed a drop in buyers. Sales volume plummeted and the company lost money, he says. Heather Holmes, one of his top agents, says that at one point she was handling 17 sellers at the same time, but had only a trickle of offers, at well below asking prices. To supplement income, she started handling rentals. "There was a lot of fear," she recalls.

Vaughn Gray, one of her clients, had agreed to buy a one-bedroom apartment the week Lehman collapsed. As he was completing the paperwork, his mortgage agent called with a request to increase his down payment to 15% of the condo's value, from the 5% they'd discussed earlier. Mr. Gray couldn't produce the cash, and the deal fell through. "It was heartbreaking," recalls Mr. Gray, a concierge at a clothing retailer.

By December 2008, the average home price in Toronto was 9% below the year-earlier level, and sales volume was down 50%, the Toronto Real Estate Board reported.

[CANHOUSEfrt]

But Canada's housing slump didn't last long. In October 2008, the Bank of Canada made the first of a series of rate cuts that eventually lowered the target for its key overnight lending rate to 0.25%, which in turn reduced banks' prime rate—the basis for calculating variable-mortgage rates in Canada—to 2.25% by April 2009. In Canada, nearly all mortgages have rates that adjust at least every few years. Currently, rates on some loans have fallen to 2% or lower.

Canada never saw the wave of foreclosures that the U.S. did, and the balance sheets of Canadian banks stayed strong. As the global credit crunch began to ease at the end of 2008, Canada's big lenders, which handle the bulk of residential mortgages, started to market more aggressively.

Toronto-Dominion Bank boosted its mortgage sales force by 10%, says Tim Hockey, head of the Canadian banking operations. Don Peard, the Royal Bank of Canada's mortgage chief for Alberta, told his sales people to double the number of calls they made seeking mortgage referrals from real-estate agents and home builders.

Home sales started to rise again in February 2009. By midyear, Ms. Holmes, the Toronto real-estate agent, was seeing the kinds of bidding wars that were common in 2007.

"It's all the people that would have bought during the slowdown," she says. In September, she says, one condominium she handled had 15 offers—her personal record.

The low interest rates and the eagerness of banks to lend attracted buyers such as Cindy Gerard of Red Deer, Alberta, who invests in residential real estate to supplement the money her husband earns as a welding inspector for the oil-and-gas industry.

Ms. Gerard has been buying and renting out apartments for years. In 2009, she went into overdrive, buying six units in six months, with mortgages at rates ranging from 2.45% to 3.95%. She says she "maxed out" on the last mortgage, which pushed the family's ratio of debt service to income into the mid-40% range—above the level many Canadian lenders are comfortable with.

Ms. Gerard says she bought all the properties for below the asking prices. "Money is growing on trees these days, lending rates are so low," Ms. Gerard wrote in December in an online forum for real-estate investors. "There are loads of properties to choose from, and the banks want to lend!"

Nevertheless, with housing prices rising, recent buyers are finding deals harder to come by. Ms. Holmes, the agent, explains that a few years ago monthly mortgage payments on downtown Toronto condos were far enough below rents that investors could count on making a profit. Now, she says, new investors are more commonly just breaking even.

Bryce Wilson, an elementary-school teacher in Toronto who bought two condominiums in December, says a 20% drop in the value of his mutual funds prompted him to shift money into real estate. He's planning to rent out one property—a one-bedroom apartment in a new condo building—for C$1,500 a month, netting him C$360 a month after mortgage and maintenance fees. He says he is prepared for his 2% mortgage rate to rise. "I've budgeted for the rate doubling," he says.

[CANHOUSEjmp]

Economists at Toronto-Dominion Bank say they think current home prices are about 12% above where they should be based on income and interest trends—not enough for a bubble, they say, so long as future price increases are slowed by home building and rising mortgage rates.

Mr. Hockey, Toronto-Dominion's domestic banking chief, says housing prices are "of interest but not a concern." If the situation worsens, he says, the bank will consider steps like raising the hurdles for borrowers.

The government is mulling action too. Finance Minister Jim Flaherty has said that if it's warranted, he would consider tightening the terms for home buyers seeking government-insured loans, shortening maximum mortgage lengths from their current 35 years, or raising minimum down payments from the current 5%.

But Canada's central bankers appear reluctant to take any steps that would hurt the economy. In a Jan. 11 speech, a representative of the Bank of Canada said: "If the Bank were to raise interest rates to cool the housing market now…we would, in essence, be dousing the entire Canadian economy with cold water, just as it emerges from recession."

For now, the housing boom shows no sign of abating.

Mr. Gray, the Toronto concierge whose home deal fell through at the end of 2008, is looking again for a condo, although he's had to increase his budget to around C$350,000, from C$250,000. Ms. Gerard, the housewife in Red Deer, says she hopes to buy a seventh unit in a few months—after she pays down enough of her credit-card debt to qualify for another mortgage.

Mr. Carrasco, the Toronto massage therapist whose condo rose in value by 40% in one year, says he's glad he sold when he did.

"I think we're in a housing bubble," he says. "I'm going to put stuff in storage, rent cheap and buy again when prices come down."

A Proposed Fat-Tail Risk Metric

Posted on SSRN.com by Peter Conti-Brown:

Abstract: This paper argues that the financial regulatory reform currently debated in the U.S. Congress misses a key opportunity to address one of the central causes of the financial crisis: the failure of risk models to account for high impact, low probability events. The paper proposes a legal solution that will create a more robust metric: require mandatory disclosure of a firm’s exposure to contingent liabilities, such as guarantees for the debts of off-balance sheet entities, and all varieties of OTC derivatives contracts. Such disclosures - akin to publicly traded corporations’ filing of 10-Ks with the SEC - will allow regulators and researchers to approximate an apocalyptic, black-out, no-bankruptcy-protection and no-bailout scenario of a firm's implosion; force firm’s to maintain daily record-keeping on such obligations, a task which has proved difficult in the past; and, most importantly, will open up a crucial subset of data that has, until now, been opaque or completely invisible. With such data, researchers, over time, will develop analytical and econometric tools that better assess the consequences of remote events for individual firms and, more importantly, the economy as a whole.

Felix Salmon's comments:

The paper itself is flawed, and the details of how it’s constructed would need to be reworked from scratch. But conceptually, the FTRM I think is a good idea.

Conti-Brown’s method for coming up with the FTRM involves adding up a firm’s total netted derivatives exposure; the size of its off-balance-sheet vehicles; and its liabilities. That gives a total-risk measure; the FTRM itself is the log of that figure.

There are lots of problems here. For one thing, netting derivatives exposure effectively eliminates an enormous amount of counterparty risk. For another thing, it’s impossible to calculate: if I write a call option on a stock, there’s no limit to how much my contingent liability might be, because there’s no limit to how far that stock can rise. And off-balance-sheet vehicles are just one of a potentially infinite line of entities which remove a company’s legal liability, but where the firm can still end up paying out a lot of money in practice. Think, for instance, the money which Bear Stearns threw at its failed hedge funds, or the money which banks used to make whole the people who invested in auction-rate securities. Those things don’t look like bank liabilities, or even contingent liabilities, until it’s far too late.

But put all that to one side: one thing which doesn’t currently exist, and which would be very useful indeed, is some kind of measure of the total amount of risk in the financial system. A lot of people had a conception, pre-crisis, of some kind of law of the conservation of risk: that tools like mortgage-backed securities simply moved risk from banks’ balance sheets to investment accounts, and therefore, at the margin, actually dispersed risk and made the system safer. What was missed, however, was the fact that total risk was increasing fast, especially as house prices rose and the equity in those houses was converted into financial assets through the magic of second mortgages, cash-out refinancings, and home-equity lines of credit.

Some types of risk are more dangerous than others, of course: if there’s a stock-market bubble, then it’s easy to see that the total value of the stock market, which is the total amount that can be lost in the stock market, has risen a lot. But stock-market investments are a little bit like houses without mortgages: where there’s very little leverage, there’s also relatively little in the way of systemic risk. It’s rare to suffer great harm from the value of your house falling if you don’t have a mortgage.

Still, stock-market bubbles can cause harm, and it’s worth including equities as part of the total risk in the system, along with bonds and loans. That’s one metric which macroprudential regulators should certainly keep an eye on; Conti-Brown’s idea is then basically to try to disaggregate that risk on a firm-by-firm basis, to see which companies have the most risk and to see how concentrated the risk is in a small number of large institutions.

It won’t be easy to do that — indeed, it will be impossible to do it with much accuracy. But even an inaccurate measurement will be helpful, especially if it becomes a time series and people can see how it’s been changing over time. It’s good to know how much risk is out there — and it’s better to know that financial institutions themselves are keeping an eye on that number, and trying to measure it as part of their responsibilities to their regulator.

Thursday, February 4, 2010

Debunking Some AIG/Fed/CDO Theories

Original posted on Naked Capitalism:

One of the impediments to getting to the bottom of the financial crisis is some of the most destructive behavior involved complex instruments like collateralized debt obligations and credit default swaps. It isn’t simply that these “innovations” had terms and features that differ from familiar investments like stocks and bonds, but the way those instruments were used, both the trading/investment strategies and transaction mechanics, also differ from those of more traditional instruments.

This matters because it is very easy to go off half cocked, and that in the end serves the financial services industry, not the cause of reform.

I assume most if not all readers are upset about the sorts of things that happened and are happening in finance. But we need to remember what we are up against. The lobbyists paid by the financial services industry to kill reform are professionals. And so far, they have done a very effective job.

So even though the enthusiasm for identifying suspicious-looking activity is understandable, if the pro-reform camp is not careful and pursues flights of fancy that are unsupported by hard evidence, or simply
overstates what it has proven, then it plays into the hands of banking industry lobbyists. It makes it easy for them to paint critics as not credible, thereby hurting efforts to rein in the industry.

Some of the discussion around the Fed/AIG chicanery falls into this camp. Now it seems almost without question that if more rocks were turned over at AIG, more creepy crawlies would emerge. Why had the Fed gone to such lengths to keep transaction-level detail at Maiden Lane III secret? Why were those CDOs bought at all? Why was Goldman so heavily involved in these transactions (both directly, via CDS it had with AIG, and indirectly, via CDOs it had created but were held by other banks?). Many of these deals were created when Paulson was CEO of Goldman; why hasn’t this aspect of his many conflicts in dealing with his former firm been probed more deeply?

And where was the Fed? CDS were a known systemic risk as of the Bear rescue; any reasonable look at that market would have led straight to AIG. The “we weren’t their regulator” excuse is spurious; they regulated AIG’s counterparties and could easily have connected the dots, particularly since the monolines were on the ropes as of early 2008.

That’s a mere starter list, but it illustrates that there are many fruitful lines of inquiry on the AIG/Fed front. But then we have some lines of attack that are wide of the mark.

I hate personalizing this discussion, but one example comes in a series of posts by David Fiderer. He’s tried digging into AIG transaction details, which is a worthwhile undertaking. However, his eagerness to come up with attention-grabbers had led him to make charges that are contradicted by other evidence or CDO market practice. While he has raised some questions, unfortunately, they do not shed any new light on these bigger, more pressing issues and may in fact confuse them.

Let’s take some examples from a recent post, starting at the top:

Did Societe Generale ever view its $1.2 billion investment in Adirondack 2005-2 as a buy-and-hold proposition? Or was the bank’s original intention to offload the risk on to AIG? The answer is central to our understanding of the portfolio of collateralized debt obligations, or CDOs, that wiped out the insurance behemoth. The circumstances of SG’s, and other banks’, holdings, suggest that CDO market was a Potemkin’s Village, a facade constructed to give the illusion of economic substance to a series of sham transactions.

Huh? These transactions in the end proved to be colossally stupid, both from the AIG and the SocGen perspective, but you need a lot more to prove nefarious intent.

First, buyers of AAA tranches of CDOs often got credit protection. That alone should in theory raise eyebrows, but it was hardly unusual, let alone devoius, particularly when the packager/guarantor that retained the position was a European bank. It was very common for European banks to hang on to the AAA tranches of CDOs, both those made primarily of residential real estate (called ABS, for asset backed securities, CDOs) and commercial real estate (CRE CDOs). Why? They had a great deal of latitude in how much (meaning how little) equity they were required to hold against AAA paper under Basel II rules, and when they hedged AAA paper with an insurance policy from an AAA counterparty like AIG, they held no equity against the position (and some banks even gave favorable treatment to guarantees from lower-rated insurers like ACA).

This regulatory capital treatment led to a good deal of behavior that was dysfunctional and destructive, but to suggest it was unusual is simply incorrect.

In keeping, Fiderer has focused on the largest CDOs that ultimately were bought by the Fed via Maiden Lane III. These were two transactions, MAX 2007 1 A-1 and MAX 2008 1 A-1, each disclosed in the Maiden Lane III financial statements, both commercial real estate CDOs (thus not part of the infamous “multi sector CDO portfolio”, click to view full image):
Picture 32

Fiderer’s comments:

The biggest and most obvious example, disclosed last May, was Max 1. Deutsche Bank underwrote the $5.8 billion deal, and held on to $5.4 billion, a 94% share. This should have been a big story at the time. Max I was one of the largest CDOs ever underwritten, and the fact that Deutsche would have attempted to bring such a deal to market in June 2008, when everyone was feeling skittish about real estate securitizations, would have been notable in and of itself. Yet Deutsche was unable to sell off more than a tiny part of the deal. The fact that the underwriting failed should have been even bigger news. However no one paid much attention, since no public disclosure was required. Deutsche quietly offloaded its risk exposure to AIG Financial products.

Yves here. Fiderer is similarly wrong about the role this deal served for AIG. This deal appears never to have been intended to be “brought to market” and in fact was designed with AIG’s cooperation, possibly even at AIG’s instigation. These comments come in a BlackRock memo to AIG in early November on the AIG exposures:

“Deutsche is financing AIG’s position in 2a7 deals, including Project Max (which comprises the vast majority of Deutsche’s portfolio with AIG)

” AIG believes there are no early termination penalties for ending this funding facility.

“If it were not terminated, Deutsche Bank’s financing would roll off in 3 to 6 years in a staggered fashion (and AIG would fund the reference CDOs piecemeal over that period)”

“Deutsche has not been approached to unwind the facility because of the liquidit beneift that Deutsche has provided to AIG”.

This was not a typical CDO; even with the collateral calls against the MAX CDOs, AIG was still getting net liquidity from these deals. Indeed, AIG had entered into these transactions as a way to raise cash. In fact, AIG was not interested in unwinding these deals, and unlike its other CDOs, AIG had not had BlackRock, its advisor, approach its counterparties about a settlement.

While the details are opaque, it seems that these deals were designed explicitly to provide funding to AIG, and was still perceived by AIG to be on balance beneficial even the in the fact of collateral calls. Given the length of the financing facility, one can presume Deutsche never intended to sell this CDO; it’s apparently collateral for secured funding. These deals look to have had their own unique set of circumstances and do not fit in with the rest of the story. Fiderer looks to be off on wild goose chase in characterizing the MAX deals as hung transactions.

Fiderer again treats bull market greed and blindness as something more nefarious:

By the standards of any normal bond underwriting, Goldman’s inability to sell down either Altius 2 or West Coast Funding would have been viewed as a conspicuous failure. And such news would have inhibited other banks and investors, including monoline insurers, from taking on incremental CDO exposures.

Had the subprime CDO market shut down in 2006, would there have been any ripple effect on other financial markets or the real economy? It’s doubtful, since the CDOs were not financing anything new. They merely repackaged versions of mortgage bonds that had already been sold into the marketplace.

Yves here. This is inaccurate in several respects. First, finding an insurer was one of the key requirements for launching a CDO, just as finding someone to take the equity tranche. In terms of timing, the credit default swap would close on the same day as the CDO or within a few days, but the CDS was integral to getting the CDO done. And remember, the CDS was only on the top tranche, not the entire deal.

So Fiderer claims that the CDO market would have shut down had the insurers realized that the banks were retaining a lot of the insured tranches. Really? The banks were selling, not retaining the lower-rated tranches. Those investors would take losses before the AAA CDO holder and the guarantors did. Had the insurers found out the sponsors were keeping the AAA tranaches, the bankers would no doubt have protested, “Yes, we are keeping this deal because we like it.” And given how keen everyone was to keep dancing as long as the music was playing, it’s doubtful that any monoline would have questioned this sort of answer.

Second, Fiderer has this bit wrong: “They merely repackaged versions of mortgage bonds that had already been sold into the marketplace.” CDOs were essential to the subprime market. They did not “repackage bonds that had been sold.” They were the means for selling the tranches of subprime RMBS that would otherwise go unsold.

While the equity tranche of subprime bonds had a loyal following among some hedge funds (the equity tranche paid down quickly when a deal worked out according to plan, and also received the overcollateralization and excess spread), the BBB tranche was not very well loved, and the A and AA tranches were not too popular either. So CDOs were the way to sell these unwanted bits, to recombine them and make them look more appetizing through structured credit alchemy. Thus the continued growth of the subprime market depended on the ability to place CDOs. This may in part explain why investment banks like Goldman and Merrill were willing to retain the insured AAA tranches: it would keep the CDO machinery going, which was necessary to the subprime business.

There are a lot of unanswered questions, both around the Fed bailout of AIG, and the CDO market in general. And the relationships among the counterparties on the deals are worth examining; they look unusual, and some patterns suggest that banks may have been working together on particular programs. But even though the additional information released by Rep. Darrell Issa, who has led the effort to force more disclosure of the AIG bailout has been helpful, it still falls short of what is needed to understand the motives and logic of the main actors, not just the banks themselves, but the individuals involved in the resuce: Paulson, Geithner, Bernanke, and their overly-close advisor, Blankfein.

Wednesday, February 3, 2010

When Goldman Sachs hates marking to market

Original posted on Reuters by Felix Salmon:

The most ridiculous sentence I’ve read today comes from Goldman Sachs, protesting against proposals that money-market funds should be marked to market. But first let’s remember what Goldman CEO Lloyd Blankfein has to say about marking to market:

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in positions that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions. We mark-to-market, not because we are required to, but because we wouldn’t know how to assess or manage risk if market prices were not reflected on our books.

Now read this, from his employee James McNamara:

We do not believe that disclosing shadow prices or market-based prices of portfolio securities would be informative to investors… Investors who perceive a NAV differential between two money market funds may wrongly assume that the fund with the lower market NAV is experiencing a material credit or liquidity problem. This may result in destabilizing — and unnecessary — levels of redemption activity in that fund, which could infect other funds managed by the same adviser or other funds as well. The Commission should be mindful of this type of unintended consequence before adopting regulations mandating the disclosure of market-based NAV’s and market-based pricing of portfolio securities.

When Goldman Sachs reduces its positions as a result of declining market prices, then, that’s a necessary, if difficult and sometimes painful, discipline. When investors in money-market funds do the same thing, however, that’s destabilizing and unnecessary. Alles klar?

David Reilly makes short shrift of such hypocrisy in his column today, and adds something important:

The industry’s case against floating values is that investors would pull cash out of money-market funds because they want investments with a stable value. That, the argument goes, would deprive American companies of a vital source of funding, since money-market funds are big buyers of short-term commercial paper issued by companies.

That is a well-worn ploy from the financial-services industry to counter any change that cuts into business. Banks used this tactic effectively in 2003 and 2004, for instance, to pressure the Financial Accounting Standards Board to water down rules that would have limited banks’ ability to use off-balance- sheet vehicles.

The result was out-of-control securitization and under- capitalized banks, both of which played huge roles in crashing the financial system.

The fact is that higher short-term funding costs for large corporations are a feature, not a bug, in terms of moving money-market funds to floating NAVs. Goldman might like to bellyache about “the diminished supply of short-term credit to corporations” that might result, but short-term credit is always the most systemically-dangerous form of credit, since it can dry up with no warning and cause a major liquidity crisis.

More generally, it’s both silly and far too easy for banks to cry “more expensive credit!” every time that anybody proposes tightening regulations on anything from credit cards to prop trading. Yes, it is true that decades of financial-sector deregulation led to cheaper credit, in the financial industry, in the housing market, in the private-equity world, and elsewhere. This was not a good thing. $1 NAVs obscure the risks inherent in money-market funds, and a sensible regulatory overhaul would put an end to them.