PrefBlog

There’s a wonderful article on risk models by Avinash Persaud at VoxEU:

Alan Greenspan and others have questioned why risk models, which are at the centre of financial supervision, failed to avoid or mitigate today’s financial turmoil. There are two answers to this, one technical and the other philosophical.
…
The technical explanation is that the market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them.
…
In today’s flat world, market participants from Argentina to New Zealand have the same data on the risk, returns and correlation of financial instruments, and use standard optimisation models, which throw up the same portfolios to be favoured and those not to be.
…
observation that market-sensitive risk models, increasingly integrated into financial supervision in a prescriptive manner, were going to send the herd off the cliff edge was made soon after the last round of crises.
…
If the purpose of regulation is to avoid market failures, we cannot use, as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator.

There are certainly a lot of advisors out there calling themselves quants without deserving the title! Pseudo-quants are entirely capable, I assure you, of producing a system that outputs a simple buy/sell signal, with no allowance for buy price and sell price.

“Cliff Risk” was referred to by BoC governor Carney in his speech to the Toronto Board of Trade that has been reviewed on PrefBlog. He was referring to credit ratings and changes thereof, but the principle is the same:

Finally, it appears possible that the incentives provided by a series of regulations may have encouraged crowded trades. The so-called “cliff risk” created by the mandated use of ratings is one example. A paradox of the current turbulence is that a desire to shelter in the perceived safety of AAA-rated assets led to a dangerous explosion in the supply of synthetically created AAA-rated assets. Since many of these assets were financed by excessive leverage and many participants were constrained by mandates to sell on downgrades, the rush to the exits has proven extremely destabilizing.

Frankly, while I’m willing to believe Professor Persaud’s characterization of the modelling environment, I want to see more detail before I endorse his views unreservedly. If all preferred share market participants blindly followed HIMIPref™, for instance, then all issues would trade within a band, within which all participants would be indifferent to holding or not holding the issue. There would be some cliff risk upon changes in credit rating, but not really all that much.

My hypothesis until then is that models have acted far to quickly to promulgate contagion. KVM pricing models for bond defaults have made the corporate bond market far too sensitive to changes in common stock price (see references in the PrefBlog CDS Primer); while the common stock price has become hugely sensitive to the procyclical change engendered by mark-to-market accounting.

And it’s not at all clear that crowded trades can be blamed exclusively on quant models anyway … right on cue, Bloomberg reports that Buy Wal-Mart, Sell Goldman Becoming Easiest Trade … typical stockbroker tell-me-a-story pablum.

In the end, it doesn’t matter, does it? Andrew Willis of the Globe asserted yesterday that:

In 2007, the Teachers fund was up 4.5 per cent, compared with the composite benchmark’s 2.3-per-cent return.

In the past, critics have taken issue with the fact that Teachers executives earn the same pay as private sector peers, without having to actually go out and raise the money they invest.

I’d be a lot happier if there were names and references attached to the “critics”, but that is the mindset of the industry. What is paid for is the ability to bring in money. Performance is a flat fee, to be enjoyed by anybody who hangs up his shingle. How many of these so-called critics have a performance track record anywhere close to that enjoyed by Teachers’? And why doesn’t it matter?

Updating my posts on the David Berry situation brought to mind one of the allegations against him:

Market participants had no knowledge of Berry and McQuillen selling shares in the new issue to clients once the shares opened for trading. They only saw Berry and McQuillen buying the shares, which is consistent with an accumulation strategy. This had the potential to mislead other market participants as to the true nature of the demand for the stock, and affect their subsequent investment decisions.

In other words, RS sees as one of its purposes the encouragement of cliff trades. Scotia’s accumulating? Holy smokes, we’d better jump right in! Fundamentals be damned, cries RS!

Naked Capitalism republishes an article on foreclosure rates … the foreclosure process is now a bottleneck:

The number of borrowers at least 90 days late on their home loans rose to 3.6 percent at the end of December, the highest in at least five years, according to the Mortgage Bankers Association in Washington. That figure, for the first time, is almost double the 2 percent who have been foreclosed on.

Lenders who allow owners to stay in their homes are distorting the record foreclosure rate and delaying the worst of the housing decline, said Mark Zandi, chief economist at Moody’s Economy.com, a unit of New York-based Moody’s Corp. These borrowers will eventually push the number of delinquencies even higher and send more homes onto an already glutted market.

“We don’t have a sense of the magnitude of what’s really going on because the whole process is being delayed,” Zandi said in an interview. “Looking at the data, we see the problems, but they are probably measurably greater than we think.”

Lenders took an average of 61 days to foreclose on a property last year, up from 37 days in the year earlier, according to RealtyTrac Inc., a foreclosure database in Irvine, California. Sales of foreclosed homes rose 4.4 percent last year at the same time the supply of such homes more than doubled, according to LoanPerformance First American CoreLogic Inc., a real estate data company based in San Francisco.

The US Jobs number came out today and the bad news was good for bonds, albeit with something of a lag. Econbrowser‘s Menzie Chinn was more interested in the revisions.

Remember SIVs? There was some news about the Sigma SIV today:

Gordian Knot Ltd.’s $40 billion Sigma Finance Corp. had its Aaa credit rating cut five levels by Moody’s Investors Service as the value of its assets fell, increasing the risk the credit fund may have to be wound down.

Moody’s downgraded Sigma’s long-term debt to A2, the ratings company said in a statement today. The investment company’s short-term debt rating was lowered to Prime-2 from Prime-1. The downgrades affect $23 billion of debt.
…
Sigma must refinance $20 billion of debt by September, Moody’s said. The company has been funding itself by borrowing through repurchase agreements, selling holdings and swapping assets with bond investors, Moody’s said.

The credit fund has $14 billion of repurchase agreements, contracts that allow it to raise cash by pledging collateral it agrees to buy back at a later date. Sigma has exchanged $4 billion of assets with investors in so-called ratio trades and sold $9.5 billion of its holdings into the market, Moody’s said.

Something of a sleepy day for the preferred market – little volume and little movement, although there was the usual quota of outliers to keep things interesting.

There were seven other index-included $25-pv-equivalent issues trading over 10,000 shares today.

This entry was posted on Friday, April 4th, 2008 at 8:52 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.