PrefBlog

If I don’t give myself a way of finding this article quickly, I’m going to go out of my mind! I think this is a very good exposition of the stocks/bonds conundrum, and regularly spend half an hour looking up the reference – no more!

How Long is a Long-Term Investment? was written by Pu Shen of the Kansas City Fed and published in the Spring 2005 edition of their Economic Review.

Unfortunately, the source-file is copy-protected (why do they do that?) but I can recommend this article as part of the asset allocation process; it has many fascinating graphs. The laboriously re-typed conclusion is:

This article confirms the conventional wisdom that in the United States stocks historically have been safer than long-term government bonds for investors with long holding periods. But the article also shows that the conventional wisdom has only been true for investors who held their portfolios for more than 25 years. For practical purposes, that may be too long a holding period for most investors. Over the years, for investors who have held their portfolios for shorter periods, both stocks and bonds were exposed to substantial risks, and stocks did not necessarily outperform government bonds. This implies that in making asset allocation decisions, investors should think carefully about how long they will be able to hold their portfolios undisturbed and how much risk they are willing to bear.

Update: A little bird has sent me an unlocked version of the paper, so I can reproduce my three favourite graphs:

The Bank for International Settlements has announced the release of Working Paper #279, The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices by Ingo Fender and Martin Scheicher.

This paper investigates the market pricing of subprime mortgage risk on the basis of data for the ABX.HE family of indices, which have become a key barometer of mortgage market conditions during the recent financial crisis. After an introduction into ABX index mechanics and a discussion of historical pricing patterns, we use regression analysis to establish the relationship between observed index returns and macroeconomic news as well as market-based proxies of default risk, interest rates, liquidity and risk appetite. The results imply that declining risk appetite and heightened concerns about market illiquidity—likely due in part to significant short positioning activity—have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007. In particular, while fundamental factors, such as indicators of housing market activity, have continued to exert an important influence on the subordinated ABX indices, those backed by AA and AAA exposures have tended to react more to the general deterioration of the financial market environment. This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors such as risk appetite and liquidity risk, particularly in periods of heightened market pressure. In addition, as related risk premia can be captured by unconstrained investors, ABX pricing patterns appear to lend support to government measures aimed at taking troubled assets off banks’ balance sheets—such as the US Troubled Asset Relief Program (TARP).

The authors observe:

With market liquidity vanishing and entire market segments becoming largely dysfunctional, factors other than credit risk became increasingly important drivers of observed prices. This, in turn, rekindled earlier doubts concerning the validity of currently available models for the pricing of credit risk, particularly for portfolio instruments such as mortgage-backed securities and other complex securitisations.

The results presented in this paper suggest that declining risk appetite and heightened concerns about market illiquidity have provided a sizeable contribution to the observed collapse in ABX prices since July 2007. While fundamental factors, such as indicators of housing market activity, have continued to exert an important influence on the subordinated ABX indices, the AA and AAA indices have tended to react more to the general deterioration of the financial market environment, such as declining risk appetite and market liquidity. These results underline the well-established view that risk premia are important components of observed prices for default-risky products, and that the relative importance of non-default risk factors will tend to increase in periods of strong repricing of credit risk. This suggests that theoretical pricing models that do not sufficiently account for these factors may be inappropriate, particularly in periods of heightened market pressure.

Assiduous Readers will be well aware that I often include articles in the blog for no other reason than to bookmark them. Having just spent twenty minutes trying to find this article after reading it some time ago, it is clear that I shall have to redouble my efforts!

Paul Fulcher of UBS and Colin Wilson of Barrie & Hibbert wrote a nice summary regarding credit spread decomposition for The Actuary, titled Financial Crisis: The Value of Liquidity. I thought they made the central point very well:

The spread on corporate bonds over the liquid risk-free rate (for example, government bonds) represents compensation for several different factors:

A Expected default losses
B Unexpected default risk, such as default and recovery rate risk
C Mark-to-market risk, such as the risk of a fall in the market price of the bond
D Liquidity risk, such as the risk of not finding a ready buyer at the theoretical market price.

Investors concerned with the realisable value of their investment in the short-term require compensation for all these risks.

However, investors who can hold bonds to maturity need compensation only for A and B. Such investors can enjoy the premiums for C and D, and we refer to these collectively as a ‘liquidity premium’.

There are some good references, too:

• Presentations at the Open Forum on Liquidity Premia, November 2008
• Credit Derivatives by the Derivatives Working Party, presented to Faculty in January 2007
• Decomposing corporate bond spreads by Webber and Churn, Bank of England Quarterly Bulletin 2007 Q4 (this has been discussed on PrefBlog)
• Decomposing credit spreads by Churm and Panigirtzoglou, Bank of England Working Paper no. 253

The Office of the Comptroller of the Currency has released its Quarterly Report on Bank Trading and Derivatives Activities. Credit trading has been a disaster:

A commercial banks was reasonably strong in the fourth quarter, the quarter was particularly difficult for number of reasons, and banks reported a sizable trading loss of $9.2 billion. Market liquidity suffered in the fourth quarter of 2008 and general economic conditions worsened, resulting in escalated write-downs in legacy credit positions, including CDOs, leveraged loans and mortgage-related exposures. These write-downs flowed through trading revenues and dwarfed the underlying strength in trade profitability from wide bid-ask spreads.

Trading results in the fourth quarter also suffered due to an unfavorable combination of rising overall corporate credit spreads and declining credit spreads for the bank dealers themselves. Rising counterparty credit spreads increase the risk of derivatives receivables. Banks account for this increased risk by lowering the fair value of those receivables. Banks report the rising credit costs associated with a write-down of receivables values as trading losses. While these higher credit costs are a part of operating a derivatives business, they can (and in the fourth quarter did) mask otherwise profitable trading operations. Typically, when credit spreads increase, much of the negative impact on bank trading results from write-downs of receivables can be offset by writedowns of derivatives payables. However, in the fourth quarter, government support for the banking industry resulted in lower bank credit spreads. As a result, the fair value of bank derivatives payables increased, and therefore banks reported additional trading losses.

This “net” current credit exposure is the primary metric used by the OCC to evaluate credit risk in bank derivatives activities. A more risk sensitive measure of credit exposure would also consider the value of collateral held against counterparty exposures. While banks are not required to report collateral held against their derivatives positions in their Call Reports, they do report collateral in their published financial statements. Notably, large trading banks tend to have collateral coverage of 30-40% of their net current credit exposures from derivatives contracts.

Continued turmoil in credit markets has led to deterioration in derivatives-related and loan credit metrics. The fair value of derivatives contracts past due 30 days or more totaled $363 million, up $302 million from the third quarter. Past due contracts were 0.05% of net current credit exposure in Q4, up from 0.01% in the third quarter. During the fourth quarter of 2008, U.S. commercial banks charged-off a record $847 million in derivatives receivables, or 0.10% of the net current credit exposure from derivative contracts, up from the 0.02% in the prior quarter. [See Graph 5c.] For comparison purposes, Commercial and Industrial (C&I) loan net charge-offs rose to $5.5 billion from $3.0 billion and were 0.4% of total C&I loans for the quarter, nearly double the ratio of the third quarter.

The report has many fascinating graphs.

The FDIC has release a Revised 4Q08 QBP with the explanation:

Shortly after the original release of the Fourth Quarter 2008 Quarterly Banking Profile, amended financial reports were received that significantly changed aggregate fourth quarter and full year earnings. Accordingly, this issue has been updated from the original release to reflect the changes. Updated results include substantially higher charges for goodwill impairment in the fourth quarter, which affected the industry’s aggregate net income and total equity capital. As a result of the amended reports, the industry’s fourth quarter net loss widened from $26.2 billion to $32.1 billion, and net income for all of 2008 was revised from $16.1 billion to $10.2 billion.

The cheery headlines are:

• Industry Reports First Quarterly Loss Since 1990
• Provisions for Loan Losses Are More than Double Year-Earlier Total
• Average Net Interest Margin at Community Banks Falls to 20-Year Low
• Full-Year Earnings Fall to Lowest Level in 19 Years
• Quarterly Net Charge-Off Rate Matches Previous High
• Noncurrent Loans Register Sizable Increase in the Fourth Quarter
• Reserve Coverage Ratio Slips to 16-Year Low
• Goodwill Writedowns Produce Drop in Total Equity Capital
• Balances at Federal Reserve Banks Increased by $342 Billion in the Quarter
• Deposit Share of Asset Funding Rises
• Trust Activities Receded in 2008
• Failures and Assistance Transactions Rose to 15-Year High in 2008

The breakdowns by type of bank are fascinating. For instance, almost all of the industry’s (8,305 institutions, assets $13,847-billion) profits were made by 26 credit card banks (assets $513-billion) and 5 international banks (assets $3,410-billion).

The Investment Industry Association of Canada has released its Securities Industry Performance Report, 4Q08 with the highlights:

• Operating revenues and profits fall 7% and 46% respectively from previous quarter and 15% and 39% from 2007.
• Margin borrowing hits five year low as client debt margin outstanding falls to $8.8 billion at year end
• Investment banking revenues drops back 33% for the year.

I found the commentary regarding proprietary trading to be of most interest:

Mixed results were witnessed in the principal trading business– while fixed-income desks experienced recent high revenue, their equity counterparts suffered a recent record low. Bond traders were successful in re-balancing inventory positions in advance of changing credit market conditions and were able to earn trading profits in 2008. Equity trading however suffered trading losses of $11 million on the year, the worst showing since 1990.

That’s the danger of day-trading. It’s immensely profitable through the cycle – but you have to have the capital to survive a bad year … or two.

The Bank of England has announced:

The 2009 Q1 issue of the Bank of England Quarterly Bulletin is published today. It contains the following articles and reports:

• Foreword, by Spencer Dale, Chief Economist and Executive Director – Monetary Analysis and Statistics, Bank of England.
• Markets and operations. This regular quarterly commentary discusses recent developments in global capital markets. It also reviews the Bank’s official operations.
• Price-setting behaviour in the United Kingdom: a microdata approach. This article examines how often prices change and how much they change by analysing data on individual price quotes. The evidence suggests that, on average, prices change once every four to five months. Evidence from higher frequency supermarket data suggests that prices change more often than this – once every two weeks. More generally, the work shows that the frequency of price changes varies across different sectors and product groups.
• Deflation. This article examines the different economic costs associated with deflation. It explains that it is important not to confuse the economic costs associated with the circumstances that caused prices to fall with the costs of deflation itself. The costs of deflation are most likely to be associated with debt deflation and downward nominal wage rigidities. But if policy responds sufficiently promptly and decisively then these costs are likely to be modest and short-lived.

The report contains the usual high-quality BoE research and commentary.

While interesting and valuable, the decomposition of the LIBOR spread into credit and non-credit components is fishy in the extreme. As explained in the box on page 498 of the 2007-Q4 Bulletin, the decomposition relies on the CDS spread being a perfect estimate of credit qualtiy – which we know is not true since there is a huge component of non-credit pricing in related bond prices … which in turn rely on equity prices as being a perfect valuator of a company’s assets. These calculations simply measure the degree of internal consistency between the various markets, but if the linchpin is removed, you’re not left with much.

After all, stock prices are determined largely by the sentiments of stock-brokers and, as Assiduous Readers will know, if a stockbroker gives you a choice between investment advice and having lunch … pick lunch.

There are a lot of great charts and commentary in the Bulletin and I won’t reproduce them all. I’ll just close with a topic near and dear to preferred share investors: Tier 1 vs. Sub-Debt spreads:

The Bank for International Settlements has announced the release of its Quarterly review, chock full of heartwarming stories:

• Overview: Investors ponder depth and duration of global recession
• Highlights of international banking and financial market activity
• Assessing the risk of banking crises – revisited
• The US dollar shortage in global banking
• US dollar money market funds and non-US banks
• Execution methods in foreign exchange markets

One sign of dysfunctionality, which has been highlighted but not quantified by PrefBlog, is the CDS Basis:

At the same time, signs of dysfunction continued, highlighting the fragile state of market conditions and investor sentiment. The fragility was apparent, for example, in measures such as the CDS-cash basis, which reflects the pricing differential between CDS contracts and corresponding cash market bonds. Though not as pronounced as in the aftermath of the Lehman Brothers bankruptcy, the basis remained unusually wide in the new year, suggesting that arbitrage activities that would usually tend to compress the price differential continued to be constrained by elevated capital and financing costs for leveraged investors (Graph 2, right-hand panel). Similar effects were observed elsewhere, as evident from high and variable liquidity premia in the markets for government bonds and swaps (see bond market section below).

In a normal world (subject to caveats about creditor status, a la Lyondell), one should be relatively indifferent as to whether one holds a cash bond or a BA+CDS package. This is not a normal world.

Also of interest is the relative size of writedowns vs. capital injections:

We talk about sub-debt and Innovative Tier 1 Capital a lot on this blog … BIS notes:

Subordinated bank CDS spreads, in turn, remained under pressure from uncertainties about the implications of government interventions for investors in lower-seniority debt instruments, including the treatment of hybrid securities issued to bolster banks’ capital positions. Earlier investor concerns over a large issuer’s decision not to call outstanding hybrid securities at the contractual redemption date, in contrast, eased after other borrowers decided to redeem their issues. Related fears about extension risk (ie the risk of maturities on similar securities being extended beyond the agreed call dates) had fed into the markets for subordinated CDS, which are widely used to hedge hybrid instruments

… and TIPS are also of interest:

Technical factors also continued to influence break-even inflation rates in major industrialised countries. While expected rapid disinflation contributed to falling break-even rates at shorter horizons, much of the recent movement in long-term break-even rates seemed to be due to factors not directly linked to inflation expectations. These included rapid unwinding of positions, intense safe haven demand for the liquidity of nominal Treasuries and rising liquidity premia in index-linked bonds, all of which helped push break-even rates to unusually low levels (see box). However, with some of these forces easing in early 2009, break-even inflation rates began to edge upwards from their lows.

The box discusses the importance of technical factors and – again! – the differing behaviour of swap instruments that do not tie up cash:

Linked to these liquidity effects, and to some extent indistinguishable from them, are technical market factors, which also appear to have been important drivers of break-even rates recently. Such factors include sell-side pressures from leveraged investors that were forced to unwind inflation-linked bond positions in adverse market conditions, which in turn resulted in rising real yields and hence falling break-even rates.

Evidence from inflation swap markets can shed some light on the importance of these effects. An inflation swap is a derivative instrument that is similar to a regular interest rate swap. However, instead of exchanging a fixed payment for a variable payment linked to a short-term interest rate, the inflation swap links the variable payment to a measure of inflation, typically the accrued inflation over the life of the swap. The fixed leg of the inflation swap therefore provides a direct break-even inflation “price”, which is unaffected by any differential liquidity conditions in nominal and real bond markets or by flight-to-liquidity flows.

The paper on the US dollar in international banking has some great graphs showing the gross up of the non-domestic-currency balance sheets of various banks:

The analysis suggests that many European banking systems built up long US dollar positions vis-à-vis non-banks and funded them by interbank borrowing and via FX swaps, exposing them to funding risk. When heightened credit risk concerns crippled these sources of short-term funding, the chronic US dollar funding needs became acute. The resulting stresses on banks’ balance sheets have persisted, resulting in tighter credit standards and reduced lending as banks struggle to repair their balance sheets.

On a related note, the paper on Money Market Funds claims:

In sum, the run on US dollar money market funds after the Lehman failure stressed global interbank markets because the funds bulked so large as suppliers of US dollars to non-US banks. Public policies stopped the run and replaced the reduced private supply of dollars with public funding.

… and …

Records of the mid-2008 holdings of the 15 largest prime funds (Table 1), accounting for over 40% of prime funds’ assets, show that the funds placed half of their portfolios with non-US banks. Thus, such US money market funds’ investment in non-US banks reached an estimated $1 trillion in mid-2008 out of total assets of over $2 trillion. To this can be added one half of the assets of European US dollar funds represented by the Institutional Money Market Fund Association, about $180 billion out of $360 billion in early September 2008.

Overall, European banks appear to have relied on money market funds for about an eighth of their $8 trillion in dollar funding. By contrast, central banks, which invest 10–15% of US dollar reserves in banks (McCauley (2007)), provided only $500 billion to European banks at the peak of their holdings in the third quarter of 2007. Given these patterns, any run on dollar money market funds was bound to make trouble for European banks.

… and …

As investors in short-term debt, MMFs are important providers of liquidity to financial intermediaries through purchases of certificates of deposit (CDs) and commercial paper (CP) issued by banks, and through repo transactions. For example, MMFs held nearly 40% of the outstanding volume of CP in the first half of 2008. Consequently, when MMFs shift away from these assets into safer ones, funding liquidity for financial institutions can be affected.

The run focussed on non-bank-sponsored MMFs:

The largest redemptions occurred at institutional prime funds managed by the remaining securities firms and small independent managers, which investors doubted could support their funds. Two-day redemptions at the largest institutional prime fund managed by the three largest securities firms were 20%, 36% and 38% of assets, well above the 16% average. By contrast, the largest such funds managed by affiliates of seven large banks met two-day calls of 2%, 5%, 5%, 7%, 10%, 10% and 17% of assets (Graph 4, right-hand panel). On 21 September, Goldman Sachs and Morgan Stanley announced plans to become bank holding companies; Bank of America had announced its purchase of Merrill Lynch on 15 September. American Beacon, an independent money fund spun off by American Airlines, faced two-day redemptions of 46% of its assets and resorted to in-kind redemption.

The authors refer to the Volker report (that I enthusiastically endorse, at least the MMF parts):

Some former policymakers and current market participants, however, have called for money market funds that offer transaction services, withdrawal on demand and a stable net asset value to be organised and supervised as banks with access to last resort lending (Group of 30 (2009)). Further, they would require any short-term funds that were not thus organised and supervised to have a floating net asset value.

Also, as I wrote in an essay, bank sponsored MMFs should be consolidated with bank assets for risk-weight and leverage purposes.