PrefBlog

Accrued Interest wrote an interesting post regarding market volatility, which is particularly timely in view of kaspu’s question in the November 15 comments. He reviews the constant 1-2% moves in the market (“Sub-prime’s over!” “Sub-prime’s worse!” “Buy!” “Sell!”) and concludes that as far as day-to-day excess volatility is concerned:

So if the market isn’t manic-depressive, and fundamental buyers don’t tend to jump in and out of their investments from day to day, who really is moving the market and why?The answer is so-called fast money. Mostly prop desks at the big dealers and some hedge funds.

I will agree that these players have a big influence; but will note that sometimes “real money” accounts hire “hot money” traders and, for better or worse, a huge pension fund can be taking a completely speculative ten-minute position. Lots of pension funds are explicitly invested in hedge-funds, for example, so the taxonomy becomes a little confused.

Other influences should not be disregarded. There are, for instance asymettric asymmetric rewards to stockbrokers: say that an issue that should be at $20 is trading at $18. After getting all their information and advice together, they are as sure of this as they will be of anything. But … say this thing is a pref that might default. If it goes to $20, they’ve made 11% on the investment and the client’s a little happier than otherwise. If it defaults, they lose the client. So they sell. Asymettric Asymmetric and non-aligned risk/reward profiles! If it subsequently defaults, they’ve got something to discuss with their clients for the next twenty years or so. If it subsequently goes to $20, they can simply emphasize how lucky the company was to avoid default and how no rational conservative investor would take such chances.

I myself have had extremely frustrating discussions with clients who want to sell something because it has gone down. If they sell it, they won’t have to worry about it any more. End of analysis.

Be that as it may, I think there’s some stuff left out of that; most notably that prices are set by the marginal buyer and seller. Royal Bank shares have a volume of what, maybe 2.5-million shares a day? The TSX advises that 1,276,215,683 common shares are outstanding, so daily volume is, on average, about maybe 0.2% of outstanding. So if Royal Bank goes up 2%, we can say that this is because investors worth 0.2% of the company decided it was worth 2% more, but holders of 99.8% of the company didn’t change their minds. There is no reason why every single one of the 0.2% minority can’t be real money.

It should be emphasized here that a great many models of efficient markets assume infinite liquidity – and infinite liquidity does not exist. If I’m a real money investor and I need to raise $10-million, the only things I can sell are the things I already own. So bang! there goes a $10-million sell order on the stock I choose and it may be expected that the price will go down, even though I haven’t changed my mind regarding that particular stock at all.

Such things are called market impact costs, virtually ignored by academics because it’s hard to measure, hard to model, and because it contradicts the Holy Efficient Market Hypothesis. One can make a whole lot of money – and many, many, many players do make a whole lot of money – simply by selling liquidity to the marketplace, taking the other side of those trades.

Accrued Interest makes another point with which I do not entirely agree -or, at least, that I feel deserves elucidation:

And of course, if XYZ is getting beat up, then other names in the same industry get beat up also. Maybe the buyer of protection on XYZ had a view specific to that company, but now there is momentum. Dealer desks will start buying protection against related companies. Suddenly a whole sector is 30-50bps wider on no news.

I have no doubt that in lots of cases the transmission mechanism is as silly as AI describes, but there is a more rational explanation.

Say I have a certain amount of my portfolio invested in Banks. At 9am I’m very happy about my portfolio, because it’s all in the cheapest bank, “A”. Without any news – or, at least, with no news I deem significant – Bank “B” starts diving. Quick! Update the valuation model! Yes! A swap is possible! Sell “A” and buy “B”! Thus, while acting as a strictly fundamental value investor, I am converting weakness in “B” to weakness in “A”.

Anyway … there was a bit more clarification on the Fannie Mae accounting panic discussed briefly yesterday. Fannie was so worried, they held a conference call. From what I could make out – without having done any prep on this, you understand; the kerfuffle is over one table in a set of three filed documents each being 100-odd pages long – what happens is this:

• FNMA securitizes & guarantees mortgage pools
• One mortage with a principal value of $100,000 goes bad.
• Fannie buys it from the pool for $100,000 (this is where they earn their guarantee fee)
• Fannie determines the actual value of the mortgage using its internal models
• Fannie determines the market value of the mortgage (this is the fun part … getting quotes on delinquent mortgages in this environment)
• Fannie puts the asset on the books at the lower of the two prices (guess which one that is) and charges the balance to expenses

As far as I could make out from the call, they are claiming:

• the expense skyrocketted this quarter because market value has plummetted, not because of any huge increase in volume, or because their internal recovery expectations have changed much
• they expect the majority of the delinquencies to be cured
• the loss recovery rate will be fairly large and will come back onto the balance sheet as income

I think. Bloomberg has a story on it too.

Same old same old in pref-land: volume is good, prices are strange.

There were twenty-seven other index-included $25.00-equivalent issues trading over 10,000 shares today.

Update, 2007-11-18: Spelling of assym asymett asymmetric has been corrected. Thanks to a Keen-Eyed Assiduous Reader!

Well, there won’t be much today, I’m afraid! What with fixing (well, patching, anyway) my server problem and a … rather exciting day in the markets, there hasn’t been much time to Stay Abreast of Current Events.

Richard Portes of the London Business School has written a very good essay on VoxEU: International Stability by Design which serves as an executive summary for a major work that he co-authored International Financial Stability.

Now, it is a little fishy of me to comment on his VoxEU essay without purchasing and reading the work on which it is based – but hey! I’m sure he doesn’t mind a little publicity. He deals with hedge funds first, denying any pressing need for regulation:

Many regulators in the US and other major markets believe that the best way to monitor hedge fund activity is indirectly, through their sources of funds.
…
We see no clear benefit from additional regulation.

So far so good! It was only yesterday that I reiterated my prediliction for a non-regulated – lightly regulated, anyway! Things like insider trading and false advertising still need to be looked at! – sector of the financial markets, where innovation is king.

He is not concerned about the potential for financial market destabilization due to carry trades.

He is concerned, however, about the regulation of Large Complex Financial Institutions:

This suggests that not only regulators, but also the major central banks must cooperate more closely in dealing with liquidity shocks.

but does not provide any specifics – in this summary – of what he means by this. The Bank of England lists LCFIs as:

LCFIs include the world’s largest banks, securities houses and other financial intermediaries that carry out a diverse and complex range of activities in major financial centres. The group of LCFIs is identified currently as: ABN Amro, Bank of America, Barclays, BNP Paribas, Citi (formerly Citigroup), Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase & Co., Lehman Brothers, Merrill Lynch, Morgan Stanley, RBS, Société Générale and UBS.

LCFIs had the incomprehensible total of USD 23-trillion in assets in 2006, according to Chart 10 of the Bank of England’s April 2007 Financial Stability Report. The Financial Times had a very good report on this at the time.

The next section of Portes’ essay deals with the somewhat related issue of new financial instruments:

Given all the benefits from innovative financial instruments, the appropriate question is how to make these instruments safer. First, market-driven, but regulatory- and supervisory-authority-guided, approaches are necessary for successful financial risk management. As new instruments are designed, regulation must keep pace. Second, financial risk-management solutions must be global.

Finally, having prepared the ground by addressing LCFI regulation and financial novelty regulation, we get to the heart of the matter (and without this section my review of the essay would have been much more cursory!):

Transactions that do not transfer risk should not be treated by regulators as if they do
…
Many of the new instruments are illiquid, and the role of ratings firms in evaluating them is highly controversial. There has been a transfer of activity from regulated to unregulated investors.
…
The shift from ‘buy and hold’ to the ‘originate to distribute’ model should not (and probably cannot) be reversed. Policy-makers and industry bodies can try to make it work better, to push it towards a more balanced, market-based model through reforms that include:

• Regulators and market participants should pay particular attention to “tail risk”
• New regulations could require originators to retain equity pieces of their structured finance products.
• Regulators need aggregate information on structured finance instrument holdings and on the concentration of risk to assist in the regulatory process.
• Industry bodies should promote product standardisation and accurate pricing in the structured finance market.
• Credit market transactions that do not definitively transfer risk should not be treated by regulators or risk managers as if they do.
• Ratings firms should provide a range for the risk of each instrument rather than a point estimate, or should develop a distinct rating scale for structured finance products.

I consider these recommendations rather breathtaking – but there is doubtless argument to support the conclusions in the full report. I will merely point out that:

• the industry, to at least some extent, likes non-standardized products and inaccurate pricing. They can make more money trading that stuff against players who have no idea what they’re doing.
• how is the requirement that originators hold equity pieces of their transactions to be enforced? If I have some kind of risky revenue stream that I want to monetize, are the regulators really going to stop me? My instinct is to leave this kind of thing with the market and make the ability to say ‘We’ve got skin in this game’ a competitive advantage.
• the ‘new credit ratings scale’ recommendation has been floated so many times it is acquiring a veneer of inevitability. But Joe Broker does not want a new ratings scale. He wants something easy to explain to his client and his client just wants his hand held. I don’t know what kind of practical effect this cosmetic measure will have.
• all these recommendations will come to nothing for as long as investors don’t care about their returns – that is, forever.

My last point deserves at least a little elucidation. I have never talked to an investor who didn’t claim he was after performance … sometimes with less risk, sometimes with more risk, but all these guys have been pretty tough cookies, you know, and want good performance … or so they say.

The OSC issued a press release today regarding their review of ICPM marketting practices. I was on the long-list for their preliminary review – I believe every ICPM was. I had to provide them with a list of my websites and a copy of all printed marketting material; after submitting it, I never heard from them again.

Have a look at their summary of results … and bear in mind that these are Investment Counsel / Portfolio Managers that are being looked at, not mere stockbrokers:

Most of the deficiencies fall into one of the following areas:

1. preparation and use of hypothetical performance data
2. linking actual performance of the ICPM’s investment fund or investment strategy with the performance of another fund or investment strategy
3. construction and marketing of performance composites
4. construction and use of benchmarks in marketing materials
5. use of exaggerated and unsubstantiated claims in marketing materials

In the absence of actual deceit, not a single one of the sharp practices listed will withstand two minutes of questioning by a client who is concerned about performance. While the OSC’s efforts in this area are to be applauded, you cannot regulate common sense.

And, briefly, the bond-insurer saga continues, with fears of a USD 200-billion hit to markets if the insurers are downgraded … but the math looks bad enough without being as pessimistic as the very gloomy assumption required to get that high:

Then there is the $1 trillion market for insured securities backed by assets such as home-equity and consumer loans. Concerns about the underlying quality of the assets and the viability of the guarantors have caused investors to price some securities relative to the credit-default swaps of the insurers, according to David Land, a mortgage-bond fund manager at Advantus Capital Management. Advantus, based in St. Paul, Minnesota, oversees about $18 billion.

Insured securities backed by home equity-lines of credit have fallen by 15 percent, based on the rise in credit-default swap rates this year on Ambac’s insurance company. If the entire insured market were to drop that far, it would reduce the value of the securities by $150 billion.

There are some reports of a change in accounting treatment of credit losses by Fannie Mae – which readers will remember is a grossly undercapitalized Government Sponsored Enterprise. As I mentioned on September 20, the GSEs are helping to bail out the mortgage sector, to the condemnation of all right-thinking individuals and cheers from Congress.

As far as I can make out from the FDIC supervision manual, the change in accounting treatment relates to the discounts at which loans are purchased from a third party. If a $100,000 loan is purchased at $60,000 (due to credit concerns), it is no longer booked as a $100,000 loan with a $40,000 credit reserve; it’s booked as a $60,000 loan.

Given that the GSEs are now purchasing impaired loans (at least, to a far greater extent than they have in the past), one would definitely expect there to be a large difference between results from the old and new calculation methodologies. In other words, the issue sounds like a lot of fuss over nothing – but to confirm that I’d have to look very carefully at the source documents and I don’t have time. I’ll leave it as an exercise for the student.

A busy day in the preferred market, with prices falling amidst the now usual amount of completely strange relative pricing.

There were thirty-eight other index-included $25.00-equivalent issues trading over 10,000 shares today.