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.
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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.
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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.
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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.
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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.
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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.

Accrued Interest notes that he’s hearing some chatter about credit markets finally troughing, and urges caution:

Anyway, as much as I’d like to believe in a bottom in credits, we need to get through mid April with some strength. April is going to be a key month for bank/finance earnings (translation, writedowns) Here are some earnings dates to mark on your calendar.

I’ll add my caution to his. Remember, it is in the interest of the sell-side to convince clients that a turning point has been reached and therefore that a rejigging of portfolios is in order. It is in the interest of the press to convince readers that right now this minute is quite possibly the most exciting time in the history of markets.

Be skeptical and remember Rule #1: Things are always less exciting than they seem. And if you take the view that things are getting worse, you can find big name support for that idea.

Felix Salmon reviewed the CDS market after an article in the NYT. Reasonable enough reviews; the NYT article made the point I’ve been making about the credit crunch:

But many speculators, particularly hedge funds, have flocked to these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.

The market’s popularity raises the possibility that undercapitalized participants could have trouble paying their obligations.

“The theme had been that derivatives are an instrument that helps diversify risk and stabilize risk-taking,” said Henry Kaufman, the economist at Henry Kaufman & Company in New York and an authority on the ways of Wall Street. “My own view of that has always been highly questionable — those instruments also encourage significant risk-taking and looking at risk modestly rather than incisively.”

I will not attempt to quantify the effect of the ability to short corporate debt easily has had in intensifying the damage of the credit crunch. But it’s there! This is not necessarily a bad thing, though; one of the great attributes of financial markets in general is that they tend to anticipate and intensify pain, thereby getting it over with more quickly so we can go back to work.

Stephen Cecchetti’s idea of forcing CDS trading onto exchanges (noted on PrefBlog on November 19 has found support from George Soros:

There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed’s decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.

Sounds nice, but I’m not certain that there’s enough volume in the off-the-run CDSs to justify an exchange. And I’d really like to know who’s going to pay for it! I will admit that the notion of controlling counterparty risk by such a mechanism does have its attractions … but I suspect that most of the trouble in this department is coming from the esoteric swaps on sub-prime paper, of which maybe one or two will exist world-wide for any given tranche.

Several exchanges were reported in 2006 to be gearing up to trade CDSs:

Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. risk losing their hammerlock on the most lucrative financial market when exchanges begin offering credit derivatives next year.

Paris-based Euronext NV, which is being bought by NYSE Group Inc., plans to create contracts based on credit-default swaps, making them cheaper to trade and easier to understand than the derivatives sold by banks. Credit-default swaps, used to speculate on credit quality, also top the product list for Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange and Frankfurt- based Eurex AG.

I don’t know why this initiative foundered – it may be fear of trying something new during a crunch, of course – but the NYSE is now promoting a service to report prices of such illiquid securities, presumably in competition with Markit.

There were further indications of skullduggery in the BSC implosion today:

The SEC opened probes last month into whether hedge funds and other investors spread false rumors in seeking to profit from declines in stocks of companies including Bear Stearns and Lehman Brothers Holdings Inc., people familiar with the inquiries said at the time.

“It looked like more than just fear, it looked like people wanted to induce a panic,” Bear Stearns Chief Executive Officer Alan Schwartz told the Senate panel today. “The minute we got a fact out, more rumors started or there was a different set of rumors.”
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The SEC can’t yet say whether market manipulation was responsible for the run, Cox told the Senate committee. During the week it occurred, the Fed passed along “extremely helpful information” on rumors from a “variety of market sources,” he noted.

New York Fed President Timothy Geithner testified regarding the BSC / JPM deal today to the Senate Banking Committee today. Of most interest was the information regarding the BSC collateral:

The New York Fed presented a one-page description of the portfolio. The assets include investment-grade securities and residential and commercial mortgage loans, all of which were current on principal and interest as of March 14.

The portfolio also holds collateralized mortgage obligations, most of which are bonds of government-sponsored enterprises such as Freddie Mac and Fannie Mae. The holdings include asset-backed securities, adjustable-rate mortgages, commercial mortgage-backed securities and collateralized mortgage obligations issued by companies other than government-chartered companies.

The (rather general) statement of collateral and the full testimony is available from the NY Fed. His main point is that action was necessary to break the cycle:

What we were observing in U.S. and global financial markets was similar to the classic pattern in financial crises. Asset price declines—triggered by concern about the outlook for economic performance—led to a reduction in the willingness to bear risk and to margin calls. Borrowers needed to sell assets to meet the calls; some highly leveraged firms were unable to meet their obligations and their counterparties responded by liquidating the collateral they held. This put downward pressure on asset prices and increased price volatility. Dealers raised margins further to compensate for heightened volatility and reduced liquidity. This, in turn, put more pressure on other leveraged investors. A self-reinforcing downward spiral of higher haircuts forced sales, lower prices, higher volatility and still lower prices.

Pity the Fed! It’s a thankless task at the best of times, second-guessed by every granny who buys a short-term bond, but the worst part must be having to tolerate grandstanding politicians.

Lehman doesn’t want to follow the path of the Bear! They’ve raised $8-billion in two weeks, helped by securitizing a package of LBO debt.

Volume was light today, but prices were up nicely. Interestingly, the S&P/TSX Preferred Share index (and the NAV of CPD) was down, as closing bids (used by the HIMIPref™ indices) and closing prices (used by a few small outfits) moved in opposite directions.

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

Sorry folks! Today’s commentary is greatly abridged … but I did post some commentary on Financial Stability and MAPF Portfolio Composition.

Not much price movement in the preferred share market today, and volume eased off.

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