Here is a great example of the flaw in risk models that rely on historical correlations. Using data from Credit Suisse on leveraged loans and distressed leveraged loans, we compute the correlation of the loan markets to the S&P500 since 1997.
Correlation of this portion of the credit markets to the equity markets has generally been unstable, registering both positive and negative measures over the past decade. But in a real financial crisis we know that correlations rise, as evidenced by the loan markets. The spike in 2008 was significant, reaching correlation of 0.8 between markets that traditionally have been loosely correlated or even anti-correlated. This was in fact the case with other credit markets as well, including corporate bonds and ABS.
Now consider capital and risk models (such as the Basle Accord) that are based on the ability to "diversify" across exposures. Supported by academicians, regulators, rating agencies, and practicing risk managers alike, these models are intellectually elegant and have proved profitable by conveniently reducing "expected" losses. This spawned what amounts to a whole industry of these participants, all with a vested interest in maintaining support for correlation based capital models.
One notorious example of such approach has been the assumption that pools of residential mortgages spread geographically across the US are sufficiently "diversified". Property values under this model (and based on some historical data) would therefore not be expected to drop simultaneously across the country. The beauty of this approach is that it makes the pools significantly "safer", even as individual loans remain risky, lowering expected loss of such pools, and allowing a large senior component to be rated AAA. As we now know, these misguided correlation assumptions have created a clear path to under-capitalization, which is where the financial system found itself in the midst of 2008.
As we discussed earlier, FAS 167 would become a nightmare for asset managers. Instead of providing more transparency, the FAS167 reporting would actually end up with less.
E&Y: As written, Statement 167 may result in asset managers consolidating many hedge funds, private equity funds and other investment funds that they manage. Some financial statement preparers and users have indicated that consolidation of funds by asset managers will result in less meaningful financial statements
FASB recently decided to defer hitting asset managers with 167 until these consolidation issues are addressed.
E&Y: At the 11 November meeting, the FASB voted to expose for comment an amendment that would defer the application of Statement 167 for a limited number of entities (principally mutual funds, private equity funds and hedge funds) until the completion of the joint FASB/IASB project on consolidation accounting.
It's good to know that when it comes to the post-crisis regulation (including accounting/transparency regulation)at least some folks are being rational about it.
Update: Looks like CLO/CDO managers are not on the list of entities that would get the FAS167 deferral. That means they would need to consolidate billions in CLOs they manage onto their management company financials.
There are numerous ways to measure how easy the monetary policy is at any particular time. Quantitative easing aside, one can look at the overnight rates as the simplest measure of stimulus levels. The Fed Funds rate fluctuating between 12 and 25 basis points feels sort of accommodative.
Of course a better measure is the real rate, which is the nominal overnight rate less inflation. The lower the real rate the more stimulus is being provided. Unfortunately inflation in the form of CPI releases is a backwards looking indicator. Any monetary policy is meant to set the stage for the next few years and should be more reliant on forward looking indicators of inflation. One such indicator is the inflation rate implied from TIPS. There are clearly issues with both TIPS and the CPI measure itself, but the implied inflation measure gives a decent forward looking indicator implied by the markets.
Many economists view low real rates that exist today as restrictive because of tighter credit in the current environment. However the market implied inflation rate already takes into account the current and the expected credit conditions. Therefore the Implied Real Rate is in fact a more holistic indicator of how loose the monetary policy really is as viewed by the markets.
Let's define the Implied Real Rate as follows:
Implied Real Rate = (Fed Funds Effective rate) - (inflation rate implied by the 10-year TIPS).
The Implied Real Rate is now at about -2%, the lowest level since TIPS have been first issued. That certainly feels quite accommodative, but let's compare the situation to the last cycle. In particular, let's look at how accommodative policy impacted asset levels - here we use S&P500. The last big drop in the Implied Real Rate was back in the 2002 - 2004 period, which launched the famous liquidity driven asset bubble.
Here is what the measure looks like right now.
Given the similarities, is the accommodative monetary policy that is currently in place setting us up for another crisis? Is the Fed behind the curve? Many argue that there will be time to take the liquidity out. By then however it may be too late:
From HSBC: The remarkable thing about such liquidity-driven asset bubbles is their long-cycles, underlining the eventual potency of loose monetary policy. Also, successive monetary tightening over the course of the bubble has apparently little impact: once the financial accelerator goes into full throttle, it takes aggressive tightening to pop the bubble – and, more often than not, policy-makers are reluctant to step up for fear of bringing down the house.
To illustrate that effect, in 2004 the monetary policy did in fact begin to gradually get tighter, as the Implied Real Rate began to rise. But as HSBC points out above, this gradual tightening is (and in fact was) ineffective, and asset prices continued to rise unabated.
Banks are ready to increase lending to corporations and will attempt to ramp their lending significantly in 2010. Here are the reasons:
1. Since the beginning of the year, bank commercial and industrial loan exposure has dropped by 14%, while real estate loan exposure has decreased by only 2%. To the extent they can, banks will rotate out of real estate loans and into corporate loans.
2. At this stage, real estate linked loans constitute some 32% of the balance sheet, while corporate loans are under 12%.
3. As the chart below shows, commercial and industrial loans as percentage of the total assets have dropped quickly. Bankers have demonstrated to their credit departments that corporate loan exposure can in fact be reduced when need be (large corporate loans can trade fairly actively).
4. The following chart from the Fed shows the end to tightening of lending standards to companies.
5. As capital markets stabilize, the bid-ask spreads become tighter, reducing profitability of market making activities. 2010 budgets will need to shift more into lending.
What is less certain is how much demand will exist for corporate loans. So far the demand for corporate loans has been weak.
The stronger companies have been able to tap the bond markets, avoiding some of the loan covenants. Other firms either have cash or simply have no major expansion plans. Given the level of unemployment, corporations continue to be cautious on expansion plans or capital projects. To the extent possible (with 08 fresh on their minds) firms will avoid increasing their leverage. The one key area where banks will be able to help is in inventory financing as corporations try to rebuild depleted inventories (see chart below).
It's not at all clear however how soon the inventory rebuilding will begin. Corporate lending will be ready for business, but will there be takers?
This chart from Hedgebay shows the full history of secondary hedge fund transactions (that Hedgebay has in their database). The discount, which seems to be permanent for now indicates the liquidity premium one would demand to go into a fund that is presumably locked (via a lock-up, a gate, or a general redemption suspension).
Some of the discount may be valuation uncertainties, but with all the scrutiny on hedge funds these days, most valuation uncertainties would have been vetted with third parties. If they haven't been, no one would buy such fund even at a 10-15% discount.
Such liquidity premium means that funds who provide the best liquidity terms (within their strategy category) will be able to raise more capital than those who have long lock-ups and sidepockets.
It's somewhat of a dangerous game because this may create an asset-liability mismatch. That is funds will offer unrealistic liquidity terms just to get the capital in the door. As assets become fully priced and rates continue to stay low, hedge funds will be pressured to seek out less liquid strategies to squeeze out incremental returns. They may deploy leverage, making less liquid investments even more illiquid. The liquidity of the portfolio will become "mismatched" with the liquidity terms for redemptions (the liability side).
And when redemptions increase, funds will put up gates and we are back where we started. As much as institutions, particularly funds of funds seek the liquidity holy grail, these investments are not mutual funds, and the most "investor-friendly" liquidity terms may not provide the investor protection these institutions expect.
Currently if you are a bank, a loan you originated will be held at par on the books and accrue interest. The loan makes you one day's worth of interest less the funding cost - every day. No volatility. That is until one morning you walk in and find out that the coupon you've been accruing never came. Now you not only have to reverse out the amount accrued on that last coupon, but also have to take a provision against principal loss. This provision reverses the life-to-date interest income on the loan and then some. This "oops" approach to loan accounting is called the "incurred loss impairment method", and is standard under current accounting rules. As a bank you could be holding a bunch of option arms, and as long as they make the minimum payments you would keep them at par (in fact you would keep them above par to account for the "negative amortization"). That's how many smaller banks that were fine a couple of years ago, all of a sudden became undercapitalized/insolvent.
To address this issue, the International Accounting Standards Board (IASB) has proposed an alternative (see attached document). It's a portfolio approach that requires the lender to continuously project total expected losses. The expected losses are then amortized over the life of the portfolio and netted against interest income. For example if you project a 20% total principal loss on the portfolio over the next 5 years, you would be deducting 4% of the initial portfolio face value from the interest income going forward. It's a constant dollar amount taken out of interest income every year. That means if loans default at some constant rate, interest income will drop off, while the provision will stay constant, creating a possibility of net interest loss.
Here is a comparison of the current method with the "expected loss model":
IASB: Interest revenue that is recognised will reflect the allocation of expected credit losses over the life of the instrument. This is a better reflection of the ‘economic’ interest that the lender expects to earn from an asset over its life than today’s approach. Hence, it avoids inappropriate front-loading of interest revenue.
This approach becomes more problematic when the expectations for credit losses suddenly change. That may mean that the reserve has been "under-accrued", and IASB would say that you have to take that difference into P&L immediately. And this concept makes it the trickiest portion of the proposal.
IASB: Using the proposed impairment method, credit loss expectations are updated each period. Any changes to initial expectations of credit losses will be recognised immediately in P&L. This change could be an increase in expected losses, or a reduction (reversal) of past expected losses (including the initial expected loss estimate).
If one uses CDS spreads for example to imply credit loss expectations, this method amounts to a form of mark to market. It effectively means that rather than holding "banking book" loans at par (current methodology), banks would be required to take a mark to market hit amortized over the expected life of the portfolio. And that could be bad news for banks that are thinly capitalized - these reserve requirements may make them insolvent.
Expect a massive industry (and political) backlash against this accounting methodology going into effect. In addition, if IASB adopts this proposal, it may impact the convergence of the US GAAP and the IAS standards, which has been the ultimate industry goal in recent years.
How many times have you heard that banks have taken on way too much leverage. And that ended up causing the current crisis. Right? But no more. The US Congress is trying to put this into action. Under the "too big to fail" proposals, the largest banks should be prepared for higher capital requirements (thus lower leverage). The smaller banks are already significantly undercapitalized because of their real estate exposure and are trying to improve their capital standing before the FDIC shuts them down. They need to de-lever more by rebuilding their capital base.
So that's what banks have effectively done - they've deleveraged. The chart below shows the ratio of total loans and leases (commercial, industrial, real estate, consumer) to book equity for all the US chartered banks.
source: FRB
Banks have reduced that ratio since 08, keeping it fairly constant in the last 6 months. The overall bank leverage is now down, though maybe not as much as the regulators would like to see. Much of it was done through equity raises, retained earnings, loan sales, and reductions in lending. Looks like we are moving in the right direction, right?
But wait! Mr. Geithner now says banks have to lend more!
Bloomberg: U.S. Treasury Secretary Timothy Geithner is echoing billionaire investor Warren Buffett in telling banks “to take a chance again on the American economy.”
So far, his appeal is falling flat.
Banks are not listening because... maybe... they were told for the last 2 years to reduce leverage.
And Mr. Stiglitz, Columbia University economist adds that if the banks were taken over by the government, we could simply force them to increase their leverage by telling them to lend more.
“Bloomberg: If we had done the right thing, we would be able to have more influence over the banks,” Stiglitz told reporters at an economic conference in Shanghai Oct 31. “They would be lending and the economy would be stronger.”
Lend more, but be prepared for higher capital requirements. Take more risk, but don't increase your leverage. Extend more credit, but no "excessive lending". Which is it?
As the credit addicted US economy goes through it's withdrawal symptoms, is the answer really more credit? Certainly the US government thinks so and has shown an enormous commitment to credit expansion. But now it wants banks to follow along.
When one thinks of the word “sociopath”, a killer of some sort generally comes to mind. It’s someone who is completely devoid of emotion or empathy for others. Someone completely focused on his/her own needs with absolutely no regard for those around them. The definition in Wikipedia states that sociopath is often used as an alternative word for a psychopath to avoid confusion with the word “psychosis” (which is unrelated). The description is divided into two factors: “aggressive narcissism” and “socially deviant lifestyle”:
Factor1: Personality "Aggressive narcissism"
Glibness/superficial charm Grandiose sense of self-worth Pathological lying Conning/manipulative Lack of remorse or guilt Shallow affect Callous/lack of empathy Failure to accept responsibility for own actions
Factor2: Case history "Socially deviant lifestyle"
Need for stimulation/proneness to boredom Parasitic lifestyle Poor behavioral control Promiscuous sexual behavior Lack of realistic, long-term goals Impulsivity Irresponsibility Juvenile delinquency Early behavior problems Revocation of conditional release
Why are we discussing this in a financial blog you may ask? Well, it is estimated that about 1% of the population has this disorder. And the area of finance is particularly attractive for people with these special “talents”. Bernie Madoff is one of them, Marc Dreier is another. There are numerous others, and not all have such a high profile. One of them lived in a peaceful suburban community in Saddle River, NJ. His name was Jim Nicholson. Jim, in his early 40s, a father of 3 young boys, was married to Donna - his high school sweetheart. Jim coached the local little league team and was the pillar of his community. He also managed money in a hedge fund he created called Westgate Capital. He didn’t like to take in institutional money – instead he managed funds for his friends, his neighbors, and his family. His returns were rock solid and new funds just kept coming in (particularly from people closest to him).
These returns would be the envy of most money managers - steady and consistent. But it was all a fraud. It’s not clear when it became fraud, maybe 2003, maybe earlier. Investors figured this guy is not going anywhere, he's got 3 kids and is happily married. But after the Madoff news hit, many tried to redeem their money and Jim's ponzi scheme began to unravel. The check he sent to redeeming clients bounced. And the thing with the "perfect family" turned out to be, well, not so perfect after all. From LoHud.com:
James M. Nicholson, accused of running a fraudulent hedge fund, cheated on his wife with another woman for more than a year as he continued to bilk investors out of tens of millions of dollars, according to his wife's divorce papers. Donna A. Nicholson's divorce papers, a copy of which was obtained yesterday, provided details into her husband's extramarital affair and the effects of the criminal case on her and their three children. ... He's accused of stealing an estimated $163 million from his clients since 2004 through his hedge fund business, Westgate Capital Management LLC in Pearl River and Manhattan.Donna Hostomsky and James Nicholson grew up in Haverstraw and were high school sweethearts. They married on Sept. 26, 1992, and lived in Stony Point before moving to Saddle River, N.J. ... Donna Nicholson's divorce papers accuse her husband of adultery with Toronto investment trader Linda Boville, starting on Feb. 1, 2008. Donna Nicholson's papers state that her husband admitted having sexual relations with Boville in New York City, New Jersey, Florida, Las Vegas, Canada and "in other locations and at other times and places too numerous to account." .... Donna Nicholson accuses her husband of extreme cruelty with the adultery and alleged crimes. She also says they have irreconcilable differences. She claims his arrest "led to the seizure of all our marital assets, leaving myself and my children penniless and without any means of support." ... Nicholson came under scrutiny by Rockland investigators a few months ago after nearly $5 million in redemption checks to clients bounced, county District Attorney Thomas Zugibe has said.
Unlike Madoff however, Jim didn't feel like having an accountant, even an incompetent one that Madoff had. Why bother? Just come up with a fake name, get a PO box and an answering machine - and you got yourself an "accountant".
LoHud.com: He also has been accused of doctoring financial statements and setting up a phony Manhattan accounting firm that sent out fictitious statements telling investors they were making money. He is accused of using money obtained through new investors to pay off suspicious longtime investors. Nicholson is being held on $10 million bail in the Metropolitan Detention Center in Brooklyn.
As a true sociopath, Jim had to indulge himself any way he could:
LoHud.com: Documents show he bought an interest in a multimillion-dollar private jet and a $27 million oceanfront estate in Southampton. He also bought a condo at the Time-Warner Building in Manhattan valued at $8.5 million. He also owned a $4.75 million condo in Palm Beach, Fla.
For those who are interested in more gory detail on this sociopath (which is not covered well by the media), see the full complaint below. But the moral of the story is that sociopaths like Jim make it that much tougher for honest money managers to make it. That's right, there really are honest money managers out there.
As an investor, follow the 3 simple rules: 1. Watch those returns to make sure they are realistic (they have some semblance to what markets are doing and the strategy makes sense) 2. Make sure there is a real accountant there who does the audits and knows what she is doing. 3. And watch for signs of the sociopath
