June 25, 2009
Regulators, Ratings and Ramblings
When it comes to regulators and rating agencies ...
I fair the rating agencies have a lot to account for in this credit crisis but we only have ourselves to blame.
Imagine the following scenario sets:
Scenario number 1-The Portfolio and Asset Manager
1) You assess an asset class or specific market segment as overbought and risky but the rating agency gives it a thumbs up. You say to your boss I don`t want to buy this, it is a bubble. He is going to say the rating agencies back it, if you miss out on earnings it`s your job mate. What do you do?
Scenario number 2-The Risk Manager
2) A risk system however sophisticated or streamlined at the end of the day finds its magic in statistics and the functioning of all things statistical is predicated on data. In scrabbling to fill the gaps risk managers will turn to any credible sources of data and what a better place than working with a rating agency whose sole purpose in life is to publish default statistics on traded entities. The problem of course is, if the source is broken the risk assessment will be as well, there was no backtest for that.
Scenario number 3-The Regulator
3) A bank makes an assessment on the riskiness of its portfolio`s how can we benchmark their assessment. Sounds innocuous but if I said oh that object is hot, you need a basis to define hot. Hot for a kettle is cold for blast furnace. So these banks are making a statement about their risk weighted assets, let`s use an independent benchmark something not from the organisation to test their assumptions. Sounds logical but where can we find such assessments, the rating agencies and the other pool of banks in a peer who are using the rating agencies.
Scenario number 4-Inside the agency
4) The rating agency needs to make assessments on assets, publish its opinion and charge the world for the assumptions that are drawn, that is how it makes money. Of course all things that are measured require an understanding of the dimension of what is being measured. Some of the instruments that are assessed such as collateralised debt obligations have more than two dimensions. They are bundles of many contracts where each contract has a unique risk characteristic but together have correlation factors that leverages the risk within them. Simply stating a specific CDO is sound because it is made up of thousands of little internal cash flows ignores the correlation factor when you aggregate these cash flows. Oh dear, we didn`t have a measurement tool for that.
So what is broken here? It`s our human nature, we need credible appraisals in life and unfortunately have lost the ability to question ourselves. Perhaps we never had it. I will put it differently, you feel a bit sick you go to the doctor. If you need a quote for a job, you look for a credible technician. To build up your knowledge you speak to more than one of these people. In banking, perhaps other places all these bodies and experts fundamentally draw their knowledge from a single network or pool, a historical museum of shared knowledge so the assessments are likely to be similar.
The solution is a cognitive one. Investors and borrowers alike have to learn to think for themselves. When they buy anything it has a rating and an approval but these people have to understand how that directly affects their world when mixed with the other assets they own. Please understand how that approval is derived rather than accepting it as simply superior authority. When dealing with banks perhaps any system, become heterodox and irreverent to anything packaged and bundled for lemmings.
Gone are the days of trusting the regulator, the rating agency and perhaps even the doctor, certainly a pilot and a lawyer.
As for the banker we are just selling instruments; you, at the end of the day will own the risk in them.
Posted by CausalEvents at 02:30 PM
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June 13, 2009
Between a hard rock and a cold place
Some readers expressed a range of interesting market based opinions to our last blog ``Greedy glut feeding frenzy`` so in the theme of this we are going to continue the topic.
Back in March you could have put capital under any stock on nearly any market and made incredible returns.
One night I did just that, I printed out the price movement for one of the notorious US banks, took a ruler on the curve and drew a line dissecting the average daily price swing for the week then went long with a doomsday stop loss and limit to close out at around 75% on the average move.
Then I went to bed.
Amazing as that may be logging off and crashing but, I had a huge day coming up and I wanted to be fresh. In the morning, I grabbed a coffee as one does, logged on and the limit order had been fulfilled. The notional contract had sold and at possibly the best rate of return I think I have made for the time invested. Foolish perhaps, irresponsible umm that depends who`s funds I put at risk; as this was my money not an investors I see the moral issue was a personal one, the type you have with your alta ego when you shave and talk to yourself in the mirror before going to work.
Would I do this now?
ABSOLUTELY NOT
This market has changed and while global equities are still climbing at a phenomenal rate when looking at the 60 day moving average, several things have occurred.
Firstly relative pricing has come back into play as it should. Not all stocks are equal and some are starting to fracture. If the fundamentals (operating margin, eps, debt to equity ratio etc) are not under the company be cautious buying it and holding long.
Secondly this huge influx of cash into stocks has encouraged some companies to value the price of equity differently. It has been difficult to borrow and some standing commercial paper bought back in the heyday on higher rates is stinging when discounted today.
Some of these companies are taking advantage of this flash of liquidity and resolving the problem by engaging in financial restructures. The most common approach is to issue additional equity as preferable shares and payout the debt. Good in principle but the investors then hurt as this process has a tendency to shock the current price of existing shares when holders see dilution in the stock they own. I have been caught on one such animal and the price fall was a cliff face with a hard landing.
There is however something far more concerning with the economy than the hike of equity values, this is just part of the picture and the focus is not GDP growth, social economic sentiment (a measure of confustication but seems to have effects) or unemployment which is umm well a few thousand less than it was a month ago.
The real concern is what is going on in the adjacent markets; commodities, money markets and bonds. The signs are concerning, let`s take the first one.
Where will be, if demand and economic output grow at a positive (oh let`s not over excite ourselves here) 0.9% and the price of oil blows the roof off every month with a 2% climb? Imagine the operating costs for businesses increasing and sales remaining weak, even slower if these businesses price in and pass on the real cost of delivery.
The bond market is even more of a worry.
The US treasury department might start to run out of takers for its debt, certainly China has expressed a concern over the last thirty days and new issues are going to eventually need higher yields to attract buyers. The ten year note has been very low, actually at a record low of 2.3% last year but that has been changing. As the ten year note rises, so does the rate on consumer loans because these bond yields are used as a baseline for the loan contracts. The ten year note is certainly closely tied to home mortgage rates and is now floating around the 3.8%.
Rising interest rates and higher commodity prices together have a compounding effect and are likely to dampen any fast V shaped economic recovery. Rising interest rates are also going to increase the default rate on standing obligations and take that nice shine off these ``new`` banks profit margins.
The effects in the equity markets are obvious, on the May 28th we had another wonderful run, not as big as March but it is graphically visible. Since then however the heat has been coming off some of the stocks away from energy and the volume of trading has been really low, notably low. On Friday I had one stock hit its entry price 15 times in the trading day, the whole market was just churning between buyers and sellers but there was little advance for what seemed like ages.
We are at pernicious juncture, somewhere between a hard rock and a cold place. Interest rates will eventually have to increase otherwise inflation is going to be a concern but the markets have become fragile again.
What is the solution?
Posted by CausalEvents at 10:43 PM
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