Positive-Feedback Trading

There has to be an opportunity for somnebody patient with resources to make enormous fortunes in this situation. Doesn't there?

Neil Unmack and Sarah Mulholland report:

Bloomberg.com: Exclusive: April 15 (Bloomberg) -- The credit-default swap market has become a lesson in being careful what you wish for now that Wall Street has taken $245 billion of losses partly tied to such exotica. Rather than dispersing risk and lowering borrowing costs as former Federal Reserve Chairman Alan Greenspan predicted, the contracts have exacerbated the debt crisis. What was intended as a way for lenders to protect against defaults spawned a market covering $45 trillion of bonds and loans where no one knows how much is traded and speculators who bet on deteriorating credit quality end up forcing that reality.

Some credit-default indexes have morphed into what Wachovia Corp. analysts led by Glenn Schultz call Frankenstein's monster'' because they now often drive prices in the so-called cash bond market, rather than the other way around....The indices are just trading on their own account with no relationship whatsoever to an underlying cash market that's ceased to exist,'' Jacques Aigrain, chief executive officer of Zurich-based Swiss Reinsurance Co., said at a March 18 insurance conference in Dubai.... The last thing the securitization market needs is another no-cash-upfront instrument that people can use to knock the markets about with,'' said Andrew Dennis, the London-based head of the asset-backed debt syndication group for UBS AG of Zurich.... Accounting rules require companies to estimate a value for some assets that are seldom traded and to record any change as an unrealized gain or loss. Where quoted prices aren't available, companies are required to use other measures, such as indexes of credit-default swaps.The dealers got caught in a vicious cycle,'' said Schultz, head of asset-backed bond research at Wachovia. ``They did a great job of selling the indexes. At the end of the day, they had to mark their own books to the prices on the indexes. They fell victim to their own sales job.''...

The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz, almost four times the 13.75 percent rate predicted by Wachovia.... ``ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,'' Swiss Re's Aigrain said at the Dubai conference....

``In a volatile market, this mark-to-market process becomes a self-fulfilling prophecy, driving prices down based on index trading activity rather than asset fundamentals,'' wrote Dottie Cunningham, chief executive officer of the New York-based CMSA.

Comments

[Matt]

"Rather than dispersing risk and lowering borrowing costs as former Federal Reserve Chairman Alan Greenspan predicted, the contracts have exacerbated the debt crisis.."

This is a contradiction in terms. Greenspan was correct, we got the risk dispersed, and that was right. What we see is that we are all sharing in the dispersed risk. The problem is that we are not sharing the risk via the monetary system in a systematic fashion, we don't get early signals from the banking sector.

Greenspan failed in misunderstanding the relationship between the monopoly money system and cyclic behavior. Until the fed is decoupled from the legislature somewhat, this is a continuing problem. Without reform, we will learn to track Ben's movements, step by step, and hedge the system, living with an enforced cycle.

Just to see the point, what were Ben's words to Congress? Something like, the Fed has done its job, and now it is up to Congress. It is this sequential, in time, path that we get on the right that is the problem. Each new phase of the cycle we get a reconfiguration of the financial houses, not a linear adjustment to values, as they adapt. They don't have enough linearity on the right, they are forced into reconfigurations when high volatility comes from the left.

[jerry]

Isn't it time to write "The Smarterest Guys in the Room" or "The Besterer and the Brighterer", maybe just "The Greedy and Thieving?", or perhaps another apologia explaining how financial investing is rational and not gambling or a big old con.

[ottnott]

That article was a lot of (presumably) strong believers in the market whining that markets don't work.

Of course the financial whizzes offer no evidence that the indexes are incorrectly valuing the real assets and don't explain why, if the indices are artificially low, they aren't out there quietly buying in quantity.

The shorter version of what they are saying is "markets don't find correct values, but we are going to whine about it instead of profiting from it." Not very convincing.

The crucial admission they are leaving out, I believe, is that their business has become so addicted to leverage that it can handle only modest amounts of volatility.

[chris]

Hey! I'm patient! Tell me what to do! How do I buy this kind of asset?

[Bruce Wilder]

"AAA rated subprime mortgage bonds"

??? Anywhere outside the Alice-in-Wonderland world of leveraged finance, this would be a contradiction-in-terms.

I love the way "mark-to-market" rules always become the root of all evil in these articles. Any kind of truth-telling is the enemy, folks.

[dbt]

"There has to be an opportunity for somebody patient with resources to make enormous fortunes in this situation. Doesn't there?"

Under the free market fairy theory of market behavior, mustn't we posit that this has already happened?

[piotr]

My take is that "the market" did what it promised, dispersed the risk, with the corollary that "the market" vastly increased its capacity of accepting risk, again, as promised, and then did what it should: used that capacity.

However, dispersing the risk is not the same as avoiding the risk.

"AAA rated subprime mortgage bonds", perhaps now these bonds are past their prime, but when they were young and brilliant, they were a sight to behold. But perhaps it is something else, perhaps now it should be a quintuple or septuple A bonds that are semi-decent.

[Barkley Rosser]

And ironic that this piece was extensively quoting an analyst at Wachovia, which has just announced major and unexpected losses for the first quarter. We can guess what the source of those losses was, hack, cough.

[Bram Cohen]

Yes, there is, but as always there's a caveat.

The current insanity has to do with credit scores, those one size fits all beasts used for everything from approving rentals to credit cards to mortgages, created using a formula which almost makes sense for credit cards but is mostly superstition. They're an extremely bad match for mortgage approvals, and yet they're the primary thing used. The opportunity lies in issuing mortgages to people with no rotating debt who put a large amount and have high incomes but lousy credit, because you can get those on good terms. Then engage in the old-fashioned practice of calling your mortgage holders once in a while to find out how they're doing and if they start to get in trouble help them sell their house instead of forcing them into foreclosure. To get around swings in credit and housing markets as a whole, do some kind of a very long term short against other mortgage companies in the areas where you're issuing mortgages.

The problem? It's a *very* long term play, requiring a *huge* amount of resources. Decades for mortgages to mature, with no plan for cashing out early. Thousands of mortgages to get noise under control, times a million bucks each in california, less because you'd be leveraged, but we're still talking well over 100 million down. Plus you need a very good quant or two, and have to figure out what that 'very long term short' instrument instrument is.

Welcome to making money from an inefficient market. You can make money, but first you have to slog through the friction which is keeping everyone else from doing it.

[Ken Houghton]

The amount of time, and the size of the negative carry involved, would require major deep pockets.

Meanwhile, those who own the underlying assets are either wondering what all the fuss is about or sitting on them for the reason you described.

[christofay]

'"There has to be an opportunity for somebody patient with resources to make enormous fortunes in this situation. Doesn't there?"

'Under the free market fairy theory of market behavior, mustn't we posit that this has already happened?'

Yes, it has, Ben delivered the Fed. Isn't the Fed the dummy at the table taking the junk for 80 cents which couldn't be sold for 20?

[albrt]

Which way are you suggesting to bet?

Buy the allegedly underpriced bonds? Very difficult, because too many originators deliberately avoided creating any records that would allow meaningful evaluation of the credit risks - plausible deniability being a paramount reason for the liar loan, per Tanta from CR.

Short Wachovia and its optimistic analysts? Very difficult with the Fed engaging in surprise rate cuts on expiration day and such like.

Sell the allegedly overpriced swaps? Actually, that's the one thing that's been working pretty well, as evidenced by the $trillions outstanding. I just hope these folks are prepared to meet obligations many times larger than the underlying bond issues when some of the bonds do in fact default and return little or nothing. Fortunately they've all got those funds tucked away safely in, err, mortgage bonds, or, uhh, something.

[a]

"There has to be an opportunity for somebody patient with resources to make enormous fortunes in this situation. Doesn't there?"

Sure. The ones making enormous fortunes are called Investment Bankers. They buy the stuff at x and mark-to-market it at y, and so take home a big bonus based on y-x. Then when the mark-to-market turns south, their investment bank and the government (so John Q Public) take a hit.

Unfortunately, if you are thinking of speculating in this stuff, the market can stay irrational longer than you can stay solvent. Indeed, it can stay rational longer than you can stay solvent, too.

[movealongnothingtoseehere]

The answer is "yes", but there is this crucial little thing called Actually Doing It. You're smart, Brad, and your university endowment has probably got a lot of patient capital. But if they handed you the cash and said "Have at it, boyo", you would probably end up losing the lot - not just on a mark-to-market basis, but actually economically losing it.

Why? Because the entire problem here is one that you've identified earlier; there are some of these bonds that are probably worth par and some that are probably valueless, and the pricing on these indices doesn't reflect the average of the two (or even the fair value of the relevant replication strategy; there is also a pitfall here from the fact that arbitrage prices are not expectations), it reflects the premium that people are willing to pay to insure against the risk that they are holding one of the issues that turns out to be worthless.

The index market is basically an insurance market (btw, give me a break on these "Frankenstein indices", where "they often drive prices in the cash markets rather than the other way round" - price discovery taking place in the futures market rather than cash is not exactly unknown, ask an oil trader). Which ought to give you a clue that there is a massive assymetric information problem here.

The strategy you're presumably thinking about is shorting the indices and buying "mortgage bonds". But you can't just buy the asset class "mortgage bonds" - you have to buy specific securities.

Strategy 1 would be to just go out into the market and put out a bid for mortgage bonds, any mortgage bonds and buy what's offered. You would be lucky to come back with the shirt on your back from this one; everyone would take the opportunity to offload their lemons onto you. I suspect that if you did this naively, you could end up with a long portfolio which was actually worthless.

Strategy 2 would be to try to construct an actual arbitrage by selling the CDS index and then buying the portfolio of the cash bonds which underly the CDS which are the index constituents. In principle, this could work. But those bonds aren't very liquid (for the arbitrage to be genuine, you need to get exactly the right tranches of exactly the right issues) and the people who have the good ones tend to hold onto them; there is a Gresham's Law that would ensure that the bonds in which you found a good offer would be the rubbish, the bonds in which it took you a lot of time to make your position were better, and that you might not get a position at all in the really high-quality ones.

Since the upside in this strategy has to come from a small number of the very best bonds, my guess is that you get screwed here too. Bond trading is a skill and you can't assume that you'll be able to find the guy who can give you a two-way price for size in every single stock you're interested in. Meanwhile, of course, while you're trying to find the stock for the good bonds, the price is moving away from you while the crap you've already bought is going to hell.

Finally you've got strategy 3, the one that might actually work. This is where we give up on the one man, one plan grand macro trade idea. You start hiring a bunch of good analysts (plus some decent lawyers) and going through prospectuses, issue by issue, tranche by tranche, taking account of the underlying loan pool statistics, the local house price patterns, the specific legal language, etc, etc, and overcome the market-for-lemons problem the hard way, by checking the quality of each issue yourself. Then you can put together a portfolio of mortgage bonds that you assess to be money-good and buy it. You can then leverage yourself up by selling protection on the indices and use the cash to buy more money-good bonds, until the price of protection moves to a level where you consider the trade no longer worth it.

This will work if you get it right (it is basically how Paulson Capital made their money on the short side; they did a hell of a lot of work in searching out the AAA bonds which were actually worthless). But it is going to take *time*; if you get your research wrong you can still end up losing a bucketload, so you do not want to hurry anyone along. It will also cost money - I am prepared to spot you that because the salaries & bonuses you pay probably would be small compared to the potential profits on the trade, but be aware that it is no joke trying to hire really good mortgage bond employees at the moment and many of them will be on 3 months' notice, not to mention that you have another assymetric information problem here in hiring them.

I'm not saying it's impossible - I bet plenty of people are actually going to put this trade on and get rich. But it's not just a matter of patience and resources; you should be thinking of "there has to be an opportunity for someone with patience, resources, a lot of contacts and experience in the market, the ability to set up and manage a significant research project and decent trading acumen to make enormous fortunes, albeit that it's pretty understandable that they haven't reached the stage of putting the trades on yet". As well as the DeLong/Shleifer/Summers/Vishny noise trader risk (which AFAICS was what knocked over Peloton), there is an important limit to arbitrage arising just from the fact that arbitrage is actually an effing difficult thing to do properly.

[movealongnothingtoseehere]

Oh and further to the above, I bet you were just preparing a bracketed interjection along the lines of:

[Why can't I just buy an equally weighted portfolio of mortgage bonds?]

Good luck doing that. You will have a good couple of days' work just getting a comprehensive list, even with a Bloomberg and a couple of helpful brokers (btw this would be a good time to temporarily hide any derogatory remarks about sell-side analysts you may have made in the past as you will inevitably be leaning on them pretty heavily in this project). It's not going to be possible to literally buy one share of every mortgage bond going - there are thousands of them and the unit size is large, plus the commission and slippage would begin to seriously hurt your returns. There's no S&P500 for cash mortgage bonds - that's partly why the trading takes place in the CDS indices. So this strategy would involve almost as much work as my strategy 3 above, in effectively constructing a mortgage bond index (a portfolio of mortgage bonds which can be taken to be representative of the average of the whole market) from scratch; if you were seriously going to do this, you might as well go the extra mile and get into stockpicking in mortgage bonds.

If you did compile your index, you could probably defray some of your costs by setting up a market for futures contracts written on it and charging a licensing fee, but now we're pretty much underling the fact that what we're talking about here to realise the profit opportunity you've identified would involve something that looked much less like a straightforward cash-and-carry arbitrage trade and much more like setting up a medium-sized financial services business from scratch, which is what it would be.

[Sean]

Movealong, what about just going long risk via the CMBX index? BBBs are now trading at a spread of 1,408 bps. I think this is what Brad had in mind.

[Sami]

There are plenty of distressed opportunity funds out there picking up extremely cheap assets at 10%+ yields, including one run by my firm; you just can't invest in them since they're institutional-clients-only. As for trading ABX/CMBX/CDX, you can't do that unless you have an institutional counterparty trading limit with a major broker.

As an aside, most of us in the market chuckled when Schumer suggested a moratorium on marking-to-market. But it's not such a crazy idea after all. The MTM construct is conceptually rooted in an assumption that markets are more efficient than individual actors in determining prices. Today's markets are broken. Structured bonds are not trading in anywhere near the volume that used to be the case. Synthetics are lightly traded. Asset owners are simply not selling at the levels that buyers are willing to bid. Levels on the few bonds that do trade are based on vulture back-bids, not an anlysis of future bond cashflows discounted at an appropriate risk premium. Why is MTM useful in a world where upside and downside speculative bubbles are possible?

[Achilleas]

If i remember correctly, i posted something similar about Market to Market in this blog about a month ago. Here it is:

http://delong.typepad.com/sdj/2008/03/morning-coffe-1.html

It seems that its not just me thinking that the amount of writedowns can actually be artificially exagerated because of Marking to a Market that doesn't actually exist. So if the market doesn't function, the price could actually be zero. I think although its called fair-value accounting, i think its fair only for accountants really, since its easier for them to assess the value of an instrument quoted on an index rather than read the OC (Offering circular) and go through the structure and the assumptions of each bond.

In a way, i think the mark to market accounting technique places a great deal of belief in assumptions like Efficient Market Hypothesis which is an issue that is still beeing debated (unless you are aware of a study that i am not aware). It also underestimates information assymetries that exist in the structures of these SF deals. Brad posted something couple of weeks ago about Akerlof's famous paper regarding the "Market for Lemons", so its not hard to see something similar happening in the case of SF deals. The thing that i don't really get is the following: if we accept the hypothesis that banks need to mark instruments to market, then why under Basel 2 banks can assess the risk using internal models and thus lower the reserve requirements? For me it is an incoherent approach and i do believe that Basel 2 has serious flaws that we ought to rethink.

I think that in a case where banks have to face huge writedowns in the market value of assets due to exagerated mark-to-market losses, this can lead to panic, risk aversion, credit crunch and generally to a downward spiral taking the real economy down with it. Personally, i don't believe in the Efficient market hypothesis, i don't think that markets are rational and i think there is strong case for implementing a more robust regulatory framework. Its common sense that we need regulations, for example if you go and decide to build a house by yourself, the authorities are going to tear it down because it will not meet the regulations and the provisions regarding safety etc. Why should the financial industry be any different, when you really don't need a degree in economics to understand that there are boom and bust cycles in finance every 7-10 years. Free markets and supply and demand equilibrium is pretty useful, but it really tends NOT to work very well in real life.

[Sami]

It's like the story about the senior and junior econ professors walking down college walk and seeing a $100 bill on the ground. As the youg professor bends down to pick it up, the old prof says "Don't bother, if it was really there someone would've already picked it up"

Incidentally, Basel II severely reduces the regulatory capital a bank has to hold against structured finance assets. The calculation for the credit risk portion of reg cap is roughly Risk Weight * 0.08 * Notional exposure. Most ABS/CMBS/RMBS is currently held at a RW of 50% or 100% currently. Under Basel II, it will drop to as low as 7% for high-quality, granuar assets. This is what is eventually going to get AAA SF assets out of the hole in terms of current market value.

[Gary]

Perhaps I'm confused, but what's all this talk about buying MBS and selling protection? If the indices are perceived cheap relative to the cash, you would sell protection (=buy index) and short MBS. Or just sell protection unhedged with the confidence that losses could never get to where they're being marked now.

[Sami]

That's correct Gary. At these prices your better off just getting long the risk and hanging-on like grim death. Particularly at the AAA level.

If you want to go "riskless" you don't just have to use the index vs cash. You can also set-up a negative basis position on a single-name basis by buying a cash bond and buying protection (shorting) the same bond synthetically through ABS CDS. The basis between the indices and single-name cash bonds is porbably too wide to extract truly riskless arbitrage.

In any case, all MBS synthetic instruments are OTC which means it's not truly riskless since you still are exposed to the counterparty risk of the bank off whom you've bought protection.