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Written by Eric

November 13, 2010 at 1:12 pm

Another word for hedged… leveraged

with 2 comments

Market turmoil is still quite fascinating to me and I still believe the current environment will be one for the history books and I’m still trying to take as much as I can from this learning experience.

My professional work experience is in fixed income. For two years, I was very “plugged in” to the markets and was meeting regularly with some of the greatest thinkers out there, but now I’m more of a pure “quant” and most of my news comes from blogs, web news, etc. Unfortunately, I’m not yet spending as much time with the traders as I’d like (but that should change soon I hope). Most of the major news sources, e.g. Bloomberg, seem to concentrate more on equity markets than credit and fixed income. I pay more attention to the Dow now than ever before. That is why I am so perplexed by the stock market. I thought stocks were supposed to be easier than bonds, i.e all the smart guys are in fixed income, right?

So while the credit markets seem to be imploding, stocks are doing just dandy. Maybe people are taking cues from the market cheat sheet?

Anyway, I’ve blabbered quite a bit on this blog (and at my former employer) expressing my opinion of CDOs. I even managed to upset quite a few people while expressing my opinions as well. No regrets though. I’m happy to have this hugely public diary, both here and on NP, to later look back and see how I did in regards to thinking events through. Occasionally, I still like to poke my nose in over at NP and I see kr is still giving out the occasional nugget. Here is one of his latest:

A few thoughts:
– If you took all the writedowns at a single med-to-large bank rather than seeing them across the street, you could have reduced that entity’s equity to ZERO. For instance, MER has only something like USD54bn of mkt cap and USD39bn of book equity.
– If the view is that there will be another round of writedowns in the same amount as Q3 then you will have banks desperate to raise equity (i.e. it is not just the monolines). Who would buy that equity right now? Prince Alwaleed for example has floated his own holdings so I see him more as seller than buyer for example. I don’t see guys like JC Flowers or Cerberus well positioned for this job – in retrospect, even Barclays/RBS have not been with respect to ABN, as can be seen by the action in their share price and cost of jr capital.
– Another possibility would be the downgrade to BBB like the Japanese banks, with all the implications that brings with it. I.e. serious change in business model. That has contagion and macro effects. One example is that flow trading of financials has cost people a lot.
– I think investors will call foul on the FAS157 Level-3 assets, and it will hit guys like GS seriously as their L3 reporteds are a big multiple of their mkt cap.
– There was a funny comment in this month’s BBG mag about “nobody really knows how desks are hedging the CDO assets.” That is bull – the answer is that most people were NOT HEDGING AT ALL, BECAUSE THEY COULDN’T. Stuff was originated to sell, and the exit has vanished, or, it was originated to live forever on a trading book even though people tried to avoid saying that, and there is no decent MTM approach so instead banks are showing huge volatility, mostly to the downside.
– Implications of SIV / CDO / CP demise are pretty vast. There seem to be an increasing amount of trade receivables on the market, b/c there are no conduits to fund them… means corp cost of cap is going up in unexpected areas.

My hunch is that the fed cuts on the 11th b/c liquidity is dropping again, especially with year-end. It is out of control – specifically Ben’s control. It looks like political support for the various subprime fixes has stalled. What I think is that liquidity of all things financial (i.e. non-corporate) is going to get weaker and cause a full-on crisis for a market-traded institution. The talk about Citi cutting their div is one tremor, trading activity in Barclays is another, and the fact that even AFTER all the reported loss numbers, people still don’t feel comfortable, is yet another.

I think vols are still cheap, maybe looking to buy some.

All the while I was complaining about CDOs, I was coming at it from the angle of a “quant”, i.e. thinking about how to model CDOs and how those models are used in risk management, asset allocation, etc. Too bad I didn’t understand more about the legal/accounting aspects of CDOs. The term everyone has now heard of is SIV. I was blabbering about off balance sheet leverage and fair value accounting, but didn’t realize that the entire CDO market was (to a jaded eye) a big play on accounting in addition to the obvious play on ratings agencies. If I had known about SIVs, I might have been able to do more to help some who may have now lost a lot of money. Maybe not. That’s all in hindsight. But what am I missing now? Where is the next weakest link? How are corporations hiding off balance sheet debt? Has anyone looked at “Level 3” assets in corporate, i.e. non-financial, balance sheets? Are they as scary as the big banks?

I’ll say it again… this is not a subprime issue. Subprime contagion does not explain the current environment. Subprime was just the first to blow. We are experiencing the blowup of a global fixed income bubble. In fact, some would say we’re experiencing a general global asset bubble.

Who’s going to get hurt? Financial institutions for sure. Anyone who depends directly on the value of paper assets.

Who’s going to win? People whose wealth depends on physical assets.

I’ve already lost all hope in Bernanke. He is not going to let his monicker “Helicopter Ben” go by the wayside in a “time of need”. Bernanke is going to lower rates and weaken the USD until oil exporters are forced to break the peg to the USD and inflation skyrockets. I predict that all these gloom mongers about home prices dropping by 30% will turn out to be wrong in nominal terms even if they are correct in real terms. In other words, home owners are going to be saved by the dropping value of the USD. All those on Wall Street who were so gleeful every time rates dropped are suddenly going to feel the pain when the value of their paper securities go up in smoke.

Watch out for the “happy stage of inflation”, i.e. wage increases. It will be interesting to see what the world will look like when oil is priced in EUR and the USD is no longer the world currency. Fortunately, I still have faith that we’ll come out of the current mess stronger as a country, but there will certainly be pain felt at the higher end of the wealth spectrum.

I’m actually ironically optimistic about the outlook for suburban and rural economic development. A weaker dollar will make outsourcing less attractive. That will bring manufacturing jobs back home. I can imagine a boon in suburban and rural development. Just imagine if communities developed decent broadband via fiber-to-the-home/business. Suddenly, there will be attractive jobs and living standards in affordable places.

Maybe a weak dollar is what this country needs, i.e. a good kick in the pants. Pain is the best teacher, right?

[Edit: PS, the title of the post was inspired by a great article on Financial Armageddon, but I never got around to explaining why, but have a look and it might be obvious.]

Corporate leverage puzzle

with one comment

I hope I’m giving enough disclaimers so that no one can possibly be fooled into thinking I actually know what I’m talking about, but I continue trying to absorb as much as I can as events unfold.

I know very little about financial statements and most of my comments on the subject of corporate leverage have been guided by simplistically thinking about basic human nature. For example, in this post

More on CDS, implied corporate leverage, and default rates

I stated (emphasis added in bold)

I’ve heard economists blabber about how strong corporate balance sheets are as they have decreased leverage since 2000-2001, but these same economists have absolutely no clue about CDOs and other avenues for off balance sheet implied leverage. In my opinion, the only thing holding default rates down was the availability of easy credit, not some increased sense of corporate responsibility. I think we will find that most corporations are more highly leveraged than balance sheets would suggest.

And in this comment, I said:

What you say about FAS 140 and particularly securitized mortgage products makes perfect sense. I don’t disagree, but my thinking is that there is something else less obvious related to FAS 140 (or at least off-balance sheet exposures) that will crop up once default rates pickup again. We’ll see. Like I said, I don’t have anything more to support the idea than basic human greed on the part of corporate executives during a period of easy credit.

Maybe I was looking in the wrong place, but my instinct may not have been too far off. Here is a very interesting article via Portfolio.com

Corporate Deleveraging May Be Overstated

Maybe instead of looking for sneaky off-balance sheet stuff, maybe it is right there in front of our eyes. “Fair value accounting” seems quite amenable to “asset price inflation”. If asset prices are inflated, this would make corporate leverage seem muted. A situation that could be quickly reversed. Hmm…

Written by Eric

August 28, 2007 at 9:36 pm

SFAS 140

with 6 comments

Over on NP, rowdyroddypiper, a.k.a. rrp, on July 26 said:

If you want to see what goes into getting something off balance sheet start reading up on FAS 140. I will send you something if you like on it.

I consider this homework that I haven’t done yet, but thought it was interesting to see FAS 140 appear on one of my favorite blogs, Calculated Risk

SFAS 140: Like A Bridge Over Troubled Bong Water

Physicists often shoot from the hip and go with what feels right. This is a bit more serious than it may sound because you spend years and years of hard core technical training to be able to discern real content from BS. A lot of that thought process becomes subconscious so I’ve learned to trust my gut over time. Another “gut” feeling is that SFAS 140 will come more and more into play as the credit cycle turns. Particularly as default rates increase. Corporate balance sheets appear to be strong and that has been one justification for tight spreads over the past couple of years. I think we’ll discover that the appearance of strong balance sheets will turn out to be little more than smoke and mirrors as default rates increase. Understanding what off-balance sheets exposures to a turn in the credit cycle corporations have will be crucial for investors in the next few months I think.

Written by Eric

August 6, 2007 at 12:00 pm