Goldman SLP Conspiracy

Tyler’s ongoing crusade against Goldman and NYSE SLP program has begun to spread, and frankly I’m really confused. What exactly are you accusing them of? I love your blog man but I don’t see the logic here.

SLP is a liquidity provision program, participants get paid to provide liquidity (not as much as DMM’s, but the quoting requirements aren’t as stringent either – as a side note, you can’t simply say one program is BETTER than the other, there are many other factors).  Goldman is one of the few houses on the street not reeling in pain, more volatility creates more opportunity for liquidity providers and as one of the few players able to deploy capital they have stepped up. If you look at the program trading volumes, Goldman has essentially taken up the slack of the other houses (and hedge funds who has also been in pain) and the additional increase can be accounted for by the subsidy from SLP as well as the higher profitability environment for market making.

As far as pushing the market around, that’s hard to do when providing liquidity. Theoretically they could be supporting the market, but SLP trading could not account for 100,000 futures being bought at market — if anything GS was the one taking the other side of these large swings. And making huge money as they have been coming back the next day…

Consequences of market manipulation

The Fed has maintained a counter-cyclical monetary policy because it is thought (I contend our sample size isn’t large enough, but in a few years I think we’ll get a good feel…) that “leaning against the wind” leads to less volatility and less overshooting in the long run for the economy and interest rates. I think it merely allows marginal companies to survive, rather than flushing the system of debt and reallocating resources more efficiently but with pain, and weakens our banking system over time as it is encouraged to take more risks.

But, there is a limit to the amount of damage the Fed can do by setting targets for the front end. While the rest of the curve and other interest rate products tend to follow, they also are free to have a mind of their own (especially further out in duration). The Fed has lowered front rates as far as they’ll go, but now wants mortgage rates lower so as to hopefully arrest the fall in housing prices. I think Ben knows what he’s getting himself into, and the final result (which he likely foresees) is that we will have a slow grinding adjustment in housing prices rather than a quick and violent one. With mortgage rates being held artificially low, an artificial demand for housing will exist in the market until the manipulation is halted and rates are allowed to return to market clearing levels. Theres a lot of benefits to this approach — it gives banks time to earn their way out of this mess and hopefully recapitalize faster than losses mount (I think it’s debatable whether slowing price drops at this point will make much difference, maybe he foolishly thinks he can turn the whole market without destroying the dollar…)

There are a lot of drawbacks too, and Fed purchases of MBS and suggestions by Felix and others that they should purchase other assets further out in duration than current programs, like Corporates, will only compound these drawbacks. The Fed is essentially replacing market forces, the invisible hand, with its own thoughts on asset valuations. Sure, right now we have banks that are essentially backstopped by the Gov’t allocating this capital, why not just let the Gov’t themselves do it (I think Interfluidity recently brought this up also) and ignore the profit motive? Profit is what makes capitalism work; even if it’s a call option instead of pure equity it’s certainly better.

Maybe these assets are undervalued right now (I would disagree vehemently, even though liquidity is so low) and they are correct in buying, but when will they sell? Models & Agents, a blog that’s new to me, is also concerned about the way the Fed is beginning to dictate who gets credit and who does not. The real cost of these programs is not the gross $ amt spent to purchase MBS or bonds, or even the net $ amt after taking into account sales prices and coupons (whenever they are sold, or likely held to maturity) , but rather the impossible-to-measure impact these false, manipulated, market prices has on the pricing of other assets. And with manipulated asset prices, we open ourselves to the certainty of misallocation, further misallocation might I add, of resources in our economy.

At this point I’m convinced we are headed to a slow grinding decline, both economically and politically. The Fed will continue trying to hold up asset prices to the detriment of our fiat currency. It is a sad state of affairs when the leaders of capitalism become too scared to take the associated pain that comes with the territory and think there is no drawback to taking pain killers and continuing on their merry way. We need to flush the system out, or we’ll be stuck making shitty cars and building McMansions 100 miles from civilization for the foreseeable future.

Negative Basis Opportunity?

Felix suggests that a great place for the government to deploy some funds is into CDS negative basis trades since it seems clearly mispriced (due to liquidity) and seemingly free money. The Zero Hedge article, a good primer to CDS negative basis trades, doesn’t put nearly enough emphasis on cross-correlations (between protection sellers and negative basis issues) and therefore counterparty risk. Some of the comments to Felix’s post correctly bring this point up. There is a very good reason CDS protection trades so cheap to the yield on cash, and cash being expensive is only part of the puzzle.

This is essentially pricing in the cost of corporate bond repo right now — there’s a reason why the cash is so illiquid; the positions are much more difficult to finance than before. The last thing we need is the US government sitting on huge slugs of corporate debt in bankruptcy; the economy would be much better off with holders that have real experience with such things.

Furthermore, Felix mentions that the Gov’t could buy the CDS protection through the new exchanges/clearing houses being proposed. Assuming it is an exchange, I find it hard to believe that it will be based on contracts that settle physically — these are rare enough OTC as it is. Without a physical settlement, the Gov’t will be stuck holding the bonds (now equity) after bankruptcy with major uncertainty as to final payout when/if the entity emerges. Don’t suggest recovery swaps either, the market isn’t there. If the Gov’t merely relies on a new CDS clearinghouse, the result is likely to be higher rates on the CDS (making the trade less attractive) since counterparty risk will be likely reduced vs. OTC via higher margin requirements, etc.

You have a lot of good ideas Felix but this one I just don’t see

Thain

Why is everyone so pissed about $20k curtains? This guy did the best job anyone could in his position, and pulled off a miracle for MER shareholders. Shit I wish he was the CEO of everything I own; I’d bonus him out of my own pocket. This is capitalism at it’s finest people, pay attention.

Rates Can’t Stay Low Forever

I’m currently half way through A History of Interest Rates, highly recommended for fans of economic and fixed income history, and couldn’t help but wonder if we are about to relive the 1800’s.

“By 1892, the great bull market in British funds [perpetual debt of the empire] was at least seventy-five years old. There had been brief reversals in times of financial crisis…The experience of several generations of British investors proved that market declines in the funds were always temporary, that new high prices always eventually rewarded the patient holder, and that every sharp decline in price was just one more opportunity to buy which probably would never recur. Three percent is now considered a high return for Her Majesty’s funds. It was worthwhile to buy funds in spite of the low yields because the buyer was virtually sure of a handsome capital gain.“

From 1800 to 1900, the rates on funds dropped from around 5% to a low of 2.5% (in 1888 Chancellor of the Exchequer Goschen was able to convert all outstanding debt into new 2.5% consols). The decline was slow and steady, leading to the popularly held beliefs mentioned above.

This was in a time of gold standard and procyclical monetary policy. There was no attempts at engineering modest inflation as in modern times. Retail prices ended lower at the end of the century (http://www.measuringworth.org/graphs/graph.php?year_from=1800&year_to=1900&table=UK&field=CPI&log=LOG) but was merely a pause in a long term climb (http://www.measuringworth.org/graphs/graph.php?year_from=1700&year_to=2000&table=UK&field=NOMINALEARN&log=LOG). The steady decline and historically low rates was common throughout Europe and abroad, although at slightly higher rates than the British. 

I’m currently short bond futures in my personal account — I think Bernanke is too afraid of sustained deflation and will do anything he can (and succeed) to engineer inflation, for better or worse. Long rates will go up sooner rather than later. But would it really be so bad to relive the 1800’s?

Has Buffet gone senile?

Since BRK has not been required to post collateral on their short puts, the counterparty is hedging their exposure through the CDS. As the puts go more in the money, there is more mtm p/l exposed to BRK credit and so more protection must be purchased. Watch for the CDS to collapse once we rally off the lows.

30 year swap spreads negative

Some people have taken note (namely alea most recently here and John Jansen daily) of the 30 year swap spread which has gone very negative recently. Sure there are definitely technical factors at work here, but perhaps the market isn’t being completely crazy. 

How is this possible? Well what if AAA multinationals are being priced as less risky than treasuries at this duration? There is the possibility of a US default (see: treasury CDS at 40 bp+). We can’t default? Really? In a situation where US simply forces certain treasury holders to take no or lower payments rather than the expected inflation-based default, any large corporations that are able to survive with non-USD revenues could very well be a safer bet.

Jump Risk and Dangers of CDS

Felix asks why people feel CDS is the main culprit even though other markets (IRS, currency fwds, etc.) have much larger notional (and likely net) outstanding exposures — why would regulating CDS into an exchange solve the problem when these other markets are so much bigger and still unregulated? All OTC markets are run pretty smoothly, with standardized contracts (ISDA) and pretty strict collateral requirements and counterparty risk control (with the exception of allowing AAA counterparties to go without collateral posting).

I think the crowd is generally right in that CDS are inherently more dangerous OTC derivs than the others, but for the wrong reason. The main risk in these markets is a jump in value (overnight, or even intraday) of widely held contracts which would require large amounts of collateral to be posted with very short warning. This massive demand for cash destabilizes the system.

CDS are essentially corporate bonds, the main cause of jumps here is sudden risk of default — this is very common.  Can IRS or currency forwards jump also? Of course, exotic IRS is an obvious but the notional here is much smaller than the vanilla (these values can jump like crazy, consider barriers near expiration, for example). Vanillas can jump during flight to quality, sometimes. Currency forwards are more likely to jump, this happens every time a country is at risk of default and/or there is a currency panic (most recently, pretty much every major country, and to the extreme in Iceland, etc.)

But, there are other factors which tilt the majority of the destabilization risk towards CDS. Correlation tends to be very high here (although this applies to currencies as well during contagion). Defaults tend to cluster, just like volatility.

Finally, and this factor differentiates CDS with OTC currency contracts, CDS exposure is very concentrated. Let me explain what I mean. When currencies explode in a certain direction, banks tend to be hedged off pretty well, leaving counterparty risk with what tend to be a diversified set of non-financial counterparties (just typical companies using forwards to hedge currency exposure). When CDS explodes, the banks are pretty well hedged off, but counterparty risk remains towards the writers of protection, and the primary writers are monolines, AIG, etc. ie, highly leveraged institutions, undercapitalized for a correlated jump and the resultant collateral demands.

This is where the destabilizing risk comes from: bank exposure to concentrated leveraged counterparties with high JUMP RISK. This is the CDS market. Moving to an exchange will put the burden of handling margining into a central party with visibility of all contracts, and with the benefit of hindsight will set collateral and leverage requirements with the understanding that these will jump in a correlated fashion. In my opinion this can be done without moving to an exchange, but it will likely improve the market overall in the long run.

Japan Real Estate Bubble and Price-Rent Ratios

A few posts, most recently one on VoxEU, got me thinking about the potential for the slide in housing prices to extend well into the next decade rather than cratering at a trendline in a year or two. The best way to get an idea as to how far our price-rent ratio will fall (or overshoot historical levels) is by looking at Japan where real estate prices have been falling since the peak in 1990. Using land price data, housing price indices, and monthly rent data from JREI, I have managed to cobble together a crude set of data going back to the 1950’s. Some fudging was done (most notably multiplying land prices by 1.75 to get an approximation of retail housing prices), leave a comment if you want to see the details or a copy of the spreadsheet.

 

Global Property Guide will give you some recent, more granular, price-rent data for Japan (and other countries). From this fudge job I would hazard a statement that Japan’s RE was far more overvalued than ours in the bubble and has been correcting down to a reasonable rental yield since then. Only recently has it reached levels that it could rebound him (overshooting to the downside levels form the 70s but right around levels from before).

Here’s a chart of US price-rent data (through may ‘08, its quite a bit lower now, around 23-24 on this chart):

Just a note on the absolute level of these ratios: in theory they should be pretty close (with differences for political risk, taxation, zoning regulations etc), but may be off due to different measures of rents, house prices, and the matching up of the two. The point is to get an idea as to how the ratio behaves over time and relative to historical levels; we want to know how much we can expect to overshoot.

Unless rents start rising rapidly (which they may given inflationary policy being undertaken now), real estate prices are likely to fall sharply for another year or two and then stay pretty stagnant before resuming a slow climb higher. Could be worse…

For this week…

GM bailout (bankruptcy less likely)

Pakistan, Iceland sov bankruptcy

Morgan Stanley takeunder

BAC, JPM, C support from gov’t, looking like senior prfds