Wednesday, May 22, 2013

Money, Credit and Collateral: Why Quality and Value Matter

The debate over liquidity deconstructed: creation of quality collateral is not sustainably possible via asset inflation schemes. Value and valuation cannot be consistently gamed and subverted.

A primary systemic risk in the 2007-8 financial crisis was relatively poor collateral underlying highly leveraged instruments. When interest rates rose due to Fed tightening after a sustained period of artificially low rates, those instruments became distressed once a negative equity condition was reached, and perhaps even prior to that condition, based on market anticipation. Duration mismatch for spread bets (borrowing short and lending long) was also an oversubscribed game, adding significant systemic risk. The evidence of these dynamics can be found in the growth of the collateralized debt obligation (CDO) and the repurchase agreement (repo) markets, among other related structured finance, debt and funding/financing markets, including mortgage backed securities (MBS), commercial paper, auction rate securities, etc. - this growth was geometric with a pronounced flare toward the 2007-8 crashes. The growth in these markets coincided with significant inflation in housing and commercial real estate, among other asset classes, and can be characterized as part of the "liquidity" bubble that fueled the asset price inflation, leading to unstable financial conditions, namely a catastrophic failure of structured financial instruments backed by inflated assets that ultimately provided the fuel to ignite other systemically wide failures. In short, parts of the financial system went from highly liquid to illiquid. The same trend occurred in Europe post-2008: from 2008-11 there was a pronounced growth in their CDO and repo markets, and inflation of similar asset classes, as well as sovereign debt. I have covered the data on these clear historical events in prior posts here, located below.

Post crises, the CDO, commercial paper, ARS,..etc. and repo markets were drained substantially and today they are reportedly nowhere near their peaks. What has not abated: the continued issuance of sovereign debt and MBS, setting records [1] in debt outstanding. Corporate debt issuance, both investment grade and high yield, are at record highs [2].

There is a prevailing school of thought that the Fed and other central banks must pump up this liquidity once again, in the case of the Fed by buying Treasurys and MBS (quantitative easing, or QE), and by leading the drive to a zero-bound interest rate environment (ZIRP). This has led to a record growth in the adjusted monetary base (AMB). As I pointed out HERE earlier in the year, this has not yet led to a growth in the velocity of money (VoM) as measured, but it most certainly has and is leading to asset price inflation across many asset classes, namely the U.S. equity and debt markets, which are sharply pegging new highs as I write this missive. In point of fact, all debt markets and related equity proxies are enjoying record price inflation as a result of Fed interventions, investor scrambling for yield/returns in a record low rate environment, and trend trading/chasing by market participants. Indeed, the pendulum has swung in the other direction, and there is even talk of pushing real interest rates further negative.

What has given the Fed license in part is the claim that broad inflation is low. However, traditional quantity theory of money (QTM) measures are not providing a useful tool for gauging inflation, particularly asset price inflation, and more to the point, the various funnels of hot money flow as a result of Fed policies and the reaction of market participants to its endogenous lead. QTM monetary measures do not accurately capture newly created monetary equivalents or credit money, or hot money flows. The Fed stopped reporting M3, which tracked repo and Eurodollar flows in 2006, and it has not been replaced by an improved metric. Liquidity as measured by new money equivalents, credit money and hot money flows that lead to asset price inflation are not part of any tracked metric. The AMB and excess bank reserves do not clarify the entire picture, and snippets such as margin debt have limited use, though these measures are again at the peak levels seen in 2000 and 2007. The view of some is that we remain in a "liquidity trap," that there is a dearth of borrowing and a propensity toward deflation. The reality is that we are coming off a significant era of inflation through disinflationary deleveraging, with a Fed providing a growing liquidity floor that has led to those funnels of hot money flow, record debt issuance by corporations and the sovereign, and asset price inflation. By inflating assets, collateralized debt and derivative instruments and collateralized funding markets become unstable if those instruments and markets are backed by inflated assets - enhanced by risks such as interest rate (duration) risk, among other risk factors. No amount of gaming or subversion of value and valuation of those assets will change this outcome. This is not sustainable, and nor is the issuance of "quality" debt at record low and lower rates. Broad real economic growth has been stagnant in the era of driven ZIRP, with asset price inflation providing a cheap high that has further systemic costs.

The point I want to leave the reader with is that the Fed and economic participants cannot create quality collateral via inflation of assets. Yet they keep trying to play this game, over and over. QED

[1] Data on issuance and outstanding levels of sovereign debt can handily be found at SIFMA for U.S. Treasurys and the BIS for ex-U.S. sovereigns. Data on issuance and outstanding levels of U.S. and Eurozone MBS and other structured debt instruments can also be found at the SIFMA link.

[2] Data on issuance of U.S. and ex-US corporate debt can be found at the SIFMA and BIS links above. The strong upward trends to net issuance and amounts outstanding are quite clear from 2010-12, with 2013 likely setting new records.




Saturday, May 4, 2013

A Black Swan in the Interest Rate Markets

A sharp, uncontrolled rise or discontinuity in interest rates can have systemically wide risk costs.

Stay Tuned...

Thursday, January 31, 2013

Why Investors Need New Markets

Can investors trust the financial markets, notably the public equity, options, futures and debt/credit markets? The short answer is: No. Why? Here are just a few salient reasons, in no particular order:

  • Rumors for Profit. With daily rumors running amok in the financial media and elsewhere, many investors are left vulnerable by this mill, controlled by those who have the power and perch to create and disseminate false or misleading information, and a conflict of interest, in that they can profit from the trade.
  • Government Intervention. With the Federal Reserve buying $1Trillion+ of Treasury and Agency/MBS debt in 2013, not to mention an open-ended mandate to increase that figure or buy up other outstanding debt, markets are manipulated, become dependent, and do not adequately factor risks from such dependencies. Moral hazard has taught the Main Street investor that those who take inordinate risks from the flow of cheap money at the top and lose will be bailed out, at Main Street’s expense. With U.S. net leverage at a 6-yr high, these inordinate risks are a red flag.
  • Dishonest Money/Asset Management. The Main Street investor is repeatedly told to put money into the public markets, even at cyclical/secular tops, on the pretense that not to do so will result in a lost opportunity. The latest cheerleading comes from such Wall Street investment banking and asset management characters as Lloyd Blankfein of Goldman Sachs and Larry Fink of Blackrock, two recipients of the bailouts in 2008/9.
  • Understated Counterparty Risks. In public financial markets, investors are exposed to counterparty risks whether they want that exposure or not. These risks range from undercapitalized market makers to highly leveraged speculation to overdependence of Ponzi Finance. Counterparty risks such as these were largely responsible for the failures in the financial system in the 2008 credit/housing market crises (for excellent references, see HERE, HERE and HERE). Underpriced risk on credit/debt instruments due to misstated ratings by market sanctioned rating agencies was, and still is, a factor.
  • Inefficient Price Discovery. When there is less transparency in a market, prices will not have absorbed hidden or less known information and become more unpredictable. Transparency includes knowing who is on the bid/offer and who makes the buy/sell. Less liquid markets will also show wide price spreads, as the market makers seek to pad the uncertainty in those markets with risk premiums. In the worst cases, prices do not adjust to reflect information that has become known to the market: this can happen in the options market, where pricing of the option becomes decoupled from the pricing of the underlying instrument.
  • Manipulative Trading. Not all speculative trading is manipulative, and there are positives in markets from the presence and participation of speculative traders, especially if they enable liquidity. However, manipulation can occur from insider trading, as well as large block trading meant to corner markets, affecting price discovery. Eliminating market corners has been as effective as eliminating insider trading. Banning speculative trading has clear negatives for existing electronic financial markets, yet some investors would rather not be in a market with such counterparties and activity, regardless of the positives or negatives, as they (correctly) perceive this activity as gambling in a casino. I will state that I believe that the casino nature of our traded financial markets has existed for well over a century, so this is nothing new.

So how can investors looking for a place to put cash/capital to work avoid these perceived market negatives? My answer: we need new markets. Innovation in new markets and investment opportunities will go a long way toward fending off the negatives that “entrenched” markets have come to acquire. Some will say that new markets will just become entrenched too, so why bother. This defeatist attitude did not hinder those in the past who pushed ahead in the face of adversities to realize new markets that go on to thrive and grow competitively. Here are just a few short ideas, all consistent with the concept of “free markets:”

  • Markets that create disincentives for moral hazard, where failures drive out bad counterparties.
  • Markets that work around the SEC “Accredited Investor” rule, which shuts out many Main Street investors on lucrative return on investment (ROI) opportunities, all in the name of “consumer protection.”
  • Markets that incentivize longer-term investments [most venture capital and private equity investors are relatively long-term, and as “insiders” can obtain higher potential ROIs].
  • Markets that build in fault tolerances that are not a result of over-regulation but of design/construction consistent with free markets.
  • Markets that spread out risks [note we have to be careful that this does not lead to moral hazard: that the large risk taken by one actor is not borne by all the others, but is proportionally absorbed by that actor].
  • Markets that maximize transparency and disclosure of information, and that optimize price discovery.

Critics may reiterate that any new markets will adopt the same market factors as I listed at the top, making it difficult to realize significantly different outcomes. Some critics may state that what I call negative entrenchments are fundamental to any market, and that investors need to learn how to cope with them, investing their money in the available choices and environments. Nonsense. Once again, if we don’t try to innovate and create, and instead adapt to entrenchment, then sure, investors will be served with the same range of outcomes. Limiting choices is what causes entrenched negatives, and only by increasing choices and competition can investors realize a broader range of outcomes, and enable investing in markets that more closely align with investor “value systems:” in short, become value propositions that cause money to shift from one market (the old) to another (the new). Absent new markets and more competition, we face further market entrenchment and stagnation, and even failures from instabilities, such as increased investor disenfranchisement and alienation. It is not impossible to imagine a run on markets that become too hostile to investors. Yet the establishment (read: the mainstream financial media, money/asset management, government regulators) will consistently claim, as they do now, that investors need to get with the program and put their money into existing financial markets, for they have few other choices to earn yield on their money. As I have written previously, this form of financial repression and coercion will backfire, as it always has, historically. Only by increasing choices in markets, and freer choices at that, providing genuine value propositions, can investors demanding trust and other value factors be invigorated. The monopoly to oligopoly financial world we live in is not a fait accompli.

Readers should note that a basic definition for a market is one where participants disagree on value, but agree on price. If investors are limited by what they perceive as value, and refuse to participate in those limited choices, then existing markets may deteriorate unless they have enough participants willing to engage in this basic process. Disappointed participants will simply walk away and hoard cash, or go to any market (even underground markets) that will serve them the process they are looking for: exchange of value at an agreed price. Financial repression and coercion via entrenched market interventions and manipulation are destabilizers. Investors have come to expect and demand more, or they should.

My suggestions for new markets contain many generalities, and need to be focused to allow for specific implementation, particularly in an environment of increasing central planning and regulation. These challenges can be overcome, and I intend on addressing these issues in future articles. I invite readers to add to the suggestions, and to provide specifics on implementation, or simply to provide links to efforts out there that look like they have a chance of success. Only by sharing and proliferating ideas can we start to see a renaissance in our markets.