Invest Skeptically

Last weekend (Nov. 17, 2007) the Globe and Mail published a good summary of the Canadian ABCP story called, The ABCP black box explodes, by Boyd Erman, Jacquie McNish, Tara Perkins and Heather Scoffield.

The reporters correctly point out that the main “trigger” behind the Canadian ABCP conduit crisis was that “investors were beginning to panic that an unknown quantity of toxic subprime mortgages had infected the assets that backed Canadian ABCP”. In fact, “had investors been able to clearly comprehend the workings of Canada’s ABCP, they might have known that subprime holdings were minimal. The boycott of buyers, and the frozen market that resulted, could potentially have been avoided.”

They quote Huston Loke, of DBRS, saying, “everyone was very conservative, from a credit perspective.” And, in general, I believe that.

There are many stories out on this subject with the majority of them leaning towards outrage and astonishment that such “toxic” products were rated AAA (or R-1 high in this case). Barry Critchley quotes Diane Urquhart as saying, “distributors [of ABCP] should also expect to contribute to accommodating settlements [...] since they too were part of the negligence or deceit in the provision of this defective product to Canadian pension funds, governments, corporations and thousands of retail customers.” (Emphasis added).

This tone from the press has permeated into the general public. On the Globe’s website for their ABCP piece a reader calling himself Henry Egan, from Cyberland, Canada, writes: “when no one knows or cares what the nature or quality of the underlying assets are, what was to prevent the lenders from deliberately creating, securitising and ejecting all of their junk onto the marketplace as high yielding ABCP’s?”

I think that the reporting to date has been very muddled in terms of the source of risk for investors. The ABCP issue can be broken down into three sub-risks: (1) credit; (2) liquidity; and (3) market risks.

1. Credit Risk - Continues to be relatively low

I believe the statements out of DBRS that the credit quality of the underlying assets is generally good. To reach a AAA rating, these transactions were structured with relatively high attachment points, or, levels of subordination. Subprime exposure was low and much of the exposure in single tranche synthetic CDO transactions (or CDS on a CDO tranche) involved corporate credit as the underlying.

And how is corporate credit doing these days? I saw this headline on the Default Research section of the Moody’s website:

Global corporate default rate hits lowest level since 1995; 1.1% in October
Despite diminished liquidity and volatility in the credit markets, the global speculative-grade default rate continued to fall in October, reaching 1.1%, its lowest level since March 1995, our latest default report reveals. The rate has now declined approximately 33% from the beginning of 2007.

2. Liquidity Risk - Usually very low… until it’s not

While it is a fact that Canadian ABCP operated under “general market disruption” language for its liquidity backstops rather than the more robust “global-style” arrangements, the risk of funding problems (i.e. rolling the paper) is low as long as the market continues to function normally. So while the Globe characterizes the conduit business as being great until “someone stops paying their mortgage,” the greater risk to the business model is that commercial paper investors will stop buying commercial paper. And that’s where we are today.

3. Market Risk

I once heard a speech in Toronto by a rating agency spokesperson who said that investors want “risk-free spread.” (This same speaker also said that the leveraged super senior transactions inside the conduits were, “very AAA”.) Canadian ABCP investors were being paid relatively high interest rates for top quality, short maturity, debt. So what type of risk were investors being paid for?

Market risk.

In the absence of robust liquidity backstops, CP investors were still protected in that the trusts could sell their underlying assets to repay the commercial paper. However, as the Globe article points out, under current conditions “there would be a fire sale of assets in tumbling markets, and ABCP investors would have no chance of getting all their money back.”

Conclusion

ABCP investors now find themselves stuck in the unenviable position of holding high credit quality paper with underlying assets that can’t be sold into falling credit markets, and, with a current illiquidity in the CP market that makes it undesirable to other would-be purchasers.

While much blame has been apportioned to the investment banks behind the CDOs, issuers and dealers of commercial paper, and DBRS, at the end of the day there is no such thing as “risk-free spread”.  All money managers, advisors, and consultants had an ethical duty to their investors/clients to exercise care, diligence, and skill when making investment recommendations and taking investment actions. And presumably this included understanding the risks they were taking.

I’ll close with this David Dodge quote from the Globe article:

“The responsibility lies on the investor and if he or she takes risks, they should expect to benefit if things turn out very well, and should be expected to pay the costs when things turn out not so well.”

As a Canadian who invests heavily in U.S. stocks it alarms me to see the value of the USD slide against the CAD (and every other major currency) so far and so fast. Is this a sign of overall bearishness towards U.S. assets? Although many large cap names derive significant revenues from overseas, I’m finding ever alarming signs of doom and gloom in the U.S.

• The economy at large
  In his Blue Magic video Jay-Z flashes 500 Euro bills instead of the more traditional Dollar. Truly there is no single economic indicator more weighty than this.
• U.S. residential real estate
  While browsing the web today I came across this blog entry about rising “real estate owned” in Orange County. They’re foreclosing on mortgages in the O.C.?!
  
• The financial system
  There has been much, duly deserved, positive commentary of the bail-out plan for U.S. structured credit vehicles. However, I think it’s noteworthy that the final list of institutions who were able to step-up to the plate (Citi, BofA, JPM) all have very large commercial banking operations. Where were the money-centre banks? Perhaps they’re in so deep that they aren’t in a position to offer market stability. Contrast this trio to the broad consortium of counterparties that bailed-out LTCM.
• The future
  There was a PBS documentary on the other night about the “space race” and I was reminded of how fast the U.S. can move when they really put their minds to it. They have contributed as much as, if not significantly more than, any other modern nation in the development of science and math into techniques that alter the course of civilization and increase standards of living. But where does the education system focus its energies nowadays (remember that I’m an outsider and that I only see the country through the eyes of the American media headlines)?: abstinence-only sex-ed programs, breathtakingly inane battles over intelligent design, and charter schools that try to fill the void left by a public education system that is viewed as failing.

As my former schoolmates (engineering school) will tell you, I don’t pretend to be an expert in math. In fact, I don’t even have a Ph.D. or masters degree in any of the popular risk management backgrounds: math, physics, engineering. But in light of recent experiences in the credit markets I’ll give you my two cents on quantitative risk management. Hopefully there are some mathematical finance readers out there who can offer me their feedback.

Why it’s a valuable management tool

Measuring risk quantitatively is a very important exercise for the purpose of financial risk management. You need to be able to quantify your exposures for the purpose of (among other things): setting capital reserves, reporting risk to regulators and investors, understanding how you’re doing in terms of managing your risk, creating scenarios for contingency planning, and, rating structured financial assets as ‘AAA’.

My naive generalization of the approach

Using a plethora of assumptions about probability distributions, relationships between asset classes, and all the required input parameters for such, you create a correlated loss distribution. In practice this is generated through simulation but in theory it is a nice continuous function. This distribution can tell you things like: how much will be lost with X probability? (you do this to calculate things like VaR or finding the rated attachment points in a CDO).

The real dangers

The problem with any purely quantitative approach, at least my version as outlined above, is that the “real” dangers to any financial operation are typically very lumpy/chunky/discrete. Examples:

1. When liquidity runs out (as with the Canadian conduit market right now, or with LTCM’s collapse), no matter how well positioned you believe you are, the game is over.
2. When a company defaults or goes bankrupt, and you’re holding the credit risk, you’re in big trouble fast. A colleague of mine once taught me that diversification works differently with credit. In your stock portfolio, your winners can make up for your losers, but the best a bond can ever do is pay you back.
3. Changes in the rules (whether from regulators, legislators, or even your suppliers) can completely ruin the economics of a business model. Check the monthly growth of the ABCP market across 2006 versus YTD 2007. This is after the press release from DBRS, DBRS Revises CDO Criteria for Canadian ABCP Issuers (January 19, 2007 ), saying CDO transactions must be, “supported by liquidity facilities from DBRS-approved liquidity providers that contain conditions to draw that are not limited to market disruption and are not dependent on a confirmation of the then-current ratings” (emphasis added).

The conclusion

While modern risk management is a mathemagician’s game, there’s always going to be an important role for people that can understand and make prudent judgements about fundamental risks that can’t be accurately modeled.

Over the last few weeks there has been intense media coverage of U.S. subprime mortgages (still), the securitization of such (still), Canadian ABCP programs (that’s new), and demands for new regulation (gasp). After much Googling and newspaper-flipping here are some of my comments.

U.S. Subprime Mortgages

I specify U.S. subprime mortgages because the Canadian version of the product is supposed to be relatively safe–isn’t it? (See chart of XMC). The media has been attributing the disaster in this industry to the ability to securitize the product. Underwriters were motivated to get more business by weakening underwriting standards and thereby making them more money when they eventually sold the mortgages to securitization programs.

• This shows a complete lack of ethical backbone. A large factor in the subprime blowup were these ticking time bomb products where the borrowers were enticed by low teaser rates for two years and then some GINORMOUS rate thereafter. How can you advise consumers to take such a product? I think history should remember this as the true scandal of the industry.
• This shows a complete lack of professionalism by the underwriters. You cannot just start underwriting junk for the sake of reselling it to the capital markets–albeit with a shiny new sticker on it. This is the financial equivalent to contaminating wheat gluten with melamine and selling it to pet food manufacturers as a high protein ingredient.
• Where was the due diligence from the investors in securization paper? Even without specialized knowledge there should have been enough scary signs in the prospectuses to set off alarm bells for credit managers and cause them to demand higher yields and more information on the underlying mortgages.

Canadian ABCP Programs (a.k.a. The Canadian Conduits)

The story here is that the independent Canadian conduits (to distinguish them from the Bank sponsored kind) have been unable to roll their commercial paper. This is an asset-liability matching problem where you have long dated assets (say 5-10 years) and short (say, 30-day) liabilities. The conduits managed this by essentially making the interest rate risk of the assets much shorter–that’s how the rating agency can believe that CP investors will be paid their interest and principal. But the value of the assets are not so much interest rate sensitive as they are credit market sensitive. And credit markets have not been a happy place (read: value goes down). So how do you pay back investors every 30-days? Just find new investors. There are no new investors? Uh oh…

What normally happens, were this corporate CP or U.S. style ABCP, is that a liquidity provider steps in and pays back CP investors. The reason this has not happened across the board is because under Canada’s DBRS regime ABCP was (but no longer) covered only under General Market Disruption (GMD) liquidity. The basic idea of GMD is that your liquidity providers must step in when Canada’s ABCP market becomes totally broken. A highly unlikely event given that, even now, bank sponsored conduits are still able to roll their CP.

• The most important point to make is that there have been no reports (that I could find on Google) of any credit related problems in these conduits. So while news reports talk about U.S. subprime mortgages and the Canadian conduits in the same breath, you can not assume that these conduit assets have had any problems. On their website, Global Securities Corporation reports that Coventree sponsored conduits have less than 4% exposure to U.S. subprime and all in pre-2006 vintage (read: before the poor underwriting mentioned above). So what’s the problem? These conduits are suffering through a period of poor liquidity in the CP markets–not necessarily poor credit quality in their portfolios. This is not entirely clear when you see Barry Critchley’s column (August 23, 2007) where he begins by quoting a voicemail message saying, “What happened here is that a bunch of people who were supposed to be watching credit quality took their eye of the ball and let a lot of stupid stuff get done in the market.”
• In the same article Critchley points out that CP investors (usually large institutional buyers or corporate treasuries) have been paid 12-14 bps more than their U.S. counterparts because of the GMD language. In other words, they knew, or should reasonably have been expected to know, what they were getting themselves into and accepted compensation for the extra risk. I tend to agree.
• While both the conduits (particularly Coventree because it’s the only public company) and DBRS have taken a lot of heat in the media, the money market managers buying the paper had a responsibility to know what they were buying. Much ink and server space has been used to ponder, “Are Money Market Funds Really Safe?” In his most recent column (August 24, 2007) Critchley quotes a money manager as saying, “[my clients] are having ulcers about their hard-earned savings, which were supposedly invested in low-risk commercial paper.” Where are the articles asking, “how much does my money market fund manager make and why does he/she deserve it?”
• As for the corporate treasuries that bought R-1 (high) ABCP and got unwittingly burned (or maybe just warmed so far), some blame must be laid upon the financial advisors that put them in this product without understanding what it was all about and clearly communicating the risks to their clients.
• Worst case scenario: the independent conduits can’t refinance the CP and have to wind down the trusts. Existing CP investors get paid back whatever the market value of the assets is. Which is…??? I think history should remember this as a serious failure in the investment process. While money market managers were buying this paper (on behalf of ordinary consumers), and financial advisors were telling corporate treasuries to buy it, did anyone actually know what was in these things? And what the NAV was? Do they know that now? Has anyone even bothered to ask the sponsors? Did they ever ask? My Google search is silent on this question.

Regulation

Of course, all this market commotion causes people to start thinking about regulation, or an increase thereof. At first I was a bit shocked and offended when I saw the title, “Thinking the Unthinkable: Regulating the Brave New World of Finance,” on the naked capitalism blog. In this post, the author quotes Clive Crook of the Financial Times as writing, “financial innovation itself is the problem.” Well that doesn’t sound too good.

In another post, naked capitalism quotes Henry Kaufman (a.k.a. Dr. Doom) as writing,

“At the heart of the long-term underlying challenges that face the U.S. financial system is the question of how to enforce discipline. One way is to let competitive forces discipline market participants: The manager who performs well prospers, while those who do not fail. This is the central precept of free market economies. But this approach is compromised by the fact that advanced societies typically do not allow the process to follow through when it comes to very large financial institutions. The fear is that the failure of behemoth financial institutions will pose systemic risks both here and abroad.”

I think lack of discipline stems from a lack of professional and ethical standards. A colleague of mine once said that, “people are either ethical or they’re not;” meaning ethical “standards” won’t do much to reform them. After factoring in the not-so-healthy dose of greed of most capital markets participants, I’m starting to come around to the idea of increased regulation. Or different regulation. Or maybe just some subtle but targeted measures as required.

But how can you enforce market discipline without tying the hands that make the markets efficient? Even in hindsight, cause and effect relationships are difficult to work through. For example, what if banking regulators had required the same amount of capital reserves for GMD style liquidity as U.S./International style liquidity? That’s a subtle and targeted measure. But would we have got to where we are now anyway?

The Conclusion

As usual, the lesson from subprime and ABCP is to know what you’re buying and invest skeptically. I’ve said it before and I’ll continue saying it, until, one day, investors change their ways and I’ll have nothing to write about.

In a previous post I alluded to the fact that most mutual funds are benchmarked against some broad market index instead of a style index. While style indices are interesting–and arguably more “correct”–the reality is that market indices are the standard comparison for marketing purposes and market index returns are the kind of data that most of us can freely access.

Market indices play another important role in that they are the basis for most ETF products–and ETFs have become a prominent means for investors to get their market exposure. This makes the market indices investable which is a key criteria for a valid index. So while they may not be sound theoretical benchmarks, they are certainly a useful measure of relative value and the opportunity cost of manager selection.