Posts Tagged ‘CMBS’
This Isn’t Good News for CMBS Holders and Erstwhile Pipelines
We occasionally write about CMBS or Commercial Mortgage-backed Securities and the CMBX index. For example, last November, we wrote CMBS Is Like Lumpy MBS and That’s Not Good. We tend to get more hits on our tongue-in-cheek post, How to Trade CMBS? and find that a bit scary.
What should truly frighten both CMBS holders and banks with large commercial-mortgage loan portfolios more than our discussion of our page rankings is this article in Saturday’s edition of The Wall Street Journal: Hotels Deliver Some ‘Jingle Mail.’ The article details how hotel owners are walking away from highly-mortgaged properties and how delinquency rates for securitized hotel loans are almost ten times higher than they were one year ago – about 4.75%.
We suspect that banks that were erstwhile structurers and had accumulated an inventory of such loans (for later bundling that has not yet materialized) may face even larger problems.
Using the logic that the last loans made before the bubble burst are likely to be less creditworthy than earlier ones, we suspect that the delinquency rates for those loans that didn’t make it into a CMBS pool before the market collapsed could be even higher than the nearly five-percent rate mentioned above.
Moreover, while we’d argue that any claimed diversification benefit of CMBS was grossly overstated, there is absolutely no diversification benefit from holding the entire loan. Those banks and structurers that are stuck holding those loans bear the entire risk of default. In some ways, it reminds us of a very expensive adaptation of the game, musical chairs. (CDOs and CDOs squared, etc., are reminiscent of “hot potato” or blind folks tossing raw eggs back-and-forth.)
Finally, we would be surprised if former structurers and banks with clogged pipelines didn’t report higher credit losses in the second half of this year. If they don’t, we will wonder whether regulators are being particularly loose in supervising how those banks calculate their loan reserves.(At this point, we suspect those loans are no longer “held-for-sale,” but have been reclassified into the regular loan portfolio.)
We hope that the financial crisis, which seems to have subsided, has actually subsided. However, we have a sneaking suspicion that it may be personified by Mark Twain’s famous quote about how the report of his death was greatly exaggerated. This is one indication that it’s not over.
How to Trade CMBS?
Our site’s statistics program keeps track of the search terms used to arrive at our humble little venue, and this morning we noticed a hit from the query, “How to trade CMBS?”
That, as they say, struck us kind of funny.
We thought: given the ongoing and (we would guess) accelerating problems in commercial real-estate such a question could come from either (1) someone completely unfamiliar with Commercial Mortgage-Backed Securities or (2) someone completely, deeply, and desperately immersed in the industry. (As a last-ditch effort for marketing help.)
In that way, we’d imagine that on a daily basis any number of commercial-loan conduit managers, bankers, structurers, traders, and CMBS investors all ponder the same question: how to trade CMBS? That, after all, is a defining characteristic of an illiquid or frozen market. Ouch.
If you’re interested in the nature of CMBS, the top post here is a good place to start.
Increases in CMBX Spreads as Evidence of “Financial Projection in a Crisis”
If It Is Much Ado About Nothing, Then It Is an Indictment of Congress.
Since we wrote CMBS Is Like Lumpy MBS and That’s Not Good on Wednesday, AAA CMBX spreads have increased another 300 basis points to a level about ten times greater than where they started the year.
That means that there has been either a large increase in the number of buyers of the insurance or a decrease in the number of sellers (or both), and that could be due to panic or not.
Unfortunately, unless one is exposed (in the same proportions) to the CMBS that comprise the index or the loans to the same underlying firms, then purchases of CMBX are more sledge than hedge. (See On N’edges and Sl’edges and Billions Lost and On Nedges and Sledges and Paving the Road to Hell.)
With sledges it is quite possible to lose on both legs. (It’s kind of like buying fire insurance on another’s house when you can’t buy it on your own. It may be valuable in a widespread forest fire, but it won’t provide any value if you burn down the house with a cigarette ash and that causes the premium on the other house to rise.)
When we see the type of panic observed this week, it makes us wonder whether CMBX buyers are making inferences based upon information about others or whether they’re projecting their own problems on others. We wrote about that on October 1st, when we defined “financial projection in a crisis” (with respect to LIBOR) as:
a bank’s determination not to lend overnight to a peer because of the suspicion that the peer’s viability (or balance sheet or asset quality or future prospects) is similar to its own.
If these recent extreme increases are analogous to our pithy and tongue-in-cheek definition of financial projection, then it seems that prospective losses related to commercial real-estate will be enormous.
That conclusion makes us wonder: what are the odds that banks would give residential mortgages to (almost) anyone but wouldn’t do the same for commercial mortgages? It is possible; so, we don’t consider to be a rhetorical question.
If they were just as reckless, then God help us all.
If they weren’t, and it turns out that they were far more prudent making commercial loans than residential, then that is a further and complete indictment of the senseless and destructive meddling of Congress in our economy (via Fannie and Freddie).
This is one time we’d prefer it to be a case of record-breaking Congressional incompetence.
OMG, Mr. Paulson Agreed with Us Twice in One Week!
Update (01−20−09): now that Mr. Paulson’s term as Treasury Secretary has ended, we must admit that the small bit of optimism we exhibited in this post was sadly and unfortunately misplaced. It was out-of-character for us, but we’re a hopeful pesimist. He quickly reverted to his behavior of September and October, and for that, the markets, the nation, and the world have and will continue to suffer.
We hope that his earlier actions haven’t caused irreparable damage, but we’re doubtful.
This is a longish post that covers several aspects of the ongoing financial crisis and, for the convenience of new visitors, contains plenty of reference links to earlier posts.
In our mind, until last week, the current Treasury Secretary had an incredibly long and unbroken string of wrong decisions and actions. Starting in March if not earlier, and through early November, in almost every important decision, when Mr. Paulson zigged we would have zagged, and vice versa.
Well, actually, we wouldn’t have zagged or zigged as that requires effort. Instead, we hope our rhetorical flourish illustrates our opposition to many of Mr. Paulson’s decisions. We would have done what we have advised all along, and what Mr. Paulson finally, finally seems to be doing: nothing.
As we advised in September, particularly in the posts Overreaction and Moral Hazard: Now That Will Be a Crisis and Public Bailout? Why Rush or Do It at All? among others, we recommend Mr. Paulson to vigorously do nothing, and advice Mr. Obama and the next Treasury Secretary do the same: nothing or more precisely, nothing much.
We italicize the “much” because we continue to (1) offer our private, non-governmental solution to the mortgage crisis, which the government has yet to address since TARP become law, and (2) offer advice on the best way to mitigate the bigger and more worrisome liquidity crisis, and that will require a bit of aggressive government action to motivate remaining bank managers to act or sell. See, we don’t think that the government should act (much), but we do think that banks and shareholders should.
In general, we’re strongly in favor of an economic version of the Hippocratic Oath: do no harm. Thus, we advise: do very little for which there will be few unintended consequences. (Although we do have two specific recommendations in mind that we’ll mention later.)
So little time, so many mistakes: what’s the point?
The Treasury’s earlier insidious approach of getting the government’s many, spindly, little fingers on all of its Vishnu-like arms into hundreds of firms will likely have no end, ever. (Our prediction: they’ll renegotiate rates when taxpayers are supposed to reap the benefit of rate increases.) It was so very disappointing – not surprising, but so very disappointing – to see our federal officials act in such rushed and expedient manners.
Until last week there didn’t seem to be any thought – even an afterthought – of the havoc they were wreaking. Given shallowness their depth of thought, we would have been convinced that Mssrs Paulson and Bush were teenagers with Progeria had text-messaged their interviews and press releases.
What’s the point: when we taught decision-making to MBAs we heavily emphasized (1) knowing the decision criterion – the objective function – and (2) identifying relevant or incremental costs and benefits across alternative courses of action.
We saw no indication that our government’s leaders operated under such a framework, particularly in September and October of this year.
In other words, it should be very clear how to account for the federal government’s decisions and actions. One would hope that officials would have some metric by which they measure the effect of their actions, but that seems to have been beyond them.
What were Mssrs. Bush, Paulson, and Bernanke trying to accomplish? What were (or are) the costs and benefits of their feasible alternatives? Which categories of costs and benefits seemed to have the most reliable and firm estimates? What decisions were most sensitive to underlying variables and assumptions? Which decisions seemed the most robust across potential changes in the economic environment?
During the both the original mortgage crisis and the larger, ensuing and ongoing liquidity crisis, has the reader heard any government official speak in those terms? Or, until last week, when Mr. Paulson said, “Nyet,” were their statements more like: “Eek! We’ve got to do something! We don’t have time to think?” Yeah, it was a rhetorical question.
As regular readers know, we have very serious doubts about the effectiveness of various aspects of the government’s plan – although “plan” seems to be too thoughtful and organized a term to describe the government’s response to the crisis of 2008. Likewise, we have even greater doubts about its efficiency, or the ratio of benefits to costs. (Is it not approaching zero?) We mean that there are at least two issues to consider: (1) will the government’s response ultimately be successful? Will it be effective? And (2) If achieved, what will that “success” cost? Will it be efficient?
Unfortunately, so far, we’ve not heard a definition of success.
However, seven weeks after the approval of TARP, the results don’t look good. In fact, unless “success” has been defined downward, the results look more like failure. The NASDAQ Index sits at roughly half of its twelve-month high, and has lost as much value since the passage of TARP – about 700 points – as it did in the period from its high last December to the end of September. Likewise, the S&P 500 has gone from about 1,524 last December to 806 today, with 366 points of that 718 point drop occuring since September 30. Ditto for the DJIA: down from 13,991 last December to today’s close three points below 8,000. It stood at 10,831 on September 30. Trillions and trillions of dollars of value destruction – both before and after TARP.
Thus, “success” however defined, seems doubtful. Moreover, any claim of success must be tempered by the very heavy cost bourne by taxpayers and investors. So, given those results, we’re very encouraged by Mr. Paulson’s newfound hestitancy to act. But is the too little arriving too late?
Don’t just do something. Stand there.
Given its similarity to our position, we very much enjoyed the recent opinion essay by our former Washington Univesity colleague, Russell Roberts in The Wall Street Journal. It was entitled, “Don’t Just Do Something. Stand There.” A month after our post, Out of Their Elements, and weeks after related posts like Well, This Is a Fine Mess You’ve Gotten Us into…., Mr. Roberts makes similar points, and he draws similar, discouraging, and almost depressing conclusions about the future. Unfortunately, that doesn’t give us even a quantum of solace.
Fortunately, however, it does seem that Mr. Paulson may have read Mr. Roberts’ column during the second weekend of November, internalized it, and vowed swift inaction in the turbulent financial markets.
Finally: doing nothing! But why did it take so long?
We write that because last Tuesday, November 11, Mr. Paulson rebuked the automakers and their advocates seeking TARP funds, and news reports both last week and this week note that the Treasury have no plans to buy troubled assets or implement new schemes. (Last Wednesday, in response to the news, we wrote Taking the TA out of TARP, and ungraciously gloated over the fact that we had correctly predicted the law’s ineffectiveness and potential harm nearly six weeks earlier.)
Last Monday, the day before Mr. Paulson denied TARP funds to the auto industry, we wrote Patience Please! They Just Need More Time!, which noted that the car manufacturers had 35 years – that’s THIRTY-FIVE YEARS – since the first oil crisis to change their ways. It seems that through the entire time – almost the life expetancy of a Russian male – management, the unions, and the dealerships have been locked in an interminable game of “chicken” with each waiting for the other swerve to avoid collision and death to reap the prideful spoils of victory.
While in some ways, Chicken seems like an apt metaphor, it ignores the fact that over the past 35 years, with each myopic decision the spoils have become smaller and smaller – and are now almost nothing. In that sense, the auto industry seems more like a black hole where a massive expanse (of warm sunshine and frenzied activity) has shrunken to a cold, shriveled, and nearly non-existent state. Yet, its mass – or more precisely, the mass of its liabilities – seems to warp and distort nearby space as it smothers and destroys everything within reach.
Unfortunately, the self-destruction of a once-vital and proud industry is not a game or a blackhole millions of ligh years away. It collapse is tragic and close and the collateral damage of the collective, short-sighted selfishness – measured in the hundreds of billions if not trillions of dollars and in terms of lives ruined – has been all too real. Moreover, the siutation is not interminable, but it finite, and the end is near.[1. We admit to being a bit overly harsh as it seems the ill-advised CAFE standards wouldn’t permit the Big Three to lever their competetive advantages with large cars and trucks. At one time, they did make the best large cars in the world (and we still love our Suburban.)]
So, in our mind, ignoring GM, Ford, and Chrysler seems to be both the efficient and just thing do, and we admire Mr. Paulson for admitting – even if only implicitly – that his earlier actions were mistakes. Clearly, we wish that he could have been a faster learner. It might have saved all of us hundreds of billions of dollars of cash and trillions of dollars of equity value.
It’s our view that The Government Will Save Us! Not!. Instead, we’d prefer that it get out of the way and provide incentives to private enterprise to act autonomously. In that spirit, we still propose A Better Solution (than a government takeover), which involves tax incentives for buyers of troubled assets. Those incentives could be implemented as investment tax credits or as extremely accelerated depreciation, and would provide large (30%-40%) and immediate tax savings that would cushion the downside risk of uncertain valuations. (The things are hard to value.)
Make an example: nationalize the worst one(s).
We’re generally almost libertarian in our free market approach to economics, but don’t get us wrong, we continue to urge the government to nationalize the worst capitalized banks: the very few, not the many. We’d much prefer the outright expropriation of the worst offenders both out of a sense of justice and as a warning to other firms to act quickly to save themselves rather than to wait for government handouts.
Just as importantly, with complete ownership of a few firms, it is much more likely that there would be many calls from many parties, especially competitors and potential investors, to re-privatize the nationalized institutions ASAP. That political pressure would prove to be very beneficial to reducing the government’s influence in financial intermediation.
Imagine if the government would have nationalized AIG, would the outcome have been any worse than what we’ve seen in the past two month? Would it have been any more expensive than it has already been? We’d argue – and have argued – that issues with collateral, including those related to AIG’s diminished credit rating, would have been mitigated through government ownership and creditworthiness.
Moreover, other than non-executive employees holding shares, we’d argue that none – not 10% nor 20% – of the old ownership structure should remain. That might induce shareholders in other firms to become a bit more activist and demand stronger and more knowledgeable representation on their boards of directors. (See our recent: The Failure of Boards to Direct.)
We’d prefer the frenzied, motivated efforts of bankers seeking creative solutions to their most vexing problem over the current scenario where hoarding of funds and waiting seem to be the preferred tactics. In that sense we as an economy, a nation, and a society are in no better position today than we were six or seven weeks ago.
We wrote about what has and continues to occur in Even A Perfect Bailout Will Fail and Financial Projection in a Crisis among other posts.
Unfortunately, the biggest difference between now and the end of September is that our collective equity holdings have lost about one third of their value, and new asset classes like CMBS are likely to depreciate like MBS already has. However, on the upside, it seems that Mr. Paulson is moving (or more accurately not moving) in the right direction.
In all seriousness, we do pray that our senior government officials take the right, reasoned, and thoughtful actions. We hope you’ll join us. Perhaps it’s working.
(This a long post; so, there are probably a number of typos, which we’ll correct during the coming days.)
CMBS Is Like Lumpy MBS and That’s Not Good
We’ve discussed Commercial Mortgage-Backed Securities or CMBS in a number of posts. So, it’s worth mentioning that spreads on AAA CMBX (CDS) increased substantially on Tuesday. At about 550 basis points, those spreads seem to be twice as high as the previous all-time high, which was reached in the late winter of this year, and are seven or eight times higher than on January 1.
It’s much harder to say where spreads on CMBS (bonds) are since they tend not to trade. Historically, they didn’t trade much, and now it is even less frequent. In fact, in June, we had a long post, On Nedges and Sledges and Paving the Road to Hell, on the difficulties of using CMBX to hedge exposure to CMBS. As that post mentioned, the now-defunct Lehman Brothers was one of the firms having difficulty with things that were Somewhat Like Hedges.
If the reader is unsure of the notion of CMBS, know that CMBS is very much like any other mortgage-backed security, except: (1) the number of loans in the collateral pool is smaller; (2) the dollar value per loan is substantially greater (into the hundreds of millions of dollar); (3) the borrowers tend to be much more sophisticated and have better legal representation; and (4) in our opinion, there is more systematic risk, which mean less diversification and higher levels of default during economic downturns.
Like almost everyone else, we’re not sure how the loss given defaults would differ residential mortgages, but we doubt that it would be favorable for commercial real estate. (By the way, readers looking for an illustration of basic MBS should see the last part of Gossamery Arguments for Transparency and Our Reply, in which we describe it in the simple terms of a spreadsheet.)
We ask: what are the odds that the housing market could crash in many parts of the country, residential mortgages defaults would rise, the economy would seemingly slow down, unemployment would increase, and the stock market would decrease substantially AND commercial real estate would not suffer? Yeah, when stated precisely, it seems like a silly question doesn’t it.
So, with CMBS, we’d guess that the really bad times are just beginning.
In fact, we’d speculate that proportionally – given the different sizes of the markets – the bad times may be substantially worse for commercial mortgages than for residential mortgages.
For example, in CMBS Market Begins to Show Fissures, two writers for The Wall Street Journal, describe two large –$209 million and $125 million – and recent (December, 2007 and July, 2007, respectively) mortgages that are close to default and mention that news was the impetus for spreads to increase on Tuesday.
Of course, we wouldn’t be a pedant if we didn’t mention that several of the factors mentioned above were starting to be present in July, 2007, and were certainly evident by December, 2007, when those two loans were made.
In that respect, and given the ongoing collapse of the CMBS new issues market, we wonder how many other bad commercial real-estate loans currently sit in banks’ conduits. As we understand it, the market for new issues has been dead for quite awhile; so, many pipelines likely contain similarly-aged mortgages (that never went into CMBS pools) and now sit in the nether world of loans available for sale (although no one wants to buy them). (Kind of like purgatory, but without hope of heaven. In this case, inside the gates of hell.)
If J.P. Morgan, the originator of those two loans, or other large players made similar loans in expectation of continued good times or a quick rebound, then one should expect larger loan-loss reserves within the next six months or so.
In fact, (1) ithout prior large and public defaults and (2) given the magnitude of losses that many banks have incurred in their other portfolios and (3) given the illiquid nature of the commercial mortgage market that leads to a lack of “marks,” it seems highly unlikely that banks have already aggressively written-down the value of their CMBS or their inventory of commercial mortgage loans.
In that case, one could infer that they – the banks (and their conduits) – were betting that markets would return to normal. Unfortunately, if that was the bet, and if the above-mentioned defaults are followed by others so spread levels stay high, then those banks will be forced to recognize additional losses at the end the fourth quarter and into next year.
We’d hate to be sitting on a large pile of recent, unsecuritized, commercial mortgages. It’s likely that they’re composting. While that might improve the prospect of growth in the future, it probably stinks now.
Idiosyncratic and Concentration Risk, Again.
It is already Thursday, and we’re just getting around to writing about a few articles in Wednesday’s (October 1) edition of The Wall Street Journal. They are worth mentioning because they are closely related to our post on Tuesday, Bigger Is Not Necessarily Better, which warns about additional concentration risk as the largest banks continue to grow larger.
One is a very small article in Deal Journal, entitled Big-Bank View: Getting Bigger! that we can’t find online and other is At Lehman, How a Real-Estate Star’s Reversal of Fortune Contributed to Collapse.1
We’ve commented a few times that bigger banks are not necessarily better for society or the economy because mammoth size exacerbates moral hazard problems, i.e., the too-big-to-fail mentality – nothing new there – and because it consolidated assets and decision-making under fewer, idiosyncratic (and rationally-bounded) personalities (and cultures). That first parenthetical comment does read better and sound nicer than the more parsimonious, “irrational,” but the point remains the same.
The big-bank-getter-bigger phenomenon is actually being encouraged and expedited by expedient federal regulators, who seem to have absolutely no long-term plan. Those regulators’ recent actions and statements remind us of a comment we once overheard in the executive suite of a large firm: “Sorry, but we don’t have time to develop a strategy, we have to act.” We’re really not talking about pulling someone from a burning car or house, but even in those dire, dangerous, and instantaneous circumstances, one should have an awareness of the environment and a plan if one is to have a chance of success.
The other article, about Lehman’s real-estate débâcle, puts most of the blame for commerical real-estate losses on one man, Mark Walsh. Of course, the ultimate blame lays with Lehman’s lax board and senior management, which presumably did not have the knowledge or courage to properly understand the business and manage risk. Additional blame can be placed on senior management for improperly designing incentives scheme that induced excessive risk-taking, which we would guess would have been exhibited by a “get it done however you can” mentality.
We don’t know Mr. Walsh, and suspect that he was doing exactly what was expected of him, but that’s our point. The folks at Lehman in residential real-estate were likely doing exactly what was expected of them, too, and the combination was deadly for the firm.
Because of someone’s tastes, preferences, favorable past experiences, ignorance, insecurity, or neglectfulness, the firm suffered from excessively-concentrated risks.
Now, who would think that the values of commercial real estate and residential real estate within a city or region might be related? Actually, we would guess most adults who didn’t make it past the sixth grade could figure it out, and the same goes for current middle school and high school students.
In fact, our own small-sample survey reveals that a high school freshman will likely respond with a “Duh!” when asked, “Do you think house prices and office or store prices would go up together and down together in, say, your hometown or do you think they would be unrelated?” We didn’t ask, but we suspect that they would likely note that on a day-to-day basis they might not be related, but over longer term they will be. Oh well. What is it about college that destroys that common sense?
Now, the argumentative reader may retort that Lehman is not a good example because it was an investment bank and so wasn’t scrutinized by the regulators as much as large commercial banks are (or will be); so, such risk won’t be an issue because bank regulators are on the case. Though the agencies and permitted leverage ratios were different, we doubt that the degree of regulatory oversight was much different across those two industries, especially for the larger firms. More importantly, does the contrary reader really want to make that argument? (Hint: consider Wachovia, Washington Mutual, etc.) As we mentioned on Thursday, regulators have their own incentive problems.
While bigger may permit consolidated operations and cost savings. Are those savings large enough to justify the assumption of additional, systematic risk or, more precisely, the loss of a diversification benefit, caused by the centralization of allocation decisions? The past year has made us very doubtful that the benefits exceed the increased systemic risks of a few business segments bottoming-out together.
- The title in the print version is slightly different, and the inside title is “How Real-Estate Star Created a Débâcle.” ↩
Moral Hazard and Another Problem with Illiquid Assets
in a Mark-to-Market Accounting Régime.
Here’s a couple of related issues that we can discuss in the context of today’s The Wall Street Journal article, Bailout Proposal Gets Hung Up Over Central Issue: Will It Work?
We’re deeply concerned about the moral hazard implications of any government bailout, and we doubt that we are the only observer to harbor such dark thoughts. However, we also think that those implications could be realized immediately rather than, say, during the “next” downturn in some far distant time. Thus our pessimism grows as does our annoyance with the federal officials who have proposed massive snd expensive actions without sufficient levels of thought.
In that respect, can the reader say, “commercial real-estate loans and CMBS?” And, does the reader know that illiquid CMBS – that’s redundant by the way-is very difficult to value, too? Not much different than CDOs of MBS. We commented on some of those valuation issues three months ago in this post: On Nedges and Sledges and Paving the Road to Hell.
We mention CMBS because we saw in the referenced article that many banks, not just the ailing ones, are trying to round-up everything they don’t want, i.e., crappy loans and securities, to make it available for sale to the government.
Can you, dear reader, blame the banks? We can’t. We’d certainly like the feds to buy our Suburban at its historical cost, too. Mr. Paulson are you listening? Can you help me, here?
As the article mentions, it turns out that the banks would rather sell these items at their currently marked values than be forced to possibly devalue them at the end of the next reporting period, which happens to be next Tuesday.
It is probably too late, so we doubt that it will happen on Monday, but we could see a banker trying to convince a government bureaucrat that the bank’s mark from June is still the best guess of where an item sells (if it were to sell to anyone in the market that doesn’t exist.)
We could also see the bankers’ expectations of the sales (to the government) to color their valuations next week. As we wrote yesterday in The Uncertain Value of Mortgage Securities that expectation will likely lead to greater adverse selection problems because of the possible increase in the uncertainty regarding the value of each bank’s assets. In our view, this will exacerbate, not mitigate, the current panicky behavior among banks as they deal with each other (until such exchanges with the government actually occur). However, we could see it leading to problems after the bailout, too.
With that in mind, we ask the dear reader to guess the multiple of $700 billion that banks have identified as assets they’d like to sell? We’re guessing a multiple of at least three – a few trillion dollars worth – with a substantial amount of CMBS and inventoried, pipelined, commercial mortgages thrown into that mix. (Those are loans that conduits made and planned to bundle into securities but are currently stuck with because no one wants the CMBS that would be structured from them.) Does the reader believe that only homes were overbuilt in former boom towns?
So, for argument’s sake, and to be excruciatingly precise, let’s say that we are correct that the bank’s collectively think that they’ll be able to sell $2.1 trillion worth of thingies to the government at prices that the banks like. How will take affect next week’s third quarter valuations, and what will happen when they’re stuck with $1.4 trillion of stuff that they wish the government had bought?
And that leads us to our second issue about the nature of disjointed and illiquid markets and how a little information can hurt a lot. You see, in social situations, more information is not necessarily better.
The fact that no one wants to buy the stuff doesn’t mean that there aren’t a lot of firms holding similar securities. So, let’s say that 20 firms are holding a part of a particular illiquid CDO issue or CMBS issue or whatever it is that no one else wants.
If the thing is illiquid then – nowadays – that means it’s not traded at all; so, there is no observable price; so, it is likely that the current marks vary across the 20 firms because they are all using slightly different models or all have slightly different – albeit, likely inflated – expectations of what a sale to the government will bring.
All things equal, it would seem to us that the most desperate firm would accept the lowest price offered by the Treasury. Again, all else equal, that’s usually how its works; otherwise, we have to add an adverse selection argument, too.
If that is true, then depending upon how much of the issue the Treasury purchases, that lowest price is now an observable “market” price for the other 19 firms, and that’s not good with mark-to-market accounting where a little bit of information, based possibly upon one firm’s desperation sale to the government set the new (likely lower) mark for the other 19 firms. It might be information and it might be the truth, but it certainly wouldn’t help society. More information isn’t always better.
That means additional write-downs may be forthcoming from, say, the other 19 firms. If that issue is part of our hypothesized $1.4 trillion above, then those write-downs in the future after the government purchase will be larger than they would have otherwise been without the bailout. Of course, that’s based upon our argument that the book values of the issues would be higher than they otherwise would have been (due to each bank’s anticipation of selling to the government at an inflated price). Such a scenaroi would lengthen the duration of the crisis and negatively influence the behavior of the firms when they lend to each other in the near term. There will be more panics that occur farther into the future.
Is this all idle speculation? Of course, we were a theorist in college. Are we wrong? It is quite possible – the chairman mentions that it often happens – but we doubt it in this case. Let us know what you think.
On Nedges and Sledges and Paving the Road to Hell
Or when is a “hedge” not a hedge? —when it is a nedge or a sledge or a wild*** guess, of course.
To paraphrase St. Francis de Sales, the road to hell is paved with good intentions because execution matters! (Elsewhere he scolds perfectionism, too, and argues for a balance: do not be rash, do not over-analyze. Realize that it is not a sin to be imperfect, but it is a sin to do wrong.)
Back on May 21, we posted On N’edges and Sl’edges and Billions Lost in reference to a WSJ article, “Trouble Hid in the Hedges.” That article cited the likely continuation of losses at large investment banks to due ineffective hedges, particularly due to the firms using various CMBX indices to hedge CMBS (commercial mortgage-backed security) investments. Some of those losses have now been recognized: “Lehman Talks a Rosy Talk.” A few weeks ago on June 10, we posted They’re Losing $Billions, But Doesn’t She Have Nice Clothes and Shoes? in which we again mentioned nedges and sledges and alluded to losses from ineffective hedges.
We define nedges as near hedges and sledges as somewhat–like hedges. (Presumably, if we were younger and hipper, we could have thought of iHedges for ineffective hedges, but we would prefer that the word “hedge” not appear in it’s entirety without scare quotes or italics, and we are not clever enough to come up with iHedge.)
We invented those terms to indicate that while some statistical relationship might exist between the two items — in the commercial mortgage case, a credit index and bonds — only a fool would believe that buying one and selling the other (in whatever “optimal” proportion) would eliminate the risk of loss. Unless one is buying and selling the same item at the same moment in time, then the complete elimination of value or return risk is not possible either in the short run or in the long run. Moreover, it is worth nothing that eliminating market risk usually comes at the cost of additional counter-party risk. That exchange of one risk for another might remind the reader of a variation of the arcade game, whack-a-mole, with the presumed goal to have smaller and smaller rodents pop-up after each hit or transaction. (Of course, one small mole can still do tremendous damage to a well-manicured front lawn.)
In the long run, if the same transaction could be repeated ad infinitum, average losses would likely be reduced if the relevant, return probability distribution function were well-behaved. Unfortunately, in the real world we can never be quite sure of that fact. We can, in theory, think of nice probability functions that arise from, say, repeated coin flips (where one gains a dollar for heads or loses a dollar for tails on each flip). At the limit when the number of flips approaches infinity, extreme losses would be rare, but avoiding any loss is not assured. In such an experiment, break-even might be expected, but even there it is not guaranteed.
In the short-run, no such asymptotic rule comes into play, and like the CMBS example, there is the chance — in some cases quite a high chance — of losing on both legs of the trade.
We believe that excluding fraud, the willful ignorance of first principles is the reason behind many huge trading losses. Such losses, while often attributed to bad luck, are not usually due to the lack of advanced “knowledge” or “sophistication.” So, it doesn’t take a PhD. It takes an PhD or MBA forgetting, ignoring, or never internalizing the basics, especially when some level of pseudo-sophistication is combined with a healthy dose of hubris, possibly due to the misspecification of past good fortune. We′ll have other posts on this issue in the near future because we find it quite annoying and extremely dangerous.
In our example below, we use simulated values rather than real return data so that we can construct it just the way we want it. We provide the example as an EXCEL spreadsheet to also show the mechanics of a simple simulation — as well as make our point about slopes, linear correlations, nedges, and sledges. Moreover, it would be difficult to provide an example using CMBX and CMBS relationships because the data are so lacking. In fact, many such instruments were not marked on a daily basis until this past winter. Furthermore, note that marking values on a daily basis is quite different than witnessing daily transactions and observing new daily prices. Deep and liquid competitive market prices do not exist for many of these securities, bonds, and instruments; so, often it is mark-to-untested-quote, rather than mark-to-market transaction.
Because our example is an introductory level statistics problem, some academics might consider it to be a straw man, i.e., a weak opponent designed by us to be easily defeated (by us). Fear not; we take pride in our cleverness and humility, but we try hard not to be devious to fool others or to be so dull that we fool ourselves.
Instead, we would argue that academics that would make that criticism are truly academic and haven’t spent much time in firms or other organizations, where it is possible to overhear comments like, “We don’t have time to think about a strategy. We have to do something!” Or, the equally bewildering, “We have to do something, or it will look like we don’t know what we are doing!” As it turns out, without a substantial degree of luck or divine intervention, such decisions rarely pay-off. As a girls basketball coach, such comments remind us of closely-contested, middle school games, when the panic sets into the leading team, teammates begin to play “hot potato” with the ball (“Ouch, it burns. I don’t want it. You take it.”) and the girls forget to breathe in their desire not to make a mistake. (Don’t worry arbiters of sexism. We’ve seen it happen with boys and men, too, but just we haven’t experienced it while coaching them.)
In this file which we have protected, we (1) generate three correlated random variables, and (2) regress two of those variables, n and sl, against the other one, x. For illustrative purposes, we do this in a very simple fashion to show that by design the betas, b, or line slopes should be the same due to the common covariance that x shares with n and sl. (In a simulation, they may not be exactly equal.) With x as the regressor or independent variable, the slopes, bn, and bsl, are equal to cov(x, n) ÷ var(x) and cov(x, sl) ÷ var(x), respectively.
So, for example, when traders or risk managers don’t have time to think because they MUST ACT, they might select either n or sl as a suitable hedge for x. Focusing only on the expected, least-square minimizing relationship, they would be indifferent between the two. Moreover, such methods and thinking might allow the trader or manager to underestimate or ignore the scale of the potential risks that they may be inflicting upon the firm via their “hedging activities,” and this is where the road leads to hell. For example, if the firm owns x and uses n or sl to hedge by short-selling either of those instruments, then low values of x combined with high values of n or sl would be particularly damaging, and the chance and magnitude of the loss is related to the total variance of n or sl—not just the covariance. With suitable leverage, it is possible to lose big, with a nedge like n, whereas with sl it is possible to generate large, two-legged loses without leverage.
This can be seen in the following graph where we have chosen many of the parameter values so that the two dependent variables can be easily distinguished. Notice, also, that as promised, both n and sl have the same slope with respect to x, and in theory, either one could be used to “hedge” x, as both would have the same expected benefit. It is just that there is a difference between expectation and realization.

Now, some may argue that they are more sophisticated than our portrayal and would not employ such a simplistic technique unless no other alternatives existed. However, given its pervasive use, we find that difficult to believe that it is a method of last resort. More importantly, while there are different and more complex hedging strategies, unless the market risk is eliminated via forward purchases or sales, all probability and statistics-based strategies suffer from the same underlying problem that we illustrate here — there is residual randomness and the possibility to lose on both legs.
With more complicated hedging strategies it might be more difficult to see this problem and while some additional variation might be reduced, some still remains. Thus, the old adage of losing sight of the forest for the trees seems particularly relevant here. We also note the many folks spend much time and energy analyzing retrospective relationships to determine such hedging strategies, and, of course, such relationships need not be persistent — the oft-mentioned problem of induction. Dynamic, unstable relationships will invalidate historical analyses as will stable relationships with rare events and small sample histories. CMBX — CMBS series have extremely small samples. So, basing hedging strategies and positions on historical analyses poses additional risk due to misspecification. That is why the recent and relatively long period of low volatility in many markets was so damaging to those who forgot or ignored this fact — per our point of ignoring first principles.
In addition, while CMBX offers protection on a basket of CMBS, if either (1) your firm holds securities not in the CMBX basket or (2) your firm holds only some securities in the basket, your firm is likely to have sledges rather than hedges when using an index to try to off-set a position.
Finally, a slightly more technical criticism is based on our observation that some analysts seem to forget that risk-neutral pricing methods don′t actually eliminate risk; they just, in some sense, ignore it for certain purposes. (Out-of-sight is often out-of-mind for the harried and/or unwitting.) We won′t dwell too much on this issue here or anywhere else until we publish more reference material, including a simple explanation of risk neutral valuation. However, please do note that some folks do tend to believe that only expectations matter, and often these same folks tend to also forget or repress the social and behavioral element of trading, especially if they haven’t shown a previous interest in human nature in their careers or education. Such observations make us wonder whether their hiring managers are cynical or naively-ignorant? See this post, Caveat Emptor, for a related complaint.
P.S. As we mentioned, the EXCEL simulation file is protected; so, other than clicking the link to our web site or pressing the function key, F9, to generate a new batch of random numbers, there is little that one can do. Interested parties should contact us directly for a non-protected version.
