By Richard Smith, a London-based capital markets IT specialist
Here’s someone with his head screwed on, back in April 2007, who proves singlehandedly that “hoocoodanode” was no defense for failing to anticipate the implosion of the shadow banking system (more on this prescient analyst in due course):
For several years now, we have marvelled at the capacity of credit markets to
accommodate ever more ludicrous developments: mortgages to insolvent arsonists, a leveraged buyout of “the world’s ‘crappiest’ steel company
Ooh, and look – he has Iceland, Greece (already) and CDS in his sights:
…sovereign spreads that don’t care whether you are Che Guevara or Maggie Thatcher, AAA rated Icelandic banks, derivative market growth rates that make your eyes water …
and Greenspan, and other cheerleaders:
We have heard such developments rationalised away with equally ludicrous new
paradigms, and repeatedly been reassured that even if there are risks, credit market innovation has allowed risk to be dispersed more healthily around the system.
Despite our scepticism, it has been very difficult to penetrate the technical innovations of these more opaque markets to pinpoint what the frailty of the mechanics might be.
all culminating in a persuasive thesis:
Now, with the subprime debacle unfolding, we have been able to get a better look under the bonnet of the machine and increase the precision of our understanding. This has allowed us to refine our instability hypothesis as follows:
The funding liquidity boom has, at its heart, explosive growth of structured credit markets. The development of structured credit markets has more to do with the models of ratings agencies and the incentives of hedge funds than the arbitraging of pricing inefficiency out of credit markets. The players involved are behaving as if they have discovered a ‘perpetual motion money machine’. The result: an unstable surge in non-bank funding liquidity and rapid expansion of debt into a very benign part of the credit cycle, which means that any inappropriate debt creation will not become apparent until the cycle turns down.
Sounds about right, doesn’t it? Here’s his roundup of his “instability hypothesis”, which fingers a few more of the reprobates:
• “Confidence in financial markets based on “abundant liquidity” is a dangerous deception created by a procyclical surge in funding liquidity, credit and leverage from non-bank financials.
• An economic and financial system which is supported by the purchasing power that non-bank funding liquidity confers, is more fragile than one which is supported primarily by balance sheet and monetary liquidity.
• The current credit cycle was kick started with macro moral hazard (Bernanke 2002) but has been driven to unprecedented extremes by a micro moral hazard overlaid on financial innovation to produce a surge in non-bank funding liquidity.
(The “micro moral hazard”, BTW, is hedge funds’ preference for high volatility assets, which maximises the chance of a big pay-off to the hedge fund managers)
• The forces shaping behaviour at hedge funds should, theoretically speaking, mean there is a real attraction for these players to migrate towards a banking business model of taking leveraged spread on illiquid assets.
• The rapid growth and development in structured credit has allowed credit risk to be distilled, providing credit instrumentation with the necessary embedded leverage to allow this migration to happen. We believe it has.
• The visible symptoms are all around us: insane mortgage underwriting standards, the tightest emerging market spreads in history, leveraged private equity transactions on multiples that imply no business cycle, explosive growth in credit derivatives, credit players who themselves admit that credit risk is being mispriced…
• The specific mechanism we highlight as the turbocharger at the heart of this funding liquidity boom is hedge fund demand for junior tranches of structured credit, which appears to be encouraged by a relative value opportunity created by ratings agencies.
• Evidence to support our hypothesis can be seen by the issues emerging from the US subprime mortgage market. Rampant demand for junior RMBS paper by CDOs ‘encouraged’ the lapse in underwriting standards over the last few ears. Rapid growth of CDO issuance has been facilitated by hedge fund demand for junior paper in CDO, the senior rated paper being easily saleable. Whether for relative value trades or straight credit bets, this demand has had a magnified impact on aggregate mortgage origination, particularly in subprime.
• At the heart of every bubble is a grain of truth to support the believers’ faith in the fundamentals supporting the bubble. In this case, the argument is that credit derivatives, structured finance and structured credit allow players to arbitrage the inefficiency in the pricing of credit. Relative value trades are part of this arbitrage process. However, distortion of absolute prices in subprime highlights the frailty of the efficiency argument.
• There are clearly various market failures which disrupt the efficiency argument. These include: inconsistent regulation (banks versus hedge funds), changing regulation (Basel II), discontinuous credit ratings systems, pricing inconsistencies (marking to model), informational asymmetries (originators of credit risk versus ultimate owners), hedge fund incentives (skewed payoffs, limited liability, and short time horizons), and rating agency incentives (paid by issuers on the basis of transaction volumes).
• Ratings agencies help create relative value through their model, rather than market driven ratings system. Static discontinuous ratings and illiquidity prevent the relative value from being arbitraged out, which simply encourages further origination of the underlying collateral, e.g., subprime mortgages. With apologies to Roald Dahl, no matter how hard they ‘suck’, the funds can’t arbitrage out ‘the everlasting relative value trade’.
• However, relative value trades in a market for credit risk that has become absolutely mispriced are vulnerable to variable market liquidity between instruments when reality breaks in and prices are forced to correct (what price a loan which has actually defaulted?). Therefore it is gross credit exposure of hedge funds that matters for considerations of financial stability.
• A fallacy of composition has allowed this inefficient outcome to persist and central authorities have not intervened to protect the public good of financial stability.
Fallacy of composition, if that’s new to you, is the set-up where everyone responds rationally to their incentives and payoffs but the system level outcome is – insanity. This is why the “blame game” is a waste of time, however much fun it is. Certainly, there are plenty of dodgy operators, some of whom will get their comeuppance in the courts, or lose their jobs, or their reputations, or their political offices, or their testicles; but don’t kid yourself, it’s “the system” that needs to be fixed. And it can be, up to a point (though certainly not enough to satisfy the more revolutionary of NC’s commenters; I am politely declining that debate, in advance).
• The off-market nature of structured credit allows the ratings agencies to hold back the downgrades until actual fundamentals (i.e., delinquencies and defaults) force a reassessment of key model inputs: default probabilities and cumulative default rates, default correlations, and recovery rates. This is the phase the US non-conforming mortgage market is in, so there will be many funds which really are “walking and talking several months after their heads were chopped off”.”
And his summary of the likely end game:
• The game can end from either the junior tranche or senior tranche side. The ‘hedge fund bank’ analogy provides a clue as to how the mania might end from the junior end. Capital loss sensitive investors (funds of funds) redeem en-masse which precipitates distressed selling/unwinding of fund assets. With little liquidity in these assets in the first place, forced sales will target the most liquid assets first. This creates conditions ripe for contagion right across the credit spectrum.
• From the senior end, investors in the higher rated paper lose confidence in the ratings system which underpins their demand. This is likely to be precipitated by downgrades which are held back as long as possible by ratings agencies. With reduced demand for senior paper, prices have to adjust, relative value trades evaporate, and the demand for junior paper disappears.
Both the “junior” and “senior” scenarios played out, if anything, rather more dramatically than our man expected, in part because there were other shadow banks in the mix besides the hedge funds. And perhaps he is overemphasizing the influence of hedge funds (and their marketers, the funds of funds). But not by much. First, consider this very important point: size doesn’t matter as much as you thought:
… Collateralised vehicles (CDOs, CMOs, CLOs) often invest in the junior paper of the MBS, ABS and leveraged loans. Let’s say this tends to be from the last 15% of any structure/deal. Hedge funds investing in these collateralised vehicles tend to invest in the junior tranches or equity, i.e., the last c.10%-15% of these structures, in order to generate the 20% gross returns they need. This implies embedded leverage of 44-66x [1/(15% x 10-15%)].
Last year funded CDO issuance hit $488.6bn (Structured finance = $292, high yield loans = $165bn, investment grade = $22bn, high yield bonds = $2.7bn [from SIFMA02/2007]). This represented 11.5% of the $4.21tn issuance of MBS, ABS and corporate debt in 2006. Using the 10%-15% ratios above, it would only need buyers of $49-73bn of junior paper to support this CDO issuance (assuming the senior rated tranches are easily sold), which itself provided support to $4.21tn of bond issuance. Such embedded leverage means that smaller pools of capital are able to determine the fate of much bigger pools of borrowing.
…This shows the leveraged impact that these investors can have on overall markets.
One of the striking common features of less-than-favourable reviews of ECONNED (which I will confess I was involved in actively through numerous drafts and proofs) has been the reviewer’s inability to grasp this simple point about leverage. For instance David Merkel, with, my runner up in the category of Most Irritating ECONNED Reviews, doesn’t notice the Magnetar Trade at all. So it is somehow heartening to see that a sufficiently astute observer can reach ECONned-like conclusions about the relevance of hedge funds to the crisis in advance; and three years ahead of ProPublica (who still only half get it).
Second, consider how our man characterizes the business of hedge funds: “a banking business model of taking leveraged spread on illiquid assets”. Viewed through that prism, all the usual suspects were playing pretty much the same game as the hedge funds: Monolines, AIG, Money Market Mutual Funds, Investment Banks (both at prop desks and in prime brokerages), some idiot British mortgage banks (Northern Rock and HBOS), SIVs and OBS vehicles, and even CDOs themselves. In a word, shadow banks. Hedge funds are in a way the acme of that precarious credit mechanism,
Hedge funds are key to this liquidity, and their activity begs the question: are they banks? Unregulated, undercapitalised, wild-western BIS-free banks?
…but one might as well pay due respect to all the other players.
So who is this fellow who got it, back in that mythical time when nobody knew what was going on? According to an email correspondent of mine, he is “a no-name equity guy” in London. Actually his name is Henry Maxey, and he is chief investment officer and chief executive elect of Ruffer LLP, a small London fund manager. So there’s no chance of making him US Treasury Secretary or head of the NYFRB, I’m afraid.
His paper, cherrypicked here, and packed with other goodies, is available as a chapter (“Cracking the Credit Code”) in a book (“Babel, The Breaking of the Banks”), easily available in the UK, but also, it turns out, in the US.
For American readers, that is going to be over $1 per page for the Maxey essay. Worth every cent, and we need the dollars over here; and you get ten chapters of sharply-written, beady-eyed ruminations on capital markets and fund management by Jonathan Ruffer, as a bonus (I hope Mr Ruffer will forgive me for *that*).
In my next post, I’ll apply these and other pieces of Maxey’s big picture analysis to a critique of current reform initiatives.