Who would think the day would come where blue chip stocks would have 30-day volatilities in the 180% range? That's a barn door so wide you can throw a pick-up truck through it blindfolded and still come up with a valid price guesstimate. No wonder the entire stock market is having an extended nervous breakdown. The key assumption of market efficiency theory, namely that price equals value, is so eroded that people no longer have a computational basis upon which to base portfolio strategies. The amazing thing is how many people continue to get up every morning and blindly pull the handles on the slot machines. There's something kooky going on when everyday folks set cell phone trading alerts to only make noise if the DJIA moves by at least 200 points.
Read our lips: Price is not presently a valid surrogate for value - maybe never was. Efficient market theory has a place somewhere in the tactical tool kit, but right now it must wait until the 80/20 rule is again satisfied where 80% of stocks represent 20% of market volatility. For now, it's time for everyone to hunker down plugging numbers to compute valuations the hard way. In rough seas, clarity and cash flow wins.
The disruption caused by the ground rules shift is visible in all aspects of business and finance. Under the Treasury's TARP, for example, deserving banks can get capital infusions from 1% to 3% of risk-weighted assets. But global regulators have proven that they don't know how to really risk-weight assets, because they're using models based on the very same assumptions about price and value which are now thrown into complete confusion. Thus the process of deciding who may or may not participate in the TARP becomes a political question because none of the data outputs make sense. Witness the Treasury assisted "open bank" acquisition of National City (NYSE:NCC) by PNC Financial (NYSE:PNC).
Q: Does anyone doubt that Basel II is now completely irrelevant?
Whether you are an investor, regulator or ratings agency, the disruption of the consensus around price and valuation, and therefore the solvency of counterparties, is creating instability, but that process of reformulating pricing methods requires time and focus. And the debate over the new framework for relating price to value (or risk) is only beginning. On October 21, 2008, former Citigroup (NYSE:C) Chairman John Reed commented in a letter in the Financial Times that, going back a decade or more, two misjudgments where made:
The first was to assume that markets could better manage and absorb risk than institutions. Most of us believe that markets are the best at allocating capital… Our second error was to embrace the notion of risk-adjusted capital, saying, in essence, that we know where the risks are. This too was accepted as a move towards using capital more efficiently, meaning less of it in relation to gross assets. It seems pretty clear, and it has probably always been that we only know where risks are after the fact.
Needless to say, Reed's letter generated a lot of mail.
A Black Hole for Liquidity?
Another example of the ongoing discontinuity in the markets comes in the linkage between the unwind of credit default swap ("CDS") positions written regarding Lehman Brothers, Fannie Mae and Freddie Mac, and dollar LIBOR rates in Europe.
The auction process begun by DTCC, by which holders of CDS on bankrupt Lehman Brothers settled in cash via the DTCC's facility, caused many tongues to wag as to the "net" amount providers of protection must pay to holders of CDS. Several members of the media called last week to ask if Don Donahue, CEO of DTCC, was speaking truth when he said that the net payments on Lehman contracts processed by the DTCC's warehouse were a mere $6 billion or so.
Of course Don Donahue is providing the straight skinny on the flow of transactions which have actually participated in the DTCC auction. But consider that other than holders of CDX and some holders of single name CDS not offended by the prospect of cash settlement, there remain a large number of total holders of CDS for Lehman who do not wish to take cash settlement and indeed are expecting to receive the underlying bonds.
Now the apparent non-event from the Lehman CDS auction is a source of media frustration. Wasn't there supposed to be a breakdown in the CDS markets, a dramatic failure event a la Lehman Brothers? But the merchants of doom should take heart.
The bad effect of the CDS market comes not merely from when there is market dysfunction and an individual counterparty fails. That happens often enough, but the prime broker-dealers clean up the mess quietly so as not to roil the markets. Remember, the dealer already owns the counterparty's collateral through the credit agreement, so there is no point forcing the issue with a messy and noisy bankruptcy. Right? This is why the media rarely hears of fails in CDS.
No, as with the repatriation of the Structured Investment Vehicles onto the balance sheets of Citi and other money center banks, the true significance of CDS comes when the markets function smoothly, as after a default event like Lehman. The trigger event putting a single name CDS contract in the money results in a liquidity-raising event for the seller of protection, who must fund the purchase of the debt at par less recovery value - whether or not the other party actually owns the debt!
This process of funding the CDS is reportedly a factor behind the high rates of dollar LIBOR in London and illustrates how cash settlement derivatives actually multiply risk without limit. Through the wonders of cash settlement, the derivative-happy squirrels at the Fed, BIS and ISDA created a liquidity-sucking monster in OTC derivatives that multiplies risk many times, for example, above the amount of underlying debt of Lehman Brothers. But remember two things: a) In some single-name CDS contracts, the buyer of protection must deliver to get paid; and b) in those contracts, where the buyer fails to deliver, the provider of protection can walk away.
We hear that there are more than a few EU banks which wrote CDS on Lehman over the past several years, CDS which were written at relatively tight spreads. These banks did not participate in the DTCC auction and instead have chosen to take delivery on the Lehman debt, forcing them to fund a nearly 100% payout on the collateral. A certain German Landesbank, for example, took delivery on $1 billion in Lehman bonds that are now worth $30 million, and had to fund same. Does this example perhaps suggest a reason why the bid side of dollar LIBOR in London has been so strong?
As one veteran CDS trader told The IRA on Friday, "It's not that people can't fund, it is that people have got to fund these CDS positions. These banks don't have access to sufficient liquidity internally to fund, so they hit the London markets... The Fed and the other central banks must start to deal with the huge overhang of currently hidden funding needs from the CDS and other derivatives." Another market observer suggests this is precisely why the Fed and other central banks have been furiously putting reciprocal currency swap lines in place.
Then there is the situation with Fannie and Freddie paper, which is currently trading 200-300 over the curve despite the Paulson quasi-nationalization this past August. Some of the very same EU banks that are getting killed on Lehman paper are also taking delivery of GSE paper on CDS positions. In this case, the payout on the CDS is small since the GSE debt is money good, at least in nominal terms, thus the net recovery value is high. But the huge overhang of paper in the markets is making the in theory "AAA" rated GSEs trade like poor quality corporates.
In both cases, the normal operation of the OTC derivatives markets is creating a cash position that must be funded in the real world and is thus distorting these benchmark cash markets such as LIBOR. This distortion is magnified by the dearth of liquidity due to the breakdown in the rules regarding valuation and price. So far, the Fed and other central banks have addressed the on-balance sheet liquidity needs of global banks. But as retail and corporate default rates rise, funding the trillions of dollars in notional off-balance sheet speculative positions in CDS, which become very real and require funding when a default occurs, could prolong the economic crisis and siphon resources away from the real economy.
A Consensus of Confusion
Finally, we note with some bemusement that rising market volatility has led to an unusual confluence of agreement among economists regarding the nature of risk and the best solutions to the immediate crisis. When an entire community of academicians suddenly changes cultural profile, that dear friends is what we call a ground rules shift. It means they are all going back to first principles analysis. Wives have a descriptive sentence for that when their husbands are driving … "You're lost, dear."
Macroeconomics models are highly evolved hypersensitive systems with somewhat linear characteristics - at least until they are driven into instability by discontinuities in underlying ground rule and assumption sets. They are all fed by statistically smoothed inputs; the same kinds of statistical methods that people used to turn collections of insufficiently documented Alt-A mortgages into allegedly AAA rated pools and securitizations. Present market conditions have further eroded the clarity of these inputs. In math terms, the widened bands of dispersion have increased uncertainty with regards to locating the true center of the input sample set. This reminds us of the old Cold War SIOP (Single Integrated Operational Plan) models where you could change the outcome of the war by arbitrarily tweaking one variable 1/10th of a percent.
To us, a big part of the way back to restoring confidence in global markets is for regulators and shareholders to start redefining the types of activities and products that are reasonable for global financial institutions and under what capital requirements. The open ended, anything goes environment of the past decade has destroyed public trust in financial markets, thus the palpable fear visible from street level banking customers to the largest institutional players. Until analysts and investors begin to reach a consensus about value and price, primarily by setting clear rules regarding market transparency and disclosure, the ability of markets and regulators to assess or measure risk is seriously compromised.
But until global regulators and politicians summon the courage to restore reasonable rules to the financial markets, particularly a balance between risk allowed and transparency required, attempts to understand price and value, and thus capital, will be fruitless and the confusion will continue. Markets like societies, after all, must have clear rules in order to function properly. What a shame that private market participants do not have sufficient political wit and savvy to lead the discussion and instead must await the judgment of the same political class that caused this mess in the first place.