Rating Agency

After the last year or so it is a wonder that anyone subscribes to rating agencies anymore but they do.  In fact it is headline news when they come out and make tweaks on their outlooks like they did for UK soverign debt on 5/21.  S&P revised its outlook for the UK to negative from stables and affirmed the AAA long term rating and A-1+ short term rating.  This event makes me think about two things.  First (1) The rigidity of the investment community and (2) what do the ratings really mean? 

I’ve complained beforethe ability the rigidity of the investment community but the idea is that if everyone is looking at the same analysis the markets don’t function well because everyone wants to sell at the same time.  This will happen even if it just a descent sized group of people blindly following ‘guidelines’ about ratings, because the smart investors know that non-economic ‘guideline’ sellers will dump securities with a downgrade occurs and thus don’t buy until that flow is well underway.  For those of you who don’t know what I mean by guideline selling it means that a investment manager has a rule about what he can invest in and when that rule is broken he must sell the asset.  This creates a very inelastic (who doesn’t care about price) or what I call ‘non-economic’ seller.  We should be hoping that no one (the big reserve holder or big custodial banks) have a rule about British debt which would disrupt the markets. 

My second question is related to the rating itself.  What is AAA mean?  Low default risk?  If that is the case rating domestic sovereign debt (with a well run finance branch) seems a little odd; worse case it the Bank of England could buy the debt (print the money) and inflation away the debt.  (Yes, I’m ignoring what happen to Russia when they defaulted on their domestic debt but the idea that domestic default seems extremely unlikely is true).  Note: I’m under the impression that AAA for gov’t  and municipals vs corporates are two different scales (you can’t compare across them in a meaningful way only within a group…yes that is annoying).  Does it mean low real purchasing power risk?  If  this where the case then lowering the sovereign debt rating would require the lowering of all other debt (because it would be driven by a macro force: inflation or currency).  So as far as I can tell, AAA mean better than AA, which mean better than A and so on.  Even ignoring the rigidity that the rating agencies put into the system one would hope we (the investment community) could come up with a better (more meaningful) syntax…like probability of default (let use implied and just get rid of the rating agencies).

US SWF and the Poltical Unwind

Little more than a year ago the world – at least one small piece of it – was focused on the new influence of Sovereign Wealth Fund and their potential impact on the financial market, as well as the potential geostrategic implications and real economy implications.  Questions included what would the impact be of a large new buyer of riskier assets?  What kind of boom would this be for institutional investment managers?  What does it mean when many companies were held in large part by semi-political actors?  And to what degree would the SWF be political? (note 1).

These  was a reasonable question; the pools of money that were large and the expectation of moving into risky assets was not unreasonable.  A lot of work went into understanding and predicting the roles that these entities would play.  That being said the over focus on SWFs missed the significance of Central banks (maybe because they wasn’t new and exciting) and now that reserves are dropping the the focus has moved away from SWFs but the work was not entirely for nothing.  The US government now runs a huge sovereign wealth fund.  The dynamics are very very different in that they run it not because of reserve build up but because of a financial crisis and the need to recapitalize the banking system.  Additionally the Federal Reserve has moved its portfolio into risk assets in a major way.  How much did these actions hold up the market?  Where would the market be without them?  Admittedly this is more complex than a ’simple’ flow and risky asset elasticity problem because it is not even close to linear; in that without these action the system may have completely collapsed.  I’ve gone back to my files on the SWF research and commentary and tried to read them in the context of the Fed and Treasury actions.  The questions that burn for me surround how it all unwinds.  I expect them to continue holding the system together and I don’t think it is big enough to bring down the dollar reserve currency status (and thus have the economic system collapse).  So I’ve focused on what happens when we get through this painful deleveraging process and how will the unwinding work through the political process.  I believe that this may have much longer term consequences.  Will the financial system be able to go back to trying to capital allocate or will it be prevented from doing so by political decision that try to force capital to go to their specific project.   Ear marks for tax spending is bad enough; ear marks for credit (what we saw in china and a number of other state controlled economies in that past) is a long run disaster.  The more I learn about the political process the worse my expectations become. 

Note 1: I think the answer to that question is almost never but they will when they need (read: want) to be …people use their influence to get what they want; pure profit maximization is very unlikely.  Consider the Suez crisis and how the capital flow influence the British response…(admittedly slightly different but it gets at the point).

Too Good to be True

Performance charts of the Madoff’s fund are ridiculously good.  When someone is doing well and statements come in month after month , year after year, ‘confirming it’ I can imagine being very pleased and becoming comfortable; arguing against the one managers who is your star is not the easiest thing to do.  Will people get to the point where occassional underperformance will be a benefit because it will increase believability.  I hope not in that understanding the logical process and reasons for excess return is a better way to handle managers.  I like to perform thought experiments and imagine how I would have responded if I was given a presentation about one of his funds.  It impossible to know for sure, but if you are truly self-reflexive – which most people are not – you might be able to learn something this way. 

The above chart is amazingly good.  My first reaction would have been (1) How? Since I already know that lot of dumb simply strategy can appear to outperform for a long time and then get crush (capital decimation fund).  I would have heard about buying equity, hedging with a long put, and financing that with a short call.  I think I would have been suspicious because I would expect that to have t-bill-ish return; not the ~1% monthly return.  One possible reason for the outperformance would security selection, so I would have needed to work through how that process was done.  If I was told it was just index buying not security selection I don’t think I would have believed it.  If I was told that they had a security selection based on informational advantages (order flow); I’d swallow in amazement (talk to a lawyer) and then ask why it isn’t leveraged up….it is well below the geometric mean.  Why waste the alpha? This is very different than I would expect from a typical hedge fund.  Not sure the response I would have received but if they had offered a leverage up version; a 100% return with 20% vol (same ratio of 5), it would have been tempting.  I’d then ask why they offered this product at all; you should just close down the fund and manage your own money.  You’d make so much more and you could in a small number of years be the richest man on the planet (assuming you weren’t liquidity capped too soon, but if this is simply god like security selection in equities that shouldn’t be a huge problem).  Don’t know what they would say to that either.  Given that I can’t think of acceptable answer to both of these question I would have to fall back to my rule that if I really don’t understand I put a very small weight on this.  It would have been a painful walk because it looks so pretty but I think I would have avoided the temptations, but who knows. 

Side Note: Are Madoff’s loses a big deal?  My read it probably not, in large part due to the fact that it did not impair the banking system.  Yes it hurt certain people; there will likely be knock on effects on Upper East Side and Palm Beach real estate but the pyramid wasn’t on leverage.  I’m under the impression that it was based on equity capital and thus the contagion is not a problem.  The fraud hurt wealthy people; and yes they have feelings too, but it doesn’t break down the system.  So there may be some knock on affects as they individuals adjust their portfolios but it’s really not a big deal from a systematic perspective.  And once again it is not the end of capitalism.

Snapback: The End of Deleveraging?

The problems in the financial sector that started in mid-2007 have created problems for the real economy, and the problems in the real economy are creating more problems for the financial economy. This self-perpetuating downward spiral is in full force.  Along with consistently negative surprises in economic data, this state of affairs has many commentators saying, ‘it’s going to get worse before it gets better.’ I find it annoying that they omit to specify which part of the economy they are talking about. Is the real economy going to get worse before it gets better, or is the financial economy going to get worse before it gets better? If they are referring to the real economy and suggesting that GDP is going to fall in real terms or unemployment is going to rise, then they are really not worth their pay. One look at the economic data will give you the short term direction of the real economy.  If they are making a prediction about the financial economy, then I’d be curious to understand their logic. On what basis do they think that asset prices will continue to fall? And how can anyone confidently make this claim?

One coherent argument is that the deleveraging cycle is not over, and that continued equity write-downs along with funding withdrawals will create more and more forced selling.  As long as expectations about deleveraging are an overhang on the market, there is not much incentive to buy because you expect to get a better price down the road.  Forced selling does two things to the market: (1) it creates an inelastic seller who will push down the price, and (2) it creates an environment that pushes away buyers.  If you know that someone has to sell a large chunk of stock, you’d rather buy the last piece of it than the first.  You will only buy early if you are given a steep discount from the present price.

This analysis is sensible enough, but because we are well along into the deleveraging process I don’t think it validates a short position-or at least not a significant one-in risky assets.  At some point the forced selling will stop, and when it does I expect the upward volatility to be higher than it typically is.  The risk for short sellers trying to take advantage of the deleveraging in the market may be higher than they realize; not only does forced selling push the price down, it also scares away buyers.  When the deleveraging is over, not only is the inelastic seller gone, but those buyers who had retreated will come back to the table. This is also the reason why downward volatility has been so nasty.

In an attempt to demonstrate this phenomenon I’ve compared the upward and downward volatility over time.  Admittedly there are some conceptual problems doing it this way, but the graph is useful.  Look at the bottoms in the stock markets, rallies off the bottom are more violent than other upward movements, meaning that the downside minus upside volatility (the blue line) is negative around a bottom (1987 being a major exception).  The red line is the S&P 500 in log space.

Side Note 1: One more reason forced selling creates a terrible market: A wise friend was waiting on the side lines with a large pile of cash, thinking that the Dow would fall to 10,000 in this downturn and likely would have considered investing around that point. But the Dow fell from 11,000 to 8,500 in the span of a week. The idea of trading on valuation was offset by an increased sense of the unknown. Although the 10,000 mark seemed like a good value when he was watching the markets in early 2008 (when the Dow was at 13,000), his view on his own understanding of what was going on and thus his willingness to take risks changed when it fell to 8,500.  When things don’t make sense you should step back. As the adage goes, invest in what you know.

The Bane of Success: Withdrawal from everyone

Performing well is preferable to performing poorly, but there are some downsides to being the best performing money manager in the middle of a financial crisis. I want to point out that the withdrawals you are hearing about from hedge funds are not all due to dying funds.

We are in a massive stampede away from risk, but it is fair to say that many hedge funds have outperformed (at least on a relative basis). Many marketed themselves as total return vehicles, and some investors feel cheated, but at the end of the day they will likely go back to hedge funds because they did outperform (although investors might demand a cheaper fee structure). As a result of this out-performance, the hedge fund portion of portfolios has grown (in some cases significantly), and in order to get back to a desired allocation investors will need to withdraw from hedge funds.

Typically this type of re-weighting is not significant, but consider the John Paulson (extreme) case. If you had 10% of your wealth with him (congratulations on that 1000% return), given that the S&P 500 fell by 40+%, it is possible that you now have about 67% of your wealth with him because of his relative out-performance. Even if you now idolize Paulson and put his picture above your mantel, you may be uncomfortable with that amount of concentrated exposure (as you should be) and thus desire to withdraw some money.

If you return the Paulson weight back to 10%, you’ll need to withdraw over 60% of your portfolio from a risky strategy (note: not risky assets). Does this mean that you are contributing to the deleveraging cycle? Not if the Paulson portfolio is a net supplier of risky assets, which given the shorts in mortgages (and financials) could be expected. If on the other hand Paulson has turned a new leaf and is using capital (balance sheet capacity) to buy risky assets, then a withdrawal would contribute to the deleveraging process (one part of which is forced selling contributing to broken markets).

Now your portfolio decision should not be a function of what is good for the system, but policy makers should be aware that capital is leaving the hand of robust capital allocators – like Paulson – and they may want to consider to what degree they wish to allow a run on the most robust portion of the capital allocation system (the players that make markets work).

[Note: I'll admit that there are lots of conceptual problems with the comparison made in the chart above, but it is designed to illustrate a simple point]