This Empty House

The Commerce Dept. just released data on US housing vacancies. It shows that vacant houses that are up for sale only (i.e. not rental properties) jumped sharply in the 4th quarter of 2006 to an all time record (see chart). This reflects two probable factors:

a) Houses completed by builders not being sold and staying empty.
b) Owners moving to a new house (purchase or rental), but still not being able to sell their old house.

Source: US Commerce Dept.

While the increase of vacancies as a percentage of the entire housing stock may seem small, it translates to 2.1 million empty homes seeking a buyer, up from 1.56 million in the 4th quarter of 2005. The difference is a very significant 534 000 more unsold vacant homes - a 34% jump within just 12 months.

Let's look at some more data to possibly give us a clearer picture. There were 1.06 million new homes sold last year (this does not account for contract cancellations, which are not tracked - the number actually sold may be lower). Thus, there are now twice as many homes (new and old) sitting vacant awaiting a buyer as there were new homes sold in all of 2006. This ratio was just 1.3 in 2000.

At the end of 2006 builders had 170 000 homes completed and for sale (and thus "vacant"), up from 115 000 at the end of 2005. So in end-2006 non-builder homeowners accounted for 1.93 million houses vacant for sale vs. 1.44 million in 2005. The vast majority of the increase in vacancies has, therefore, come from regular homeowners and not builders.

Seems that, under the circumstances, builders did a half decent job of getting rid of the new houses they built. This means that factor (b) above may account for almost all of the jump in vacant houses currently up for sale.

The data suggests that there is a record and growing number of households that are forced to pay double mortgages, double property taxes, insurance, etc., putting extra strain on their finances. This condition does not bode well for the overall health of the real estate market and it may result in rising defaults, repossessions, forced sales and the like.

Nail Salon Tips

The market is so hot lately that 20-somethings are borrowing money from their parents to plunge in. Then their parents jump in, too. Money managers are making huge bonuses. Brokerages have run out of floor space and rush to install screens in floor landings. Day trading from home via the Internet is zooming. One mutual fund raised $5 billion in a single day. Everyone is asking for trading tips. “When I go to the beauty salon, even the girls who give me a manicure are talking about stocks! They ask me, ‘What should I invest in?’ They say they are doing research.” Everyone's dream is to get rich, rich, rich. The NY Times lays it all out in a story today.

Sound familiar? Of course it does. It is the standard bubble scenario that has played out in dozens of markets and places for centuries. It may involve tulip bulbs, the South Seas, railroad stocks, silver, dotcom IPO's or - as in this case - Chinese stocks, but the scenario is always the same. And so, sadly, is the preordained end. Crash and burn for those unfortunates that climb aboard the "rocket" just as it runs out of fuel - and those that "double up" on the way down.

The Chinese stock market has tripled in just 18 months: the chart below tells the whole story.

The last time I saw this was in late 1999: I was on my way to work and right outside the train station there was this gypsy woman with a makeshift "shop" (a piece of fiberboard on folding legs) selling home-made bead jewelery. What surprised me was that she completely ignored her potential customers. Her ear was glued to a small transistor radio, raptly listening to the stock market report. A few days later a broker friend told me that an 18-year old kid had walked into his office and demanded to open an account with $30. It seems he wanted to buy a $3,000 motorbike and needed the money in a hurry. When told that stocks were not sure thing lottery tickets, the 18-year old got offended and huffily proclaimed he would take his business elsewhere.

Astute investors and speculators are always on the look-out for just such signs of excess. There is an apocryphal story that Barnard Baruch decided to get out of stocks in 1929 when his shoeshine boy asked him for a stock tip. There is a real, fundamental reason for this: markets set prices based on supply and demand. If demand has reached the point where even nail salon girls are trading, who is left to buy? Where is the incremental demand going to come from?

Oh, but of course...."This time it's different". Isn't it always?

P.S. I would not normally write about stocks but there is a debt tie-in here. Please remember that it is Chinese savings that finance a very large portion of US deficits. If it all goes up in smoke in their local market, it is unlikely that they will have the stomach - or the money - to keep buying US Treasuries.

Bulls Make Money, Bears Make Money
But Pigs Become Sausages

Back in the days when I used to write a daily market commentary for professional traders and dealers, I often did it in verse. So here goes once again, for old times' sake...

To be sung to the tune of "Who's Afraid of The Big Bad Wolf?"


Who's afraid of the Big Bad Drop
Big Bad Drop, Big Bad Drop ?
Who's gonna pay when it Stop?
Tra la la la la

We now are full of bloated pigs
Big and stuff-ed piggy-wigs
For the big, bad very big very bad drop
They don't give three figs.

One of them was too fond of loot
And so he sold one giant put.
As he sails in his yachts
With his brokers he so chats
He snickers, "hoot, my man, all risk is moot".

The other one keeps selling out vol
So sure he is it never will a-call.
As he smirks with a giggle
His options he so wiggle.
While it lasts, he's having a ball.

Ah, but the last one is smart
With his stash he won't part.
He has no position
In all that is fiction.
'Cause profit is not shown by a dart.

Ha ha ha! How the other two laugh
How they just wink and laugh ha ha!

Came the day when markets did frown
And correction brought risk into town.
With a swoon and a dive it raised all fears
And brought the piggy put crashing down.

Oh, and how fast volatility appeared
Where none was before afeared.
Strangles and spreads crumble and soar
Unlike anyone knew before -
And piggy vol is ruined forever.

No one left but number Three
To save the piglet family.
But this is not a funny cartoon,
There is no bailing for One and Two,
As Three cries: "Let them eat doom!"

Oh! But.....(for now)...

Who's afraid of the Big Bad Drop
Big Bad Drop, Big Bad Drop ?
Who's gonna pay when it Stop?
Tra la la la la.

The Global Mispricing of Risk

In previous posts I showed that debt and debt derivatives have expanded at explosive rates over the past few years, caused by an unprecedented under-pricing of credit risk. A BBB+ rated corporation can now theoretically borrow at just 32 basis points (0.32%) over what the US Treasury pays – according to where CDS’s are trading right now. Actual costs may be higher, however, because it is one thing to actually borrow a billion dollars in cash and quite another to sell a $10 million credit swap for $32,000. Yet, this last tiny transaction is deemed as indicative of actual risk as actually borrowing a billion - that’s the effect of “marking to market”.

Despite the explosive growth in notional amounts outstanding in the CDS market (according to ISDA, $26 trillion on June 30, 2006 and likely $35 trillion at year end), the market value of all such swaps was around $375 billion or 1.45% of the notional on June 30, 2006. This percentage has now dropped to probably around 1%, as risk premiums have since come down at least 35-45 bp for the whole market (i.e. average of investment plus non-investment grade). This means that 100% of debt, the whole of the bond market, is being marked to market and priced by swaps that cost a tiny 1%. It seems derivatives are now pricing bonds instead of the other way around, i.e. the tail is wagging the dog.

Apart from price, there are also serious quality concerns. Who is selling this credit insurance is even more important than how much they are selling it for. What good is it to pay just $100 for fire insurance if the insurer cannot pay in the event your house burns down? Credit swaps may be priced against US Treasuries or German Bunds (in Europe), but it is not the AAA+ US or German government that is the insurer. It is hedge and private equity funds and large banks that sell default insurance – what are their credit ratings? And how much have they reserved for potential losses against the trillions in insurance they have sold?

Unlike property and casualty insurance, this is essentially a totally unregulated business. A hedge fund can sell as much insurance as it can convince someone to buy from it – there are no statutory limits or reserve requirements. Flip the premium numbers upside down: by accepting just $320,000 per year a hedge fund has the obligation to come up with $100.000.000 in cash to fulfill its insurance obligation in the event of a default by what is today a BBB or A- borrower: this translates to 312-to-1 leverage. For insuring B rated “junk” bonds the leverage is “just” 44-to-1. How likely is it that all, or even most, hedge funds and other CDS sellers will come up with such enormous sums of money if real defaults occur? Remember that hedge funds and private equity firms have zero reserve requirements. They are the weakest link in what is already a very stretched chain.

What is even more concerning is that it is not even necessary for defaults to occur in order for the chain to snap. There are now tradable CDS indexes that can be bought or sold on the aggregate of 100 corporate names. Such index trades are margined and settled for cash: if the market goes against the speculator, he has to come up with money regardless of any default. If anything happens to suddenly raise the overall level of risk perception, margin calls alone could wipe out many players and even result in crushing losses, if margin calls are not met, for whoever took the other side of the trade (banks and investment banks?). According to BIS, about one third of all credit swaps are now against such multi-name instruments.

In the past it used to be that we measured risk perceptions indirectly by the exuberant or morose behavior of primary markets and their relative performance: stocks, bonds and commodities. We have now constructed a market for pricing and trading risk itself and it is telling us there is very little risk out there. Are we to believe it? I don’t know, but there is an obvious oxymoron here: the CDS market that is right now proclaiming that risk is very low is by itself creating more risk.

Cousin Trouble at The Market Ball

Debt and equity are first cousins. Both are named "Capital", but that's were the similarity ends.

When invited to the Market Ball, Mr. Bond - not exactly a young buck - sedately and somewhat lazily danced to the inflation and credit risk waltz, while young and pretty Miss Stock shook her stuff to the earnings samba - she was always much too frisky. Bond hung out with the uppity middle age banker, CFO and Treasury crowd, eating canapes and drinking Cristal, while Stock spiked the punch with smuggled moonshine and flirted shamelessly with the raucous brokers, analysts and money managers. Always a free spirit, she occasionally had a go with the hoi polloi waiters, too.

But no more. Seemingly bored with Strauss and pate, Bond has fallen head over heels for his young and sexy cousin and is now burning the dance floor with her to all known versions of "Ring My Bell". Everybody in the Ball was shocked at first, but most of them are now in full Saturday Night Fever mode. They are lustfully ogling and cheering the pair on as it sashays on the parquet floor discharging pheromones grinding and sweating. Seems someone spiked Bond's champagne with some credit derivative mickey and he is throwing all inhibitions overboard in his middle age.

But not everyone is amused. The central banker old maids, sitting primly on a stiff couch near the restroom, are all a-titter and a-flutter. Their chaperone instincts do not approve. If they let those two go on, they say, it won't be long before Mr. Dollar and young Miss Euro start making googly eyes at each other... and haven't Petrol, Copper and Gold been seen stepping out with Inflation? Oh no, this is definitely getting out of hand.

The old maids go into scheming mode. As they put their heads together, Boe - the oldest and most respected - announces she has already taken some action: she has unexpectedly turned down the music a notch, but no one seems to have noticed. Fed, the richest, was hoping to stare everyone to submission but she's realizing sterner stuff may be needed. Eseebie reports she is constantly warning everyone to cool it in the most explicit terms, but it seems the crowd is brushing her aside. Boj, the youngest and most timid of the group, is twisting her hankie in her hands worrying like, well, an old maid - she just doesn't know what to do.

Whatever the old maids finally decide, however, they also need to the catch the guy who slipped Bond the mickey and throw him out of the party. Otherwise they may have to set the place in fire before everyone decides it's time to go home to bed. Alone.

Who's Flying the Plane?

Central banks are finally getting concerned about the rapidly escalating systemic risk posed by credit derivatives. Just the sheer notional amount outstanding (est. at $35 trillion) and the very nature of the beast - it is nothing but naked put writing - is certainly reason enough for alarm. Speaking at the World Economic Forum in Davos yesterday Zhu Min, the Vice President of Bank of China, said: “You can easily get liquidity from the market every second for anything…We really don’t know what the risks are”. The ECB President Jean-Claude Trichet has previously said that investors may not be accurately assessing risk and so has ex-Fed Chairman Alan Greenspan.

But before discussing risk, let’s first concentrate on another aspect - that of interest rate control. Central banks consider interest rate control one of the few tools they have to regulate monetary policy. If rates are totally hijacked by the market central banks may end up having to use blunt instruments to achieve policy goals: open market purchases and sales of government bonds, banks’ reserve requirements, margin regulations, etc. Now, a determined central bank will always ultimately win – “you can’t fight the Fed” – because it can raise short rates to such an extent that even the most obdurate trader will eventually stand up and salute smartly. No central bank can long afford to be accused of pushing on a string, as the Fed was in 1999-2000 in the face of the dotcom IPO mania that had supposedly made interest rates irrelevant.

In previous posts we saw how demand for “free” money from writing credit default insurance is lowering CDS premiums, thus lowering overall market-driven interest rates. Of course this money is not really “free”, it is just that its price has ceased to be expressed in interest rate terms and has been replaced by the assumption of ever more risk. At some point, however, the course will reverse, risk premiums will rise and so will the cost of money.

Therein lies the Fed’s and other central banks’ quandary: long rates stayed flat even as the economy strengthened and credit demand soared, despite repeated hikes in short interest rates. I believe this has happened due to the CDS effect explained above (more detail in previous posts).

If the economy weakens and the Fed needs to stimulate by cutting rates, will market rates fall too? If my explanation is correct, they won’t – they may even rise substantially as the weakening economy heightens credit risk and raises CDS premiums from all time lows. In short, the central banks’ traditional role as the economy’s “punch bowl” provider and taker-away may no longer be relevant to the “real” economy. This is certain to give pause to central bankers: they can’t have the inebriated partying passengers flying the plane. Pretty soon the Fed and other central banks will have to wrest the controls back for themselves or face unintended financial aviation terrorism.

Back to discussing risk: central bankers have a language all of their own. Alan Greenspan was the Triple O Master (Obfuscation, Obscurantism and Opaqueness), having famously said that if you thought you understood him, you understood wrong. Thus, when they speak openly of risk we better listen and listen carefully. These are not people that are paid to provide opinions but to judge conditions and act accordingly. If they publicly say things are getting too risky it's because they are warning markets. If they pay attention and self-correct, fine: that's called moral suasion. If they don't, next comes intervention. Because no central banker ever wants to be accused of talking big but carrying a limp rope.

P.S. From our reverse indicator dept.: PriceWaterhouse reports that 92% of 1,084 corporate executives polled said that they are either "confident" or "very confident" about their prospects this year, the highest reading since the survey began ten years ago. And the market keeps selling naked puts; but then again there is that extra bit of "juice" - we could perhaps go to 99% confidence? As in "Stocks have reached what looks like a permanently high plateau". Need I remind anyone who and when made this memorable pronouncement?

In 1929 it was margin debt.

In 1987 it was junk bonds and program trading.
In 2000 it was dotcoms.
In 2007?

First let's ask: what moves global markets right now? The answer comes easily: an excess "liquidity" tide that raises all ships. But what is this "liquidity" and where does it come from? Since all money is debt, increased liquidity naturally comes from more debt. When the price of this debt is cheap, i.e. when interest rates are low, more "money" is created and it chases assets like a tomcat in heat. For as long as the cost of money is cheaper than the expected marginal returns, the chase goes on.

At some point asset prices reach such a high level that no matter how cheap borrowing is, there is no significant extra return to be had: diminishing returns set in. But what if the price of money is zero? Then the marginal return on assets bought with such "free" financing is infinity (anything divided by zero results in infinity). But who would be foolish enough to give money away for nothing - except in Dire Straits lyrics? Keep reading, because it seems there are financial alchemists that act as if they have discovered the monetary equivalent of the philosopher's stone and the perpetual motion machine, rolled into one.

For professional money managers competing ferociously for that extra bit of return that passes for genius in their trade, a tad of infinity goes a long way in boosting performance and year-end performance bonuses. So there is, indeed, lots of demand for free money - if you can get it - for as long as markets are going up, of course. Because if the direction is down, the process works in reverse: no one wants to borrow to invest and speculators rush to liquidate positions to repay their loans even if they got them at zero interest - after all, they still have to return the principal amount in the whole.

All right, we have the demand side identified: market speculators of all sorts. So how is the free money supply created? The Japanese yen carry trade has been already identified as one source of ultra cheap money. Indeed, it has been pumping liquidity onto markets for at least five years. But it still carries an interest rate cost, however modest, plus the day-to-day FX volatility that requires constant mark-to-market adjustments. And, crucially, even when you borrow yen at 0.1% the whole process is still a loan, subject to credit qualification criteria. The price may be almost free, but those pesky bankers won't give it you unless you can prove that you have the ability to pay it back. Plus 0.1% interest, of course. The loan also goes in the banks' books and is subject to reserve requirements. Though it comes rather close, this is not the "free" money capable of producing infinite returns and $200 million performance bonuses.

But Credit Default Swaps (CDS) is free money to those that sell them. The premium payment money keeps coming in free and clear for as long as no defaults occur. Money you get against assuming someone else's default risk does not carry a clearly visible x% interest cost per year. What is happening, then, is that the cost of money is shifting away from paying an interest rate and onto risk assumption - and this is where trouble lies.

Let's look at an example:

Ace Diceroll, manager of Hedge Fund ABC, wants to boost his annual return by 1% on the $1 billion he manages - he has to come up with an extra $10 million in bookable profit. He calls Bob Lencalot, the account manager at his friendly prime lender Bank XYZ and arranges to sell as much credit protection as it takes to generate $10 million in income. Bob informs him that he has two choices: he can provide insurance for $3.3 billion of investment grade bonds, or for $435 million of risky "high yield", or "junk", bonds. Ace is mildly perturbed - just a few months ago, when he had also pondered the same strategy, he had to insure "only" $2.4 billion and $312 million respectively. Be that as it may, Ace swallows hard and sells the insurance. Construction of his new ski chalet in Aspen is costing more than originally planned.

Seems lots of "Aces" have been in the market recently for just such free "performance boosts", helping to drive CDS prices down. Indeed, one can see this plainly in the performance of the CDX Index

The CDX index tracks investment grade CDS - the red line is the annual cost of insurance expressed in basis points, i.e. Ace can only get $3.1 per year for insuring $1,000 versus $4.1 last September. The equivalent for insuring junk bonds has gone from $32 per $1,000 to $23.

Bank XYZ is acting both as principal and intermediary here: It is unlikely that Ace's ABC hedge fund could get its own name accepted as an insurer in the market, so it sells the CDS to XYZ who either keeps it in its own books or turns around and markets it under its own name and credit rating. Why would XYZ do that? Two reasons: a) it makes an immediate fat spread profit on the transaction and b) it gets lots of Ace's other business such as commissions on securities' transactions, margin loans, custody fees, etc. (thus the term "prime bank"). Plus, all this stuff is strictly "off balance sheet", so it does not swell the bank's asset/liability ledger.

The money ABC receives from selling the CDS doesn't just sit around collecting dust, of course. Ace will put it to use to further enhance performance - if he gets just a 10% return on the CDS money he will boost his return by another 0.1% for a total 1.1%. If he really loves a crapshoot (and most hedge fund managers do), he will further leverage this money, say 2 times, and boost his performance even further, to 1.3%. Hey, every little bit helps when it comes to ski chalets - have you priced one lately?

And when you add it all up it is certainly not "a little bit". A notional $35 trillion is outstanding in CDS (see previous post): 75% of them cover investment grade bonds (generating 0.3%) and 25% cover junk (generating 2.3%) resulting in a blended insurance income of approx. 0.80%, or a stunning $280 billion annually (before potential credit losses, of course). Just five years ago this source of "free money" liquidity did not provide more than approx. $5-8 billion as CDS's were essentially non-existent. If this money is leveraged just once, the total purchase power impact on markets doubles to $560 billion. More debt piled on top of "free" money that came about through leveraging other people's debt!

Think about it: people totally unrelated to GE - for example - can make a bundle by leveraging its AAA credit rating to the sky! Can you blame financial alchemists for believing in magic?

OK, then, let's assume this is where CDS supply is coming from these days. But, who is buying the stuff that ABC is selling through XYZ? - who is the ultimate provider of all this "free liquidity" that buys protection to the tune of $280 billion?

a) Hedgers
b) Speculators

Hedgers: In a previous post I explained that the only way a rational hedger (i.e. a bond holder) would buy CDS is if it were mis-priced vs. real risk, i.e. if he could buy risk protection on the cheap. For example, if a pension fund holds a BBB rated bond he would gladly buy insurance from a AA rated CDS issuer if it cost significantly less than the difference in yield between the two. If the BBB bond yields 6% right now and the AA's bonds yield 5%, the holder of the BBB bond would gladly buy CDS insurance at, say, 0.50% per annum. He would have effectively turned his BBB bond into a synthetic AA bond and still collect 5.50% (6.00% - 0.50%), i.e. more than a straight AA bond. Indeed, this is happening right now: the rush to sell CDS and collect "free money" has resulted in just such seemingly impossible imbalances (though not at these hypothetical levels, of course).

Speculators: sell anything for cheap and smart money will eventually show up. Quietly and slowly. And patiently...

Where's the bottom line? Where it always is, of course: RISK. Just think of it this way: if anything happens to raise risk premiums by 100 basis points the mark to market loss for CDS alone will be $350 billion. Throw in leverage and the impact across all markets could easily double or even triple. If there are major defaults, too, the potential losses could be in the trillions, since CDS issuance is so concentrated amongst just a few hundred bond issuers: GFI, the major interdealer broker, reports that it regularly sees just 650 unique names in the CDS market. Do the math: $35 trillion divided by 650 means there is an average of $54 billion in CDS outstanding for every issuer. Averages being what they are, it is certain that some names have hundreds of billions of CDS outstanding against their credit.

The double bottom line: Such derivatives do not serve to moderate risk but to concentrate it, both at the original credit default level and across other, unrelated markets, since "free" money is undoubtedly finding its way into them as well.

Stay tuned - Tomorrow I'll try to provide some perspective on how I think the Fed is viewing all of this and what it means for interest rates going forward.

To The Moon, Alice

There is no doubt that financial derivatives are a booming business. Actually, booming is too mild a word. "Bang, Zoom, To the Moon" is a better description, to quote Jackie Gleason from the classic US TV comedy series The Honeymooners.

According to ISDA , the global Credit Default Swaps business has gone from $920 billion in outstanding notional amounts at the end of 2001, to $26 trillion at the end of June 2006 (see chart below). A 26-fold increase in just 4 1/2 years undoubtedly qualifies as "zoom". And keep in mind, this is not an annualized figure - I estimate that the 2006 year-end figure was around $35+ trillion.

Global GDP is around $45 trillion and total debt is estimated at around $120 trillion, so $35 trillion in CDS is around 78% of global GDP and 30% of all debt. How long before the whole of global economy and debt become "credit swapped"? More importantly, who is selling all this credit insurance?

The US Office of the Comptroller of the Currency (OCC) reports that CDS positions held by commercial banks ($8 trillion) are heavily concentrated: 95% are held by just 4 banks: JPMorgan Chase (54%), Citibank (17%), BofA (15%) and HSBC USA (9%). Likewise, it is highly likely that in the global business no more than 10-15 institutions (commercial and investment banks plus a few hedge funds) carry the vast majority of the $26 trillion on their books.

Which begs the question: who "insures the insurers"? How can issuers hedge themselves against such massive exposure? It's not as if CDS's are proper swaps (i.e. a balanced exchanges of one risk for another). They should more properly be called credit put options: the option writers (the CDS sellers) collect a premium and must purchase the defaulted bonds at par in the case of a default event. For CDS's backing corporate bonds the most likely hedge would be shorting stock and it is possible that even a small rise in default risk could cascade into a self-fulfilling domino effect.

Furthermore, CDS issuance is not limited by the actual amount of debt outstanding: $1 billion in bonds issued by a single borrower may have $5 or even $10 billion in CDS's outstanding against it. Thus, a $1 billion default could snowball into many times more losses: instead of a risk hedge we may end up with a risk multiplier effect, like a runaway nuclear reaction.

No wonder Warren Buffet has called such derivatives "financial weapons of mass destruction".

Mike is Back - This Time It's Derivatives

First a primer for those unfamiliar with Credit Default Swaps (CDS):

CDS are contracts that transfer default risk of a given borrower (usually based on a bond): The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the bond. By doing this, the risk of default is transferred from the holder of the bond to the seller of the swap. Buyers usually pay an upfront lump sum and regular annual payments to keep this "insurance" in force. Prices are usually quoted as X thousand dollars per $10 million protected. For example, a swap buyer may pay $65,000 per year in order to receive $10 million in the event of default by ABC Inc., whose bonds the buyer may or may not possess. Apart from hedging, CDS are also used for speculation. If you believe that ABC's creditworthiness will deteriorate, you can buy a CDS with the expectation that its price will go up.

Let's consider a simple bond: it is a contract that stipulates that a particular borrower (the bond issuer) will pay interest on the money borrowed and return the principal at maturity. As such, the coupon rate of the bond itself when issued (i.e. the interest rate) should fully reflect the risk of default. High quality borrowers pay less, low quality pay more. Furthermore, the price variations of the bond itself after issuance (i.e. the secondary market) should also reflect all available information about its current ability to service its debt. Increasing risk will lower the price and decreasing risk will increase the price. Two observations:

1. Creditworthiness is, by definition, included in and reflected by the price of the bond itself at all times. Theoretically, therefore, bond holders already own imputed default protection within the bond itself. By buying a CDS on a bond they already own, bondholders pay twice for the same thing - unless of course such credit-protected bonds are always mis-priced. Not a likely state of affairs in efficient markets, but possible.
2. The issuer of CDS is operating as an insurance company selling life policies against corporate "death". It collects premiums from CDS sales, invests them and calculates it will get to keep more than it has to eventually pay out. Underwriting corporate health is extremely risky business; unlike human actuarial data, corporate default risk is very volatile and uncertain. Still, if you price the stuff properly you should end up with a wash, i.e. right around the risk-free rate of return. Add #1 above plus cost of doing business and this business can't possibly exist - at least on paper. But it does! So what gives?
   

There are only two - mutually exclusive - logical explanations for this state of affairs. That on average:

a) The CDS buyers are strictly un-savvy speculators constantly and wrongly punting on credit deterioration and who routinely overpay for their bets - resulting in handsome profits for the underwriters.
OR
b) The CDS issuers are underpricing their policies to such a degree that both speculators and hedgers are buying them like hot cakes.

I don't know for a fact which is true, though I suspect (b) strictly from the astonishing growth of the amounts involved. Keep in mind that as long as the business cycle stays positive defaults are low and premiums are almost pure profit, i.e. the current return is almost infinity. But, of course, in order to properly price credit risk one has to take into account the other side of the business cycle, where all defaults normally pile up. It doesn't seem that CDS issuers are looking past the crest.

The last time an industry was born out of mis-pricing credit risk we got junk bonds: Mike Milken, Drexel Burnham, LBO's, The Predators Ball - and the collapse of S&L's plus the Crash of 1987. It looks to me like we are again mis-pricing risk today: all sorts of credit derivatives, sub-prime loans, the real estate bubble and - again - LBO's and "private equity" funds. And, ominously, a blast from the past:

Bloomberg reports that Michael Milken (long out of jail by now) will make a speech at a conference in London on high yield debt organised by BNP Paribas. He will say that by adding derivatives on loans, bonds and credit cards, poor nations could raise between $50 trillion and $100 trillion.

Can you imagine the fees involved in raising $50-100 trillion? Yum Yum Yum. Well, I don't know about you, but I lived through the Drexel era and the ding-ding-ding I'm hearing surely can't be the lunch wagon.

Goldilocks At The Slimming Salon

For the past three years we had "everything up" markets: stocks, bonds, commodities, real estate, FX. Goldilocks had a field day in the kitchen. A little bit of this, a little bit of that - she ended up binging on a whole lot of everything. Is she heading for the slimming salon soon? I think so.

First, let's consider the precipitous drop in oil and basic metal prices. Welcome by consumers, it is not at all welcome by those producers who took the buyers' money and invested the excess. We know that some 55 mbpd of oil is sold at or around market prices (the rest going to heavily subsidized local consumption); the difference between $75 and $50 per barrel thus equates to $500 billion dollars less per year. Similarly for copper, nickel, zinc, lead, etc. Let's call the whole thing $750 billion in extra cash per year. And this has now been taken out very, very fast.

Given the rapid rise in hedge fund and private equity inflows during 2005-06 it is natural to assume that this excess oil and metal revenue money had found its way there, too - where leverage reigns supreme (5:1 leverage is not at all uncommon). All the extra money was not invested, of course, so let's say that the effect was $1 trillion annualized, leverage included. What I mean is that this money will not be available to further pump up markets. There are indications this is already happening: according to Hedge Fund Research, net inflows to hedge funds were down 64% in the 4th quarter of 2006 compared with the previous three months.

Secondly, consider leverage. Prof. Markowitz (of portfolio theory fame) recently showed that high leverage increases prices for all risky investments, even those that are un-leveraged and thus results in more disequilibrium and higher potential volatility. In this blog I have posted ad nauseam about high total debt in the US (i.e. high economic leverage). Derivatives are another form of leverage, too: the explosion in total derivatives outstanding is well documented by the Bank of International Settlements. Over the counter derivatives held by the reporting large international banks reached $370 trillion in notional value in June 2006, up from $220 trillion in June 2004. Almost all of the increase came from interest rate contracts and credit default swaps. Another sign of high leverage is margin debt: as of November 2006 (latest available) margin debt reported to NYSE is up to $270 billion - very close to an all time high, see below.

Hmmm.. seems like Goldilocks has to go on a diet pretty soon, eh?

More on Interest Rates

There is a corollary that can be drawn from yesterday's post about the influence of derivatives on longer-term interest rates (my opinion is that explosive growth in credit derivatives helped keep rates down even as debt kept shooting up).

Here it is:

As Credit Default Swaps (CDS) and other such derivatives become less popular and/or more expensive, borrowing costs will rise, i.e. interest rates will go up. I am referring to longer rates (5 years plus) and those for less credit-worthy borrowers. In market lingo, the yield curve will steepen on the long end AND credit spreads will widen. This is a double whammy, particularly for the mortgage, LBO, hedge fund and private equity business. The fact that those are exactly the sectors that have been so hot during the past 3-4 years is not at all a coincidence.

This means that even if the US economy slows down further during 2007, such interest rates could still rise or stay roughly the same, even if credit demand drops sharply. This is obviously contrary to the conventional wisdom that has rates dropping during a slowdown. But then again rates did not go sharply higher during the recent expansion either. The extra boost of credit derivatives during an expansion could turn into a drag during a slowdown.

I have been very vocal in saying that in commodities - oil in particular - it is the tail (derivatives trading) that has been wagging the dog (cash prices) for at least 12 months now. This could also happen in the more sedate bond business....

Debt, Derivatives and Interest Rate Conundrums

The rise of total debt in the US economy has been tremendous in the past few years, reaching 315% of GDP in 2006. Despite this high demand for borrowed funds and the sharp rise in Fed Fund rates, interest rates set by the free market (i.e. rates for borrowing longer term) have not gone up by much at all and the yield curve is inverted. Why? The answer, what Mr. Greenspan called a “conundrum”, may lie in derivatives - particularly credit default swaps. Let’s start from the beginning.

Any debt has two major risks: interest rate risk and default, or credit, risk. Interest rate risk is determined by the market – if rates rise and the debt carries a fixed interest rate then its price in the secondary market will drop until its yield to maturity becomes equivalent to current returns and vice versa. The rise and fall of prices are mathematically driven and therefore exact and objective. There are several ways to hedge this risk with futures, swaps, options, etc, but the process is also mathematically exact and not subject to interpretation. We'll ignore this risk for now.

Credit risk is a much more relative: it measures the ability of the borrower to repay principal and interest on a timely manner and has always been subjectively judged and rated (not always successfully or honestly, I might add). There are several credit rating and reporting agencies scoring business and individual borrowers based on cash flow, income, debt load, guarantees, collateral, etc. Credit risk is the main determinant of the interest rate a borrower has to pay. Enter financial engineering and Credit Default Swaps (CDS).

The massive power and ready availability of modern computers has allowed mathematical modeling to reach every nook and cranny of the finance business. A new “science” was born - financial engineering. Let’s stop for a moment to consider the oxymoron of that expression. Finance is certainly not an exact science, since it ultimately depends on people’s psychology and temperament - evanescent quantities, both. How, then, can you construct something solid on top of them, as the term “engineering” implies? No matter how much statistical analysis and back-testing you perform, people are not as predictable as steel beams. Yet investment banks, brokerages and trading firms are now full of “financial engineers” busy devising one model after another to fit what is, in the end, an impossibly chaotic process. Foolish? Yes and no.

Yes, because in the end reality always “outs”. Fundamentals govern the ultimate return of any investment, not expectations. You cannot make a silk purse out of a sow's ear and, no matter how much you may desire it, there is no philosopher’s stone.

No, because people are funny animals – if they believe something is true then they behave accordingly until proven wrong. Thus, belief is much more important than fact and nowhere is this more apparent than finance. Advertise there is gold in the bottom of Lake Erie and you will find people willing to invest millions to finance the construction of mining submarines. You can make a pile from taking advantage of “irrational exuberance”.

The most dangerous form of gullibility is that which is self-induced, i.e. “believing your own sh*t”. To wit, if your model shows that time and again (in the past 20 years, anyway) sub-prime borrowers were better credit risks on average than was originally calculated, well then “you have a market” and can make billions lending at lower rates than before. Presto, an industry is born. Never mind that the data pool was tiny or that low interest rates and plentiful cash lowered defaults only temporarily – the “model” showed an opportunity. Lenders rushed in – and how! The creation of CDS’s was extremely rapid. In the chart below from the Bank of International Settlements (BIS) you can see the notional amounts outstanding in CDS quadrupling to $20 trillion in just 18 months!

What does a CDS do? It supposedly uses the “market” to more accurately score credit risk, instead of the traditional credit agency methods. It also spreads out the risk amongst more participants who buy and sell such default protection. In theory it lowers overall portfolio risk and thus lowers average borrowing costs and/or allows for the lending of more money at a given cost.

Bingo! The next chart is also from BIS. It shows the phenomenal increase in issuance of Collateralized Debt Obligations and the performance of related indexes. (The recent price of the ABX.HE.06-02 BBB- index has collapsed to 93.41 and that of BBB to 95.31).

The conundrum is apparently solved: the explosion of credit derivatives has allowed interest rates to stay low even as debt burden expanded very rapidly. But keep in mind that the default risk has not gone away - it has only been spread amongst many more participants (including your very own pension fund, no doubt). Is that a benefit? Up to a point, yes. But beyond it lies this very simple fact: there is now much more risk shared among many more entities.

And that is not good engineering...

Competence Versus Ideology

I am an engineer by training and a money man by profession. Therefore, to me results matter.

I don't care if you are the most polite or despicable soul in the world, if you kiss babies or have rabies: if in the end the bridge you designed collapses you are nothing but a bum. Furthermore, if it was I that let you design it, then I am an even bigger bum.

Likewise for running a country. If you let your ideology run the show but fail to come up with the desired results you are a bum and a fool. Believe in Jesus, Yahve, Bhudda, Mohammed or the immortal soul of a giant jelly fish - you still have to provide for peoples' safety and sustenance. Subscribe to the theories of Karl Marx, Adam Smith or Joe the tipster down in the racetrack - but you better make sure that there's plenty of bread, milk and extra trimmings.

The problem I have with the current US administration is that it has allowed its "small government" and "free market" ideology to permeate and destroy the core competence of the country. It was not a tornado that struck New Orleans but an emasculated and incompetent FEMA. It is not the US Army that has lost the war in Iraq but the Transformational Army of an ideology-stuffed Defence Secretary. It is not the good people of America that are responsible for the rest of the world turning its back to the US, but a leader so full of himself that he believes he speaks directly to God.

And now this car wreck of ideologists are upping the ante even further, not because it will get the job done but because they believe. But competence is not faith-based and results require more than just mulish persistence.

"When I am wrong, I change my mind. What do you do, sir?"

J.M. Keynes

Some Rather Unpleasant Charts

The chart below is self explanatory. Just to update the numbers since 2005, the ratio of total debt to GDP is now near 315% (total debt $42 trillion, GDP $13.3 trillion). Note that this does not include the debt owed to the Social Security Trust Fund (another $4 trillion) - that would take the ratio to 345%.

Source: Gabelli Mathers Fund

The next chart is an index of sub-prime mortgage pool securities rated BBB-, used in pricing credit default swaps and such insurance products for the exotic mortgage market. It is calculated by Markit and the link is:
http://www.markit.com/magnoliaPublic/affiliations/abx
Sub-prime mortgage originators are facing increasing difficulties in packaging and re-selling their loans; several have already shut down. You really can't make a silk purse out of a sow's ear no matter how much financial engineering you apply - not for long, anyway.

The next chart shows how much money was taken out during the housing bubble in the form of equity withdrawal (to spend on plasma screens, woolly socks and such: the Fed estimates that 2/3 of this money was consumed - not saved). The amount is now going down fast and the impact is being felt in the retail sector.

And last, but certainly not least, American households have been acquiring less and less financial assets (stocks, bonds, mutual funds, bank deposits, etc). While still adding to their portfolios, the amount is going down rapidly. That can't be all that healthy for financial markets as they make new highs - where is the fresh money coming from?

Baby Boomer Debtors

Between 1946 and 1964 there were 75 million people born in the US. This "bulge" is clearly seen in the chart below.

Economic growth is ultimately based on a rising population and the boomer demographic nicely fits in with recent US economic history. For example, right around 1980 the first boomers reached age 35, widely seen as the onset of a person's high productivity - high consumption period (35-60). If we knew nothing else about causes and effects shaping the US economy but what we saw in the chart, we would easily predict that 1980 onwards could be a period of rising demand for all kinds of goods and services.

And here is another "easy" prediction: as the first waves of boomers approach retirement age this process will reverse. People preparing to retire cut down consumption, save more, alter investment strategies and in general act as a "brake" on growth. At the same time, they become heavy users of health services: a person consumes 90% of his lifetime's total medical care after the age of 60. Given that the US has a "social" medical system for retirees (Medicare), the boomer demographic has profound consequences for its future viability. Indeed, the US Treasury now calculates the present value of unfunded Medicare liabilities at $29 trillion, up from just $13 trillion in 2002.

The first boomers are already a year away from the statutory age for early retirement (62) and with every year that goes by the number of people retiring will rise sharply, reaching a peak around the year 2020. Given the current vastly swollen debt load of American households it is highly unlikely that this process will be smooth and painless - or last just a few years.

The Great Bull Market (in everything) commenced right on time in 1980 and has lasted for an unprecedented - but almost predictable - quarter century. Do not be surprised if the Great Bear Market (in everything) starts during the first decade of the 21st century.

Population is destiny.