• Stuart Fowler

No nonsense economics: what’s gone wrong in credit markets, why it was predictable and what lessons

Economics matter to wealth managers like No Monkey Business. To plan household finances and manage portfolios, we model financial market behaviour. How we model it requires some implicit views of how economies behave. At the heart of our views are some old-fashioned, let’s say orthodox, ideas about banking practice and its impact on the business cycle and asset price cycles.

Bankers can be relied on to screw things up. They have again. Lax lending (including to non-bank investment funds who were effectively taking over their lending function but without the discipline of banking regulations and capital adequacy) has created unsustainable pricing of credits, credit derivatives, residential and commercial property and equity securities. ‘Unsustainable’ does not necessarily mean ‘overvalued’. It means the levels will come under pressure when liquidity stops expanding or shrinks. If the underlying assets are impaired, as is bound to be the case for home loans and some heavily-leveraged companies and investment structures, the first stage of disappearing liquidity, which can be eased by central bank intervention, will be followed by bad debts, which can’t. Balance sheets in the expansion phase therefore hold the clue to the likely severity (if not timing) of the next recession.

With the exception of Japan in the 1990s, central banks in liberal democracies have responded to recessions by renewed monetary inflation. If history repeats itself, the recession will hold the clue to longer-run inflation. A difference this time is that America’s public and foreign financial position is already so bad that inflation may not be an option. The Japanese example may therefore be the relevant one.

Household finances, including investment portfolios, always need to be organised to withstand intolerable outcomes, however low their probability. It looks like many advisers forgot this priority in managing family wealth.

Explaining liquidity Financial exposures are undertaken for any number of reasons and for any number of time frames, whether by individuals or firms. What they all have in common is some need for liquidity, varying from little (say for an individual investing for long-term returns) to a lot (say for a bank which might have deposits withdrawn, a company which might suffer a loss of cash flow from sales or a fund if it suffers redemptions). Any of these also need liquidity to roll over debt-financed exposures. The more short-term the debt financing, the greater is the liquidity requirement.

Short-term liquidity is normally intermediated by banks. But bankers (attuned to daily balancing of their balance sheets) also need liquidity to be readily available between banks. When it isn’t, they need a central bank, as lender of last resort, even if at a penal rate of interest. Banking liquidity and corporate liquidity meet in the wholesale money markets, where overnight (or slightly longer) funds are lent and borrowed as needed.

Wholesale and interbank money markets only run smoothly if there is no hiatus in the perceived status of the participants, so that nobody finds access to liquidity is suddenly different from past experience. The most likely source of any hiatus is a perceived change in the credit risk of borrowers, either individually (such as a single bank) or as a class (such as hedge funds).

Anatomy of this liquidity crisis Realisation early in the year that a high proportion of recent mortgage loans in the US housing market are probably going to end up impaired, because they were based on inflated prices and were not affordable, has progressively led to a decline of liquidity to specialist lenders in this area.

I warned of this accident waiting to happen in September last year in a post called US house prices: you thought we had a problem. If you want to understand the proximate cause of today’s illiquidity crisis, read it – even though it is even scarier now we know what has happened since. I later explained why this would trigger predictable events in my post on 9th April: Drowning in debt: the American way.

Because about half the home loans created have been passed from originating banks to credit-orientated hedge funds or special purpose vehicles, both of them outside bank balance sheets, the credit-worthiness of these has also become questionable.

Up to this point the liquidity problems were of a wholesale nature, between financial institutions of different types. There has been relatively little liquidity requirement due to redemptions but only because the problem only surfaced in investors’ minds after the wholesale liquidity problem started to impact asset markets they were selling into. Only now is redemption liquidity likely to add to the problems. These happen to be funds that can delay the redemption process if they need to. Because the end investors are typically pension funds and wealthy individuals, the knock-on liquidity effect of delayed redemptions need not have too many further liquidity effects on other parties but will add to the questions trustees and individuals are asking themselves about exactly what they got into.

The next stage in the process of declining liquidity arose in the first week of August. Firstly, unconnected assets (such as large liquid equities) came under pressure because they are the most readily available form of turning investments into cash. This liquidation may have been prompted in part by prime brokers to hedge funds who are the immediate source of their financing, in the form of ‘margin’ but appears (so far) to be mainly a problem for credit lines with banks. This has spread the problem from firms directly affected by sub-prime mortgages to, for instance, equity long/short hedge funds and asset-backed vehicles.

Secondly, specific losses at several European banks led to refinancing issues in the Euro and dollar interbank markets which required unprecedented intervention by the European Central Bank. In this second instance, individual banks were being named but it is likely that confidence between banks was sapped in a fairly indiscriminate way. This is also a consequence of many banks in Europe either having no known record of successful management of exposures of this complex kind or, worse, a known record of being accident-prone.

Meanwhile, in London the interbank and commercial paper markets continued to function without problems. No doubt there are plenty of impaired exposures but the impression amongst market participant is that they are well spread rather than concentrated.

The impact to date on mainstream financial asset prices has been surprisingly modest. Daily volatility in equity markets has increased and markets are ‘gapping’ both up and down at the opening but cumulative losses for broad indices have not been severe. This has been true throughout the bull-market phase that began in 2003: short-term set-backs have been smaller and briefer than in previous cycles.

For UK investors with geographically diversified exposure, the losses have also been cushioned by sterling weakness against both the yen and dollar.

The next phase: still about liquidity What happens next, in London and all other financial centres, must still be largely about access to liquidity and its knock-on effects.

The problem could be eased by banks and wholesale market participants recovering their confidence to lend. This is the bit that people hope central banks can engineer.

Or it could be eased even without that, because the affected parties have already done enough to bring their balance sheets back under control so that they do not need access to third-party financing.

Or else more needs to be unwound but it ends up being sold at broadly unchanged prices because unaffected investors see it as a good buying opportunity.

Otherwise, it becomes a self-fuelling cycle, as participants attempt to cut exposures to organisations holding potentially impaired assets, the organisations cut their exposure to assets to raise liquidity but in doing so drive down the price and asset cover for their loans, undermining lenders’ confidence instead of improving it.

Is the next phase predictable? We do not believe it is. Since the randomness of short-term market movement is hard-wired into the No Monkey Business psyche, this should not be too surprising. Portfolios need to be able to withstand volatility at any time.

Lessons for clients of the investment industry This is one of those important episodes in market history when investors discover that what they hold is not what they thought it was, whether it be the riskiness of their overall portfolio or of particular positions or strategies. It may be too late to put the clock back but it is never too late to learn lessons for the future. The fact that this episode follows within eight years of a busted technology boom, also supposed to be all about ‘things being different this time’, suggests that investors are poor students.

Particular lessons apply to diversification. Many individual products or product types, as well as a concept called ‘absolute-return investing’ (a meaningless term without definition and an axiomatic one when defined), were sold on the basis of low correlations. In a modelled framework of portfolio construction, the correlation assumptions are critical to the outputs but these rarely reflect the true uncertainty about time-varying co-movement between assets. In a purely judgemental framework for taking decisions, the assumptons about how assets behave jointly are only implicit and may not even be evidenced.

The truth is that path volatility – the smoothness of the ride for a portfolio as a whole – can never be tightly managed without dilution with risk free assets. Correlations alone will never do the job. The most likely failure of correlation assumptions is when liquidity conditions are either very loose or very tight – like now or, for that matter, in every cycle.

A general lesson, it is particularly important where investors have low risk tolerance or need to consume capital within say 5 or 10 years (itself depending on risk tolerance). Endowment funds or individuals that followed the Harvard and Yale model of multi-asset class investing would be wise to assume that the smoothed, ‘sustainable’ rate of drawdown from such an approach, regardless of volatility, is probably lower than their advisers told them.

A further lesson applies to credit-related investments. A mistake regularly repeated is to seek more credit risk when market yields are low, which then drives risk premiums to irrational levels. Instead of accepting low yields for good credits, investors accept the poor risk/reward tradeoff on riskier credits. They are also often tempted by exotic structures that appear to escape this inconvenient law.

I wrote about the investing public’s expensive fascination with supposedly ‘low-risk products’ in an FT article in 2004 and a pdf copy is on the site. I thought it would help people resist them if they also understood the reason for the industry’s fascination with selling them: high fees and commissions.

An important general lesson is that clever people know less than you think – or their knowledge is less useful than you think. A good dose of scepticism about managers’ skills will help you spot intellectual arrogance in the face of the ubiquitous randomness of financial markets.

Models: a particular feature of this episode This lesson is hard to earn because it is so counter-intuitive. How can you possibly manage money if you don’t believe you know what is most likely to happen?

Ironically, the answer to this question is straight out of the risk-management manuals of the firms now experiencing blow-ups. Whether you have a view or not, you need to know what can happen (which is where modelling of the behaviour of individual exposures and portfolio combinations of exposures comes in) and you need to know whether the range of predicted values is within the tolerance of the investor.

The failure of some professional mathematical, computer models to capture risk accurately is mainly a failure of complex and short-term trading strategies. It is not a failure of long-term asset models (like ours) and it may not even be a failure of most short-term ‘value-at-risk’ models. Lessons will be learned by the industry about unrealistic model architecture or assumptions and insufficiently representative data in backtests. But it is also likely that model risk will itself be better managed by senior management, by restricting the uses for profit maximisation versus risk management.

The wrong lesson to learn is that we should dump the models and go back to intuition. Modelling forces people to think about how asset behave, jointly and individually, and tests whether an instrument, product or strategy is sufficiently understood by its buyers. More of this would have kept a lot of investors out of trouble.

How do you know you are in the right relationship?

A recurring feature of this website is that disappointment and regret in investment arises much more as a result of flaws in people’s relationship with the financial services industry than because of what happens in markets.

If investors are starting to experience regret, it is sensible to ask themselves some questions before they ask their advisers:

  • Did they really know what they were getting in to?

  • If the bets they made were not familiar ones, did they have good reason to trust the technical competence of their adviser?

  • Did they think about the agenda conflicts when complex products carry high fees?

  • Were they relying on the very people profiting from the bets they made or did they have proper access to unbiased and fully competent advice?

  • Were their advisers as guilty as them of slavishly following fashion?

In my experience, uncomfortable answers to these questions will be tightly correlated with a lack of clarity in the relationship (no quantification, fuzzy language – particularly about risk tolerance – and unaddressed internal inconsistencies in expressed goals and preferences) and a lack of personal control (demonstrated by the absence of an explicit mandate from client to agent).

Contrary to the popular canard that UK consumers have lost their trust in financial professionals, this new episode is likely to reveal, yet again, that there is much too much trust, much of it blind.

#economics #models


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