"Hope, the best comfort of our imperfect condition." - Edward Gibbon, English historian
While thinking about correlations in particular and risk in general, we reminded ourselves of one of our pet subject we have touched in different musings, namely the fascinating destructive effect of "
Rogue waves". It is a subject we discussed in details, particularly in our post
"Spain surpasses 90's perfect storm":
"We already touched on the subject of "Rogue Waves" in our conversation "the Italian Peregrine soliton", being an analytical solution to the nonlinear Schrödinger equation (which was proposed by Howell Peregrine in 1983), and being as well "an attractive hypothesis" to explain the formation of those waves which have a high amplitude and may appear from nowhere and disappear without a trace, the latest surge in Spanish Nonperforming loans to a record 10.51% and the unfortunate Sandy Hurricane have drawn us towards the analogy of the 1991 "Perfect Storm".
Generally rogues waves require longer time to form, as their growth rate has a power law rather than an exponential one. They also need special conditions to be created such as powerful hurricanes or in the case of Spain, tremendous deflationary forces at play when it comes to the very significant surge in nonperforming loans.", source Macronomics, October 2012
You might already asking yourselves why our title and where we are going with all this?
The MS München was a massive 261.4 m German LASH carrier of the Hapag-Lloyd line that sank with all hands for unknown reasons in a severe storm in December 1978. The most accepted theory is that one or more rogue waves hit the München and damaged her, so that she drifted for 33 hours with a list of 50 degrees without electricity or propulsion. The München departed the port of Bremerhaven on December 7, 1978, bound for Savannah, Georgia. This was her usual route, and she carried a cargo of steel products stored in 83 lighters and a crew of 28. She also carried a replacement nuclear reactor-vessel head for Combustion Engineering, Inc. This was her 62nd voyage, and took her across the North Atlantic, where a fierce storm had been raging since November. The München had been designed to cope with such conditions, and carried on with her voyage. The exceptional flotation capabilities of the LASH carriers meant that she was widely regarded as being practically unsinkable (like the Titanic...). That was of course until she encountered "non-linear phenomena such as solitons.
While a 12-meter wave in the usual "linear" model would have a breaking force of 6 metric tons per square metre (MT/m2), although modern ships are designed to tolerate a breaking wave of 15 MT/m2, a rogue wave can dwarf both of these figures with a breaking force of 100 MT/m2. Of course for such "freak" phenomenon to occur, you need no doubt special conditions, such as the conjunction of fast rising CDS spreads (high winds), global tightening financial conditions and NIRP (falling pressure towards 940 MB), as well as rising nonperforming loans and defaults (swell). So if you think having a 99% interval of confidence in the calibration of you VaR model will protect you againtst multiple "Rogue Waves", think again...
Of course the astute readers would have already fathomed between the lines that our reference to the giant ship MS München could be somewhat a veiled analogy to banking giant Deutsche Bank. It could well be...
But given our recent commentaries on the state of affairs in the credit space, we thought it would be the right time to reach again for a book collecting dust since 2008 entitled Credit Crisis authored by Dr Jochen Felsenheimer (which we quoted on numerous occasions on this very blog for good reasons) and Philip Gisdakis.
Before we go into the nitty gritty of our usual ramblings, it is important we think at this juncture to steer you towards chapter 5 entitled "The Anatomy of a Credit Crisis" and take a little detour worth our title analogy to "Rogue Waves" which sealed the fate of MS München. What is of particular interest to us, in similar fashion to the demise of the MS München is page 215 entitled "LTCM: The arbitrage saga" and the issue we have discussing extensively which is our great discomfort with rising positive correlations and large standard deviations move. This amounts to us as increasing rising instability and the potential for "Rogue Waves" to show up in earnest:
"LTCM's trading strategies generally showed no or almost very little correlation. In normal times or even in crises that are limited to a specific segment, LTCM benefited from this high degree of diversification. Nevertheless, the general flight to liquidity in 1998 caused a jump in global risk premiums, hitting the same direction. All (in normal times less-correlated) positions moved in the same direction. Finally, it is all about correlation! Rising correlations reduces the benefit from diversification, in the end hitting the fund's equity directly. This is similar with CDO investments (ie, mezzanine pieces in CDOs), which also suffer from a high (default) correlation between the underlying assets. Consequently, a major lesson of the LTCM crisis was that the underlying Covariance matrix used in Value-at-Risk (VaR) analysis is not static but changes over time." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
You might probably understand by now from our recent sailing analogy (
The Vasa ship) and wave analogy (
The Ninth Wave) where we are heading: A financial crisis is more than brewing.
It is still time for you to play "defense", although we did warn you well advance of the direction markets would be taking at the end of 2015 and why we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up (it did...). Although some like it "beta" or more appropriately being "short gamma" such as the "value" proposal embedded in Contingent Convertibles aka CoCos (now making the headlines), we prefer to be "long gamma" but we ramble again...
Moving back to the LTCM VaR reference, the Variance-Covariance Method assumes that returns are normally distributed. In other words, it requires that we estimate only two factors - an expected (or average) return and a standard deviation. Value-at-Risk (VaR) calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence.
LTCM and the VaR issue reminds us of a regular quote we have used, particularly in May 2015 in our conversation "
Cushing's syndrome":
"The issue with so many pundits following "similar strategies" and chasing the "same assets" in a growing "illiquid" fixed income world is a Cushing's syndrome impact. Excess stimulants have compressed yield spreads too fast leading to "unhealthy" rapid bond prices gain.
The growing issue with VaR (Value at risk) and bond volatility is that it has risen sharply from a risk management perspective. This could lead to a sell-fulfilling "sell-off" prophecy of having too many pundits looking for the exit as the same time, namely "de-risking".
To that effect and in continuation to Martin Hutchinson's LTCM reference, we would like to repeat the quote used in the conversation "The Unbearable Lightness of Credit":
Today investors face the same "optimism bias" namely that they overstate their ability to exit.
“Liquidity is a backward-looking yardstick. If anything, it’s an indicator of potential risk, because in “liquid” markets traders forego trying to determine an asset’s underlying worth – - they trust, instead, on their supposed ability to exit.” - Roger Lowenstein, author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” – “Corzine Forgot Lessons of Long-Term Capital“
So what is VaR really measuring these days?
This what we had to say about VaR in our May 2015 conversation "
Cushing's syndrome" and ties up nicely to our world of rising positive correlations. Your VaR measure doesn't measure today your maximum loss, but
could be only measuring your minimum loss on any given day. Check the recent large standard deviation moves dear readers such as the one on the Japanese yen and ask yourself if we are anymore in a VaR assumed "normal market" conditions:
"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured." - source Macronomics, May 2015
Therefore this week's conversation we will look at what positive correlations entails for risk and diversification and also we will look at the difference cause of financial crisis and additional signs we are seriously heading into one like the MS München did back in 1978, like we did in 2008 and like we are most likely heading in 2016 with plenty of menacing "Rogue Waves" on the horizon. So fasten your seat belt for this long conversation, this one is to be left for posterity.
Synopsis:
- Credit - The different types of credit crises and where do we stand
- A couple of illustrations of on-going nonlinear "Rogue Waves" in the financial world of today
- The overshooting phenomenon
- The Yuan Hedge Fund attack through the lense of the Nash Equilibrium Concept
- Credit - The different types of credit crises and where do we stand
Rising positive correlations, are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by this sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:
"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing.The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016
When it comes to the classification of credit crises and their potential area of origins both the authors for the book "Credit Crisis" shed a light on the subject:
- "Currency crisis: A speculative attack on the exchange rate of a currency which results in a sharp devaluation of the currency; or it forces monetary authorities to intervene in currency markets to defend the currency (eg. by sharply hiking interest rates).
- Foreign Debt Crisis: a situation where a country is not able to service its foreign debt.
- Banking crisis: Actual or potential bank runs. Banks start to suspend the internal convertibility of their liabilities or the government has to bail out the banks.
- Systemic Financial crisis: Severe disruptions of the financial system, including a malfunctioning of financial markets, with large adverse effect on the real economy. It may involves a currency crisis and also a banking crisis, although this is not necessarily true the other way around.
In many cases, a crisis is characterized by more than one type, meaning we often see a combination of at least two crises. These involve strong declines in asset values, accompanied by defaults, in the non-financials but also in the financials universe. The effectiveness of government support or even bailout measures combined with the robustness of the economy are the most important determinants of the economy's vulneability, and they therefore have a significant impact on the severity of the crisis. In addition, a crucial factor is obviously the amplitude of asset price inflation that preceded the crisis.
Depending on the type of crisis, there are different warning signals, such as significant current account imbalances (foreign debt crisis), inefficient currency pegs (currency crisis), excessive lending behavior (banking crisis), and a combination of excessive risk taking and asset price inflation (systemic financial crisis). A financial crisis is costly, as they are fiscal costs to restructure the financial system. There is also a tremendous loss from asset devaluation, and there can be a misallocation of resources, which in the end, depresses growth. A banking crisis is considered to be very costly compared with, for example, a currency crisis.
We classify a credit crisis as something between a banking crisis and a systematic financial crisis. A credit crisis affects the banking system or arises in the financial system; the huge importance of credit risk for the functioning of the financial system as a whole bears also a systematic component. The trigger event is often an exogenous shock, while the pre-credit crisis situation is characterized by excessive lending, excessive leverage, excessive risk taking, and lax lending standards. Such crises emerge in periods of very high expectations on economic development, which in turns boosts loan demand and leverage in the system. When an exogenous shock hits the market, it triggers an immediate repricing of the whole spectrum of credit-risky assets, increasing the funding costs of borrowers while causing an immense drop in the asset value of credit portfolios.
A so-called credit crunch scenario is the ugliest outcome of a credit crisis. It is characterized by a sharp reduction of lending activities by the banking sector. A credit crunch has a severe impact on the real economy, as the basic transmission mechanism of liquidity (from central banks over the banking sector to non-financial corporations) is distorted by the fact that banks do a liquidity squeeze, finally resulting in rising default rates. A credit crunch is a full-fledged credit crisis, which includes all major ingredients for a banking and a systemic crisis spilling over onto several parts of the financial market and onto the real economy. A credit crunch is probably the most costly type of financial crisis, also depending on the efficiency of regulatory bodies, the shape of the economy as a whole, and the health of the banking sector itself." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
The exogenous shock started in earnest in mid-2014 which saw a conjunction of factors, a significant rise in the US dollar that triggered the fall in oil prices, the unabated rise in the cost of capital.
If we were to build another schematic of the current market environment, here what we think it should look like to name a few of the issues worth looking at:
- source Macronomics
So if you think diversification is a "solid defense" in a world of "positive correlations", think again, because here what the authors of "Credit Crisis" had to say about LTCM and tail events (Rogue Waves):
"Even if there are arbitrage opportunities in the sense that two positions that trade at different prices right now will definitely converge at a point in the future, there is a risk that the anomaly will become even bigger. However typically a high leverage is used for positions that have a skewed risk-return profile, or a high likelihood of a small profit but a very low risk of a large loss. This equals the risk-and-return profile of credit investments but also the risk that selling far-out-of-the-money puts on equities. In case of a tail event occurs, all risk parameters to manage the overall portfolio are probably worthless, as correlation patterns change dramatically during a crisis. That said, arbitrage trades are not under fire because the crisis has an impact on the long-term-risk-and-return profile of the position. However, a crisis might cause a short-term distortion of capital market leading to immense mark-to-market losses. If the capital adequacy is not strong enough to offset the mark-to-market losses, forced unwinding triggers significant losses in arbitrage portfolios. The same was true for many asset classes during the summer of 2007, when high-quality structures came under pressure, causing significant mark-to-market losses. Many of these structures did not bear default risk but a huge liquidity risk, and therefore many investors were forced to sell." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
You probably understand by now why we have raised the "red flag" so many times on our fear in the rise of "positive correlations". They do scare us, because they entail, larger and larger standard deviation moves and potentially trigger "Rogue Waves" which can wipe out even the biggest and most reputable "Investment ships" à la MS München.
The big question is not if we are in a bubble again but if this "time it's different". It is not. It's worse, because you have all the four types of crisis evolving at the same time.
Here is what Chapter 5 of "Credit Crisis" is telling us about the causes of the bubble:
"A mainstream argument is that the cause of the bubbles is excessive monetary liquidity in the financial system. Central banks flood the market with liquidity to support economic growth, also triggering rising demand for risky assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentally fair valuation. In the long run, this level is not sustainable, while the trigger of the burst of the bubble is again policy shifts of central banks. The bubble will burst when central banks enter a more restrictive monetary policy, removing excess liquidity and consequently causing investors to get rid of risky assets given the rise in borrowing costs on the back of higher interest rates.
This is the theory, but what about the practice? The resurfacing discussion about rate cuts in the United States and in the Euroland in mid-2005 was accompanied by expectations that inflation will remain subdued. Following this discussion, the impact of inflation on credit spreads returned to the spotlight. An additional topic regarding inflation worth mentioning is that if excess liquidity flows into assets rather than into consumer goods, this argues for low consumer price inflation but rising asset price inflation. In late 2000, the Fed and the European Central Banks (ECB) started down a monetary easing path, which was boosted by external shocks (9/11 and the Enron scandal), when central banks flooded the market with additional liquidity to avoid a credit crunch. Financial markets benefited in general from this excess liquidity, as reflected in the positive performance of almost all asset classes in 2004, 2005, and 2006, which argued for overall liquidity inflows but not for allocation shifts. It is not only excess liquidity held by investors and companies that underpins strong performing assets in general, but also the pro-cyclical nature of banking. In a low default rate environment, lending activities accelerate, which might contribute to an overheating of the economy accompanied by rising inflation. From a purely macroeconomic viewpoint, private households have two alternatives to allocate liquidity: consuming or saving. The former leads to rising price inflation, whereas the latter leads to asset price inflation." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
Where we slightly differ from the author's take in terms of liquidity allocation is in the definition of "saving". The "Savings Glut" view of economists such as Ben Bernanke and Paul Krugman needs to be vigorously rebuked. This incorrect view which was put forward to attempt to explain the Great Financial Crisis (GFC) by the main culprits was challenged by economists at the Bank for International Settlements (BIS), particularly in one paper by Claudio Borio entitled "
The financial cycle and macroeconomics: What have we learnt?".
"The core objection to this view is that it arguably conflates “financing” with “saving” –two notions that coincide only in non-monetary economies. Financing is a gross cash-flow concept, and denotes access to purchasing power in the form of an accepted settlement medium (money), including through borrowing. Saving, as defined in the national accounts, is simply income (output) not consumed. Expenditures require financing, not saving. The expression “wall of saving” is, in fact, misleading: saving is more like a “hole” in aggregate expenditures – the hole that makes room for investment to take place. … In fact, the link between saving and credit is very loose. For instance, we saw earlier that during financial booms the credit-to-GDP gap tends to rise substantially. This means that the net change in the credit stock exceeds income by a considerable margin, and hence saving by an even larger one, as saving is only a small portion of that income." - source BIS paper, December 2012
Their paper argues that it was unrestrained extensions of credit and the related creation of money that caused the problem which could have been avoided if interest rates had not been set too low for too long through a "wicksellian" approach dear to Charles Gave from Gavekal Research.
Borio claims that the problem was that bank regulators did nothing to control the credit booms in the financial sector, which they could have done. We know how that ended before.
But, guess what: We have the same problem today and suprise, it's worse.
Look at the issuance levels reached in recent years and the amount of cov-lite loans issued (again...). Look at mis-allocation of capital in the Energy sector and its CAPEX bubble.
Look at the $9 trillion debt issued by Emerging Markets Corporates.
We could go on and on.
Now the credit Fed induced credit bubble is bursting again. One only has to look at what is happening in credit markets (à la 2007). By the way Financial Conditions are tightening globally and the process has started in mid 2014. CCC companies are now shut out of primary markets and default rates will spike. Credit always lead equities...The "savings glut" theory of Ben Bernanke and the
FED is hogwash:
"Asset price inflation in general, is not a phenomenon which is limited to one specific market but rather has a global impact. However, there are some specific developments in certain segments of the market, as specific segments are more vulnerable against overshooting than others. Therefore, a strong decline in asset prices effects on all risky asset classes due to the reduction of liquidity.
This is a very important finding, as it explains the mechanism behind a global crisis. Spillover effects are liquidity-driven and liquidity is a global phenomenon. Against the background of the ongoing integration of the financial markets, spillover effects are inescapable, even in the case there is no fundamental link between specific market segments. How can we explain decoupling between asset classes during financial crises? During the subprime turmoil in 2007, equity markets held up pretty well, although credit markets go hit hard." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
As a reminder, a liquidity crisis always lead to a financial crisis. That simple, unfortunately.
This brings us to lead you towards some illustration of rising instability and worrying price action and the formation of "Rogue Waves" we have been witnessing as of late in many segments of the credit markets.
- A couple of illustrations of on-going nonlinear "Rogue Waves" in the financial world of today
Rogue waves present considerable danger for several reasons: they are rare, unpredictable, may appear suddenly or without warning, and can impact with tremendous force. Looking at the meteoric rise in US High yield spreads in the Energy sector is an illustration we think about the destructive power of a High Yield "Rogue Wave":
- source Thomson Reuters Datastream (H/T Eric Burroughs on Twitter)
When it comes to the "short gamma" investor crowd and with Contingent Convertibles aka "CoCos" making the headlines, the velocity in the explosion of spreads has been staggering:
- graph source Barclays (H/T TraderStef on Twitter)
When it comes to the unfortunate truth about wider spreads, what the flattening of German banking giant Deutsche bank is telling you is that it's cost of capital is going up, this is what a flattening of credit curve is telling you:
- source Thomson Reuters Datastream (H/T Eric Burroughs on Twitter)
Also the percentage of High Yield bonds trading at Distressed levels is at the highest level since 2009 according to S&P data:
2015: 20.1%*
2013: 11.2%
2011: 16.8%
2009: 23.2%
- source H/T - Lawrence McDonald - Twitter feed
In our book a flattening of the High Yield curve is a cause for concern as illustrated by the one year point move on the US CDS index CDX HY (High Yield) series 25:
- source CMA part of S&P Capital IQ
This is a sign that cost of capital is steadily going up. Also the basis being the difference between the index and the single names continues to be as wide as it was during the GFC. A basis going deeper into negative territory is a main sign of stress.
We have told you recently we have been tracking the price action in the Credit Markets and particularly in the CMBS space. What we are seeing is not good news to say the least and is a stark reminder of what we saw unfold back in 2007. On that subject we would like to highlight Bank of America Merrill Lynch's CMBS weekly note from the 12th of February entitled "The unfortunate truth about wider spreads":
"Key takeaways
• We anticipate that spread volatility, liquidity stress and credit tightening will persist. Look for wider conduit spreads.
• While CMBX.BBB- tranche prices fell sharply this week we think further downside exists, particularly in series 6&7.
As investors ponder the likelihood that economic growth may slow and that CRE prices may have risen too quickly (Chart 3), recent CMBX price action indicates that a growing number of investors may have begun to short it since it is a liquid, levered way to voice the opinion that CRE is considered to be a good proxy for the state of the economy.
In the past, this type of activity began by investors shorting tranches that were most highly levered to a deteriorating economy and could fall the most if fundamentals eroded. This includes the lower rated tranches of CMBX.6-8, which, as of last night’s close, have seen the prices for their respective BBB-minus and BB tranches fall by 13-17 points for CMBX.6 (Chart 4), 14-20 points for CMBX.7 (Chart 5) and 17-19 points for CMBX.8 (Chart 6) since the beginning of the year.
We agree that underwriting standards loosened over the past few years, which, all else equal, could imply loans in CMBX.8 have worse credit metrics compared to either the CMBX.6 or CMBX.7 series. Despite this, and although prices have already fallen considerably, for several reasons we think it makes sense to short the BBBminus tranche from either CMBX.6 or CMBX.7 instead of the CMBX.8. First, the dollar price of the BBB-minus tranche from CMBX.6 and CMBX.7 is materially higher that of CMBX.8 (Chart 7).
Additionally, although the CMBX.8 does have more loans with IO exposure than series 6 or 7 do, we think this becomes more meaningful when considering maturity defaults. By contrast, the earlier series not only have lower subordination attachment points at the BBB-minus tranche, but they also have more exposure to the retail sector, which could realize faster fundamental deterioration if the economy does contract." - source Bank of America Merrill Lynch
Now having read seen the movie "The Big Short" and also read the book and also recently read in
Bloomberg about Hedge Fund pundits thinking about shorting Subprime Auto-Loans, as the next new "big kahuna" trade, we would like to make another suggestion. If you want to make it big, here is what we suggest à la "Big Short", given last week we mentioned that
Italian NPLs have now been bundled up into a new variety of CDOs according to Euromoney's article entitled "Italy's bad bad bank" from February 2016 and that the Italian state guarantees the senior debt of such operations and thinks it is unlikely ever to have to honour the guarantee (as equity and subordinated debt tranches will take the first hit from any shortfall to the price the SPV paid for the loans), maybe you want to find someone stupid enough to sell you protection on the senior tranche of these "new CDOs". In essence, like in the "Big Short", if the whole of the capital structure falls apart, your wager might make a bigger return because of the assumed low probability of such a "tail risk" to ever materialize. and will be cheaper to implement in terms of negative carry than, placing a bet on the lower part of the capital structure. This is just a thought of course...
Moving back to the disintegration of the CMBS space, Bank of America Merrill Lynch made some additional interesting points on the fate of SEARS and CMBS:
"To this point, Sears’s management announced this week that revenues for the year ending January 31, 2016, decreased to about $25.1 billion (Chart 8) and that the company would accelerate the pace of store closings, sell assets and cut costs.
Why could CMBX.6 be more negatively impacted by the negative Sears news than some of the other CMBX series? Among the more recently issued CMBX series (6-9), CMBX.6 has the highest percentage of retail exposure. When we focus solely on CMBX.6 and CMBX.7, which have the highest percentage exposure to retail among the postcrisis series, we see that although the headline exposure to retail properties is similar, CMBX.6 has considerably more exposure to B/C quality malls than CMBX.7 does" - source Bank of America Merrill Lynch
Sorry to be a credit "party spoiler" but if
U.S. Retail Sales are really showing a reassuring rebound in January according to some pundits with Core sales were 0.6% higher after declining 0.3% in December and the best rise since last May, according to official data from the Commerce Department, then, we wonder what's all our fuss about CMBS price action and SEARS dwindling earnings? Have we lost the plot?
Not really this is all part of what is known as the overshooting phenomenon.
- The overshooting phenomenon
The overshooting phenomenon is closely related to the bubble theory we have discussed earlier on through the comments of both authors of the book "Credit Crisis. The overshooting paper mentioned below in the book is of great interest as it was written by Rudi Dornbusch, a German economist who worked for most of his career in the United States, who also happened to have had Paul Krugman and Kenneth Rogoff as students:
"Closely linked to the bubble theory, Rudiger Dornbusch's famous overshooting paper set a milestone for explaining "irrational" exchange rate swings and shed some light on the mechanism behind currency crises. This paper is one of the most influential papers writtten in the field of international economics, while it marks the birth of modern international macroeconomics. Can we apply some of the ideas to credit markets? The major input from the Dornbusch model is not only to better understand exchange rate moves; it also provides a framework for policymakers. This allow us to review the policy actions we have seen during the subprime turmoil of 2007.
The background of the model is the transition from fix to flexible exchange rates, while changes in exchange rates did not simply follow the inflation differentials as previous theories suggest. On the contrary, they proved more volatile than most experts expected they would be. Dornsbusch explained this behavior of exchange rates with sticky prices and an instable monetary policy, showing that overshooting of exchange rates is not necessarily linked to irrational behavior of investors ("herding"). Volatility in FX markets is a necessary adjustment path towards a new equilibrium in the market as a response to exogenous shocks, as the price of adjustment in the domestic markets is too slow.
The basic idea behind the overshooting model is based on two major assumptions. First, the "uncovered interest parity" holds. Assuming that domestic and foreign bonds are perfect substitutes, while international capital is fully mobile (and capital markets are fully integrated), two bonds (a domestic and a foreign one) can only pay different interest rates if investors expect compensating movement in exchange rates. Moreover, the home country is small in world capital markets, which means that the foreign interest rate can be taken as exogenous. The model assumes "perfect foresight", which argues against traditional bubble theory. The second major equation in the model is the domestic demand for money. Higher interest rates trigger rising opportunity costs of holding money, and hence lower demand for money. In the contrary, an increase in output raises demand for money while demand for money is proportional to the price level.
In order to explain what overshooting means in this context, we have to introduce additional assumptions. First of all, domestic prices do not immediately follow any impulses from the monetary side, while they adjust only slower over time, which is a very realistic assumption. Moreover, output is assumed to be exogenous, while in the long run, a permanent rise in money supply causes a proportional rise in prices and in exchange rates. The exogenous shock to the system is now defined as unexpected permanent increase in money supply, while prices are sticky in the short term. And as also output is fixed, interest rates (on domestic bonds) have to fall to equilibrate the system. As interest-rate parity holds, interest rates can only fall if the domestic currency is expected to appreciate. As the assumption of the model is that in the long run rising money supply must be accompanied by a proportional depreciation in the exchange rate must be larger than the long term depreciation! That said the exchange rate must overshoot the long-term equilibrium level. The idea of sticky prices is in the current macroeconomic discussion fully accepted, as it is a necessary assumption to explain many real-world data.
This is exactly what we need to explain the link to the credit market. The basic assumption of the majority of buy-and-hold investors is that credit spreads are mean reverting. Ignoring default risk, spreads are moving around their fair value through the cycle. Overshooting is only a short-term phenomenon and it can be seen as a buying opportunity rather than the establishment of a lasting trend. This is true, but one should not forget that this is only true if we ignore default risk. This might be a calamitous assumption. Transferring this logic to the first subprime shock in 2007, it is exactly what happened as an initial reaction regarding structured credit investments. For example, investment banks booked structured credit investments in marked-to-model buckets (Level 3 accounting) to avoid mark-to-market losses.
...
A credit crisis can be the trigger point of overshooting in other markets. This is exactly what we have observed during the subprime turmoil of 2007.
This is a crucial point, especially from the perspective of monetary policy makers. Providing additional liquidity would mean that there will be further distortions. Healing a credit crunch at the cost of overshooting in other markets. Consequently liquidity injections can be understood as a final hope rather than the "silver bullet" in combating crises. In the context of the overshooting approach, liquidity injections could help to limit some direct effects from credit crises, but they will definitely trigger spillover effects onto other markets. In the end, the efficiency of liquidity injections by central banks depends on the benefit on the credit side compared to the cost in other markets. In any case, it proved not to be the appropriate instrument as a reaction to the subprime crisis in 2007" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
On that subject we would like to highlight again Bank of America Merrill Lynch's CMBS weekly note from the 12th of February entitled "The unfortunate truth about wider spreads":
"As spreads widened over the past few weeks, a significant number of conversations we’ve had with investors have revolved around the concern that the recent spread widening may not represent a transient opportunity to add risk at wider levels, but instead could represent a new reality earmarked by tighter credit standards, lower liquidity and higher required returns for a given level of risk. While it may be easy to look at CRE fundamentals and dismiss the recent spread widening as being due to market technicals, it is important to realize that while that may be true today, if investors are pricing in what they expect could occur in the future, there may be some validity to the recent spread moves. As a case in point, given the recent new issue CMBS spread widening, breakeven whole loan spreads have widened substantially over the past two months (Chart 16).
Not only do wider whole loan breakeven spreads result in higher coupons to CMBS borrowers, which, effectively tightens credit standards, but it also can reduce the profitability of CMBS originators, which may cause some of them to exit the business. As a case in point, this week Redwood Trust, Inc. announced it is repositioning its commercial business to focus solely on investing activities and will discontinue commercial loan originations for CMBS distribution. Marty Hughes, the CEO of Redwood said:
"We have concluded that the challenging market conditions our CMBS conduit has faced over the past few quarters are worsening and are not likely to improve for the foreseeable future. The escalation in the risks to both source and distribute loans through CMBS, as well as the diminished economic opportunity for this activity, no longer make our commercial conduit activities an accretive use of capital."
If, as we wrote last week, CRE portfolio lenders also tighten credit standards, it stands to reason that some proportion of borrowers that would have previously been able to successfully refinance may no longer be able to do so. The upshot is that it appears that we have entered into a phase where it becomes increasingly possible that negative market technicals and less credit availability form a feedback loop that negatively affects CRE fundamentals.
To this point, although a continued influx of foreign capital into trophy assets in gateway markets can support CRE prices in certain locations, it won’t help CRE prices for properties located in many secondary or tertiary markets. If borrowers with “average” quality properties located away from gateway markets are faced with higher borrowing costs and more stringent underwriting standards, the result may be fewer available proceeds and wider cap rates." - source Bank of America Merrill Lynch
This is another sign that credit will no doubt overshoot to the wide side and that you will, rest assured see more spillover in other asset classes. Given credit leads equities, you can expect equities to trade "lower" for "longer" we think.
Furthermore, Janet Yellen's recent performance is confirming indeed the significant weakening of the Fed "put" as described in Bank of America Merrill Lynch's note:
"With Fed Chair Yellen’s Humphry Hawkins testimony, in which she stressed the notion that the Fed’s decision to raise rates is not on a predetermined course, the probability that the Fed would raise interest rates at its March 2016 plummeted as did the probability of rate hikes over the next year. During her testimony, however, the Fed Chair mentioned that the current global turmoil could cause the Fed to alter the timing of upcoming rate hikes, not abandon them.
As a result, risky asset prices broadly fell and a flight to quality ensued due to the uncertainty of the timing of future rate hikes, the notion that the Fed put may be further out of the money than was previously anticipated and the prospect that a growing policy divergence among global central banks could contribute to a U.S. recession. While delaying the next rate hike may be viewed positively in the sense that it could help keep risk free rates low, which would allow a greater number of borrowers to either refinance or acquire new properties, we think it is likely that many investors will view it as a canary in the coalmine that presages slower economic growth, more capital market volatility, wider credit spreads and lower asset prices.
Ultimately, the framework that has been put in place by regulators over the past few years effectively severely limits banks’ collective abilities to provide liquidity during periods of stress. As global economic concerns have increased, investors and dealers alike have become increasingly aware of the extremely limited amount of liquidityavailable, which has manifested through a surge in liquidity stress measures (Chart 21) and wider spreads across risky asset classes.
- source Bank of America Merrill Lynch
When it comes to rising risk, it certainly looks to us through the "credit lense" that indeed it certainly feels like 2007 and that once again we are heading towards a Great Financial Crisis version 2.0. For us, it's a given.
When it comes to the much talked about
Kyle Bass significant "short yuan" case, we would like to offer our views through the lens of the Nash Equilibrium Concept in our next point.
- The Yuan Hedge Fund attack through the lense of the Nash Equilibrium Concept
Hyman Capital’s Kyle Bass has recently commented on the $34 trillion experiment and his significant currency play against the Chinese currency (a typical old school Soros type of play we think).
Indirectly, our HKD peg break idea which we discussed back in September t2015 our conversation "HKD thoughts - Strongest USD peg in the world...or most convex macro hedge?", we indicated that the continued buying pressure on the HKD had led the Hong-Kong Monetary Authority to continue to intervene to support its peg against the US dollar. At the time, we argued that the pressure to devalue the Hong-Kong Dollar was going to increase, particularly due to the loss of competitivity of Hong-Kong versus its peers and in particular Japan, which has seen many Chinese turning out in flocks in Japan thanks to the weaker Japanese Yen. This Yuan trade is of interest to us as we won the "best prediction" from Saxo Bank community in their latest Outrageous Predictions for 2016 with our call for a break in the HKD currency peg as per our September conversation and with the additional points made in our recent "Cinderella's golden carriage".
Overall, we think that if the Yuan goes, so could the Hong Dollar peg. Therefore we would like again to quote once again the two authors of the book "Credit Crisis" and their Nash Equilibrium reasoning in order to substantiate the probability of this bet paying off:
"Financial panic models are based on the idea of a principle-agent: There is a government which is willing to maintain the current exchange rate using its currency reserves. Investors or speculators are building expectations regarding the ability of the government to maintain the current exchange-rate level. An as answer to a speculative attack on the currency, the government will buy its own currency using its currency reserves. There are three possible outcomes in this situation. First, currency reserves are big enough to combat the speculative attack successfully, and the government is able to keep the current exchange rate. In this case there will be no attack as speculators are rational and able to anticipate the outcome. Second, the reserves of central banks are not large enough to successfully avert the speculative attack, even if only one speculator is starting the attack. Thus, the attack will occur and will be successful. The government has to adjust the exchange rate. Third, the attack will only be successful if speculators join forces and start to attack the currency simultaneously. In this case, there are two possible equilibriums, a "good one" and a "bad one". The good one means the government is able to defend the currency peg, while the bad one means that the speculators are able to force the government to adjust the exchange rate. In this simple approach, the amount of currency reserves is obviously the crucial parameter to determine the outcome, as a low reserve leads to a speculative attack while a high reserve prevents attacks. However, the case of medium reserves, in which a concerted action of speculators is needed is the most interesting case. In this case, there are two equilibriums (based on the concept of the Nash equilibrium): independent from the fundamental environment, both outcomes are possible. If both speculators believe in the success of the attack, and consequently both attack the currency, the government has to abandon the currency peg. The speculative attack would be self-fulfilling. If at least one speculator does not believe in the success, the attack (if there is one) will not be successful. Again, this outcome is also self-fulfilling. Both outcomes are equivalent in the sense of our basic equilibrium assumption (Nash). It also means that the success of an attack depends not only on the currency reserves of the government, but also on the assumption what the other speculator is doing. This is interesting idea behind this concept: A speculative attack can happen independent from the fundamental situation. In this framework, any policy actions which refer to fundamentals are not the appropriate tool to avoid a crisis. " - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
If indeed the amount of currency reserves is obviously the crucial parameter when it comes to assessing the pay off for the Yuan bet, we have to agree with Deutsche Bank recent House View note from the 9th of February 2016 entitled "Still deep in the woods" that problems in China remains unresolved:
"The absence of new news has helped divert attention away from China – but the underlying problem remains unresolved
- After surprise devaluation in early January, China has stopped being a source of new bad news
- Currency stable since, though authorities no longer taking cues from market close to set yuan level*
- Macro data soft as expected, pointing to a gradual deceleration not a sharp slowdown
- Underlying issue of an overvalued yuan remains unresolved, current policy unsustainable long-term
−At over 2x nominal GDP growth, credit growth remains too high
−FX intervention to counter capital outflows – at the expense of foreign reserves
- source Deutsche Bank
When it comes to the risk of a currency crisis breaking and the Yuan devaluation happening, as posited by the Nash Equilibrium Concept, it all depends on the willingness of the speculators rather than the fundamentals as the Yuan attacks could indeed become a self-fulfilling prophecy in the making.
This self-fulfilling process is as well a major feature of credit crises and a prominent feature of credit markets (CDS) as posited again in Chapter 5 of the book from Dr Jochen Felsenheimer and Philip Gisdakis:
"Self-fulfilling processes are a major characteristics of credit crises and we can learn a lot from the idea presented above. The self-fulfilling process of a credit crisis is that short-term overshooting might end up in a long-lasting credit crunch - assuming that spreads jump initially above the level that we would consider "fundamentally justified; for instance reflected in the current expected loss assumption. That said, the implied default rate is by far higher than the current one (e.g., the current forecast of the future default rate from rating agencies or from market participants in general). However the longer the spreads remains at an "overshooting level", the higher the risk that lower quality companies will encounter funding problems, as liquidity becomes more expensive for them. this can ultimately cause rising default rate at the beginning of the crisis; a majority of market participants refer to it as short-term overshooting. Self fulfilling processes are major threat in a credit crisis, as was also the case during the subprime meltdown. If investors think that higher default rates are justified, they can trigger rising default rates just by selling credit-risky assets and causing wider spreads. This is independent from what we could call the fundamentally justified level!
The other interesting point is that the assumption of concerted action is not necessary in credit markets to trigger a severe action. If we translate the role of the government (defending a currency peg) into credit markets, we can define a company facing some aggressive investors who can send the company into default. Buying protection on an issuer via Credit Default Swaps (CDS) leads to wider credit spreads of the company, which can be seen as an impulse for the self-fulfilling process described above. If some players are forced to hedge their exposure against a company by buying protection on the name, the same mechanism might be put to work." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
As we highlighted above with the flattening of MS München and/or Deutsche Bank and the flattening of the CDX HY curve,
the flattening trend means that the funding costs for many companies is rising across all maturities:
"Such a technically driven concerted action of many players, consequently can also cause an impulse for a crisis scenario, as in the case for currency markets in financial panic models" - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis
So there you go, you probably understand by now the disappearance of MS München due to a conjunction of "Rogue Waves":
"The laws of probability, so true in general, so fallacious in particular." - Edward Gibbon, English historian
And this dear readers is the story of VaR in a world of rising "positive correlations" but we are ranting again...
Stay tuned!
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