Musing On The Great Credit Unwind

The how, why & when of what is happening right now according to my colleague at ...


PHASE 1:

Rising home values encourage a proliferation of sub-prime mortgages sales.

Sub-prime mortgages become the cornerstone of structured financial products (ABS).

Increasingly opaque ABS (CDO etc) facilitate a proliferation of this asset class.

Rapidly increasing sales of ABS allow liquidity conditions to improve even as credit quality deteriorates.

Liquidity manifests itself in abundant short term (wholesale) funding.

Short term funding is used to purchase higher yielding assets (either higher risk or longer maturity).

This “carry trading” pushes risk premiums even lower, promoting a “chase” for yield.

As yields compress further, more leverage is needed to garner the same results.

Carry trades now dominate global investing patterns.

The USD becomes the main casualty of the carry trade.

Emerging Markets and commodities become the main beneficiaries.

Higher commodity prices slow consumer spending in the West and increase inflation in the East.

Expected policy responses (notably by the Fed) drive the USD lower and commodity prices higher – creating a vicious circle.

The cycle is broken when the music stops playing for the ABS issuers (triggered by the collapse of the Bear Sterns CDO funds) – just as commodity prices have driven the US consumer into recession.

Lehman’s default removes all the other musical chairs, in one go.

The world de-levers.

THE LARGEST CARRY TRADES IN HISTORY ARE FORCED TO UNWIND.

The US dollar becomes the main beneficiary of unwinding carry trades.

Emerging Markets and commodities become the main casualties.

High correlations ensure that de-leveraging in one asset class is swiftly followed by de-leveraging in other risk assets.


PHASE 2:

This brings us to the policy response. The above perspective is essential in understanding what the Fed subsequently tried to achieve. The evaporation of trillions of dollars worth of carry trades meant the Fed was forced to use its balance sheet to fill the void.

The irony, of course, is that carry trading (selling low risk/low yield assets to buy higher risk/higher yielding assets), based on artificially available and cheap short term funding, was the cause of the credit crisis. However, the Fed had little option but to provide the exact same poison – I suppose much in the same way as one might give a heroin substitute to an addict suffering from too severe withdrawals.

In both cases, however, it is clearly not the long term solution – the side effects will eventually outweigh the benefits. And that is where we currently stand, with the inflection point passed somewhere during the course of QE2.

Once the initial liquidity black holes were filled, subsequent liquidity found its way into speculative carry trades (Emerging Market currencies and commodities) which hindered, rather than helped, global growth.

POLICY THEN CHANGED.

After 3 years of deliberately and explicitly recreating an even bigger beast of a carry trade, policy has changed.

THE FED IS NOW UNDWING THE BIGGEST CARRY TRADE IN HISTORY.


PHASE 3:

Again, the above is essential to understanding how markets are likely to evolve in the coming months. The Fed has DELIBERATELY broken the carry trades – a STRONG US DOLLAR POLICY IS NOW IN PLACE.

Full QE, let alone “twists” and “shouts”, has little more to offer. The only policy tool of any power left (and it has considerable power) is crushing the speculative element of the carry trades: INFLOWS to Emerging Markets, and COMMODITIES.

THE DAM HAS JUST BROKEN ON 3 YEARS WORTH OF CARRY TRADE BUILDING.

DO NOT EXPECT THE PROCESS TO COMPLETE IN A FEW WEEKS - LET ALONE DAYS.

DO EXPECT ENORMOUS COLLATERAL DAMAGE TO OTHER RISK ASSETS. THIS IS NOW THE “ACCEPTABLE” SIDE EFFECT OF POLICY.

Anyone long a Copper/ Short USD carry trade, for example, would have lost 30% over the past 3 weeks alone! Anyone more than 3x levered would clearly have been entirely cleaned out.

Given the ferocity of both the EM currency and commodity reversals, it’s hard to believe that more than a small fraction of those involved in these trades managed to unwind a meaningful amount of their positions. Again, anyone with any sort of leverage will now be in an impossible position – hoping for a massive bounce. If everyone’s hoping for a huge bounce, and the trades are exceptionally crowded, then I’d put the chances of those wishes being granted at zero. On the contrary, margin calls will soon start to bite, and de-leveraging of other risk assets will accelerate.

My biggest fear – given the role of the Chinese in commodity speculation – is that forced de-leveraging of commodities could lead to de-levering on the real estate side there, opening up a whole new front in the war against deflation.

In conclusion, one needs to see recent events from the proverbial “30,000 foot view”. This isn’t about the market discounting a US recession – or a drop in earnings (forget P/Es for the moment) – it is about changing policy and the resulting unwind of concentrated risk trades. This creates the wanted effect of lower commodity prices (good for the vast majority of the world), but it also creates the unwanted side-effect of higher volatility in risk assets, for a short period at least. The stakes are clearly being raised by the inertia amongst European leaders to their solvency issues, so I’m not in any hurry to change stance here. I remain negative on cyclical sectors and extremely negative on commodity related investments. Consumer Discretionary – particularly Restaurants – would be the only cyclical area I’d have decent exposure to – but that’s more as a hedge (as markets could easily bounce). On the defensive side I would favour the domestics over the internationals (i.e. Utilities and Telcos) – as the US dollar is likely only at the beginning of a major move higher. This is not meant as a trading call - markets don't tend to go in straight lines - but I would use any oversold bounces to continue to position defensively. Anecdotally, I still get the impression investors are confusing defensive with neutral, so I suspect we've got a way to go yet..


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Musings on Recessions

8/12/11

Re: Recessions

History would disagree with you on the necessity of a financial event to push us into recession.  Recessions follow quarters of below potential growth (now popularly called stall speeds) that are not self sustainable: growth falls to a level where job growth cannot be in excess of population growth which leads to rising unemployment, falling real estate values, and eventually falling business and consumer confidence.  You essentially fall into a disequilibrium state that has always resulted in a recession absent extraordinary monetary or fiscal action.  We are in such a state right now and certainly a bad financial or oil price event could accelerate a recession, but they are not necessary to have a recession.  Some would argue that we are Japan and we will just stay in stall speed for an extended period.  I have my doubts because stall speed has very different implications for a shrinking population than it does for a growing population.  A different argument is that temporary factors (e.g. Fukishima nuclear disaster and MENA unrest) make it look like stall speed but we are not actually in it.  I would argue that indicators like GDI (gross domestic income), CFNAI (Chicago Fed National Activity Index), and the employment to population ratio which declined to stall speed before the temporary factors argue otherwise.

EFSF (European Financial Stability Fund)

The EFSF is a vehicle which issues bonds guaranteed by Euro area sovereigns, with the purpose of on-lending the funds to sovereigns in need of liquidity.  The guarantees are provided on a pro-rata basis, with the shares determined by the relative weights in ECB's capital subscription key (broadly reflecting GDP weights).  When a sovereign accesses liquidity, it stops providing guarantees, and the remaining guarantee weights are readjusted (each sovereign still guarantees the same amount in nominal terms, but its guarantee weight rises out of the total overall amount).

In its original form, the EFSF included total guarantees worth 440B but, in order to keep its triple-A status, the fund could on-lend at most 255B, the amount of guarantees provided by triple-A rated sovereigns.  In its new form -- approved by Euro area finance ministers in June 2011, but still not ratified by parliaments -- the EFSF's total guarantees were extended to 726B ( a total of 780B from which Greek, Irish, and Portuguese guarantees have been deducted), with the triple-A rated countries contributing around 450B, enough to enable it to lend at least 440B without losing its triple-A status.  This lending capacity is of course conditional on the sovereign ratings being maintained as they are.  Under the current structure, a downgrade of a triple-A sovereign would clearly reduce the effective lending capacity (a French downgrade for example would reduce the lending capacity to below 300B).

8/11/2011

Assuming ratification for extending powers and effective lending capacity to 440B Euros in September, spare firepower will be 280B Euros.  Further expansion, possibly necessary if market pressures persists, would be hard.  To fully cover Italy & Spain over next three years, lending capacity would need to be at least double to 880B.

One problem to extension would be that the size of new commitments means sponsoring sovereigns would accumulate large amounts of contingent liabilities, something that would risk impairing their own financial solidity without the support of an appropriate governance framework.

Metrics To Track Funding Stress

Some metrics to be wary of in light of European Sovereign Stress...

Swap Spreads

• A sharp widening in two-year swap spreads reflects an increase in expected Libor rates versus short-term government borrowing and is a measure of increased funding stress / deteriorating credit conditions in inter-bank borrowing.
• A sharp widening in five-year swap spreads reflects a flight-to-quality trade when investors seek safer government debt over a proxy for highly rated, non-financial corporate borrowers.
• The EUR Basis swap represents the give-up in the market rate in Euribor versus Libor and represents the scarcity of dollar funding for borrowers in the euro zone.  A very large negative spread represents a larger premium for Libor funding over Euribor funding.
• (Swap spreads are a popular way to indicate the credit spreads in a market.  It is defined as the spread paid by the fixed-rate payer of an interest rate swap over the on the run treasury with the same maturity as the swap.  For example, if the fixed-rate of a 5-year fixed-for-float LIBOR swap is 7.26% and the 5-year Treasury is yielding at 6.43%, the swap spread is 7.26% - 6.43% = 83 bps.)

Eurodollar Futures

• A sharp increase in yields in the first four contracts and a simultaneous rally in the next four represents signs of funding stress, as short-term borrowing rates spike relative to the rest of the funding curve.
• ( Eurodollar futures contract refers to the financial futures contract based upon Eurodollar deposits (which are US dollar-denominated deposits), traded at the CME.  They are a way for companies and banks to lock in an interest rate today, for money it intends to borrow or lend in the future.  Each CME Eurodollar futures contract has a notional of "face value" of $1,000,000.
  
  CME Eurodollar futures prices are determined by the market's forecast of the 3-month USD LIBOR interest rate expected to prevail on the settlement date.
  
  A single Eurodollar future is similar to a forward rate agreement to borrow or lend US$1,000,000 for three months starting on the contract settlement date.  Buying the contract is equivalent to lending money and selling the contract short is equivalent to borrowing money.  (Note that a contract is different from an actual loan due to a lack of convexity as well as the fact that credit risk is only on the margin account balance.) )

Liquid Forward Spreads

• The 3s1s basis is a spread to one-month Libor that investors can lock in in exchange for three-month Libor at a specified forward date.  Widening occurs as long-term funding becomes more scarce, reflecting higher liquidity and term premium
• Similarly a widening in the 3s6s basis reflects scarce long-term funding in the money market and reflects higher liquidity and term premium.
• The FRA-OIS spread represents the spread between the uncollateralized Libor borrowing rate in the inter-ban market versus a highly correlated proxy for the expected funds rate over a three-month period at a specified forward date.  A widening in spread represents increased funding stress in teh banking system.

Credit Default Swaps

• A widening in CDS across major indices represents a deterioration in the credit outlook

EU Debt Spread

• Represents the spread of five-year European sovereign debt to the five-year German benchmark.  A sharp widening in these spreads represents a deterioration of the fiscal outlook for these sovereigns.

FX

• A strengthening of the dollar versus euro represents scarcity of overseas dollars potentially driven by funding stress.

3M LIBOR

• Represents the three-month rate that banks are willing to lend in the inter-bank market.  A sharp increase in rates is reflective of more demand versus supply of loanable funds in the inter-bank market.

French Banks Equity and CDS

• A decline in the French bank stocks and/or a widening of their CDS may reflect an increase in the likelihood of a sovereign default by Greece given the large exposure of French banks to Greek sovereign debt.