Toro's Running of the Bulls Market Blog

Financial Innovation - Newer Ways to Blow Us Up

Financial innovation has been less beneficial than advertised.

From the Peterson Institute for International Economics

Unlike pharmaceuticals, aerospace, and a host of other technical fields, financial innovations have been allowed to proliferate unscrutinized and untested for safety or effectiveness. Yet the negative spillovers on the public at large from faulty financial engineering and toxic products have now been clearly demonstrated to be enormous. In particular, there is some solid evidence that the most recent batch of financial innovations was used in manners inconsistent with their labeling, and not only had terrible side effects, but did not even yield the advertised benefits.

Like most innovations, the theory behind the most-recent financial developments made sense. Innovative financial products such as credit default swaps and collateralized debt obligations were supposed to promote an efficient allocation of risk and hence allow those market participants to bear the risk of an asset who could do so best. Freed from the burden of such risk, nonfinancial companies would be able to engage in more-productive capital formation, generating growth for the entire economy. Furthermore, financial companies would be more stable because they would be able to get illiquid assets off balance sheets and not be tied to collateral. This mantra of Wall Street investors and financial economists alike implied that expansion in the use of newer derivatives and the like would lead to an expansion in the country’s capital stock, and that these financial products would be useful to nonfinancial companies, not just to banks.

The growth of derivatives and real-sector investment in the United States tell a different story (figure 1). Between 2003 and 2008, US gross fixed capital increased by about 25 percent, a reasonable number during an economic expansion, but hardly a boom. During the same five-year period, the global amount of over-the-counter (OTC) derivatives increased by 300 percent, while derivatives held by the 25 largest US commercial banks rose by 170 percent. Clearly, growth in new financial products has outpaced fixed capital formation both globally and in the United States by a large margin. This has been especially true since 2006, when investment stagnated, but derivatives continued to grow at a rapid rate. There only seems to be a weak link, if any, between the growth of the newest complex—and now proven dangerous if not toxic—financial products and real corporate investment. ...

Going forward, the US Congress and its international counterparts will have to decide how much to increase regulation and supervisory oversight of financial institutions. We are already hearing warnings from the financial industry that government should be careful not to overreach in its attempts at reform, for fear of harming financial innovation. While that is a worthy principle, our belief is that the record of recent financial innovations acts as a warning to be skeptical about excessive claims that all financial innovation is worthwhile. What was advertised as something to redistribute risk, and thereby increase productive investment, generated little capital formation; what was supposed to benefit nonfinancial businesses was mostly used in a speculative game between financial players.

The Dangers of Leveraged ETFs

From The Wall Street Journal

At 3 p.m., do you get queasy just thinking about the toll that the final hour of trading might take on your portfolio?

New research suggests that on days when the indexes make big moves, leveraged exchange-traded funds could trigger a trading cascade, turning the market close into a buying or selling frenzy. ...

Leveraged ETFs offer double or even triple the daily return of a market index. Some of them, called "inverse" ETFs, move opposite to the market -- for example, going up twice as much as an index goes down. Each day, they all adjust their exposure by rebalancing, or "releveraging," their positions. ...

Further amplifying the ETFs' actions: Every day, trading desks at big banks and brokerage firms blast out customized spreadsheets to favored clients. These tools, linked to live data feeds, predict whether the leveraged ETFs will be buying or selling as 4 p.m. approaches. That enables hedge funds and other big investors to trade ahead of the ETFs.

The excessive trading set off by releveraging is perfectly legal -- but upsetting to many people. "The market doesn't seem like a fair, level playing field," says Andrew Brooks, head of U.S. equity trading at T. Rowe Price in Baltimore.

Now a respected analyst -- Ananth Madhavan, head of trading research at Barclays PLC's Barclays Global Investors -- has released a report arguing that the potential ripple effects of releveraging have been underestimated.

Leveraged ETFs usually generate a multiple of the market's daily return by using something called a "total-return swap." Imagine a fund with $100 million in net assets and 200% leverage, meaning that it seeks to deliver twice the market's daily return. That requires the fund to maintain $200 million in swap exposure.

In a long swap, a counterparty like a bank or brokerage firm agrees to pay the fund $2 for every $1 rise in the closing value of a market index that day. On the other hand, if the market falls, the fund must pay the counterparty 2-for-1.

Now let's say the fund's net assets grow by $10 million during the day, to $110 million. The fund must raise its swap exposure from $200 million to $220 million to honor its 2-for-1 investment objective. That is $20 million in extra buy orders, all coming into the market after 3:30 p.m., typically in the final 10 minutes.

An inverse fund also must buy on a day when the market is up; since the value of its hedge has gone down, the fund must increase its exposure to keep its leverage ratio constant. Thus, all these ETFs buy in lockstep in the last few minutes of an up day for their index -- and sell in a swarm at the end of a down day.

Mr. Madhavan estimates that if a market index moves 15% in a day, leveraged ETFs could constitute 75% of all volume at the close of trading. Remember, the Dow fell 23% on Oct. 19, 1987. A major move could send volatility through the roof, and prices through the floor, in a day's final minutes.

Narrower markets may already be feeling an impact. William Bernstein of Efficient Frontier Advisors says that between 2002 and 2007, there were only two days on which U.S. real-estate investment trusts went up or down by an average of more than 5%. Since the beginning of 2008 there have been 83 such days. That period includes the collapse of the real-estate market, of course, but also the rise of leveraged real-estate ETFs, which command $1 billion in assets. Trading in the largest of these funds averages about 8% of the total dollar volume in daily REIT turnover.

"I don't want to sound like a Cassandra," Mr. Madhavan says of the ETF releveraging, "but this could create a lot of problems. Could it lead to a systemic risk? We may not have seen the biggest effects yet."

I own a few leveraged ETFs but am reconsidering the wisdom of these investments.

Why Credit Default Swaps Encourage Bankruptcy

From Salon

Here's how it works: A lender buys the bonds of a company -- let's say General Growth, the huge mall operator that declared bankruptcy this week. But then, hoping to hedge against the risk that General Growth might default on its bond obligations, the lender purchases a credit default swap protecting against that event from another party, in effect buying insurance against the chance that those bonds will go bust.

But the kicker is that owning a credit default swap on General Growth bonds turns out to make the lender less willing to cut a deal that would allow General Growth to avoid bankruptcy, because the lender can get paid in full in the event of that bankruptcy by collecting on the insurance policy. So it's better for the lender to force the company to its knees rather than come to a less disastrous arrangement.

"We have seen CDS becoming a significant factor" when negotiations on out-of-court restructurings fail, said Alan Kornberg, the partner in charge of the bankruptcy practice at Paul, Weiss, Rifkind, Wharton & Rice, speaking generally. "We used to talk about the practice theoretically but now we see cases where it is hard to get lenders to agree to tender or to compromise and then you find out that these holdouts had significant CDS protection."

Be Careful with Leveraged ETFs

First, the empirical evidence.

In this paper, we study leveraged ETFs, in particular, Ultra ETFs and UltraShort ETFs from the ProShares family. These Ultra (UltraShort) ETFs are designed to provide twice (twice the opposite) of the performance of the benchmark on a daily basis. We focus on the relation between long term performance of leveraged ETFs and benchmarks. Our results show that over holding periods no greater than one month, an investor can safely assume that the Ultra (UltraShort) ETF would provide twice the return (twice the negative return) of the underlying benchmark. Over the holding period of one quarter, the UltraShort ETFs can deviate from twice the negative returns of the benchmark. For Ultra ETFs, this deviation occurs when the holding period is one year. Overall our results show that leveraged ETFs are not long term substitutes for long or short positions of the benchmark indices.

Forbes picked up the theme.

According to Maister, ETFs fail to mirror their underlying index because of fees and expenses, intentional "optimization" by fund managers and changes in the index itself. In some cases, compliance is a problem.

"The SEC diversification rule mandates that certain funds can have no more than 25% of their assets in one security," says Maister.

For the purposes of his study, Maister excluded certain gold and silver tracking ETFs as well as inverse and leveraged ETFs that have gained widespread popularity in the declining market. These funds come loaded with surprises all their own. Inverse and leveraged ETFs are designed to replicate the daily performance or opposite daily performance of their underlying index. This means these funds effectively reset every trading day, potentially causing wildly unexpected returns for buy and hold investors who thought they were merely making an opposite bet on an underlying index.

For example, anyone buying and holding ProShares Ultrashort Financials would have gained 4.3% in 2008, versus a decline of 50% for the Dow Jones U.S. Financials Index. Since the fund seeks to double the opposite of the Dow Jones Financials Index, many buy and hold investors presumed they would instead have gained 100%. Sorry, Charlie, the devil is in the details.

I have been watching this for awhile.  Most leveraged ETFs track their respective benchmarks reasonably well over time.  However, if you are a long-term investor in a few these ETFs, you will be shocked at the performance. 

For example, for the year ending March, the ProShares UltraShort Real Estate ETF (ticker SRS) has returned -41.7% in total even though the underlying index fallen 60.4%.  The ProShares Short MSCI Emerging Markets ETF (EUM) has risen 11% while the index is down 52.9%.  The ProShares UltraShort Oil and Gas ETF (DUG) is down 10.1% compared to a decline of 40% for the index.

These instruments are not suitable for long-term investing.  I have heard of one broker banning the sale of leveraged ETFs to the firm's clients.  Given the performance, it would not be a surprise.

Frank Partnoy NPR Interview on Derivatives

You can listen to Terry Gross's interview with Frank Partnoy on NPR's program Fresh Air here.  It is well worth the listen.

George Soros on CDS

From The Wall Street Journal

Up until the crash of 2008, the prevailing view -- called the efficient market hypothesis -- was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don't deal with the current reality, but with the future -- a matter of anticipation, not knowledge. Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. (I call this feedback mechanism "reflexivity.")

With the help of this new paradigm, the poisonous nature of CDS can be demonstrated in a three-step argument. The first step is to acknowledge that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling.

The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.

AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.

Blow Up the CDS Market - Myron Scholes

From Curious Capitalist

Myron Scholes, whose Black-Scholes option pricing model provided the intellectual underpinning for modern derivatives markets, thinks one particular derivatives market—that for credit default swaps—is due for a Red Adair style rescue. Or a Fred Adair style rescue.

Red Adair put out oil well fires by setting off gigantic explosions at the wellhead. "My belief is that the Fred Adair solution is to blow up or burn the OTC market in credit default swaps," Scholes said this morning. What that means, he elaborated, is that regulators should "try to close all contracts at mid-market prices" and then start up the market anew with clearer rules and shorter-duration contracts.

Berkshire Hathaway - The CDS Market is Irrational

Markets at times are rational, efficient, information-processing mechanisms which correctly price asset markets.

And at other times, the market is an idiot.

This struck me - as it does every day looking at my screens - reading this article from Bloomberg.

Warren Buffett's Berkshire Hathaway Inc. and Jeffrey Immelt's General Electric Co. are being battered in the market for credit-default swaps, treating both AAA companies like junk.

Let's put aside GE for a moment, because I think there is some legitimate debate regarding this company.  But Berkshire Hathaway a junk credit? 

Investors are paying as much for contracts that protect against a default on the bonds of Omaha, Nebraska-based Berkshire, which has $25.5 billion in cash, as for KB Home, the homebuilder that lost money for seven consecutive quarters. The cost of credit-default swaps on the finance arm of GE and its $45 billion in cash is about the same as for building materials- maker Louisiana-Pacific Corp., which posted nine straight quarterly losses. ...

Swaps on Berkshire have soared 2.26 percentage points the past two weeks to 5.35 percent a year, CMA data show. That compares with 4.9 percent annually for Los Angeles-based KB Home.

Berkshire and KB Home priced the same in the credit default swap (CDS) market?  Tell me that the market isn't completely nuts right now.

Now, full disclosure, for the first time ever, I purchased Berkshire shares last week. But I would be writing this article even had I not.

There are three issues with Berkshire I see that could spook the market.  The first is that the company writes CDS swaps on corporate debt.  What is Berkshire's total exposure?

Berkshire in 2008 started writing credit-default swaps on individual companies, with contracts guaranteeing $4 billion of debt from 42 borrowers, Buffett said in the letter.

In other words, if every single borrower whose debt Berkshire insured went under, instead of $25 billion in cash, Berkshire would have $21 billion.  Berkshire does not need to post collateral on its CDS positions, so there is no threat of a financial company death spiral, as I explain below.

The next issue are the puts Buffett sold on the market.

Buffett has struck deals with firms that Berkshire hasn’t identified to protect them against declines in four equity indexes and guarantees on indexes of non-investment grade debtors that require the company to pay out when there’s a default.

The derivatives that garner the most attention are the ones Buffett wrote on stocks.  However, those options are European options, meaning they can only be put back to Berkshire when they expire, which do so in a decade.  So there is no cash liability for Berkshire until that time.  Any market-down on Berkshire's books is an accounting one, not an economic one.

Finally, there is the issue of insuring municipalities.  States and municipalities are in a great deal of trouble.  However, Berkshire entered this market within the past year, and would barely put a dent into the company's cash pile if all the contracts - which are often second and third behind other bond insurers - had to pay out, i.e. if all the municipalities failed.

Near as I can tell, Berkshire has not sold any variable annuities which are hammering the likes of Hartford Financial.  Berkshire's insurance risks are primarily the non-financial kind.  Have there been any massive earthquakes or hurricanes the past few weeks that I am not aware of?

The playbook for collapse for many financial companies has been underwrite CDS, not post enough collateral, bond spreads widen, CDS liabilities rise, CDS prices rise, underwriter's stock falls, spreads widen further, liabilities rise more, CDS prices rise further, underwriter's stock falls further, market gets fearful that the underwriter will have to issue more equity, stock falls further, CDS prices rise (sometimes with no spread widening of the issuer), ratings agency downgrades debt because of rising CDS liabilities and falling stock price, underwriter must post more collateral, underwriter's stock falls even further making it even more difficult to raise stock, ratings agencies downgrade debt again requiring more collateral be posted, and so on until the stock price has collapsed that it becomes virtually impossible to raise common share capital from private interests.  There is great interest in breaking stocks through this process.

Now, that is not to say that many firms did not deserve to go under.  Companies such as Bear Stearns, Lehman, AIG, Countrywide, and many, many others were extraordinarily stupid, and set their fate, even without any help from the derivatives market.

However, this downward spiral of fear can feed on itself. 

A lot of traders “are in a position of where it’s sort of hedge or lose your job,” Backshall said. When GE credit swaps soared to as high as 20 percent upfront yesterday, “that was likely driven just by a desk deciding to desperately hedge,” he said, “rather than a real belief” that the company had a high risk of defaulting. 

This is George Soros's theory of reflexivity, where a negative loop feeds on itself and the perception becomes reality.

This occurred during The Great Depression.  A study by an economist at the Federal Reserve found that banks which failed during the Depression were often as financially strong or stronger than banks that did not.  This, of course, runs counter to classical economic theory which postulates that investors and depositors are rational economic agents.  Rather than processing information in a rational manner, people became scared and pulled their money out of banks, regardless of the bank's financial health.

This is what I believe is occurring now.  All deposit-taking institutions and most financial companies are being taken out and shot, regardless of their intrinsic health.  Financial companies especially are prone to this irrational reality since they are highly levered institutions and can easily fail.

The CDS market, which is fairly illiquid, facilitates and enhances this process. It too can be irrational.  For example, there has been a disconnect in the high-yield market as prices in the cash market were up this year while prices in the derivatives market were down.  The difference in return has been 15% in two months.  That is enormous.  And ridiculous!

Markets can act irrationally.  I believe they are now.  Always using a market, any market including the derivatives market, as an accurate gauge of financial and economic health is folly as the perception of the market can become the reality itself.

UPDATE - Here is a post from Accrued Interest on problems in the CDS market.

Rocket Scientists Fail

From The Financial Times

Almost half of all the complex credit products ever built out of slices of other securitised bonds have now defaulted, according to analysts, and the proportion rises to more than two-thirds among deals created at the peak of the cycle.

The defaults have affected more than $300bn worth of these collateralised debt obligations, which were built from bits of other asset backed securities (ABS) such as mortgage bonds, other CDOs and structured bonds, or derivatives of any of these, according to analysts at Wachovia and Morgan Stanley.

So-called CDOs of ABS caused huge losses to banks such as Merrill Lynch, UBS and Citigroup, which held large amounts of the supposedly safest, top-rated chunks of them. They have since been damned by bodies such as the Bank for International Settlements as being too complex to risk manage effectively.

CDOs of ABS were used increasingly at the peak of the credit bubble to keep the securitisation machine moving by recycling hard to sell bits of subprime mortgage bonds and other risky tranches into new structures with top-notch credit ratings.

However, the ratings of these deals proved unsustainable, as evidenced by the fact they have accounted for 92.9 per cent of all 16,587 ratings downgrades globally from all rating agencies since the beginning of last year, according to Morgan Stanley.

What a joke the financial system became.

Exchange Traded CDS

Saw this as a note from Howard Simons on RealMoney.

CDS contracts trading in volumes greater than the underlying bonds outstanding provide information to the market and allow for more efficient pricing.

The rejoinder at this point is, "Didn't that get AIG into trouble?" Yes, and that was true for the municipal monoline insurers (remember them?) as well. The answer is with central clearing and margining of outstanding CDS, you can support almost any volume of contracts. The futures industry has done this for years; only a small fraction of contracts ever go to delivery, but the remainder used for purposes of price discovery, risk management and speculation do not wreak havoc.

A derivatives market limited to the size of its underlying asset will collapse immediately. Whatever benefits existed from CDS, such as institutional investors being more willing to hold various corporate and municipal bonds, will disappear as well. Provide for centralized clearing and margining and everything should function just fine without Congressional interference.