Thursday, August 23, 2007

Credit Ratings, Mark-To-Market, and Quants

Sorry for posting off-topic these days. The financial turmoil engulfing the markets is bringing back a lot of memories. I do think that folks interested in Green Biz need to have some understanding of what is roiling the markets. After all, a recession will hurt all of us.

Back in the late 1990's I was the lead Quant for a small hedge fund, and was around for the 1998 financial crisis. I'm of course referring to the months in 1998 when LTCM caused a fair bit of panic in the markets. I have to say, that qualitatively speaking, what we are seeing is a lot more spooky that what we lived through back then.

First off, in 1998 there was panic followed by the requisite "flight to quality", much like what we are seeing today. However, things seemed calm after a few weeks. Most of the damage was confined to LTCM (and some lesser known cohorts) who placed yield-arb trades involving illiquid foreign bonds. In fact, my memories of that period is filled with jokes and comments about how LTCM had it coming. The pent up resentment against LTCM's perceived arrogance was surprising. For the most part calm was restored in a matter of weeks. In the current crisis, Quants and other Wall St. professionals seem lost -- you get the sense that this will play out over months, and those months will be plagued by volatility and much nervousness.

How did we get to this point? There are several excellent bloggers and columnists who have posted on this topic ( see [1], [2], [3]), and I recommend you read the links I just cited. In this post I'll attempt to list some of the issues I feel are worth emphasizing.

The CDO's are a product of complex financial engineering, and by their very nature are quite opaque. They are structured credit products, broken up into tranches each of which is rated by a credit rating agency. But hasn't the securitization of loans been a standard practice for years? You take a hot potato (those risky loans), and pass it on to the next person in line. The answer of course is yes, but, the whole industry depends on the credit rating companies actually getting things right, or at least close to right:
Here's the recipe for a CDO: you package a bunch of low-rated debt like subprime mortgages and then break the package into pieces, called tranches. Then, you pay to play. Some of the pieces are the first in line to get hit by any defaults, so they offer relatively high yields; others are last to get hit, with correspondingly lower yields. The alchemy begins when rating agencies such as Standard & Poor's and Fitch Ratings wave their magic wand over these top tranches and declare them to be a golden AAA rated. Top shelf. If you want to own AAA debt, CDOs have been about the only place to go; hardly any corporation can muster the credit worthiness to garner an AAA rating anymore. Here's where the potion gets its poison potential. Some individual parts of CDOs are about as base as bonds can be — some are not even investment grade. The assumption has been that even if the toxic waste bonds really stink, the quality tranches can keep the CDO above water. And life goes on.
Imagine needing a loan for a house, and in particular needing a home appraiser to come up with a value for the house you are wanting to buy. Chances are your Realtor already knows an appraiser who probably will come through and appraise the house accordingly. If the appraiser doesn't come up with the right number, well, let's just say the Realtor won't be working with that appraiser much in the future. Unfortunately, the credit rating agencies are the home appraisers of the bond market. Either they come through with the desired rating (AAA baby!), or you just shop that CDO around to another agency.

So while default risk is of minimal concern, the unraveling can be traced to the fact that these CDO's are being marked-to-market. Before the Bear Stearns hedge fund collapsed, the CDO's just sat in the books of all these funds. The collapse of the Bear Stearns fund forced people to grapple with mark-to-market values en masse.

Because the CDO's raised questions about the credit quality of securities in general, the bond market has pretty much shut down. Loans are harder to come by, and the commercial paper market, which is an important financing channel for companies has dried up. Its hard to blame investors though. Even Hedge funds were raising commercial paper to finance currency carry trades and other leveraged positions. Understandably, in times of uncertainty, investors do not want their fortunes tied up in complex financial instruments..

Its interesting to see European and other foreign banks get entangled in the US bond markets. In recent years, Foreign investors starved for extra yield started buying the same products (CDO's and other complex securities) as their US counterparts. The stuff was AAA after all, right? I have to give a shout out to bond salespeople on Wall Street. They are the best salespeople in the world, bar none. Seriously, these guys are paid to sell beaten down, toxic bonds for a living :-) Set them loose on a bunch of yield-starved foreign investors with AAA stuff to sell? Game over, deal closed.

During the LTCM crisis, there was a lot of talk about how Quants were to blame for the mess. It turns out the bond arbitrage trades (based on yield spreads) that LTCM put in place, worked out quite well. IF you had the pockets to ride out the margin calls and the period when the correlations went to 1, you would have done fine. LTCM did not have the resources to see their trades through, but the folks who did, profited. I suspect that there will be quant traders in the same boat during the next several months.

Quants in the credit rating agencies probably need to do some soul-searching. Either get the math right and don't succumb to external pressure, or get out of the ratings game.

Let's get one thing straight: Quants are here to stay. If you need to hedge risk of any kind, chances are you'll need some serious quantitative firepower. My experience included work in designing quantitative trading strategies, valuation of structured notes, portfolio management, and risk management. In each of those areas, I believe extensive probability/stats/math background really comes in handy.

Finally, a word about hedge funds. There are too many of them, and at their core, a lot of the newer ones seem to really have only one or two trading ideas to work with. There will be a cleansing period, and a lot of hedgies will fold. I remember taking solace in the fact that not only did we have several quantitative strategies to trade with, we had tons of markets to play in (commodities, equity indices, bonds, currencies, etc.). Diversification does not necessarily protect you in times of panic, like what we have now, but you feel better knowing you have several ideas at work increasing your chances at recovery.

So what is an individual investor to do now. A few days ago I was quite gloomy, and I have to admit my outlook hasn't changed much. In a recent conversation with a friend who is the lead fixed-income quant for a major US bank, he seemed quite worried about the UK housing market. Investors in the UK are just as spooked:
The most serious situation is in the UK, where the 3mths รข€“ repo rate spread has widened by 50bps to 100bps in the current environment practically equivalent to two BoE 25bps rate hikes in terms of market squeeze. In 1998, the same spread remained in the 15/35bps area during the crisis (was negative after the CBs interventions).
When in doubt, and especially when the professional investors seem lost, Cash Is King!

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