Physicists Tried to Outwit Wall Street. They Faileda year or so ago.
The most recent edition of International Financing Review has an article entitled "The Copula That Killed" which describes the work of one David Li of JP Morgan, who produced an explanation of correlation which was clear, simple... and fundamentally flawed. Mr Li must empathise with Thomas Midgley, a well-meaning scientist in the early 20th century who developed two clever solutions to industrial problems-lead tetraethyl in petrol (poisoned lots of people); and chlorofluorocarbons for refrigeration and aerosols (made big holes in the ozone layer). Wikipedia says of Midgley "While lauded at the time for his discoveries, today his legacy is seen as far more mixed considering the serious negative environmental impacts of these innovations."
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That's the headline in a newsletter from Another Financial Portal, received today. Whatever can they mean?
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These is an increasing trend for issuers to buy back bonds at a discount. In the banking world, Macquarie Bank is offering between 50 and 60 cents on the dollar for $340m of its own subordinated bonds.
This is a good deal for the bank-if I borrow $10 from you, and you agree to extinguish the debt if I pay you $5, I have a $5 profit/increase in capital.
In the structured world, we have recently seen Terra Firma's GRAND (another contrived acronym, don't ask) buying up its own sub notes at 30-50% of par; and Canary Wharf Finance II offering to buy various notes at between 15 and 50% of par. Some of these notes were issued only 2 years ago, in April 2007!
This is just one more sign of markets being artificially depressed by technical factors, or irrational behaviour if you prefer, and the tremendous value to be had in some (not all!) structured bonds. According to Fitch's analysis, typical UK AAA prime RMBS starts to incur losses when peak-to-trough house price declines are 60%, and defaults are 30%. And that will be on par, not the currently extremely low market prices.
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...that the first securitisation deal I put together was signed. It was a £165m financing of a large “trophy” building by the Thames. There were several tenants of differing credit quality and leases of various maturities. The rights to the lease payments and the building were transferred to a Liechtenstein SPV, smoothed to even quarterly payments using swaps, and sold into the market with a 7-year maturity.
Compared to more recent times, doing this and several subsequent deals was like hacking through the jungle rather than driving down the motorway. Everything was new, and had to be worked out from first principles. This was a hard school, but extremely challenging & interesting. It certainly gives you a strong background for doing new things, or doing things in new ways, as I and colleagues still do.
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Fitch, the rating agency, held a seminar on the commercial paper (CP) market yesterday. CP, which is a short-term IOU, was very popular until 2007.
In the asset-backed world it was a bit of a capital dodge: if you put AAA assets on your bank balance sheet, you had to set aside 8% in capital. Park them in a CP conduit and provide a liquidity line and you used 0% capital. They called it credit arbitrage, but it was really liquidity and capital arbitrage. When the lines got called, banks such as Sachsen LB just didn't have the liquidity, and went under.
This "credit arbitrage" market has pretty much dried up, but some deals based on real assets such as trade receivables are still getting done in the CP market.
One anomaly in current markets is that if you issue in USD and swap to EUR via the spot and forward markets, you get a big saving. On 26 Jan 2009 this equated to issuing at Euribor MINUS 44bp. Efficient markets? Surely someone would arbitrage this away?
I asked in the seminar why this would be, but there was no clear and persuasive answer. One person later mentioned the imbalance in Europe between banks' USD assets and natural USD funding. In other words, European banks are short USD funding, so part of the way they are getting USD is by issuing in EUR or STG and swapping. This is the other side of the "issue USD CP and swap into EUR" trade. But much bigger.
So our CP issuers are benefiting, but there is still a real arbitrage opportunity out there, e.g. US investors could buy EUR paper and swap into USD with a big spread pickup. But arbitrage is now a dirty word. Which is another reason why the market is not efficient.
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