Hedge ClippingThat was told to me as a child, and I have never forgotten it. There have been plenty of illustrations of hubris throughout the ages, from the mythical-Icarus flying too close to the sun-to the fall of the multi-Nobel-prizewinner-toting hedge fund Long Term Capital Management in 1998.
The current bunch of hedge funds seem to be coming a cropper too. They were premised on the unlikely proposition that they would perform in all market conditions. They didn't. Anyone who thought that clever people armed with equations and computers could create value ("absolute returns", "alpha"..."whatever", as my daughter would say) over and above the fat 2 [% per year] plus 20 [% of profits] in fees was suffering from what Dr Johnson said when he heard that a friend had married for a second time: "that, Sir, is a triumph of hope over experience".
It's the same problem as we have with securitisation: managing assets and structuring pools of assets are perfectly sensible. It's going too far (CPDOs/Subprime ABS/Funds of Hedge funds) which causes the problems, and ruins things for the whole market.
By the way, this is not "20/20 hindsight"-please have a look at my letter to the FT from October, 2004
http://www.ft.com/cms/s/0/ab6c40e0-2490 ... 511c8.html
My only disappointment is that no-one ever did advise me how to short these funds. Otherwise I might be writing this from my yacht. Bought from a fund of hedge funds manager.
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I do quite a lot of work in Ireland. On a recent visit I was speaking to a contact in the public sector, who was disappointed that some members of the press and others were sloppily and indiscriminately condemning securitisation en bloc, rather then taking the trouble to disentangle the positive side. The result was an article which the Irish Independent newspaper printed on 23rd October.
http://www.independent.ie/business/iris ... 06086.html
The writer was billed as "Robert Senior", which is odd, since I distinctly remember writing it myself!
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I chaired a panel at a German conference five years ago, and introduced the session by saying "Voltaire once said that if God did not exist, it would be necessary to invent Him. Can we, ladies and gentlemen, say the same about Landesbanks?". The panellist from a Landesbank did his best to defend the indefensible, but the fact remains that, even then, it was clear that Landesbanks were an anachronism, desperately looking for a role. They only still exist, of course, because they filled their boots with funding prior to 18th July, 2005 when the state guarantee went away. Otherwise these wholesale-funded entities would all be long gone.
Fast forward five years. I met the head of a monoline insurer last week. Trying to be polite, I said that it would no doubt be necessary to change the business model. The reply was short, clear and not to be repeated in this blog, but the essence was that the old monoline model is dead. This man was moving his business model well away from the old monoline approach.
Which brings us to what Nietzsche can teach us about the current markets: "Umwertung aller Werte" ("Revaluation of all values"). There are many people in the market yearning for things to be as they were. It isn't going to happen, just as we're not going back to primary school.
Setting aside those who go on about "transparency" more as a Pavlovian reaction than a subtle analysis (I've been hearing this in one form or another for 15 years or more), we need to answer the basic business question as to how we get funding from those who have it to those who need it. Traditional securitisation is not the answer, certainly at present. There are several possible ways forward-for example, I'm currently involved in a Sharia-compliant trade financing project.
But one which to my mind has a real future is covered bonds.
Covered bonds are far more flexible than in the past; are simple and transparent; and can be based on a wide range of assets, not just mortgages and public-sector debt. In addition, the "moral hazard" problem is not there, since the issuing bank is fully liable for the debt.
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The Stranglers were one of my favourite bands from college days. In "Hanging Around" they sang "There's a million of them selling/And a buyer can't be found". Sounds like current markets.
I'm concerned that accountants (and I am one) have played a significant role in the current crisis. Fair value accounting has become the norm in the last few years. The underlying assumption was that market value (mark-to-market or MTM) and fair value are pretty much the same thing.
Maybe in stable markets, but not at the moment. Is the "fair value" of oil $147 or $90? We've seen both in the last 2 months. Do market prices of ABS reflect the amount investors are likely to get back over time? Fitch did an exercise in stress-testing Irish RMBS a couple of months ago. They assumed in their "severe" case 9% defaults and 40% market value declines-but not only did the AAA bonds not default, they were not even downgraded.
Nonetheless, banks holding such assets have to take MTM "losses" through their P+L accounts, which reduces their capital base and destabilises their position in the market, contributing to the current panic. $500bn+ has been written off as losses by banks already. Does this really reflect what is likely to be lost over time, or is it just a function of a febrile market? There's much to be said in favour of old-fashioned historic cost less reserves accounting in times such as these.
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The ECB announced last week a significant increase in haircuts for ABS used as repo collateral to 12% from a minimum 2%. In addition, there is a further 5% haircut (5% of 88% being 4.4%) on ABS created and kept on balance sheet, making a total of 16.4% in such cases.
The amendments were clearly designed to bring the scheme back to its intended purpose, and exclude the likes of Macquarie's Australian car loan deal which some viewed as being exclusively designed to "game the system".
What are the lessons from this?
-Even with a haircut of 16.4%, 83.6% of cheap money is still available;
-Covered bonds attract a much lower haircut, but are still eligible as repo collateral with the ECB
I shall have more to say on the attractions of covered bonds on another occasion.
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