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Guest Post: High Yield And Market Makers
Submitted by JM
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Great lessons learned.
+1
Also, it's refreshing to see honest review of past assumptions. There's nothing wrong with assumptions: We all need to "round" somewhere to make sense of what's going on. The important thing is to understand (and be honest) regarding where you are "rounding". In theory, "professionals" would do that, but IMHO the majority of the time we see CYA rationalizing (which injects further noise, obscuring the discussion).
From the article:
I agree with the author regarding the very impressive "Magic Show" put on by the central banks. However, the author is too professional to state it:
(My assertion, not the article's): Default rates are low because of accounting fraud (not marking assets to market, not accounting for realized losses).
We see it in the MBS market where no payments in years doesn't even trigger accounting of "late" and when jingle-mail doesn't trigger the house to be listed. We similarly see it when "well capitalized" banks are taken over the very next week, with tens-of-billions in losses directly to the taxpayer. These things are only possible through outright "go-to-jail" accounting fraud (it's not about "financial innovation" nor "being clever").
But, the article's main premise is true: Central bank cash pumping is time-shifting the "moment of truth" from the author's prediction (Q2 2010) to sometime later (anytime now, maybe another year).
All of this "liquidity" is simply diluting currency and thereby transferring vast amounts of wealth from the average person to a very small number of very wealthy individuals. It is no coincidence (in my opinion) that on the same week where the CEO of Walmart talking about a large number of his customers buying baby formula right after 12:00am, and the equity market "popping" to a new high.
In short, the only thing that the central bank (and governments) cannot control is the political response to all of their meddling. Once the public realizes what has occurred, you will start to see (just like in the 1930's) some very radical political officials sharping their axes and going after these officials. History has never been kind to individuals doing what is occuring right now. It can end in a ballet box, or by pitchfork and torches in the middle of the night. The choice is simple, and I am hoping the federal reserve realizes this as a side affect of what they are currently doing.
Mikla, I like "time-shifting the moment of truth...to sometime later." It sounds so much more elegant than "kicking the can down the road."
i agree whole heartedly. for 20 years i've talked with accountants and they always told me the same thing: "the books are fine." now the government did nail Arthur Anderson--but the issue of the day now is "who is auditing the goverment"? We all know the answer: no one. They've ALL just quit. Welcome to "Squawk Box" government style. It doesn't get reported in any place amazingly other than here and the WSJ! And I'm a conservative not some "change agent"! That should speak volumes about "what we're looking at." I like to call it "anti-truth." Worse than lies--just pablum repeated passing for reality. Well...thank God for the internet! Maybe someone on Wall Street will actually act like a real capitalist and start not giving their capital to where they know it will be raped! "The delusion of bailouts being cost free is large" however. We see it repeated right here everyday: "the guys gettin' the goverment money have got it made." Nooooooo. "The guys stealin' the private money and not paying it back" are the ones who "have it figured out." Provided you give yourself the biggest income possible then okay, right? I will give one specific: real estate. THIS IS REGULATED. Sure "there were trillions"--but now you have the Justice Department and "housing discrimination"! So "bye-bye banky!" In other words "fail now or fail later"? To save THEMSELVES these folks should have failed during the crisis. Now we're "morphing." Into what you ask? Well...isn't that an interesting question.
OTC derivatives are not evil, just as weapons are not "evil".
The evil is found in who wields the derivatives: The Vampire Squids.
Look at the BIS reports and tell me, who wields the OTC derivatives?
Do you really think they are doing "God's work" as the Chief Squid snidely professes?
Let's not be too hasty to assign evil. Things are seldom as simple or as complicated as they seem.
My point is that the vast majority of OTC use was for a legitimate purpose. That purpose was to help market maker control risk on their inventory. Prop desk activity has the same origins, although it turned into using order flow to firm advantage. The guys on the other side... AIG/central banks/treasuries are the ones who need their head examined. Too much concentrated risk.
The alternative to these instruments is higher transaction costs and even more illiquid markets for end users. Pick your poison.
Riddle me this: when for example, Hugh Hendry uses CDS for pure speculation to cash in on Greek troubles, people love the guy for it. And he probably funded the trade by selling protection on Bunds. Good for him, BTW. When a market maker deploys them for risk managment purposes, they are evil. Map out the morality violations here.
too much concentrated risk? They're the government! Your puny company can STILL go bye-bye anytime. (and in this evironment believe me GS is PUNY.) The "police benevolent association"? that will live on in one form or another. In other words "if your counter party is the government maybe you should simply fail and just start over." right now we've "covered the castrophe with debt." that's great!...until it's not, right???!!!! again "we're talking fluid dynamics" here. the water (debt as money) goes in...but it flows out, too. (buy the world) and it would appear some people are "flowing out" now with it. so again...just repeat to yourself "the world is not enough. the world is not enough" and you'll get the "big picture." it's a surprisingly little one, actually.
My point is 1) the rationale for OTC use. Almost all of it is for risk management purposes. 2) is it a market makers fault that some idiot at AIG priced protection to cheap and couldn't pay out?
You are right that ultimately brokers should have to face up to a failure to evaluate counterparty risk. Not even trying to justify all the bailouts. Shareholders and if necessary bondholders should have been wiped out. Go the Sweden 1991 route IMHO.
But many speak with too broad a brushstroke about these things. Probably doing it myself. It's not like hedge funds and mutual funds didn't find themselves bleeding as a result of the Lehman collapse and such. Collateral was locked up, they never saw a dime of bailout money, etc.
I remember i was trying to explain to someone why CDSs werent all evil and got flamed a few months back.
Regardless, excellent points regarding der's. I wish people here who view all bankers/finanseers as evil would take the time to understand some of the tools but i think asking for this is a bit much.
People get these "OTC meltdown" headlines in their heads and you just can't communicate anymore. They just want to be pissed at something and somebody.
And the other sore point is "leverage". People that put 2% down on a mortgage are 50x levered. Guess they are satanic spawn too. Oh, I forgot... a bank put a gun to their head and made them take the loan.
For one thing, when market makers' counter-parties can't pay the U.S. taxpayer is forced to bail them out: Goldman, Deutsche etc. etc. etc.
Derivatives provide cheap hyper-leverage. Your "hedging" is an illusion. And the next time the markets blow-up there will be no short-term, central bank fix...
Everything indeed seems "magical" when a gambler is having a lucky streak. Everyone around the craps table is pressing their increasingly exotic bets when he's on a hot roll. And yet the house always wins.
There's really no magic here at all.
When capital markets froze in late 2008 and didn't thaw significantly until mid 2009, half the companies on the S&P 500 had a near death experience, unable to roll massive debt and fund ongoing operations. There was a threat of mass extinction. Once mighty GE (now humble and firing their old guard), former darling of the Dow30, was brought to its knees, as only one example.
Reality is simply this: at one time a "Sound" US company had cash and no debt. That morphed. Gradually at first from the time when the dollar first became funny money somewhere during the Nixon "devalue and impose wage and price controls" Administration, then at an accelerating pace that climaxed in the great debt orgy of the 2000s during the GWB "Reagan proved deficits don't matter" Administration.
Then came the tempest when successive debt bubbles were bursting in cascading series, threatening to take down the entire interlinked matrix. US corporates were unable to fund operations in the absence of more liquidity.
In the early days of the Obama Administration there was a priority need to bail out the US corporate sector just to keep the S&P500 from shrinking to the S&P25. Wall Street, key banks and mortgage peddlers had already been bailed out prior to the inauguration and a political backlash against direct bailouts was already well developed. So the Administration in league with the Fed devised ways to ensure that liquidity could be provided. Answer: the high yield market and the stock market. Strategies were devised to fund these markets in order to effectuate a backdoor bailout. The magician would distract the audience with one hand while passing money under the table with the other. It was considered a matter of "national security".
We've examined in detail how the Fed has been able to bail the stock market out through it's many and various minions, spreading money around town as it went along to grease the wheels (who would argue?). This had the immediate effect of permitting corporates to issue secondary equity that magically sold out AND didn't depress share prices despite dilution (Bof A, for example). Sheer Magic!!
High yield debt was another perfect vehicle for a backdoor bailout. Quick, fast and risky money traverses this market as a matter of course. Working through the same bailed out Wall Street banks that the government in essence "owned" it wasn't hard to mobilize the necessary infrastructure if the price was right. And it was. Magic!!
There's no magic to how the Fed plans to proceed from here either. Inflation is desperately needed to keep the whole levered interdependent matrix from crumbling. Ben has told us as much.
"...estimating a common density for high yield...seems inappropriate because of granularity." Whatever professor...
What you see in the credit markets is called a "bubble." In other words, you are witnessing the mother of all stupid stretches for yield, brought to you by desperate central banks.
Non-investment grade companies have not generally reduced debt; they have bought a little time via refinancing. Bonds are worth the present value of future coupon and principal payments. If defaults are delayed a couple years it doesn't change the math that much. You and the dumber owners of high yield bonds will have to wait to appreciate the brutality of this simple reality.
You gotta keep learning, man. Saying "it's all a bubble" doesn't really mean much to people who count on you.
Wow, that's deep "man." Say something intelligent. Shock me...
http://www.youtube.com/watch?v=pc0mxOXbWIU
About what I expected. Now go play frisbee with the other kids...
not only companies but "countries" now. Iceland, Greece--soon Ireland, Portugal and maybe even Spain. If "debt didn't matter under GWB" what would you say about today!!!! Ridiculous of course what we have going on right now. At a certain level...funny. But this is no laughing matter (and let me tell you i have a hard time controlling my giggle..but i've suddenly gotten better.) The point of TARP was simple: "we can as the United States raise capital." Big deal? HELL YEAHHHH MOFO. I personally didn't think we'd be able to do that! What we're doing now is...well, who the hell knows what to call it. Not bad does come to mind though. There is an alternative at some point however. "When the toilet gets plugged up fluid dynamics work in reverse."
"Central bank teat"
"On book zombies"
"...when the FED became the Whore of Babylon".
LOL! Good ones.
OTC derivatives and speculative debt in secondary markets is the cause.
They create risk rather than mitigating it.
They are a magic act of their own, appearing to mitigate aggregate risk, but actually creating it because of the speculative leverage that is gambling on the failure of what is supposed to be the creation of productive capital.
Thus, when failure inevitably arises, the amount of leverage is so great that no one is allowed to fail, perversely rewarding the worst speculative risk and excess leverage. Ben Bernanke begins to pull rabbits and rainbow chains of hankerchiefs out of his hat, and you have on book zombies, central bank teats, and the Whore of Babylon preventing anyone from reaching the epiphany of failure.
The greatest freedom a person or the markets have is the freedom to fail. Once that is removed the freedom to succeed is debased in an equal amount.
Your statement makes the assumption that we were in a sustainable system before, which was certainly not the case. In my opinion, the repeal of Glass Steagall Act as well as the creation of the OTC market did not create the problem, but rather was an inevitable attempt to continue the current unsustainable system a little longer. The unregulated markets solved a short term problem and allowed a stealthy mechanism to provide even higher leverage ratios required to keep the economic system functional for just a few years longer.
In short, the current economy reality we are in is the great reset that has been expected (and successfully delayed) for over 30 years now. At this point, there is little that can be done other than softening the blow the way down until the public is conditioned and prepared for the harsh economic reality that comes next.
interesting. "had enough...of bad love. no more bad love."
In general, market maker use of OTC to protect marks doesn't create risk. It transfers risk. When the risk is concentrated in a handful of really stupid organizations (AIG and other monolines) and pricing of risk is so far-off that the morons (Gary Gorton et al) dreaming up these schemes should be tarred and feathered, then you have a systemic problem.
water is surprisingly sticky and shockingly heavy. you can "drop the dimes in the cup" and man can you put a lot of dimes in that thing before "the cup over-floweth." Then what? AIG is stupid? AIG is "too big to fail" and now surprisingly profitable. i have no idea who Gary Gorton is but when you talk "speculative schemes" none are bigger than war. It's like painting: once you step off the ramp all you have before you is a blank sheet. The painting starts immediately. Needless to say "the masterpiece you make at home."
I year after TARP you still think derivatives effectively "transfers risk"? At least banks and hedge funds know leverage is just a compensation scheme. You should probably stop calling other people morons...
Read before you type. What I said above:
If you don't understand that this quote makes your comment just... stupid... then stop commenting on subjects you don't understand.
That's swell Sparky. But your reply has nothing to do with my comment. Don't hurt yourself...
excellent reading, so far. thanks.
Excellent recent postings. Thanks ZH for keeping it real and thought provoking.
"The BOJ succeeded in lowering risk premiums through all kinds of liquidity
programs"
Yeah, but what about risk spreads? Just lowering premiums in 'aggregate' by buying/repoing government bonds will lead to yields falling but no 'inflation'.
Central banks know this. It would seem to me they are 'hedging' their bets, attempting to inflate the currency (risk up) by buying the 'risk free' securities. Kinda schizophrenic.
OTC market failed miserably. Whether you were AIG or the banks that traded with AIG (all of em) you miscalculated risk and needed the tax payer to bail you out. Margin. Lets see some margin.
No disagreement. I believe the problem was with horrible risk pricing models, and extreme risk concentration in the likes of AIG and co. on one leg, and inadequate counterparty risk management from prime dealers on the other leg.
The business of collecting tail risk has been going on a long, long time. It works.
Lets see if the clearinghouses which will be owned by their members (banks) will charge enough margin.
Well, SwapClear works for interest rate derivatives, and it probably serves as a benchmark for IRS that are non-exchange traded.
Do you think credit derivatives will use it as a model?
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"China's amorous feelings"... hmmmm.
Ha, I think a lot of us underestimated the impact of debt restructuring. I was short early and got burned.
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