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Rearranging the Deck Chairs on the Titanic?
On Monday morning, I had breakfast with Leo de Bever, CEO and CIO at Alberta Investment Management Corporation (AIMCo).
We spent almost two hours conversing but time flew by so fast. Leo is
one of the smartest pension fund managers I ever met and he grasps the
complexities of many issues facing pension funds.
I am not going to delve into details but will share some key points below:
- The
biggest problem Leo sees in the US economy is the lack of business
confidence which is impacting investment, much like Keynes wrote about
years ago. - On bonds, he is worried
that the amount of debt issuance in the US will exert upward pressure on
bond yields over the next couple of years. He did, however, highlight
the possibility that we are heading down some sort of "Japan scenario."
- I told him that the Fed will do whatever
it takes to reflate risk assets and introduce inflation into the
system. The last thing banks want is a protracted period of debt
deflation. - He agreed but added all the QE in
the world is just like "rearranging the deck chairs on the Titantic."
He is also worried about income inequality exacerbating the jobs crisis. - On the Canada bubble, he mentioned an outfit called Demographia, which shows the ratio of housing prices to incomes is exploding especially in cities like Vancouver.
- But he also admitted he thought the music would have stopped
in the stock market and was underweight last year. "You are right, I
underestimated that they're going to do whatever it takes to drag this
out for as long as possible." - We talked
about levered versus unlevered benchmarks for private markets, but he
and I are on the same page, the opportunity cost of being in private
markets is public markets, adjusted for illiquidity and a spread for
leverage. On benchmarks, keep it simple. - He
agrees with Jim Keohane, CIO at HOOPP, that too much money flowing into
private markets is driving up prices and lowering expected returns. - On seeding funds,
he was a little more cautious telling me that he agrees emerging
managers are hungrier than more established managers who tend to be
asset gatherers but very few will succeed long-term.
I also exchanged emails with Jim Keohane, CIO at HOOPP, on an article I read this morning on Zero Hedge, The Real "Margin" Threat: $600 Trillion In OTC Derivatives. Jim shared these thoughts:
With regard to the article, clearing house practices have been adopted in the OTC derivative market as standard market practice over the past number of years, so there won’t be some giant margin call if and when some of these contracts move to central clearing . Right now, every OTC derivative contract requires the posting of collateral and daily mark-to-market to maintain the counterparty credit risk of the contract within acceptable ranges. The major difference is that in the OTC world, the amount of credit being extended will differ from counterparty to counterparty depending on their creditworthiness. For example, most investment banks will extend a larger threshold level for margin calls to an organization such as HOOPP which has a large balance sheet and is very credit worthy than they would to a hedge fund which may have a very small balance sheet and limited ability to meet the obligations of the contract. In the central clearing world, there is no differentiation made between market participants – if you can meet the margin requirements you can participate.
Also, that $600 trillion number is the gross notional of the outstanding contracts. The actual amount of market risk associated with those contracts is a much smaller number. If this were measured on the same basis as listed contracts, it would be a much smaller number. For example, if I traded a listed contract with you, that would create an open interest of 1 contract. Under the OTC measurement, that would be counted twice – you have and open contract and I have an open contract. In the listed market, if I then traded my position in the market to a third party, there still would be 1 open contract. In the OTC market, if I entered into an identical offsetting trade with a third party, we now would have 4 open contracts. So you can see that the $600 trillion number contains a significant amount of double counting.
You also have to keep in mind that the largest component of that $600 trillion is interest rate swaps. The payments and margin calls on interest rate swaps is based on the difference in the interest rate movements between short term rates (generally measured by 3 month LIBOR) and longer term rates. That differential does not create large payments or large margin calls relative to the notional value of the contract.
I do have some concerns around the rush to move to central clearing. First, the amount of capital backing these contracts will be substantially reduced. In the OTC world, if we enter into a derivative contract with an investment bank, the full capital of that bank backs the contract – and inability to pay is the same as a debt default. Under central clearing, that banks liability on that contract is limited to the capital backing the clearing corp. In effect, we will be moving to a “source and sell” business model, a model that proved disastrous in sub-prime mortgages. If institutions don’t retain the exposure on their balance sheets, they tend to be more lax in their underwriting standards.
Secondly, the move to centralized clearing envisions a move to standardized contracts. As an end user of these contracts, the reason why we frequently employ bespoke contracts is that they are more effective at managing risks. This is particularly true in the interest rate swap market and in the currency forward market where you are trying to hedge specific exposures to which standard contracts are very ineffective. So by moving to standard contracts and central clearing, the ability to hedge risk will be diminished and overall systematic risk may rise.
In my view, the move to central clearing does not address or solve the real problems that lead to the credit crisis. For example the counterparty credit losses resulting from the Lehman bankruptcy are mostly a result of outdated bankruptcy laws with don’t allow for an orderly reorganization of financial institutions the way that Chapter 11 allows for an orderly reorganization of other public companies.
To conclude, people like to throw out these huge notional numbers because they make great headlines, but the amount of exposure associated with these contracts is a small fraction of that number and there is already a daily mark to market and collateral posting taking place in the OTC market which is similar to the clearing house model. I think that there are some issues that will be created by moving to central clearing but not the issues referred to in this article.
Finally, I also received feedback from another sharp pension fund manager who shared these thoughts on the real margin threat:
There’s been a fair amount of commentary about “financial repression” (Carmen Reinhart has been going on about that recently) – governments forcing banks to hold govvies for liquidity management, and as a convenient way to finance their deficits.
It should have the effect of reducing bank profitability ratios, but it should also reduce risk in the system. And it’s great for the conspiracy theorists – they have yet another excuse why their predictions about the impending demise of the Treasury market was again wrong.
There is general agreement that moving to central clearing will increase demands for collateral, but OTC positions already have collateral posted against them. And the collateral does not have to be government bonds, so I would guess this will not be a huge problem. But it should widen bid/offer spreads, as banks will have to embed more capital costs into pricing.
Hope you enjoyed reading this comment and the feedback from senior pension fund managers. Please remember to contribute to this blog through the PayPal button under the pig at the top of the page.
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leo you keep on doing whatever it is that you are doing, and I will keep accumulating my shinny metals.
Sounds nice, but the key is what valuation will be used for the collateral versus what it is really worth at the time of posting. Now try to unload a couple hundred billion of collateral in the event of a default and see if you can get its valuation.
This all ends in a debt jubilee.
Better Post.
But some points to understand. "Financial Repression" theory has long antecedents but is not likely to work this time. Never been tried with this much debt. Productive capacity of country is greatly impaired. Debt is linked to transfer payments to aging population so 'innovation' economy wont fill gap. So the manager's point about 'stability' is likely to be horribly wrong, unless he means the same stability you get in hospice.
On the OTC derivative apologist comments. I believe the ZH article mentioned the potential exposure was $2-8 trillion, not the $600 notional. This is a far smaller number but still big enough to blow a deadly hole in the system. Also, there is no proof that derivatives -- even simple interest rates swaps -- hedge risk. In fact, the evidence is to the contrary. The entire CDO/CDS experiment proves that the unregulated exposures create systemic risk that no one understands until the tarp is pulled back on everyone. One need only look at the AIG balance sheet to understand what happend when these things run amok.
So net risk to the 600 trillion market is 599 T, 60T, 6T? All significant when the interconnectability web of who owes who on what and can they pay at that moment without moving the market. IMO still no one knows
The analogy of QE representing "rearranging the deck chairs on the Titanic" is not even close to its real impact.
QE is more like taking on water purposely on the rising stern of the ship to help balance and offset the sinking bow.
well stated WSL.
It may be true that under the OTC measurement contracts can be counted 2 or more times, but we should not so easily discount the amount of money needed to cover margins.
Even if we were to divide the $600 trillion by 4, which was given as an example, that still accounts for $150 trillion, which by my account would be a rather difficult margin call if all the contracts were to suddenly clear.
If I remember right, some of the smartest people in the room thought it would be prudent to securitize sub-prime mortgages by hiding them behind higher rated mortgages and selling them to gullible pension funds and other banks, and we can now see where that led us.
On paper, people can build complex systems and think they have all the exits covered, but very few folks that were trading those synthetic mortgage backed securites spent much time considering the consequences as to what would happen if and when the sub-primes started defaulting on their loans.
The real question still looms unanswered. What would happen if the all those notional contracts were to try to exit the drain at practically the same time, would the banks have enough money on hand to handle the margin calls?
Is it possible that this could happen? Probably not, but could enough contracts close as to where there wouldn't be enough cash on hand to handle the margins? Well, the article didn't go into detail on any of this.
We're just supposed to accept the fact that he's the smartest guy in the room, and don't worry about the fact that he's brushed aside our concerns with his feel good "can't happen here" lingo, and just concentrate on getting a good eight hours of sleep at night.
As some have mentioned previously, everything works fine, until it doesn't.
Some of the smartest people in the room thought the Titanic was unsinkable, but as history shows, humans are unable to account for every random variable when building complex systems.
"He is also worried about income inequality.."
And what does he propose to do about it while chumping on his fillet steak?
Can he do something about the widening gap between club tennis players and professionals like Federar and Nadal too? ...of course he can't, the world does not revolve around a pension managers alturistic thoughts, however genuinely faked and fawned they may be
Like politicians these 2 Leos chew the cud with the pretence they are moral thoughtful human beings when in fact they're merely wallowing in their own self satisfaction of being 'us' not 'them'
You need a sick bag to read Mr Kockupalot and his latest dullard musings at lunch
Right. "Income inequality" is a bogus, quasi-Marxist point that people keep trotting out.
What's it to anyone else if some guy makes a boat load of money? As long as he doesn't lie or steal, it's no one's business.
And who presumes to dictate how money "should be distributed"? That is arrongant tyranny.
On the one hand Leo is a smart investor, on the other he is asking for donations. Is it me or does something not add up??
Too honest to charge 2 & 20 for beta. The only thing you have to ask yourself is why do you bother reading my comments on ZH? Why don't you show your support for our blogs and appreciate the time and effort we put into them? Stop the snide remarks.
Stop the snide remarks.
Stop the internet panhandling.
Hmm, when Zero Hedge asks for contributions, no problem, but when I mention it, problem. Stop being so cheap and pay for quality info!!!
When TD kicks you and GW off ZH then yes I'll donate to ZH.
Cheap?....cheap is creaming a living off a persons life savings by you and your ilk.
Hmmm... No mention of declining net energy and the end of growth. If he's the smartest pension fund manager the rest must be pathetic.
You took the words right out of my mouth.
Yes, of course, the problem facing the US economy today is NOT systemic corruption, the utter death of the rule of law, the vast and accelerating income and wealth disparity, the fraudulent and unsustainable nature of our central banking and fiat currency regimes, the all but complete destruction of REAL democratic rule and the substitution of an oligarchic, technocratic, total-surveillance police state in its stead --- no, we are merely bedeviled by a lack of confidence!
Forgive us, Leos, for not having confidence in our political leaders cum prison guards, torturers and (debt) slavemasters.
You had me at breakfast with the Beav.
I had a hard time reading it, the posting somehow ended up with open tags that messed up the formatting. Every time I re-read, I found that I misunderstood some of it.
I fixed it
What is this 'central clearing'? I can agree.
However, I say let the banks, firms and funds that made malinvestments default, plain and simple. The prudent ones fill the void, pain is taken now than experienced 100 fold later, problem solved. Actually, here is a better way. Trade the derivitives on the exchange margined to cash. Lets see how long that lasts.
Leo that great stuff, please keep it up.
what a bunch of Leos
"the possibility that we are heading down some sort of "Japan" scenario."
Would that be Hiroshima or Nagasaki?
Fukushima...It's what's for breakfast!
Leo, do you beg for these breakfasts like you do for donations to your blog?