Risk Management

It was only logical that following its most profitable year in history, the world's most successful hedge fund (by absolute P&L), which generated $77 billion in profit in the past year, would follow up with mass promotions. In other news, it is now more lucrative, and with better job security, to work for the FRBNY LLC Onshore Fund as a vice president than for Goldman Sachs as a Managing Director. Also, since one only has to know how to buy, as the ancient and arcane art of selling is irrelevant at this particular taxpayer funded hedge fund, think of all the incremental equity that is retained courtesy of a training session that is only half as long.

One of the ironclad assumptions in CDS trading was that recovery assumptions, especially on sovereign bonds, would be 40% of par come hell or high water. This key variable, which drives various other downstream implied data points, was never really touched as most i) had never really experienced a freefall sovereign default and ii) 40% recovery on sovereign bonds seemed more than fair. Obviously with Greek bonds already trading in the 20s this assumption was substantially challenged, although the methodology for all intents and purposes remained at 40%. No more - according to CMA, the default recovery on Greece is now 20%. So how long before both this number is adjusted, before recovery assumptions for all sovereigns are adjusted lower, and before all existing risk model have to be scrapped and redone with this new assumption which would impact how trillions in cash is allocated across the board. Of course, none of this will happen - after all what happens in Greece stays in Greece. In fact since America can decouple from the outside world, it now also appears that Greece can decouple from within the Eurozone, even though it has to be in the eurozone for there to be a Eurozone. We may go as suggesting that the word of the year 2012 will be "decoupling", even though as everyone knows, decoupling does not exist: thank you 60 years of globalization, $100 trillion in cross-held debt, and a $1 quadrillion interlinked derivatives framework.

If there is one lesson to be learned from the Japanese experience with deleveraging over the past few decades it’s that deleveraging cycles have there own special rhythm of reflationary and deflationary interludes.  Pretty simple thinking as balance sheet deleveraging by definition cannot be a short term process given the prior decades required to build up the leverage accumulated in any economic/financial system.  If deleveraging were a short term process, it would play out as a massive short term depression.  And clearly any central bank would act to disallow such an outcome, exactly has been the case not only in Japan over the last few decades, but now also in the US and the Eurozone.  We just need to remember that this is a dance.  There is an ebb and flow to the greater (generational) deleveraging cycle.  Just as leveraging up was not a linear process, neither will the process of deleveraging be linear.  Why bring this larger picture cycle rhythm up right now?  The recent price volatility we’ve seen in assets that can be characterized as offering purchasing power protection within the context of a global central banking community debasing currencies as their preferred method of reflation for now, specifically recent the price volatility of gold.

The bond market has always had clever names for bonds in specific markets.  Eurobonds, Yankee bonds, Samurai bonds, and now, Ponzi bonds.  I’m not sure what else to call these new bonds, but Ponzi bonds seems as good as anything. NBG issued these bonds to themselves, got a Greek government guarantee (how can a country that can’t borrow, provide a guarantee?) and took these bonds to the ECB to get some financing.  The ECB won’t buy National Bank of Greece bonds directly, they won’t buy Hellenic Republic bonds in the primary market, but they will take these ponzi bonds as collateral?  Greece, and Italy, is sacrificing the people and the country for the good of the bank. The market had made some attempt to charge banks with bad risk management, awful assets, and opaque books, more than they charged the country they were domiciled in.  But rather than let the market (and common sense) rule, a mechanism to let banks fund themselves cheaper than the countries they rely on, was created. Asides from giving Ponzi a bad name (at least until the ECB just admits that they are printing faster than even Big Ben) this is tying the banks and the countries ever closer.  A long, long, time ago (1 month) it was conceivable that a bank could fail and the sovereign survive.  That is becoming less clear.

There has been a large debate as of late about the economy going into 2012.  Will it "muddle through" at a sub -2% rate, rebound sharply to more than 3% as currently estimated, or will we decline into a secondary recession?   Cases can clearly be made for all three scenarios and only time will tell who is correct.  However, this debate entirely misses the essence of what we are most concerned about - our investment portfolios and the risks to those investments from economic pressures. I have clearly made the case in past missives about the potential for a recession in 2012.   When real GDP has declined below 2% growth on a year over year basis the economy has normally been, or was about to be, in a recession.   With today's downward revision to Q3 GDP we have now had two consecutive quarters of sub-2% GDP growth.  There are only two instances in history (Q3-1956 and Q1-2007) where there were two consecutive quarters of sub-2% GDP annual growth and the economy wasn't already in a recession.  In 1956 the economy rebounded for one quarter to 2.93% annual growth in Q4, slipped to 1.88% in Q1 of 1957, rebounded once again to 2.99% growth in Q2 1957 as the recession officially started.   The other was in Q1 and Q2 of 2007 and we all know how that worked out in next couple of quarters.  These are the only instances where the economy "muddled"  along for a period of time before way to the recession.  The reality is that an economy cannot muddle along - it will either grow or contract.  "Muddling" isn't historically an option.

The Fed just released its 'framework' for thinking about planning to implement their proposals to take notice of the Dodd-Frank rules. There is little if any detail in here but the main points, via Bloomberg headlines from the 173 pages of admittedly well structured, but unclarifyingly disappointing prose are as follows:

• *FED BOLSTERS TOOLS FOR AVERTING COLLAPSE OF BIG FINANCIAL FIRMS
• *FED REGULATIONS FOCUS ON CAPITAL, LIQUIDITY, STRESS TESTS
• *FED RULES TARGET RISK MANAGEMENT, REMEDIATION, CREDIT RISK
• *FED PROPOSES `TRIGGERS' TO `EARLY REMEDIATION' OF WEAKNESSES
• *FED RULES TO LIMIT FIRMS' CREDIT RISK TO A SINGLE COUNTERPARTY
• *FED RULE REQUIRES BANK DIRECTORS TO APPROVE LIQUIDITY RISK
• *FED: FIRMS MUST ANNUALLY HAVE STRESS TESTS, PUBLICIZE RESULTS
  

So the market has completely latched on to the idea that LTRO is back-door QE. Does this make any sense and can it even work? So banks can borrow money for up to 3 years from the ECB.  They can buy sovereign bonds with that money.  Those bonds would be posted as collateral at the ECB. The bull case would have banks buying lots of European Sovereign Debt with this program. The purchases would be focused on Italian and Spanish bonds with maturities less than 3 years. Buying bonds with a  maturity longer than the repo facility is risky.  The banks would need to be assured they can roll the debt at the end of the repo period.  Some may be convinced, but the bulk of the purchases will be 3 years and in so that they loans can be repaid with the redemption proceeds. So banks buy the bonds and earn the carry and all is good?  Not so fast. The LTRO can help the banks with their existing funding problems without a doubt, but it is unclear that encourages new bond purchases. I think we have already seen the initial impact.  There will be significant interest in tapping the LTRO for existing positions.  Some small amount of incremental purchases may occur at the time, but the banks will use this to finance existing positions. Now we will wait to see rates do well, but will be disappointed.  The big banks with risk management departments will decide to decline.  The risk/reward just won’t be attractive to them. In the end, this won’t do much for the sovereign debt market, but will shine a spotlight on which banks should be shorted and will possibly expedite their default.

The financial crisis of the last few years has created not just a perceived shift in the creditworthiness of our financial entities but a real crack in the foundation of their business model and more importantly any explicit or implicit supports or guarantees. Moody's, in a special report on credit post crisis "The Great Credit Shift" look at the impact of the crisis on every major asset class within the credit space from sovereigns to corporates to structured finance. Noting that this crisis has profoundly changed the credit picture for sovereigns and financials, Moody's note there is some dispersion in the latter as banks have seen systematic downgrades while insurers (for now) remain on par with pre-crisis levels. More interestingly, large US regional banks represent an exception to this broad downgrade but we suspect that the continued low interest rate, low NIM, and high volatility spread environment will cause both insurers (we have long considered proxies for HY portfolios, no matter how well cushioned from vol their business models may be) and US regionals (consolidation will have the opposite effect of TBTF in our view as it will lead to more comfort with more risk-taking and expose them to more current-bank-like volatility) to face more pressure going forward (despite their lower apparent sovereign risk exposure). As BofA and Morgan Stanley trade at extreme 'crisis' levels in both CDS and equity markets, we suspect the raters have further to go and while the systemic shifts are apparent, we would expect less and not more differentiation going forward - especially if we sink into another solvency crisis.

Paul Mylchreest, author of the Thunder Road, releases his much anticipated latest report, and it's a doozy: "2012: Dear Portfolio Manager, you are leaving the capitalist sector and heading into a full-spectrum crisis." He continues: "You were to hear a report on the world crisis. That is what you are going to hear. For twelve years you have been asking: Who is John Galt? This is John Galt speaking….Now it’s  getting serious. 2012 will be a year to remember as the globalist agenda comes into focus amidst economic and geo-political crises: The titles of the last two Thunder Road Reports were prefaced with “Helter Skelter” - “The Illusion of Market Stability” followed by “Gentlemen Start Your Engines”. Sadly, the Helter Skelter I was writing about – the second part of the Great Financial Crisis is in progress and I’m expecting it to come to a head next year (2013 if we’re very lucky). The only question is WHAT brings it to a head? We’re not short of possible causes – a bank failure, sovereign default, Eurozone tipping into recession or the Middle East. Despite all the evidence to the contrary, like overwhelming debt levels and insolvent banks/sovereigns, the consensus seems convinced that we can “muddle through”. Dow Theory veteran, Richard Russell, explained it best: “In the coming two or three years we will be going through unprecedented situations beyond the understanding of most analysts.”"

What I said in the title, well... sort of...

There is NEVER just ONE roach!!!

The market rallied this past week, albeit in a very volatile manner, to end the week on a positive note as the hopes of a final resolution to the Euro crisis has been reached.   In reality, today's announcement of the EU treaty is only the first step and there are many legal challenges that will still have to be resolved.  While the reality is that there is still a very long road ahead before anything will actually be accomplished the implication that the with the ECB willing to buy bonds, at least for the moment, and the coordination of two bailout funds the Eurozone can play "kick the can" for a while longer.  Those headlines, even without much substance were enough to drive return starved managers into the market for the year end rush.

We have spent a great amount of time recently discussing both the re-hypothecation debacle and the 'odd' moves in CDS - most specifically basis (the difference between CDS and bonds) shifts and the local-sovereign-referencing protection writing. Peter Tchir, of TF Market Advisors, provides further color on the latter (as the 'Ultimate' trade) and in an unsurprising twist, how the former was much more critical during the Lehman 'moment' and will once again rear its ugly head. Exposing the underbelly of these two dark sides of the market must surely raise concerns at the fragility of the entire system - as we remarked earlier - but the lessons unlearned, on which Peter expounds, from the Lehman period are reflective of regulators so far behind the curve that it is no wonder the market's edge-of-a-cliff-like feeling persists.

So I don’t have a good answer for the fundamental problem of tails. But there is an observed regularity in life reflected in the sayings “it is always darkest before dawn” and “where the danger grows, so grows the saving power” to quote Holderlin. And when no one can know the future, and the mechanism governing the future is unstable, anticipation of heightened risk premia warrants a barbell. In financial markets, extreme meltdowns are met by extreme policy reactions. Practically stated, it seems best to play center bets when others do not, and the tails when others do not. After markets price in heightened risk, actively manage the position by lowering exposure to the big gain leg. Move the proceeds to the center or double down on the other tail. Perhaps this is how one should manage tails. Given that the known categories of human experience do not provide adequate predictions, luck dominates control. Nobody has it all figured out. Even when you think you have it all figured out, everything blows up in your face again. We'll never figure it all out. Nobody can predict the future, and we don't have good enough imaginations to dream up every contingency.

While one of the bigger commodity funds out there, in this case Fortress Commodities Fund, has not done too hot recently (down 7.4% in October), which it humbly admits to and says, "the month of October was a wakeup call for us and we are adjusting accordingly" here are some must read perspectives that lead the Fortress Commodity group to conclude that "We're Long Gold, Short Base Metals, Patient Crude Strength Seller & Buyer Of Corn On Any Real Flush In Prices." Oh, and that it's "macroeconomic outlook remains pessimistic."