If you owned something and wanted to determine its current value, wouldn’t you look to see where it last traded?

For many financial assets, like most of those held by insurers, you go to the latest quotes from listed markets or from broker/dealers involved in the market.  But, what happens when most of those trades are not being made by longer term investors, like yourself, but by investors with extremely short term horizons.  Yes, it’s the hedge funds who do a large share of the trading and so their collective views on markets tend to shape those prices.

A few views on the influence of hedge funds on trading activity:  It is estimated that nearly 1/4 of all trading on the New York Stock Exchange is done by hedge funds and nearly 1/3 of London Stock Exchange trading is so domniated.  Some have estimated that 3/4 of actively traded convertible bonds, 45% of emerging market bonds, 47%% of distressed debt and 25% of high yield bond trading is done by the hedgies.  As one would expect, in the derivatives markets, hedgie trading domination is even greater: 55% of credit derivatives trading, and a large chunk of interest rate derivaitves.  And, let us not forget that much of cash bond pricing is influenced by all that derivatives trading.

Hedge funds still control asset totals in amounts much less than insurers, pension funds, banks and other traditional institutional investors, but they have a disproportionate control of trading.  That means when they all head for the door, markets shake in the same direction (up or down, depending upon your perspective).  And, a few negative bits of news finally caused the hedgies and their risk models to capitulate on what was a sunny view of credit, the economy, etc.  Those risk models basically say to reduce risk when results start getting shaky and they started getting shaky in a hurry as these big traders started groping for the exits (why does that sound peculiarly like ‘portfolio insurance’ in the late 80s?).  And that has meant rising credit spreads (finally) and more sensitivity to credit in general.

However, let us not forget what economist Paul Samuelson once noted:  "The stock market has predicted nine of the last five recessions."

And that will most likely be true in this case.  As we’ve been telling our clients for some time:  Don’t expect those equity returns to continue, as long term expected mean returns for US equities are closer to 8%, not what we registered through the beginning of last week.

We’ve been telling our clients for over a year now that residential real estate price weakness (the so called ‘wealth effect’) is not the issue, but the repricing of ARMs (many times resulting in a doubling or more of monthly payments) will cause economic problems.  And that problem impacts all types of borrowers, from ‘A’ credits all way through sub prime, albeit to differing degrees.  We estimate that this phenomenon has about a year and a half to work its way through the system. 

The ultimate economic impact of this is still to be fully played out, but at this point, we would side with Dr. Samuelson and add the immortal words of Bette Davis in  ’All About Eve’:  "Fasten your seat belts, it’s going to be a bumpy night!"

Meanwhile, if you want to see where the markets will go next, just follow the money…and that means anticipating to where the hedgies and their risk models will run next.

…Not yet, but this could happen quicker than any of us might imagine.

Other Than Temporary Impairment (OTTI) rules vary by company, auditor, region and, seemingly, time of year.  However, they all have in common a comparison of market to book values.  When it comes to structured securities, like ABS, CMOs, etc, getting good valuations can become problemmatical in certain markets.  And, these are definitely problemmatical times for tranches of sub prime mortgages.

Of course, your friendly investment manager has probably told you that your company owns very few sub prime mortgage tranches and, these tranches are all investment grade, well protected by lower rated tranches.  However, the market may beg to differ.

Simply go to Markit’s web page that lists prices for indices of various ABS secured by sub prime mortgages.   These indices, called the ABX, are stratified by issuance date and credit rating.  As of today, A rated ABS in the index that were originated since the second half of last year, now have a market value of 68 to 75, well below the standard for typical OTTI review.

Could this be merely a short term, overly pessimistic view of these securities?  Yes, these securities may improve in value and this can be a temporary move, but, alas, things could also get worse.

But, this move below 80 has primarily occurred over the last week, so is OTTI really an issue?  Not yet, but this certainly has the potential to be an OTTI question from your auditors.  The recent high profile nature of this investment and the fact that few, if any, insurers have finalized their Q2 results, mean your auditors may be sniffing around this issue.

Please remember, the ABX is an index of tranches, and your company’s ‘investment grade’ holding of a sub prime ABS may have either a higher or lower value.  The real problem will be assigning an accurate price for a given tranche.  In the case of the ABX, it is an index that is traded and does indeed provide a better estimate of fair market value than many of the matrix pricing schemes used by various broker/dealers.  It is with this in mind, that your auditors may come a sniffing.

As noted in my previous blog post, With a more conservative approach imbedded in the rating agency models, we can expect further downward pressure on subpime ‘matrix’ pricing, even if the bond has not been noted as downgraded in the agency press releases. 

Apparently, the trading of the ABX tells us that, as usual, the market is ahead of the rating agencies in repricing sub prime mortgage tranches.  And, with Bear Stearns closing two subprime hedge funds due to the "unprecedented declines in the valuations of a number of highly-rated (AA and AAA) securities", it is probably time to question the pricing of subprime tranches rated higher than A.

Please feel free to join the discussion at the Insurer Investment Forum Online

Today Standard & Poor’s said it placed 612 classes of residential mortgage-backed securities backed by subprime collateral on CreditWatch with negative implications.  Although this affected only about 2% of the total outstanding RMBS rated by S&P from the fourth quarter of 2005 to the fourth quarter of 2006, it still is a significant issue.  S&P says that poor collateral performance, higher-than-expected loss trends, decreased credit support and changes in future rating methodology are all reasons behind this action.  Tranches affected range in credit rating from A+ to BB.  Importantly, the bulk of the RMBS market is AAA or AA.

However, I wonder if this wake up call by S&P is really being caused by the conflict of interest ‘chickens’ now coming home to roost.

Although every rating agency has the obligation as well as the right to change credit ratings due to deteriorating trends in a security or its collateral, one must take a more jaundiced look at revisions due to methodology changes.  The models used to rate subprime collateral and related tranches are basically an open book available to any issuer to "game" as they see fit.  One must wonder how much issuers knew about a given RMBS versus what the rating agencies knew via their standard models.  Now those models are being changed but, they still remain open to issuers and the potential for more gaming by issuers remains.

This brings up the issue of legal as well as reputational risk not only of the rating agencies, but of the investment bank issuers and mortgage brokers.  When all of the players in the mortgage market are incented to issue debt; all of the players will find ways to meet production goals…even if that means producing problems for investors down the road.  This, of course, sets up a deep conflict of interest between what your friendly broker/dealer is telling you about a security and what the reality is.

Related to this is the conflict of interest on the pricing of these subprime mortgages.  Broker/dealers who act as prime brokers for HF’s, as well as broker/dealers who finance portfolios of HFs, as well as the HFs themselves all have a similar interest….generally keep pricing high, unless there is evidence to the contrary, like a liquid market.  However subprime mortgages and several other relatively illiquid asset classes are not priced in a liquid market.  They are priced based upon some ‘matrix pricing’ variation and this approach will now be further complicated by S&P’s rating methodology change. 

With a more conservative approach imbedded in the rating agency models, we can expect further downward pressure on subpime ‘matrix’ pricing, even if the bond has not been noted as downgraded in the agency press releases.

However let’s not just focus on subprime mortgages.  A similar conflict of interest is readily apparent in Leveraged Buyouts (LBOs).  In that case, private equity players look for advantageous financing and covenants.  Banks, realizing that they will not have to maintain the credit on their books, are more than obliging to provide financing and subsequently layoff credit risk in the CDS market (credit default swaps).

However the credit risks of mortgages, as well as corporate debt all need to find a home.  They cannot simply be continually traded amongst hedge funds and other "mark to market" (MTM) oriented investors.  Thus the best spot for these credit oriented instruments to find a home would be with investors who are not required to mark portfolios to market, but can instead be long term investors not subject to the short-term vagaries of market pricing.  Perhaps the best and most liquid source of such funds are found at many insurance companies.

S&P made a wake-up call on subprime deals and Moody’s and Fitch will undoubtedly follow (note: later in the day, Moody’s downgraded nearly 400 tranches).  There is, of course, the risk that the agencies will now try to out do each other in the downgrading game.

But the real issue is how the warehousing of credit risk at long-term investors not subject to mark to market will eventually play out.  So far so good, but news like this from the rating agencies should get insurers to take a long hard look at levels of credit risk embedded within the portfolio….both immediately and potentially apparent.

Please feel free to join the discussion at the Insurer Investment Forum Online