We’ve all heard about the ‘carry trade’ in the press.  Although, it did arise in discussions more often earlier in the year than it does now. 

However, it may now be time to resurrect the discussions about what might be going on and the impact for US financial makets.

When an investor enters the carry trade, it typically involves selling Japanese bonds (in effect borrowing at the low JGB rate of about 1%) and investing in other securities (typically US Treasuries) that yield well in excess of the cost of borrowing.  Even with Friday’s drop in UST yields, the carry trade still creates ‘positive carry.’  Of course, as this gap in yields decreases, investors (mostly hedge funds), will look to reduce their exposure in the carry trade, since negative movements in prices between UST and JGB can more easily swamp the gap in carry trade yields.

I think that one obvious trade to reduce risk in those instances would be selling risky assets (for example, the S&P 500) and buying back the JGB.  Thus, if there is an unwinding of the carry trade, one would expect that movements in the S&P 500 might have some correlation with the Japanese Yen/US$ exchange rate.  In other words, an unwinding would bring drops in the SP500 along with strength in the Yen/$ exchange rate.

Back in late February, people were blaming China’s stock exchange price turmoil for its negative impact on the SP500.  Interestingly, before that sharp downward movement in US equities, there appeared to be virtually no correlation between the SP500 and the Yen/$ rate.  However, once that movement occurred, the correlation turned sharply positive.  In other words, the carry trade has indeed been unwinding.

Please note from the chart above that there has been a 46% correlation between the SP500 and Yen/$ exchange rate since that day in February, versus virtually no correlation in the six months prior.

Importantly, the correlation has been north of 30% since the latter part of May, with the SP500 sinking and the Yen strengthening versus the $.  And for the most recent two weeks of SP500 turmoil, the correlation has been quite high at 89%.

The carry trade is unwinding and, with recent rate drops in the UST curve, appears to be getting even less attractive.  Hedge funds are strong players in the carry trade.  They are pulling in their horns and risk profiles, hoping to ride out this tough spell in the markets. 

One can only hope that the herd instinct (and quantitative models) of these hedge funds does not produce a more virulent downward spiral in equities.  My concern is that this herd instinct may be further ignited by quarterly redemptions due hedge fund investors at the end of this month.

"…the swings in almost all financial markets this month have made dispersed risk suddenly morph into dispersed mistrust." -The Economist, August 16, 2007

"The oldest and strongest emotion of mankind is fear, and the oldest and strongest kind of fear is fear of the unknown." - H.P. Lovecraft

As markets seek to recover from what one hopes is the bottom of the fear/greed cycle, it may be worthwhile to continue thinking about how the insurance regulators will react.  In my prior post, I noted the potential huge problems in valuing securities in an illiquid market.  Apparently, the SVO and the NY Insurance Department have been thinking about valuation long before the current market.

Back in November, 2006 the Valuation of Securities Task Force of the NAIC exposed for comment a valuation proposal that would allow insurers to choose their valuation source and note the source as follows:

"1" - SVO database, "2" - an approved pricing service, "3" - a stock exchange, "4" - a broker or custodian, or "5" - determined by the insurer.

Thank you to Chris Anderson at Merrill Lynch for providing the latest on this interesting valuation proposal from the NAIC.  Chris has noted this may be approved at the VOS Task Force as early as next month.

Although a step in the direction, I think a bit more disclosure as to the name of the source might be useful, much as is now required for the broker used on trades.  Importantly, this should not result in a ‘wild west’ of pricing, as the SVO would develop a mechanism to compare reported prices for a given CUSIP to those reported by all insurers holding that CUSIP.

Given the current (and potential state of the financial markets at year end), we applaud the SVO and the NY Insurance Department for moving in the right direction.  Transparency and disclosure are a strong antidote to fear and mistrust.

Based upon historical behavior, the NAIC and other insurance regulators will react like generals fighting the last war. 

First, they will wait to see if and how the overall repricing of risk impacts insurers.  Amazingly, reductions in earnings and risk capital are not the biggest issue here.  Potential insolvencies or rehabilitations are.  Depending upon the ultimate impact on individual insurers, the NAIC will then slowly make changes, most likely, through the various model law vehicles.

But, what if the threat to common sense regulation of insurers is not the NAIC and others regulating with their eyes squarely on the rear view mirror? 

What if the real threat comes from the Securities Valuation Office (SVO) of the NAIC? 

Insurers must use pricing as noted by the SVO when filing statutory financials at year end.  However, what if the craziness of pricing ABS, CMOs, CDOs, etc. that is occurring now, persists at year end?  How will the SVO get accurate pricing for use by insurers?  And, how realistic would those prices be?  Of course, unrealistically low prices could feed into lower risk capital and increased pressure on insurer financial condition.

Also, as many of you know, the insurance industry worked for several years to convince the NAIC that the SVO should use the ratings of the rating agencies with a ‘look-up table’ to determine the SVO rating.  (i.e. A- or higher meant SVO 1, BBB meant SVO 2, etc.).  Before this change, one of the insurers holding a given rated security or tranche would have to pay a fee to the SVO for their imprimatur.  (Non-rated securities have always required independent credit review by the SVO.)  With many of the problems that have started with sub prime mortgages aided and abetted by the rating agencies to some degree, will the NAIC change its tune?  Will the SVO now be required to rate all securities, irrespective of rating agency letter rating?  And, how much more in resources (read: fees from insurers) will this require? 

On top of this, the SVO has not exactly developed a reputation for accuracy and reasonableness in their rating process.

From a small acorn, a large oak can grow.  It’s starting to look increasingly like the small acorn of sub prime mortgage problems will grow into a large oak of problems and challenges previously unimagined.

Your comments are much appreciated.

18 months is a good estimate.  We’ve said that before (see previous post) and now others have more eloquently presented supporting evidence.

David Leonhardt of the NY Times has an excellent piece on this today.  (registration may be required)  Basically, he says what we’ve been telling our clients for over a year now:  The problems with the residential real estate market is not one of valuation (the overly hyped ‘wealth effect’ in reverse), but one of upwardly adjusting mortgages challenging borrowers (both good and bad credit risks).  Take a peek at the graph below.

And Chris Whalen of Institutional Risk Analytics takes a more detailed look at Countrywide’s results, especially its banking subsidiary (thanks to details required in public filings to regulators).  Chris’ article backs up David’s article: "you would know (or at least suspect) that loan defaults were likely to bounce sharply in 2007-2009 as CFC and the rest of the mortgage peer group revert to the LT mean — figure at least two standard deviations from year-end 2006 levels."
 

Thank you to both David and Chris for continued excellent writing on this and related subjects.

We continue to counsel detailed monitoring of all non-GSE residential mortgage exposures, especially any tranche tied to a subprime deal or whose rating has not been updated/reviewed recently.

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

As noted earlier, this will continue my series of posts on the deleveraging of financial markets.

This time it is the unraveling of a couple of hedge funds run by the investment bank Bear Stearns that is weighing on the markets.  The ‘High Grade Structured Credit Strategies Fund’ invested in cash and derivative instruments tied to CDO’s backed by sub prime residential mortgages.  As that market has been hit hard, due primarily to repricing of ARMs (i.e. significant increases in monthly payments required of home owners), delinquencies and foreclosures, those securities have been repriced downward.  Of course, to juice returns in the fund some leverage was used.  Leverage plus declining security values have meant margin calls by Bear’s fellow Wall Street investment banks who did the lending.  When one bank, Merrill Lynch, found it difficult to find buyers for their loan’s collateral, the result was severe downward pressure on those and similar CDO tranches.

And, when selling of large blocks of securities is not met with a wash of liquidity, the result is that other similar securities (in this case, certain kinds of CDO tranches of subprime mortgage pools) must be marked to market downward, along with those currently looking for a buyer.  This repricing pressure has the potential to negatively effect several investors (i.e. hedge funds) who hold investments other than this type, as they might be forced to sell those other securities to meet margin calls.

Meanwhile, deep concern has set in and Bear Stearns, seeing a huge problem not only across this fund but in its much larger, related High Grade Structured Credit Strategies Enhanced Leverage Fund and in its affiliated Everquest Financial, Ltd. holdings decided to provide a temporary solution to the problem: A $3.2 billion bandage in the form of a loan from Bear to the fund without ‘enhanced leverage’ in the name.  Most likely, in this way, existing investment bank creditors would have their margin calls met and/or be paid down.  Undoubtedly, the plan will be to find an orderly market to sell the securities in the fund and repay the loan.

www.bloomberg.com/apps/news

However, since apparently Bear’s colleagues on the Street were not interested in advancing more $ to the fund,  what is the real value of that $3.2 billion band aid loan on Bear’s balance sheet today?  As of the quarter ending Feb 07, the Bear had about 13B in shareholders’ equity against 394B of assets.  And, it still has to determine the ‘cost’ of the loan or other bailout of the larger ‘enhanced leverage’ fund, where borrowing was even more pervasive.

Why doesn’t the Bear just walk away from those troubled funds?  One reason could be that they own similar securities, as noted above, and ‘fire sale’ pricing would directly cause a mark to market hit to shareholders’ equity.  Another could be the Bear’s concern about its own reputation.

As I write this, S&P sees no problem in all of this on the Bear’s A+ rating. 

www.forbes.com/markets/feeds/afx/2007/06/22/afx3848541.html

Meanwhile, I am unshocked by the fact that just a few weeks ago, the Bear announced an IPO for Everquest Financial, another related player in the sub prime CDO market.  As we all know, when John Q. Public can buy into a hot ‘idea’, there must be something behind the ‘idea’ to worry about.

And, we will reiterate what we have been telling all of our clients every quarter, for the past four quarters:   "Perhaps the press has overstated the negative ‘wealth’ effect from falling house prices and what the real residential realty bogeyman will be is upwardly adjustable mortgage payments…unless mortgage brokers get even more creative."  To that we must add that it is those ‘creative’ mortgage brokers that have been forced to close in droves…many by the implosion in the sub prime CDO market.

To sum it all up, I would like to draw your attention to the ultimate irony in all of this:  Last year, Euromoney Magazine named Bear Stearns as the "Best in Risk Management" in the U.S.  Alas, that is no joke:

www.euromoney.com/article.asp

I do not know who finished second.

We wish the Bear the best in solving this very serious problem. 

Yes, you read that right.  Hedge fund growth slowed to only 37% year over year from a 53% previously.  Total hedge fund assets are now estimated at $2.5 trillion.  http://www.institutionalinvestor.com/Article.aspx?ArticleID=1361809 

At this slower rate of growth, hedge funds will control about $10 trillion in assets at the end of the next four year period (2011). 

Now, a more realistic assessment. 

I do not know if the $2.5 trillion is net of borrowings (which would be significant), but I do know that the financial press loves large numbers (see previous blog post on SWF’s).  More importantly, what does this mean for insurers?

Many large insurers have been HF investors for well over a decade now.  The acceptance of such vehicles as ‘proper’ for insurers has gradually come down the insurer asset size spectrum to where we now see insurers in the 1-5 billion size range seriously considering them.  (Of course, there are a handful of smaller insurers whose Boards have pushed them to dabble.)

Hedge funds are NOT an asset class.  If they are, then Mutual Funds are an asset class, and that would be a grossly incorrect characterization.  HF’s consist of several different strategies.  Thus, they might be considered for an insurer’s portfolio based upon what a given strategy/style can do for the portfolio.

Something that HF’s can probably not do is consistently beat equity market returns.  When lumped together, HF’s have tended to provide BELOW equity market returns.  So, why bother?  They have also tended to provide much lower volatiltiy than equities and lesser correlation with other assets typically held by insurers.  For more on this, we highly recommend AllianceBernstein’s report, "What Lies Beneath?" https://www.alliancebernstein.com/institutional/Registered/ArticleDetail.aspx?cid=32263

Because of this, in analyses we have performed for our clients, it is readily apparent that hedge funds can generally be expected to add a material amount of risk adjusted return to the traditional insurer’s portfolio.

However, before you begin to jump on the HF bandwagon (and risk trying to explain the risks inherent in HF’s to a Board of doubting Thomases), you should remember that using a hedge fund of funds is a great way to pay more fees WITHOUT a concomitant advantage in returns.  The most successful investors in hedge funds (and here we are speaking of certain pension and endowment investors) have focused on choosing individual HF’s after much detailed research about the quantitative and qualitative issues.

An asset class growing at a "paltry" 37% cannot be pushed aside as an alternative for insurer’s non fixed income (or ‘risky bucket’) portfolio.  However, caution, prudence and detailed research is advisable.

The recent survey just announced by our friends at PriceWaterhouseCoopers noted that only 11% of financial services CFOs will NOT use the FAS 159 fair value option, effective November 15 for most companies.  More than a quarter of the CFO’s see implementing fair value (FAS 159 coupled with FAS 157) will have the greatest impact on their business or finance team.  Survey respondents were the nearly 400 senior finance executives attending PwC’s Finance Executives Forum, responsible for various industries, including banking, capital markets, consumer finance, real estate and asset management firms.  (Read more at CFO.com’s web site: http://www.cfo.com/article.cfm/9254335/c_9256135?f=home_todayinfinance&x=1). 

Reading this article reminded me of this famous scene from E.T., the Extra Terrestrial:

Elliot: He’s a man from outer space and we’re taking him to his spaceship.
Greg: Well, can’t he just beam up?
Elliot: This is REALITY, Greg.

Is this PwC survey an accurate reflection of reality?  Or, could this be a more self-serving effort on the part of the Final Four firm to push their expertise in implementing FAS 159?    More importantly, does this survey accurately depict what insurers will do?

In brief discussions on this topic with large insurers, the answers tend to be a non-committal "We are reviewing it."  But, can the largest, publicly held insurers shy away from FMV when their competitors for capital (other publicly held institutions) are doing so?  And, if the largest insurers move toward FMV, won’t medium and then smaller sized GAAP filing insurers be under pressure to follow?

Is the PwC survey reality?  Or, are they trying to ‘beam up’ a solution to a non-existent problem?

Join the discussion, by going to our forum, under the FAS 159 topic.