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Thursday, June 16, 2011

A TruPS UPdate

The TruPS CDO market has shown renewed signs of life over the last six or so months, for the first time really since 2007.

While the rating agencies continue to downgrade these bonds, and while certain serious risks remain to their performance, the market is (finally?) reacting to a number of positive developments in the underlying bank market. Several TruPS CDO securities, we believe, are now grossly mis-rated by the rating agencies. Our analysis suggests that many securities rated CCC or below will pay off in excess of their ratings-implied losses; some are likely to pay off in full.

Default Risk

A key risk for TruPS CDOs remains the default rate on smaller banking institutions. (Aside from banks strictly being pulled into receivership, TruPS CDO noteholders remain exposed to losses that may result on their preferreds to the extent troubled banks restructure, recapitalize or file voluntary petitions for relief under Ch. 11 of the Bankruptcy Code – see for example the cases of AmericanWest, or Builders Bank.)

On the plus side, the rate of bank failures has gone down from 2010. Adjusting for the cohort size – depending on the number of institutions reporting – we’re down from a default rate of approximately 2.05% last year to 1.37% annualized this year, based on the FDIC’s most recent quarterly report (March-end 2011).

This difference is substantial. From the looks of it, one of the key components of this reduction was that bank regulators were more successful in having banks absorbed through a merger process, evading failure: if we consider mergers plus failures, the sum is little different, from 4.62% in 2010 to 4.33% annualized for Q1 2011. But the distribution is now heavier towards the merger side of this equation, implying in the reduced bank failure rate.

The staving off of default, through the merger process or otherwise, almost always proves advantageous to TruPS CDO noteholders.

Balance Sheet Conditions & Outlook

The FDIC notes that “[more] than half of all institutions (56.2 percent) reported improved earnings, and fewer institutions were unprofitable (15.4 percent, compared to 19.3 percent in first quarter 2010),” and that net loan charge-offs (NCOs) have declined for the third consecutive quarter, resulting in an overall 37.5% reduction since March-end 2010. Deposit growth remains strong and the net operating revenues reductions were concentrated at the larger institutions – less of a concern for the average TruPS CDOs which are more heavily exposed to smaller rather than larger banks.

Banks' balance sheets, too, are in better condition: the ratio of noncurrent assets plus other real estate owned assets to assets decreased from 3.44% in 2010 to 2.95%. Also, while the overall employment of derivatives has increased almost 13% over the last year, the heightened exposure is more heavily concentrated among the larger banks. Based on PF2's calculations, if you exclude banks with more than $10bn in assets, you’ll notice a reduction of almost 30% in derivatives exposure over the last year.

These numbers are still much worse than pre-crisis numbers. Historically banks defaulted at an annual rate of approximately 0.36%, on a count basis. We’re at roughly four times that number now. Back in ’06, fewer than 8% of reporting institutions were unprofitable. We’re still at double that number. The ratio of noncurrent assets plus OREO assets to assets was slightly below 0.5% in 2006. We’re sitting at six times that level. But the trends are moving in the right direction – certainly if you’re an investor in the average TruPS CDO.

On the downside, the FDIC’s problem bank list has grown by a not-insignificant amount, from 775 banks (or 10.12% of the cohort) in 2010 to 888 banks (11.72% of cohort) as of March 31, 2011. TruPS CDO noteholders will doubtless hope that these troubled institutions turn around, or are merged or resolved in any other fashion that circumvents default on their trust preferred securities. (For TruPS CDO noteholders exposed to deferring underlying preferreds, the acquisition or merging of the deferring bank by or with a better-capitalized bank brings with it the possibility of the deferral’s cure.)

With the downward trend of bank default rates (and the possibility of deferrals curing), some of the more Draconian bank default probability assumptions can be relaxed, boosting values on TruPS CDO tranches.

We think the market is starting to appreciate this additional "value."

Tuesday, June 14, 2011

An Aversion to Mean Reversion

Last Wednesday’s Financial Times hosted a scathing column by Luke Johnson, which questions the usefulness of economists, as a whole (see “The dismal science is bereft of good ideas.”)

The column’s title is misleading: Johnson focuses his frustrations only on economists – not economics. Importantly, it is the application of the science, not the science itself, which seems to have caused Johnson's concern.

Indeed the purity of all mathematical sciences can be spoiled by its application. Johnson comments that he “[fails] to see the point of professional economists,” that economists “pronounce on capitalism for a living, yet do not participate in private enterprise, which is its underlying engine.” He ends off his piece by prescribing “[the] best move for the world’s economists would be to each start their own business. Then they would experience at first hand the challenges of capitalism on the front line.”

To be fair, the direct application of economic theory was never intended to satisfy the depths of the dynamic puzzle we put before them, a puzzle for which the answer lay not in the data but in the incentives. [1]

We cannot pretend not to have known that economic models work best in reductionist environments, and that the introduction of complications (like off-balance sheet derivatives) tend to reduce the effectiveness of economic models. Conceptually, once models start to consider too many inter-related variables, or degrees of freedom as statisticians call them, they become so rich and sensitive that no empirical observation can either support or refute them. And so any failures of economists to spot the housing bubble or predict the credit crisis, as Johnson mentions, become our failures too. We would have done better to equip our economists (or academics) with the tools necessary to perform the “down and dirty” analyses that take into account the complex and changing nature of our economy. [2]

Seeing no reason why they ought to have succeeded, we’re perhaps a little we’re more forgiving (than Mr. Johnson) of economists’ shortcomings. But we share his concerns that mathematical sciences are being too directly applied, that the practices and the incentives are being largely ignored.

On Endlessly Assuming “Mean Reversion”

Rather, we ought to encourage our researchers to go into the proverbial field – and to learn to think, and study dynamics, differently.

We can no longer allow ourselves to be informed purely by static analyses of historical data and trends, without seeking a keener appreciation for the underlying dynamics at play. The lazy assumption of mean reversion is simply an assumption, not a rule. When the fundamentals are out of whack – and a direct analysis of data alone cannot tell you that – the market can and will act very differently from a mean-reverting economic model.

Thinking Differently

Given that many market participants have emotions (one could argue that computer algorithms are to an extent emotionless), the tendency for panic or at least the capacity for panic ought to make the direct application of mean reversion models less appealing – and their results less informative, predictive or meaningful.

Ask not “is this a buying opportunity” based on a simple historical trend. But what are the underlying fundamentals? If the game changed based on underlying issues, have they been resolved? Or were they underestimated or overestimated. If the latter is determined after sufficient exploration, one could recommend a "buy." If the former, initiate a "sell." To do otherwise - to simply present a graph and suggest an idea, is folly – it's simply a guess.


Mean reverting economic forecast models continue to be constructed to this day without the thought necessary to support their assumptions (despite the realization that we’re in a very different world).

The outputs, unfortunately, are never better than the inputs.


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[1] See our earlier commentary “The Data Reside in the Field

[2] In light of this fact, it is perhaps troublesome that when questioned by JP Morgan CEO Jamie Dimon as to the extent of the government's investigation of the effect of its banking regulations, Bernanke purportedly responded "has anybody done a comprehensive analysis of the impact on -- on credit? I can't pretend that anybody really has," ... "You know, it's -- it's just too complicated. We don't really have the quantitative tools to do that." Source

Wednesday, June 8, 2011

Is Wall Street Guilty?

“If Wall Street is bilking Main Street on such simple deals–basic trade execution-and yet the only way to recover is to sue, what real chance do individual investors have of getting a fair shake in the financial markets? And what if you add sophisticated computer models, derivatives structuring technology, and secret Cayman Island companies to the mix? Do we have any chance at all?” — Frank Partnoy (1998) in his postscript to F.I.A.S.C.O.

A couple of weeks ago, Bloomberg BusinessWeek ran a story by Roger Lowenstein, entitled “Wall Street: Not Guilty,” that largely absolves Wall Street of criminal culpability for the financial crisis. 


This courageous conclusion—and if nothing else one must concede it is courageous—runs counter to popular opinion that malfeasance on Wall Street was an integral cause of the crisis, if not the chief cause. The story widens the debate at a time when a number of vocal critics (including Inside Job director Charles Ferguson and New York Times contributor Jesse Eisinger) are calling for criminal prosecutions.

Putting aside the accuracy of Mr. Lowenstein’s supporting arguments[1], we find it interesting to consider Mr. Lowenstein’s argument against criminal prosecutions from a legal, economic and philosophical perspective.

Society criminalizes conduct to achieve many policy goals, above all, prevention and punishment. (Of course, punishment should have a deterrent effect but it retains significance without regard to its deterrent effect.) Juridically, the primary goals of punishment center on the protection of society from criminal conduct, the stigmatizing of the conduct and the serving of justice to the victim(s).

The economic argument is simple, as it relates to the protection of society. From an economist’s viewpoint, punishment can be described as the “price” a criminal must pay to society for breaking the law, for criminal conduct. This “price” has two elements: the severity of the punishment on the books and the likelihood of its imposition in practice. In proper balance, they work together as deterrents to criminal activity, reducing its incidence. But what happens if we introduce an imbalance between these elements, if our laws create stiff penalties that are never imposed? We already know the answer to this question: when potential criminals believe ex ante that misconduct will not be punished, the marginal wrongdoer is incentivized to seek economic rents from misconduct.

Mr. Lowenstein agrees that “[t]o prosecute white-collar crime is right and proper, and a necessary aspect of deterrence.” However, in the current crisis, he sees a wrong but no wrongdoer: “[T]rials are meant to deter crime—not to deter home foreclosures or economic downturns. And to look for criminality as the supposed source of the crisis is to misread its origins badly.” But the hunt for wrongdoers in this crisis is no mere quest for a scapegoat. Rather, it proceeds from the need to protect society from future crises. This will only happen if punishment deters (or incapacitates) the specific wrongdoer from repeated misconduct and deters the general public from similar misconduct by the example of the punishment of the wrongdoer.

The philosophical analysis is more complex—but worth exploring in a wider context. It forces us to examine how well our present regulatory system is capable of dealing with the special types of problems presented by the complex and opaque world of derivatives dealing, problems with which is it is repeatedly and increasingly being required to cope.

Mr. Lowenstein doesn’t quite make the best philosophical argument against criminal prosecutions in this crisis, but he might have suggested the following: any criminal conduct in this crisis was so wide-spread that no wrongdoer’s action stands alone. If any one wrongdoer had not acted improperly another one would have. In other words, where everyone is guilty, no one is.

In other words, while well-constructed derivatives provided certain wholesome benefits, the opportunity to benefit from abusing derivatives was not limited to a single bank or even a single type of financial institution. Rather it transcended the banks and hedge funds and included all types of market participants, from the buy-side to sell-side to the rating agencies and beyond, and all types of individuals working for those participants. In the end, the entire profit maximization motive and the human nature from which it proceeds must be put on trial, so that ultimately we all find ourselves sitting right next to every other defendant in the dock.

Thus, a defense might argue that the “system” seems to have encouraged (and rewarded) wide-spread misconduct and that, given the existence of such a dysfunctional dynamic, one ought to excuse a defendant's acting as a willing participant (or instrument) in this unjust system, if for no other reason than to advance his or her self interests, or lofty ambitions.

The philosophical response may simply be this: an abyss exists between actual wrongdoing and potential wrongdoing. Those who kill while part of a mob really are different from those who are just part of the mob.

But while philosophically that response might appear to suffice, legally there remain certain challenges. Among other things, a prosecutor has to prove both components of a criminal act: criminal conduct and the requisite mental state. The requisite mental states—intentional, knowing, reckless or even negligent conduct—may vary by jurisdiction and they may pose a barrier to the extent they require a determination of the defendant’s level of deviation from that of the ordinary person in a similar environment. (The similarly improper conduct of many or all parties surrounding the defendant may obscure the analysis of a “punishable mental state.”)

But they should not prevent prosecution: the critical question is not “Shall we prosecute?” but “Whom shall we prosecute?”

Nor does the argument hold weight that a subordinate can excuse her role as a mere functionary carrying out the role of her superior. Whether the defendant was only a tiny cog in the machinery, or the motor driving the faulty operation, the relative importance to the resulting order of magnitude of the misconduct serves only to help define the gravity of the sentence imposed—not the probability of its imposition.

17th century Dutch jurist and statesman Hugo Grotius, paraphrasing an earlier Roman authority, explained that "punishment is necessary to defend the honor or the authority of him who was hurt by the offence so that the failure to punish may not cause his degradation."

Given the continued proliferation of improper derivatives dealing, it is punishment alone that can protect our society for future wrongdoing—through stigmatizing the improper acts and by serving as a material deterrence for potential wrongdoers. In this way, restitution will meet the material concerns of the victims of these crimes—the tax-payers.

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[1] The facts have been argued by, among others, Ryan Chittum and Prof. William Black.