The REcapitulator was asked by an acquantance the other day how the CDO market is effected by the MBS markets, and I found my response was far too complicated for a layman. This deficiency cannot stand uncorrected, and thus I write today to simplify how these two derivatives interact.
An MBS, or mortguage-backed security, is a derivative that provides cash-flow rights from a group of mortgages to a buyer of the security.
Lenders to homes like to securitize liabilities like mortguages because it frees
up capital for other purposes in addition to being a profitable business itself.
However, when the MBS is backed by "sub-prime" borrowers, it is difficult to find bidders for the securities (one of the reasons investors like MBS's is because they exhibit a property called negative convexity, and a post on this will be forthcoming).
I-banks cater to needs of disparate investors, some of whom like very safe investments, some willing to hold more risk, and some willing to hold a great deal of risk, of course hoping to reap a more handsome reward.
So I-banks divide the MBS securities into several different "levels" (spatially speaking, not geographically speaking) of risk and return. The levels are typically described, proceeding from lowest risk level to highest risk level, as "Investment Grade",
"Mezzanine", and "Equity". These categories as also known as "tranches" and are now grown up to become "CDO"s, or Collaterlized Debt Obligations - securities that depend on the values of the MBS groups so divided.
And so we follow the money. Cash flows from the mortguage payments now flow first to capitalize the safe, from a probablistic standpoint, investment grade bonds. Any remaining cash flows go to the mezzanine level, and then any remaining cash flow finally makes its way to the (by now somewhat nervous) "Equity" level CDO holders.
When there are mortguage defaults and slowing cash flows, firms like Bear Stearns, which opened a coupld of hedge funds for the specific purpose of investing in the "Equity" level of CDOs, get in trouble very quickly. Since the securities depend on the cash flows from the underlying mortguages, no money flowing to the Equity level means that these securities, which are not often traded, must be valued at far, far less than when the housing market was booming.
Saturday, June 30, 2007
Friday, June 29, 2007
Inflation Expectations and the Fed
It is well-known among the finance community that Ben Shalom Bernanke believes inflation expectations is a more useful predictor of future inflation trends than current (that is, "current" in the sense that CPI figures is a compliation of data gathered in the past) inflation.
Mr. Bernanke has been very transparent about this. So now the REcapitulator is wondering how our wonderful Fed, the most important central planning organization on the planet, is going to react to the inflation expectation figures complied by the University of Michigan:
Month Inflation Expectation (one year ahead)
July 3.4%
June 3.5%
May 3.3%
April 3.3%
March 3.0%
This will be an interesting test for close observers of the Fed to see how Mr. Bernanke deals this report, and compare it to previous central bankers who are now part-time consultants to very large bond funds.
Mr. Bernanke has been very transparent about this. So now the REcapitulator is wondering how our wonderful Fed, the most important central planning organization on the planet, is going to react to the inflation expectation figures complied by the University of Michigan:
Month Inflation Expectation (one year ahead)
July 3.4%
June 3.5%
May 3.3%
April 3.3%
March 3.0%
This will be an interesting test for close observers of the Fed to see how Mr. Bernanke deals this report, and compare it to previous central bankers who are now part-time consultants to very large bond funds.
Wednesday, June 27, 2007
Modus Ponens
Economic theory and economists tend to make arguments based on narrative causal connections based on some sort of "equilibrium" theory. The REcapitulator thinks pundits like Jeremy Siegel are amusing when he opines that it is "more difficult to analyze" commodities than traditional asset classes like stocks and bonds. If "more difficult to analyze" is a euphemism for "I don't have the proper tools to B.S. an answer", then I completely understand.
Modus Ponens (B follows A, A is present, therefore we have B) is a simple logical format, and, finding little fault with the basic logical structure of the argument, we instead find that Modus Ponens is misapplied to a system that is far too complex
to simply collapse "N" (where "N" is a very large number) variables into "B follows A".
I am reminded of Ludwig Van Mises and his unending critique of this system of thought. This quote sums it up nicely:
"there is no experience of future happenings…the experience to which the natural sciences owe all their success is the experience of the experiment in which individual elements of change can be observed in isolation. The facts amassed this way can be used for induction…No laboratory experiments can be performed with regard to human action. We are never in a position to observe the change in one element only, all other conditions of the event remaining unchanged”
The REcapitulator agrees. Thinking participants alter the game, and 3rd order thinking ("What does he think I think he is thinking") is not observed amongst the natural sciences.
Modus Ponens (B follows A, A is present, therefore we have B) is a simple logical format, and, finding little fault with the basic logical structure of the argument, we instead find that Modus Ponens is misapplied to a system that is far too complex
to simply collapse "N" (where "N" is a very large number) variables into "B follows A".
I am reminded of Ludwig Van Mises and his unending critique of this system of thought. This quote sums it up nicely:
"there is no experience of future happenings…the experience to which the natural sciences owe all their success is the experience of the experiment in which individual elements of change can be observed in isolation. The facts amassed this way can be used for induction…No laboratory experiments can be performed with regard to human action. We are never in a position to observe the change in one element only, all other conditions of the event remaining unchanged”
The REcapitulator agrees. Thinking participants alter the game, and 3rd order thinking ("What does he think I think he is thinking") is not observed amongst the natural sciences.
The Fed's Perspective
This excerpt from the FT, in light of my previous post on the Fed, is important:
By Krishna Guhain Washington
Federal Reserve officials are expected to discuss ways to redirect market
attention from current core inflation to its forecast of headline inflation at
this week's meeting of the rate-setting open market committee.
The meeting, the first since the sell-off in the bond market pushed up long-term
interest rates, will end with the Fed affirming its focus on inflation risk.
However, there could be extensive changes to the statement to reflect evolving
concerns on prices.
To date, the Fed has talked about the current level of core inflation, which
excludes food and energy prices, as "elevated" and emphasised the need to ensure
it comes down.
But with core inflation as measured by the personal consumption expenditure
deflator likely to edge below 2 per cent in May, Fed officials no longer agree
on whether it is elevated or not.
By Krishna Guhain Washington
Federal Reserve officials are expected to discuss ways to redirect market
attention from current core inflation to its forecast of headline inflation at
this week's meeting of the rate-setting open market committee.
The meeting, the first since the sell-off in the bond market pushed up long-term
interest rates, will end with the Fed affirming its focus on inflation risk.
However, there could be extensive changes to the statement to reflect evolving
concerns on prices.
To date, the Fed has talked about the current level of core inflation, which
excludes food and energy prices, as "elevated" and emphasised the need to ensure
it comes down.
But with core inflation as measured by the personal consumption expenditure
deflator likely to edge below 2 per cent in May, Fed officials no longer agree
on whether it is elevated or not.
Tuesday, June 26, 2007
The Fed's view
It is axiomatic when analyzing the Federal Reserve's opinion of their management of short-term interest rates (the price of Federal Funds), one must attempt to determine which factors the Fed over or under weights in their view of the economy.
To that extent, the REcapitulator submits these words from Mr. Bernanke in his Humphrey-Hawkings testimony from 2/14/07:
Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the members of the Board of Governors and presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts--which are based on the information available at that time and on the assumption of appropriate monetary policy--is for real GDP to increase about 2-1/2 to 3 percent in 2007 and about 2-3/4 to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. This difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4-1/2 to 4-3/4 percent.
The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006.
To that extent, the REcapitulator submits these words from Mr. Bernanke in his Humphrey-Hawkings testimony from 2/14/07:
Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the members of the Board of Governors and presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts--which are based on the information available at that time and on the assumption of appropriate monetary policy--is for real GDP to increase about 2-1/2 to 3 percent in 2007 and about 2-3/4 to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. This difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4-1/2 to 4-3/4 percent.
The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006.
Monday, June 25, 2007
Paper Dragon
Readers of this blog already know the REcapitulators opinion of China. Now, the Bank of International Settlements weighs in with a good rendition of the "somewhat" obvious...
The Chinese economy seems to be demonstrating very similar,
disquieting symptoms," it said, citing ballooning credit, an asset
boom, and "massive investments" in heavy industry.
Some 40pc of China's state-owned enterprises are loss-making,
exposing the banking system to likely stress in a downturn.
It said China's growth was "unstable, unbalance, uncoordinated and
unsustainable"
Still Communist. Still Centrally Planned. Still harboring great masses of people that have no access. Hayek's "The Fatal Conceit" contained all of the intellectual groundpinnings for the refuation of such a plan.
Now let's add massive corruption and near institutionalized cronyism, which appear to be invevitable evolutionary appendages to Communism, and you have the paper dragon of China.
The Chinese economy seems to be demonstrating very similar,
disquieting symptoms," it said, citing ballooning credit, an asset
boom, and "massive investments" in heavy industry.
Some 40pc of China's state-owned enterprises are loss-making,
exposing the banking system to likely stress in a downturn.
It said China's growth was "unstable, unbalance, uncoordinated and
unsustainable"
Still Communist. Still Centrally Planned. Still harboring great masses of people that have no access. Hayek's "The Fatal Conceit" contained all of the intellectual groundpinnings for the refuation of such a plan.
Now let's add massive corruption and near institutionalized cronyism, which appear to be invevitable evolutionary appendages to Communism, and you have the paper dragon of China.
Autocorrelation
The REcapitulator has reviewed many prospectuses in his day. Most of the statistical studies included therein are utterly depressing.
The most glaring problem is the sample period of returns. Mutual funds, as a rule, cannot help but fit their returns to the time period that produced the greatest period of compounded returns...fancy that.
And do not get the REcapitulator started on "risk" parameters such as beta or the sharpe ratio, both of which fall prey to difficulties with autocorrelation.
Since "Beta" (again: WHY do we insist on using Greek variables in Finance?) is a measure of the covariance between an asset and the "market" in terms of the variance of the "market", autocorrelation, or the tendency for time-series data to be MORE dependent on adjacent values than values from the past, rears its ugly head.
The REcapitulator has never seen good mutual fund reports that include all the correct statistical studies...but that would not be good for marketing, now would it???
The most glaring problem is the sample period of returns. Mutual funds, as a rule, cannot help but fit their returns to the time period that produced the greatest period of compounded returns...fancy that.
And do not get the REcapitulator started on "risk" parameters such as beta or the sharpe ratio, both of which fall prey to difficulties with autocorrelation.
Since "Beta" (again: WHY do we insist on using Greek variables in Finance?) is a measure of the covariance between an asset and the "market" in terms of the variance of the "market", autocorrelation, or the tendency for time-series data to be MORE dependent on adjacent values than values from the past, rears its ugly head.
The REcapitulator has never seen good mutual fund reports that include all the correct statistical studies...but that would not be good for marketing, now would it???
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