Monday, June 6, 2011

Rearranging the Deck Chairs on the Titanic?

On Monday morning, I had breakfast with Leo de Bever, CEO and CIO at Alberta Investment Management Corporation (AIMCo). We spent almost two hours conversing but time flew by so fast. Leo is one of the smartest pension fund managers I ever met and he grasps the complexities of many issues facing pension funds.

I am not going to delve into details but will share some key points below:
  • The biggest problem Leo sees in the US economy is the lack of business confidence which is impacting investment, much like Keynes wrote about years ago.
  • On bonds, he is worried that the amount of debt issuance in the US will exert upward pressure on bond yields over the next couple of years. He did, however, highlight the possibility that we are heading down some sort of "Japan scenario."
  • I told him that the Fed will do whatever it takes to reflate risk assets and introduce inflation into the system. The last thing banks want is a protracted period of debt deflation.
  • He agreed but added all the QE in the world is just like "rearranging the deck chairs on the Titantic." He is also worried about income inequality exacerbating the jobs crisis.
  • On the Canada bubble, he mentioned an outfit called Demographia, which shows the ratio of housing prices to incomes is exploding especially in cities like Vancouver.
  • But he also admitted he thought the music would have stopped in the stock market and was underweight last year. "You are right, I underestimated that they're going to do whatever it takes to drag this out for as long as possible."
  • We talked about levered versus unlevered benchmarks for private markets, but he and I are on the same page, the opportunity cost of being in private markets is public markets, adjusted for illiquidity and a spread for leverage. On benchmarks, keep it simple.
  • He agrees with Jim Keohane, CIO at HOOPP, that too much money flowing into private markets is driving up prices and lowering expected returns.
  • On seeding funds, he was a little more cautious telling me that he agrees emerging managers are hungrier than more established managers who tend to be asset gatherers but very few will succeed long-term.
I also exchanged emails with Jim Keohane, CIO at HOOPP, on an article I read this morning on Zero Hedge, The Real "Margin" Threat: $600 Trillion In OTC Derivatives. Jim shared these thoughts:

With regard to the article, clearing house practices have been adopted in the OTC derivative market as standard market practice over the past number of years, so there won’t be some giant margin call if and when some of these contracts move to central clearing . Right now, every OTC derivative contract requires the posting of collateral and daily mark-to-market to maintain the counterparty credit risk of the contract within acceptable ranges. The major difference is that in the OTC world, the amount of credit being extended will differ from counterparty to counterparty depending on their creditworthiness. For example, most investment banks will extend a larger threshold level for margin calls to an organization such as HOOPP which has a large balance sheet and is very credit worthy than they would to a hedge fund which may have a very small balance sheet and limited ability to meet the obligations of the contract. In the central clearing world, there is no differentiation made between market participants – if you can meet the margin requirements you can participate.

Also, that $600 trillion number is the gross notional of the outstanding contracts. The actual amount of market risk associated with those contracts is a much smaller number. If this were measured on the same basis as listed contracts, it would be a much smaller number. For example, if I traded a listed contract with you, that would create an open interest of 1 contract. Under the OTC measurement, that would be counted twice – you have and open contract and I have an open contract. In the listed market, if I then traded my position in the market to a third party, there still would be 1 open contract. In the OTC market, if I entered into an identical offsetting trade with a third party, we now would have 4 open contracts. So you can see that the $600 trillion number contains a significant amount of double counting.

You also have to keep in mind that the largest component of that $600 trillion is interest rate swaps. The payments and margin calls on interest rate swaps is based on the difference in the interest rate movements between short term rates (generally measured by 3 month LIBOR) and longer term rates. That differential does not create large payments or large margin calls relative to the notional value of the contract.

I do have some concerns around the rush to move to central clearing. First, the amount of capital backing these contracts will be substantially reduced. In the OTC world, if we enter into a derivative contract with an investment bank, the full capital of that bank backs the contract – and inability to pay is the same as a debt default. Under central clearing, that banks liability on that contract is limited to the capital backing the clearing corp. In effect, we will be moving to a “source and sell” business model, a model that proved disastrous in sub-prime mortgages. If institutions don’t retain the exposure on their balance sheets, they tend to be more lax in their underwriting standards.

Secondly, the move to centralized clearing envisions a move to standardized contracts. As an end user of these contracts, the reason why we frequently employ bespoke contracts is that they are more effective at managing risks. This is particularly true in the interest rate swap market and in the currency forward market where you are trying to hedge specific exposures to which standard contracts are very ineffective. So by moving to standard contracts and central clearing, the ability to hedge risk will be diminished and overall systematic risk may rise.

In my view, the move to central clearing does not address or solve the real problems that lead to the credit crisis. For example the counterparty credit losses resulting from the Lehman bankruptcy are mostly a result of outdated bankruptcy laws with don’t allow for an orderly reorganization of financial institutions the way that Chapter 11 allows for an orderly reorganization of other public companies.

To conclude, people like to throw out these huge notional numbers because they make great headlines, but the amount of exposure associated with these contracts is a small fraction of that number and there is already a daily mark to market and collateral posting taking place in the OTC market which is similar to the clearing house model. I think that there are some issues that will be created by moving to central clearing but not the issues referred to in this article.

Finally, I also received feedback from another sharp pension fund manager who shared these thoughts on the real margin threat:

There’s been a fair amount of commentary about “financial repression” (Carmen Reinhart has been going on about that recently) – governments forcing banks to hold govvies for liquidity management, and as a convenient way to finance their deficits.

It should have the effect of reducing bank profitability ratios, but it should also reduce risk in the system. And it’s great for the conspiracy theorists – they have yet another excuse why their predictions about the impending demise of the Treasury market was again wrong.

There is general agreement that moving to central clearing will increase demands for collateral, but OTC positions already have collateral posted against them. And the collateral does not have to be government bonds, so I would guess this will not be a huge problem. But it should widen bid/offer spreads, as banks will have to embed more capital costs into pricing.

Hope you enjoyed reading this comment and the feedback from senior pension fund managers. Please remember to contribute to this blog through the PayPal button under the pig at the top of the page.

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