Why Stress Test Really Means Guesswork

Well, we’ve heard a ton about stress tests recently. Want some details on what a stress test entails? The Journal has some details about the tests here. Now, as much as I think GDP and unemployment are fine things to project forward for economists, let’s walk through the way one would use this to actually price an asset. Let’s start with something simple, like a 10-year treasury note (note that treasury bond specifically refers to bonds with a 30-year maturity). Here are all the components one would need to stress test the value of a treasury note.

1. Characteristics of the note itself: coupon, payment dates, maturity dates, etc.
2. What the yield curve would look like at the date you’re pricing the note.

Why would one need to know the shape of the yield curve (term structure of rates)? This is important, in order to “PV” the bond’s cashflows most accurately, one would discount each cashflow by it’s risk–the simplest proxy is to discount each cash flow by the rate of interest one would need to pay to issue a bond maturing on that date. For the government, this rate of interest is the point on the treasury yield curve (actually, the par zero curve) with the same maturity date. An example would be, if I were going to price a cash payment I will receive in two years, and the government can currently issue two-year debt at 5%, I should discount my cash payment (also from the government, since it’s a treasury note) at 5%. Treasuries are the simplest of all instruments to value.

Here’s an example, form the link above, of what a treasury yield curve might look like:

Now, it is completely and totally guesswork to figure out, given unemployment and GDP figures, what the yield curve will look like at any date in the future. Indeed, one can plug these projections into a model and it can come up with a statistical guess… But the only thing we know for sure about that guess is that it won’t be accurate, although it might be close. However, things like inflation will drive the longer end of the yield curve and monetary policy will drive the shorter end, so these certainly aren’t directly taken from the stress test parameters, but would need to be a guess based on those parameters. This is a large source of uncertainty in pricing even these instruments in the stress test.

Next, let’s examine a corporate bond. What would we need for a corporate bond?

1. Characteristics of the bond: coupon, payment dates, maturity dates, special features (coupon steps, sinking funds, call schedules, etc.), where in the capital structure this bond sits, etc.
2. What the yield curve would look like at the date you’re pricing the bond.
3. The spreads that the corporation’s debt will carry at the date you’re pricing the bond.

Oh no. We already saw the issues with #2, but now we have #3. What will this corporations credit spread (interest/yield required in excess of the risk free rate) at the time of pricing? Will the corporations debt, which could trade at a spread of anywhere from 5 to 1500 basis points, be lower? higher? Will the corporations spread curve be flatter? steeper?

Here is a good illustration of what I’m referring to (from the same source as the figure above):

There, the spread is the difference between the purple line and the black line. As you can see, it’s different for different maturity corporate bonds (which makes sense, because if a company defaults in year two, it’ll also default on it’s three year debt.. but the companies’ two year debt might never default, but the company might default during it’s third year, creating more risk for three year bonds issued by that company than two year bonds). It shouldn’t be a surprise, after our exercise above, to learn that the best way to compute the price of a corporate bond is to discount each cashflow by it’s risk (in my example above, regardless of whether the company defaults in year two or year three, the interest payments from both the three year and two year debt that are paid in one year have the same risk).

Well, how does one predict the structure of credit spreads in the future? Here’s a hint: models. Interest rates, however, are an input to this model, since the cost of a firm’s borrowing is an important input to figuring out a corporation’s cashflow and, by extension, creditworthiness. So now we have not only a flawed interest rate projection, but we have a projection of corporate risk that, in addition to being flawed itself, takes our other flawed projections as an input! Understanding model error yet? Oh, and yes unemployment and the health of the economy will be inputs to the model that spits out our guess for credit spreads in the future as well.

Next stop on the crazy train, mortgage products! What does one need to project prices for mortgage products?

1. Characteristics of the bond: coupon, payment dates, maturity dates, structure of the underlying securitization (how does cash get assigned in the event of a default, prepayment, etc.), etc.
2. What the yield curve would look like at the date you’re pricing the bond.
3. The spreads that the debt will carry at the date you’re pricing the bond.
4. What prepayments will have occurred by the date you’re pricing the bond and what prepayments will occur in the future, including when each will occur.
5. What defaults will have occurred by the date you’re pricing the bond and what defaults will occur in the future, including when each will occur.

Oh crap. We’ve covered #1-3. But, look at #4 and #5 … To price a mortgage bond, one needs to be able to project out, over the life of the bond, prepayments and defaults. Each is driven bydifferent variables and each happens in different timeframes. Guess how each projection is arrived at? Models! What are the inputs to these models? Well, interest rates (ones ability to refinance depends on where rates are at the time) over a long period of time (keep in mind that you need rates over time, having rates at 5% in three years is completely different if rates where 1% or 15% for the three years before). General economic health, including regional (or more local) unemployment rates (if the south has a spike in unemployment, but the rest of the country sees a slight decrease, you’ll likely see defaults increase). And a myrid of other variables can be tossed in for good measure. So now we have two more models, driven by our flawed interest rate projections, flawed credit projections (ones ability to refinance is driven by their mortgage rate, which is some benchmark interest rate [treasuries here] plus some spread, from #3), and the unemployment and GDP projections.

I will, at this point, decline to talk about pricing C.D.O.’s … Just understand, however, that C.D.O.’s are portfolios of corporate and mortgage bonds, so they are a full extra order of magnitude more complex. Is it clear, now, why these stress tests, as they seem to be defined, aren’t all that specific, and potentially not all that useful?

The Real Problem with the Citi Bailout

We all know that Citi was “bailed out” last week. However, as far as I can see, Citi’s is a unique situation for several reasons:

1. The company was not taken over, and
2. Management was allowed to stay on, and
3. The government is shouldering losses coming from securities that are already identified.

Taken together, these leave a huge hole in this “living bailout” (I call it that because, obviously, Citi was in dire straights but was allowed to survive, essentially, as it existed before) that, obviously, Treasury never thought out (setting aside my prior concerns). I’ll put the problem into a single statement…

When taxpayers agree to pay for losses of a company that is continuing to operate, but the losses being referenced pertain only to specific assets, there are a huge amount of games that can played and the government has no way to stop or monitor what is truly going on.

As a matter of fact, as I write this the news of the G.A.O. report (PDF) on T.A.R.P. is making the rounds. One of the main criticisms is the lack of monitoring of bailed-out institutions. And those institutions don’t have explicit guarantees like Citi does. It is extremely surprising to me that, for example, there aren’t auditors or officials from Treasury meeting with traders and executives of Citi’s mortgage groups regularly. As a matter of fact, I would station some people on the trading desks where these assets are being managed to give status reports and monitor the situation. Further, Hank Paulson’s and Vikram Pandit’s interests are aligned here. Vikram shouldn’t want these assets languishing or Citi being accused of sitting on assets that might lead to a taxpayer loss in the future and Hank Paulson should want to know Citi still feels some obligation to minimize taxpayer’s exposure to losses.

Now, the question of what “games” can be played is the next natural question. Well, if I’m a trader, I mark my own position every day. In mortgages, there is little to no verification of these prices–the markets are so illiquid that only the people that trade the product know the actual value of a given instrument. This conflict, in general, is controlled for by the organizational structure: the person most likely to know the product as well as, if not better than, the trader is the trader’s boss. Obviously, the trader’s boss has little incentive to allow his employees to incorrectly mark the trading book because he can be held accountable. With this “living bailout” though, what incentive does Citi have to sell assets in a liquidity-challenged environment? If no pressure is applied from Treasury, and how can they apply pressure without being deflected if they aren’t “on the ground,” then why wouldn’t Citi just hold assets they currently view as having positive value? Citi likely has assets that are obviously going to go bad, in which case there is likely no way they can offload those assets (perhaps around, oh, say… $29 billion worth…), and assets they view as merely undervalued due to liquidity concerns. Why would I seek out a guarantee on further losses for assets I can sell today? If losses are guaranteed then what’s my downside in just holding illiquid assets?

Because Citi won’t absorb all the losses on the assets viewed as undervalued, those assets are worth more to Citi than others. And, as a trader that gets paid based on his/her personal P&L, I have every incentive to avoid losses that I view as not being inevitable and I have a defensible reason to not mark my position merely to the price I can sell it today. Another nuance comes from how traders actually mark their books…

1. A trader buys mortgage bonds, loans, or any other security. The current profit or loss of that trade (we’ll call it “the bonds” or “the position”) is the purchase price and there is no net P&L.
2. The trader then enters into another transaction that is considered a hedge for the position. This transaction could be buying credit protection, shorting treasury bonds, or any number of other possibilities. We’ll refer to these transactions as “the hedges.” This trade generates no net P&L.
3. On an ongoing basis the position is marked “flat” to the hedges. This means that, dollar for dollar, any loss or gain in the hedges is added or subtracted from the original position so as to generate no net P&L. This isn’t perfect, but it’s theoretically very clean since the point of the hedges is to eliminate the risk in the position.
4. Generally, a price movement in the position that isn’t reflected in similar price movements in hedges is marked manually–usually this takes place at month-end. However, if the original position is sold then the difference between the most recent marked price and the sale price will generate positive or negative P&L as well.

So here’s a good question: Why does a trader, now, have any incentives to hedge? A better question, though, is why would I mark my positions accurately versus hedges? Can’t I make the claim that all the gains in the position, as evidenced by losses in the hedges, should be taken as P&L but only 10% of the losses, as reflected by gains in the hedges, should be taken as P&L? Because the positions hedging the guaranteed mortgage positions are either derivatives or other products that likely aren’t also guaranteed this asymmetry becomes problematic. It’s not even clear that whatever scheme generates the most profits for Citi isn’t the correct way to account for the gains and losses of a typical hedged mortgage position in this atypical arrangement. I know that traders are asking these very questions. However, the possibility that taxpayers could shoulder costs while Citi also books profits whose existence depends on taxpayer-funded guarantees is troubling.

I don’t think anyone would disagree that this arrangement is complicated enough that a higher degree of oversight is required (and should be desired by all parties) to ensure that nothing improper is going on for the sake of taxpayers and Citi’s reputation. One thing we’ve learned from A.I.G. is that even if billions of dollars are at stake expenditures on the order of one hundred thousand dollars can become P.R. nightmares. Treasury should be auditing all of Citi’s mark-to-market procedures and setting standards to protect taxpayers (more so than non-“living” bailouts). Also, as I stated before, there is no reason that there shouldn’t be some sort of watchdog presence on the trading floors to ensure Treasury is keeping watch and being kept in the loop.

House Republicans and the Bailout

Okay, on the Bailout, I’ve been silent for a while. Mainly because it’s not the same from day to day and my thoughts change a lot… Also, John McCain decided he should get in the mix, although Americans seem to have disagreed, and confused the whole thing… But today I heard some things that prove the Republican party, specifically the House of Representatives’ Republicans, are complete and utter idiots.

From Politico:

House Republicans say the potential losses for the taxpayer are excessive. Rather than purchase bad assets, one alternative would be to extend government-backed insurance for the securities with industry paying a fee for the added coverage that could improve their value.

(Emphasis mine.)

Okay, geniuses, what are you going to charge for this magical insurance? I don’t have to remind readers that there is no way to determine this… If one could know what “insurance” like this would cost then they would know what the underlying securities were worth.  Oh, and let’s not forget that the same person who would have to use this authority, Hank Paulson, thinks it’s useless..

“Frankly, he said, ‘If that was added as an option, it wouldn’t hurt, but I couldn’t use it,’” the chairman said of his discussion with Paulson. As for Frank himself? “I wouldn’t mind, but it doesn’t do anything. It’s useless but not harmful,” Frank said. “The problem was in displacing the other stuff.”

(Emphasis mine.)

Oh, and these same stupid partisan arch-conservatives cited Fannie and Freddie as proof that mortgages can be insured… Need an educated person, with even a minimal knowledge of finance and current events, say anything more?

My favorite, though, is how the House Republicans, just like the Underpants Gnomes, want to suspend the capital gains tax so that the economy can recover (“Step 1: Remove Capital Gains Tax, Step 3: Economy Fine”)! What do they say?

“By encouraging corporations to sell unwanted assets, this provision would unleash funds and materials with which to create jobs and grow the economy,” an outline of the proposal said. “After the two-year suspension, capital gains rates would return to present levels but assets would be indexed permanently for any inflationary gains.”

(Emphasis mine.)

Someone needs to tell these free market champions the definition of the word “gains” …

To be sure this is a complicated problem. However, having idiots running around pandering to their base with senseless proposals that are counter-productive complicates things further.

As for the other provisions? Well, I think one needs to step away from their “Wall St.” hat here and look at what’s best for everyone… For many reading this blog I anticipate that’s a hard thing to do. In general, oversight is something I support. I also think that companies that want to avail themselves of public money should give the taxpayers some upside and assurance that they won’t be rewarding people who were responsible for this problem in the first place. How does one implement those things? Seems like the consensus bill being reported gets closer than the other proposals… We’ll have to see what emerges.

Craziest Weekend in Wall St. History: Questions Abound!

What a weekend. I’m sure Wall St. feels a bit brutalized by the events. Now, here are my questions…

1. Doesn’t Lehman have to be involved in moving trades that are facing them? I simply do not understand what the “Lehman Risk Reduction Trading Session” is all about. Indeed, if one looks at the I.S.D.A. Novation Protocol Guide, it’s the case that the “Transferor” (the “Stepping out party”) needs to agree on certain terms. For example:

Negotiating a proposed Novation Transaction:

The Transferor will contact the Transferee to agree a price [sic] for the Novation Transaction.

Seems like “negotiating” and “to agree” seem to indicate the transferor has some decisions and veto power. Also, let’s be honest, all the banks sitting at the table for this situation showed that they aren’t willing to lend a helping hand to their competitors and are acting in self-interest while potentially risking the entire system’s stability (more on this in a bit). How do we know they will be candid with each other and the world regarding their exposures? If I were a bank, I would seek to novate all the in-the-money trades with Lehman and not the ones that are out-of-the-money, right?

And, now that Lehman is winding down, the trades that will be novated away could be hedges. So you have Lehman, sitting with assets it now needs to sell, as their hedges are being novated away and without the ability to put new hedges on. What does this mean? Lehman, in trying to recover maximum value for creditors, will now have to sell quicker or will be holding assets that are unhedged and much more exposed to further market deterioration. Something just doesn’t make sense with this whole thing…

To further complicate things, since the holding company is filing for chapter 11, not chapter 7 does that trigger this special session? Does it matter which entity it is? I suppose we’ll see. Oh, and then there’s this that seems to indicate there’s really no reduction of risk occurring at all, from the W.S.J.:

Some traders said it was difficult to find new counterparties for many of their outstanding trades with Lehman. The snags included different terms and maturity dates on derivatives contracts, and market prices changed rapidly Sunday afternoon. “People were screaming at each other over the phone, asking: How can this work?” one trader said.

William Gross, chief investment officer at bond-fund giant Pacific Investment Management Co., said very few Lehman trades were offset. “There’s an immediate risk related to the unwind of these positions,” he said.

(Emphasis mine.)

2. How is a solvent company with a recovery plan, on Wednesday, now insolvent? If you say it’s similiar to Bear or you mutter the words “run on the bank” then you’re either making something up or you have insider information that has been reported nowehere in the media. Proof? From the W.S.J.’s Marketbeat Blog:

“Ongoing pressure and anxiety in the markets resulted in significant cash outflows toward the week’s end, leaving Bear with a significantly deteriorated liquidity position at end of business on Thursday,” the agency wrote.

Lehman’s prime-brokerage business is smaller than Bear’s relative to its more diverse portfolio, Mr. Sprinzen noted. And Lehman doesn’t depend on hedge-fund clients’ free credit balances to the same extent. In Bear’s case, the “run on the bank” by prime-brokerage clients was a major contributor to its fall.

(Emphasis theirs! [Again, wow!])

Lehman’s prime brokerage certainly isn’t anywhere near large enough to bring down the firm, as was Lehman’s. So, did the Fed and Treasury cause this? By trying to set up a suitor did they make other firms unwilling to fund them and thus cause their death?

Remember that there was consensus before that Lehman could survive.

3. The Treausury and the Fed have a lot of decisions to make. What will they do? Why did they choose this path?

First, it was earlier reported that the Merrill-Bank of America tie-up would be unde-rcapitalized and need regulatory approval. That reference, from the New York Times article has since been removed.

Second, A.I.G. is now hunting for government loans to survive. How can they provide those when they refused Lehman? How can they refuse those when they provided them for Bear? A.I.G. is hardly at the center of the financial system. And, by the way, they went from selling units to not selling units and needing loans in a matter of hours!

Also, what of stability? First, Lehman is just as at the center of credit derivative markets as Bear Stearns was, in corporate credit default swaps and interest rate derivatives probably more-so. And what’s to stop people asking questions and begin to pummel Morgan Stanley or Goldman Sachs?

As Barry cites, perhaps the Fed has caused it’s own problems here:

To be eligible for a bailout, firms must also demonstrate a particular genius for screwing up. Before it went bust, Bear Stearns had a monstrous $33 of debt for every dollar of capital, and hedge funds it owned destroyed hundreds of millions of dollars of clients’ cash. It got a bailout. Lehman Brothers, which has taken painful measures to reduce its risk, is perversely less likely to get direct government help. “The worst Lehman can do is destroy the firm,” said Barry Ritholtz, CEO of Wall Street research firm FusionIQ and author of the forthcoming Bailout Nation. “Bear Stearns, on the other hand, set up the firm so that if they screwed up, they could threaten the entire financial system.” That may explain why Treasury Secretary Paulson has thus far resisted providing federal succor to Lehman.

(Italics theirs.)

4. As for Lehman’s assets, who gets them and what are the terms? I would claim that there should be an auction run. And, perhaps, when that auction is run there would be enough capital to save Lehman? Well, Lehman owns those assets at a different leverage ratio so how would that play? Depends on the price. We have to see if investment banks, like Goldman, did the math and withheld capital from a rescue assuming they could buy the assets on the cheap later.

Okay…. more to come, but that’s what is initially sitting uneasily with me.