Risks Of Irrational Fear In The Market

As the credit confidence crunch takes a major victim in Bear Sterns, there are a growing group of investors and financial advisors that are talking about the next bank to fail. The current speculation is on Leman Brothers, with some still talking about Citigroup, Merrill Lynch, and the other usual suspects. While recent events do lend credence to the worrywarts, the level of negativism has sunk too far into the nadir of pessimism. It is the growing strength of the negative sentiment that is driving the market right now and causing significant loss in market value of many firms, especially the financial institutions.

What can an informed investor do? First take note of historic data, below, which indicates that the losses, while large, will be easily absorbed by the market correction. Second, know that the fear factor is driving the market right now. And it is this driving fear that is causing the irrational moves that can easily lead investors to substantially losses.[i]

So, let’s take a look at the facts, then figure out the potential losses, and conclude with why all of that really doesn’t matter in the current market.

A Look At Past Major Economic Events
One thing that investors need to realize and understand is that the fear of losing money created the actual losses to the creditors. While some of the Alt-A loans securities and high-yield bonds are going to default, the default rate will not be in the range that begets a run on the bank.

Junk Bonds: According to Moody’s, historic default rate of corporate bonds, from 1920 to 1999, have been below 2%. However, there have been periods of high default rates:

1. 1932, the historic peak during the Great Depression: peak of 9.2% in July
2. 1970, due to default of Penn Central Railroad and affiliates: approximately 3% (>8% for junk bonds)
3. 1991: 4.1% (5.71% default rate for junk bonds)
4. 1999, after the Russian financial crisis: 2.19% (5.51% default rate for junk bonds)
5. 2000: 2.28% (5.71% default rate for junk bonds)[ii]
6. 2002, post dot-combust: 10.9% default rate for junk bonds[iii]

Additionally, from S&P, via the way of Sterns Business School, is a chart of the recent junk bond default rate from 1998 to 2006:

Mortgage-back Securities: According to Fitch Rating, the average annual default rate of Fitch-rated
MBS and CMBS, from 1994 to 2005, were 0.231% and 0.268%, respectively.

Rational View Of Potential Defaults And Losses In 2008-2009
Moody’s report notes that the average recovery was 43%[iv]. This means that if a bond defaults, an investor received, on average, 43 cents back for every $1 invested.

So the doom and gloom forecast of near total collapse by fly-by-night blogging charlatans seem way too pessimistic and unreal, when put into historic perspective.

Junk Bonds: Moody’s is now projecting the global junk bond default rate to rise to 4.2% in 2008 and reach 4.7% by November 2009.[v] Moreover, Professor Edward Altman, the New York University professor who created the Z-score mathematical formula for measuring a company's bankruptcy risk, stated that the junk bond default rate would go to 4.64% in 2008[vi]. So there is a range of 4.2% to 4.7% rate of probable default out of the $1.1 trillion junk bonds currently outstanding.

Assuming that this range is correct, we can arrive at a loss potential of $46.3 billion to $51.7 billion in junk bonds will default. Using a recovery rate of 43 cents on a dollar, the net loss to investors is expected to range, approximately, from $31 to $34.6 billion.

Mortgage-back Securities: As for MBS, which had $6.1 trillion outstanding as of 1Q 2006, the historic default rate is lower than the junk bond default rate. Even if we apply the Moody’s 2008-2009 default rate projections for junk bonds to the MBS, the total loss potential ranges from $256.2 billion to $286.7 billion.

Applying a recovery of 60cents on a dollar, which conservatively assumes that the value of the real estate securing the loans will drop by a total of 40%, the net loss to investors is expected to range, approximately, from $102.5 billion to $114.8 billion.

The Future Looks Bad But Is Not All That Bleak
While a potential loss to investors of $133.5 billion to $149.4 billion in 2008-2009 is a large sum, most of the projected losses has been baked into the market already. In their paper "Leveraged Losses: Lessons from the Mortgage Meltdown," by David Greenlaw, Jan Hatzius, Anil Kashyap, and Hyun Song Shin, the total credit loss from the mortgage melt down is expected to be $400 billion with U.S. leveraged financial institutions experiencing about $200 billion of this loss[vii].

However, Pessimism Runs Deep
So, while the reality is not that bleak, as Fed Governor Miskin had said in his February 2008 speech:

“…relatively small losses in one sector of the credit market can have an outsized impact on aggregate economic activity if they cause a disruption to the financial system that leads to an amplified impact on lending.”

“It is not just the impact on leveraged financial institutions that matter, but on the overall ability of the financial system to channel funds to those institutions with productive investment opportunities.”

For a Fed Governor to come out and clearly articulate that there is a major disruption to the financial and investment industries is, given the current nervousness of the market, a clear indication of how pervasive this irrational fear is gripping our economy.

Conclusion
So, informed investor take note that, due to the currently high level of irrational fear in the market, the slow down in the U.S. economy will be more severe that if this was a simple case of the market correcting itself, as was the case after the dot-com bubble popped. Even if the facts are indicating the slow down may not be that severe, the market is now being driven lower by a collective movement built around irrational fear that things will get worse than it is already. While the facts indicate otherwise, it is not a wise move to fight the market when it is stampeding. And right now, the market is stampeding right over a cliff.

May Your Trading Be Profitable

Regards,
Ed Kim
riskyops.blogspot.com
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[i] http://blogs.wsj.com/deals/2007/12/20/joseph-lewis-cautious-bear-stearns-tale/
[ii] Default Risk.Com
[iii] http://www.cfo.com/article.cfm/3551981?f=search
[iv] http://www.moodyskmv.com/research/whitepaper/52453.pdf
[v] http://www.cfo.com/article.cfm/10272612?f=search
[vi] http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aYqRAVjaH4DY
[vii] http://www.chicagogsb.edu/usmpf/docs/usmpf2008confdraft.pdf

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Federal Government To Revamp Credit Rules: Good Intent, Bad Execution

The Wall Street Journal reported today that the U.S. government would release a broad blueprint for preventing a re-occurrence of the current credit crisis:

“Mr. Paulson told The Wall Street Journal that the recommendations of the President's Working Group on Financial Markets, which he leads, include strengthening state and federal oversight of mortgage lenders and brokers. The group will also recommend implementing what he termed "strong nationwide licensing standards" for mortgage brokers, a move that will probably require legislation.

The group also will propose directing credit-rating firms and regulators to differentiate between ratings on complex structured products and conventional bonds. In addition, it wants rating firms to disclose conflicts of interest and details of their reviews and to heighten scrutiny of outfits that originate loans that are enveloped by various securities.

Another recommendation from the panel is to push issuers of mortgage-backed securities to disclose more about "the level and scope of due diligence" and about the underlying assets of the securities. The panel is also seeking disclosure of whether "issuers have shopped for ratings" -- that is, have had to go to more than one credit-rating firm before getting the triple-A stamp of approval.

And the panel will urge global bank regulators to revisit the latest version of bank capital requirements, known as Basel II for the Swiss city where they were negotiated, so that banks that take on risks hold sufficient capital. The panel also wants regulators to complete updated standards for how banks manage liquidity.”

While the intentions are good, it appears that the execution of these good intentions is going to be done badly. The attempt by Henry Paulson and Co. are well intended but the draft of what they are proposing raises far more question about how the revised oversight will work and what will be done about the existing regulations.

Strengthening State And Federal Oversight Of Lenders And Brokers:
Currently, each State maintains oversight of mortgage brokers. While the States oversights lack uniformity, to enforce a national standard would risk infringing on the State’s rights to self-govern. Moreover, there is a high probability of risk that the national standards would be a very watered down, compromised legislation that may not address the core issue of preventing unscrupulous broker and/or lending activities.

As for the oversight of the lenders, we already have an interagency governmental body, the FFIEC, which is charged with ensuring uniformity of bank examination between FDIC, OCC, FRB, OTS, and NCUA. Moreover, FFIEC has an advisory State Liaison Committee that is composed of five representatives of state supervisory agencies. So, as for the strengthening of the federal oversight, what is the working group proposing that the FFIEC cannot currently do?

Separate Rating Standards For Complex and Conventional Bonds:
Who determines what is complex and conventional bonds? What happens if a bond structure contains only different AAA rated traunches of various municipal bonds?

Would this bond be considered to be a complex bond when it only consists of AAA municipal bond traunches?

Are we increasing the risk of creating a confusing array of ratings that may lead to investors comparing ‘Apples to Oranges’?

Potentially, we could have a situation where the AAA rating of a conventional bond is a better credit than the AAA rating of a Complex bond.

Who gets the asterisk next to their AAA rating?

Who will ensure that the rating agencies will apply uniform rating standards for new issues as well as re-rating of existing issues? There is also a knock-on risk to the bond insurance business.

Rating Firms To Disclose Conflicts Of Interest And Details Of Their Reviews:
How will the regulators monitor what is appropriate disclosure or insufficient disclosure?

How will the regulators determine if there is a conflict of interest of insufficient details of review?

Does this mean that the regulators will have to review and approve the actions of the rating agencies prior to the rating agency publishing their rating? How will that work?

If the regulators determine that the disclosures and details are insufficient or improper, does this mean that the rating is invalid?

Are we adding a risk that the regulators will be asked to rate the rating agency?

Currently, the rating agencies are paid by the issuers to rate their proposed transaction. If this process remains the same, then every rating will have a standard conflict of interest language embedded in their rating. So, if that is the likely outcome, then what really is the benefit? After all, the current disclosure by the rating agencies include conflict of interest and other disclaimers:

Moody’s disclaimer:
“NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling.

MOODY’S hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODY’S have, prior to assignment of any rating, agreed to pay to MOODY’S for appraisal and rating services rendered by it fees ranging from $1,500 to approximately $2,400,000.”

S&P disclaimer:
“Analytic services provided by Standard & Poor's Ratings Services (Ratings Services) are the result of separate activities designed to preserve the independence and objectivity of ratings opinions. The credit ratings and observations contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Accordingly, any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision. Ratings are based on information received by Ratings Services. Other divisions of Standard & Poor's may have information that is not available to Ratings Services. Standard & Poor's has established policies and procedures to maintain the confidentiality of non-public information received during the ratings process.

Ratings Services receives compensation for its ratings. Such compensation is normally paid either by the issuers of such securities or third parties participating in marketing the securities. While Standard & Poor's reserves the right to disseminate the rating, it receives no payment for doing so, except for subscriptions to its publications. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.”

Lastly, this basically seems to be a repeat of the Investment Company Institute’s 2002 request to SEC on rating agency, which recommended that:

“the Commission [SEC] consider adopting the following regulatory improvements:

§ a new regime of vigorous and continuing Commission oversight of the credit rating agencies;

§ public disclosure of the resources, standards, procedures, and policies employed by the agencies in their rating process;

§ a new public comment and review process regarding the agencies' performance, standards, and methodologies; and

§ legal accountability.”

Heighten Scrutiny Of Outfits That Originate Loans That Are Enveloped By Various Securities:

What type of heighten scrutiny is the working group seeking to accomplish that the SEC, OCC, FDIC, and other regulatory bodies currently not performing?

Isn’t this a backhanded slap at the regulatory bodies for not doing their jobs properly?

Are we at risk of creating an additional layer of regulatory framework that may hinder the existing one?

Issuers Of MBS To Disclose More About "The Level And Scope Of Due Diligence" And Underlying Assets:
How much more disclosure is required and how is that disclosure going to prevent a similar crisis? Isn’t the Prospectus already providing the level of disclosure and detail required? Isn’t this what Regulation FD is supposed to provide?

Disclosure Of Whether "Issuers Have Shopped For Ratings":
Again, how is this disclosure going to prevent a similar crisis?

Typically on a MBS transaction, at least two of the three rating agencies rate the transaction. Most times, all three rating agencies rate the transaction. If the issuer did shop around, given the very finite number of rating agencies that investors typically look for – S&P, Moody’s, and Fitch Ratings – there really isn’t much this disclosure will do to help the investors.

Urge Global Bank Regulators To Revisit The Latest Version Of Bank Capital Requirements:
The Basel II framework already stipulates the methodology for calculating reserves using a risk-based approach. The reason the banks did not hold sufficient reserves in the first place was the ability of the banks to take the loans off their balance sheet via securitization. There is no need to revise the Basel II capital requirement. Rather, prevent offloading of loans from banks balance sheet, which will then force the banks to include the loans into their capital reserve requirement calculation.

In conclusion, I would have hoped to read that the Federal government would at least allow the market to take its natural course in the current credit crunch. However, it is very clear that the government is taking a heavy-handed approach to save financial institutions that made large bets on MBS and credit derivatives and are now losing their shirts. I wonder if the Federal Government would have done the same if Enron was a brokerage house.

Regards,
Ed Kim
http://riskyops.blogspot.com/
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