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The Asian financial crisis: 10 years later.
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Credit may not be as dirty a word as you think. |
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Volatility hedges have performed well for investors since the beginning of the year. |
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Welcome to Variance Capital's monthly newsletter covering key issues of the global hedge fund industry.
If you wish to contribute or comment on a subject in the coming weeks, feel free to
drop me a line.
Virtually yours,
Martin
 Disclaimer
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As of last night’s close the S&P was up (not by much) and most Asian indices had recovered from the lows of the month. Although, equity indices have held during the month, the Hang Seng as well as several other Asian markets appeared for a while as they were faring much better. This led to some talk of decoupling of emerging markets and risky assets over the more developed economies.
The fact that China is letting a lot of its extra liquidity flow into the Hong Kong market and the increased likelihood of a Fed rate cut (and the government’s commitment to the HK$ and US$ peg) will contribute to increase the value of assets across the region. This may go one for some time but are there any lessons to be learned from what happened 10 years ago?
From the Thai Baht devaluation that heralded the Asian financial crisis in July 1997, much has changed, but much has also remained the same. What has changed was Asia’s central banks have swung from one extreme to the other in their foreign exchange policies: never again is Asia going to use balance of payment deficit to finance growth; instead, each country sought to keep their interest rates and currency lower than normal for longer, accumulate reserves and use consequent expansion in their monetary to finance growth.
What has not changed is Asia’s deep seated structural issues, which will only become visible during financial stress. It was corruption that largely caused NPLs in Thailand to exceed more than 50% of total outstanding loans ten years ago, yet corruption across Asia still alive and well today. It was largely government sponsored capitalism by way of political-economic institution (e.g. Chaebols) that went bankrupt in Korea ten year years ago; today, government sponsored capitalism is alive and well across all of Asia. It was mainly the dominance of capital-demanding and labour intensive (i.e. Cyclical) industries in Asian economies that resulted in large swings in GDP during downturns 10 years ago; today, cyclical industries continue to dominate Asia’s economic landscape. It was excess Japanese capital that crested financial excesses and asset bubbles that eventually burst 10 years ago; today excess global capital from Japan, the middle east, and everywhere else are again building financial excesses and bubbles that have started to burst this summer.
If the Asian financial crisis provides any lessons to money managers, it’s that the big triggers can only be identifiable in hindsight and we are globally interlinked; when the Thai baht devalued, who in the world would have imagined the resultant global consequences?
It is strikingly ironic that Asian markets are alive and active in these summer months in ways only reminiscent of the summer of 1997. Increasingly, stocks become only numbers driven by a wall of liquidity, a sign we may have entered the last wild phases of this cycle.
In the internet/telecom bubble, the dividing line was between the so called “new economy” and the “old economy”. While the prices for new economy stocks went to the stratosphere, old economy stocks languished and became great value plays.. the end game was as such as brick prices went up and click prices went down.
In this cycle, the dividing line is between “emerging markets” and “developed markets”. Never mind many companies listed in developed markets do more business in emerging markets than indigenous (i.e. Asian) companies; and never mind growth characteristics and financial performance of those listed in developed markets are superior, beauty in the eyes of the beholder can indeed depart from reality.
What’s the end game this time? |
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The S&P/LSTA Leveraged Loan Index’s record 3.35% loss in July ranks as a true statistical anomaly: a six-sigma move that is rare to any asset class, let alone the sleepy loan market.
“Of course July’s six-sigma loan move does tarnish the mystique of the loan market as a superb risk/return play. From January 1997 through June 2006, the Sharpe ratio of the loan market was a robust 0.94, towering over high-yield, at 0.44, 10-year Treasuries, at 0.26, the S&P 500, at 0.41 and investment grade bonds, at 0.60. Factoring in July, the loan market’s ratio fell by about a third, to 0.6” concludes Steve Miller of Standard & Poors and adds “This gutted most of the loan market’s lead over the four other asset classes, with high-yield at 0.38, 10-year Treasuries at 0.29, the S&P 500 at 0.38 and investment grade bonds at 0.60.”
August has been peppered with some good news (or perhaps less bad news) but it doesn’t mean investors aren’t nervous. Quite the contrary…. September will bring everyone back at the table and the arm wrestling match between the banks which have committed to financing the latest mega LBO deals and the private equity managers will probably lead to more uncertainty. There’s’ close to $250Bln in commitments that will hit the markets in the next 4 months which we need to absorb.
“Hostilities will begin again in September when the constituencies in the relationship triangle; borrowers/LBO firms, underwriters and investors will be back in the trenches” claim the managers of the Novator Credit Opportunities fund in London and go on to add “The underwriters will continue to be stuck in the middle, caught in the crossfire and exposed to an uncomfortable amount of market risk. Faced with these difficulties and the prospect of a lengthy war of attrition the underwriters are adopting a tactic of playing for time while working covertly to place unwanted subordinated debt on a privately negotiated basis with large hedge funds and mezzanine funds.” As long as the managers have already delevered and can access the markets, the opportunities could be very good. Novator were flat for July and are up for August. They have quite a bit of fire power to directly benefit from the current fire sale.
Another interesting point is the indiscriminate nature of the selling. The outcome of these price actions has led to a secured asset class which is profoundly mispriced versus unsecured credits. They’ve thrown the baby but kept the bathwater opined an investor last week. “Consider the LCDX8 bank loan index of 100 loans” claims David Rich, CIO of the Amida Partners Master Fund “The average LCDX8 borrower is levered 2.8X Debt/EBITDA while the index yields LIBOR + 300. The unsecured HYCDX8 index, which incidentally shares 41 names with the LCDX8 index, has an average leverage multiple of 4.6X and an index yield of only LIBOR + 440. When applying a historical recovery value of 80% to secured levered loans in a cross default scenario, unsecured recovery needs to be a lofty 71% in order to justify the current pricing relationship.” For capital structure arbitrage teams such as Amida’s, this has brought down the cost of hedging dramatically. In essence the ratio of secured (which they’re long) to unsecured (which they short) has gone down from 3:1 (and sometimes 4:1) to 2:1 at present.
“We attribute the relative lack of demand for secured bank loans to the absence of CLO buyers, the overhang from leveraged buyout loans to come and continued deleveraging which should continue for some time” opines Rich. “With the current availability of hedges, the risk reward for Amida going forward looks very favourable” he concludes.
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Volatility hedges have performed well for investors since the beginning of the year. |
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It doesn’t take a PhD in mathematics to observe that a diversified portfolio of hedge funds carries structural beta exposure to equities. A simple regression analysis between the CSFB HF index and the SP 500 confirms FoF manager’s daily observance that the better the equity markets, the better the fund of fund performance. Calculating equity market beta exposure to the CSFB LS index may even scare off some of the more adamant partisans of the efficient frontier theory.
Although this beta seems to remain positive over almost any 36 month rolling periods (long term structural betas range from 0 to 0.4 overall for all strategies Goldman Sachs published in a report early this year), over shorter periods of time beta fluctuate dramatically….and it’s usually on the downside that we feel it most.
We therefore embarked on a mission with Philippe Gazil of Wealth-at-risk in Geneva who offers tailored risk management solutions to Fund of Hedge Funds or single fund managers, introducing him to several of you. At the time the initial impetus was to make the most of risk management products such as variance swaps on equity indices (forward and spot) which were trading at historical lows and offered risk/reward ratios of 4:1. These products gave investor exposure to bursts of implied volatility as markets correct therefore compensating for most of the loss they may have suffered on the rest of their tactical beta exposure. If the markets did well and volatility ground down during that period, they would lose the collateral they placed whilst strongly benefiting on the rest of the portfolio. The insurance product would have cost them less than 50bps on the overall portfolio. On the other hand, if the markets were to correct, the increase in value of the forwards was calibrated as such to “give back” what was lost on the portfolio.
This may appear to some as if we were writing with the benefit of hindsight but for those of you who have met with Philippe, this has been very well documented throughout. Anyway, the proof is in the numbers where our typical overlay program implemented in April when volatility came back down and generated close to 10X the value of the collateral that was put to work.
Our typical program in April was predicated on the relative cheapness of forward volatility in the variance markets for the S&P 500 as well as the fact that the carry trade was alive and well and $JPY spot volatility (its best proxy) was grinding lower from almost historical lows. We recommended FoHF take a 2/3 exposure to forward starting variance swaps on the SPX (starting in September for 3 months) and 1/3 on spot variance for $JPY. Interestingly enough forward variance on the SPX went up from 14.5 vegas (where it was purchased) to close to 16.5 vegas on June 22 when ½ the position was closed. This occurred whilst the indices were going up which clearly showed that even though the markets were strong the risk of a correction (of higher magnitude) was slowly being priced into the September contracts. Clearly a good proposition as investors won both on their portfolio and on their hedges.
By early June the environment was starting to change as was evidenced by the run up in the bellwether 10 Year Treasury yields (June 13) breaking through the downward trend in rates (which was in place for 21 years). This brought many players ( at least in the Fixed Income space ) to reevaluate the risk reward and the risk premia of many assets. The amplitude of the movement and the fact that contagion hadn’t spread to other asset classes led Philippe to amend the program slightly. In late June it was decided to cut the SPX positions by ½ and take profits as investors had already made 100% on the collateral that was put at risk and focus on protection which helps in the riskiest phase of bull markets, when a lot of money can be made but as much can be lost just as quickly. Clearly the sub prime “situation” could act as a catalyst and act as a “reverse liquidity effect” on the US investment banks.
Consequently, it was advised to put that money into CDS on Goldman Sachs as well as the LCDX. Philippe’s thinking was the following:
- Goldman Sachs has known unprecedented growth in its balance sheet since its IPO thanks to several activities that are derived from its IB business (PE, LBOs, M&A, Mortgage issuances, Hedge Funds). Clearly, liquidity can be a problem for the bank in case of the extension of re-rating of leveraged finance structures. Furthermore, Goldman’s profits are very sensitive to a slowdown in trading. These 2 factors were explicitly mentioned by Moody’s and S&P in their credit rating note on Goldman in early July. For a hedge fund of funds this CDS acts as a double hedge.
- The well documented issues on CDOs and the shift in the balance of power these past years from the debtors in the LBO/ PE deals and the bankers/investors has led to a reduction in credit standards (covenant light or no covenants at all with PIKs…). An index which well know too well now called the LCDX was issued in May to help with arbitrage and hedging strategies against the billions in CLOs which were outstanding since 2005. Clearly the problems with CDOs were at some point going to start affecting the CLO market in a pari passu fashion.
The rest is very well documented and these CDS positions, after being implemented on June 22, were closed between August 3 and 16. All it took is to wait out a spike on Dollar/Yen spot variance which occurred in earnest in the first 2 weeks of August and was closed off at 11% also on the climax date of August 16th.
Overall, the P&L generated a close to 10 fold return on the sums that were used as collateral:
- SPX forward variance swaps bought at 14.5% were sold at 16.25% (for ½ the position) and 22% for the rest;
- $JPY spot vol was entered into at 7.2% and sold at 11%; and
- The CDS on Goldman and the LCDX which were entered into at 30 and 140 bp p.a. on June 22 were covered at 80 and 263 respectively on August 6 and 3 (after reaching highs of 90 and 367).
Bottom line is that we’re not at the end of this movement in volatility and have simply reached an August plateau, very instable given the high intraday volatility, post FED and ECB moves. We may still face a third liquidation wave any time from now, that could lead to another higher risk “plateau “ at levels probably another 30-50% on the upside for volatility and credit spreads. As we have retraced a bit, it looks like a reasonable risk/reward proposal to keep some hedges on such as :
- We’re not looking at forwards and prefer spot (short term) volatility at present. It can also be financed in part by selling long term volatility (2 years) which shouldn’t move as much if markets move down from here.
- Spreads on the investment grade index in the States the IGCDX.NA which had gone from 40 to 90 have come back down to 62 bps and represent good risk reward.
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Charles Gave of Gavekal research explores the reasons why this liquidity crisis was special and why we are entering a period where money will be cheap but unavailable.
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Three Reasons Why This Liquidity Crisis Was Special
The liquidity crisis we have just lived through has been nothing short of extraordinary for at least three reasons:
1. The Violence of the Crisis: As our more faithful readers know, we compute a daily velocity indicator whose aim is to measure the private sector’s willingness to take risk (or what Keynes called the markets’ “animal spirits”). Never before had we seen our indicator move from bullish to bearish in such a short period of time (below is our velocity indicator and its six-month rate of change). The damage occurred over less than a month…
2. The Irrationality: The scramble to move into “safe assets” has reached proportions which, very honestly, we would have been deemed to be impossible just a few weeks ago. For example, take the spread between the Fed Funds rate and the 3-month T-bill rate. Both are government controlled interest rates which typically trade fairly close to one another. But today (see chart below), 3-month T-bills are trading at a 40% premium to where they should rationally trade (incidentally, each time this has occurred in the past— 1974, 1981, 1992, 1998, 2002, 2003—one wanted to pile into some form or another of a financial asset). 
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3. The Timing: Our biggest surprise was that the crisis took place because of exposure to “subprime loans” and that the crisis took place this summer. After all, problems with US housing and subprime have been in the news for at least a year (homebuilders started to tank in the summer of 2006). So why, all of a sudden, were markets gripped by fear? A possible answer is on the next page….
The Fear of Downgrades
Reading about the struggling German Landesbanken, it sounds as if a number of banks around the world decided that originating loans was not a very interesting game. Instead, it was much simpler to buy a pre-packaged set of loans benefiting from a rating provided by somebody as reputable, serious and trustworthy as Moody’s or S&P.
And this could also prove to be far more profitable. Under the Basel II Capital Accord, assets rated AAA to AA- have a risk weighting of 20%, assets rated A+ to A- have a 50% weighting, assets rated BBB+ to BB- have a 100% weighting and lower-rated assets are weighted at 150%. So, if you are a bank, the idea is simple: you issue CDs. With the proceeds, you buy a AAA portfolio and keep 20% of capital as reserve. And then, the only thing you need to check is that the difference between the returns of the AAA portfolio and the cost of the CD plus the cost of the reserve remains positive.
Actually, you (the bank) also need to check that the AAA portfolio you hold does not rapidly become an A+ portfolio because, if that happens, everything falls apart in a very short amount of time.
1. If/when a portfolio is downgraded from AAA to A+, the bank must all of a sudden provide 2.5x as much regulatory capital against its portfolio exposure (if the portfolio falls to BBB+, then 5x as much capital must be provided).
2. The trade will typically move into negative cash flows.
3. The portfolios not only becomes un-sellable (since other banks are trying to get out of the same trade), but on top of that, no-one has a clue about how much it is worth (as the market has disappeared).
4. If, by luck, the bank manages to sell the portfolio, it has to take a huge loss on the capital value (say 10%). This has to come directly out of the capital of the bank, which may, or may not, be sufficient to take such a hit.
5. Even if the capital base is sufficient, banks will suddenly support a lot less investments with their newly-reduced capital than they did before.
6. Banks thus sell whatever is liquid (especially shares, which have a very high reserve requirement). The stock market takes a hit, which further increases the cost of capital across the system.
7. Whatever capital banks have left, they place in 3-month T-bills, comforted in the knowledge that the pain will now stop.
From this chain of events, it is easy to conclude that the recent rout did not start with the subprime problem, but instead with the growing realization (acknowledged or not by the ratings agencies) that AAA portfolios may not be quite what they were expected to be.
It is also hard to avoid the conclusion that banks will now be far more constrained in their lending. In the coming months, we should expect the ability of banks to go out and make loans to be seriously inhibited. Which brings us back to a point we have made time and again: When it comes to matters of money, two things have to be considered:
♦ The Cost of Money (which is usually a function of a central bank’s monetary policy)
♦ The Availability of Money (a function of how aggressive the banking and financial systems are in recycling money)
Because of recent events, there is little doubt that the availability of money is falling fast (in fact, it had been deteriorating for a while, as we highlighted in our June 2006 piece A Tighter Liquidity Environment). This means that inflation is going to disappear sooner rather than later. And, from there, we should conclude that it is now time for the Fed to start cutting the cost of money. We are entering into a period where money is going to be cheap, but unavailable.
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Using CFTC data, Ahmad Abdallah of Gavekal research, explains why the price of oil will probably fall after the hurricane scares have subsided. |
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The Commitment of Traders, as published by the CFTC, is a great source of information.
After all, why should we not use the actual positions held by traders to better understand
price formations in the oil markets? Conveniently, the CFTC reports the
position of three separate groups: “Speculators”, “Commercials” and “non-reportable”.
Of the three, “Commercials” (also called “the Trade”) are by far the most important:
In A Few Charts on Energy, we reviewed Net Speculators positions and found them to be not only unsustainably high, but also thought that the new record in net speculative length would prevent WTI from breaking out on the upside. In Back to Backwardation, we wrote that the forward-curve term structure, combined with the very high inventory levels, meant that Commercials would be massive sellers of futures at current prices. In essence, we had one side (the Trade) acting on fundamentals against the other, speculating that prices would make new highs. At the time, we thought that the strong hand was with the Commercials.
The CFTC data can be further mined for interesting information. By measuring the net position of the three reported groups, and by plotting the single largest net position week after week against WTI, we come up with the chart below, which helps us identify the following: a) Since 2005, the Trade has become the biggest buyer of dips/seller of highs; b) the funds (Speculators) have remained trend followers; and c) the small Non- Reportable (retail investors) have remained fond of buying the highs and selling the lows.
It is quite significant to find that the Trade has been huge sellers of the recent WTI price climb to US$78. And, indeed, as we warned in A Few Charts on Energy and Back to Backwardation, while the Speculators entered into massive new net length, Commercials entered into new massive net short.. And, given that the Trade’s fire power far exceeds that of Speculators, oil prices duly sold off.
As we write, the market is growing anxious of the looming hurricane season, so oil has stabilised around US$70. The move to backwardation has also now switched into a shallow contango in the prompt end of the curve. This is an indication that there are still ample stocks out there, at least enough for the market to offer a discount to hold those barrels in storage. This means that the Commercials are recharging their fire power and will be able to sell again, once the market offers a premium.
There are today no reasons to worry about inventories or the supply side. Meanwhile, gasoline prices keep on falling and so, if/when we pass the hurricane season without undue damage, oil prices will most likely correct further.
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