The (Price) Discovery Channel
by Brian Pretti CFA, Contrary Investor. October 12, 2007
How wonderful. The Fed has once again bestowed upon the masses (to say nothing of their Wall St. handlers) the magic elixir of a Fed Funds rate cut. More to come from here? C'mon, are you kidding me? Prepare yourself as I can already hear it coming. "How low can they go?" will be the question asked again and again as we move forward. I won't even go there in this discussion, but rather pose a question. In terms of the reality of the financial and greater credit markets, what will Fed rate cuts actually accomplish in the current environment? Of course the feel good aspect of the simple perceptual act has literally been ingrained in the investment mindset throughout the Greenspan reign of monetary terror. Cut interest rates and all is well. Cut rates and stocks rally big time. Cut rates and consumers borrow. Cut rates and… well, you get the picture. Sound familiar?
But one of the important questions certainly becomes, will Fed rate cuts necessarily help those in the real world who need to refi their mortgages over the next 12 months (and beyond)? That depends on whether those who lend in the credit markets follow the Fed as the short end of the curve declines. In a macro sense, given that so many credit spreads were at or near historic lows prior to the first Fed Funds rate cut for this cycle, it may very well be that as the Fed cuts rates, greater credit market yield spread widening is accomplished on a de facto basis, while costs of mortgages, corporate lending, etc., simply stay static on a nominal cost of funds basis. If this is to be the case, then no one is going to be helped in the world of the real US economy. As you'd guess, we need to let the markets "show us" where outcomes may lie ahead. Fed funds rate cuts in and of themselves mean very little. It's the nominal cost of capital to consumers and businesses that make the world go around. That's controlled by the credit markets, not the Fed.
Speculating on financial market outcomes is fun, but quite unproductive in foresight. What we do know is that post the first Fed rate cut, oil and gold went to new highs. The dollar hit new multi-decade lows, and long dated bond yields rose as long maturity bonds sold off. The vote of the financial markets for now seems pretty clear. The tribe has spoken and voted any sense that the Fed is an inflation fighter off the island. The markets are screaming that monetary inflation ahead will indeed have a meaningful impact on real economic inflation. But, instead of engaging in relatively mindless speculation about the Fed and the theoretical cure all of rate cuts, I want to discuss another macro issue I believe is very important right here and right now. I'll do my best to keep this short, but can’tpromise much. Right to the bottom line, what I believe is most important, especially to the credit markets so essential to the functioning of the US and the global economy, right now is the process of price discovery. Although I can assure you I'm going to gloss over the specific details here, the important point is the concept, not describing credit market vehicles in detail. As is clear, in many parts of the globe, credit market conditions continue to remain "abnormal." And it seems clear as a bell that this state of affairs is set to continue until true price discovery takes place in the credit markets.
Let's set the scene a bit. You already know that structured finance has been the hallmark credit market characteristic of this and a good chunk of the last decade. New age credit market vehicles developed by new age quant arrivals to the Street, sold to supposedly new age investment "managers," that are now the new age financial market problem de jour. And the problem emanates from the fact that so many of these structured finance vehicles have been "marked to model" in global investment portfolios far and wide for years now. There has been no continuous or quoted market for these products conjured in the minds of math Ph.D's and statistician wizards far and wide. CDO's, CDO's squared, CDO's cubed, CLO's, etc. – what is the specific value of these and maybe other new age structured products in the open market? This is the key. No one really knows. As you may know, for years I have been documenting the character of the US banking system derivatives holdings. A long-term key issue being over 90% of these vehicles are OTC (over the counter). There is no stated or quoted market for these financial contracts. Ongoing values, against which theoretical real world risk management techniques are performed are derived from mathematical models, not from the daily and ongoing vote of actual supply and demand in a free market environment.
My bottom line macro comment of the moment is that before the credit markets can even begin to return to a sense of some type of normalcy (whatever that means in today's much different world), we need to know what these credit market instruments are worth. Not what the models suggest they are worth, but what they can bring in a public auction – otherwise known as the global credit markets. We need to go through the process of price discovery. Period. And that clearly has not happened yet. I'm not even sure it has begun. Yes the problem has been identified. Yes, it’s the 800-pound gorilla in the room. But can those involved with this gorilla see it? Or is it that they really don't want to see it? It seems everyone involved is simply waiting "for the next guy" to make the first move.
How can investors in a hedge fund be expected to pay fees when the real market driven value of the collateral underpinning securities held by that fund are truly unknown? How can insurance companies mark their credit market portfolios to market, and make insurance pricing decisions based on their investment returns, when market values of some of their investments are unknown outside of a value driven by a quant model? How can banks truly assess their credit risk or their capital flexibility when they may be forced to take back onto their balance sheets commercial paper whose market value is in good part a guess? The Fed can provide liquidity and put on a very good perceptual show of lowering the Fed Funds rate, but does this really help in terms of moving toward credit market price discovery – a key to the normal functioning of really any market? I can't see how.
So how does price discovery really begin? First, I wish I knew with certainty, but there really are no rules. There is no quoted or centralized market for modern era structured products. Does price discovery begin with insolvency events? Does it begin with the failure of a large financial institution whose assets are ultimately liquidated, forcing "market values" to be realized? Does it begin with fiduciary boards who now find out they own such vehicles, realize exactly what they are, and act to jettison them from institutional portfolios because what they were sold as a AAA credit simply isn't?
Very, very simplistically, credit markets function by acting to lend against collateral whose value is either known or can be readily ascertained in public markets. In today's modern credit era, we simply took this to a new level of lending against and leveraging against derived values. Values driven by mathematical models. Unfortunately, human beings do not function in line with mathematical models. And we have been shown again and again throughout history that neither do financial markets. LTCM should have taught us this lesson almost a decade back, unfortunately it seems few in the credit markets were listening. Again, in today's world of CDO's, CLO's, etc., there seems to be a conceptual LTCM around every corner – an institution basing both its investment decisions and ongoing "market information" (prices) on mathematical models. So as we stand here today, enter the real world.
I've alluded to this price discovery issue in the recent past, but really wanted to get the point across in this period of yet more Fed Funds rate cuts to come in that the real and most important issue for really the global credit markets has not been solved. In fact, it has not even been addressed. Plain and simple, price discovery HAS to occur if any attempt to reflate the financial markets has even a prayer of succeeding. Do you really think this very meaningful process of price discovery is to be without pain? Without admission of risk management mistakes? Without actually booking credit related losses? In 3Q earnings reports, the banks and a number of assorted financial enterprises have started the process of writing off identifiable credit problems. But with credit market turmoil only really rearing its ugly head in the summer of this year, there is no way the totality of mark-to-model leveraging has been completely addressed and "put behind us," as we've heard a number of analysts and commentators suggest. We're in the first inning here, not the bottom of the ninth.
Before getting too carried away with yet another Fed monetary inflation train ride, be aware that this train is on the same track as the credit market price discovery train headed directly for it. Point blank, credit market issues have not been solved because the Fed cut the Funds rate. Nor will they be solved if the Fed cuts again, which they surely will. The only way to reflate the system, if that's the Fed's intent (which it is), and to return some sense of order to the credit markets is to tune into the discovery channel. The price discovery channel, that is. It just seems no one yet has had the guts to pick up the remote and tune in. C'mon credit markets; let's do like they do on the Discovery Channel. You know you're gonna have to sooner or later. Might as well get it over with and get on with life, okay? The longer the price discovery process in the credit markets is forestalled or avoided, the more dysfunctional will be the credit creation process. Not a good thing for a major economy running on a credit cycle. After all, God forbid the discipline of an actual business cycle starts to take hold, right?
One last point, especially in light of recent Fed action. It is now more than clear that Bernanke will talk out of one side of his mouth, but act in an opposite manner literally days later. Please forget the rhetoric and spin from the Fed and their brethren. The actions are clear. Reflation is again the order of the day. Problems I described above resulting from the misallocation of cheap credit over prior years will be addressed by the Fed with more of the same - cheap credit. As I have maintained for years, the Fed is a one trick pony. There are no other tricks. So, as long as these credit market issues of price discovery exist, expect more of the same - more rate cuts and accelerated open market operations. Do yourself a favor and read the FOMC statement following the first rate cut. What's different this time? The big difference is that they directly use the words "financial markets" a number of times. Any questions? Could it be any more clear than that? And please don't forget that the equity markets and the real economy are two different things over the short run.
The US economy that is running largely on a credit cycle needs to accelerate credit expansion in order to maintain stability and move forward. Please remember, I'm referring to the real economy here, not the world of financial markets (specifically equities). For that to happen, the credit production engine needs to be restarted and accelerated. And that means collateral values need to be trusted, or at least obtainable in a market quote, not that "models" have shown themselves once again to be a bit lacking. After all, just how many banks do you believe are willing to lend forward against collateral values produced by a mathematical model at a hedge fund? Just how many university endowments or pension funds will be willing to commit capital to investments whose return, or price, is derived from a model each quarter, as opposed to a quote on the Bloomberg screen? You get the point. The KEY issue for the credit markets – price discovery – has not been yet addressed. I'll leave you with one last table of numbers that really says it all for an economy running on a credit cycle. It's either ever faster or else. Capiche?
|Credit Market Debt And GDP Growth By Decade|
|Decade||Total Credit Market Debt Growth ($billions)||GDP Growth ($billions)||Dollars of Credit Market Debt Growth For Each Dollar Of GDP Growth|
|2000's To Date||20,923.93||4,255.40||4.92|
© 2007 Brian Pretti