Thursday, March 01, 2007

Fear will keep the local systems in line...

OK so the other day when I claimed it wasn't a real flight to quality... never mind. Fear is gripping the bond market. Its causing spreads on all products to move substantially wider, from MBS to corporates to even agencies.

Forget the little rally in stocks yesterday. Forget the little sell-off in bonds yesterday. For at least the next week or so, the market will remain extremely skittish. And only Treasury holders like vol. Fear will prevent any bond sector from keeping up with Treasuries over the next several sessions. So whether rates are up or down, everything will lag the Treasury market.

Are there opportunities here? Heck yeah. All you have to do is separate the real possibilities from the fear. Oh yes, it sounds simple. But its very very very very hard. When the market is gripped by fear, you are either playing momentum or being contrarian. I like to think of myself as more of a contrarian than anything else. But at times like this, being contrarian is harder than ever. Consider the following on contrarion investing.

1) The irrational can get even more irrational. Consider the case of the ABX index. I wrote that it seemed out of wack with fundamentals when it was priced at $80. Then it went to $60 in a matter of days. As a trader, particularly if you're leveraged like most CDS players are, a 20 point drop is hard to stomach. You can't help but question your view, and you might just bag the trade. If you aren't prepared to accept this kind of outcome, you can't play the contrarian game.

2) When you are a contrarian, every one thinks you are wrong. Its a tautology. Unless every one disagrees with you, you aren't a contrarian. But the thing is, you are going to hear very reasoned arguments from intelligent people about why you are wrong. Look, the market isn't dumb, so if every one has a certain view, its bound to be compelling. You have to be prepared to consider consenting opinions, but not allow their ubiquity to color your analysis.

3) A contrarian's career is always at risk. This is a reality of the investment business, particularly at large mutual fund firms. If you are wrong, but every one else is wrong too, your fund will still score decent Morningstar ratings, and Lipper rankings, and your investors will likely stick with you. But if you are wrong and every one else is right, you're fired. Oh and after the big mutual fund company fires you, good luck finding another job in investment management. That's a one-way ticket to a job as a retail broker. If you work for a big firm, you have to be prepared to accept this risk when making contrarian bets.

4) It isn't being contrarian to simply bet against the trend. Making any investment on the basis of a trend alone is a roll of the dice, unless you really know what you're doing. Betting on a reversal for no reason other than "it can't keep going in this direction forever" is flat out irresponsible.


Apolitical said...

Hey Tom. Now that I've thought about it some more, I have even more doubts about the 70% recovery number for HELs that would potentially make buying the ABX a good trade.

When I worked on a CDO desk, we used to assume 35% recovery for RMBS. Assuming 35% recovery rate, what's that saying about the implied default probability on the ABX?

Tom G. said...

That's interesting that you assumed 35% on RMBS. What that on 2nds? I've never bot ABS CDO's because of the correlation problem. At least for the moment, I'm feeling good about avoiding the sector. Anyway, I know I was pitched deals where the recovery was projected to be in the 70's. Obviously a sales document is going to be optimistic.

As far as how many defaults they can withstand, its still a question of how fast they happens. If you worked on a CDO desk, you know that these deals can build subordination over time, so it really does make a difference.

I'm re-reading the Bear Stearns research I mentioned the other day that estimated a fair value of $90. They assumed around 15% defaults at 55% recovery. The problem is that the loss rate on the deal vs. the loss rate on the CDS isn't linear. In other words, BS is expecting like 8% losses (15% defaults, 55% recovery) in the deal, and that makes the CDS worth around $90. It isn't like 10% losses makes it worth $88. It should accelerate the decline in value of the CDS. So in order to justify a price of $70, losses may only need to be around 15-20%. I'm guessing because I don't have access to all the subordination in all the deals, but you see where I'm going.

So if we say 15-20% losses, and 35% recovery, we're probably looking at 23-31% defaults. Whether you think that's realistic or not, up to you.