Tuesday, December 15, 2009

Debt Wars Episode II: Attack of the Traders

My post from last week on debt generated some conversation about leverage and the value of arbitrage-free prices. Basically I'm arguing that if leverage (a.k.a. trading debt) is exceedingly expensive, then arbitragers won't be able to perform their essential function.

I wanted to illustrate this in a bit more detail by giving a admittedly stylized example. As you are reading this, bear in mind that I'm merely explaining why some degree of leverage is needed to produce efficient markets. This shouldn't be taken as an endorsement of any particular level of leverage, simply as an argument that Wall Street leverage is basically good.

Let's pretend we live in a world where there is a discrete amount of "real" money that is investable in the short-run. That is to say that all long-term investors have fully allocated their investments and any change in their demand for investments only occurs in the long-run. We can imagine this sort of like a world of dollar cost averagers who put some set amount of money aside for investment at the end of each year. However during the course of the year, the level of investable capital is constant.

Now let's assume we're at equilibrium and the market is perfectly efficient. Suddenly a new bond issue comes to market. Who is going to buy it? Given that investors don't have any uninvested assets, the only way an investor could buy this new asset is if they sell other assets. This can't work, of course, because if one investor sells another investor has to buy. There isn't any available net capital in the system.

Now many readers are thinking to themselves that this is a dumb example, since obviously my initial assumption doesn't hold. We see capital flowing back and forth all the time. Investable assets obviously aren't fixed.

Or are they? Consider who makes up real money investors. Individuals? They might have some assets sitting in their checking account which could in theory be invested, but its clearly limited. They have bills to pay with their liquid money. Corporations? Similar to individuals. Mutual funds? On any given day, they only have what they have.

Maybe we can't say that investable assets are literally fixed, but I argue that in the short run its damn close.

Furthermore, real money isn't going to react to relatively small arbitrage opportunities. Let's assume the yield curve is dead flat at 5%. Let's further assume that ABC Corp has bonds outstanding due in 2018 currently trading with a 6% yield. Now ABC wants to sell new bonds which will have a maturity in 2019. What should the yield be? With a flat yield curve, the yield should be extremely close to the 2018 bonds.

But if real money has limited excess capital, there will be a supply/demand imbalance here. Real money will have to be enticed to bring in new capital, and therefore the absolute yield will have to be large enough to do the enticing. Relative yield doesn't apply.

Put yourself in this situation. You wake up one morning comfortable with your investments when some poor bond salesman calls you up and asks about these new ABC Corp bonds. You admit that you have some money in your checking account, but are you going to tie up your liquidity for a 6% yield? Or 6.5%? Or 7%? Depends on your own situation. Might have to be 9% or 10%.

Now let's introduce the possibility of fast money. They also have limited capital, but we'll assume they also have access to leverage.

So back to ABC Corp. They look to sell new bonds. Real money is strapped and wouldn't be enticed unless the yield is 8%. But fast money can afford to go long new bonds vs. a short of the 2018 bonds with a yield differential that is much smaller. If fast money can get 10/1 leverage, a 1% differential earns them a 10% IRR. Or even better, fast money can speculate that once ABC Corp has sold their large bond issue, the supply/demand picture will improve. That is to say, if ABC Corp wants to sell $1 billion in bonds, real money can't take it down. But once the deal clears, fast money can sell the $1 billion bonds in smaller chunks at a tighter spread. Maybe fast money would therefore take the bonds at 6.25% and try to sell them off at 6%. That would be about a 2% price gain. At 10/1 leverage, that's a 20% IRR.

Why do we care about ABC Corp's cost of funding? Because the markets are supposed to be an arbiter of capital. If the cost of capital is distorted by technicals, the market can't function in this manner.

This problem is most glaring when the market is in panic mode. Last fall, real money almost universally wanted to sell at the same time that fast money had no access to capital. Efficient markets completely broke down.

Again, it isn't that unlimited leverage is a good thing. But without leverage, markets can't work.


Josh Kalish said...

Good post.

You could also give the example of basic futures/cash arbitrage. If they are not kept in line then they will not send the right price signals. You might think that future oil is cheap but really it could just be a function of there being no one to trade the calendar.

Erick said...

1) What is someone doing that he needs to issue a bond? Who values what that person wants to do and how much savings do they have? Those people will fund this opportunity.

The bond has to be valuable enough to entice people to change their long-term strategy now, in the short run.

You mention one reason good reason, a high yield, but I see plenty of room for other possibilities: I love my son who has some disease. So I want my savings to fund the creation of a cure.

2) If there is a discrete amount of available money, 6% interest rates sounds unsustainable. 0% or a negative interest rate (0% + fees on deposits) seem to be the only thing that makes sense.

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Accrued Interest said...

The Catholic Church is spamming my blog? Someone call Dan Brown!

Jakedeez said...

Great post - reminds me off all the negative basis that was going on for a while there... man that was good eating.

In Debt We Trust said...

Here is my holiday present to you, a Star Wars game theory example:


Extended said...

Great post thanks
I also really got a good laugh from you not taking down the Catholic church spammer...Hilarious

IF said...

It seems like a rather short sighted post. It seems it exists just to explain why you are getting a salary.

"But fast money can afford to go long new bonds vs. a short of the 2018 bonds with a yield differential that is much smaller."

The world has to be net long, so who is going to by the extra 2018 bonds sold short if the same world is not interested in the 2019 bonds?

Anonymous said...

No doubt that leverage which creates kind of virtual money does ease all kind of good an BAD transactions, BUT:

your example does NOT explain that it also creates more instability!

In a stable systems those who want to do rapid investments must have the required liquidity!


Anonymous said...

Here is a timely theoretical/empirical back-up to your claim on leverage - Via Econbrower blog - http://www.newyorkfed.org/research/staff_reports/sr406.pdf

nobody said...

just curious, Do u still like the flattener trade? were sitting near record steepness for the 2yr/10yr spread.

Accrued Interest said...

I don't think a reasonable level of leverage makes the system unstable. I think zero leverage makes the system worthless.

I love the flattener trade, but I'm not sure it really starts paying off for another month or so. I'm going to write more about this maybe today.

In Debt We Trust said...

By the way, I just noticed the 2 year's yield has consistently stayed under the 50 day MA since early 2007. What do you think of that?

Anonymous said...

So ... within this theoretical closed system, where does the money come from that the trader is borrowing in order to make this leveraged play?

Ah, yes, banks and thin air.

MikeT said...

I seriously do not understand this post.

If "real money" is not available, where does the traders get the leverage to fund their 10:1 levered 6% bonds?

Or maybe you can argue they can borrow some 5% bonds, sell it, and buy the 6% bonds... But who do they sell to if the "real money" is all tied up?

If you borrow money, SOMEONE is committing "real money" to you so you can do something else with it. Therefore, I don't see how you can make such a distinction between "real money" and "fast money"

nobody said...

not much of a yield curve anymore, more like a vertical line. this will be the story next year, all eyes on the curve.

Anonymous said...

could you write about something more interesting? Your earlier posts were much better & more relevant.

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