Tuesday, July 27, 2010

Are jobs the left tail risk?

 Left tail risk in my view is likely the rapid displacement of jobs, this will gain momentum remember this is the gift that keeps on giving and the faster technology develops the faster people will be displaced.  Another left tail risk is definitely real estate, real estate appears to moving forward and holding it's own the real test will be the spring of next year to see if it sticks.

Guest Article: Left Tail Risk
by Duncan Frearson, Smith Street Capital , July 22, 2010

Seemingly small initial events have cascaded many times into far from normal outcomes. These can both act in a positive way, such as birth of the Web browser or the discovery of oil, or in a negative way, such as the 1929 panic, by damaging economic conditions severely.

Popularized as “Black Swans” these three sigma events tend to occur slowly at first and then rapidly escalate. In 1929 a bankruptcy of a large conglomerate is said to have begun the great unwinding that led to the initial stock market crash and then the subsequent Great Depression. In early 1997 funding problems at major Thai finance companies and the consequent decision to float the Baht began a run on Asian currencies. In 2007 some initial defaults in the U.S. subprime mortgage market escalated into a nationwide housing collapse and financial panic.

Why does this happen?
Collapses generally involve high degrees of leverage. Large scale leverage can be gained by very loose lending or by the use of derivatives with incredibly low collateral requirements.
Leverage in and of itself is not such a bad thing as it can be used to finance a house, or a car or a new factory for production, but when it becomes concentrated into certain end markets in a large enough way it can have devastating consequences. If this lender or borrower is also connected in some way to another institution that also faces the same type of concentrated exposure, then the pain has been multiplied. Two becomes four which becomes eight which becomes 16, etc.

This happens rapidly. Once a critical mass is reached, the problem becomes somewhat unstoppable under normal conditions. However, if this rapid escalation gets muted by hitting a well capitalized diversified number of lenders only one or two institutions would then be the ultimate victims. One way to mitigate this risk within a closely knit system is to require concentration limits to various borrowers and categories. In the U.S. banking system individual loan limits have been in place for awhile, but no hard limits for lending to entire categories have been put into effect. In our latest bust we saw a chain reaction occur due to a huge build up in exposure to housing both in construction and development lending and in mortgage lending.

Once this trend began to come undone banks found they were all connected in a fairly concentrated way to one another. To make matters worse, a certain segment of their borrowers were the same people involved in constructing the houses.

Source: SNL
The cascade across Asia in 1997 had the same fundamental issues. Concentrated lending in real estate and infrastructure development caused one failure to cascade through the regional lending system, multiplying the initial problem across many players.

In all these instances the banking system itself was unable to stem the cascade and the only solution was large scale involvement from both the central bank and the government. In the case of large foreign debtors the IMF was also called in to provide dollar funding.

Is there a way to reduce this tail risk to the system? It would seem that imposing limits on concentration not just to individuals but also to categories would provide the ideal roadblocks to this type of dangerous cascade.
The question of whether this was tackled in our latest financial reform is certainly a good one.
In 1933 Glass-Steagall approached the problem by limiting the activity of the deposit banks. Investment banks were left to run stock lending activity but margin requirements were put in effect to keep the down payments high.
If some stock market players began to default depositors would not be impacted because the investment banks that tended to borrow widely from the capital markets would spread the pain around. There was a cut-off in place that isolated the risk.

This was eventually overcome by investment bankers using securitization markets to get into the bank lending business through finance companies which caused a boom in lending in housing related markets at the deposit banks.
The two players became connected again and once the investment banks began to get into trouble, the concentration that had built up at the deposit banks in the same market began to cause problems.
All this was accentuated by the build up of credit insurance written against that same lending that was now facing claims and by the off balance sheet lending that created far greater leverage than was immediately apparent.
In today’s environment there has been talk of another cascade from the build up of sovereign debt at some of the less stable nations of the world. Sovereign debt has been used to provide a bridge to allow private market participants to restructure their own finances. We might look to budget deficits as a far from normal condition but this is a different state of affairs as governments will only default when they have foreign debt exposure that can’t be paid back by raising domestic currency.

In the case of Europe the banks have access to dollar swap lines from the Federal Reserve and access to domestic currency has been assured by the ECB. This means that despite challenges in certain European nations there is virtually zero risk of a cascade as principal payments are essentially assured.
There is also talk of another cascade to be set into effect from a further decline in U.S. house prices. I think one of the fundamental changes at present however is that the concentration risk in the U.S. system has been reduced and housing collateral values have been reset at far lower levels.

There has also been a build of protective capital at the large and regional banks capable of preventing the type of cascade we have recently seen. This new capital buffer would require a very large decline in what is arguably a less concentrated book of business in order to cause the same sort of chain reaction we saw in 2008.
Government involvement in the housing market provided an initial boost but as they wind down these programs a subsequent drop off in activity is almost inevitable.

This uncertainty can cause tremendous volatility.and we must be careful about any premature extrapolations.
For example, when the “cash for clunkers” program approached its roll-off date, auto sales rose to over 14 million annualized units and then dropped to around 9 million a month later. Auto sales now stand at 11.3 million units, according to industry data.

The housing market may well see the same sort of volatility in sales activity.
It should also be noted that the sensitivity of consumer discretionary income to declines in interest rates, given the 15% or so of disposable income that is taken up by debt service is especially pronounced and the rise in refinancing activity will not only facilitate the large rollover burden, but will also help keep those teetering on the edge from losing their homes.
There is an increase in the margin of safety in both buying or deciding to remain in one’s home because of the decline in interest rates. The build-up of monetary stock in the economy and the Fed’s communication of an “extended period of low rates” will continue to keep both short and long term interest rates low for the foreseeable future.
Ultimately, the question is how does a manager price this tail risk and is the pricing for this protection reasonable.

We believe the risk of another negative cascade is low.
If this is the case, the premium required for portfolio protection in the next 12 months is not such a great deal. Another option is to hold cash as a protection of principal, but at a 0.32% yield for 12 months, it becomes economically expensive considering the higher yields available in owning high quality equities.

If you believe, like we do, the tail risk is low, then holding high quality equities with stable earnings in a zero growth environment will provide you with a far better yield than holding cash. If the economy eventually grows then this will be icing on the cake.



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