Wednesday, December 15, 2010
More on one of our pet themes. After Moody's fun with the US yesterday they have turned their attention to Spain now. If the ratings agencies don’t state anything new but only officially "time stamp" what we know already on the risk curve, why do markets insist on step change moves in response to their announcements? Are there really investors so comatose that they don’t react until a ratings agency announcement tasers them out of their torpor? Yes, apparently there are and people even pay fees to these people to manage their money. How do they justify these fees? Well, dear investor, it's called Benchmarks and, to paraphrase the Sex Pistols (and to nick a chapter heading from from a friends book), "Never mind the benchmarks". Because benchmarks are indeed bollox.
It's all part of the cycle of unintended consequences. The investor tries to protect himself from risk by insisting that his money only be put in "safe" investments, but who decides whether they are safe or not? Enter the ratings agencies who then carve up a normal curve of risk into thick histogram buckets with Hoover Dam-like edges. The difference in real risk between a top BBB+ rated bond and a single A- may be non-existent in reality. But to the benchmark-driven, ratings agency-dependent passive bond fund, investment dicta handed down from a board of fund trustees made up of laymen advised by "consultants", it can make a difference on the order of 1000bp of performance (just look at where the crossover indices got to in 2008). Does that reflect TRUE risk? No, it reflects a self-inflicted market distortion, which just adds risk to the very portfolios that introduce these rules to try and reduce it.
What is more, as the rest of the investor community can see the ratings agency changes coming a mile off, it means that any portfolio changes based on their actions hit a market that has already discounted them, undermining performance even further. But the really magic trick is that it doesn’t matter because performance is measured against a benchmark of similar passive funds that have to follow the same rules! And as a benchmark reflects the average, then on average, they are average. Collect the fees and shrug.
That is the case for passive managers. But there are examples of active investors doing their proper bottom up research on assets, discovering that they are hugely undervalued despite the risk of downgrade, but can't take the risk of buying them, because in the event of a downgrade the contract they have with the client (usually advised by a top consultant) makes them a forced seller into the "mark-to-market" price freefall. To make things worse this is the moment the supposed risk-taking "Market Maker" suddenly backs off, becoming an "agency broker" on commission! Or in the case of a bank, the regulator forces them to increase the amount of "risk-weighted capital" held against the asset following the downgrade, making the original investment case untenable. What is more, the derivatives of ratings agency-dependent products have their margins and haircuts set against the same ratings, creating a horrible negative feedback loop in response once a downgrade occurs.
This is exactly what happened with the ABS/MBS market and in particular the genuinely high-quality end of the US MBS market, where ratings agencies changed their methodology on rating bonds for the potential of default. Despite the fact that an MBS might only suffer a projected default over its life of 1 dollar, the security was rated sub investment grade, destroying the investment thesis of even a good researcher and closing a massive investment opportunity to bond fund managers and the back books of banks alike.
The fundamental problem is there is a total disconnect between the "risk taker" and the "risk controller". In this case the "risk taker", the real name for whom in the modern market is "investment manager" and the risk controller, i.e. the legal rules and compliance depts set up to control the dangerous risk taker (because as we all know taking any kind of risk is far too dangerous for the masses) and "protect" the capital of the end investor. The good investment manager does the research, finds the asset, works out the fair value, compares this to the market price and, if the market price is cheap to fair value, should be able to buy as much as possible within his level of prudence and conviction. But then in steps the risk controller who has no more information than an arbitrary set of rules thereby emasculating the investment manager and guaranteeing that the investor's capital is put at higher risk than it needs be.
This is all the more pertinent because we are only a gnat's crotch away from some regulating do-gooder kicking the plug from the comatose UK public sector pension's life support system. It has been noted that the deficit has doubled in the last 3 years to £100bln and we know what happens next by looking back at what Myners did to the UK Pension funds in 2001/2. Scream outrage at the losses occurring, look at where the funds were invested and regulate that they are no longer allowed to invest there at the absolute bottom of that market. So with the "consultant" on the radio today complaining that 70% of these UK local funds' money is in equities, you can be pretty sure the next move will be to tell them they have to go into bonds. RIP.