Saturday, March 1, 2008 3 comments ++[ CLICK TO COMMENT ]++

Illiquid Market Actions Provide No Signals

One of the reasons I have maintained a somewhat optimistic view of the monolines even with CDS on Ambac and MBIA trading at high levels and the ABX index continuously deteriorating, is due to my belief that a lot of these markets are illiquid (or at least not liquid enough). During stressful times (like now), a lot of irrational events occur in illiquid markets. Who knows if the monolines will survive but it is hard to dispute the notion that there will be misleading pricing signals from illiquid markets. I'm going to point out an example cited by The Economist in an article covering the conflicting views of the bond market and the stock market.

...The need to reduce risk forces investors to sell assets into an illiquid market. Those firesales drive down prices which, in turn, prompts more investors to reduce risk.

A good example is a mischievous security called a constant-proportion debt obligation, or CPDO. These ungainly contraptions played on the fact that investment-grade bonds had historically offered returns that more than compensated for the risk of default. The CPDOs took advantage of this spread by using borrowed money (up to 15 times leverage) to sell default protection against a basket of such bonds. But the leverage proved to be a curse when spreads widened rapidly.

According to Jonny Goulden of JPMorgan, by late February the prices of some CPDOs had fallen so far (to 30% of the original net asset value) that they forced managers to buy insurance against further falls. This required them to buy about $30 billion of protection against an index of credit-default swaps. That pushed up the cost of such insurance, and thus made it appear more likely that corporate bonds would default. In turn, this forced down the prices of the bonds themselves.

Think about what just happened. Someone issuing CPDOs (constant-proportion debt obligation; if you want a bearish overview of a CPDO, here is one from Grant's Interest Rate Observer), which I assume are illiquid to begin with, runs into problems and then tries to hedge by going long an index of CDS (credit default swap). The CDS market is also likely illquid (depending on the index) so it pushes up prices on the basket of CDS that make up that index. Depending on the size of the market, buying $30 billion of the index will likely have a material increase.

The end result is that the CDS of the companies that made up that index go up, hence making it look like those companies' default risk has gone up. All this happens without any fundamental change in the default risk of the companies.

I'm sure the proponents and sellers of the ABX index will disagree but my impression is that the ABX index likely does not provide much meaningful signals either. Since the ABX index is probably the most popular of the choices, anyone that is worried about ABS of subprime RMBS is going to hedge by shorting the ABX index. If enough people are shorting the ABX index, the ABX index will fall even if the underlying components don't deteriorate.

Now, I'm not saying that everything is fine and dandy in the subprime mortgage space, and that we should pretend the ABX is not faling. That's not what I'm saying. My point is that illiquid markets may or may not mean anything--especially during stressful times. Just like how the CDS of some companies would have gone up (in the example mentioned above) without any increase in fundamental default risk, a similar thing can happen in any illiquid market.


3 Response to Illiquid Market Actions Provide No Signals

March 3, 2008 at 9:17 AM

Thornburg is fast becoming the poster child for "illiquidity". They are now on the brink of failure due to the severity of non-stop margin calls.

March 3, 2008 at 10:53 AM

I don't follow Thornburg much but the problems are being exacerbated by mark-to-market writedowns which have nothing to do with real losses (similar to the situation faced by monolines).

March 3, 2008 at 10:55 AM

Unlike monolines, Thornburg is in a riskier position because they are forced to sell assets are likely depressed prices to cover margin calls.... In contrast, monolines don't have to sell anything--although their cost of raising capital to maintain AAA increases significantly...

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