Bill Gross's comments on the debt markets

jrumph

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Hearing Bill Gross say "tramp stamp" is priceless.
 
I can't speak for him obviously, but I think generally what he means is the job of the risk manager would be to avoid getting in this situation in the first place. Relatively to what you see going on now, it would mean realizing long ago that a fund with a strategy focused specifically on leveraged investments in illiquid ABS CDOs, even highly rated ones, could cause liquidity problems. A good risk manager would recognize that even though there is "diversification" in the collateral in terms of individual borrowers, this stuff is mostly subprime RMBS and when the market gets panicked the correlation goes close to 1 very quickly.

Prudence would have dictated having appropriate exposure to other assets that could be liquidated when one specific market locks up. For example, there are plenty of hedge funds that are probably facing painful marks on their ABS CDOs, but most of them also have substantial holdings in other assets that can still be sold in this market. Only monoline funds like at BSAM are really getting in trouble, because they have nothing else to sell to meet margin calls. I think that is what he means by liquidity planning.
 
OK - so I have a big mezzanine exposure in CDO's in which the underlying collateral is subprime mortgages. This sucks, but there isn't a lot to be done about that directly right now. If I think that the subprime mortgage world is going to be a complete rout, I should probably get rid of these things but it's going to cost me. Obviously, there are times and reasons for doing that. But it's a real short conversation - "Yep according to my model if the index goes down another 10 points, we would be looking at $50 M worth of losses and that's unacceptable. Since I now view that as reasonably possible, we have to bite the bullet and sell". What really should have happened is that as the risk became too big, I pared my position at better prices. There is no question that the risk of owning these things changes as defaults near attachment points, as credit reasons start making defaults past the attachement point more likely, or as correlation among the underlying collateral increases (btw - correlation isn't really the right measure of association here since correlation only exactly applies in normality). As the risk increased, I should have been on top of that and started doing something about the positions.

Recently, we had some discussion on AF about cutting positions as they lose money. There were a bunch of the usual objections. Of course, guys who deal with negative gamma in options books do that all the time and it is obvious to them. As the portfolio loses money, you still need to keep risk at some reasonable level. Since losing money is some indication that you are wrong, you might want to cut positions even more. In equity and fixed income investing, this is not normally the case. A stock that has dropped a lot contributes less risk to your portfolio than it did prior to the drop (you simply have a smaller proportion of your portfolio devoted to it). A CDO position that drops has lots more risk than it did before, but it's contained in esoteric models and obscured by manager marks and illiquidity. I wonder how many banks looked at BBB credit ratings and didn't realize they were taking on some negative gamma-like risk (like once it starts running it goes from BBB to default in no time).

Anyway, if you've got them, you probably have other credit risky positions. I'd be concerned that correlation among seemingly unrelated collateral will pick up in a subprime mortgage crisis. I think I can tell a story that says that a subprime mortgage crisis can spread to nearly any credit-risky security simply by starting a credit crunch that causes spreads to widen and available credit to dry up. How many credit risky securities were affected by Russia defaulting on bonds that were largely held by Russians? (ans: all of them)
 
Big Nodge Wrote:
-------------------------------------------------------
> I can't speak for him obviously, but I think
> generally what he means is the job of the risk
> manager would be to avoid getting in this
> situation in the first place. Relatively to what
> you see going on now, it would mean realizing long
> ago that a fund with a strategy focused
> specifically on leveraged investments in illiquid
> ABS CDOs, even highly rated ones, could cause
> liquidity problems. A good risk manager would
> recognize that even though there is
> "diversification" in the collateral in terms of
> individual borrowers, this stuff is mostly
> subprime RMBS and when the market gets panicked
> the correlation goes close to 1 very quickly.
>
> Prudence would have dictated having appropriate
> exposure to other assets that could be liquidated
> when one specific market locks up. For example,
> there are plenty of hedge funds that are probably
> facing painful marks on their ABS CDOs, but most
> of them also have substantial holdings in other
> assets that can still be sold in this market. Only
> monoline funds like at BSAM are really getting in
> trouble, because they have nothing else to sell to
> meet margin calls. I think that is what he means
> by liquidity planning.


That was pretty good. You can speak for me like that whenever you want.
 
I think Bill Gross's comments are directly linked to this discussion on risk. Diversification and subordination got the tranches at the top of CDO cap structures AAA and AA ratings. How do risk managers argue to traders/PMs that we have too much exposure to a AAA rated asset?
 
First, AAA refers to credit risk not other kinds of problems like liquidity risk.

Gross isn't really talking about the most senior tranches in these strcutures which probably should get AAA ratings and probably aren't especially risky. However, a AAA buyer is someone who wants no risk. A risk manager should point out that for these tranches to have no risk you have to believe either that the rating agency models are correct or that they have reached correct conclusions despite being incorrect. If you believe the first, you should just read all the caveats the rating agencies add. If you believe the second then the AAA rating is irrelevant.

That AAA rating is just modelling risk. For an excellent example of how silly those ratings can be check out CPDO's which are given AAA ratings because of a crazy double-down in loss policies. If I was a risk manager for a large insurance company buying lots of these in the AAA part of their portfolio, I'd be sending out hateful e-mails to everyone involved.
 
"2008 holds even more surprises with nearly $700 billion ARMS subject to reset, nearly � of which are subprimes."

Ouch. I wonder if this is a bad time to be buying a house in an expensive market that just topped out. (I'm closing in three weeks).

Oh, and since I doubt anyone else in my office reads Bill Gross, I'm going to steal shamelessly and dub myself the "Curmudgeon of Credit".
 
OldSchool Wrote:
-------------------------------------------------------
> "2008 holds even more surprises with nearly $700
> billion ARMS subject to reset, nearly � of which
> are subprimes."
>
> Ouch. I wonder if this is a bad time to be buying
> a house in an expensive market that just topped
> out. (I'm closing in three weeks).
>
Is this the first time you have ad that thought?
>
> Oh, and since I doubt anyone else in my office
> reads Bill Gross, I'm going to steal shamelessly
> and dub myself the "Curmudgeon of Credit".

Bad idea. He's earned it. You almost certainly haven't.
 
As to my house, no, but I've already sold my old house, quit my old job, and I need to live somewhere. It's not like I'm buying a condo in Miami.

As to the nickname, my direct reports, as well as the bankers they support, would disagree with you.
 
OldSchool Wrote:
-------------------------------------------------------
> As to my house, no, but I've already sold my old
> house, quit my old job, and I need to live
> somewhere. It's not like I'm buying a condo in
> Miami.
>
> As to the nickname, my direct reports, as well as
> the bankers they support, would disagree with you.


Gee I saw some of Bill Gross' stamp collection today. Some of those stamps are worth more than $1M apiece. He's earned something.....
 
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