“The Enemy is Us”: Principles of Circular Valuation, Part 3

Just a short note here today (hopefully), but I had to report what is an epiphany of sorts – for me at least – in regards to the market yield valuation “problem” that I’ve discussed in prior posts.  (See here and here.)  Also, I highly recommend today’s Barron’s article by Randall Forsyth, which covers some of the same ground and inspired the title for this post.

The market values income-producing assets as a function of risk-weighted yield expectations.  Asset values, I have argued, have been substantially distorted over the years of accrued loose monetary policy, which have tended to suppress the “safe rate” end of the spectrum, as typically measured by US treasury yields.  The lower the required yield, the higher the resulting value of the asset.

Perhaps I am merely arriving late to the party, but in watching the latest Greek Tragedy unfold, it has become increasingly clear that, despite the obvious risks that derivatives have injected into the market generally, credit default swaps have only become more influential over the past year or so. 

These, you may recall, are the dreaded CDS derivatives that many blame for “killing” the likes of AIG.  (It may also be recalled that some $680 trillion or more in total notional derivative exposure remains outstanding in the market.)  Aside from the sheer magnitude of the counterparty risks associated with these instruments,  one must also wonder at the effect that both complexity and a lack of transparency are having on market pricing. 

After all, these products are actually intended to both help “compartmentalize” the risk weighting of particular financial instruments and to hedge against such risks.  This allows the market, one would hope, to more accurately value various risk factors. 

At the moment, for instance, Greek bonds have been commanding CDS “risk premiums” of some 300 to 400 basis points over those for German bunds.  Presumably, this premium reflects the market’s (lack of) speculative appetite for higher risk Greek debt.   

All well and good, one might suppose.  Except, of course, for the fact that, sometimes, the more layers of information we have, the less clear an answer actually becomes.  For instance, to the general complexity of CDS pricing, we must also add risk premiums associated with the foreign exchange market.  What we might imagine is that we’re merely layering one moving target with another. 

As noted also in prior posts here, it’s gotten almost comical trying to ascertain the value of any particular instrument from the vantage point of one slowly sinking currency to another.  The market, it would appear, has lost any and all sense of a fixed point of reference.  Yeah, maybe it never really had one, but there was enough stability to stay on one’s feet.

In this context, then, we must ask ourselves what a 3.6% yield on a ten-year US treasury note really means.  After all, for many investors, it is still the closest thing we have to a “fixed point of reference”. 

Well, for one, many presume to “know” that these rates are somewhat higher than the “real” rate of inflation.  Of course, I say good luck even figuring that one out.  But, as it happens, the real problem here is still good old-fashioned pricing discovery.  

Do we really know that the market is pricing 10-year treasuries with that yield?  What might buyers be paying for a CDS on a UST?  What effect, if any, is added by layering other derivatives, such as total return swaps or currency swaps, into the equation?   

Well into the global economic crisis, clearly CDSs and other derivatives, are still where most of the action is.  But, as an individual investor, just try to figure out how they are affecting the prices you’ll pay.  The first thing you’ll discover is that this is a very complex analysis problem.  (See a few helpful resources at the end of this post.)

Of course, many have been attempting to regulate CDS (and other) derivatives….without much success.  PIMCO’s Bill Gross, for instance, helped to alert the world in January 2008 to the surprising size and danger represented by what he called the “shadow banking system” and it’s (then) $43 trillion CDS exposure.   Yet, today, according to the Globe and Mail, PIMCO is balking at the sort of regulation that would make the CDS market more transparent.

And, while I am no fan of regulation per se, clearly free market’s thrive on transparency and efficient pricing discovery.   All that can be said at the moment is that virtually all of the action is taking place well out of sight in the realm of this same “shadow banking system”.   As noted before, this makes for very uncertain asset pricing.

You’ll have to dig pretty deep to make any real sense of it….that, of course, assumes that anyone really can.  For most of us, I suggest that we don’t dare to trust the easy answers or the obvious metrics.  This market is more opaque than ever before.      

Harry Tuttle


Helpful resources:

The Bank for International Settlements

The CME Group – at the Chicago Board of Trade (CBOT)

Markit.com – Financial Information Services – See their CDS clearing data page and their “Last Quote” page.

Tavakoli Structured Finance – Private consulting firm

Across the Curve – A daily bond market chronicle, now defunkt, but helpful nonetheless.


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