Information Arbitrage: A Prescriptive for Today's Volatile Markets

We need to get full and truthful disclosures from our public companies. Period. Remember my post discussing the underpinnings of today's market turmoil? Investors everywhere are on edge. Debt. Equity. Structured products. It doesn't matter. There is no place to hide. The VIX has skyrocketed, and one need not be a market technician to both see and feel the intra-day volatility taking place. One can say that the market is overreacting on both the upside and the downside, but I think it is important to take a step back and ask - why?

I have written a lot lately about the importance of good financial disclosures as a vehicle for building investor confidence and stabilizing the markets, but I think even I may have understated the magnitude of its impact. If investors are waiting for the other shoe to drop, waiting for that next unexpected write-off, that next accounting scandal, what do you think happens when even a whiff of such an event gets leaked into the market? Investors react quickly and violently, especially in the face of imperfect information. This is a major source of volatility at a time when information is extremely imperfect - one might even say crappy - and is further leveraged by a growing interdependence among companies, countries and markets.

An article in today's MarketWatch discussed the possibility of financial institutions marking everything to market and getting all the bad news out at once, in an effort to rebuild confidence in their financial disclosures and prospects. Dramatic, yes, but provocative and worthy of discussion:

A couple of analysts I spoke to said that the best thing financial firms can do to rebuild confidence is to look at every asset on the balance sheet and mark it to market. If it can't be sold or if its value is unclear, it should be written off. That write-off should be a one-time event.


"They need to be as straightforward as possible about what their credit risks are," O'Shaughnessy (Patrick, analyst at Morningstar) said. "What's really killing them and killing investors is the uncertainty that surrounds it. Nobody's sure if the write-down is going to be $500 million to $1 billion or more."


O'Shaughnessy doesn't recommend that everything be written to zero, but underestimating risk is what initially got these firms in a bind. Erring by being overly conservative may cause some short-term anguish with investors, who could see some eye-popping numbers. For instance, what if the $45 billion in total write-downs is only half, or a quarter, of the final amount, as Deutsche Bank analyst Michael Mayo suggested Monday?


But a tough line on marking to market would lessen the likelihood of dragging down the industry and the economy this winter, and it leaves open the possibility that the market may revive and those securities might actually produce a dividend down the road.

Blythe Masters, a long-time credit derivatives pro at JP Morgan and now global head of currencies and commodities, had some interesting advice for her Wall Street peers:

"We need to raise the game and acknowledge our weaknesses," Masters told attendees of the Securities Industry and Financial Markets Association's annual meeting, adding that in the credit crunch, "we are experiencing a crisis of unprecedented proportions" that will "damage the economy."

Geez, Blythe is starting to sound like me. This is good for the industry - if her words are heeded. Corporations and managements everywhere have an aversion to pain, and this aversion is an adaptive response if, say, you are running from a predator. Unfortunately, this hard-wired dislike of facing into ugliness is something that causes crises to drag on for way, way too long, and we run the risk of having this exact thing happen if managements and their Boards don't have a come-to-Jesus moment - and soon.

John Authers, one of my favorite writers at the Financial Times, had a piece in today's paper that discussed today's market volatility but from a different perspective, one driven more by another quant meltdown than investor psychology:

Have the quants had another accident? Or have many people, operating in separate markets, independently decided to take profits at the same time? Or has a dose of risk aversion suddenly grasped almost everyone in the world markets?

The answer to all three is probably 'Yes'. And whatever the most important driver, there is a palpable sense of deepening gloom over the world's economic prospects and the chances for financials to muddle through the credit crisis.

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As for the role of quantitative funds, bizarre moves in US equities are redolent of the week in August when the largest names in the sector dropped by a third. Perverse effects can be caused when several quant funds, which tend to use similar models, pile in and out of the same stock at once.

Last week's sudden fall in tech stocks, which had strongly outperformed the market, certainly had that look about it.

Intraday trading patterns also had a crazy look. No news, or sudden change of Mr Market's heart, lay behind the 1.8 per cent fall of the S&P 500 in the last 38 minutes of trading on Friday, according to Bloomberg data. More likely, the move was dictated by shifts in the trading books of quant funds.

I see what John is saying, and believe me, few people have a greater appreciation for the impact of stat arb funds than myself. That said, based on anecdotal evidence of investors with whom I've spoken coupled with the intuition of market psychology and trading in an information vacuum that I've explained above, I think John's argument tells only part of the story. It may well be that quants are having the effect of increasing the amplitude of the waves due to crowded trades, but I believe the trend ball is getting rolled more by market psychology than automated trading.

Now if investors had the confidence that what was coming out of corporate PR departments was the truth, the whole truth and nothing but the truth (and not until the next time they release a new version of the truth), I believe the amplitude of the ups and downs we've witnessed would be muted. Why? Because trading would be based on fundamentals, not on persistent uncertainty. And if one adjusts cash flow discount rates to take into account these extreme uncertainties, models become very, very sensitive to changes in perception. And these perceptions, given the lack of investor confidence in the information they're receiving, are changing literally by the minute. This is no way to run an organized, orderly market. Things have got to change, and corporate managements and their Boards hold the keys.

Comments

But what if the result of marking everything honestly to market is to reveal that many -- perhaps even most -- of the major players are in fact bankrupt?

A disturbing number of firms whose solvency is critical to financial system stability appear to have losses that will wipe out their capital. Consider the recent news from FNMA, and reports on the major bond insurers (e.g., MBIA) -- the capital of these firms is a pitifully small fraction of the guarantees they claim to back.

And I suspect that a large element in the CDO and SIV game was that ways had been found to make unsound securities offering higher yields appear AAA and so make them a compelling investment for yield-starved pension funds -- could any officer at such a fund have kept his or her job had they refused to reach for that yield? But though it's clear that everyone along the supply chain producing that toxic waste knew or suspected the truth, all had plausible deniability, and all faced the same consequences -- go along or else be fired as an underperformer. So a large fraction of the fortunes made by the people responsible for this debacle has almost certainly come from the nation's already-underfunded pension apparatus.

I think the underlying reality is that most of the nation's retirement savings that should have been invested so as to enhance our manufacturing and medical-services productivity has instead gone into McMansions, real mansions, yachts and private jets, siphoned out in bonuses that should never have been paid.

If an honest accounting were to reveal this, the public's rage might completely overturn the system. And if rage didn't do it, well, we need only contemplate what the consequences would be of a return of the national saving rate to the level that would be needed to properly support -- by the productivity-enhancing investments we really need -- the baby boom generation's retirement.

Posted by: jm | November 17, 2007 at 02:31 PM

bubbles: humans, as we assign a cause, continue to misinterpret the cause. as we assign blame.

Posted by: Michael | November 15, 2007 at 10:43 PM

Problem? What problem?

I've probably said, with so many others, the latest volatility is caused by funds liquidating. For them, cash is imperative.

Certainly the repeal has added to retail jumping in fast and furious. If it spreads beyond retail, the algo's will look for this herding and take advantage.

So many words crying out for normalcy in the markets. Again. The markets will continue evolving 2 chaos. AKA volatility.

With chaos, comes new depths of understanding. Stop fighting it - flow with it. We'll have deeper understandings of Climate Change too.

ps: PR departments ... ... the truth - that's an oxymoron :) Let's examine realtime quotes as an example. A public company can only display a delayed quote for their "public" data. Can you not see how far off focus we are? Cheeses.

Posted by: Michael | November 15, 2007 at 10:04 PM