Zero Beta

The Steroid Scandal and the Credit Crisis

While watching the Mitchell Report today on Bloomberg and seeing many baseball legends discredited forever while major market indices, in the early innings of a credit crunch, quietly rallied from lows after two of the wildest days in the history of markets, I couldn't help but smile at it all. 

The Steroid Scandal went relatively unnoticed in Major League Baseball for some years.  Steroids are taken in eight week on and eight week off cycles and take a few cycles to really kick become noticeable..  As players started to hit more home runs, and get a little bigger many people attributed it to their hard work at the gym.  Then other players started to talk and learned the real reason for success, it began to spread. Superstars who already had advantages now needed an edge, and took got it through steroids.  At first when records started being smashed and statistical averages that tracked the history of the game started to go up, the All Stars of the era, Barry Bonds, Sammy Sosa and Mark McGwire found themselves battling for home run dominance for a few years. Until Sammy Sosa, who came out of nowhere, went from Goliath to David in a few seasons, the idea of performance enhancing drugs went from being discussed in small circles to a major issue.  Then, Jose Canseco came public and started naming names and more skepticism started to form.  Great players who either didn't want to do them for an ethical reasons, pride, or for the eventual health risk they cause lost millions of dollars to those players who did.  This is when things started to unravel. Statistics began to fall, the legends of the last few years ,who were touted as better than anyone at the game of baseball fell from grace, testified before Congress, and today many more followed them in the downward spiral.  Most importantly, years of baseball statistics have been shown to be artificially inflated, lessons have been learned, and credibility has been lost. 

With both Bloomberg and CNBC broadcasting this, traders, bankers, and brokers around Wall Street watched - some reacting with disgust, others with happiness, and others with astonishment that more names weren't on the list. I watched with hope that at least a few people on the Street took some time to look in the mirror.  Isn't Wall Street less than a year into its own Steroid Scandal?  Isn't this performance enhancing credit that has been pumped into the system over the past few years the financial equivalent of steroids? 

Credit in its simplest isn't something that is bad, rather it is healthy for markets.  Companies leveraging their assets to take on risks and hopefully earn returns is essential to a healthy financial market. Leverage is by nature designed to enhance returns.  If I borrow $100 at 5% to invest $200 in a stock that earns me a 10% return I made $10 more than another guy who just used cash.  I also made a much more impressive return on my $100, and look like a more astute investor. Much like steroids, credit has the ability to make an investment or investor better than it really is and as long as you consistently earn returns it can mask many of the risks that exist.  It especially has the ability of making those with talent, assets, or both look like rock stars.

Although it is true that credit enables great returns to be had, along with them comes greater risk.  Just as steroids have enormous excess health risks that may go unnoticed at first but develop after more and more cycles, credit has long term excess financial risks that grows with more and more cycles.  Both are also susceptible to sudden large losses - with steroids its the risk of your dignity or worse your health or life, and with credit is is risk of sudden financial ruin - insolvency.  Just as reputation, legal, and health risks due to steroids can be postponed with the help of a lawyer or doctor, financial risks due to can be postponed with the access to more credit - in the form of refinancing, restructuring, Fed intervention, or taxpayer-funded bailouts.  While most people agree that this illusion of relative safety causes excessive use, with steroids they seem to generally accept the fact that this causes more inevitable damage down the line with steroids and abhor the use altogether, and with credit they accept the complete opposite.  The reason for this of course isn't that steroids are illegal and credit is not (although many of the recent forms of it should be), but that we all have used too much credit and do not want to face the truth that we must someday experience the risk. If were were all steroid-fueled MLB superstars we wouldn't have seen this report today What if you are a superstar in a credit-fueled global economy?

At this point in time, it is 2005 and we are all Jose Canseco.  We are acknowledging the fact that excess credit is in the system and inferring that it is a problem, but severely underplaying the risk in a sad act of denial. In his autobiography, where he first brought the issue to the forefront by name-dropping alleged steroids users, he plays down the risk of the drug:

"As a result, baseball and other sports will be more exciting and more entertaining. Human life will be improved, too. We will live longer and better. And maybe we'll love longer and better, too."

"If you start young enough, when you are in your twenties, thirties and forties, and use steroids properly, you can probably slow the aging process by fifteen or 20 years."

Does this not sound eerily familiar to "adjustable rate mortgages if used properly can be beneficial for those who wish to own homes."  Or, "people remaining in their homes benefits us all"?

Other interesting parallels that I found:

• Is the undetectable Human Growth Hormone (HGH) the same thing as a Structured Investment Vehicle (SIV).
• Will Goldman Sachs, Blackstone, many Hedge Fund Managers, and the asshole on your block with the Lamborghini be the Credit Crisis's equivalent of Barry Bonds, Mark McGwire, the 2000 Yankees, and Sammy Sosa?
• Isn't it fascinating that Wall Street was glued to the TV today during one of the most volatile markets in history to watch this report - which has no effect on the market whatsoever?
  
• Is the decline in baseball's popularity around the country during the last 10 years symbolic of the decline of the United State's popularity around the world for the past 5 years?
• It is argued that steroids set a bad example for the youth, and I would agree.  What example does excessive credit set for the youth?
• Isn't it interesting that one of the main things to happen to baseball during the Steroid Scandal was the emergence and gradual dominance of baseball players from Latin America and Asia?  Is the recent emerging markets dominance in the global economy the past few years?
• Isn't the S&P 500 just a statistic?  How inflated is it from the performance enhancing credit and will the market follow the trend that home runs has over the past few seasons?
• Will the chart of the major stock markets have an asterisk next to this time period it in the future?

Most importantly, for years steroids had the effect of making the rich richer and the poor poorer.  The superstars became unstoppable legends and grabbed a lion's share of the overall profits. To those with a certain level of talent, steroids were a great thing. On the other side the good players who didn't use them were punished and the average players took too much of the health risk and never were really rewarded because they did not have enough talent.  As the public began to turn the game off, baseball moved to other emerging markets and signed players to help expand its revenue base.  Players trying to work their way up in the minor leagues found the low probability of success to now be much lower. Likewise, excessive credit has been no different. It has caused inflation and those with the financial equivalent of talent - assets have been able to benefit tremendously.  Those who did not have many assets have faltered.  The successful have been praised as genius and the youth has idolized those who made money by no other reason than just having it, or being leveraged up to their eyeballs.  Additionally, Finance is as much "America's Pastime" as baseball, and it, like baseball, has been moving overseas to emerging markets as real economic growth domestically has faltered. 

A few years from now while watching a ball game will we be interrupted with another list - this time listing all those companies and investors who suddenly went bust due to a massive margin call named deflation? Although it would be ironic at the very least, I doubt it will ever happen because in our financial system, unlike in Major League Baseball, the biggest users are also the regulators.

Some thoughts on the Fed's two day bender (aka "Mr. Bernanke's Wild Ride"

The last few days will no doubt be included in the Fed's perverted little scrapbook and many investors as well as the wild roller coaster ride saw the market basically cover nearly as much ground as it has moved since the beginning of the year, but essentially remain unchanged.  As I watched the market bounce around like a maniac on a pogo stick, some thoughts and questions came to mind, that I figured I would share.

• Immediately, when today's Term Auction Facility was announced I thought, "Why wasn't this announced yesterday?"
• Extending the the puzzlement above, I wonder if anyone was privy to this information, allowing for a VERY profitable two days of trading - much more profitable than the futures/spot "reporting error" that occured back in February.
  
• Many people believe this was a response to the  market's reaction to the disappointing 25bp, but somehow I don't think Bernanke recieved a ton of angry phone calls from Wall Street, Hank, and Dubya, and said "Don't worry, I'll whip something up by tomorrow morning"
• Rather I think this was the equivalent of a fire extinguisher they developed, put behind glass with a sign saying, "In Case of Emergency, Print Money" and in this case they were forced to use it. 
• Didn't a Fed cronie hint that the Fed was toying with an idea of using an alternate method of providing liquidity to the markets and would discuss it at its December meeting? (Can't find any links to articles but feel free to share. 
• Is its action today just a way in which the Fed will try to make its 100bps of rate cuts a reality.  Since its old tricks have failed to be effective
• Does anyone find an issue with the fact that this process is completely opaque, subject to expansion, and could further add moral hazard to the system?
• Is this essentially telling companies such as Citi and Bear Stearns if you need money don't go to Abu Dhabi or China - "If you need money then you come to me!" and doesn't think create an image of Pauly from Goodfellas in your head.
• Does this have anything to do with the fact that the SIV bailout plan is falling apart?
• Does the collusion with other countries show just how weak the dollar is (along with our credibility).  We have moved from telling other nations "It's our currency but your problem" to "them now telling us, "There is a real problem with your currency. 
• Does this $40 billion injection enable Wall Street to pay year end bonuses, and is it really politically wise under these conditions to pay a bonus this year.
• Is this why they all downgraded each other today - so as not to be seen as benefiting from such greed?
• How odd was the Citi CEO press release two minutes before the Fed?
• Did the structure of this announcement allow dollar holders abroad to sell dollars into yesterday's rally, before today's announcement put the greenback back in its place?
• Who or what sold off furiously around 3 pm today, as the major indices dropped 50 bps in a few minutes?
• Is this Term Auction Facility the equivalent of issuing the major banks and brokers a Federal Reserve equivalent of the American Express Black Card?
• How many more bailouts can be rolled out before people really start to get pissed off and turn off "Dancing with Stars" to scrutinize all these undertakings?

Risk Perversion Revisited and the Idea of Inflation Risk Arbitrage

Today, while perusing a favorite site of mine, Minyanville, I came across a great op-ed piece that touches on an idea of risk perversion that I very very poorly examined a few months back (I just reread it and stared blankly at the screen).  A few months older and maybe wiser, this article helped me better drill down on the ideas in my head and I would like to comment on and add to his analysis. 

The op-ed piece is basically an assault on the recent government bailouts and moral hazard surrounding fiscal and monetary involvement in the markets.  He writes,

As a result of my values and life experiences, I chose conservative personal finances. Due to my preference for security and prudence, I forgo the opportunity for larger gains and windfalls in exchange for the lower risk and security. It used to be that I could live with this trade-off. However, the last decade (and last few years in particular) have made this choice increasingly difficult. Not only have risky investments been deliberately supported by government policy, but less risky paths have been infected by overspill from the risk-taking activities; worse yet, my very own government is treating me as a sucker. I mean openly, which is kind of new.

This gets at the heart of the idea of risk perversion - a phenomena where investors accept misunderstood view of risk which spreads throughout the market and through processes such as reflexivity becomes dogma.  A great example of this is "home prices always go up".  This slowly infiltrated the real estate market over the past few decades and caused many of would-be renters to leverage themselves beyond their means and rationality in order to invest in an asset that they thought was risk free.  In doing so, the massive shift of renters to buyers caused this assertion of risk to appear to be correct by many statistical measures over extended time periods - up until recently. 

Extending this to the Modern Portfolio Theory definition of risk budgeting between the risk-free and the the risky asset leads to more interesting conclusions.  The risk-free asset, usually defined by a Treasury Bill, is supposed to be, well free of investment risk.  Since fixed income investment risk is made up primarily of purchasing power (inflation) risk, default risk, interest rate risk, and liquidity risk.  Since T-Bills are highly liquid, usually held to maturity, and virtually default-free, this leaves us with only inflation risk.  Inflation risk is a very sneaky risk, because it is not usually evaluated post-facto.  Although CPI measures can be subtracted to get a real rate of return.  An investor who invests $950 and receives $1000 a year later usually doesn't factor in the fact that his $1000 can only now buy $980 worth of goods and services, mainly because  that is not what it is used for as the investment proceeds are reinvested and 2% inflation over one year is hardly noticeable.  Although this should be and usually is considered before such an investment is made, it is usually not evaluated directly afterwards.  It is usually years later, when inflation begins to compound that these effects are realized and evaluated.  Additionally, under a normal yield curve environment, inflation should gradually push yields up therefore compensating the investor for inflation as he/she reinvests.  Should inflation risk get out of control, risk-averse investors soon find themselves taking on no risk and taking a loss to do so - which is not a characteristics of a healthy economy and capital market.

The slutty stepdaughter of Modern Portfolio Theory is the Capital Asset Pricing Model (CAPM), which has been used and sometimes abused by almost everyone in Finance over the past quarter century.  When choosing to diversify between the risk-free and risky asset, this formula gives an expected rate of return for an individual investment:

Expected Rate of Return = Risk Free Rate + Beta*(Expected Market Return - Risk Free Rate)

E(r) = R(f) + B*[R(m) - R(f)]

Let's assume that this risky asset is the S&P 500 SPDR (SPY), with a Beta of 1 the equation quickly reduces to what we would expect.   

E(r) = R(m)

I mentioned earlier that under NORMAL conditions inflation risk on the risk-free-rate of return is not really evaluated, however a inverted yield curve and inflationary period where year over year inflation (as measured by CPI and PCE) has increased more than the risk free rate.  The chart using CPI shows this to be a very recent and rare phenomena - occurring post-bubble from 2002 to mid 2005

and using PCE as inflation benchmark....

Well what does this all mean?

First, the obvious observation is that for a substantial period of time, the real risk free rate of return was actually negative.  During this time period, the risky asset dramatically outperformed the risk-free asset as the market roared back from the post bubble collapse. This is important because a large pool of investors allocated to the risk-free asset experienced a relatively substantial negative real return over an extended time period.  Up until 2003, any time that this phenomena existed or got close to existing it was immediately corrected. As the always appropriate George Dub once said, "Fool me once shame on me.  Fool me twice shame on you." I add, "Fool me three times and I'm a fool."

Next we should look at how this all factors in to the CAPM model, substituting the risk free rate, with the factoring inflation into the expected market return and risk free rate

R(e) = R(f) - i+ B*[R(m) - i - R(f) + i] = R(f) - i + B*[R(m) - R(f)] = R(e) - i

Therefore as expected we can conclude that by adjusting the various input returns for inflation we get an expected return that is adjusted for inflation. 

So, then we can conclude based on CAPM, adding inflation into the calculation does not fundamentally change anything, however the fact that the risk free rate of return is negative will affect how one allocates between the two portfolios. 

A fundamental concept of CAPM is that an investor should be compensated based upon the time value of money and risk.  The time value of money is represented by the first half of the expression, R(f), whereas risk is represented by the second half, B*[R(m) - R(f)].  If the real risk free rate is negative, the investor is not compensated for the time value of money, but rather PENALIZED for it, since he is not taking any risk.  Therefore the rational investor will not allocate towards it unless of course he is being compensated even less for risk. 

Whereas the time value portion of the equation is very straightforward and can be almost perfectly analyzed ante-facto, the risk portion is very difficult to analyze before investing.  Forecasts must be made based for market return and assumptions for beta. 

If an investor assumes that at the very least, he will be compensated more for allocating towards the risky portfolio and should be compensated at least at level equal to inflation risk for investing in the risky portfolio, thus substituting inflation, i, for R(m), the the second half of the equation changes to

-B*(R(fr)), where R(fr) is the real risk free rate

Then the new equation can be constructed where

R(e) = R(fr) - B*R(fr)

In a situation where the real risk free rate is negative, the equation is always maximized when the investor allocates away from the risk-free portfolio.  Only when inflation expectations turn positive will an investor in this situation ever allocate different.

Another important feature of all of this is that if real risk free rates are negative both market risk as well as any types business or financial risks of the risky portfolio that are added to expected market returns above inflation are irrelevant.  In any case he will choose the risky portfolio, if he believes both the risk free rate will remain negative and that risky returns will at least equal inflation. 

Thus, the perversion of risk.  Facing a negative return on the risk free asset, the investor is FORCED to either take a loss or take risk - sometimes much more than he or she would like or will get paid for.  Although inflation risk is the same for both portfolios, it becomes much more "rational" to risk loss to make a gain then to accept loss with almost 100% certainty, thus inflation risk is proportionally much higher in the risk free portfolio than in the risky portfolio although it is the same in magnitude in both.  In its crudest form, this may be  the framework that has perpetuated much of the madness that many of us have griped about for a few years now.  The relative risk free asset has been the one that doesn't take your money but gives you a shot at making money by taking risk - if that does not make sense then you are not alone.

The fact that investors would only need inflation to pass through earnings is what created a risk free asset from a risky asset.  Although this has not happened throughout history, I hypothesize that a debt infused economic boom devoid of real wage growth and characterized by rampant consumption and the outsourcing of fixed labor costs would almost exclusively be inflationary and any earnings growth should be equal to inflation plus any operating gains or losses.  If the credit fueled demand caused the price of Good A to increase almost 10% in the store and globalization and other factors only caused costs to increase 2%, the company selling widgets should grow its earnings by about 8% - add financial leverage to the situation and these earnings increase even more - offsetting any input cost inflation.

Essentially, this phenomena spawned what appeared to be a very profitable trade for many who picked up  it.  Inflation risk was priced differently in two very liquid markets.  In the risk-free market taking on inflation risk generated a negative expected return, whereas in the risky market it generated an expected return that greater and presumably could be magnified proportional to market risk as well other underlying investment risk.  Therefore the "astute investor" - and I use that term loosely - thought that they were simultaneously buying and selling inflation risk and capturing the spread - let's call it inflation risk arbitrage.   Obviously this thought process wasn't so technical, but has simplified by many notable investors and journalists who recommend that equities are the only way or easiest way to keep up with inflation and nurtured by famous investors such as Joel Siegel, who claimed that over time stocks offer greater return for much less risk.  The fact that many years passed where "safe" investors started to realize that they were losing money helped perpetuate such a trade and change the entire market's outlook on risk. 

The reality of the situation is that the risk profiles have not changed.  Inflation masked business risk and financial risk for risky investments as the special, global, credit driven, [insert whatever you want here] inflationary environment enabled companies to increase profit margins enough that any volatility in earnings, sales, or poor capital investment, went relatively unnoticed - which feeds into the idea that liquidity and volatility are polar opposites.  As liquidity dried up, many investors in financial and consumer discretionary stocks were introduced to business and financial risk that they unknowingly or perhaps were "forced" to take on.  This wiped away a few years inflation gains in only a few months.  The fact that bailouts are now punishing those who did not realize this even complicates the situation further. 

The probability distribution that describes business risk has a much higher kurtosis than that which describes inflation risk (bigger more infrequent observations).  This enabled the risk it to lurk underneath unnoticed and unseen and create what seemed to be a risk free arbitrage. When receiving a fixed payment inflation risk is easily approached ante-facto and managed.  When expecting to sell sometime in the future at a higher price, inflation risk is more or less embraced and hoped for.  Investors who thought they were capturing some sort of spread (whether they outwardly realized it in such technical terms or not) hoped to end up on the bright side of an inflation trade.  It wasn't until they got burned that they found out what they were really capturing was extra risk premium that was defined by infrequent and large (or severe) observations.  This trade was able to carry on for quite some time as many conservative investors after one or two years of investing in T-Bills, woke up to the fact that they were losing money and prices going up everywhere. 

To finish up touching upon the op-ed piece, the moral hazard of all these bailouts is not only that it encourages wild risks to be taken, but also does not allow for the pain and reflection that is associated with a loss and for the real reasons for that loss to be explored.  Loose monetary and fiscal policy and too much credit in the system enabled a dangerous situation where risk-averse investors lost money to take no extra risk rather than lend money to earn a return.  Poor oversight and suspect conflicts of interest enabled this to spiral into many years of perceived risk perversion and a damaged market psyche.