26/4/21: What Low Corporate Insolvencies Figures Aren't Telling Us

 

One of the key features of the Covid19 pandemic to-date has been a relatively low level of corporate insolvencies. In fact, if anything, we are witnessing virtually dissipation of the insolvencies proceedings in the advanced economies, and a simultaneous investment boom in the IPOs markets. 

The problem, of course, is that official statistics - in this case - lie. And they lie to the tune of at least 50 percent. Consider two charts:

And

The chart from the IMF is pretty scary. 18 percent of companies are expected to experience liquidity-related financial distress and 16 percent are expected to experience insolvency risk. The data covers Europe and Asia-Pacific. Which omits a wide range of economies, including those with more heavily leveraged corporate sectors, and cheaper insolvency procedures e.g. the U.S. The estimates also assume that companies that run into financial distress in 2020 will exit the markets in 2020-2021. In other words, the 16 percentage insolvency risk estimate is not covering firms that run into liquidity problems in 2021. Presumably, they will go to the wall in 2022. 

The second chart puts into perspective the IPO investment boom. Vast majority of IPOs in 2020-2021 have been SPACs (aka, vehicles for swapping ownership of prior investments, as opposed to generating new investments). The remainder of IPOs include DPOs (Direct Public Offerings, e.g. Coinbase) which (1) do not raise any new investment capital and (2) swap founders and insiders equity out and retail investors' equity in. 

The data above isn't giving me a lot of hope, to be honest of a genuine investment boom. 

We are living through the period of fully financialized economy: the U.S. government monetary and fiscal injections in 2020 totaled some $12.3 trillion. That is more than 1/2 of the entire annual GDP. Since then, we've added another $2.2 trillion. Much of these money went either directly (monetary policy) or indirectly (Robinhooders' effect) into the Wall Street and the Crypto Alley. In other words, little of it went to sustain real investment in productive capital. Fewer dollars went to sustain skills upgrading or new development. Less still went to support basic or fundamental research. 

In this environment, it is hard to see how global recovery can support higher productivity growth to bring us back to pre-pandemic growth path. What the recovery will support is and accelerated transfer of wealth:

• From lower income households that saved - so far  - their stimulus cash, and are now eager to throw it at pandemic-deferred consumption; 
• To Wall Street (via corporate earnings and inflation) and the State (via inflation-linked taxes).

In the short run, there will be headlines screaming 'recovery boom'. In the long run, there will be more structural unemployment, less jobs creation and greater financial polarization in the society. Low - to-date - corporate insolvencies figures and booming financial markets are masking all of this in the fog of the pandemic-induced confusion. 

31/5/20: S&P500 Shares Buybacks: Retained Earnings and Risk Hedging

Shares buybacks can have a severely destabilizing impact on longer term companies' valuations, as noted in numerous posts on this blog. In the COVID19 pandemic, legacy shares buybacks are associated with reduced cash reserves cushions and thiner equity floats for the companies that aggressively pursued this share price support strategy in recent years. Hence, logic suggests that companies more aggressively engaging in shares buybacks should exhibit greater downside volatility - de facto acting as de-hedging instrument for risk management.

Here is the evidence:

Note how dramatically poorer S&P500 Shares Buybacks index performance has been compared to the overall S&P500 in recent weeks. Since the start of March 2020, S&P500 Shares Buybacks index average daily performance measured in y/y returns has been -15.04%, against the S&P500 index overall performance of -0.89%. Cumulatively, at the end of this week, S&P500 Shares Buybacks index total return is down 10.18 percent against S&P500 total return of -0.967 percent.

While in good times companies have strong incentives to redistribute their returns to shareholders either through dividends or through share price supports or both, during the bad times having spare cash on balancesheet in the form of retained earnings makes all the difference. Or, as any sane person knows, insurance is a cost during the times of the normal, but a salvation during the times of shocks.

19/5/18: Leverage risk in investment markets is now systemic

Net margin debt is a measure of leverage investors carry in their markets exposures, or, put differently, the level of debt accumulated on margin accounts. Back at the end of March 2018, the level of margin debt in the U.S. stock markets stood at just under $645.2 billion, second highest on record after January 2018 when the total margin debt hit an all-time-high of $665.7 billion, prompting FINRA to issue a warning about the unsustainable levels of debt held by investors.

Here are the levels of gross margin debt:

Source: https://wolfstreet.com/2018/04/23/an-orderly-unwind-of-stock-market-leverage/.

And here is the net margin debt as a ratio to the markets valuation - a more direct measure of leverage, via Goldman Sachs research note:

Which is even more telling than the absolute gross levels of margin debt in the previous chart.

Per latest FINRA statistics (http://www.finra.org/investors/margin-statistics), as of the end of April 2018, debit balances in margin accounts rose to $652.3 billion, beating March levels

And things are even worse when we add leveraged ETFs to the total margin debt:

In simple terms, we are at systemic levels of risk relating to leverage in the equity markets.

8/4/18: Tail Risk and Liquidity Risk: What about that Alpha?

An interesting data set that illustrates two key concepts relating to financial returns, covered extensively in my courses:

1. Liquidity risk factor - inducing added risk premium on lower liquidity assets; and
2. The importance of large scale corrections in long term data series (geometric vs arithmetic averaging for returns)

Indirectly, the above also indicates the ambiguous nature of returns alpha (also a subject of my class presentations, especially in the Applied Investment & Trading course in MSc Finance, TCD): micro- small- and to a lesser extent mid-cap stocks selections are often used to justify alpha-linked fees by investment advisers. Of course, in all, ranking in liquidity risks helps explain much of geometric returns rankings, while across all, geometric averaging discount over arithmetic averaging returns helps highlight the differentials in tail risks.

Sounds pretty much on the money.

2/2/18: CFR: What Financial Economics Tells Us About Bitcoin

My new contribution to the Cayman Financial Review is available, covering the key aspects of the fundamentals (or lac of such) behind the crypto currencies valuations: http://www.caymanfinancialreview.com/2018/01/29/learning-from-the-present-what-financial-economics-tells-us-about-bitcoin/.

8/12/17: Coinbase to Bitcoin Flippers: You Might Flop

If you need to have a call to 'book profit', you are probably not a serious investor nor a seasoned trader. Then again, if you are 'into Bitcoin' you are probably neither anyway. Still, here is your call to "Go cash now!" https://blog.coinbase.com/please-invest-responsibly-an-important-message-from-the-coinbase-team-bf7f13a4b0b1?gi=f51a107183c9.

In simple terms, Coinbase is warning its customers that "access to Coinbase services may become degraded or unavailable during times of significant volatility or volume. This could result in the inability to buy or sell for periods of time." In other words, if there is a liquidity squeeze, there will be a liquidity squeeze.

Run.

So a couple of additions to this post, on foot of new stuff arriving.

One: Bloomberg-Businessweek report (https://www.bloomberg.com/news/articles/2017-12-08/the-bitcoin-whales-1-000-people-who-own-40-percent-of-the-market) that some 40% of the entire Bitcoin supply is held by roughly 1,000 'whales'. Good luck seeing through the concentration risk on top of the collusion risk when they get together trading.

Two: Someone suggested to me that ICOs holding Bitcoin as capital reserves post-raising are part problem in the current markets because by withdrawing coins from trading, they are reducing liquidity. Which is not exactly what is happening.

Suppose an ICO buys or raises Bitcoins and holds these as a reserve. The supply of Bitcoin to the market is reduced, while demand for Bitcoins rises. This feeds into rising bid-ask spreads as more buyers are now chasing fewer coins with an intention to buy. Liquidity improves for the sellers of the coins and deteriorates for the buyers. Now, suppose there is a sizeable correction to the downside in Bitcoin price. ICOs are now having a choice - quickly sell Bitcoin to lock in some capital they raised or ride the rollercoaster in hope things will revert back to the rising price trend. Some will choose the first option, others might try to sit out. Those ICOs that opt to sell will be selling into a falling market, increasing supply of coins just as demand turns the other way. Liquidity for sellers will deteriorate. Prices will continue to fall. This cascade will prompt more ICOs to liquidate Bitcoins they hold, driving liquidity down even more. Along the falling prices trend, all sellers will pay higher trading costs, sustaining even more losses. Worse, as exchanges struggle to cover trades, liquidity will rapidly evaporate for sellers.

It is anybody's guess if liquidity crunch turns into a crisis. My bet - it will, because in quite simple terms, Bitcoin is already relatively illiquid: it takes hours to sell and spreads on trading are wide or more accurately, wild. Security of trading is questionable, as we have recently seen with https://www.fastcompany.com/40505199/bitcoin-heist-adds-77-million-to-hacked-hauls-of-15-billion, and the market is full of speculation that some of these 'heists' are insider jobs with some exchanges acting as pumps to suck coins out of clients' wallets. The rumours might be total conspiracy theory, but conspiracy theories turn out to be material in market panics.

24/11/17: Learning from the GFC: Lessons for Investors

My article, summing up the key lessons from the Global Financial Crisis that investors should review before the next crisis hits is now available via Manning Financial newsletter: http://issuu.com/publicationire/docs/mf_winter_2017?e=16572344/55685136.

16/5/17: Insiders Trading: Concentration and Liquidity Risk Alpha, Anyone?

Disclosed insiders trading has long been used by both passive and active managers as a common screen for value. With varying efficacy and time-unstable returns, the strategy is hardly a convincing factor in terms of identifying specific investment targets, but can be seen as a signal for validation or negation of a previously established and tested strategy.

Much of this corresponds to my personal experience over the years, and is hardly that controversial. However, despite sufficient evidence to the contrary, insiders’ disclosures are still being routinely used for simultaneous asset selection and strategy validation. Which, of course, sets an investor for absorbing the risks inherent in any and all biases present in the insiders’ activities.

In their March 2016 paper, titled “Trading Skill: Evidence from Trades of Corporate Insiders in Their Personal Portfolios”, Ben-David, Itzhak and Birru, Justin and Rossi, Andrea, (NBER Working Paper No. w22115: http://ssrn.com/abstract=2755387) looked at “trading patterns of corporate insiders in their own personal portfolios” across a large dataset from a retail discount broker. The authors “…show that insiders overweight firms from their own industry. Furthermore, insiders earn substantial abnormal returns only on stocks from their industry, especially obscure stocks (small, low analyst coverage, high volatility).” In other words, insiders returns are not distinguishable from liquidity risk premium, which makes insiders-strategy alpha potentially as dumb as blind ‘long lowest percentile returns’ strategy (which induces extreme bias toward bankruptcy-prone names).

The authors also “… find no evidence that corporate insiders use private information and conclude that insiders have an informational advantage in trading stocks from their own industry over outsiders to the industry.”

Which means that using insiders’ disclosures requires (1) correcting for proximity of insider’s own firm to the specific sub-sector and firm the insider is trading in; (2) using a diversified base of insiders to be tracked; and (3) systemically rebalance the portfolio to avoid concentration bias in the stocks with low liquidity and smaller cap (keep in mind that this applies to both portfolio strategy, and portfolio trading risks).

18/4/16: Rollover Risk, Competitive Pressures & Capital Structure of the Firm

Capital structure of the firm, as we discussed in our MBAG 8679A: Risk & Resilience:Applications in Risk Management class in recent weeks, is about counter-balancing equity (higher cost capital with greater safety cushion for the firm) against debt (lower cost capital with higher risk associated with leverage risk). As we noted in some extensions to traditional models of leverage risk, decision to take on new debt as opposed to issue new equity can also involve considerations of timing and be linked to future expected funding demands by the firm.

An interesting corollary to our discussions is what happens when risk of debt roll-over at maturity enters the decision making tree.

A recent paper by Gianpaolo Parise, titled “Threat of Entry and Debt Maturity: Evidence from Airlines” (April 2016, BIS Working Paper No. 556: http://ssrn.com/abstract=2758708) tries to address this question.

In the presence of low-cost competition airlines, traditional, large airlines tend to alter their debt structure. This effect, according to Parise, is pronounced in the case of legacy airlines forced to defend their strategically important routes from new entrants. Per Parise, “…the main findings suggest that airlines respond to entry threats trading off financial flexibility for lower rollover risk.”

More specifically, Parise found that “…a one standard deviation increase in the threat of entry triggers an increase of 4.5 percentage points in the proportion of long-term debt held by incumbent airlines (a 7.4% increase relative to the baseline of 60%). This effect is particularly strong for airlines whose debt is rated as “speculative” and that are financially constrained, i.e., airlines that have in general a more difficult access to credit.”

On the other hand, “the threat of entry has no significant effect on the leverage ratio.”

Overall, “threatened airlines issue debt instruments with longer maturity and with covenants” and that debt issuance aiming to increase maturity comes via intermediated lending (loans) rather than via bond markets (direct market).

“The results are consistent with models in which firms set their optimal debt structure in the presence of costly rollover failure As Parise notes, “Longer debt maturity allows firms to reduce
rollover (or liquidity) risk, i.e., the risk that lenders are unwilling to refinance when bad news
arrives. Rollover risk enhances credit risk…, magnifies the debt overhang problem…, weakens investment,… and exposes the firm to costly debt restructuring…”

A very interesting study showing dynamic and complex interactions between capital structure of the firm and exogenous pressures from competitive environments, in the presence of systemic roll-over risks in the financial system.

3/5/2013: Basel 2.5 can lead to increased liquidity & contagion risks

Banca d'Italia research paper No. 159, "Basel 2.5: potential benefits and unintended consequences" (April 2013) by Giovanni Pepe looks at the Basel III framework from the risk-weighting perspective. Under previous Basel rules, since 1996, "…the Basel risk-weighting regime has been based on the distinction between the trading and the
banking book. For a long time credit items have been weighted less strictly if held in the trading book, on the assumption that they are easy to hedge or sell."

Alas, the assumption of lower liquidity risks associated with assets held on trading book proved to be rather faulty. "The Great Financial Crisis made evident that banks declared a trading intent on positions that proved difficult or impossible to sell quickly. The Basel 2.5 package was developed in 2009 to better align trading and banking books’ capital treatments." Yet, the question remains as to whether the Basel 2.5 response is adequate to properly realign risk pricing for liquidity risk, relating to assets held on trading book.

"Working on a number of hypothetical portfolios [the study shows] that the new rules fell short of reaching their target and instead merely reversed the incentives. A model bank can now achieve a material capital saving by allocating its credit securities to the banking book [as opposed to the trading book], irrespective of its real intention or capability of holding them until maturity. The advantage of doing so is particularly pronounced when the incremental investment increases the concentration profile of the trading book, as usually happens for exposures towards banks’ home government. Moreover, in these cases trading book requirements are exposed to powerful cliff-edge
effects triggered by rating changes."

In the nutshell, Basel 2.5 fails to get the poor quality assets risks properly priced and instead created incentives for the banks to shift such assets to the different section of the balance sheet. The impact of this is to superficially inflate values of sovereign debt (by reducing risk-weighted capital requirements on these assets). Added effect of this is that Basel 2.5 inadvertently increases the risk of sovereign-bank-sovereign contagion cycle.

The paper is available at: http://www.bancaditalia.it/pubblicazioni/econo/quest_ecofin_2/qef159/QEF_159.pdf