You only find out who is swimming naked when the tide goes out.

Transcription

1 Hidden Risks Eric Jacobson, Director of Fixed Income Research June Morningstar, Inc. All rights reserved. <#> You only find out who is swimming naked when the tide goes out. -Warren Buffet, Berkshire Hathaway Letter Morningstar, Inc. All rights reserved. 1

2 Introduction: Core Problems & Hidden Risks 3 Introduction: Core Problems Data Analysis Fixed Income Data is a Different Breed Size - $83 Trillion / 9-14 million issues Dynamic issuance, maturation, prepayment Number of unique and critical datapoints per security OTC, decentralized, structurally opaque market Disclosure Based primarily on rules devised for accounting treatment, equity markets and an earlier age Voluntary disclosure complicated by legal concerns, inertia, computer systems and it s not my problem thinking Morningstar, Inc. All rights reserved. 2

3 Core Problems Effective Communication Reports and client collateral design driven by inertia Communication hasn t kept up with complexity Historically driven by regulation rather than client service Often the province of marketing rather than client service Failure of imagination 5 Putnam Income Morningstar, Inc. All rights reserved. 3

4 Putnam Income 7 Introduction: Hidden Risks Balance Sheet Leverage Off balance sheet, hidden leverage and risk A look at past blow-ups of hidden risk Candidates for the next surprise Morningstar, Inc. All rights reserved. 4

5 Balance Sheet Leverage 9 Balance Sheet Leverage Analogous to margin borrowing Using borrowed money to gain additional market exposure Magnifies both risk and return Multiple methods Items in Schedule of Investments: Preferred shares Bank debt Commercial paper TBAs Reverse Repo & Dollar Rolls Municipal inverse floaters (tender-option bonds) Morningstar, Inc. All rights reserved. 5

6 Balance Sheet Leverage Investor Capital (Net Assets) Borrowed Capital Total Assets Investor Capital + Borrowed Capital Investor Capital $1,000,000 $500,000 $1,500,000 Total Assets = = 150% Net Assets Market Exposure = 150% of Net Assets 11 Balance Sheet Leverage Risk and Return Magnifier Return Magnifier Risk Magnifier Morningstar, Inc. All rights reserved. 6

7 Finding Balance Sheet Leverage 13 Economic vs. Accounting Leverage Morningstar, Inc. All rights reserved. 7

8 Economic vs. *Accounting Leverage 15 Economic vs. Accounting Leverage If it s cash, cash equivalent, or demonstrably similar? Accounting Leverage If it s very short, but has any credit risk, structure risk, or other unusual feature? Economic Leverage Morningstar, Inc. All rights reserved. 8

9 Off Balance Sheet, Hidden Leverage and Risk 17 Off Balance Sheet Leverage - Derivatives Interest Rates Treasury futures Interest rate swaps Credit Credit default swaps (single-name CDS) Credit default swap index baskets (CDX, ABX, etc.) Total return swaps (on indexes) Currency Currency futures Currency forwards Morningstar, Inc. All rights reserved. 9

10 Off Balance Sheet Leverage - Derivatives Pros minimal capital commitment, discreet targeted exposures, hedging tools, liquidity Cons basis risk, counterparty risk, model risk, leverage effect, liquidity, margin adjustments 19 Off Bal Sheet - Derivatives: Default Swap Exposure Morningstar, Inc. All rights reserved. 10

11 Off Bal Sheet - Derivatives: Finding Default Swap Exposure 21 Off Bal Sheet - Derivatives: Finding Total Return Swap Exposure Morningstar, Inc. All rights reserved. 11

12 Off Balance Sheet Leverage: Derivatives Does this really happen? Western Asset Core (WAPIX) 2008: -11.1%, 1640 bps behind BarCap Agg Index Credit Default Swaps as of 09/30/08 report 22 pages CDX: $2,164,187,213 inv-grade index basket CDS: $312,304,388 single name default swaps ABX: $358,349,221 subprime index baskets Credit default swaps: $2,834,840,822 Bal sheet leverage: $383,266,366 Total Mkt Exposure: $8,853,749,048 = 157% Net Assets: $5,635,681, Hidden Risks: A Sordid History Morningstar, Inc. All rights reserved. 12

13 A History of Surprises 1989 & Leverage Credit Liquidity Mortgage Derivatives Liquidity Leverage Off balance sheet leverage Liquidity Deleveraging cycle Double digit unlevered losses Deep double digit balance sheet levered losses Orange County Citron & Leverage Piper Jaffray inverse IO, IFRN, PO, Z tranche Large duration bets Leverage on and off balance sheet Hidden subprime, corporate, and securitized exposures 25 Candidates for the next surprise? Morningstar, Inc. All rights reserved. 13

14 Oppenheimer Rochester National Municipals FASB rule now requires municipal IFRN/TOBs to be fully reported on balance sheet i.e. including liability, looks like balance sheet leverage Rising short rates will cut income Rising long yields will trigger loses 27 Oppenheimer Rochester National Municipals Putnam Income IFB Inverse Floating Rate Bond IO Interest Only Bond 2/26/10 Portfolio Inverse IO 21.93% Interest-Only 5.85% Total 27.78% Morningstar, Inc. All rights reserved. 14

15 Putnam Income Average Duration small/negative Sensitivity to two parts of curve LIBOR Mortgage mkt/ir/spread Negative Convexity (negative asymmetric price performance) Low dollar price / leverage * Data for illustration purposes only; not representative of any actual portfolio Morningstar, Inc. All rights reserved. 15

16 Balance Sheet Leverage: Risk and Return Magnifier Net Assets: $100,000,000 Unleveraged Portfolio: $100,000,000 Leveraged Portfolio: $150,000, Balance Sheet Leverage: Return Magnifier Net Assets: $100,000,000 Unleveraged Portfolio: $100,000,000 10% Market Return: $110,000,000 Leveraged Portfolio: $150,000,000 10% Market Return: $165,000, Morningstar, Inc. All rights reserved. 16

17 Balance Sheet Leverage: Return Magnifier Net Assets: $100,000,000 Unleveraged Portfolio $100,000,000 10% Market Return $110,000,000 Leveraged Portfolio $150,000,000 10% Market Return $165,000,000 (Subtract $50 MM Leverage) Dollars Gained: $10 MM $10 / $100 MM Net Assets 10% Portfolio Return Dollars Gained: $15 MM $15 / $100 MM Net Assets 15% Portfolio Return 33 Balance Sheet Leverage: Risk and Return Magnifier Net Assets: $100,000,000 Unleveraged Portfolio: $100,000,000 Leveraged Portfolio: $150,000, Morningstar, Inc. All rights reserved. 17

18 Balance Sheet Leverage: Risk Magnifier Net Assets: $100,000,000 Unleveraged Portfolio: $100,000,000-10% Market Return: $90,000,000 Leveraged Portfolio: $150,000,000-10% Market Return: $135,000, Balance Sheet Leverage: Risk Magnifier Net Assets: $100,000,000 Unleveraged Portfolio $100,000,000-10% Market Return $90,000,000 Leveraged Portfolio $150,000,000-10% Market Return $135,000,000 (Subtract $50 MM Leverage) Dollars Lost: $10 MM $100 - $10 = $90 MM -10% Portfolio Return Dollars Lost: $15 MM $100 - $15 = $85 MM -15% Portfolio Return Morningstar, Inc. All rights reserved. 18

19 Off Balance Sheet Leverage - Derivatives Credit Derivatives Other issues Pro Isolation of credit risk from interest-rate risk, cheap Con Credit risk is often not factored into credit breakdown Private contract Counterparty risk (same as other swaps) In 2008, more liquidity but tighter spread Structural issues notional value doesn t change Liquidity single name, TRS 37 Off Balance Sheet Leverage - Derivatives What kind of exposures does it effect? Can this be observed indirectly in other metrics? Interest Rate Risk - e.g. Treasury Futures, Interest Rate Swaps Should be captured in duration calculation Currency Futures & Forwards, Credit Derivatives Typically reported statistics, designed to total to 100% will not capture effects Morningstar, Inc. All rights reserved. 19