Monday, May 6, 2013

Global CIO - A macro view

Finally the day has come that your Ivy League (please note that the spell checker capitalized that, not me) education and hard work are paying off: Congratulations, you were just appointed Global CIO.  You are now responsible for investing all of the world’s financial assets and, given your history as a highly educated CIO, steeped in finance and highly experienced managing other pools of capital your goal is to create a diversified portfolio with uncorrelated assets.

On the first day of work you decided to use a three step process in setting up the portfolio 1) see what you have, 2) determine what you want to have and 3) make changes to create the desired portfolio.

The first thing you do is send your star analyst to give you a rundown of what is in the portfolio you inherited. S/he starts out with collating and aggregating the portfolio which consists of stocks, bonds, and a number of derivatives such as futures, options and credit default swaps as well as a number of hedge fund investments.  After burning the midnight oil s/he comes to your office with a shocking discovery - all the long and short derivative positions are offsetting and net to zero, the short equity and bond positions in hedge fund portfolios are offset by levered longs held by other funds and therefore also net out to zero and all you have in net exposure is a portfolio of stocks and bonds.

You may want to re-read the above paragraphs a few times to make a small dent in you denial that on the most extreme macro level of financial instruments all there are is stocks and bonds.

Once you start to get your head around this observation is becomes easier to understand that there only are three return streams available to a financial investor and they are dividends, interest payments and capital appreciation/depreciation on equities. Three you say - what happened to capital appreciation on bonds, which have done so well?


Let's assume you buy a 6%  US10 year treasury note when it is issued at par. Soon after you bought it rates go down to 5% and, as the Wall Street Journal so tirelessly points out, the price of bonds moves inversely with yields, and the bond price goes up to 107. You just made 7% in just a few short months courtesy of the Fed/ financial markets/ your investment genius! However, as you are the Global CIO and own all financial assets you have nobody to sell it to. So you hold it to maturity and which point the bond gets redeemed at, you guessed it, par. Total capital appreciation over the life of the bond: zero. You did however collect 10 years worth of interest.


Even the capital appreciation on equities is a paper-only exercise. You can’t “realize” the gain because you can’t sell. On a macro level this is exactly what happens in the real world; collectively market participants cannot sell their positions and that is what sets assets up for large price swings which can’t be explained by fundamentals. The notion that a certain asset is over or under owned is nonsensical – somebody always owns the asset – you can’t sell without somebody else buying it from you. Markets then function primarily as a wealth redistribution mechanism and a valuation tool secondly although when it matters that function does not seem to work.


As Global CIO all you can do is sit there, lean back and collect interest, dividends and watch the value of your stocks and bonds fluctuate with the level of economic activity and whatever financial models you choose to use to value them and the psychology of market participants. On occasion you buy new stock and bond offerings and write off assets which went to zero. Your investment genius or lack thereof has no effect on the cash flows, stock and bond valuations or the value of the portfolio overall. Brokers won’t take you golfing or for steak dinners either because they no longer have any secondary trading activity nor the fees that come along with that.

(So perhaps you don’t want to be the Global CIO but engage in something useful like teach finance and share what you learned with them or learn how to make an omelet.)

On the second day on the job it has become obvious that collectively your active strategies add no value so you redeem in kind from all your active managers and collapse all offsetting positions. And that, surprise, surprise will cause your performance to better than the performance in the world where there are lots of separate pools of capital especially when actively managed. Actually, you’re shocked by how much better the collective performance is than the sum of the individual performances. The amount of money paid in transaction costs, management fees and incentive fees and financing charges is absolutely staggering. The concept of negative carry no longer exists and bid/offer, slippage and netting risk also are removed from your financial vocabulary. In fact, the only words your financial vocabulary contains at this point are issue price, coupon, dividend, credit and business risk.

Clearly this financial model would have issues, mainly lack of discipline on the side of the issuers of financial instruments because the Global CIO is a forced buyer and therefore a price taker, but it makes for an interesting thought experiment. And although derivatives like futures net out to zero the risk transfer function of them can add value to the real economy by redistributing risk……

Friday, February 1, 2013

Some (un)intended consequences of mortgage refinancing

As mortgage rates are decreasing and households take on mortgages with lower rates there are several consequences, not all of them obvious.

The amount of interest paid, C.P goes down which at first glance is a good thing. The consumer now has the option to allocate the difference between the old and the new payment to other purposes. The downside of lower payments is that somebody else is now receiving less, and likely that somebody else is a pension fund, life Insurance Company or another entity which needs long dated cash flows. Chances are that as the homeowner refinances the NPV of his/her pension or insurance decreases at the same time. The economic effect of the increased cash flows to the household sector and the decreased cash flows to pension funds, life insurance companies et al. is not symmetrical because the household sector has a high marginal propensity to consume – they spend most of the savings – whereas the financial savings institutions buy financial assets (in other words, they save).

Another aspect of refinancing, and the generally lowering of interest rates on mortgage debt is less obvious though which is worth looking at.

Assuming a 100,000 mortgage for 30 years at 8% the monthly payment is 733 of which (for the first month) 666 is interest, 67 is principal and therefore the initial ratio of interest to principal (I/P) is 9.9. When that mortgage gets refinanced to 4% the payment decreases to 477, interest is 333 and principal is 144 so the I/P ratio goes to 2.3.

This means that the homeowner in a lower rate environment builds equity much, much faster which means that it has a positive effect on household net worth even if the reduction in payments is completely consumed.  If homeowners were to take the monthly savings in interest and use it to prepay their mortgage the equity build would be even faster. The flip side is of course that the holder of the mortgage has reduced interest income and an increased principal flow which needs to be reinvested. At the same time the total monthly cash flow to be invested (presumably in financial assets) by the mortgage holder goes down).

As the amount of interest paid by the household sector decreases so does the tax deduction they receive on this. In other words, the lower the interest paid by the household sector the higher their effective tax rate, c.p.. That means that although rate reductions lead to an increased ability to consume, it is less than 100% of the interest savings, and tax revenues increase.

Another consequence is that as total monthly payments go down the servicing fees servicers receive decrease as well. Generally servicing fees are a fixed percentage of the monthly payment so less dollars flow into the financial sector. Similarly, as rates fall the interest rate exposure which needs to be hedged by parties who want to neutralize interest rate risk also is reduced. This is because as rates go down the dollar value per basis point also shrinks, and leads to reduced dollar weighted interest rate hedging transaction.

The overall this aspect of lower rates, a policy with the initial intention to rescue the financial sector and secondarily to increase aggregate demand, may have the (unintended?) effect of transferring wealth from the financial sector to the household sector and the government.