Bubbles: How I Learned to Stop Worrying and Love the Bond

5 Jun

Yada yada QE yada yada debasement yada yada bubbles as far as the eye can see yada lifted on a tidal wave of money yada yada tulips yada yada will end in tears yada yada we have learned nothing yada yada subprime contained yada

Every single opinion-former on the planet, basically

I compared QE to persuading a fat man to exercise by paying too much to buy his car, and expressed reservations about how the mechanism relies on pumping money to the (ideally leveraged) asset-rich. But the bubble thing has run out of control, with people who’d struggle to distinguish an interest coverage ratio from a sucking chest wound holding forth on the sharp rise in cov-lite loans. Let’s concede that much about asset prices which is worrying, but shutting down QE on the basis of what we see so far is akin to responding to a stalled elevator by drawing lots to decide who gets eaten first.

What is a bubble? The current definition appears to be “anything that has gone up a lot in price”. This won’t do.

I suggest that to qualify as a toxic financial bubble you need:

1) Yes, a big ramp up in prices sucking in investors through force of sheer momentum

2) Prices to reach levels that make them uneconomic. The only rational reason to own assets is the prospect of an even bigger sucker willing to pay even more. A loss of interest in sensible funding models.

3) The diversion of money to activities that are pointless and damaging.

4) Not so much the hallmark of a bubble as a “thing to watch” Bonus marks for extra damage – a high degree of leverage applied to said assets.

The above are a much higher bar than just “expensive”. Most financial assets are fairly expensive on most conventional metrics – PE ratios, real yields, spreads. But they’re typically 1-1½ standard deviations rich – not wild levels. But this is how QE is supposed to work. Investors pay more for fundamentally productive assets to drive them into creating marginally productive assets. The key is avoid generating the garbage – in #4. In short: paying too much for Amazon or Ebay, fine. Pets.com or Webvan? not so much. Similarly, Brazilian debt at 80bps over US Treasuries (or GE, or MacDonalds), fine; AAA-rated subprime MBS at the same level? Not so much.

1) prices gone up? sure.

2) Stuff at silly levels? Questionable. Looking back to the Nasdaq bubble – on pretty much any measure, stocks had reached silly levels. Use Tobin’s Q, Cyclically Adjusted Price Earnings, Dividend Yields, on almost any measure we were on a multiyear high. Similarly with the housing bubble – look at housing affordability, rental yields or price to rent. Yet this time round, most of these indicators look tolerable. Certainly credit yields look low, but within historical precedent.

3) Bubbles result in some damaging, wasted activities. Ireland’s ghost estates are worth less than the land they were built on (“Cows can’t eat fecking concrete” as a NAMA executive pithily put it). The NASDAQ bubble produced some very very rum ideas (here are 10 of the worst). I haven’t seen much evidence of similar happening yet. This example popped up today, but if this is the worst the bubbleers can do – a $70m Chinese IPO – we’re some way from AOL-Time Warner type distractions.

In funding terms too, it’s not clear that “CovLite” (loans with fewer strings attached) are quite the problem we’ve been told. (good roundup with back links to discussion here). Covlite remember was supposed to be “Corporate Subprime” until it wasn’t. If we look at other traditionally-tricky areas like PIK (payment in kind – a kind of built-in Ponzi scheme), stuff which really did blow up during the Recent Unpleasantness they have not remotely picked up at the same rate.

And when things do go wrong, it’s noticeable that you do get strong, watertight accounts of “Why this is a bubble/why this stuff is crap”. Here is Pershing Capital’s 64-page presentation more than a year before the crisis broke – when the securitisation machine was still running, whcih accurately captures chapter and verse of the subprime fiasco.

4) what turns a bubble into a bomb is leverage. Look at the difference between 2000 and 2008′s worst mainstream investments – the NASDAQ and AAA Residential Mortgage Asset-backed paper. The difference is that massive leverage was applied to the latter – with disastrous consequences. As I’ve noted before, the Shadow Banking system is in severe remission, and mainstream bank leverage remains very contained.

bubbles

source: Bloomberg, Markit

Key elements of a bubble – a wild departure from any historical precedent of valuation, and glaring engagement in downright demented economic activity – appear to be missing so far. The nature of QE is that “financial instability” will be a nagging risk – but so far that’s all it is. Perhaps a little bit early to be assessing fellow lift passengers for edibility.

Oh and one final note: We in finance are entirely capable of making the same mistakes again. However we won’t make literally exactly the same mistakes again. In 1998, Hedge Funds blew up and (despite what Taleb says) VaR was discredited. Not coincidentally, hedge funds had – broadly speaking – a better crisis than the rest of the financial sector. While the resurrection of the Synthetic CDO market is no cause for joy, it won’t be Ground Zero next time around, if only because anyone in the vicinity will be thinking “how do i avoid getting fired for being involved in this?” .I have tentative confidence that we’ll be able to avoid another massive bubble, especially if regulators stay awake this time. I have absolute confidence it won’t be a reenactment of 2008. Look for stuff that did ok in 08 and has grown immensely since then.*

 

* I did not say ETFs. absolutely not.

9 Responses to “Bubbles: How I Learned to Stop Worrying and Love the Bond”

  1. SK June 5, 2013 at 1:37 pm #

    UK Housing – serious big bubble waiting to explode in our faces.
    and the “moron” is throwing alcohol in the fire (which btw is a another bubble. have you checked whisky prices?)..

  2. willyrobinson June 6, 2013 at 8:55 am #

    Many thanks for the link to the Pershing Capital report, it’s pure gold.

    Very well written as ever (there’s even a half decent argument this time :)).

Trackbacks/Pingbacks

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