Toxic assets

Despite all the talk about ‘toxic assets’, the fact is that the large majority of this structured paper is at virtually no risk of default. This fact should not come as a surprise. Consider for example an ABS structure containing, say, vehicle or student loans. The individual borrowers will mostly make an effort to repay, since they do not want to face the difficulties of having a poor credit record. Most will have the income to repay as well. In a pool of such loans, even in a deep recession, it would be quite out of line with all previous experience of such lending to have losses of more than say 10 or 15 per cent on the portfolio. This means that the senior investment-grade tranches, the top, say, 80 per cent of the structure, are indeed very safe. Allowing for the other forms of credit protection in these structures, overcollateralization and interest income, the losses on the portfolio have to go well above 20 per cent before these tranches are at risk. The very best investment-grade tranches, those rated AAA, have even more protection. They might be the top 70 or 75 per cent, so losses have to rise well above 25 per cent before they are in difficulties.
The big problem for the banks – the reason they can no longer fund themselves – is that investor confidence in all structured assets has now evaporated. Even the AAA tranches of safe asset-backed securities cannot be sold. Where there are transactions, they are at prices 10 or 20 per cent below par value – that is, so far below any sensible assessment of their fundamental value that no holders will part with them at this price unless forced to do so.
The amount of this good-quality but illiquid paper is extremely large. Some further calculations using the data as a starting point suggest that, after excluding around $600 billion of dubious restructured ABS-CDOs and CDO2 which never deserved AAA ratings in the first place, there is still about $4.8 trillion of extremely safe AAA structured paper outstanding.
Who was holding all these securities? Regrettably, there are few statistics on who was holding what. The IMF has collected views from the market participants and reports broad estimates of holdings in its global financial stability reports. Commentary from many industry professionals makes it clear that the majority of the AAA paper was kept by banks, either in trading or treasury portfolios. My own judgement, based on this information and discussion with a number of industry professionals, is that about $3 trillion of the investment grade paper has remained with banks.
What about the riskier mezzanine and equity tranches? Much of the mezzanine tranches were sold into restructured vehicles, so were again often held by banks. Equity tranches were sometimes held by the structuring departments. It is very difficult to say where the rest have ended up.
If most of the new credit securities were sound, what then went wrong? The big weakness of the new credit arrangements was that banks assumed that there would always be a liquid market for trading these securities. If this were true – that securities could always be sold – then it was safe to finance portfolios of long-term credit securities using large amounts of low-cost short-term borrowing.
Banks pursued this flawed strategy on a huge scale. Analysis of bank accounting statements suggests that banks worldwide held at least $3 trillion (nearly a quarter of US national income) of supposedly high- quality AAA credit securities, financed short term. But this maturity mismatch, borrowing short to hold long-term assets, is an inherently risky portfolio strategy, susceptible to collapse whenever there is a loss of investor confidence.
The growing losses on US sub-prime mortgage lending triggered a loss of confidence in all forms of structured and mortgage-backed credit instruments. This had a global impact because so many banks worldwide held and manufactured different kinds of these instruments. They all tried to reduce their exposures at the same time. As a result there were now many sellers of these securities but hardly any buyers. Sellers but no buyers meant that trading slowed to a halt, and prices collapsed. The liquidity which all banks assumed they could rely on was no longer there.
Why were there no buyers from outside the banking system? Because of the market freeze, prices of senior structured and mortgage-backed securities had fallen well below any reasonable estimate of their underlying value. They should have been attractive investments at these bargain prices. But non-bank investors did not understand these instruments very well and if they did perceive opportunities they were subject to regulatory and other constraints that prevent them purchasing assets when prices are low.
A particular problem seems to have been so-called ‘solvency regulations’, which are supposed to help financial institutions avoid insolvency but actually have the opposite effect, exaggerating swings in market prices and making it more likely that institutions will fail in a financial crisis. These impacts are further exaggerated by the mark to market accounting rules. No one has an incentive to ‘catch a falling knife’ – that is, to purchase an asset that has fallen in value – until they are very sure that prices have bottomed out. Until then the asset has the potential both to add to your capital requirement if the asset is downgraded (under banking and insurance regulations) and to result in short-term losses if the price falls further (IFRS and US GAAP accounting standards). Such mispricing could be substantial and last a long time.
So the principal explanation of why this has been such a global crisis is that banks worldwide (wrongly) assumed that they were safe borrowing short to hold long-term structured mortgage assets. If funding withdrew they could always limit their exposures by cutting back on their portfolios, for example by selling loans to other banks, or taking out ‘hedges’ (insurance contracts) against further losses. But this idea, of active credit portfolio management, does not work when all banks are in trouble. Another analogy is with a fire in a crowded hotel lobby. Everyone tries to get out through the revolving doors, but only a few can do so at any one time, and in the crush everyone is trapped. What is required instead is an orderly exit, one investor at a time, to allow all to exit their positions without huge loss.

Missed Orders

Because the profit objective, projected daily range, holding time, and end-of-day constraints all put limits on a day trade, there are situations in which the market jumps after a news release and you cannot get filled anywhere close to your intended price. With most of the potential profit gone before you enter the order, it would not be surprising to simply skip that trade. These missed orders, called unables, can add up to a large part of your profits; at the same time they never reduce your losses.
Some markets are prone to more unables. For the energy complex, heated military or political activity in the Mid-East can cause a prolonged period of very erratic price movement, resulting in as much as 20% unexecuted trades during a 1-month period. If we consider the normal profile of a short-term trading system as having an average net profit of $250, an average loss of $150, and a 50% frequency of profits, we expect a profit of 85.000 for every 100 trades and a reasonable profit-to-loss ratio of 1.66. If, however, there are 10% unables, that missed opportunity must come from the profits; if the market was moving in the opposite way, you would get all of your positions filled. Then 10% of the profitable trades means 5 trades out of every 100 for a total of $1,250 missed. This reduces the total profits to $4,750 and the profit factor to 1.50. It may turn a marginal trading strategy. or one with small profits per trade, from a profit to a loss.

IMPACT OF TRANSACTION COSTS

Transaction costs are the greatest deterrent to day-trading profits. The failure to execute near the intended price, plus the commission costs. can remove a large part of potential profitability and even turn expected profits into losses. An aspiring day trader has two ways of improving performance: by paying lower commissions and by careful selection of opportunities. The average dollar volatility for the years 1990 through 1996 is shown next to the percentage represented by a $100 transaction cost. In general, $ 100 is a modest value for the combination of commissions and slippage, and traders would be very pleased to extract an average profit of one-half the daily volatility. A practical approach would therefore use twice the percentage effect of a $100 cost shown here.
Realistically, a day trader would choose the index markets, more volatile currencies, and long-term interest rates as their best opportunity for profits. Com represents the least desirable market because very low volatility leaves more risk than opportunity. Although a $ 100 transaction cost may seem high for this market, a $20 commission and slippage equal to a minimum move of 1/4c, or $12.50, totaling $45, would be the smallest possible costs. An occasional fast move in the market, based on unexpected economic news, or large orders entering at one time, must result in a larger number, raising the average.
To keep dollar volatility of a futures contract to a level acceptable by most traders, exchanges have been forced to resize contracts, specifically stock index markets, as overall share values have climbed. During 1997, the S&P was reduced from $500 per basis point to $250, and the FTSE-100 from £25 to £10. In 1998, the French CAC40 contract was cut to 25% of its previous size. This increases the relative size of transaction costs.

Day Trading

A day trade is a position entered and liquidated during a single trading day. The techniques of time of day and daily,patterns, are put to use by the day trader. Day, trading requires extreme discipline. excellent planning, anticipation, and concentration. The need for a fast response to changing situations tends to exaggerate any bad trading habits as in other fields. the shorter the response time, the greater the chance for error. We will extend the idea of class-trading to systems and methods that may also be held overnight, but expect to limit the trade to about 24 hours.
To keep mistakes to a minimum, each day’s strategy must be planned in advance. It should focus on the most likely situations that might occur based on the nature of the current price movement. There should also be a contingency plan for the extreme unexpected moves in either direction. Making spot decisions during market hours m-ill cause more frequent errors.
Computers have caused the number of day traders who rely on systems to increase. and have created an entire class of screen traders. The steady- increase in automated exchanges, led by Germany’s DTB and followed by France’s conversion of Matif. is sending a strong message that electronic trading will dominate the future. The availability. of intraday price feeds and system development platforms, such as Omega’s TradeStation. have greatly increased the number of day-trading participants. Only, 10 years ago the best one could expect was to display standard indicators and moving averages on a real-time price chart. Now you can fully program complex trading strategies that combine more than one market and more than one time frame into a single package and display bus, and sell signals on the screen as well as record a historic log of trades. All of these tools have greatly increased competition among individual and commercial traders.
For the arbitrageur, computers have had an even stronger impact. Sophisticated systems at banks and large financial institutions consolidate data feeds that bring current transactions on every type of interest rate vehicle in even- maturity and major currency. Analytic programs can find issues that are outliers and show which combinations (called strips) can produce a riskless profit. For the individual trader. few of these opportunities are available, although they add liquidity to the market. Individuals, however. find it much easier to create spreads of different deliveries -within the same market as as spread between two related products. Stock traders can create sector baskets or look for performance differences within a sector. Spread trading and formulated values. such as the energy crack or soybean crush, can be improved using similar displays, Many of the opportunities that now seem so easy to see would previously. have been missed. This faster. more systematic response to the market allows traders to improve profits and reduce risk in anyday-trading method.

Investor Constraints

In addition to attitude toward risk, an investor’s investment strategy will be affected by various constraints. We discuss five of the most common and important constraints next.
RESOURCES
Probably the most obvious constraint, and the one to which many students can most easily relate, is resources. Obviously, if you have no money, you cannot invest at all! Beyond that, certain types of investments and investment strategies either explicitly or effectively have minimum requirements. For example, a margin account must normally have a minimum of $2,000 when it is established.
What is the minimum resource level needed? It depends on the investment strategy, and there is no precise answer. Through mutual funds, investments in the stock market can be made for as little as $500 to start, with subsequent investments as small as $100. However, since there are frequently minimum commission levels, account fees, and other costs associated with buying and selling securities, an investor interested in actively trading on her own would probably need more like $5,000 to $50,000.

HORIZON

The investment horizon refers to the planned life of the investment. For example, individuals frequently save for retirement,.where the investment horizon can be very long depending on your age. On the other hand, you might be saving to buy a house in the near future, implying a relatively short horizon.
It is true that stocks outperformed the other investments in the long run, but there were shorter periods over which they did much worse. Consequently, if you have to pay tuition in 30 days, stocks are probably not the best investment for that money. Thus, in thinking about the riskiness of an investment, one important consideration is when the money will be needed.

SPECIAL CIRCUMSTANCES
Beyond the general constraints we have discussed, essentially everyone will have some special or unique requirements or opportunities. For example, many companies will match certain types of investments made by employees on a dollar-for-dollar basis (typically up to some maximum per year). In other words, you double your money immediately with complete certainty. Since it is difficult to envision any other investment with such a favorable payoff, such an
opportunity should probably be taken even though there may be some undesirable liquidity, tax, or horizon considerations.
A list of possible special circumstances would be essentially endless, so we make no attempt to produce one here. Just to give a few examples, however, the number of dependents and their needs will vary from investor to investor, and the need to provide for dependents will be an important constraint. Some investors want to only invest in companies whose products and activities they consider to be socially or politically suitable, and some investors want to invest primarily in their own community or state. Finally, some investors, such as corporate insiders, face regulatory and legal restrictions on their investing, and others, such as political office-holders, may have to avoid (or at least ethically should avoid) some types of investments out of concern for conflicts of interest.

Weekday Patterns

During their constant exposure to the market, professional traders often observe patterns in weekly price movement; their acceptance of these patterns is as old as the market itself. In Reminiscences of a Stock Operator, the fictional character Larry Livingston (assumed to be jesse Livermore) begins his career recording prices on a chalkboard above the floor of the New York Stock Exchange, eventually becoming aware of patterns within these prices. The most accepted occurrence of a pattern is the Tuesday reversal, which is taken as commonplace by close observers of the market. When questioned why a strong soybean market on the first of the week is followed by a weak day, a member of the Board of Trade would shrug his shoulders and quote: “Up on Monday, down on Thesday” if this is true, there is a trading opportunity
if a commonly accepted idea is not enough to be convincing, consider the additional rationalization about human behavior: The weekend allows a buildup of sentiment, which should result in greater activity on Monday. Coupled with adding back positions that were liquidated prior to the weekend, this may cause a disproportionate move on Monday, especially early in the session. This pattern may be further exaggerated when a clear trend exists. With this overbought or oversold condition, it is likely that Tuesday would show an adjustment. So much for hypothesizing.
The first aspect of the test was to define the weekday pattern. This was done in terms of the Friday- to-Monday move (close-to-close). Monday always received the value X, regardless of whether its direction from Friday was up or down. For each day that closed in the same direction as the Fridayto-Monday move, another X is used; when the close reversed direction, an 0 is recorded. Therefore, XOXXO means that Tuesday and Friday, represented by 0, closed in the opposite direction from the prior Friday-to-Monday move, while Wednesday and Thursday were in the same direction.

Treasury Bonds

This market, as with the S&P, has had an upward bias during the past 10 years; therefore, the symmetry of the patterns may be affected. For bonds it is interesting to view the small gap open, for example .125 equal to 4/32. There is an 86% chance that prices win cross the prior close during trading, but a much smaller chance (38%) that prices win close lower. The 52% chance that prices will close above the open creates an opportunity for buying, provided risk can be controlled.

Trading Decisions

For markets such as the Deutschemark, which has a steady chance of posting a new high or low anytime after the first 15 minutes (remember that this interval includes any reaction to U.S. economic data that is released 10 minutes after the open), trading could be approached by deciding, after 15 minutes, whether the market has already made a high or a low for the day. For example, if an economic report indicates a weak dollar, and the price of the D-mark jumps 50 ticks, we could reasonably assume that we have seen the lows of the day. If prices make a new high during the next 15 minutes, we are even more likely to have seen the lows in the first 15 minutes. It is possible that we have seen both the lows and the highs. but it A-as the lows only that occurred at the most common time. If we assume that the high can occur anytime during the day, then buying sooner will give more opportunity to profit by the end of the day.
You can increase the confidence in your decision by waiting about 2 hours into the trading day, when most markets have a 50% chance of seeing a high or a low already established. While this may make it easier to identify the correct extreme, it reduces the opportunity for profit by the end of the trading day. A projection of volatility, which can be reasonably constant for many markets, could help decide whether there is enough opportunitv to enter a trade.

TIME OF DAY

Market participants, especially floor traders, are the cause of periodic movement during the day. Angas called these the “tides of the daily prices.” Over the years, the great increase in participants has added liquidity to each pit but has not altered the intraday time patterns.
There are a number of reasons for the regular movement of prices, Because most of the daily volume is the result of day trades, those positions entered in the morning will be closed out by the afternoon to avoid the need for the margin required of positions held overnight. Orders that originate off the floor are the result of overnight analysis and are executed at the open. Scalpers and floor traders who hold trades for only a fewminutes frequently have a midmorning coffee break together; this natural phenomenon causes liquidity to decline and may result in a temporary price reversal. All traders develop habits of trading at particular times. Some prefer the opening, others 10 minutes after the open. Large funds and managed accounts will have a specific procedure for entering the market, such as using close-only orders.
A day trader must watch certain key times. The opening moments of trading are normally used to assess the situation. A floor trader will sell a strong open and buy a weak one; this means the trade must be evened-up later and thus reinforces the opening direction. On a strong open without a downward reaction, all local selling is absorbed by the market and later attempts of the locals to liquidate will hold prices up. In any event, floor trades can be expected to take the opposite position to the opening direction, usually causing a reversal early in the session.

Put-Call Ratios

The ratio of put option volume to call option volume, called the put-call ratio, is the major sentiment index for listed options. It too is used for its contrary value. The interpretation of extreme levels of the put-call ratios (in particular, the index option) points out a problem that may reflect on the proper use of all contrary indicators.`
Prior to 1986, the market was considered ready for an upturn when the total put volume exceeded 65% of the total call volume. Similarly, when the put volume fell to 35% of the call volume it was a bearish indication. In the volatile markets of 1986 and 1987 these levels proved to he far too close, and as McMillan said, “Not surprisingly, the put-call ratios fell into some disfavor at that point.” This could easily happen with a contrary indicator, or any indicator that rarely reaches its extreme values. Because contrary opinion is a valuable addition to analysis, use of these indicators now focuses on relative highs and lows. This can be accomplished by smoothing the ratio using a standard moving average or momentum indicator (a simple difference over ndays). When the ratio moves over 65% and turns down it is time to sell. Such an approach gives up a timing edge but greatly reduces risk and increases reliability.