Quantum Finance: The Science of Making Money Appear Out of Nowhere

Only in finance do the losers get to write history. The government then prints their memoirs in the statute books, while a new volume of folly and greed is begun.

Witness Barnard's Act of 1734. It sought "to prevent the infamous practice of stock-jobbing" that had peaked and exploded with the South Sea Bubble of 1720. Investors had long since fled Change Alley, however, and gone back to trading government bonds instead.

Come 1934, and the Securities Exchange Act tried to protect US investors from the Great Crash of five years before. It guaranteed liquidity to investors who were already broke. And in 2002, Sarbannes-Oxley set new standards for US corporate accounting, stock options and boardroom ethics.

Enron and Worldcom could never happen again, not least because they had already happened. But the US government started fighting the last war regardless, banning cavalry charges and fixed bayonets as the arms race went nuclear.

By the time Ebbers and Lay were trying to raise bail, Wall Street and the City had already moved on, massing asset-backed bonds and deploying collateralized debt obligations. Production of interest-rate swaps went into over-drive, and crack squads of investment bankers began planning leveraged buy-out deals to make Iwo Jiwa look like a picnic.

Let's call it "Quantum Finance" for now, with a nod and a wink to Quantum Physics of course. No doubt the historians will come up with a better name in good time. But the financial science is just as complex as theoretical physics, based on the fact that "energy is not continuous but comes in small and discrete units," as one definition puts it. "The movement of these particles is inherently random. It is physically impossible to know both the position and the momentum of a particle at the same time...[and] the atomic world is nothing like the world we live in."

Just like today's financial markets, in other words - a random, unknowable and unreal world of atom-sized yields.*

Quantum Finance - the science of making money appear out of nowhere - is too complex for all but the very brightest young guns to grasp. Yet it underpins the entire financial universe today. The very fabric of money, mortgages and markets has come to rely on concepts and con-tricks not even the sales desks can follow. And Quantum Finance in its higher forms remains unregulated of course, which is just as it should be. For by the time the SEC and FSA get round to hiring the PhDs they need to make sense of the mess, the smart money will have already moved on, selling out as their Lear Jets get cleared for take-off.

What about the dumb money, you may wonder. Well, if you can't spot the patsy, then it must be you. And only two questions sit between us and the next raft of "last war" regulations today: Where will the bubble explode, and what should private investors do for a helmet?

First up, the bubble - or bubbles...

"The number of [corporate] defaults will rise even in the absence of an economic downturn or interest rate increases," said Wilbur L.Ross, the 'King of Bankruptcy' to a conference in London late last month. Chairman of W.L.Ross & Co. in New York, he says default rates will rise to around 7% of all companies in 2007. The rate is just 1% now.

"There will be some tragedies," Ross warned the conference by videolink. "When you pay higher multiples, you have less margin of error." The average leverage in European corporate deals today stands at 8.2 times EBITDA. In 2001 it was just 5.2 times.

Fitch Ratings say there's also trouble ahead in emerging markets. "With the carry trade fuelled by ample global liquidity and record financial market flows to emerging markets," it said this week, "big shifts in interest rate expectations and a further weakening of the US dollar would test those emerging markets with fragile policy credibility and large external and fiscal financing needs."

But perhaps the AAA-rated bond market will implode first. Bill Gross, head of Pimco, says we've reached a peak in making money from nowhere. Leverage on complex bond trades simply cannot get any higher, he believes, citing "a new derivative credit product retailed to institutional buyers under the sticker known as a CPDO or 'constant proportion debt obligation'."

"These multibillion-dollar instruments lever investment grade indices up to 15 times the amount invested," says Gross, "and offer or have offered a spread of 200 basis points over LIBOR with a AAA rating. Hard to pass up I suppose...

"But this AAA rating is subject to numerous (more numerous than usual) subjective assumptions," he goes on. "Increasing multiples of leverage beyond 15x near current yield spreads cannot maintain either a AAA rating and/or the 200 basis points in yield spread that have made this derivative so attractive...The increasing use of leverage, in other words, at least as applied to this particular area, appears to have run out of its magical ability to increase returns."

The problem is one of momentum. For if leveraging cannot increase, then it's apt to shrink back, rather than stick. And the most likely cause of leverage recoiling, if all previous bubbles are a guide, will come with a bang, not a whimper.

Then there's the asset-backed bond market, most especially mortgage-backed securities (MBS). This draws the heavy-gun shelling away from Manhattan and onto consumers - first in the way their home loans are funded, and then in the investments made by their pension and insurance fund managers. It brings Quantum Finance right into your home!

The United States had $6.2 trillion in these mortgage-backed securities (MBS) at last count, nearly a quarter of the entire US bond market and 50% larger than the US government's own Treasury debt issue. Appetite amongst professional investors in Europe is so great, Sampo and ABN both flooded their MBS into the market in the very same week last year. Britain is late to the party, but it got $9.4bn from one lender last month, plus another $15bn from HSBC, the world's third largest bank.

And why ever not? Selling a bond backed by mortgage debt means the banks can lend that much money again, doubling their assets per Dollar of deposits. In Britain alone, this little scheme helped the major banks lend nearly $1 trillion more than they took in from savers between 2002 and 2005. Money from nowhere means money for nothing, and the banks have always loved that!

But "mortgage-related debt differs from most other categories of debt," notes a 2003 paper for the US Federal Reserve, "in that it is subject to the risk of prepayment." You might think the risk of early repayment hardly worth fretting about. Not compared with, say, the risk of never getting your money back at all. But when interest rates slip, homeowners refinance. So the MBS backed by the first loan now gets repaid...and that leaves MBS buyers holding cash instead of income.

What's a pension fund manager to do in the scramble for yield? Buy bonds of course, preferably long-dated Treasuries...thus pushing all bond prices higher...sending bond yields lower...and causing more mortgage re-fi that then repays more MBS!

"The market rallies, mortgages prepay, and all of a sudden people have to buy," says one MBS strategist. "It can turn into something that snowballs and causes the [bond] market to rally for a significant period of time."

The MBS market seeps into the wider financial universe via another leaky pipe, too. "When mortgages, or other debt instruments, are chopped up for securitisation," explains John Dizard in the Financial Times, "the more risky slices may go to high yield mutual funds and people who think they're sophisticated investors. The 'residual risk', 'first loss' or 'equity' slices go either to hedge funds or are retained by the dealers or banks who package the securitisations."

These dealers and banks don't use the Treasury market to offset the prepayment risk of MBS bonds, says Dizard. They go instead to the market for interest-rate swaps, where they can exchange one stream of income for another stream of yield, tweaking their earnings without selling their assets. As of June, interest-rate swaps - in nominal outstanding value - were worth $65 trillion.

"It's big, invisible plumbing," says Dizard, "like water mains, of little interest most of the time until there's a gurgling and nothing comes out of the pipe."

A gulp of air glugged out of the pipe at the start of this month. On Dec.7, the day that sub-prime US mortgage lender Ownit went bust, the spread on 10-year interest-rate swaps in the Dollar jumped 2.5 basis points. That might not sound like a lot, but it's five times the market's standard deviation. "A five standard deviation move in the Dow Jones Industrial Average would be a decline of 350 points," Dizard points out, "or a 40-point drop in the S&P500. That would have got your attention."

Remember, the interest-rate swaps market is worth 5 times the United States' annual economy. And maybe those cheap swaps between bankers - their little-seen deals that pump credit from the mortgage market into the bond market into the profits of banks, insurance managers and hedge funds - are about to get pricey.

"Ownit may have been the canary in the coalmine," says one MBS fund manager. Hell, he's so worried, he's switched to buying AAA-rated debt from Fannie Mae - which finally filed its 10k accounts for 2004 only this month - and the other government-backed agencies in the crumbling US mortgage market.

The money's got to go somewhere. Professional investors abhor cash. But "there are not enough quality assets to go round, so people are buying up the rubbish, closing their eyes to the risk and hoping that nothing will go wrong," as Anthony Hilton put it in the London Evening Standard, also on Dec.7 for some reason.

"This is the case whether they are buying 20-year bonds issued by the current Iraqi government, sub-prime mortgages on slum property in Baltimore or a parcel of 130% mortgages issued to unemployed people in Wigan," Hilton went on. "The world's financial markets have forgotten the meaning of risk."

Not even Quantum Finance will stop the markets rediscovering risk in 2007, we guess. Cheap money could only ever get cheaper in this bubble, just as in all other bubbles. Higher rates would unwind the leverage, yet the leverage has now gone as high as it can with Dollar rates at just 5.25%. And the search for yield, when it blows up, will become a scramble for settlement...a rush into anything offering simple ownership over complexity, real value instead of gearing.

If that sounds a little like gold to you, you might be advised to pick up some more at $620 today.

Adrian Ash
for The Daily Reckoning Australia

* The phrase Quantum Finance already exists, by the way, thanks to a paper of 2002, which looks like a spoof, and a book of 2004...which looks all too real...published by Cambridge University Press with the subtitle "Path integrals and Hamiltonians for options and interest rates". If that means anything to you, and you're reading this, you might want to fire up the Lear Jet before the gold market opens on January 2nd.

Editor’s Note: City correspondent for The Daily Reckoning in London, Adrian Ash is head of research at www.BullionVault.com, the world’s top site for direct gold ownership.

 

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