Category: Illiquidity

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Easily the worst media explanation of LDI yet

See BBC News at Ten, 12 October 2022, for easily the worst media explanation of LDI yet. The fun starts 7:10.

Presenter “So let’s turn to our business editor, Simon Jack, who’s the expert on all these things.

Jack:

8:00 “Investors want more interest to justify the extra risk”. Not really. A gilt is risk free because the nominal payment (coupon and principal) is risk free. What investors are demanding is compensation for the extra inflation implied by the market.

8:05 “The cost of borrowing shot up”. Gilts are an asset, not a liability, and don’t involve borrowing. Of course, arbitrage implies the cost of long-dated borrowing will go up commensurately, so perhaps we could forgive him.

8:20 “Some pension managers have used them as security to get ready cash now”. Argh. Pension schemes have bought them using borrowed money, using them as security for the borrowing. No cash, apart from the haircut (‘margin’).

8:25 “To be able to pay out on those pension promises” Argh again. The scheme assets, typically risk bonds or equities, enable the payout. And again, there is no cash apart from the margin (and margin doesn’t have to be cash, necessarily).

Jack’s Wikipedia entry says “Before entering journalism, Jack worked for a decade as a corporate and investment banker in London, New York City and Bermuda. He has said that he neither liked the work, nor showed much ability at it.” Fair enough.

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Shareholders’ association slams UK’s IFRS 17 discount rate paper

Interesting article here on the horrible UKEB paper that I mentioned earlier this week. I am quoted extensively.  Behind a paywall, but the main points are

  • the paper conflicts entirely with the points raised in the UKEB’s priorities list, published last week, and fails to reflect concerns raised by Sharon Bowles among others.
  • The paper says that absolute precision (in the ‘measuring’ the illiquidity spread to be used in discount rates) is not necessary, whereas the UKEB’s priority list says that discount rates often have a material impact on accounts.
  • The paper concedes that estimating the illiquidity spread is a matter of judgment, but that is OK because “such judgements and estimates are integral to insurance business and insurers have extensive relevant experience”. The article quotes Hoogervorst (ex chair IASB) highlighting discount rates as one of the inconsistencies IFRS 17 was aiming to correct.

The paper was beyond even the usual joke expected of accounting standards bureaucrats.

 

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Wirecard illiquidity


Wirecard ticks all the Eumaeus boxes for things that went wrong for entirely predictable reasons. More on that later.

Meanwhile, the chart above shows the yield of the bond that Wirecard issued last September. Notice how it explodes a bit at the end. The Sam Woods theory is that such explosions are the effect of illiquidity.

Note the smaller blip upwards in the middle of October 2019 which happened to coincide with the FT’s revelation of internal documents from Wirecard pointing to “a concerted effort to fraudulently inflate sales and profits”.

Why would such a revelation affect the liquidity of the bond? And why would the later revelation this month that nearly €2bn had gone missing affect the liquidity so much that the bond is now only worth 20c?

Still, if Sam is right it looks a great buy. Repays in 2024 with a 99.5% probability of full repayment. Any offers?

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Liquidity again

Sam Woods was questioned by the Treasury Committee on Wednesday. Transcript below, starting 16:50.

A few odd things. Woods says there have been defaults and downgrades, but soon after claims that ‘blowouts in bond spreads’ are driven by liquidity. He mentions the Matching Adjustment as the ‘piece of machinery that is operating quietly in the background’, and Baldwin asks whether without it there would be actual insolvencies. Woods first says that there wouldn’t, or he thinks there wouldn’t, then says that without it there would be ‘a major problem’.

Why don’t they just state the accounting numbers as they are, i.e. some firms with no net assets at all, or negative assets, adding that this doesn’t make the firms insolvent, because it’s merely a liquidity effect and the spreads will narrow back again? Why falsify the accounting?

More later, I expect.

Continue reading “Liquidity again”

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Artificial bloodbath

Markets are looking ultra grim this morning. The Eumaeus portfolio down 10% on the month, and that is after a nasty previous month. High yielding bond markets are also suffering badly, with significant investor outflows.

Well it’s all artificial volatility I suppose!

Time for an admission from me, namely that my own pension is largely invested in risky assets.  Is that consistent with my view that insurance firms shouldn’t be booking risky profits in advance?

Yes perfectly. I recognise that risky investments are risky, and that the risky profits might not materialise for a long time, perhaps a very long time. I willingly bear that risk. I don’t make commitments that assume the risk isn’t there, and I have household ‘management actions’, namely not going on holiday, cutting down on the port etc, that will absorb the risk if realised.

It will be an interesting year.

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More sirens

This  (the Siren Call of illiquidity) refers. “Illiquidity is not costless”. But now see this teaser from Moody’s analytics.

“Constructing discount curves for IFRS 17 presents insurers with a number of challenges,” said Christophe Burckbuchler, Managing Director at Moody’s Analytics. “These include the selection of an appropriate methodology that provides stable and robust valuations of liabilities, and production of curves and necessary documentation to meet reporting timelines. Our new service addresses these challenges and enables insurers to accelerate their IFRS 17 project and production timelines.”

It’s difficult to comment without sight of the product, but it looks like a way of using the IFRS 17 provision for a matching adjustment-like illiquidity discount. Moody’s is well-placed to offer such a service with their copious data on default rates. With a suitably chosen historical period, the realised default rate will be lower, perhaps much lower, than the spread-implied default rate. So the difference between the two rates ‘must’ correspond to an illiquidity premium!

It will either end well, or it will not.

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From the postbag – Merton model

Source: Bank of England

The Retriever has found another juicy bone. He (or she?) writes in raising a number of points about credit spreads, questioning my suggestion (following John Vickers’ assertion) that credit spreads rose in 2018 ‘Largely, if not wholly, because corporate credit risk has gone up’.

Retriever raises a number of interesting points. For the moment (and in a subsequent post) I will focus on the challenge presented to our case by the Bank of England’s structural credit model. As Retriever points out, Chart E of this 2016 inflation report (page 13 of the PDF, and copied above) suggests that the Bank of England thinks that the illiquidity premium is something like 50% of the corporate bond spread.

Presumably you must think that either 1) the Merton model is inappropriate here; 2) that the BoE has parameterised the Merton model incorrectly; or 3) that this “residual” bit of the spread is accounted for something other than credit and liquidity.

Continue reading “From the postbag – Merton model”

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Illiquidity and arbitrage

The main argument for the illiquidity premium is that it cannot be arbitraged out, as I discussed here.

So let’s set up a company where we borrow long dated liabilities at risk free, and invest the proceeds in long-dated illiquid assets. Persuade shareholders/PRA etc that there is an illiquidity premium because ‘it can’t be arbitraged out’.

Create a pile of equity by discounting liabilities at risk free + premium, pay yourself a lot of dividends or sell the company, and retire to the beach.

Congratulations! You have just arbitraged out the illiquidity premium!