Interpolated Yield Curve forecast

Each month Bloomberg surveys 60 to 70 economists to get their estimates of where Fed Funds, the 2-year Treasury, and the 10-year Treasury will be over the next several quarters.  I take this data and interpolate for the points in between the survey data to create the attached report.  This allows us to get a broad view of where various economists see interest rates going over the coming quarters.

You’ll notice from the section titled “Change from Previous Months Survey” that expectations for Fed Funds and the 2-year have dropped the most.  The Median forecast for the 2-year Treasury in 3Q 2011 in this month’s survey is a 1.60%...that is down from a 1.85% in July and a 2.40% in August.

You’ll also see from the report that forecasts dropped for almost every forecast period…the exception is the near term Fed Funds forecasts.  It’s not much of a surprise, after all how difficult is it to forecast “0 percent” for two quarters when the Fed just got done saying that rates will remain exceptionally low for an extended period?

If you have any questions or if there is anything I can be doing for you just let me know.

Regards,

Steve Scaramastro, SVP

800-311-0707

 

 

 

Market Update: Follow up on last weeks Prepay Update letter

I thought this afternoon would be a good time to provide a follow up on last weeks Market Update titled “Very Important Update on MBS prepays” that discussed rumors of a new effort to generate refi activity.  The e-mail discussed selling higher coupon MBS to lock in gains and/or avoid an increase in prepays that would erode gains and burn down yield. 

The idea was to first decide if you thought this was a realistic risk factor.  If you didn’t view it as a risk then there would be nothing to do. 

For those that viewed the risk as material we discussed quickly identifying bonds that you wanted to sell and to do so before the market reacted and began pricing this risk in.  The idea was that prices on higher coupon MBS would drop, and prices on the lower coupon MBS would rise (and put further downward pressure on reinvestment yields).

This afternoon the market began pricing in this risk.  MBS with maturities of 15 years or longer and coupons higher than 5.00% are trading lower today despite a big rally in the Treasury market.  The 10-year Treasury is up 21/32’s right now to offer a 2.68% yield while MBS prices on the aforementioned coupons are down anywhere from 4/32’s to 7/32’s this afternoon.  At the same time, prices on the lower coupon MBS are trading higher.  This is exactly what we warned of in last week’s e-mail.  Many investors have already made their decisions and have taken appropriate action. 

For those that are still on the fence it might be helpful to note that bids are starting to fade and prices are rising on reinvestment options.

As we said from the outset, each investor will have to make their own decision as to whether or not this risk factor has a high enough probability to compel one to act.  If you don’t view this as a material risk factor then you can move on to more productive things.  If you fall into the camp that is concerned about this issue then you should note that your timeline for action just got shorter.  The market is beginning to move against this trade.

If you have any questions or if there is anything we can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

Market Update: 8 6 10 _ Treasuries Rally into the weekend

We got some much anticipated economic data this morning and there appears to be a huge gap between the markets view of this data and the view of the market commentators.  I was on my way in to work when the data was released so I listened to it on Bloomberg radio.  They put such a positive spin on every number that I thought Treasury yields must be rising.  Imagine my surprise when I get to my desk and the 10-year Treasury price is going straight up.

Below is a screenshot that shows a breakdown of this morning’s numbers:

 

I took the liberty of highlighting the numbers in green, yellow, or red to point out which direction the releases were in relation to the survey data.  Green numbers beat the survey, red were worse, and I used yellow on the Unemployment rate because it was unchanged from last month.

On the surface it might appear that there was more good news than bad.  However, not all numbers carry the same importance.  The market is reacting this morning largely to the Change in Non-Farm and Private Payrolls figures.  These not only missed the estimate  this month but were both subject to large downward revisions last month.  Notice that in the “Prior” column, last month’s release for Non-Farm Payrolls was -125k jobs…but the revision took that down to -221k jobs.  Likewise the Private Payrolls were reduced downward 62% last month.  Private Payrolls doesn’t have a lot more room to give on downward revisions before it goes negative. 

The 10-year Treasury is up 21/32’s this morning to trade at a 2.84%.  We last saw this level on 4/15/09.  That’s all the news to report at the moment.  If you have any questions on this material or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

 

 

FW: Very important update on MBS and prepays

The next scary story

We have maintained over this entire cycle that if the government wants something then the government will get it.  It goes in the same category as “you don’t spit into the wind, you don’t pull the mask off the ol’ Long Ranger and you don’t mess around with Slim”.  This outlook is the primary reason that we have cautioned everyone away from high premium MBS as long as we could.  The longer the final maturity and the higher the premium the less we liked it.  When most of the world was squawking that “nobody can refi so there is no risk in big premiums” we took a more cautious, and I believe a bigger picture view.  It has been our belief that there are more risk factors at work in this market than the normal, easy to predict factors.  Once the government gets involved there is a huge wild-card at play…and it’s terribly difficult to figure out how the card will be played.

We are beginning to hear of a new push by the government to ignite a refi wave.  The idea behind this strategy is nothing new…refi’s will lower monthly payments which will put more money in consumers’ pockets and also reduce the rate of foreclosures which will in turn help home prices in general.  What’s not to love?  While I try not to involve politics in any of these write-ups I would be remiss in my duties if I didn’t point out that this idea is being pushed just a short time before a very important election cycle.

The idea to get refi’s going has been an ongoing theme with the Fed and the Administration.  Thus far it has been difficult to implement despite some very drastic efforts.  The current idea that is being kicked around is that the GSE’s will waive or provide for much more lenient LTV and FICO requirements which will make it a slam dunk to get refi’s going.

If this happens prepays will go through the roof on longer final/higher coupon MBS.  This means a few things for investors. 

1 – If you bought high coupon MBS at lower premiums a few years ago you have big gains.  These gains will quickly evaporate as the market shifts toward expectations of the refi wave…the bid will go away on your bond. 

2 – If you bought the high coupon MBS more recently…and therefore at a huge premium…then you could be introduced to negative book yields as you are forced to burn down that premium over a very short time horizon.

3 – Yields on available lower coupon MBS will likely drop as a massive wave of refi generated cash flow is reinvested into the sector.

What should you do? 

There are two answers here.

First…if you don’t think this will happen…then you don’t have to do anything.

Second…if you fall into the camp that does see this happening then you’ll want to take some action in advance.  The first thing to consider is selling bonds that are in the strike zone so you can capture gains rather than let the market erode them as prepay expectations get priced in.  It would really stink to be in a “rates unchanged” environment yet watch the “unrealized gain” section of your bond accounting report drop like a rock. 

If you recall a few months ago when the GSE’s decided to clear the “log jam” of late pays in their pools, prepays spiked and traders quit bidding bonds.  There was a period of time where you couldn’t sell your MBS.  Someone might throw out a low-ball bid that was several points below market but the reality was that you had two choices… get scalped or don’t sell.  It was an anxious month.

OK so I sell…now what?

The next issue is what to go back into.  I would think that the most popular route (based on current market activity) would be to refinance into Full Faith and Credit, low coupon ARM structures.  If you do this before everyone rushes for the door you will get both the benefit of higher prices on the sell side and higher yields on the buy side.

These aren’t great choices…but you can’t hope for much better given that the plan itself is a terrible idea.

It’s important to note that this is not a done deal yet.  Portfolio managers will have to make their own determinations as to whether this plan will come to fruition or if it will die in the planning stage.

Once you make the first decision as to the probability of occurrence you can begin making plans for your next move.  If the refi wave comes history will record two types of investors…those that got out of the way early and those that got crushed.

If you would like us to help you identify and monitor bonds that may be in the strike zone just shoot us a copy of your most recent bond accounting report.  We have the analytics to quickly identify bonds that are likely to be exposed to this event and we can quickly provide swap ideas to remove you from harm’s way.

If you have any questions on this material or if there is anything I can be doing for you please let me know.  I’ve included links to two stories on this topic for reference.

http://www.investors.com/NewsAndAnalysis/Article.aspx?id=117087239&source=Newsfeed&Ntt=Slam

http://www.marketwatch.com/story/could-the-government-create-a-backdoor-stimulus-2010-08-04?dist=WSJfeed&siteid=WSJ

 

Steve Scaramastro, SVP

800-311-0707

 

Market Update 8 4 10 _ The heat index is 90 over Fed Funds and deflation is the talk of the day

It’s August in Memphis, Tennessee and the heat and humidity hang in the air as heavily as the phrase “double-dip” at an FOMC meeting.  It’s so hot and wet outside that even the mosquitoes are on strike.  As I walk through the neighborhood there are no people on the porches to say hello to…everyone has retreated inside air-conditioned fortresses and they are praying for November and the change in the weather that comes with it.   It’s 9:00 PM and I’m sweating bullets as I walk lazily down the street with the dog and my thoughts.  With weather like this it’s no wonder that music we know as “the blues” was born here.

In a way this weather is analogous to the market.  The government intervention hangs so thick in the air that it affects everything…and everyone is sweating.  No product is immune from the heavy hand of the Fed and the Government and investors are singing the blues.  Many investors are no longer on their front porch and wanting to talk…they’ve retreated inside the air conditioned confines of the bank and find the discomfort of selling Fed Funds at 25 bps preferable to being on the front porch talking about bonds.  In a way it’s hard to blame them.  Nominal yield levels are so low that even I find myself periodically asking “Really?  The yield is THAT low?”

From a purely investment portfolio standpoint (that is ignoring asset/liability and liquidity concerns for a moment) we are presented with an ugly set of options.  The combined actions of the Fed and the Government have created an environment of low yields and high uncertainty.  The Fed’s asset purchase program has crushed spreads on investments, and their monetary policy is keeping the short interest rates exceptionally low “for an extended period”.  

What is an investor to do?  The short answer is that it’s not much different than before…you’re just doing it at lower rates.  Asset/Liability concerns are still addressed first, then liquidity, then investment structure, yield, and price volatility.  We’ll talk about these a bit further down the page.  Before that lets briefly look at the two issues that currently dominate the discussion.

Inflation or deflation?

Up until very recently the Fed has maintained that they are concerned about inflation.  That is understandable as the Feds dual mandate says they must maintain maximum employment and price stability (i.e. they must keep inflation in check).  From the outset of this business cycle the Fed has focused exclusively on inflation and virtually ignored the “D” word…Deflation. 

In fact we’ve asked some very pointed questions of the Fed Presidents that we’ve been able to corner.  It’s always a bit funny to me that Fed Presidents show up at meetings such as the Economic Club of Memphis and they get the usual cabal of business owners who have general concerns about the economy but really don’t have enough knowledge to launch a serious question.  Then we come in.   Sometimes I’m there by myself…other times there will be a whole table of us…Fixed Income Salesmen. 

Oh, they must loathe us.  We have the knowledge to ask some tough questions and we have absolutely nothing to lose by asking them.  So…if we rewind the tape a few years we find ourselves at a meeting where Fed President Sue Bies is the speaker.  I worked for Sue a number of years ago and it was good to see here come back to Memphis.  With the formalities and dinner out of the way we got on with the speech and the Q&A. 

After a bunch of softball questions from the crowd Sue recognized our table to provide the next question.   Will Taylor, Director of our office launched one at her.  He asked her what the Feds plan was for deflation.  The room was silent and our Fed official verbally parried and spun past the question and returned an answer about inflation, then she tried to move on to the next question.  Before she could do that Will pounced on her with a clarification that he had asked specifically about deflation not inflation and he wanted to know what the Feds plans were to combat this threat if it were to materialize.  The short answer was that the Fed had no plan to combat deflation…then the answer returned again to inflation.  She moved on to the next question and we stared at our mass produced desserts and banquet hall coffee and cogitated on our newly found knowledge that the Fed had no plan they could implement to combat deflation.  It was a sobering moment.

Over the next several years the Fed would continue to ignore deflation as a threat and focus instead on inflation. By most measures we don’t have an inflation problem on our hands.  The one exception I can proffer immediately would be that of hot wings.  I was driving home the other night and I passed a guy on the sidewalk waving a sign that said “50 cent Wings.”  I said out loud “wow…I remember nickel wing night.”  I couldn’t bear to ponder what a bucket of beer would cost at that joint. 

So to say there is no inflation anywhere would be incorrect.  However…on average we’ve had disinflation for a period of time followed by very subdued inflation currently.  The Fed would love nothing more than for some inflation to pop up.  It’s the easiest thing in the world to fight…you just raise rates...and since they are starting at zero percent the Fed really has a lot of ammo with which to fight the war on inflation.

Deflation however is another story.  How do you combat falling price levels?  This is a very dangerous thing as it relates to entities that are highly leveraged.  In this situation the value of the asset falls but the value of the debt you hold remains the same.  You become more underwater as deflation sets in.  As prices fall you become less and less able to liquidate the asset to discharge the debt.  Margin calls come next as your LTV numbers get out of whack, then comes the forced selling which causes prices to decrease at an even faster rate, which in turn worsens your debt ratios which triggers even more margin calls.  This is what Irving Fisher called the Debt-Deflation spiral and his works conclude that this ends only after an almost universal bankruptcy. 

His solution is to “re-flate” asset prices back to the levels at which the debt was contracted on them.  The implication there is for the government to spend their way out of deflation…or monkey with the system to get prices back to where they were before deflation set in.  There are no pretty solutions for deflation.  So far we’ve seen the government do a little of both (think huge stimulus bill and mortgage modification programs). 

What do you do?

If your outlook is for inflation then you buy short maturities or floating rate bonds.  As bad as bond yields are they are almost universally better than the rate offered on Fed Funds.  Make sure you have you’re A/L and liquidity bases covered and then make sure the bonds you are buying match your outlook on rates.  If you are having trouble coming to a decision on an interest rate forecast you might start with the monthly survey data that I put out and make changes from there.

If your outlook is for deflation then you buy the longest bonds you can find.  Most banks can’t execute a “best case” plan for deflation because the ultimate bonds for that scenario would be the longest final maturity, lowest coupon bonds you can find.  We’re talking something like a 30 year zero-coupon bond.  First of all you’d have to have the ability to buy such a product…and not many banks do.  Secondly you’d have to have the guts to buy such an instrument…it could easily turn into accidental suicide. 

If you are wrong on the “deflation/longest maturity you can buy scenario” then you are very…very…wrong.  You are the type of wrong that gets your name on a billboard in town with bad words printed underneath.  You are the type of wrong where everyone who works at the bank ever again will be told the story of how wrong you were.  It’s the kind of wrong that has you saying things like “it seemed like a good idea at the time” as you cry in your beer and tell the bartender how you were so right until the impossible happened.  Lucky for us we all have policy constraints that would keep us from embarking on such an ambitious plan even if it were to come to us.   

The real point here is that if your forecast is for deflation then you need to be extending duration.  Buy longer product that has call protection.  This will provide higher yields (yes…current yields will seem high if deflation visits us), large gains, and will insulate you from having to make reinvestment decisions on those dollars in a deflationary environment.

What is the definition of risk?

A long time ago I read that a good definition of risk is that more things can happen than will happen.  The point of a risk manager is to navigate through this uncertainty.  Generally this involves not making any big bets one way or the other.  If the ship is properly loaded you can take some waves and not capsize.  If on the other hand you have loaded the boat all to one side you stand a good chance of losing the ship when you encounter the wrong wave, wind, or current. 

So we start Asset/Liability management.  Once we have our earnings insulated from adverse interest rate moves we can move on to liquidity.  After we establish that we’ve got the necessary liquidity to fund our upcoming obligations we can move on to the final step.  Given our prior constraints, how do we deploy our investment dollars to maximize our earnings? 

Rates up or down?  You call it.

Rates up

Our interest rate forecast will guide this process (remember…if you don’t have one we can provide some guidance).  If we expect rates to begin moving higher in the next year or two then you either buy short final maturities or you buy floating rate product.   Short final maturities obviously have a significant drawback right now…they offer very little in the way of yield.  But such is the price for staying short.  No risk, no reward.  A 2.5 year non-call 1 year callable will bring roughly 1.00% currently.  While that is an awfully skinny yield it beats Fed Funds by 75 basis points and it insures that you’ll have all of your dollars back to reinvest inside of two and a half years. 

Floating rate product offers more options for the short buyer.  The two most popular vehicles in this arena have been Hybrid ARM MBS and corporate floaters.  There are pros and cons to each, but they represent higher yielding options for those that want to stay short.   In this arena we’re not talking about short FINAL maturities…we are talking about the time until the instrument re-prices.  A hybrid ARM has a 30 year final…but it re-prices on a much shorter basis which keeps your coupon near the current market and reduces price volatility.  The point here is that you have options that allow you to minimize your price volatility yet pick up more yield than you could on a short final maturity product. 

Rates down

If on the other hand you expect rates to fall then you need to extend your duration and get call protection.  Think bullets.  Possibly the best bond for this scenario would be a zero-coupon bullet municipal bond in the 10 to 20 year maturity range.  This offers call protection and a great deal of yield.  Currently you can get yields well north of 6% on AAA rated Texas PSF insured municipal paper.

Another popular option among buyers with this outlook has been 7 to 10 year Agency bullets. 

I’ve got no idea

If you’re unsure which way this thing will go then maybe you consider a barbell strategy.  Most investment portfolios are very short right now.  As bonds have been called many investors have replaced them with very short instruments.  This leaves room for some longer final maturities that will allow you to pick up yield without saddling the entire portfolio with undue risk.  So the barbell keeps a great deal of money in the short buckets to fund your liquidity needs, and still allows you to generate some earnings on the longer maturities.  How long you go is up to you. 

If you have any questions on this material or if there is anything I can be doing just let me know.

Steve Scaramastro, SVP

800-311-0707

 

Interpolated Yield curve forecast

Each month Bloomberg surveys 60 to 70 economists to get their estimates of where Fed Funds, the 2-year Treasury, and the 10-year Treasury will be over the next several quarters. I take this data and interpolate for the points in between the survey data to create the attached report. This allows us to get a broad view of where various economists see interest rates going over the coming quarters.

You’ll notice from the report below that the average forecasts are down for every time period in this month’s survey. If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

Market Update 6 15 10 _ Florida, the oil spill, sharks and other stuff

 

The sacrifices I make for you people

 

I know that you all have a lot of concerns and questions regarding the oil spill in the Gulf of Mexico.  Rather than leave your concerns unaddressed I went to get answers for you.  I spent the last week travelling the Florida panhandle.  I was up and down the Florida coast from Destin down to Carrabelle, through pines and palmettos, past the bays, the emerald waters, white sandy beaches, and palm trees, and all along the Gulf, and I did it all for you.  Very selfless…I know. 

 

The plan was to work during the day and be back at the house in the afternoon to hang out with the family…a combined work/family trip.  The timing of my trip was accelerated due to the BP Oil spill.  I’ve wanted to fish Apalachicola Bay for as long as I can remember and I thought that if I didn’t do it NOW then it might be a decade or more before it was fishable again.

 

Along the way I interacted with bankers, local folks, fishing guides, tourism employees, and workers at the local grocery store.  I briefly flirted with the idea of attending a meeting at city hall to listen in on the latest thoughts and plans for the oil spill but the wife drew the line there.  No municipal meetings for me while on “vacation”.  She stopped just short of actually calling me a nerd but I could see from the look on her face that it’s what she wanted to do. 

 

After a week of travelling, meetings, and conversations (all done for your benefit) I grabbed a 60 lb sack of oysters, two lbs of shrimp and a 6 pack of beer one evening and I sat down on the third floor deck that overlooks the Gulf of Mexico.  From this lofty perch I watched the sun set and listened to the waves crash on the shore.  The Gulf breezes blew, the dolphins played in the surf in front of me, and I sat back and thought about everything I’d seen and heard over the preceding days.

 

Lessons

 

The first thing I’m always reminded of is just how good of a barometer a community banker is.  They always have their finger on the pulse of the local economy and are very good at providing you with the vital signs of their community.  One of my banker friends that I met with had just done a tour of the public beach parking lot.  At first I thought “wow…this Florida banker gig is a really cool job…he’s cruising the beach during the middle of the day.”  As it turns out a parking lot is a very good source of real-time economic intel.  On that particular day there were only two parking spots open…a sign of pretty healthy activity in the beach area.  This is the type of thing a local banker would know to do.  As a tourist I’d never pick up on it…I’d be too busy griping that there are no good parking spots.  So at the moment activity is pretty good…but the cloud on the horizon is that there are a lot of people cancelling their vacation plans…even though there is no oil on their beaches.  It’s guilt by association at this point. 

 

The second thing is that I met nobody looking for a bailout of any sort.  The Americans that I met wanted to WORK.  That’s all they wanted…they wanted for people to come to the beach so that they could make a living.  They weren’t asking for government funds, no handouts, no government dole.  They just want the opportunity to work.  That is a very refreshing change of pace from a lot of the news you see now-a-days.  It’s nice to get away from the headlines and go meet real people that just want to work for a living, no complaints, no asking for handouts, they just want to keep doing their jobs and live the American dream…its America the way you remember it…before bailout fever broke out.

 

The third thing I realized is that there were no signs of oil anywhere I went.  The beaches in Destin are still the picture perfect turquoise-water and white-sand gems that they have always been.  Apalachicola Bay is still pristine and full of seafood waiting to be caught and eaten (that’s my view…if you take the Disney view of the world then it’s full of sea creatures living in harmony and talking with each other).  If you’re looking for great beaches and a great vacation then I would urge you to ditch work next week and head to Florida.

 

Central Banks are like Sand Crabs

 

The other night we were walking on the beach…the whole family.  My 10 year old son and 7 year old daughter were chasing sand crabs as we went.  At one point they had chased a crab so far from his hole that his back was against the surf and they stood directly between him and the safety of his hole in the sand.  The crab had run from his problems for so long that when he finally turned to face them head on he literally had nowhere to run and nowhere to hide.

 

These are no ordinary problems…from a sand crab’s point of view they are almost insurmountable.  The crab is two inches tall weighs maybe an ounce…and he’s up against a combined weight of 100 lbs of my kids (these are your standard kids…their destructive force is approximately 200 times their combined weight…the crab has no chance). 

 

To my astonishment, as the kids slowly moved in on him…he got all bowed up like he was going to fight.  The look on its crustacean face seemed to say “don’t make me!”  I couldn’t believe my eyes…who did this crab think he was fooling?  He was posturing to make himself look as big as possible in an attempt to fool the world into thinking that he had some hope of controlling the issues in front of him.  Moments later he was buried alive by a torrent of sand.  

 

I laughed when I realized that this little sand crab trying to bluff my kids into backing down is a bit like a central bank trying to bluff the world into thinking that they can solve all of our problems with a bit of monetary policy and some market manipulation.  With a balance sheet that has swelled to over a trillion dollars, economic problems raging on a global scale, and interest rates at zero I can only hope we don’t get buried alive as well. 

 

 

Sub-prime Mortgages, shark fishing, and risk management

 

As I strolled on the beach with the family one evening I happened upon on a guy with a fishing pole.  It was a picture that could have been taken right out of a salt-water fishing magazine…the sun had just set and he was out there with his family and he was surf-fishing…it was awesome.  As I got closer I could hear the drag on his reel just singing as something stripped line from it.  Despite the apparent action he looked fairly calm.  I asked him “I hear your drag screaming…what do you think it is?”  He pointed out into the Gulf and he said “it’s my dad”.  I looked out in the direction he was pointing and about 300 yards out there was a guy in a small kayak…waaaaaay out there. 

 

I then asked the next logical question “what’s he doing?”

 

The answer was that they were shark fishing and his dad was taking the bait out (they wanted the bait further out than they could cast…so they used a kayak).  I told him good luck and began to walk off.  Before I got a few steps away it hit me, and I turned around and congratulated him for being smart enough to send someone else out into shark infested waters at dusk in a small boat full of dead fish to get the bait right where they wanted it.  He laughed and said that he himself had made the first six trips and this was his dads first.

 

Now…I love fishing…and catching sharks is pretty manly…but even I have to question the judgment involved with paddling out into previously chummed water at dusk in a small kayak full of shark attractant.  I began to wonder if these guys get the Discovery channel.  Surely they’ve seen sharks hammer things about the size of that kayak…its dramatic footage.  I saw no beer anywhere near them…these looked like sober decisions. 

 

It’s the kind of event you think about for a while.  The first thought I had was that I need to buy a kayak ‘cause I’M DOING THAT next time I come down…but with beer so I have an excuse for the paramedics on my flight to the hospital. 

 

So as I reflected on this shark-fishing technique from the tranquility of my beer and oyster infested balcony I realized that their method of catching sharks isn’t a whole lot different than the risk management analysis employed by sub-prime borrowers and investors. 

 

Like the sub-prime borrower/investor the shark guys are completely ignoring the “tail risk” in the distribution of potential outcomes.  The tails of a distribution are where the low probability events live. It’s the stuff nobody thinks about because “oh the chances of that happening are so low…blah blah blah”.  If the severity of the low probability outcome is low…then it’s no big deal…you don’t get hurt too bad if the unlikely event comes to fruition.  On the other hand…if the low probability event is accompanied by a high severity outcome then you could be in real trouble if you ignore it.

 

These guys are hoping that there is a big shark in the area.  In a wonderfully ironic twist, if they are correct, and there is indeed a big shark in the area, then the severity of the low probability outcome increases dramatically…thus skewing their risk/reward tradeoff.  This is a lot like the sub-prime borrower/investor assuming that home prices will never drop because it almost never happens…there is a very low probability of that outcome occurring so they ignored it.  However…what they also ignored is that given their exposure, the severity of such an outcome would be crippling. 

 

The way the shark guys are looking at it is this: if they are successful they might catch a three foot shark, if they are really successful they might catch an eight-footer...if unsuccessful they catch nothing.  It’s a pretty sweet risk reward profile.  It offers plenty of reward and not too much risk.

 

A more realistic view of their risk/reward profile is that if they are successful they catch a three-footer, really successful an eight-footer, unsuccessful they get nothing, and by using the fish-covered kayak they are really upping the probability of the previously unmentioned “very unsuccessful” scenario where the whole family gets to watch as one of them is eaten “Discovery Channel style” by an eight-footer.  Given this more inclusive risk/reward profile people might make a different decision on how they fish for sharks.

 

In summary: when the low probability events just hurt you then you can probably get away with ignoring them.  If however the low probability events can actually KILL you…then you need to pay more attention to them. 

 

From a risk management standpoint fishing from the beach is a hedged bet.  Using a kayak full of dead fish at dusk in shark filled waters to get your bait right where you want it is a leveraged bet.  The risk/reward profiles can be wildly different.  This provides a nice analogy for our sub-prime mortgage investors.  

 

Chumming shark infested waters from a small kayak during prime feeding times for sharks isn’t all that different from buying houses in a real estate bubble using neg-am, interest only, whole loan hybrid arms and betting on the appreciation of the property to get you out of the loan. 

 

They are both classic examples of low probability/high severity combinations.  Both could easily kill you if the dice come up wrong. 

 

In closing

 

Ultimately I’d say that if you want to help out in any way with this oil spill then the best way to do it is to go to Florida right now.  Hit the beaches, enjoy the seafood, take in the sunsets…it’s all still there.  I don’t know if the oil will hit these places at a later date or not…but I do know that it’s not there right now. 

 

From Destin to Panama City, Port St. Joe, Apalachicola, Carrabelle and beyond it’s all pristine Gulf of Mexico beaches, waters and bays…and it can’t be beat.  If you make the trip I know they’ll be glad to see you, you’ll help some hard working American’s keep their jobs, and you might even be able to see some sub-prime investors get eaten by sharks.  What could be more fun than that?

 

Steve Scaramastro, SVP

800-311-0707