Tuesday, 24 March 2015

"Which leads me on to" - A collection of observations.

Take a share, any share. If it pays a dividend how do you calculate its theoretical price? To be honest I don’t know because it would appear that if there was a right way then a share price wouldn’t move much at all as the efficient market hypothesis, which let me make clear right now, is the biggest load of tosh ever unleashed on the poor economics student, would, in its completely tosh way, dictate that the price is fairly priced.

Which leads me on to asking - Is a price a fair reflection of what it is meant to be? A reverse argument if you like. If we look at a price can we deduce the components that make it up? I ask as one of my greatest bugbears is the way the price of credit default swaps is examined and backward assumptions made that the price reflects the actual probability of default. We had it with Greece and we have it now with Austria. CDS is examined and the cry goes out in media land “There is a x% chance of y defaulting’. This is also tosh. The price is an ‘implied’ probability just as implied volatility in option pricing isn’t the actual volatility, instead being where people think it will be.

The difference between what people think the chances are of something defaulting and what the actual chance is are very different. Think of it this way. There is a horse in a stall quietly munching on its hay waiting for the start of its race. The horse is unknown and as such no one is betting on it and it is pricing at 100/1. Someone sees the price and thinks that's a fair bet on an unknown and bets on it in good size. The price moves to 33/1. This attracts attention and others bet on it and even some of the other jockeys bet on it in case they lose as a hedge (this happens in CDS). The price comes in to 15/1. At which point a rather drunken fellow fancies impressing his drunken friends by placing a massive wager on it and drives the price to evens. Meanwhile the horse is still quietly standing in its stall wondering what all the fuss outside is about. So at which point in all of that did the actual likelihood of the horse winning the race change from 100/1 to 50/50? The horse didn’t get any fitter nor did the competition get nobbled. Nothing has changed with respect to the actual probability of outcome. Yet the market price has. So it is with CDS.

The assumption that is used to counter this argument is that of the wisdom of crowds - "Well if everyone thinks that, then there is a pretty good chance I am wrong". But for many outcomes the wisdom of crowds is no better than random. If you were to ask the whole population to guess the outcome of the next lottery and then bet on the modal forecast you would have no better outcome than betting on any other set of numbers. Yet the belief that mass market behaviour can effect independent outcomes is rife. In a market where the guesser can interact and effect the outcome then yes, market prices and beliefs in them will move hand in hand. But in markets where the outcomes cannot be influenced by the actions in that market then they cannot.

Which leads me on to the #NFPGuesses twitter tag, where we all have a lottery type guess at what the Non Farm Payroll data will be that Friday. All fun and games but under no circumstance should the analysis of all the results be deemed to indicate the correct outcome. Yet they are often cited as such. Short of the participants running off to get jobs or to resign their posts to get the result they are betting on, it really is not linked. Where of course this analysis is useful is determining how the market may react after the announcement, but not what the announcement will be.

Which leads me on to recommend that prices that are estimates are not turned into inputs into further models that are used to create further estimates. If they are then there will be horrible feedback loops where the likes of CDS are used as an input into the probability of default in a model that then sees that default risk rising because CDS prices are higher and so buys.. errr CDS. And on we go.

Which leads me on to Central Banks and Goodhart’s law, whereby CB policy influences market behaviour towards the assets and indicators that are themselves inputs into policy models. Here we are talking inflation expectations as measured through the 5yr/5yr which are driven by bond purchases anticipating CBS loosening because the 5yr/5yr is moving down as much because funds are buying bonds in anticipation of.. etc. More excitingly though, the reverse will apply in an unwind.

Which leads me on to government borrowing. There is simply gaaarillions of it and none of it is really seen as a problem as the interest payments on it are so stupidly low. To the point that Germany get paid. But should prices of bonds start to fall, yields will go up as will the running costs. Most unpleasant. But isn’t there some sort of borrowing cap that is applied to governments for risk reasons? No, as long as the coupon is paid the government can keep borrowing. The fact that the debt can probably never be repaid is rarely taken into consideration.

Which leads me on to mortgages.  Lets talk about the UK to start with. The government has knee-jerk reacted to the last banking crisis by laying down affordability tests for you and me that they themselves would have failed and failed in evermore spectacular style since 1823. If you are to be allowed to buy a house in the UK you have to be able to argue convincingly that you will be able to repay the whole of the debt within a relatively short space of time. That’s pay interest AND capital. A test any government would fail. Yet if I was to have retired (I haven’t) own a house worth £5 million have a pile of cash in the bank of £1m off which I am living then the bank would not be allowed to lend me a bean as I don’t have an income. The value of the underlying asset is ignored as you are not allowed to consider that the debt could be paid off by selling the asset.

Which leads me on to unaffordable housing. Which first begs the question “If it is unaffordable then how come it sells”? Ahh! You mean people who can’t afford it can’t afford it. That’s different. Someone is now making a judgement call as to who should be allowed to afford it. I notice that the government is reintroducing 'right to buy, whereby state tenants can buy their property from the state. Fine, create another first generation of cash winners, but the benefit doesn’t last further than the gentrification of some prime location hell holes. But the right to buy should not be confused with the right to have enough money to buy. It’s a market. I am a firm believer that market interference in the case of property leads to further distortions and that natural market forces should play out, even if, like a nature film, that involves big lions eating cute deer (note that there always seem to be plenty of deer left or the lions would have died out). If areas of London are too expensive for people who want to live there to live there then sorry, that’s life. I would like an Aston Martin DB5 yet I don’t launch a campaign protesting over unaffordable Aston Martins.

‘But that's where the jobs are” - Well they won’t be if no one can afford to live there. The employers will move and that would be the best thing for London, the workers and the rest of the country.

“But my family have always lived here, I was brought up here and I can’t afford to live here and I’m local’ - Well if your parents have lived here all there lives, what’s happened to all the cash they have made on their property? Just wait, as the greatest redistributer of cash between the generations is death.

Which leads me on to bubbles. Does it matter how high the price of something goes? I am inclined to answer "no, as long as no one borrows against its theoretical value". Whether that’s directly to buy it, as in a mortgage, or to use it as collateral to borrow against to spend on something else. If my humble cottage is worth a billion trillion pounds and I continue to live in it and don’t raise debt agaist it, nor spend profligately on other thing in the belief I can sell my cottage (effectively borrowing) then its price is immaterial to me or the rest of the economy. Should someone purchase my cottage from me for a billion trillion pounds and they haven’t borrowed to do so and carry on as I had, unborrowed, then nothing in the world is effected, we have just exchanged positions.

If house prices are moving to infinity why do you want to own a property in the first place? To live in of course! But there are alternatives.

Which leads me neatly back to central banks, theoretical prices and equities. In a world of super low interest rates, let's say zero in many cases, a stock paying a dividend can be priced to infinity and still have a better yield than a zero yield bond. I have often mentioned the lunacies involved in negative yield land but we can now expand the collection of absurdities to the housing market. As with stocks, house prices can go to infinity and, as long as the tenant is paying maintenance costs, the rent can be infinitesimal and the owner is still yielding more than they will be getting on zero yield bonds. Looking at that in reverse it means, dear friends, that rather than paying £10^21 for a shoebox you do the owner a favour and rent it from them for £0.0000001.

In fact, if European yields are negative, the efficient boundary would suggest that a property owner could buy a property and pay you to live there and still outperform German government debt. Now how about that? Being paid to live in your house! Yet you still insist you have to be able to borrow money to buy your own house whatever the price?

Pray, tell me why you are so completely stupid?


SC said...

aaannnd breathe...

Polemic said...

SC :-)

I Will Never Accept The Terms of Service said...

Price is the intersection between what people are willing to pay and what other people are willing to receive. Nothing more.

All debt is someone else's asset. Maybe the reason everyone can issue debt at real negative rates is because there's so much money out there looking to earn rent with zero downside?

theta said...

Regarding UK debt (national and private), I'm not sure I would call it unsustainable as long as the release valve of a relatively soft currency remains in place. Ability to service and repay the debt is a function of (nominal) income and interest rates. As long as nominal income stagnates, so will rates. If (and only if) the former increases, then rates will do, but slowly, so that ability to service the debt remains more or less unaffected.

Polemic said...

IWNATTOS - Well put. But I don't believe anything has a zero downside.

Hi Theta - I wouldn't cal UK national debt unsustainable either. I am saying that if the UK State had to abide by the rules it enforces on other borrowers with respect to affordability it would never be able to issue a Gilt again. I agree with the chicken and egg argument with regards to income/rates and ability to repay, but the problem is that CBs are targeting inflation as a whole rather than solely wage inflation on the assumption that rising inflation always leads to wage pressures in the end. Which it hasn't yet.

So we could see inflation lift, maybe due to the base effect of falling commodities tail off, and CBs respond before we have proper wage inflation. This would mean real incomes fall as costs to service debt increase.

I wish CBs would target wage inflation rather than other types of inflation that they think lead to wage inflation but often don't. The problem is the lag. If they don't act til wage inflation is underway they may be too late to keep the lid on it.

theta said...

I believe that if commodities rebound and thus inflation upticks but wages don't follow, the BOE will declare it temporary and stick to low rates. As your friend MM would put it, it will one more case of Mervinflation (maybe Carneyflation?).

I agree on your point that if the UK State had to abide by the rules it enforces on other borrowers with respect to affordability it would never be able to issue a Gilt again. Put another way, if it didn't have monetary sovereignty it wouldn't be able to run the fiscal deficits it has been running. If it were in the Euro for example, we would see its CDS closer to the top of the league tables than the bottom. But as this is not the case, I don't find it wrong or hypocritical (if anything its cynical) to make clear to everybody what the rules of the game are, and that said rules are indeed different for a state that issues the currency of its own debt and any other poor bugger that has to find the money elsewhere to pay back their mortgage.