Tuesday, November 22, 2011

The Implicit Assumption

The issue of risk measurement and the relationship of perceived risk to expected return has been a principal occupation of finance theorists for the past several decades. It is received wisdom that as risk rises, return must also rise, and vice versa (perhaps with a lag).

That admittedly simplistic formulation suggests that when a risk-reducing element is added to an investment opportunity, the rationally expected return should fall.

We’ve all witnessed repeated failures of the rational-investor hypothesis, the efficient market hypothesis and of modern portfolio theory over the past decade.

We’ve witnessed the well documented flame-outs of risk pricing models demonstrating that the “greek” factors of financial math, when stressed, can be as reliable as Greek bond ratings.

So the question of the day is: when is it NOT rational for expected returns to fall when new risk-reducing conditions are introduced?

The answer… (drum roll, please)…is: when risk wasn’t being rationally priced PRIOR to the application of the new measures.

When returns fall in the face of new risk-mitigation measures, the implicit assumption is that pricing prior to the introduction of the new measure already correctly reflected risk.

The extent of the decline should rationally be a function of the gross risk reduction less the cost of the risk reduction, modified by the confidence that can be placed in the “before and after” risk measurements.

New risk-mitigation measures have been applied to some TRE transactions in recent days.

It is too early to draw conclusions about their long-term impact.

In the short term, though, the reaction has been clear. Returns have fallen sharply.

If the reduction in returns was observed only in the cases where risk mitigation measures have been introduced, the problem of analysis would be made more straightforward. But that has not been the case.

The deterioration in expected yields that we commented on in our last post has persisted. So returns had already begun to fall; apparently as a result of excess liquidity; before the reaction to the risk-mitigation measures began.

And there is not yet enough data to support an analysis allocating the overall decline between the two apparent sources.

On a preliminary basis, though, it does not appear to me that the extent of the initial price reaction can be rationally supported as a reflection of the net value of the risk mitigation measures.

And it is far from clear to me that risk was being appropriately compensated BEFORE this latest development.

Having written a rather lengthy series of posts on the subject of Appropriate Compensation, which is really all about risk; and having not yet proposed a definitive conclusion on that question; I can understand that Buyers of TRE auctions will and do analyze appropriate pricing differently.

But all Buyers and, indeed, all observers of TRE, suffer from a similar impediment in their assessments of risk i.e. lack of disclosure of actual TRE experience in sufficient detail to make reasonably informed risk assessments.

I have previously stated that the actual early experience of TRE might not be an appropriate basis on which to analyze current or forward-looking risk. And I continue to believe that.

Because TRE has responded in meaningful ways to its early experience I believe that risk today is lower than it was 2 years ago.

But a RELATIVE shift in risk says nothing particularly useful about the ABSOLUTE level of return necessary to compensate for that risk. And the absolute level of average expected return to Buyers has fallen far more over the last 2 years than warranted, in my opinion, by the change in auction risk profile.

It might be that the current price action is a temporary condition and that we’ll see an adjustment of the sort that occurred earlier this year. In that case we might look back on the current period as a temporary overreaction.

If that does not occur, and the current conditions persist, my guess is that we’ll see reactions within the Buyer community that will drain some of the current liquidity from the market.

Friday, November 11, 2011

Absolutely Relative vs Relatively Absolute

In September 2011 TRE announced its new affiliation with the New York Stock Exchange. I wrote in my post of September 13 that “the benefits to those whose involvement is limited to the SMB market (would be) pretty obvious and (would) become clear over time.”

The operative phrase there was “over time”.

It might have been coincidence; but I doubt it; that new Buyer money clearly came into the market as the “bell rang” on October 1. And since that time the pricing of SMB auctions has reflected the enthusiasm of increased demand relative to supply.

That also happened in 1Q 2011, when we saw a significant drop in average returns that lasted for about 90 days.

It appears that the combination of October’s influx of new money and structural issues arising from process changes recently instituted by TRE might now push returns even below the levels of 1Q 2011. Whether that will be a short-duration phenomenon, as was the dip in 1Q, or will have more lasting impact cannot yet be known.

But it does raise a question that I think is critical, more for those who look to the possibility of trading on TRE as a stand-alone business than for others, perhaps; but to TRE as well, in my view.

I’ve written previously about the difference between Buyers whose activities on TRE are ancillary to their principal business; who might be looking for short term, opportunistic means to improve returns on excess cash balances; as opposed to those whose business is actually investing in accounts receivable and are looking to make investing in TRE auctions a viable business on its own.

In the case of the short-term “money parkers”, the TRE market is probably viewed in an absolutely relative light.

If a Buyer, whose business is actually investing in other asset types, has excess cash balances from time to time on which very little can be earned, the prospect of picking up a few hundred basis points over Libor, for example, might look very attractive.

Such a Buyer might well have minimal marginal costs involved in its TRE activities and, unless (or until) it is faced with defaults, might be quite pleased with the incremental returns received.

But the nature of that Buyer’s activity is that it is driven by lack of sufficient opportunity in its primary business or in its usual short-term investment options. And as those opportunities and options improve it will likely move its cash back to its normal operations and withdraw liquidity from TRE.

The supply/demand balance in TRE trading is still delicate. Volume of auction activity has certainly grown over time but relative to other financial markets, TRE volume is still within rounding error. What might seem to some investors to be relatively small increases in funds allocated to TRE purchases can have a meaningful impact on the market.

In the short run, TRE probably has little control over Buyer allocations of funds or the impact of meaningful changes in market dynamics caused by shifts in those allocations.

In the longer run, however, I believe TRE should strive for the relative stability that would more likely come from a Buyer community largely composed of those who are approaching the Exchange as a part of their primary business activity.

It is that class of Buyer that can be expected to be consistently participating in the market and seeking to match growth in the market with growth in their own level of commitment.

But it should be recognized that the return requirement of that class of Buyer is not absolutely relative; rather, it is relatively absolute.

Those Buyers whose business is investing in accounts receivable will know that the TRE transaction structure has certain risks that are not typical in their normal activities and that those risks will have to be adequately compensated if the TRE activity is to be supported in the long run.

The cost of money might be similar when the absolutely relative Buyers are compared to the relatively absolute Buyers. But it’s likely that there will be meaningful differences between the two classes of Buyers in the areas of:

1. Operating costs
2. Credit loss assumptions, and
3. Net return requirement

The short term parkers of excess funds will probably attribute little, if any, marginal operating cost to their TRE trading activity.

Until they actually experience the potential risks involved in buying invoices in the TRE structure, it is likely that the credit loss assumptions of the absolutely relative Buyers will be minimal.

And the net return requirement of the absolutely relative Buyer will also likely be minimal. The Exchange activity of that Buyer is a footnote to its business plan. For the relatively absolute Buyer, its Exchange activity is the BASIS of its business plan!

The long term growth and prosperity of TRE, in my view, depends on attracting, retaining and supporting the activity of the relatively absolute Buyers.

To the extent that the absolutely relative Buyers threaten the ability of the relatively absolute Buyers to price transactions sensibly in light of the actual risks being assumed, they also threaten the long term success of TRE.