Monday, June 27, 2005


Additional flaws in MDL reporting: Duration

This is the first of a two-part post to address what we see as some significant recent flaws in the reporting on MDL - signficant in the sense that they serve to downplay how risky, stupid and irresponsible those around the MDL debacle were.

Duration Redux:
We know that some of these concepts are difficult to grasp, so what we have to say below isn't really a slam at reporters covering the MDL scandal - it's more of a warning that they still don't understand what the MLD "strategy" was.

Case in point is a story that appeared this weekend in the Blade, the AP, the Dispatch, the B-J and elsewhere. The jist of the story is that consulting firm, Callan Associates, has documented the leveraging the MDL did, and confirmed that Mark Lay ran the leveraging up to about $5.6 billion (previous guesstimates had put the number at $3 billion - $7 billion). That's billion - with a "b" as compared to $225 million originally allocated to MDL.

But the newspapers' explanation falls short of explaining the massive risk behind Lay's scheme. For example, the Blade says this:
MDL’s primary investment strategy was to short U.S. Treasury bonds that would mature in almost 30 years. The strategy was based on the continued rise in short-term interest rates by the Federal Reserve.

When an investor shorts a bond or stock, he is speculating that the price is too high and will eventually drop. He sells borrowed securities to other investors and agrees to buy those securities back at a later time, when he presumes their price will be lower.

The practice of shorting depends on financial leverage, investing with borrowed money to amplify potential gains.

[. . . ]

[B]y the end of September, 2004 . . . MDL had leveraged 26 times the amount of money the bureau had committed to the fund.
This is a huge muddle with several faulty leaps in logic. Let's see if we can sort this mess out.

First, shorting, indeed, does require borrowing a security, but it does not require multiple leverage. If you have a good credit rating and accessible collateral, any Tom, Dick and Mary can engage in short selling. Working through a stock broker, if you want to gamble that a share of GM is going to drop in price in the near future, you borrow a share of GM for a fee or interest payment, sell it and stick the proceeds in an interest paying account.

If you gamble wrong, you may be screwed in a big, big way. As we have noted before, shorting exposes you to unlimited losses if the security price rises instead of falls.

But, if you've gambled right, the stock soon drops in price, you buy it at the new lower price and give the share back to the loaning entity. You keep the difference in price plus whatever bank interest you earned. If that total is more than whatever shorting fee or interest you had to pay to borrow the stock in the first place - you made money. More on this last point later.

But - listen up reporters - that is only Phase I of the MDL strategy.

Phase II was to synthetically alter the effective "duration" of the investments. (Remember, Mark Lay described the strategy as being and Active Duration Fund. This is no accident.) We have struggled to come up with a simple description of "duration" in previous posts and still feel less than satisfied. Here's another try. Duration is an indicator of how the relative return a bond-related investment.

For the sake of this, let's say duration is the measure of relative return of an investment. If you look at bank ads for CDs, you'd see that a 3-month CD might be paying 3.5% interest, a 6-month CD is paying 3.75% and a 1-year CD is paying 3.9%. So, interest rates are sort of a proxy for duration.

Now, if you think you are a clever investor, you might look at these CDs and ask yourself, "Wouldn't it be nice to be able to get a 3-month CD with something close to a 1-year return!"

Well - believe it or not - that is what clever leveraging can do. (You'll have to trust us on this part of it because the math is too hairy to present here.) By actively manipulating the leverage, you can manipulate the effective duration of the investments. You synthetically create a 3-month CD paying 3.8%, close enough to the 1-year rate to make it worth while. You have manipulated the duration to amplify potential gains."

In the real world, things aren't really this simple. If you manipulate durations, you also amplify potential losses. It's amazing how much symmetry there is in finance.

Back to MDL, the point of all this is that playing with the duration of Mark Lay's investments was the strategy. Leveraging was not the strategy, only the means to get there.

Now, we have been asked, "Could have leveraging, by itself, been a valid strategy?" The answer is, probably not. The field that MDL and Mark Lay (unlike Tom Noe) operated in is considered to be very "efficient". Efficient markets have a strong tendency to quickly level themselves out. If a player in the market has some tip or insight that allows he or she to make an unexpected profit, the market quickly shifts to make make additional moves like that less likely.

Roughly speaking, a pure leveraging strategy wouldn't work for the same reason that a person can't borrow money from his or her bank, and then turn around and buy a CD from the bank. This would be the financial equivalent of a Perpetual Motion Machine - a "free money" machine.

In the real world, the bank sets its lending rates higher than it's interest rates, so you never earn enough to cover your costs. The bank's executives and financial staff exist for the nearly the sole purpose of making sure that "spread" between lending rates and interest rates.

Thus, according to financial theory, if Lay had guessed right about the direction of the bond market, and had just stuck to a simple borrow-and-buy shorting scheme, it is doubtful that he would have made much more of a return that if he had put the money in the bank.

To sum up, Mark Lay and Terry Gasper knew that the only way the investment made sense is if they could amplify the returns from short-selling, not by expanding the investment which, by itself, would have accomplished nothing, but by structuring the leverage to manipulate the duration. This is where the big, irresponsible, calculated risk came.

As we have noted several times, the whole MDL affair parallels the infamous Orange Co. (CA) bankruptcy case. More precisely, MDL is the photographic negative of what happened back then. The investor in Orange Co. leveraged millions on a long-stock bet and lost billions. MDL leveraged millions on a short-stock bet and got lucky when it only lost hundreds of millions. But they are the two sides of the coined minted from ignorance, hubris and the arrogance that comes from playing with other peoples money.

Now, we have to admit that we haven't seen the Callan report, so we have to go on what others said about how it places blame and criticizes the bureau and MDL. Again, from the Blade:
At that point, MDL had leveraged 26 times the amount of money the bureau had committed to the fund. The bureau maintains that MDL was only permitted to leverage 1.5 times the fund’s principal and broke its contract.

The Callan report concluded that $100 million could have been chopped off the bureau’s losses if MDL had only leveraged between 10 and 20 times the fund’s capital.
The notion that the mistake with MDL is that it leveraged the fund 26 times instead of 10-12 is just wrong. We can't say that strong enough. Wrong, wrong wrong. It is too hard to tell at this point if this is bad reporting or bad analysis on Callan's part, or both.

You simply cannot accept the MDL leveraging strategy, and then criticize them because they did it few times too many times. In fact, going to the extreme with the number of times the investment was leverage was perfectly consistent with the overall strategy. At least give Lay and Gasper credit for that.

The problem with MDL wasn't the number of times they leveraged. The problem was that the package of shorting and manipulating the durations was an irresponsible high-risk strategy to begin with, being played by amateurs, without even the crudest financial risk-management systems in place to sound warnings when the bets started going south.

So, Ohio reporters, our advice is this (with apologies to Deep Throat): Follow the duration!

Someone needs to nail down where Callan is on this issue because this is really the crux of what- if anything - the government investment funds will learn from the MDL scandal.


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