Monday, May 18, 2015

Is Chicago Really a "Junk" Issuer?

Last week, Moody’s downgraded Chicago general obligation bonds into speculative (i.e., “junk”) territory. As a critic of low municipal bond ratings, I saw a good opportunity to take Moody’s to task. But after diving into Chicago’s financial data, I’m not so sure. The data I compiled are in this Google sheet and my analysis follows.

In April 2012, Moody’s affirmed Chicago’s general obligation municipal bond rating at Aa3. Just over three years later, this rating stands at Ba1 - a cumulative reduction of seven notches. Since Moody’s entire rating scale, which ranges from Aaa to C, contains a total of 21 notches, the Chicago ratings changes have been quite dramatic. The magnitude of this downgrade does not appear justified by changes in the city’s finances..

When it affirmed Chicago’s Aa3 rating three years ago, Moody’s wrote the following:

The affirmation of the Aa3 rating on Chicago's general obligation debt is supported by the city's long-standing role as the center of one of the nation's largest and most diverse economies; a tax base that remains very sizeable despite several consecutive years of estimated full valuation declines; significant revenue raising ability afforded by the city's status as an Illinois home rule community; and its closely managed use of variable rate debt and interest rate derivatives. These strengths are somewhat moderated by the city's persistent economic challenges, including elevated unemployment levels and a large foreclosure backlog; narrow, though improving, General Fund reserves; relatively low levels of expenditure flexibility, as a high percentage of the city's operating budget is dedicated to personnel costs for a heavily unionized workforce; and above average levels of slowly amortizing debt.

Three years later, Chicago’s situation is about the same or slightly better. The city is still the center of a large and diverse economy and it continues to benefit from a strong revenue base. Although official property valuations (EAVs) are lower, both Zillow and the Case-Shiller Index show substantial property price gains since bottoming in early 2012. The city’s unemployment rate has also fallen substantially.

Gradual economic improvement has brought rising revenues. According to the city’s CAFR, its largest fund saw revenue grow from $2.8 billion in 2011, to $2.9 billion in 2012 and $3.0 billion in 2013. Unaudited figures in the city’s latest budget show further growth to $3.1 billion in 2014 and a projected $3.5 billion in 2015.

Although expenditure flexibility continues to be limited, Chicago has cut its retiree health insurance costs by reducing premium support and shifting beneficiaries onto Obamacare. These cost saving moves are still being litigated, but have yet to be overturned.

Chicago’s pension funds are seriously underfunded, but that is nothing new. At the end of 2011, Chicago’s four pension funds had a composite funded ratio of 37.9% - based on market value of assets. At the end of 2013 (the latest date for which complete statistics), the funded ratio was little changed at 37.0%.

That said, Chicago’s pension costs are quite large relative to city revenues. In 2013, actuarially required pension contributions totaled $1.74 billion, or 22.3% of the city’s total revenues of $7.82 billion.  This proportion is very high by national standards - higher, for example, than every single city in California.

I am skeptical of Actuarially Required Contributions (ARC) as a solvency measure, because a city can, in theory, meet its pension obligations on a pay-as-you-go basis. In other words, the city’s pension funds can all have a zero percent funded ratio, and all pension benefits and administrative expenses can be paid out of revenues.

But a review of Chicago’s benefit costs does not offer solace. In 2013, expenditures by the city’s four pension funds, totaled $1.84 billion, or 23.5% of total revenue. (Under current Illinois law, the city will have to pay much more than this in future years because it will be mandated to both meet existing pension obligations and raise its funded ratio to 90% by 2040).

One solvency ratio I find especially useful is the sum of pension costs and interest expenses to total revenues. In studying Depression-era government bond defaults, I found that when interest expense exceeded 30% of revenue, default often occurred. Back then, pension expenses were not that significant - now they are much larger and they enjoy similar or even preferential legal treatment to debt service.

In 2013, Chicago reported $478 million in interest payments, amounting to 6.1% of revenue. If we add this expense to the cost of providing constitutionally protected pension benefits, we get a composite ratio of 29.6% - dangerously close to the 30% threshold.

Even worse, the trend is not in the city’s favor.  Each plan’s actuarial valuation contains projected benefit payments through at least 2041. If we add up these future expenses, we find that they are projected to grow by about 4% annually through 2023. After that, benefit cost growth decelerates, as “Tier 2” beneficiaries - who are entitled to reduced pension benefits - begin to retire. The benefit growth rate from 2013-2023 is faster than the rate of revenue growth the city experienced in the previous decade. Between 2003 and 2013, revenue grew from $5.75 billion to $7.82 billion - an annual rate of 3.1%, significantly slower than projected

If its revenue growth trends continue, Chicago’s pension benefits and its interest expenses will exceed 30% of revenue later this decade. While this situation does not automatically trigger a default or bankruptcy, it leaves the city vulnerable in the event of an economic downturn. With so much of the city’s spending locked in, it would be faced with making deep service cuts or defaulting on its obligations in the event that revenue falls during a future recession.

So while Chicago’s situation is not much different than it was in 2012, the city’s fiscal status was and remains fairly dire. Although a seven notch cumulative downgrade seems inappropriate, the city’s current Ba1 rating does not seem very far off to me. Perhaps the problem lay with more with the city’s 2012 rating than the one it carries now.

Friday, May 15, 2015

Short Selling & the Squeeze

In the aftermath of the 2-minute Swiss franc movement earlier this year -- and with so much attention surrounding the Herbalife short-squeeze (on Bill Ackman's Pershing Square) -- we have put together a short & sweet presentation describing the concept of the short squeeze. 

We have included some examples towards the end, like Sears stock in November 2014 and that "exciting" day when Volkswagen suddenly became the world's most valuable company: thanks to its stock jumping over 300% in a day. 

Welcome to the world of short squeezes. May you never be on the wrong side!


A brief thank you goes out to our outgoing intern Mr. Ferreira for his helpful work preparing this set of slides.

Tuesday, May 12, 2015

Flash Spoofing, and "Normal" Market Operations

The criminal case filed by the DoJ against U.K. trader Navinder Sarao is the latest case to capture the media’s attention in what must be the early stages of a series of investigations into what we’ll broadly term “issues of market manipulation.”

 The potential for manipulative behavior has been garnering more attention over the past year since Michael Lewis’s “Flash Boys” more forcefully drew regulatory attention to issues around high frequency trading (HFT) activities and current market structures.

Regulators have received their fair share of criticism for taking nearly five years to investigate the Flash Crash, finally getting around to examining orders, and not just executions

While Mr. Flash Crash protests that he has “not done anything wrong apart from being good at my job,” regulators clearly have their sights on spoofing.  Just last week came news of the CFTC bringing civil charges against two prop traders in the UAE for allegedly spoofing in the gold and silver futures markets. All of this comes on the heels of several other low-profile players charged with spoofing over the past couple of years, such as Panther Trading

Spoofing, sometimes referred to as “hype & dump,” is basically when a trader enters orders with the sole purpose of influencing market prices and with no intention of actually executing those orders. 

Obviously the law does not require traders to openly state their intentions regarding whether they are buying or selling, and how much. Likewise, we don’t play poker with our cards face up. But what type of bluffing is kosher? To what lengths can one go to cloak his intentions so that others don’t run ahead, increasing transaction costs?

Kraft was recently hit with a CFTC complaint regarding its wheat futures trading, and this case seems to be more of a gray area.

But there's more to come, no doubt.

The general areas of interest concern front-running, spoofing, time advantages, and trading on insider information. Just a couple of weeks ago, we saw a situation which must fall smack in the middle of the realm of the regulatory whip: the Aussie dollar moved significantly just (milliseconds) before the announcement by the Reserve Bank of Australia (RBA). But even worse – this has now happened three consecutive times!

Let’s have a look at the overall movement, just before 3am, and then we’ll focus on the movement and its occurrence just before news came out.

Here's the movement, generally, at 00:30.

But the important note is the movement occurs just moments before (any) news is released.  See all the news items at the top?  Each news item corresponds to a blue box in the graph.

The first one, the rate decision, "flashes" into our screen, just AFTER the movement.

It's worth mentioning that we're not alone in discovering this market movement. The Australian Securities and Investment Commission is on top of things, having opened an investigation into these wild, yet accurate, swings.  Notices have purportedly "been sent to many financial institutions and platform providers to understand the basis of the trading on these markets at the point in time of interest." More troubling, however, is that preliminary findings have revealed to ASIC that:
"moves in the Australian Dollar ahead of the announcement to be as a result of normal market operations in an environment of lower liquidity immediately ahead of the RBA announcement. The reduction in liquidity providers is a usual occurrence prior to announcement in all markets. Much of the trading reviewed to date was linked to position unwinds by automated trading accounts linked to risk management logic and not misconduct." 
Call us skeptical (or sceptical, given they're in Australia).

One more likely explanation is that the news was leaked, or sold, to one or more firms that could execute quickly based on an incredibly fast network connection, likely linked to an algorithm. (If not, why wait for the seconds or milliseconds before the announcement – why not execute a minute before, or two minutes before?) 

So that opens up the door to the question of “time advantages” – more specifically, whether some preferred clientele can buy early access to the news. Let’s just say, it’s a little like gambling on a football game, in which most people are watching on tape-delay, but some gamblers are allowed to see the game “real-time.” The real-time gamblers can add or remove bets once the game is really finished, while the other gamblers with the lagged connection don’t yet know the final result. Can we call that a rigged market? 

The next legal question becomes: do the ordinary gamblers know that the preferred gamblers have a time advantage, or whether they know that they’re on a lagged connection (and that others are not). In other words, there’s the question of proper disclosure. Whether or not the market is rigged in favor of some parties, should the “unfavored” parties have been made aware of their material disadvantage?


For more on Time Advantages in the Financial Markets, and corrective actions taking place visit any of the following links:

The Crucial Piece of Information That Big Traders Get Before Everyone Else

Firm Stops Giving High-Speed Traders Direct Access to Releases: Warren Buffett Involved in Berkshire Unit Business Wire's Decision to End Practice

Traders May Have Gained Early Word on Fed Policy, Study Finds

Thomson Reuters ends early access to key market data

Behind One Second of Trading Mayhem
(Article chronicles impact of earnings results released to paid clients milliseconds before news services released earnings, while those results impacted closing price of shares.)


Tuesday, February 24, 2015

Ocwen Wins this Weekend

Shortly after our blog posting went out on Friday evening, Ocwen (OCN) and Nationstar (NSM) and affiliated companies announced two agreements that sent all of their shares higher.

It will be interesting to see if some of them come back today: the reasoning for the bounce isn't immediately clear -- certainly for some of the Ocwen affiliates (AAMC, ASPS and RESI) who might reasonably be expected to miss out on future revenue opportunities as a result of the sale of HLSS.

Or is this just a win-win-win-win-win-win-win?

Ocwen selling MSRs to Nationstar ($9.8 billion of loans). 

New Residential (NRZ) to buy HLSS:

Friday, February 20, 2015

Serving Up the Servicing Complaints

It's February 20th, and time to update our post from Feb. 20th last year, when we investigated state of the mortgage servicing arena.

Firstly the good news: overall, complaints for the year 2014 are down roughly 12% over 2013 levels.

Non-bank servicer Ocwen has been all the rage of late, and has risen to the most complained-about mortgage servicer out there in 2014.  Meanwhile many of the bank-servicers have decreased their servicing businesses and platforms -- often selling to non-bank servicers -- and with it their tally of complaints!

Notably, Ocwen has settled with the CFPB and related state AGs for alleged misdeeds between 2009 and 2012.  The settlement was to the tune of $2.1 bn, but much of this cost may well be absorbed by investors in RMBS trusts services by Ocwen.  Importantly, though, Ocwen's complaint count seems only to be rising, and is now roughly 70% higher than in was in 2012.

Also of interest, if you look in the list below at the five servicers whose complaints grew fastest between 2012 and 2013, all five of them continued to have complaint growth in 2014.  This unwelcome trends seems not to be abating.  For example, for Select Portfolio Servicing, Inc (SPS) complaints more than tripled from 2012 to 2013.  They're again up another 65% from 2013 to 2014.

For another take on this, see Tom Adams' interesting read in Naked Capitalism, entitled "Ocwen’s Servicing Meltdown Proves Failure of Obama’s Mortgage Settlements."

Tuesday, February 3, 2015

S&P Settles: Now How About that US Bond Rating?

In its settlement with the Department of Justice, S&P has backed off its assertion that the federal lawsuit was filed in retaliation for its 2011 downgrade of US Treasury debt. But the downgrade subjected S&P to a barrage of criticism both at the time and ever since, raising the question of whether the decision was appropriate. My view is that the downgrade was the correct credit decision in 2011, but that it is now time for S&P to restore the US to AAA status.

Since rating agencies earn minimal revenue from sovereign ratings, the downgrade was clearly not in the firm’s short term commercial interest. This speaks well for the sovereign group and senior management at the time: the analysts looked the numbers, decided that the US was no longer a triple-A credit and were allowed to implement and publicize their decision. While we often hear negative generalizations about rating agencies, it is worth noting that these firms are heavily siloed; the behavior of the structured finance group does not necessarily reflect on the work of the sovereign team.

Not only was the downgrade principled, but it was also justified. In 2011, the US debt-to-GDP ratio was skyrocketing, the country had an unsustainable fiscal outlook and it lacked the political will to deal with the imbalance between future revenues and swelling entitlements arising from baby boomer retirements. While the British and Italian governments were able to address population aging by raising taxes and delaying eligibility for social insurance programs, divided government in the US prevented a grand bargain from occurring here.

Further evidence that the US did not merit a top credit rating emerged in October 2013 when both parties engaged in brinkmanship over raising the debt ceiling. Had the debt ceiling not been raised, the Treasury would been forced to prioritize payments. While I believe that the Treasury would have prioritized debt service over other obligations, my confidence in this belief does not approach the 99.9%+ level normally associated with AAA ratings.

So what has changed and why am I suggesting an upgrade? First, after taking widespread blame for the debt ceiling debacle, Republicans have changed tactics. It is now extremely unlikely that they will trigger a similar confrontation when the debt ceiling has to be raised again. Since failure to raise the debt ceiling and failure to prioritize debt service are both low probability events, the chances of both occurring seem to be within the AAA risk band.

More relevant to S&P’s original downgrade decision, the nation’s fiscal long term outlook has changed since 2011. When I say this, I am not referring to the marked decline in headline deficit numbers. The fact that the annual deficit declined from $1.3 trillion in fiscal 2011 to a projected $468 billion in fiscal 2015 is not a surprise. Looking back at CBO’s ten year projection from 2011, the agency estimated a $551 billion deficit for the current fiscal year – pretty close to what we are actually seeing. While politicians from both parties may be congratulating themselves for this improvement, the downward deficit trend is exactly what one would expect from an improving economy. Rising tax revenues and lower unemployment insurance costs – not any major reform – are reducing the deficit. There was no grand bargain, nor is there likely to be one anytime soon.

But two developments since 2011 have greatly altered the country’s longer term outlook: reduced healthcare cost inflation and persistently lower interest rates. Between 2000 and 2007, annual healthcare expenditure growth averaged 8.5%. Since 2009, the rate of growth has averaged only 3.9% and health expenditures have stopped rising as a percentage of GDP. Back in 2011, the decline in health cost inflation could be dismissed as a temporary effect of the Great Recession – but now that it has persisted into the recovery, we apparently have a lower baseline rate. Since healthcare costs are such a large component of future federal spending, less cost escalation in this sector is a very important factor in the long term fiscal outlook. 

Last year CBO projected that in 2039 the US debt/GDP ratio would reach 106% under current law and 183% under a likely set of alternative policies. As healthcare disinflation persists these forecast levels are likely to fall. 

Lower interest rates should also slow the accumulation of debt. After years of recovery and many months after the end of quantitative easing, Treasury rates remain near record lows. Rather than assume that rates will return to pre-recession levels, it now seems more reasonable to assume that we have entered a new normal of ultra-low rates just as Japan did after 1990.

While discussion around government solvency often revolves around a nation’s debt-to-GDP ratio, a better measure is the ratio of interest expense to revenue – because it focuses on the government’s ability to maintain debt service. Just after World War II, Britain reached a debt-to-GDP ratio of 250% but did not default because it faced very low interest rates. If interest rates remain low in the US, the federal government can comfortably service the 183% debt load envisaged by CBO’s most pessimistic scenario.

In 1991, the nation’s interest/revenue ratio peaked at 18% - but there was no discussion of a default. Currently, the ratio is below 8%. My study of fiscal history suggests that a Western style government becomes vulnerable to default once this ratio reaches 30%. While the US can always avoid a default by printing money, it is possible that an independent Fed Chair would refuse to do so, out of fear that the resulting price inflation would have worse consequences than a Treasury default. 

Under the CBO’s most pessimistic scenario, the interest/revenue ratio reaches 46% in 2039, well into the danger zone. But this outcome assumes an average interest rate on federal debt of 4.85%. Right now this average is below 2% and falling as higher coupon bonds mature and are replaced by new low-rate issues. Even if the government’s average financing rate drifts up to 3%, its interest/revenue ratio will remain below the critical threshold.

S&P had good reason to downgrade the US in 2011. If health cost inflation and interest rates had returned to pre-recession historical norms, the case for the lower rating would still be strong. But now that we have entered a new normal of quiescent healthcare cost escalation and low interest rates, it appears that the US is due for an upgrade.

Sunday, January 25, 2015

SEC Shines a Light on Inflated CMBS Ratings

On January 21, S&P settled a number of complaints with the Securities and Exchange Commission as well as two states’ attorneys general.  The issues primarily involved ratings of Commercial Mortgage Backed Securities (CMBS), although the rating agency also paid a relatively small fine for a self-reported lapse in its RMBS monitoring.
The settlements show that the SEC making use of the new regulatory powers it gained under Dodd-Frank and the earlier Credit Rating Agency Reform Act of 2006. While the complaints illustrate the fact that commercial considerations continue to affect credit ratings in the post-crisis era, regulators were able to identify and address (some of) them before another disaster occurred.
The CMBS market is much smaller than RMBS market was in its heyday, so a wave of unanticipated CMBS defaults may not have been enough to trigger another financial crisis on its own.  Nonetheless, it is nice to know that (some) misbehavior was caught early -- so we won’t have to find out.
Another difference between the contemporary CMBS market and the RMBS market of yore is greater competition. Six rating agencies currently vie for CMBS ratings mandates:  the “Big Three” plus DBRS, Kroll and Morningstar.  Neither Kroll nor Morningstar was around when bankers were shopping for higher RMBS ratings a decade ago.
After S&P temporarily suspended CMBS ratings in 2011, its market share position was quickly captured by Kroll. S&P’s subsequent misstep - distorting a Great Depression data set to justify lower AAA credit enhancements – was likely motivated by the fear of being permanently dislodged from the top three in a highly profitable asset class.
Ironically, the SEC enforcement actions, which include a one year suspension of conduit CMBS ratings, will cement S&P’s also-ran status. A takeaway here is one we have warned of many times previously: that more competition results in more ratings shopping by issuers and more pressure on rating agencies to dumb down their criteria - the type of concern that had motivated the Franken Amendment.

Competition in the Market for Single-Asset CMBS
S&P can still compete with the other players in rating single asset CMBS – a category that should worry any observer of the rating agency business. As the name suggests, single asset CMBS deals are collateralized by a mortgage on just one commercial property. The property can be an office building, a hotel or a shopping mall.
Typically investors in AAA structured finance paper have at least two protections:  seniority and diversification. With AAA securities at the top of the heap, collateral defaults usually have to destroy most or all of the value of more junior securities before the AAA holders are impacted. The second protection afforded to AAA structured finance investors is diversification:  the fact that the collateral pool contains a large number of loans whose risk attributes can be expected to offset one another.
Single asset CMBS deals kick this second protection away.  If the one loan backing the deal stops performing and has to be liquidated at a large discount, all investors lose – including those holding AAA paper.  The question in rating these deals is thus a fairly simple one:  what are the odds that the property will suffer a catastrophic loss in value?
According to the Moody’s idealized default probability table, the default probability on Aaa securities should be 0.0001% annually.  For an instrument rated Aa1, the annual default probability should be 0.0006%.  Differentiating between an event that has a 1 in 100,000 probability from one that has a 1 in 16,667 probability is difficult for any mere mortal – even one that happens to be employed by a credit rating agency.
But is it really credible to believe that any given shopping mall has just a 0.0001% chance of a catastrophic decline in value?  A brief review of recent history should refute this notion.
We have already seen one shopping mall devastated by a terrorist incident.  Although this tragedy happened in Nairobi, similar events are possible in the US which has already seen mass shooting incidents at Florida and New Jersey shopping centers.  But shopping malls can easily be laid low without an act of violence.  The closing of an anchor store or the opening of a competing mall can decimate traffic in short order.  And these aren’t theoretical possibilities as one can see by perusing the Dead Malls website.  This site lists over 100 US shopping malls that have closed or become largely vacant in recent years. Indeed, the rise of standalone big box stores like Walmart and the increased popularity of online commerce have placed enormous pressure on the entire shopping mall business.  Earlier this month, large tenants Macy’s and J.C. Penney both announced the pending closure of tens of stores around the country.
With such obvious risks, it’s hard to understand how a security collateralized only by a single shopping mall loan could be rated AAA.  Yet despite previous defaults on AAA shopping mall loans (see below) we continue to see AAA single shopping mall deals in the aftermath of the financial crisis.
Interestingly, the two pre-crisis shopping mall transactions with defaulted AAA securities weren’t single loan transactions – but they were overly dependent on individual loans that went bad.  Bear Stearns Commercial Mortgage Securities Trust 2007-PWR15 contained a loan to Las Vegas’ World Market Center II that accounted for 12.3% of the deal’s collateral pool. The default on this loan, in 2010, together with a large loss on the Aiken Mall in Aiken, SC have proved sufficient to trigger losses on the Aaa-rated AJ class.
CSFB Commercial Mortgage Pass-Through Certificates Series 2005-C2 included an exposure to the Tri-County Mall in Cincinnati that accounted for nearly 10% of its collateral pool. The liquidation of this mortgage at a deep discount eventually inflicted losses on AAA investors.
Despite these cautionary tales, we now have at least seven post-recession deals, with 100% exposure to a single shopping center, carrying AAA senior ratings.  These deals and their associated malls are as follows:
Aventura Mall
Miami, FL
Tysons Galleria
McLean, VA
Fashion Show Mall
Las Vegas, NV
Santa Monica Place
Santa Monica, CA
Green Acres Shopping Center
Valley Stream, NY
North Star Mall
San Antonio, TX
Altamonte Mall
Altamonte Springs, CA

If readers are aware of others, please pass them along.

Thursday, December 4, 2014

High Frequency Hiccups

This week has been an interesting one in the world of HFT worries...

Citigroup, somewhat surprisingly, announced the closure of its premier alternative trading system, or ATS, called LavaFlow.  LavaFlow had been the subject of regulatory scrutiny, leading up to a small settlement with the SEC back in July.

Citigroup maintains at least two other ATSs or ECNs, much smaller in size than LavaFlow.  LavaFlow, despite some negative press associated with the July settlement, had gained significant traction recently -- see the table of weekly flow, below -- which makes its closure all the more intriguing.

Citigroup reportedly explained that "Following a recent review of the LavaFlow ECN, we have decided that our capital, resources and efforts would be better redeployed to other areas within Citi’s Equities Division, ..."

Citi had previously spent heavily to get into the game.  We dug up a couple of their multi-million dollar purchases from 2007 and before that, including the $680mm purchase of Automated Trading Desk LLC.  The newly shut down LavaFlow likely took over the reins from Lava Trading, a division bought from Knight Capital back in July 2004, purportedly to "catapult [Citigroup] to a leading position in the electronic-execution arena."

Barclay's dark pool, the subject of one of our earlier posts, continues to grow, although it remains a fair share away from its lofty heights of early June.

Meanwhile the SEC is purportedly nearing the end of a lengthy investigation into the way BATS Global's Direct Edge Holdings LLC exchanges handled customer orders.  Among the concerns are whether all parties were allowed access to the same information about how the order types worked (or would be executed) and the order of execution among various open orders -- and whether they were indeed executed as they were advertised to be executed.  

We'll blog more on this issue in the coming months, as order types are an area of significant regulatory investigation, in addition to the focus on how or where brokers choose to execute their trades, as we covered previously.

Thursday, November 20, 2014

California Municipal Default Probabilities and a Reply to Lumesis

Earlier this month, we published default probability scores for 490 California cities and counties using a municipal scoring model I developed during previous research. The scores and a description of the model can be found on the California Policy Center’s website. The methodology – which relies solely on financial statement data – is further justified in this academic paper.

The accompanying CPC study identified thirteen cities that had heightened risk of default or bankruptcy. The median city in the universe had a one year default probability of 0.11%, while cities in this highly distressed category had default probabilities of 0.74% and up.

Our findings were reported in the Los Angeles Times and produced rebuttals from two of the cities on the distressed list – Compton and San Fernando.

We also received a rebuttal from an unexpected source: a municipal bond analytics provider named Lumesis. In a November 10th commentary, they compared our county default probabilities to their Geo Scores, which measure relative economic health. Finding little correlation between the two sets of results, Lumesis concluded that our model “needs improvement”.

But this conclusion begs a fundamental question: are municipal bond investors better served by socioeconomic metrics like those provided by Lumesis or by metrics that rely upon financial statement data? Even our colleagues at Lumesis appear to recognize that economic health is not conclusive, noting the “ability of bad management to create a mediocre credit from a strong economy.”

Fortunately, we have some empirical evidence at hand to assess the relative strength of fiscal and economic predictors. Back in December 1994, Orange County California filed for bankruptcy. Thanks to the magic of the MSRB’s EMMA system, I was able to locate the County’s 1993 and 1994 financial statements –as appendices to old offering documents.

For the reader’s convenience, I have posted the statements here and here. Next I input relevant numbers from the statements into my fiscal scoring tool which you can see here and in the screenshot below.

The result was a default probability of 0.85%, well above the current median and comparable to the worst performing entities in the current universe. As of June 30, 1994, the County had a negative general fund balance and had experienced declining year-on-year governmental fund revenues – two harbingers of trouble we have seen in other default and bankruptcy cases.

Would the Geo score have singled out Orange County in this way? Perhaps Lumesis can run the numbers for us and report back. Short of that, I note that according to 1990 Census figures, Orange County had the 5th highest per capita income among California’s 58 counties. So it would seem that a methodology based solely on economic health (like the Geo score) would have missed this particular calamity.

Monday, November 17, 2014

Broker Order Routing, in a High Frequency Trading World

The brokers/dealers have had their fair share of scrutiny among the recent revelations in the high-frequency trading (HFT) saga.

Among the questions being asked are whether Brokers are routing orders to whichever venues pay them most handsomely for the flow ... and potentially not to whichever venue provides best execution for their clientele.

We previously covered the discount brokerage world in which TD Ameritrade is being sued
(see for example Gerald J. Klein, on behalf of himself and all similarly situated v. TD Ameritrade et al, 14-cv-05738) for their order routing decisions.

You may recall that shortly after New York's AG filed a complaint against Broker Barclays in June 2014 for issues relating to its dark pool, Broker Barclays saw a precipitous decline (of roughly 66%) in trading within its own dark pool.   Some of that has returned, but while the tide has turned and the "true" nature of trading activity in some of the dark pools has been revealed, others like Wells Fargo have had to shut their dark pools: each venue requires a certain amount of trading activity to be relevant, or advantageous.

Brokers' Routing Decisions - Where to Send the Trades

Today we're covering a little of what we've found in the brokerage world itself: the changing nature of Brokers' routing orders to their own dark pools. We're spent some time digging through order broker routing information in their quarterly Rule 606 reports, and found some interesting changes in the regularity with which some of the large brokers are routing "non-directed" orders -- orders for which the client hasn't specified a specific execution venue.

The data are sparse, and the time periods short, but it seems like Credit Suisse (which has the largest dark pool) is generally substantially increasing its order routing to its internal dark pool, while Goldies and Broker Barclays are generally decreasing their self-routing decisions.