The Price of Stability is Pathology: Thoughts on Some Intervals

JM

Hat tip: Kay Giesecke, Francis A. Longstaff, Stephen Schaefer, Ilya Strebulaev, Corporate
Bond Default Risk: A 150 Year Perspective

The working paper above reports some findings related to corporate bond default
rates going back to 1866. The focus is on constructing a regression-based
mechanism that depends on hypothetical yield curves and risk-free spreads. The
deeper inquiry the historical data makes possible is about mean reversion.

The authors at least approach the issue themselves, formulated in the following
question: “How is historical corporate default experience dating back as far as the
Civil War relevant to current financial research?”

Their answer comes in two parts:

1) “[W]hile the names of the bond issuers and the industries they represent
may change and evolve over the centuries, the applicability of financial
theory to the determinants of default risk and the pricing of corporate bonds
should not change.”

2) “…in coming to grips with the current financial market situation which has
been termed a ‘historic crisis’ or ‘the worst financial crisis since the Great
Depression,’ nothing is so valuable as actually having a long-term historical
perspective.”

I have some reservations with these answers. The implicit assumption is that there
are constant laws of motion (arguably this is nothing more than quantitative
ideology) that hold in all cases. Given this assumption, the basic idea is to
determine an appropriate level of generality that is robust to different initial
conditions. But there is a deeper assumption at work: it is assumed that initial
conditions don’t matter in that the laws of motion are invariant to initial conditions.
In short, the starting point doesn’t matter, because every observed element
converges to the same final resting place in time. This is the core intuition behind
mean reversion, but it has a formal characterization.

Formal Convergence

Consider a law of motion T on a state space X. If T: X → X is measure preserving

then almost every point in any set of positive measure must return to the set under
the action of T. The average value of a function f along the range of T
has a convergent limit if T preserves a finite measure, and if the (real valued)
function f is integrable. The notions of f(Tx) and f(x) have an intuitive meaning.
f(x) is the physically observed space of a dynamical system. f(Tx) constitutes a
representation space where each point Tx corresponds to a point x in X. This
representation is a way to trace out a law of motion starting from a point of initial
conditions and passing through the collection of points which represent how the
system evolves over time.

The set of points f(Tx) reveals deep properties of dynamical systems. For example,
when you collect all possible paths initiating from a collection of starting points, the
set is called a dynamical flow. These flows often show clearer patterns of behavior
than f(x). Instead of having to process the sometimes jagged ups and downs of
f(x), f(Tx) describes those ups and downs as a circle (periodicity), a spiral (almost
periodicity) a donut (quasi-periodicity) or some other three dimensional attractors
that can be so complex as to be practically unpredictable (chaotic motion).
Sometimes these sets of points can be self-similar, meaning that one observes
recurring behavior but on different time scales. When people talk about fractals,
this is what they mean. The simplest case is where flows converge to a state of
rest (a fixed point).

Mean reversion really implies something about how a given law of motion evolves
over time. It means that for almost all initial conditions x in X, the average value of
f(Tix)) of the dynamical flow as it evolves through time is the same as the average
value of f(x). Such laws of motion are called ergodic: one can recover all the
information about a process from almost every instance of the process. Probability
becomes equivalent to frequency.

It is clear how the ergodicity concept provides some logical support for the “mean-
reversion” world-view. A “typical” corporate bond of same maturity will behave like
other bonds regardless of whether they were issued in Thailand months ago or a
hundred years ago in Manchester England.

There are, however, only a few ways to implement ergodic concepts in a concrete
situation. Where these methods finds closest connection in finance is with entropy
measures of random variables. These measures tend to zero for underlying
processes that are mean reverting but random (like white noise) or bounded and
deterministic (like the sine function over the interval 0 to 2π).

There are a variety of ways to calculate entropy. However, the corresponding

author (respectfully) wouldn’t share the dataset informing the working paper.
There aren’t enough data points to do anything serious like calculating entropy or
stability via Lyapunov exponents anyway.
Divergence

Given the insufficiency of the time series, ergodicity of historical bond defaults can’t
be deductively proven or disproven in a mathematical sense. Mean reversion is just
a claim that must be evaluated on the basis of strength of evidence. There’s some
evidence against it.

Bonds have been around since Ur [1], and if there is a bond then there is credit
risk. Credit risk can be measured in a simple intuitive fashion, like how pool
players make amazing shots without knowing the physics behind it. There are
contrasting quantitative frameworks like the Hull-White model: these are good for
pricing hedge ratios and making decisions as to when the bid is good. No doubt
there are some constants in the world.

However, the concept of a lender of last resort didn’t exist in ancient Mesopotamia,
and in most parts of the world didn’t exist until after the Second World War. The
Fed/BOJ/ECB becoming forcing functions of the global economy in the past 24
months is entirely new. People interact; are changed as a result; and radically
adapt their behavior. Big picture: financial markets are not physics labs.

The decisive issue is how radical the change is. If the change is sufficiently radical,
then the hypothetical flows of bond dynamics do not converge in the average, and
the laws of motion are meaningless because nothing about the behavior of the
system can be determined from them. This can be because no discernible patterns
about bond behavior can be gleaned because the behavior is so complex. This can
also be due to every bond being a unique phenomenon that depends on time,
place, and culture.

One could argue that in finance change is so rapid that even a few years ago seem
antiquated. If this is the case, then trading off 150 years of default rates can
actually be more misleading than trading off of bond yields and default rates since
the last crash in 2008.

Casual Empiricism

To apply these concepts to the historical data on default rates, I applied some
labels to the chart of default rates the authors put in their paper. They also
provided summary statistics in addition to the other stuff.
  “Default-­‐Free  Zone”  
 Dot  Com  
Or   Boom  and  
Post  Civil  War  
Crash  
Adjustment      The  Unbearable  
 WWI   Lightness  of  Stability    Junk  
Bond  
 Railroad    Effects  of    The  Great   Defaults  
Boom  and   1893  Bank   Depression  
Crash   Panic  

From the perspective of bond defaults, the Great Depression wasn’t nearly so
terrible as prior crises associated with the railroad bubble or bank crises. In fact,
by eyeballing, it looks like default rates in the Great Depression are simply mean
reverting to the historical average preceding it.

The most remarkable aspect of the chart is that from around 1942 to 1985, the
United States entered a nearly default-free period. Anybody who traded mean
reversion to the average default rate of 1866 to 1941 would have been killed. To
repeat: Would.Have.Been.Killed. This lasted for 43 years. There is a reason why
the JGB10 has the name the Widowmaker. Time decay kills. The unbearable
lowness of bond yields under Japanification is just another example of how long
“untenable” things can go on. It doesn’t make much sense given debt to GDP
ratios, but it doesn’t have to make sense. It is what it is.

The Unbearable Lightness of Stability

Even within the interval of stability, there have been relatively big moves in default
rates—but not massive absolute moves. They are “big” only when one looks at the
closed time-scale from 1942 to 1985. Outside of that zone, default rates look
historically low and as calm as the Pacific: this is a fractal dynamic.

It is unclear how massive the differences are in bond characteristics across time.
Rating agencies may have started in the bond business only the 1920s, but there is
no reason to doubt that intelligent people discriminated among credit entities.
There were clearly publications like the Commercial and Financial Chronicle related
to this, and probably more than a cottage industry existed (including Goldman
Sachs) going all the way back to 1866. Perhaps a generation of people untroubled
by the high default rates of the 19th century would lend to even the riskiest credits
at the right interest rate and off-par.

Starting in 1990, there’s been resurgence in default rates. Although not on the
chart, we saw another spike in default rates in 2008. In 2009, high yield
(admittedly a small fraction of all issues) default rates hit 13.7%. There are
qualitatively different debt instruments like leveraged loans and synthetic positions
that increase stress on default rates in a crisis. It would seem that because of this
the very notion of default rates is inferior to loss rates (combination of default and
recovery rates) are a better metric than default rates alone for anything other than
secured debt anyway: put financial assets under stress.

Stability Sux

There was one other factor going on in the default-free zone… the rise of central
banking and deficit spending fiscal policies as a global ideology. Check out the
quantiles the authors calculated to see the differences:

1866-1899 1900-1945 1946-2008

Minimum 0 0.107 0
25th percentile 1.976 0.347 0.009
Median 3.022 0.903 0.098
75th percentile 5.195 1.957 0.38
Maximum 16.255 6.725 3.071
Default rates went from 3% in one interval to a little less than one percent after
introducing an institutionalized lender of last resort, to less than a tenth of a
percent when you add activist of monetary ideology and deficit-driven expansion
into the mix. Why?

The simple reason is that such policies diffuse risk held by debtors and creditors to
taxpayers and savers. Can’t pay your debt? Savers will eat a portion of the loss
through devaluation. Facing default? Taxpayer bailouts, baby. This provides a
low-risk environment that has some benefits for everyone. Entrepreneurship and
innovation is higher. Technology breakthroughs are more frequent. Both
contribute to big jumps in standards of living.

But there is a dark trade-off. Diffusing risk doesn’t take it away. Rather it is
hidden in the footnotes of dealer balances sheets and counterparty exposures. Yet
there are clues to find the aggregated risk if you know where to look. The cost of
stability is pathology.

The ideologies that condone unloading fiscal costs onto future taxpayers and savers
clearly suppress default rates and default vol. But it creates seriously nonlinear
returns: there may be massive upside as a result of nuclear fusion research
subsidies, but there can be equally massive downside. What you get in exchange
for control of fundamental laws of motion is asymmetry in outcomes and a much
higher probability of extreme outcomes.

Complexity and interconnectivity within the financial system—crowded trades and

herd behavior—create fundamental asymmetric instabilities. Asymmetry implies a
false sense of security. The result can be massive concentrated positions in either
paying or receiving on a swap because “an adverse unhedgeable move can never
happen”. Such positions are great when the good times roll, but under stress
performance collapses. This is clear in the skewness and kurtosis statistics since
1946.

Standard
Mean Deviation Skewness Kurtosis
1866-
1899 3.998 3.571 2.012 4.725
1900-
1945 1.345 1.383 1.853 4.127
1946-
2008 0.304 0.53 3.233 12.783

OTC markets are a good example of how well-understood risks that can be marked
are transferred into unquantifiable balance sheet risks. Exposures of OTC swaps
are publically available only in aggregate, which is fragmentary, and there is no
public data about specific counterparties. I’ve heard that brokers bid and offer the
same position to different counterparties at different prices. Dealers can mask a
trade so that some counterparties can’t see it. Prices are not based on model
implied cashflows as much as a herd mentality based on hitting the bid someone
else just did.

It is true that asymmetry in JGBs and junk yields is nothing new: it’s the nature of
the business of bonds. At par a bond has limited upside and big downside risk in
exchange for stability of coupon (not yield). At par there is limited price
appreciation potential and much greater downside potential. But there is
something deeper at work in the heightened asymmetric payoffs since 1946.

The increased kurtosis or fatter-tails seen in default rates since 1946 imply higher
probability of extreme things happening and a smaller probability mass. The
implications are profound. For most American fixed income history, prudence in the
large was the real requirement for a fixed income investor. You needed to be risk-
averse enough to handle the stress associated with greater default rates and
volatility. Hedging was an unnecessary luxury because the risk of extreme swings
in defaults from expectations had less impact relative to the mean. Since WWII,
the probability of extreme events is much higher. Higher kurtosis implies priority in
hedging against extreme outcomes more than before.

When a return distribution has these characteristics, sudden price changes are
more likely. Ideologies that incent leverage are an effort to maintain returns in
ever more “crowded trades”, raising the vulnerability of the financial system as a
whole. Prices, implied volatilities and spreads then move away from sustainable
levels in a dramatic way.

[1] Dercksen J.G., Silver and Credit in the Old Assyrian Trade. In Trade and Finance in Ancient
Mesopotamia, pp. 55-84. Leiden: Nederlands Historisch-Archaeologisch Instituut te Istanbul, 1997.