Investment Dealers' Digest Nothing To Fear...
Associated Press, January 1, 2009

"The most destructive element in the human mind is fear. Fear

creates aggressiveness."-Dorothy Thompson

The lives of anyone remotely connected to Wall Street-which is to say everyone-have been turned upside down by 18 months of chaos in the financial markets. Some of those folks are now mired in such fear and pessimism that they are unwilling to take on risk, and the dramatic selloff in stocks and bonds, the collapse of major financial institutions and huge writeoffs have investors scurrying for the exits. Perhaps most importantly, trust has been eroded.

But even as these recent events have shaken global markets to their core, there remains one question, one easy-to-ask-but-hard-to answer question: has the fear investors have shown in the past year-and-a-half been overdone?

The fear syndicate

Prior to his work as an assistant professor at University of Pennsylvania's Wharton School, Alex Edmans worked on Wall Street. He started as a mergers and acquisitions banker in London and then went on to fixed-income sales and trading in 2004.

On the bond desks of Morgan Stanley, Edmans noticed how fear and enthusiasm were infectious. The enthusiasm was particularly acute when a national team won a sporting event. In Europe, that usually meant the win involved a soccer match, and Edmans noticed that investors rooting for a losing team would sell holdings of securities in a fit of pessimism. "People are not rational. They are affected by what everybody else is doing," says Edmans.

Years later, Edmans further explored what he saw on trading floors. He had left investment banking and in a January 2006 paper, Edmans and two academics examined how soccer can influence investors. What they found was that in nations where the sport has great meaning the elimination of the national team from a major international competition could bring stock markets down by 0.4%. That may not sound like much, but in UK markets that meant a loss of $11.5 billion in a single day. Edmans found that rugby, cricket and basketball could also sway the emotions of investors and impact financial markets.

In the US, geography may play a role in how people invest. A December 2005 study published in The Journal of Finance, entitled "Thy Neighbor's Portfolio: Word of Mouth Effects in the Holdings and Trades of Money Managers," found that managers in the same city or geographic region were more likely to gravitate to the same company stock. "Trades of any given fund manager respond more sensitively to the trades of other managers in the same city than to the trades of managers in other cities."

Of course, if the purchase of a company stock can be impacted by a herd mentality, the same is true for other types of risk-taking, such as extending credit to a hedge fund, lending money to a corporation or providing liquidity in debt markets.

"Some people feel incredibly threatened so many will run and take on avoidance strategies. They just shut down," says Mel Fugate, assistant professor the Cox School of Business at Southern Methodist University. Fugate says this shutdown occurs not only among individuals but entire markets.

The idea of emotion in financial markets has only been considered seriously since the mid-1980s and much of the field of behavioral finance has been pioneered by Richard Thaler, professor of behavior science and economics at the University of Chicago's graduate school of business. An article published by Thaler and Werner De Bondt asked "Does the stock market overreact?" and the suggestion that emotion can govern price moves was challenged by other academics. After all, followers of Milton Friedman believe that asset prices are set by rational investors. Thaler argued that if asset prices are set by only rational investors it may be good to know what these investors have in mind.

While it is generally believed that retail investors are more susceptible to emotional ups and downs, studies and anecdotal evidence suggest that emotions can shape decisions on a Wall Street dealer firm's trading floor, a bank's credit committee or even in the M&A deal process.

The fear among investors does not only show up in a drop in stock prices or wider yield premiums of bonds. It can also prompt investors to back out of financial markets in other ways. Redemption requests for hedge funds, for example, have surged in recent months, forcing hedge funds to sell off large quantities of their portfolio holdings.

"If you have less money, property is worth less, stocks are worth less, it [the selloff] is rational. Part of what you are seeing is that investors... even large funds, are not comfortable with the kind of risk we could take a year ago," says Russell Walker, assistant director for the Zell Center for Risk Research at Northwestern University's Kellogg School of Management.

Emotional rescue

Wall Street professionals-among them senior managers, traders and attorneys doing legal work for the investment banks-who see Dr. Bonnie Jacobson in her Upper East Side office in Manhattan want a way to come to terms with the changes in the industry and uncertainty about their jobs and careers. The concerns about the markets bubbled up dramatically in the weeks after Lehman filed for bankruptcy and have since worsened, according to Jacobson, a psychologist who is an adjunct professor in New York University's department of applied psychology.

"What has happened now I have never seen before," says Jacabson, who has been practicing for 40 years. "Every session is almost like a wake."

Jacobson says that for some Wall Streeters, the last 18 months have been worse than the terrorist attacks on Sept. 11. "This is actually worse. With 9/11 there was an outside enemy. In this environment it is all of us," she says, adding that many clients on Wall Street are asking themselves: "How are we to survive? Who do we trust?"

After 9/11, the US economy eventually righted itself. Now, there is a greater uncertainty about the future of the economy. In recent weeks, the alleged Ponzi scheme engineered by Bernard Madoff has only magnified fear for some and eroded trust (see related story). Also, "that a place like Lehman, which was such a revered organization, could just fold, that is the cause of fear," says Jacobson.

Other differences between the current environment and September 2001 are rooted in the fact that the current credit crisis has shaken everyone's belief in the financial system.

The New York psychologist says that colleagues overseas have witnessed a similar trauma, particularly financial-services professionals in nations living on borrowed money or "countries emulating our economic system."

So how are people coping? Some are "raiding the refrigerator late at night. They feel empty," says Jacobson. "What comes after shock, fear and panic ... is clinging to each other, and a lot of overeating."

Where is the true value?

If fear is irrational, the absence of reason may best explain how and why investors today value assets such as bonds backed by commercial real estate, high yield debt and high grade loans. Wall Street dealer firms are reluctant to make markets in many securities unless they have lined up a buyer. No one wants any inventory and this has contributed to the decline in asset values.

In the case of high yield and high grade corporate debt as well as commercial mortgage bond markets, yield premiums, or spreads, have burst to historic levels even though the underlying debt for the securities has not yet seen a big spike in defaults or delinquencies.

Within the commercial mortgage debt market yield premiums are so wide that they have put a chill on lending. This has some worried that borrowers won't be able to refinance their debt next year.

Susan Merrick, analyst at Fitch, says the current yield on AAA-rated CMBS classes of debt known as super seniors is at about 15%. "In a more balanced market a 15% yield is more appropriate for high yield bonds," says Merrick. "That return on a bond which has 30% credit enhancement is inconsistent to begin with."

The 15% yield on AAA-rated CMBS suggests that half of the loans pooled in the bond would have to default, and each one would have to take a 60% loss, something that has never happened in the CMBS market, which was started in the early 1990s.

"Even though the markets are illiquid that [yield premium] says to us there is something else going on in the market. Rather than just poor credit, people are very uncertain and fearful about what will transpire in the economy and how that will impact commercial real estate," says Merrick.

These days delinquencies are at 0.65%, or 65 basis points, meaning just under 1% of the $550 billion worth of CMBS rated by Fitch is in default. The yield premiums would suggest that far more than that percentage of CMBS debt is set to default. "We do expect a 2% default rate within the next year," says Merrick.

Wide yield premiums are also evident in the corporate debt market and some participants believe the widening may be overdone.

According to the Standard & Poor's measure of investment grade corporate debt yield premiums, spreads are at 546 basis points. At the beginning of the year these spreads were at 204 basis points and their five-year average is 168 basis points.

"They are clearly overdone. They have been infected by the entire [debt] market," says Diane Vazza, head of global fixed income research at S&P. "Cearly, there has been an infection [of worry]. When paint spills everyone gets splattered."

Yield premiums for high yield debt are also dramatically wider. Last week, a measure of high-yield spreads published by S&P showed that yield premiums are at 1,713 basis points. The five-year moving average is 473 basis points.

According to Vazza, defaults are expected to rise for speculative grade debt, but the current spread widening has been exacerbated by fear among investors. She says the market has run up the spreads in anticipation of a large-scale default even though they have to ramp up in a dramatic way. "There is a lot of fear built in. There is a lack of confidence," says Vazza.

Todd Youngberg is one investor whose firm decided to step up its investments in high yield. The senior vice president at Aviva believes that "when you do the math, price in the spread and default risk, you are getting paid a lot of yield."

Today, high yield default rates are at just over 3% but the market is pricing in default rates that eclipse the 1991 and 2002 default rates, according to Youngberg. "Current yield premiums suggest that investors expect a 20% default rate, far greater than the 16% default rate witnessed in the Great Depression."

Aviva's senior vice president says pessimism in the financial markets spiked in October and November. "This is probably the most negative I have seen the Street" become, he says. "Everyone is fearful of losing their jobs and that is filtering through to how they are assessing the market."

Anxiety in financial markets, meanwhile, has spread to mergers and acquisitions, according to Scott Kolbrenner, an investment banker at Houlihan Lokey. Strategic buyers and financial sponsors are taking much longer to complete their M&A deals, only in part due to difficulties with financing. "At a time when cash is king, we've seen some decision-makers hesitate to pull the trigger on deals. Transactions are still getting done but buyers are insisting on significantly more diligence on target companies than ever before, particularly with respect to projected results."

Some participants, though, believe that the drop in prices of assets in bond and equity markets cannot simply be chalked up to fear and anxiety.

The current pricing and the unwillingness of institutions to lend is reflective of the cost of capital, says Thomas Priore, chief executive of ICP Capital. "The fear is a reaction to the market deleveraging. It is a not a cause of the market environment. Generally, it is bad business to lend against depreciating assets, which better explains why there is so little lending going on."

(c) 2009 Investment Dealers' Digest and SourceMedia, Inc. All Rights Reserved.

Russell Walker