Comments on: Schwab’s lies http://blogs.reuters.com/felix-salmon/2011/01/14/schwabs-lies/ A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 http://wordpress.org/?v=4.2.5 By: fixedincome http://blogs.reuters.com/felix-salmon/2011/01/14/schwabs-lies/comment-page-1/#comment-23203 Sat, 15 Jan 2011 23:39:50 +0000 http://blogs.reuters.com/felix-salmon/?p=6945#comment-23203 Your other commenters are right Felix.

A) What Schwab was almost certainly providing is more accurately described as “effective duration”. As another pointed out, the “weighted avg time to maturity” calculation is Macaulay Duration, which has other useful applications (liability matching), but isn’t of much help in cases like this.

B) The maturity issue is relevant only insofar as it helps point in the direction of the credit risk that was otherwise being obscured.

I understand why you interpreted and said “it also gives one indication of market risk”, but that’s just not so. Duration is not designed to bake in basis and credit risk. It has limitations, plain and simple. The only way to avoid the problem of duration not telling the whole story is to use other measures and metrics. Would a nominal maturity or weighted avg live number been helpful in this case? Absolutely.

Even that wouldn’t have told the whole story, though. In theory I could have constructed a portfolio with just about identical durations and WALs to the Schwab fund, but entirely comprising agency-backed MBS. Its risk would have been entirely different, and not because those measures were wrong. I can show you portfolios with those constructions–i.e. relatively short duration, long nominal maturity–that had relatively decent performance in 2008. Their credit/default risks were different; the Schwab fund had significant default risk underneath. Full Stop.

C) Does any of that mean Schwab’s managers WEREN’T trying to deceive clients? Absolutely not. Whether the ratings reflected the portfolio’s credit risk in real time,, the Schwab managers knew what was in those portfolios and how risky the collateral was. Those deceptions, to the degree that they existed, were the product of omission and misdirection, not the duration and maturity measures themselves.

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By: MathieuJVL http://blogs.reuters.com/felix-salmon/2011/01/14/schwabs-lies/comment-page-1/#comment-23171 Fri, 14 Jan 2011 19:23:55 +0000 http://blogs.reuters.com/felix-salmon/?p=6945#comment-23171 You’re really talking about Macaulay duration that only applies to fixed cash flow instruments. Modified duration applies to other types of bonds as well. But then it becomes dangerous to talk about it as if it was a time (even though it’s homogenous to a time). It can be misleading as you say, become it can create confusion with WAM and WAL (weighted-average life). Modified duration is really a sensitivity to rates. 6-month duration would mean same sensitivity to rates as a 6-month zero-coupon bond… no?

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By: dWj http://blogs.reuters.com/felix-salmon/2011/01/14/schwabs-lies/comment-page-1/#comment-23170 Fri, 14 Jan 2011 19:07:11 +0000 http://blogs.reuters.com/felix-salmon/?p=6945#comment-23170 I would also like to note that, depending on how exotic these “bonds” get, it’s possible to have a negative duration instrument, which would actually reduce the portfolio duration from where it would be if that money were instead in cash. Nothing that owns IO mortgage bonds should be marketed as “a cash alternative”.

In any case, there is no sense in which calling the next reset date a “maturity” date is not simply a lie. Schwab should be sued and at least one person there should be drummed out of the industry.

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By: Greycap http://blogs.reuters.com/felix-salmon/2011/01/14/schwabs-lies/comment-page-1/#comment-23165 Fri, 14 Jan 2011 16:25:34 +0000 http://blogs.reuters.com/felix-salmon/?p=6945#comment-23165 “Duration is one way of measuring interest rate risk, but that’s not all duration does.”

Wrong wrong wrong: that IS all it does – it has nothing to do with credit risk. But it is true, as you say, that it doesn’t do it’s job very well.

The primary “interest rate risk” of a floating structure is basis risk: the risk that the reference floating rate will diverge from the actual rate of interest. It is true that in most cases – ABCP, LIBOR term-spreads etc – these diverges arose from credit considerations, but you really ought to have stated that explicitly. And anyway, maturity risk is about liquidity rather than credit risk per se.

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