January 24, 2010
What is going on with these crazy credit ratings
An associate of mine posted me this article (click the link to read). It is an interesting overview on the reversal of credit ratings, well written and articulated. It also has an interesting insight into emerging markets so I thought I would share the posting in this forum.
His question ``What is going on with these crazy credit ratings reversal?`` - I have taken to put an opinion to that a little later on.
\\ As far as I know, there's no financial-markets law saying that if some countries get a credit-rating downgrade, then others must get a credit-rating upgrade to keep the system in balance.
But right now it seems to be working that way.
The past year has brought credit-rating downgrades to Portugal, Spain, Ireland and Greece, and credit-watch warnings to the United Kingdom and Mexico.
And it has brought credit-rating upgrades to Brazil, Peru, Turkey and Indonesia, and credit-outlook improvements to Russia and India. \\
Author : James Jubak
Click to read
So what is going on with these crazy credit ratings?
I have a couple of general theories knocking around in markets at the moment.
Firstly most fundamental valuations including credit are relative and secondly I believe and talk about it often, first world demise is in full play.
Where the action is at in my opinion is in local markets and BRIC, especially as the governments from the first world overreact to a crisis that should be behind us now. The first world is lifting taxes to exorbitant levels to fund their deficits, collapsed interest rates to flood the markets with liquidity and are in the process to over regulate the banks with enough new policy to build a Tower of Bable in mandates.
So what is going on - relative valuation principle:
A is graded at 10
B is graded at 12
C is graded at 3
Total possible investment capital in a horizon is stationary, if the grading on A and B falls to say 6 and 7 respectively the relative grading on C goes up when compared to the other assets, that is the spread narrows. As the relative rating on C rises, the hurdle rate or interrelated beta factor of WACC which translates to the effective interest rate slides and the volatility of the assets net value is dampened. It`s a story of the world and one of the systems that drives the rich get richer while the poor can never escape their interest constrained domain but that is all changing at a sovereign level. To put it another way, those that are risk adverse and price in such positions can actually drive the dysfunction.
So what is going on- Demise of the first world:
Let`s just quote the article here: ``At the start of the decade, Peru's national debt equaled 50% of the country's gross domestic product. It now stands at just 25%. (The United States is on track to finish fiscal 2011, ending Sept. 30, 2011, with a debt equal to 98% of GDP, according to the International Monetary Fund.``
Again in fundamental valuation if the value of an asset used to secure a loan is less than the outstanding balance on the loan you have negative equity. America is 2 percentage points off a strict measure of bankruptcy. The reason why Moodys, Fitch and S&P won`t down grade the country is elusive but perhaps such an action would impact their own business because they are headquartered in this nation or may be they probably don`t want to take flack from their biggest market - I would say nepotism probably lives on.
Posted by CausalEvents at 03:10 AM
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September 12, 2009
There`s no such thing as a free lunch
It`s often said ``There`s no such thing as a free lunch.` Or is there?
To make FREE work one has to apply a strategy so to answer this question we are going to look at various strategies for FREE.
Nothing is for free including time and nothing comes from nothing, free works if there is an underlying strategy behind the business model.
So with that in mind how do companies generate revenue from FREE, here are eight example strategies of FREE?
Strategy 1: FREE The Competitor Reverse Buyout Game
In this strategy a business will build a service delivery model that will offer such low prices (FREE is pretty low) that it inevitably ``steals`` customers from the existing market. As the client base expands, the business incrementally increases in value potential. Eventually the competition will look to acquire the business from the existing shareholders and pay a premium for the unrealised revenue channel.
Strategy 2: FREE Incremental Purchase Program Game
Free for the first unit of consumption and incrementally as consumers buy more they pay for the marginal units consumed, rather than receiving discounts for the more they buy which is the traditional sales / pricing model. In the 1st degree price discrimination curve (depending on the operating leverage of the firm), it is possible to charge only for marginal consumption especially if the operating costs can be deferred or marginal consumption will lift the total units sold high enough to tip or bend the price discrimination curve upwards. Instead of sell one get one free, it`s give one away and sell two because the first tasted so good.
Strategy 3: FREE Alternate Revenue Game
Imagine a firm that generates most of its revenue or has improved economies of scale from its B-product line not it`s prime or spearhead product. Instead of advertising at huge expense, simply give away your prime product to sell your B-line. Other strategies in ARG would include changing the final price of a product to absorb the component and incremental costs thus fooling the consumer to believe they receive some parts for free.
How many companies sell a system for nothing but charge you for the support or maintenance, each new feature thus will attract more support calls.
Strategy 4: FREE The Intellectual Property Game
Attract and bed customers because it`s FREE but build intellectual property in the background. In start-ups the value of the firm is priced from its future potential cash flow especially if the firm is funded heavily through equity. If the intellectual property can find a resale price; it as an asset class will leap from one side of the sign to the other on the price to book ratio, how valuable is that.
Strategy 5: FREE The Classed Society Game
What do you want, first class or economy class? Has anyone seen the difference in price? The spread can be so wide that in fact first class is often carrying economy class however economy class is adding to the volume, contributing to in-viral marketing and allowing for incremental sales.
Strategy 6: FREE The Subsidy Game
Why charge high prices to the private sector when the public sector will pay for it? Charities sometimes and many businesses servicing the community often have tax exemption and subsidies to reduce the cost of goods sold. There are a lot services that are ``near public`` because of heavy subsidisation. This model can if extended, bring down the cost of goods sold to a point that it is negative thus EBIT becomes positive.
Strategy 7: FREE The Reverse Value Added Reseller
Here is a great but possibly ethically flawed model. Reverse engineer the ABC cost model. Instead of charging the customers you charge the suppliers (from buy side to sell side, switch them). Wow how does that work? Imagine we are a firm that endorses or rates companies in the market and companies with the best endorsement attract more clients. We of course give our advice away for free but we charge the companies we rate for the audit.
Strategy 8: FREE The Naked Hedge in Treasury
How many airlines have made profits not from tickets sold but the hedge on the price of oil? Many business models are nothing more than a reverse semi naked hedge, they exist to support treasury. Profit is generated by the future contract sold rather than the physical contract and the physical is used to hedge the future rather than the reverse. A dangerous game no doubt but one that is increasingly becoming popular.
Free works but you need to have a game plan.
Posted by CausalEvents at 02:17 PM
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June 13, 2009
Between a hard rock and a cold place
Some readers expressed a range of interesting market based opinions to our last blog ``Greedy glut feeding frenzy`` so in the theme of this we are going to continue the topic.
Back in March you could have put capital under any stock on nearly any market and made incredible returns.
One night I did just that, I printed out the price movement for one of the notorious US banks, took a ruler on the curve and drew a line dissecting the average daily price swing for the week then went long with a doomsday stop loss and limit to close out at around 75% on the average move.
Then I went to bed.
Amazing as that may be logging off and crashing but, I had a huge day coming up and I wanted to be fresh. In the morning, I grabbed a coffee as one does, logged on and the limit order had been fulfilled. The notional contract had sold and at possibly the best rate of return I think I have made for the time invested. Foolish perhaps, irresponsible umm that depends who`s funds I put at risk; as this was my money not an investors I see the moral issue was a personal one, the type you have with your alta ego when you shave and talk to yourself in the mirror before going to work.
Would I do this now?
ABSOLUTELY NOT
This market has changed and while global equities are still climbing at a phenomenal rate when looking at the 60 day moving average, several things have occurred.
Firstly relative pricing has come back into play as it should. Not all stocks are equal and some are starting to fracture. If the fundamentals (operating margin, eps, debt to equity ratio etc) are not under the company be cautious buying it and holding long.
Secondly this huge influx of cash into stocks has encouraged some companies to value the price of equity differently. It has been difficult to borrow and some standing commercial paper bought back in the heyday on higher rates is stinging when discounted today.
Some of these companies are taking advantage of this flash of liquidity and resolving the problem by engaging in financial restructures. The most common approach is to issue additional equity as preferable shares and payout the debt. Good in principle but the investors then hurt as this process has a tendency to shock the current price of existing shares when holders see dilution in the stock they own. I have been caught on one such animal and the price fall was a cliff face with a hard landing.
There is however something far more concerning with the economy than the hike of equity values, this is just part of the picture and the focus is not GDP growth, social economic sentiment (a measure of confustication but seems to have effects) or unemployment which is umm well a few thousand less than it was a month ago.
The real concern is what is going on in the adjacent markets; commodities, money markets and bonds. The signs are concerning, let`s take the first one.
Where will be, if demand and economic output grow at a positive (oh let`s not over excite ourselves here) 0.9% and the price of oil blows the roof off every month with a 2% climb? Imagine the operating costs for businesses increasing and sales remaining weak, even slower if these businesses price in and pass on the real cost of delivery.
The bond market is even more of a worry.
The US treasury department might start to run out of takers for its debt, certainly China has expressed a concern over the last thirty days and new issues are going to eventually need higher yields to attract buyers. The ten year note has been very low, actually at a record low of 2.3% last year but that has been changing. As the ten year note rises, so does the rate on consumer loans because these bond yields are used as a baseline for the loan contracts. The ten year note is certainly closely tied to home mortgage rates and is now floating around the 3.8%.
Rising interest rates and higher commodity prices together have a compounding effect and are likely to dampen any fast V shaped economic recovery. Rising interest rates are also going to increase the default rate on standing obligations and take that nice shine off these ``new`` banks profit margins.
The effects in the equity markets are obvious, on the May 28th we had another wonderful run, not as big as March but it is graphically visible. Since then however the heat has been coming off some of the stocks away from energy and the volume of trading has been really low, notably low. On Friday I had one stock hit its entry price 15 times in the trading day, the whole market was just churning between buyers and sellers but there was little advance for what seemed like ages.
We are at pernicious juncture, somewhere between a hard rock and a cold place. Interest rates will eventually have to increase otherwise inflation is going to be a concern but the markets have become fragile again.
What is the solution?
Posted by CausalEvents at 10:43 PM
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May 06, 2009
Greedy glut feeding frenzy
Cash for trash, writes Paul Krugman and is what many sceptics labelled Henry Paulson`s 700 billion rescue plan. To be honest the same could be said for some of the securities that are part of this invincible recovery and not just restricted to US markets but across the entire wagon of global equities.
Without any doubt the lows of March 09 are gone and some firms were priced very much on the cheap end.
Back only a month ago or so there were actually firms with negative enterprise value, amazing as that may be and how could that be?
Enterprise Value or Transaction Value is the sum of claims of all security holders and can be derived by taking the (equity value + debt + preferred equity) minus (cash + marketable securities). That is tradable securities fell so much, some firms were perceived to have more cash than ongoing claims and one would deem such a place as an arbitrage opportunity of all occasions, where you could buy all of the debt of the firm and use its cash balance to cover the investment cost. As the number of firms with negative EV grew, the steepness of the slope of decline diminished and eventually the market reached capitulation (bottomed out) and then just as it couldn`t be any darker, the world sprung to life and it keeps leaping back, so much so that we are now reaching another bad place; the correction.
As Bloomberg writes ``Aprils, record rally in European stocks pushed market valuations to the highest level in more than four years`` and ``The 13 percent advance in the Dow Jones has sent the measure to 16 times its average companies earnings`` This is all good surely where some firms` stock price has climbed so rapidly that you wouldn`t even know you had been in a recession, in some cases the price of the stock is about where it was last October. What recession do I hear you say, it`s endless but if you scratch below the surface you will find that some of the real big movers are the small caps. Now it isn`t uncommon for the small caps to lead the market as a whole out of a recession and in past recessions this happens about seven or eight months before the recovery. If however you pull the covers aside on some of these companies and look at their reported balance sheets, it`s a very oh dear me, perhaps this little lot aren`t such a great buy.
One firm I looked at in particular has a negative current ratio (liabilities are greater than assets), sales down 70% from the year before, operating costs about the same and well umm profits negative. The share price, WOW up 80 percent plus and if I have ever seen a badly dressed date for a ball, that has to be one.
When UBS announced its 1.98 billion Swiss franc loss yesterday and the share blew to another 4.7 percent up, I knew for sure the world had gone crazy. Well I suppose if everyone was that pessimistic in the past to think that a loss of 1.98 percent today is a good thing because last year the bank did over six times that, we all need a reality check.
This is all fine, speculate on; it`s all been a negative place for a few months but where are the fundamental economics under all this buying? EU Business reports that retailers in the 16 nations using the Euro saw a slump in their sales accelerate in March. According to official EU data released on Wednesday 6th May, brings the decline over one year to 4.2 percent, twice as much as many analysts had estimated. February of course was worse, so again with our pessimistic glasses on we take a little less bad news as brilliant news but nota bene ladies and gents that while the acceleration or slope of decline has diminished, it`s still going down. What about US unemployment, well last month that soared to 8.5%, its highest level since 1983 and Germany`s unemployment rate has risen to its highest level in over a year with consumption declining by 1 percent instead of the forecasted 0.2 percent gain analysts saw as reasonable.
I know it all sounds doom gloom and hey who wants to be a party pooper but with climbs in some security prices of 10% every second day, one starts to believe that it is a tad premature after the last greedy glut feeding frenzy denial that everything has to go up all the time.
Posted by CausalEvents at 10:16 PM
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February 12, 2009
The US compensation battle
The latest musings on the credit crisis or perhaps the outcome of the event (one single occasion is usually driven by many causal factors), is corporate compensation.
This week president Barack Obama called the bonus payouts for banks receiving rescue funds as "shameful" and that the government will require financial companies on the aid trade to cap compensation for top officials at USD 500,000 a year.
Obama stated that he was responding to a public outcry "in bad taste" over bonuses paid to bankers and wanted to enforce greater transparency of expenses and restrict severance pay when executives leave the company.
Read with charts
The Irony
He has a point of course, why should the tax payer fund the compensation of corporate individuals who have been partially responsible for destroying rather than created value in their firm. Ironically there is a sniff of pharisaicalness in all of this considering that his cabinet has been implicated with their own inability to manage tax liabilities. Not even one month in, Tom Dasche the former senator selected by Obama for Health and Human services was scrutinized for lodging tax errors and secretary Nancy Killefer appointed last month by the president to probe government spending, has also fallen through the moral floor of the inland revenue system.
This is all partially jocular but it is not the feature of this journal. More importantly we want to ask ourselves:
(1) What is the purpose of this blanket policy over its decorous gesture?
(2) Is corporate banking compensation policy skewed or failing in the first place?
(3) Could such caps drive some kind of different dysfunction?
If a broker wants to propagate ever increasing returns against this baseline, they have little or no choice but to go deeper on a position even though that might have negative marginal utilities of return. The foundation of this very system needs to be addressed, not the size bucket but the downside; the risk-reward-appetite of each individual or team in the bank needs perhaps a different approach. More concerning is that most incentive programs are short term and aggregate the upside but do not weight the downside equally.
Then of course as employees climb the corporate ladder their compensation accelerates and their ability to influence the executive team also becomes more prevalent.
In most cases or measures there is going to be a left or right zone and it is argued that Merrill Lynch sits squarely in that flange. Bloomberg Jan 29 ~ ``New York Attorney General Andrew Cuomo may demand the return of $4 billion in bonuses paid by Merrill Lynch & Co. just before it was acquired by Bank of America Corp. Cuomo also wants to know whether [ALT] Bank of America Chief Executive Officer Kenneth Lewis knew about the accelerated bonuses and about Merrill`s surprise $15 billion net loss in the fourth quarter`` ~~~ That is probably pushing the boundaries however a blanket policy might not be the right approach either as it paints all banks with the same brush.
On Consideration
Within hours of the Obama blanket policy, there was also a response from the industry. Goldman Sachs Group stated that it “wants to repay the 10 billion it received from the US Treasury last year to signal the firm is healthy and escape any imposed limitations on the funds” and is going to raise additional funds in the equity markets to balance this when the time is appropriate. What value is going to be derived from transferring one obligation to another is yet to be determined.
One of the main problems for blanket incentives is that they can drive institutions to become baron places of innovation especially when the floor is adjusted to some arbitrary mean as it is in the current process. In such a situation an executive might only work till they reach the incentive barrier and then take an attitude of languor in their work, others might simply leave the institution.
Some argue that the incentive scheme for large banks should actually be focussed more on share options than cash incentives; in this way if the firm actually performs bonuses should be reflected appropriately in the share price.
Last year when the Troubled Asset Auction Program was launched by the federal reserve, it also inserted the following ruling “Any financial institution participating in the Capital Purchase Program will be subject to more stringent executive compensation rules comprising of three key criteria:
(1) Incentive compensation for executives does not encourage excessive risk taking that may threaten the value of the financial institution.
(2) Clawback of any bonus or incentive compensation paid to a executives based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.
(3) Prohibition on the financial institution from making any golden parachute payment to a executives.
So what went wrong?
Well firstly there are no limits on pay or linking of pay to performance. In addition, definitions around what is risk taking and when are such risks to be booked to the balance sheet is also omitted. The definition of what is excessive pay is actually totally lacking and there was no criteria on the clawback of bonuses. While firms that sold troubled assets to the government were not allowed to deduct pay that exceeds USD 500k from their corporate income taxes, such a ruling was only applied to these firms in the program and not to the broader industry that might have received support.
The web site common dreams puts it this way
The current U.S. tax code places a $1 million cap on tax deductibility for executive compensation, but this provision has been meaningless in practice because it allows exceptions for "performance-based" pay. Most companies simply limit top executive salaries to around $1 million and then add on to that total various assortments of "performance-based" bonuses, stock awards, and other long-term compensation. The bailout legislation was designed to close this loophole by eliminating that exception for executives of bailed-out firms.
Where does that brings us up to today?
Going forwards I would say this is going to be a contentious area that will require more carefully thought through policy. A policy that perhaps balances talent retention with performance based incentives that are linked to risk-adjusted reward and the downside outcome.
Posted by CausalEvents at 06:10 PM
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January 16, 2009
Call it what it is, pawn cars
The acronym GM should be renamed from General Motors to Gross Manipulation and while there are some that reckon I am heavy handed with my criticism of the US government response to the General Motors collapse, I stand by view.
Oh I hear the argument that if GM fails the outcome to the manufacturing supply chain may be devastating; huge job losses could amplify the broad decay of the US economy further (if that is possible with interest rates hovering above nothing) and lead the world to a deep seated recession as marginal retail consumption declines. Personally I believe the world is greater than General Motors however the domain I am going to pitch from in this article is NOT some rhetoric to argue this point.
I simply believe we should paint it as it is; an angel or a prostitute even though one can be both. It is in that, the inability to see ourselves for who we are or perhaps the lack of being honest with real outcome which is a major play on the entire financial crisis. No regulation can resolve what has and inevitably what is likely to be again unless we truly accept what is.
Without digressing too much, there are three key maxims that to me I question from a moral perspective. These need to be painted as they are even though they may be well intentioned.
The Structured Finance Maxim
In structured finance we have broadly three types of duration in funding: They are short, medium and long term funding. The exact delineation of when funding is short, medium or long has disparate consensus however nearly all agree that using long term funding for short term problems is a portentous decision.
You don`t finance capital expenditure projects on revolving credit such as an overdraft or plastic (please I would like to buy that house on a credit card) unless you are American.
Why? - Simply, the compounded risk priced hurdle rates destroy the intrinsic net present value from the working capital that pursues from the investment.
It thus follows that you don`t apply long term funding to short term liquidity issues because little intrinsic value is normally created from the funding. The result of which generally dampens the distant valuation of the firm while the liability remains.
The process of cash debt sweeping as it is often called generally does have a short term positive outcome as a real higher debt charge when measured as a single payment strip is spread across a long term commitment. In the end however, the firm will continually pay in the future for what it consumed deep in the past and the final or effective charge is normally higher reducing the ability of the business to re-borrow.
Put it another way, one has to be hopeful that cash debt sweeping meets the ends it is designed for as most businesses can only use this joker card once in a game.
Where does it lead us? In the light of a company such as GM which is clearly a cash addict (it did go to the senate with its pants around its ankles) probably to more handouts or additional support such as import protection, early tax redemptions or even exemptions.
The Capitalist Maxim
In communist government regimes, the line between the public and private sector is hazy. Now I am not going to defend either economic principle (there are benefits and pitfalls with both) but if you state you are a capitalist market free society then be true to yourself. What the market wanted to expel, short, liquidate and consolidate the government defends. Worse it does this with tax payers funds, the very tax payers that sold GM stock on the exchange in the first place.
Good or bad, makes no difference however it is what it is.
When you pay a tramp like GM; they will all start to come out from every dark damp corner of the market, begging with their hands out.
The porn industry has been hurt by the downturn like everyone else and they are going to ask for $5 billion from the US government
- CNN
How do we value the porn industry? - Does it really matter?
The US government clearly didn`t value much when it sent funds to GM but I tell you the porn industry is probably a lot more exciting than driving an overpriced mediocre automobile manufactured in Detroit.
Side Track Regulatory Maxim
Late last year GMAC won Federal Reserve Approval to become a bank enabling the auto lender to access funds that were `estimated` and set aside for the banking community.
Why should the banks have access to Federal Reserve funds and not private companies a lot of people ask me, surely that is inequality?
The Federal Reserve sole purpose today as it has always been is to support the banks and it does this in good and bad times to control the heating or cooling effect of the economy. By directly manipulating the money supply to banks and inevitably the producer and consumer, the change in interest rates will ultimately alter the savings function of the nation.
Back to our GMAC animal, it is all quite ironic really as this beast is an avid fan of the SPV securitization market and has a history playing with such things well back in the days of Enron. Now of course GMAC is a bank not a finance house and a bank which needs to hold capital, a bank that needs to implement lending practices like any other regulated entity and in GMAC`s case it needs to at least pretend to reach some form of regulated decorum as the others in the ostensible dib-dib-dib toffee banking club have done.
Ladies and gentlemen we have Freddie, Fannie and now a GMAC; all sordid creatures conceived in similar vein and I fair the story is going start all over again. Remember one thing though, you have to call it what it is otherwise the pain of the sub-prime crisis isn`t going to be a lesson.
Posted by CausalEvents at 12:58 PM
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December 15, 2008
The Gray Swan
In the theme of the Nassim Taleb dissection of risk systems in the world of finance, the black swan is something extraordinary rare but hugely negative (or positive) to our current strategy and a white swan is the normal mode of operation. It might follow then that the gray swan must be systemic failure of the normal, a platykurtic distribution (a distribution which is peeked and wide around the normal position) where white is not so white when viewed from an External Perspective.
We use an External Perspective to test a system, an anchor if you may that allows us to measure something against a standard not from the system otherwise it is biased to the system. The purpose of course is more than academic because it should allow us to understand if a system is positive or negative in a more celestial way. If you take that External Perspective on the current global markets, equity or fixed income; they are gray swans.
In the unknowingly failing perspective of the avid investor, it is possible in itself (the investors risk response) that the masses and enhanced globalization might have given rise to a new disorder, the mediocrity of the gray swan.
IT WAS ON THE HORIZON
A yield curve inversion often has one of the greatest impacts on fixed income investors as profit margins fall for companies that borrow cash at the short-term rates and lend at the long term rates. Normally long term investments have higher yields because investors are risking their money for longer periods of time. An inverted curve eliminates the risk premium and changes the dynamics of the investor reward system. It is a serious indication of a recession, has always been in the past and has proven to be this time round.
Aubie Baltin puts it this way
Fed Chairman Bernanke like Greenspan before him once again raised the conundrum of the divergence between short term and long term rates. At the end of Jan 07, the yield on the 10-year Treasury-Note stood at 4.4% still below the 4.6% rate in June of 2004
More on Aubi Baltin here and
You heard it here first
HAVE WE LEARNED ANYTHING IN INDUSTRY?
If current market practices, government announcements and general responses to the economy are anything to go by, more or less nothing.
Let`s take a look at the auto industry, save them or let them fry?
Argument for saving them is that millions of employees will be made redundant increasing the unemployment rate and deepening the recession as consumer spending will diminish. This is a one sided argument and to be honest throwing 15 billion, 20 billion or 30 billion at a liquidity problem will be simply that, a liquidity solution not a growth and structure solution. These companies clearly have massive liabilities with relatively little restructure potential as it stands, they aren`t particularly geared on this finance line and are demanding capital expenditure type funding for liquidity issues.
Humbled U.S. automakers pleaded with Congress Thursday for an expanded $34 billion rescue package making a trip from Detroit in new-model hybrid autos made by their respective companies, two weeks after a botched appeal for $25 billion in which they were chided for flying on private jets to beg for money.
- By KEN THOMAS, The Associated Press
Absolutely pathetic, just like class of sweaty pubescent children grabbing daddies legs for pocket money as he worries about what has happened to his banking sector.
If you save them you support the gray swan; keeping what market forces would eliminate, what needs to be liquidated and consolidated so that something fresh and new can take its place.
HAVE WE LEARNED ANYTHING IN THE MARKETS?
While the total amount of U.S. government debt outstanding rose to $10.7 trillion in November, the amount of interest paid in the last two months fell by $10 billion, according to the Treasury Department. Investors can`t get enough Treasuries. Demand continues to increase as investors flee risky assets around the world and put their cash into U.S. bonds paying, in some cases, nothing in yield just to ensure the return of their principal.
- By Matthew Benjamin, Bloomberg
The world has gone mad and while the auto industry doesn`t have to return a profit and still have a chance of survival most investors can`t afford to tie up free cash on non yield bearing investments. If time is money and for many who do bill their time it is, you are asking the investor to work for free. Oh gosh, can`t wait to have my hands on those T-Bills! Let me gaze out the window and contemplate the universe for a while, it is kind of more rewarding and I might be lucky enough to miss out on the deal. Yet these gray swans are lining up in droves just to ensure return of their principal no reward and that is totally lame. Question they should all be asking themselves is, what is the risk?, nothing; then what is the opportunity cost?
HAVE WE LEARNED ANYTHING IN REGULATION?
The current regulatory system consists of the following; a Board of Governor, Federal Open Market Committee, twelve federal reserve banks with nine member boards reporting to the US treasury, an Office of Comptroller of currency, Office of Shift Supervision, Securities Exchange Commission, Federal Deposit Insurance Corporation, Commodities Futures Trading Commission, National Credit Union Administration and a Financial Accounting Standards Board. The most normal response of course is to create new regulation and there have been plenty of rumours to this effect however in an environment which is already heavily regulated would an additional rule set resolve this problem in the future or are the current bunch of regulators redundant?
Perhaps the credit crisis is a cycle response to those that took too large a position. Nothing wrong in that, some overindulge. Do you save them and do you install sterile rules to prevent others in the future of choosing whether to go deep or not?
In reality it is another gray swan, top heavy, politically enabled wanting to please everyone and ensure the investor has a maximum return and NO risk, a place that fits well in ideology but not in reality.
The global financial crisis is perhaps a cyclical event (one to be expected) where those unprepared or overextended are rewarded as they should be; negatively. Saving them delays the inevitable and extends the pain. Saving them rewards them for their foolish oversights and adding stringent regulation or safety nets expunges additional funds which at zero percent and 10.7 trillion in the hole, are running on empty with a limited internal rate of return.
Posted by CausalEvents at 05:34 PM
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July 28, 2008
Senate to question market liberty
To question market liberty is perhaps equivocation of itself. To be precise, if one was to look up the dictionary definition of `market` they would find something on the lines of `an open place where buyers and sellers convene for the sale of goods` and while these places have rules, markets work best when price discovery is a true representation of demand or supply. As soon as that is not the case such peddlers generally go elsewhere to satisfy their disports.
Last Friday such a notion was put to the senate bill S.3268 by Leader Harry Reid on ``Stop The Excessive Energy Act`` but has not generally been received well by many traders or institutions including The Coalition to Protect Competitive Markets. Made up of eight associations including the biggies CME, ICE, ISDA, NYMEX, FIA were not supportive of the bill stating that ``Restricting the ability of U.S. investors to participate in these global markets will make it harder for American citizens, including millions of baby boomers saving for retirement, to diversify their holdings and offset losses in equity and bond markets``.
They have a point and nicely put as such baby boomers would also implicate those who might pass the notion as being affected adversely by it. Where will such people put their wealth, on the volatile equities markets, perhaps US property or the deflated fiat US dollar itself, there is really nowhere to hide on US soil. Actually that is what would happen, commodity trading would be driven offshore reducing the liquidity in the US markets and making it more expensive for hedgers to seek cover from adverse price movements.
Such a bill has more serious implications. Firstly, when is a hedge not speculation and how difficult would it be to enforce such a stance. Businesses that use raw materials such as coal, oil and gas purchase forward contracts for delivery of a commodity or mostly settlement of cash differential in the future and that allows them to crystallize their price. If say a firm purchased such contracts long using privately borrowed funds and actually showed a profit from this action would that be a better investment than a firm that priced everything on the spot. If that firm was good at doing this, it might find more investors willing to assist; it might even share a spread with them. How can you regulate that?
A forward contract is a bucolic way of raw material planning, it becomes a lot more complex than this and businesses are using options (puts and calls), caps, collars, straddles, swaps and forwards all mixed together to reduce price volatility. Each one these or the structure of many could be speculation or a hedge depending on why the firm bought them in the first place.
Let`s ask a different question; don`t all option contracts have a component of speculation within them?
Well, the instrument has `asymmetry risk` which means the most the holder can lose is their premium yet, the most they can gain is limited by how far the market moves. Is this just like a ticket in a horse race, an important horse race.
Away from financial instruments for moment, the senate is not the only group people asking this question. Only a month before in June 2008, an Interagency Task Force on Commodity Markets chaired by the Commodities Futures Trading Commission carried out an assessment into the market factors affecting the crude oil market. The interim report found that fundamental supply, demand and the roles of various market participants to be the best explanation for the recent crude oil price increases.
So finally where did the Senate end up?
Well on Friday 25th July the motion to stop speculation was not passed with only 50 yes votes being accepted and 60 being the required bar for the bill to move forwards however, this may not be the last we hear of this. The House Agriculture Committee cleared its own bill that would impose position limits on the number of futures contracts that can be owned by speculators past a price-setting role and is again going to be difficult to implement. They are going to make it mandatory for the reporting of Over-The-Counter trading and look-alike energy products which is an incredibly nebulous task. They are also only going to grant hedge exemptions for commercial purposes and that will relegate such hedging strategies as less successful if open interest in the market diminishes.
Perhaps in the end the only way to address this problem would be to solve the demand and supply differential then speculators will be less attracted to what is easily available for what they are holding onto at present will become more valuable if it is difficult to trade.
Posted by CausalEvents at 06:03 AM
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July 20, 2008
The Barometer of the US Equity Market
There is a theory in many US equity market centres known as the January Barometer which goes something like the following:
During the month of January the stock market`s direction for the year as a whole can be set by comparing the market at the end of the first month against where it began as trading opened for the year.
Barometer Definition
So firstly how did we look on the January Barometer this year?
Well, the Barometer for 2008 and the market differentials for the Dow Jones, S&P500 and Nasdaq were the following:
Dow Jones from Jan 02 to Jan 31 down 3.10%
S&P500 from Jan 02 to Jan 31 down 4.74%
Nasdaq from Jan 02 to Jan 31 down 8.17%
You can take a look yourself by following this thread QID
So what does that say about this year? (In the theme of the Equity Market Barometer, markets are obviously more complex than this)
Well if the last week`s performance is anything to go by I would say the January Barometer might just hold true just like another barometer often does. `Congress should consider legislation even before a new president takes office. The urgency is too great and markets will not wait` says Henry Kaufman often better known as Dr Doom. The president of the New York Based investment and consulting firm Henry Kaufman has been correct with predictions in the past but his comments around the US financial institutions lacking direction might just have accelerated the decline of the markets over the last week. Shares of Fannie Mae fell on its knees by 23% on Friday and Freddie Mac went out backwards as much as 51%.
In the fear that these two institutions would follow the same path as other prominent US financial corporations have done this year, the SEC issued an emergency rule limiting certain types of short selling. The regulator focused predominantly on naked shorting and not just across stocks in Fannie Mae or Freddie Mac but across all major financial firms. Nineteen institutions were targeted including Freddie Mac, Fannie Mae of course but also Goldman Sachs, Lehman Brothers, Morgan Stanley, JP Morgan Chase, Citigroup, Merrill Lynch, Barclays, Bank of America and Royal Bank ADS were also part of the list.
For those that are not familiar with short selling, it`s quite a simple although alternative trading strategy. In short no pun intended, an investor would arrange to borrow shares they consider overvalued and sell them in the hopes of making profit by buying them back cheaper.
In this case short selling might have accelerated the decline of weak organizations however; it is still claimed by many traders as being an important feature of the market especially as it self-regulates price spikes and concentrations within the market.
It all becomes a bit clearer with an example: Assume the shares of bank F&F were trading at $10 per share, a short seller would borrow 100 shares from an investor and then immediately sell those shares of F&F for a total of $1000. If the price of F&F shares later falls to say $9 per share, the short seller would then buy the 100 shares back for $900, return the shares to their original owner, pay him a fee for having borrowed his shares and make a profit of $100.
In the emergency rule that the SEC proposes, they are not directly prohibiting short selling just enforcing a strong stance against naked selling. In this case the SEC would require a short seller to borrow the securities before executing the sale and it is also going require the investor to deliver the securities on the settlement date.
This is not a first for the SEC and in the past it has considered emergency rules such as prohibiting naked short selling before. In mid 2007 the SEC attempted to implement a `tick test rule` which only approbates a short sale when the last stock price is higher than the previous quoted price but that mandate was revoked.
The SEC`s purpose here with all of these rules is obviously to avoid any additional collapses of US financial institutions and to improve confidence in the markets. Generally the industry as a whole has been struggling with tight liquidity and is still recovering from the now well known sub-prime lending crisis. If the SEC can control the steepness and acceleration of declining stock, some banks might have a softer landing and more time to react to downward pressure on their stock price.
In reality the number of banks that have actually collapsed since 2000 can be found at this address Failed-Bank-List. Those institutions such as Bear and Stearns which were acquired at an incredible discount or banks that have been pulled back from the edge of liquidation through aggressive recapitalisation techniques will not feature in this failed bank list. None the less, losses to investors holding onto such stocks might still have been huge.
Posted by CausalEvents at 05:13 PM
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June 15, 2008
Its not an oil crisis, its a dollar crisis
If you want to boil a frog as the saying goes you put it into cold water and raise the temperature slowly for if you throw a cold frog into hot water it will leap out. The US dollar is such an animal and over the last few years there has been some speculation on the deprecating value of the dollar but such talk until lately seems to have been background noise. Like our boiled frog until the temperature raises too high no one notices but in the last five years the US dollar has depreciated against the Euro by 35%.
We are going to look at what has caused the US dollar to collapse, how this affects international trade and what a business can do to protect itself in another article. Before any of this and to understand how the world found itself in this mess we have to look back in history, just a touch.
`A nation taxes its own citizens, while an empire taxes other nation-states` writes Krassimir Petrov and is probably the best summation I have read on what brought us to this place today and very much inspires this article considering the state of the US dollar at present. In the Early 20th Century the US dollar was tied to gold and so the value of the dollar would be entirely pegged to that of the commodity however, after the great depression there was a spout of inflation and with an increase amount of currency in circulation the Roosevelt government was forced to decouple the dollar from gold, well nearly decouple. Some years had to pass until 1945 when the Bretton Woods agreement was engaged and other governments could impress on US reserves that the dollar be convertible to gold on demand. During the years of the Second World War the US had supported many of its allies and been insisting on gold as payment so its reserves of the commodity were bountiful, well abundant enough that conversion of commodity to currency should not have presented a problem.
What is important about all of this is that up until recently the US currency has been looked at by the rest of the world as the reserve currency of the world. It`s a perception but such a strong vista in that a convertible paper (paper for goods) has base value and the US dollar became the status quo underline on a quote in trade. If the dollar supply was kept vaguely close to the market price of gold in store this perception would have been real but during the Vietnam War the supply of the dollar volume was increased to finance the extension of US forces overseas and the currency was handed over to foreign businesses in huge volumes in exchange for imported goods. The catch here is, without the ability to buy the US currency back at the same value once it was sent off shore. In 1970 when foreign governments demanded payment of dollars in gold the link between the US dollar and gold was ``severed`` and the US would be in debt to the world, well theoretically.
So why didn`t the global community unwind at that point?
Well the argument is that in 1971 the US government made an agreement with Saudi Arabia for accepting US dollars for oil and that is a resource that the rest of the world was addicted on. When the remainder of OPEC followed by settling oil contracts in US dollars there was a reason to hold the currency and the switch from gold to oil was achieved. The currency in effect had moved from one base commodity to another and in today`s market this is a significant link and as the dollar weakens the price of oil is going to have upward pressure. There are many of those in the markets that are saying we don`t have an oil crisis, we have a dollar crisis. The market place is much more complex than this as you can obviously imagine and that the rising prices of oil are due to many factors some of which are indirectly orbiting around currency differentials and some of which are positive feedback loops.
For example, one would expect that as the price of oil raises (in USD terms) the demand for such a commodity would fall off however oil is generally ``a necessity`` rather than ``a want to have`` for the commercial world so price increases are often passed on in the value chain and become inflationary catalysts for the consumer. These inflationary measures often end up contributing to the cost of imported goods where US dollars are sold for another currency and add to the bottomless hole of the US trade deficit.
We`ll look at oil and trade deficits in detail later the big question here apart from the positive feedback loops, is; why is the dollar falling?
It is argued by some that what broke the dollar away from gold to oil the first time is perhaps the same cause that has driven its deflation this time, war. Instead of Vietnam in this case it is Iraq.
The irony in it all is that Saddam Hussein demanded Euro as a settlement currency for his oil and that a war with Iraq stood to free Iraq from his grip, possibly a good thing in hindsight; but, it also stood to protect the sovereignty of the US dollar even though engaging such an act might actually put the very currency at risk.
To be concise then if this is the case, the underlying problem with the dollar lies with the large federal budget deficit and the huge growing trade deficit.
Later on we are going to look at the implications of a weak US dollar on the global economy and why the dollar is struggling to recover.
Posted by CausalEvents at 02:37 AM
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July 17, 2007
Is this the demise of Dow?
Like all things in the universe nothing is forever and an era that stretches out a hundred and eighteen years is about to come to closure. Dow has been so tied to that of markets, market risk and trading that I felt it worthy to pay homage to something that has been the very genius loci ('The Spirit') of the American markets for over a century.
To be precise Rupert Murdoch's News Corp is making a bid of USD $5Bn for the ownership of the Bancroft's Dow Jones business. While this occurred a couple of months ago, News Corp has been battling accusations that the paper won't remain independent. Tomorrow the Bacroft's family will hold a meeting to discuss the latest offer by Murdoch and the very future of Dow Jones is tied to that outcome. The directors of Dow Jones are of course searching for a bidder to rival the News Corp pitch and for many reasons however no-one has come forward with an offer that puts a lid on News Corp's $60 a share.
So you are probably wondering what has any of this got to do with risk ... Well a hundred or so years ago the very reason Dow Jones existed was because of risk, perhaps today that still is still the case.
In November 1882 Charles Dow and Eddie Jones, two aspiring journalists with an analytical bent clambered into bed with a banker of that time known as Charles Bergstrasser. It certainly does sound like a precarious bunch for a brokerage publishing business but within two years they had their own hand cranked printing press and the company had so many clients they updated their brokerage news feed into an electronic news ticker which was originally referred to as 'broad tape'.
Peter Bernstein's book Capital Ideas puts it this way:
'At heart Dow was a scholar rather than a speculator. He was more interested in interpreting the history of the stock market than in devising a system for predicting its future. The world has read his interpretation otherwise.'
This journalist Mr Dow was a market publisher that contributed to the world of risk by creating the Dow Jones Averages. In its essence it consisted of closing prices grouped by company type to provide an overall measure of the performance from trading activity throughout each day on the New York Stock Exchange.
As Dow was known to put it 'The industrial market is destined to be the great speculative market of the United States' and the embodiment of a mean for daily risk taking that Dow published day in day out became the auspicious paper for traders both in and out of the United States. The approach was eventually coined Dow Theory and it attempted to explain trends in stock prices by aggregating indicator variables within the market.
Now many market risk people of today run around with Gaussian copulas and complex netting systems to explain volatility in overall trades and they are likely to see this as really quite a primitive explanation of what goes on in the market place. Yet, it was a very first publication attempt to introduce central limit theorem to investors when back then speculation printed on carbon paper was all the rage.
Some months before Dow died his analytical publication business was sold to Clarence Barron for the sum of $130,000. Barron was so proud of the business he was quoted saying 'Savings in the United States may become investments, when guided by financial knowledge' and apparently passed away holding the posts of the Dow Jones and Wall Street Journal. The business was handed down to Barrons daughter and has remained in the Bancroft family till today, well perhaps Thursday this week. A successful bid by News Corp will bring Dow Jones publications and the Wall Street Journal into the same realm as News Corp's New York Post and The Times in the UK.
One does ponder what Dow would think of such a deal if he were here today?
Posted by CausalEvents at 10:28 PM
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