Thursday, January 31, 2008

High Yield Spreads: Up, Up, and Away

As we have been doing periodically for several months now, below we have updated the latest spreads between high yield corporate bonds and comparable treasuries. As of 1/23, spreads hit a high for this period of 748 basis points (although they have recently contracted by 63 bps down to 685 bps). This translates into a 210% gain from the lows reached in June of 2007 and marks the largest spike in the series' history. Additionally, the only time spreads were this high over the last ten years was during the bear market from 2000 - 2003.


Treasuries: Steeper

Julian Robertson's big macro bet right now, according to Brian O'Keefe, is a curve steepener.

Here's the idea: In the fall, Robertson invested in a derivative called a "curve steepener" that allows him to be long the price of two-year Treasury and short the price of the ten-year Treasury - betting that the difference, or curve, in the yield between the two will increase.
The investment reflects a negative outlook on the prospects for the U.S. economy that has been building in Robertson for years. He believes that the Federal Reserve will continue to flood the economy with money, weakening the currency and ultimately causing the Japanese and Chinese central banks to stop purchasing Treasuries, which will drive the price of 10-year bonds down. It's a macroeconomic hedging strategy that has already paid off handsomely.
So far in 2008, the difference in the between the two bonds has already increased from 97 to 138 basis points. "I've made a big bet on it," he says. "I really think I'm going to make 20 or 30 times on my money."

Dean Baker notes that in the wake of the Fed's 50bp cut today, the yield on the 10-year Treasury bond rose by 5bp to 3.72%, 34bp higher than its lows earlier this month. Right now, with the 10-year at 3.71% and the 2-year at 2.21%, the spread between the two has hit 150bp, which means that Julian Robertson can probably afford another golf course or two.

I can see why Robertson loves this trade so much. The Fed seems set to cut even further, which will only serve to keep the yield on the two-year note depressed. But inflation isn't going away, and one should be able to expect a positive real return on the ten-year note - which, it's worth noting, was yielding more than 5% as recently as July.

If you are thinking about refinancing your mortgage, then, perhaps now's the time to do it. Long-term rates could be headed back up, even if short-term rates continue to fall.

Wednesday, January 30, 2008

High Yield Bonds Getting Attractive?

Easy? You call that easy?

Markets like this one are the enemy of solid fundamental analysis. It can cause otherwise good traders to start just guessing, resulting in either panic selling or simplistic buying (you know the old, “if you like it at $30, you love it at $15!” trade.)

One area where the value proposition is relatively simple is high-yield bonds. Bonds offer a very straight forward fundamental risk-reward situation: the reward is the yield, the risk is defaults. As of 1/25, Lehman’s High Yield Index yields 10.08%, or 672bps over Treasuries. That’s your reward in hard numbers. So what about defaults?

The following chart shows annual credit losses (that’s defaults less recovery) for high-yield bonds since 1982. The data is from Moody’s 2007 Default Study, and includes all Moody’s rated high-yield bonds.

I've labeled the recessionary periods of 1990-1991 and 2001. So in 1990, if you had owned the entire universe of Moody’s rated high-yield bonds, you would have suffered credit losses of 6.3%. The greatest credit loss rate of the last 25 years was in 2001 at 8.3%. So if the 2001 experience were to repeat itself in 2008, investors would earn 10.08% in interest versus 8.3% in credit losses. Determining the exact total return would depend on the timing of the defaults, but the number would almost certainly be positive.

So could defaults be worse in 2008 vs. 2001? Remember that the 2001 recession was all about over-investment in technology and telecommunications. There were also some very large defaults that were due to unique circumstances, namely Enron, Worldcom, and various airlines. If there is a recession in 2008, it will be about over-investment in housing. Very few high-yield issuers are involved in the housing market. Virtually all banks, brokerage firms, mortgage insurers, etc. are investment grade.

Of course, its possible high-yield spreads move even wider. According to Lehman Brothers, the high-yield index spread got as wide as 1036bps in 2002 vs. only 672bps today. Perhaps spreads will widen further, but don’t get caught fighting yesterday’s war. In 2001-2002, the corporate bond market suffered from a series of accounting scandals, which resulted in investors questioning the veracity of financial statements in general. That fear hit the high-yield market directly. Today the fear is related to mortgage lending, a business dominated by investment-grade companies.

For that matter, the 1990-1991 period was also unique, in that it saw the demise of Drexel Burnham Lambert. Drexel and its star banker Michael Milken created the modern high-yield market, and for several years was the primary market maker. Drexel’s fall from grace put the future of high-yield in serious doubt.

If we do have a recession in 2008, high-yield default rates will certainly increase. But at today’s valuation levels, high-yield already has a recession priced in. Given that there is good reason to believe credit losses will be no worse, or perhaps even better than the last two recessions, high-yield looks fundamentally attractive.

Historical US GDP Numbers - Perspective

Today's initial GDP reading of 0.6% was the lowest since the first quarter of 2007. GDP was this low just 3 quarters ago, so it's not that out of the ordinary. And it's important to remember that the number will be revised two more times before it is final. It could go higher, but it could also go lower. Below we highlight the historical final annualized GDP numbers going back to 1947 (4Q '07 is the only one that is not a final number). We also highlight with red dots any time that GDP was less than 1%. While a drop below 1% often times means we'll end up getting 2 consecutive quarters of negative growth, it doesn't always mean it will happen. In fact, while the NBER declared a recession in 2001, we haven't had 2 consecutive quarters of actual negative GDP growth since 1991.


Saturday, January 26, 2008

Lifting the Lid: Auction-rate debt tying up corporate cash

Thu Jan 24, 2008 3:44pm EST

By Emily Chasan

NEW YORK, Jan 24 (Reuters) - Corporate finance managers are starting to find themselves cash-strapped by one of the very financing tools they use to manage cash flows.

Auction rate securities, debt instruments once touted as a highly liquid cash management strategy, have been hit by the credit crunch and are failing to attract bidders. For companies, the result is that cash once thought to be readily accessible may be locked up indefinitely.

Auditors and regulators are also growing concerned that companies may not be telling investors properly about their exposure to the vehicles.

In the past few months, companies including, ADC Telecommunications Inc (ADCT.O: Quote, Profile, Research), 3M Co (MMM.N: Quote, Profile, Research), and STMicroelectronics (STM.PA: Quote, Profile, Research) (STM.N: Quote, Profile, Research), have recorded, or said they expect to record, impairment charges ranging from $8 million to $46 million due to auction rate securities, and analysts that could become a more common scenario.

"What was intended to be a highly liquid asset now has to be treated as something more akin to plant property and equipment," said Adam Dean, president of SVB Asset Management, which manages corporate cash accounts. "It's not tradable , and companies are realizing they have a problem on their hands."

Auction-rate securities are municipal bonds, corporate bonds, and preferred stocks whose rates, or dividend yields, reset through periodic "Dutch auctions."

In the auctions, which typically happen every 7, 28, or 30 days, investors enter a blind competitive bid process to set the rate on the securities, allowing the current holders to liquidate for cash if they want to.

But as the collapse in subprime mortgages has hurt the credit markets, demand for auction-rate securities has been drying up.

"It's truly an auction and if there aren't buyers coming to the market the auction can fail," Dean said. "If the auction fails, you end up holding something that is highly illiquid and it is something you will certainly lose principal with if you sell it in between auctions."

Some 60 auctions have failed in recent months, representing about $6 billion in tied-up assets, according to Peter Crane, president and CEO of Crane Data LLC, which tracks the market for mutual fund managers.

"The ones that have failed continue to remain in limbo," Crane said. "They just keep on failing and I haven't heard of any auctions that have been resuscitated or where a dealer has stepped in and said we're going to revive this structure."


Companies typically classify auction rate securities as "highly liquid" and say as much in their regulatory filings, but investors should be wary that it may no longer be the case.

"I've heard CFOs say, 'These were marketed as securities that never fail'," Dean said. "There are auctions out there right now that have not failed, but there's nothing implicit in those to prevent them from failing."

Some companies have claimed they were misled about auction rate securities, or never intended their funds to be invested in them in the first place.

STMicroelectronics said a financial institution investing on its behalf placed its funds in auction rate securities without authorization. Also, wireless operator MetroPCS Communications Inc (PCS.N: Quote, Profile, Research) has sued Merrill Lynch (MER.N: Quote, Profile, Research) in Texas state court claiming it improperly lost money in auction rate securities.

Regardless of intent, some investors may not even be aware of companies exposure because many have misclassified the securities as cash equivalents on their balance sheets, when they should be marked as a short-term investment, or a long-term investment if it is impaired.

Officials at the U.S. Securities and Exchange Commission have begun notifying companies about improper classification of auction rate securities, according to Stephanie Hunsaker, associate chief accountant in the SEC's Division of Corporation Finance.

"Auction rate securities are not cash or cash equivalents -- they are investments," Hunsaker told accountants at a New York State Society of CPAs conference on Wednesday. She said impairments of the securities should make auditors give them a second look.

Deloitte & Touche [DLTE.UL], one of the Big Four accounting firms, issued an alert on its Web site this month telling its auditors that auction-rate securities "deserve particular attention," and must be scrutinized for impairments. (Editing by Tim Dobbyn)

ABCP Making its Triumphant Return

While certainly not a resurgence, the issuance of ABCP has been surging the past few weeks, especially in the real short term paper. With short term Treasury notes yielding 2%, the Fed conducting auctions and slashing rates, global markets selling of resulting in investors flocking to cash, some demand is probably starting to creep up as the “sell ABCP backed MMF, buy Treasury Fund” trade is over. The fact that the Fed is behind the curve allows banks to cut their Money Market Fund rates for their clients and still remain attractive over standard treasury based money markets. This enables them to start to get the Fed’s money working, when unable to really lend to consumers. This is a very interesting thing to watch, as it illustrates the impact of Fed cuts on the velocity of money as well as market’s collective view of risk and signal of the beginning of a potential reflation.

Friday, January 25, 2008

Insider alert after SocGen - and a squeeze on the middle office

Who benefited from the Soc Gen rogue trader?

That’s the next big questions for regulators - and they seem set on looking beyond the obvious candidate, Nick Leeson, who flogged his insights to the highest media bidder (the BBC.)

The Times reports that regulators in Paris and London have launched an investigation into whether anyone improperly profited from knowledge of SocGen’s predicament as the French bank early this week sought to unwind the huge positions built in equity derivatives by Jerome Kerviel. The AMF, the French counterpart to the FSA, will also look at trading in SocGen shares.

The potential for serious market abuse was high because SocGen took five and a half days after it learnt of rogue trader Jérôme Kerviel’s activities to go public on the disaster…

…There were unconfirmed suggestions today that Mr Kerviel may have confided in a friend who worked at a rival investment bank last Sunday.

Many other people inside and outside SocGen knew of the problem by Monday morning, including the Banque de France and the AMF.

The pool of professionals “in the know” is thought to have mushroomed during the early days of the week as SocGen drafted in JPMorgan and Morgan Stanley to orchestrate the €5.5 billion emergency capital-raising, which was also formally unveiled on Thursday.

Rumours swirled on Wednesday that SocGen was poised to announce vast write-downs of about €40bn - a figure in excess of the bank’s market cap. The €40bn figure then came back inexplicably quoted in French francs, equating to about €6bn. The rumour-mongers had struck upon the right bank, but had yet to unearth the true reason behind its losses.

By Friday, focus had turned to the explanation given for Jerome Kerviel’s success in concealing his huge positions - namely that his previous position in the middle office of SocGen had left him with detailed knowledge of risk controls and procedures which enabled him to mask his outsize bets.

There are noises already from some banks about a ban on moves from the back and mid offices to the front line of the business. The Times adds that the FSA is to stress the importance of segregating the activities of the various areas - with a note added to the file of those who move from one to the other alerting managers to the risk.

This sounds like classic knee-jerk stuff to us. Regulation tends to be counter-cyclical, and the authorities, as the latest news from Davos on efforts for transparency in OTC derivatives trading indicates, often like to focus on regulating the latest balls-up rather than looking for the next one.

The middle office operates to some extent at the behest of the trading desks - not least because those working in the former may wish not to cause undue trouble in the hope that the next spot on the floor goes their way. But a formalisation of the first class/second class citizens divide between the middle and front offices could create as many problems as it cures. The reason that bright, ambitious types take middle office jobs is to stand a chance of gaining promotion to the purportedly more glamorous front office. An outright ban on moves would, as it currently stands, only serve to limit the pool of talent headed for the middle and back office’s risk management and clearing and settlement functions to the mediocre.

Avoiding sub-standard staff in critical areas would require a beefing up of these positions perhaps in pay, but more importantly in terms of internal prestige. In that case, the need for a ban on frontward moves should evaporate. In any case, the idea that three years spent filling out forms in the middle office qualifies one to circumvent the supposedly multi-layered and nuanced risk controls in a large investment bank is either fanciful or highly worrying.

But tarring Jerome Kerviel with the middle office brush may suit on other fronts. The upper echelons, mused one Francophile recently returned from working in France, may find it easier to dismiss their rogue trader as exceptional - a lone, troubled agent - because he appeared to be an outsider. His meagre CV and education - a masters in finance from the University of Lyons - marked him out as not belonging to the French elite, let alone his passage up through the ranks of the middle office.

Another reason to put the squeeze on upward mobility in the French workplace then? Or will President Sarkozy - himself deemed an outsider and who might yet seize the opportunity to crash together a national champion as a result of France’s banking embarrassment - see matters differently?

Wednesday, January 23, 2008

Draaisma speaks: “That’s enough for now”

We don’t want to kick off some kind of cult of the outsized ego - but it is our duty to alert readers to the fact that Teun Draaisma, head of Morgan Stanley’s European equity strategy team, has a new stance.

If you’re not familiar with Draaisma, you can read about him in Wednesday’s People column in the FT. The long and short of it is that Morgan Stanley’s man told his clients to keep buying, then sell, buy again and sell at the appropriate times last year.

The latest call is that, despite highly uncertain fundamentals, the 20 per cent drop in MSCI Europe from the peak last June is enough for now. With sentiment bearish and valuations attractive, they’re moving into equities, on a tactical three to six months basis.

The move, says Draaisma, is based on three factors:

1) Sentiment is at extremes. As we wrote on January 21, a range of sentiment measures is at or close to all-time bearishness, including AAII survey, and put/call ratios.
2) Valuations at recession levels. Our Fundamentals, Capitulation and CVI indicators all say buy now. Our CVI closed on 21st January at -1.2 and fell as low as -1.85 in early trading on the 22nd, close to the -2 crisis ‘must buy’ level. Our combined market timing indicator said -0.77, from which equities have traditionally rallied by an average of 9.5% over the next 6 months and with a hit ratio of 87%. The trailing PE of 11.2 for MSCI Europe implies a fall of 23 percent in earnings to take us back to the long-run average PE of 14.5. The percentage of companies with a dividend yield above
the real bond yield is 74 percent.
3) More reflation. Fundamentals are highly uncertain, but after the recent market turmoil we except more reflation efforts from authorities, including further rate cuts and fiscal stimulus that should help to stabilise markets. There have been 15 Fed rate cuts of 75bps or more since 1970, the average 6-month performance of MSCI Europe post such a cut is 10.3% and with a 79% probability of positive performance. As one client put it to us: when authorities start to panic, markets stop panicking.

These kind of bear rallies, say MS, can last for two to six months and are likely to be in the 10 to 20 per cent range. Fundamentals continue to be weak - they expect a fall in European earnings of 1 per cent this year, but with risks very much to the downside.

If this is a mild recession then this could well be the low point for markets in this recession. If it is a more severe, global slowdown - which we think is more likely - then we may well go to lower lows after the bear market rally. But the market is oversold enough for us to be wanting to buy a bit today.

Tuesday, January 22, 2008

Every Major U.S. Bank Was Profitable Last Year

Commentary by John M. Berry

Jan. 22 (Bloomberg) -- With all the large writedowns and losses announced for the fourth quarter, hardly any attention is being paid to just how profitable U.S. banks really are.

That inattention has raised unnecessary concerns that the banks may be so crippled by losses that they will cut lending to the point it might undermine the U.S. economy.

Some commentators have said the banks are in the worst shape since the Great Depression. That isn't close to being correct.

Other analysts have raised the specter of the stagnant Japanese economy of the 1990s, when banks there were crippled by huge losses when a real estate price bubble burst at the beginning of that decade. This comparison also is off base.

Even Citigroup Inc., by far the hardest hit of the big U.S. banks by subprime-related problems, earned $3.62 billion last year. That was with a $9.83 billion fourth-quarter net loss and more than $22 billion in writedowns and additions to loan-loss reserves.

For JPMorgan Chase & Co., the third-biggest U.S. bank, the focus was on the 34 percent drop in fourth-quarter profits from a year earlier. Its full-year $15.4 billion profit, a record, was largely ignored. So were the bank's record annual revenue of $71.4 billion and its record earnings per share of $4.38.

Bank of America Corp., the nation's second largest, plans to report earnings today. Analysts surveyed by Bloomberg estimate that the bank was profitable in the fourth quarter, as well as the full year.

Seidman Compares

William Seidman, a commentator at CNBC who headed the Federal Deposit Insurance Corp. from 1985 to 1991, said the situation now is nothing like that period, when hundreds of banks and thrift institutions went broke.

``The banks are not in anywhere near the trouble they were in when I was at the FDIC,'' Seidman said in a Jan. 17 interview. The handful of banks the FDIC regards as troubled today don't include any big ones, he said.

One should be cautious, though, and make sure institutions aren't cutting into their capital by paying dividends beyond what they're earning, he added.

Economist Robert E. Litan, a senior fellow at the Brookings Institution who has done numerous studies of the U.S. financial system, said the banks are in far better shape than the dire assessments suggest.

``Strip out the losses and Citi could make close to $10 billion a quarter,'' Litan said.

`Japanese Situation'

Noting how quickly the bank has been able to raise money to replace the capital depleted by losses, he added, ``Why would anybody buy stock if they thought Citi was going down the tubes?''

``And this is nothing like the Japanese situation,'' Litan said. ``In that case, the banks sat on their losses and were unable to make loans. That's just not where we are now.''

During the 1990s, former Federal Reserve Chairman Alan Greenspan and other Fed officials advised Japanese regulators to push the banks to write off their bad loans, recapitalize themselves and get back to business. That didn't happen for years, and after it did -- and Japanese corporations also cleaned up their balance sheets -- economic growth resumed.

So instead of just moaning about how much some institutions have lost, everyone also should be applauding that the potential losses are being recognized and new capital is being raised.

Merrill's Losses

The story is largely the same at Merrill Lynch & Co., the world's largest brokerage, though the losses are greater relative to its size. It reported a fourth-quarter net loss of $9.83 billion after writedowns of $15 billion on assets related to subprime mortgages and hedges. It also had a full year loss of $7.8 billion.

Merrill also has raised substantial capital from outside investors and additional cash from selling assets.

Some analysts tracking the growing losses on subprime mortgages and assets tied to them, such as collateralized debt obligations, have added all the writedowns to their tallies.

What they should also do is to acknowledge that for the most part the losses, other than those on the mortgages themselves, represent gains to investors who bet the other way. Among them are Goldman Sachs Group Inc. and hedge-fund manager John Paulson.

Goldman Sachs avoided big losses on subprime-related investments by hedging its positions. Its net income for 2007 was a record $11.6 billion.

Mortgage Rates

And a Nov. 29 Bloomberg News story about Paulson said his Credit Opportunities funds rose an average of 340 percent in the first nine months of 2007 on bets against subprime. That earned Paulson an estimated $1.14 billion in performance fees for that period, and fees on Paulson's other eight funds brought his total to $2.69 billion.

Credit isn't as readily available as it was for several reasons, including a less favorable economic outlook, tighter lending standards, particularly for mortgages, and a lack of a secondary market for some types of loans such as jumbo mortgages.

On the other hand, the interest rates many borrowers are paying have dropped. The bank prime rate, to which many loans are linked, is 7.25 percent, the lowest since January 2006.

As of Jan. 17, the average interest rate on 30-year fixed- rate mortgages dropped to 5.69 percent, the lowest level since June 2005.

In the two weeks ended Jan. 18, corporate borrowers sold $50 billion worth of investment-grade bonds at the lowest interest rates since April 2007.

The credit well hasn't run dry and it's not about to. And the nation's banks will be supplying a large share of it.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: John M. Berry in Washington at

Last Updated: January 22, 2008 02:39 EST

Monday, January 21, 2008

Global Market Sell Off

YahoofinanceEven while US markets are closed in observance of Martin Luther King Day, global equity markets are experiencing their worst sell-off since 9/11. While most sell-offs of this magnitude typically can be traced to a single catalyst, today's declines do not seem to be based on any specific news event that was not already known in the markets last week. Instead, the declines appear to be rooted in a loss of confidence on the part of global investors over the current handling of the credit crisis.

Drudge121_3With today's declines, the benchmark equity indices of several countries are now in 'official' bear markets. Based on the current levels of S&P 500 futures (which are likely to change between now and Tuesday morning), the S&P 500 is likely to open tomorrow 19% below its intraday high reached October 11th. Fed Chairman Ben Bernanke has repeatedly told the public that the Fed was ready to take "substantive additional action as needed to support growth and to provide adequate insurance against downside risks". Fortunately for us, Bernanke has done extensive scholarly research on preventing stock market crashes and depressions. Unfortunately for us, he has yet to put that research to use. Last week's declines of 5% are likely to be matched in one day's worth of trading tomorrow, so the question remains -- what are they waiting for? Do the headlines above and the numbers below call for a need to act? If not now, when Mr. Bernanke?


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Tuesday, January 15, 2008

LIBOR, TED Spread, and Fed Funds

Even though it was a foreign term to most investors six months ago, the TED spread (3-month Libor minus 3-month Treasury) has quickly become one of the main indicators investors look to as a gauge of stress in the credit markets. While the indicator rose to historically high levels as 2007 came to a close, since the start of '08, the TED spread has been in a rapid descent, indicating that stress in the credit markets is showing signs of improvement. Today the TED spread fell to its lowest level since August 13th.


Three-month LIBOR, which is one component of the TED spread (along with 3-month Treasuries), was also highly elevated as 2007 came to a close, but since then it has also come down sharply. In fact, as of today, 3-month LIBOR closed below the Fed Funds Rate for the first time since June 2003.

Does the rapid decline in the TED Spread and 3-month LIBOR have any impact on the stock market going forward? Since 1985, this marks the 12th occurrence where LIBOR traded below the Fed Funds rate after trading above that level for at least 100 days. Below we highlight the performance of the S&P 500 one and three months following each occurrence. While the S&P 500 outperforms its average performance over the one-month period, over a three-month period, its performance is inline with average, indicating that any major positive impact on stocks is short lived.


Veryan Allen: Investing, trading or gambling?


What is the difference between investing, trading and gambling? The first two come down to a divide in the holding period continuum; microseconds to months is trading but years is investing. Superficially investing and gambling are quite similar; putting money at risk in the hope of making more money. But most investors would balk at the idea of being called a gambler.

Surely the difference is that investing is deploying capital when you have an edge while gambling is betting when you do not have an edge. To make consistent absolute returns it is necessary either to have an advantage or identify someone else with one. An edge does not eliminate the possibility of small, manageable losses but it does mean persistent and predictable performance.

By definition there is no edge in beta and it is not very reliable over less than multi-decade time frames. Short only equity seems to be working quite well so far in 2008 and stock indices in many major developed markets have erased most gains from last year. The S&P 500 is now around 1400 just as it was 12 months ago and in January 2000. Investors don't seem to have received much equity risk premium or been compensated for the volatility despite what the economics textbooks say but then stocks can't read. It could be worse; in Jan 1988 the Japanese Nikkei was at 24,000 and now, 20 years on, it is at 14,000. Prudence mandates acknowledging the possibility of an extended bear market and constructing a portfolio that can grow without the benefit of beta. It just snowed in Baghdad; unlikely things can and do happen. Buy a snowplow even if you have never seen snow.

There are reasons to be bullish of course. There always are. The "private equity put" and "Greenspan put" evaporated in 2007 to be replaced by the "Sovereign Wealth Fund put". Many economists are predicting a recession which, given their track record, means there is a good chance there won't be one. Many US financial institutions will report earnings soon and with new CEOs and new stock options the temptation to write down doubtful CDOs, SIVs and loans to very conservative levels and adopt a kitchen sink approach to disclosing bad news must be very high. Last quarter can be blamed on former management but not the next quarter. Ben Bernanke promising substantial rate cuts was clearly preparing the market for the bad news to come. Short sell the rumor, buy the fact?

Sometimes a stock, bond, commodity, currency or any other specific asset goes up and sometimes it goes down. Timing these moves is hard but a few can do it. The relationship between them opens up anomalies and inefficiencies that can also be exploited. Casinos and the CIA are now using something called NORA or Non-Obvious Relationship Awareness in their security work. Successful investing is very dependent on non-obvious relationship awareness between securities. It was the key to success in 2007 and will be more so in 2008. This is where many go wrong; looking at a single stock, pair of securities or one asset class when it is the ENTIRE interrelated puzzle that needs solving.

Assets cannot be looked at in isolation as they all have an effect on each other. Commodities move stocks, currencies impact bonds and vice versa. NORA showed how long biased credit strategies could hurt some of the more crowded "market neutral" equity trading strategies. Some central bankers think raising interest rates will curb inflation and lowering interest rates will help the economy. Not necessarily anymore as global capital flows and new, non-obvious relationships between assets and geographies may have changed the economic game. High rates in Iceland or New Zealand or low rates in Japan or Taiwan haven't had quite the effect that "theory" anticipated.

Strategies make money out of and between assets. But in implementing a strategy a fund must either have a wide protective moat of a talent-based barrier to entry or keep it secret. Many things in the public domain did NOT work last year but is that surprising? The Dogs of Dow, the January effect, the "Magic formula" of value investing are too well known to work anymore. Those arbs, among others, are gone. I hope for the sake of the long only crowd that the "First 5 days in January" effect is NOT predictive for 2008. However I would be pleasantly surprised if the Dow and Nikkei don't dip below 10,000 sometime this year.
I spent New Year in the bastion of statistical arbitrage, Las Vegas, the only city in the world named after a volatility metric. I am always long vega and long Vegas. The "usual" opinion on casinos is you can't beat the house just like conventional wisdom in finance is that you can't beat the market. In general that is indeed true. The sweat equity, concentration and aptitude required to perform such a difficult task on a consistent basis is rare. Difficult yes, impossible no. Like others I've taken the time to try to develop an edge in picking fund managers and picking securities.

As in financial markets there are advantages that can be developed in casino games to change the negative expectation of gambling to the positive expectation of investing. But it requires dedication and proprietary research. Losses may still occur since the edge applies over time. Many people are aware Blackjack can be beaten but disclosure of many of the techniques and changes in the rules have reduced that edge. The first time I visited Vegas I knew basic strategy and the probabilities almost as well as Ed Thorp and could memorize cards almost as well as Dustin Hoffman and I did reasonably well; nowadays I am content to break even.

Despite the increased sophistication and monitoring at casinos there are still professional backjack players making good money from innovating their strategy and developing their talent. Just like a hedge fund keeps refining and adapting its edge and finding new ones. Even roulette and dice games can be "beaten" where beaten means having a small probabilistic bias that overcomes the house's advantage; it just takes very high skill AND practice to do it. Poker is a game of luck over one deal but skill over many deals. When I look up at the sports book in a Nevada casino I see potential mispricings and arbitrages all over the board just like on a futures floor or page of stock price quotes; it just takes hard work and deep domain knowledge of the teams, players and horses to identify them.

Slot machines are interesting too. The house always has the edge but that does NOT mean they should ALL be avoided. The POSSIBILITY of enormous returns for a very low capital outlay provides a different value proposition so I did sometimes play slots with mega jackpots. "Experts" say that the odds of winning are so remote (1 in 100 million or so) as to make them a loser's game but that is because they don't understand the payoffs and probabilities correctly.

Just like a national or state lottery, the chance that the jackpot will be won is 1.00, ie a certainty. Someone WILL win it. If you don't play you have ZERO chance of winning. If you DO play you have an unlikely but NON-ZERO chance. Since any number divided by zero is infinity, that means the simple act of risking a few bucks increases the chance of winning by an infinite multiple! Therefore the optimal trading algorithm on a lottery or a Megabucks slot machine IS to play but only with small cash. Similar to buying far out of money options; even if most expire worthless, you only need a single high pay out.

On New Year's Eve I happened to put $20 into a Wheel of Fortune slot machine and won $1,000. Deducting fees of 5% and 50% that is a return of 2,400%! So now you know what the "highest" performing "hedge fund" was last year - the Nevada Slots Opportunities Fund. A stupid claim of course but sadly such dumb, unrepeatable luck has been used to market many a fund. That return was "pure alpha" of course as I had the "skill" to pick the right machine in the right casino at the right time. I have seen even sillier arguments in powerpoint presentations and at investment conferences.

Suppose I had then lent the $1,000 to someone who "promised" to pay back $2,000 if they won speculating on real estate. What if I assigned an overly optimistic default probability to this "trade" and launched the Enhanced Nevada Credit Fund on the back of this "amazing" mark-to-model yield. Sounds even dumber but that is what Merrill Lynch, Citigroup, Bear Stearns, Northern Rock, Sowood and Dillon Read among several others were effectively doing last year. Dress it up with the high finance of Klio and Norma subprime CDOs but basically it was all alchemy of loan finance and fictitious capital that was unlikely to be paid back. High yield only makes sense if it is higher than the risk.

Whenever I hear the argument for long term passive investing I wonder what temporal era is meant - geological or cosmological time? Over periods of relevance to living humans I'd rather invest in alpha than gamble on beta. Suppose in 2020 or 2030 major equity indices are LOWER than today? Lost year, lost decade? Gold may be above $900 today but remains far below its inflation-adjusted high set over 600 years ago. I'll take different strategies applied to assets over asset classes themselves every time.

Most investors cannot wait long enough for the beta bet to pay off and why should they when they can allocate to fund managers with the skill to generate reliable absolute returns from their edge? Investing and trading both have important roles to play in a portfolio but it is no place to gamble. The only trades to make and the only managers to pick are those with positive expectation and the odds in their favor.

Minsky recast: why 2007 was different

Our favourite economist is back under discussion. As chaos hit in August 2007, economists, analysts and the media looked to the ideas of Hyman Minsky to help make sense of the seizures in credit markets. Minsky argued that a capitalist economy becomes ever more fragile over a period of prosperity, as stability encourages leverage, new ambitious debt structures (known as Ponzi financing) and eventually breeds financial and economic instability.

It all made so much sense. There was even something of a written tussle over who was first to apply Minsky’s concepts to the credit crunch of 2007.

But now it seems that we may not have had our Minsky moment after all: RGE Monitor points to a paper by Jan Kregel, a senior scholar at the Levy Institute where Minsky himself worked. It serves as an admirably clear recap of the past six months.

Kregel argues that despite the focus on Ponzi finance in recent commentary, Minsky’s most important contribution to the analysis of repeated financial crises was the idea of endogenous, or inevitable instability - or the concept of a lifecycle whereby stability gives way to fragility, through a declining “cushion” of safety in financial transactions and increased leverage. The current crisis though differs from a traditional Minsky crisis, says Kregel.

While the subprime mortgage debacle involved both Ponzi financing and declining margins of safety, the conditions were not produced by the kind of endogenous process described by Minsky, where as the universe of borrowing experiences become more positive a more confident and optimistic outlook become the rational reaction. No need for euphoria here.

The evolution of banking after the Glass-Steagall Act of 1933 created what is now known as the “originate and distribute” model. The ensuing deterioration in the cushions of safety did not arise from evaluation of credit risk in a period of stability; the bankers lost interest in credit risk all together.

The structures of the 2007 unwind are certainly Ponzi. But, says Kregel:

Since an investment-grade rating was crucial to the success of these instruments, financial institutions consulted with the rating agencies on the appropriate composition of the corpus collateral of the instrument, as well as on the structure of the liabilities. Thus, it was again the rating agencies that determined the appropriate margin of safety,which was determined by the agencies’ assessment of the statistical probability of the prepayment rate and the default rate of the underlying subprime mortgages.

We are left then with the economy caught “between the Scylla of falling consumer spending and the Charybdis of increasingly restrictive credit conditions”, with a bunch of assets that show every sign of being impossible to price efficiently, and an impotent Federal Reserve: “The discount window cannot provide funds to rebuild bank capital.”

From this perspective, the current crisis has little to do with the mortgage market (or subprime mortgages per se), but rather with the basic structure of a financial system that overestimates creditworthiness and underprices risk.

Friday, January 11, 2008

Stocks with Institutional Ownership performing worst

We recently broke the S&P 500 into deciles (50 stocks in each decile) based on a stock's institutional ownership. When then calculated the average year to date performance of each decile. As shown in the chart below, the decile of stocks with the highest institutional ownership is by far down the most. The two deciles of stocks with the least amount of institutional ownership are holding up the best year to date. Clearly, institutions are unwinding positions. This is probably due to a combination of increased bearishness, investor redemptions, and a decrease in the amount of leverage allowed.


Meanwhile, Back on Planet Wall Street

The 10-year T-bond yield (^TNX) is at a 46-month low. This brings us to Elfenbein's Rule of Financial Journalism #11587: You will never hear the words and "bonds" and "bubble" used in apposition in any financial media anywhere at anytime. The bond market is always assumed to be right.


The headline CPI rose 4.31% from November 2006 to November 2007 (the most recent data). That's over 50 basis points above the current 10-year yield.

Posted by edelfenbein at January 9, 2008 1:53 PM

Wednesday, January 09, 2008

25 CDOs to meet their maker; billions poised to liquidate

Beginnings of a CDO firesale? After two months of tension, all of a sudden, senior debtholders can’t seem to liquidate their CDOs fast enough.

FT Alphaville understands that 25 CDOs are currently being “accelerated” - half of the 50 Moody’s tells us are now in Events of Default. Acceleration is typically a precursor to the liquidation of a CDO, for it declares all the notes to be immediately due and payable, enforcing a true capital waterfall.

Separately, Reuters reports on several liquidations they’ve heard of going through in the next few days:

Managers of several so-called collateralized debt obligations are liquidating more than $5.0 billion of distressed securities from their portfolios over the next few days, market sources said on Tuesday.

One auction occurred late Monday and two other auctions are slated for later Tuesday. The auctions total $1.5 billion for the “TABS 2006-5″ portfolio, which includes collateralized mortgage obligations, other CDOs and home equity ABS securities.

And another auction is being held on Wednesday - the $1.56bn Carina CDO is being liquidated. On Thursday, TABS 2007-7, with $2.3bn under management, will also have its assets auctioned off. This latest round of liquidations comes on the back of three notices to liquidate at the end of December: Tricadia ($500m), Vertical ($1.5bn) and Adams Square Funding ($507m).

Why this sudden rash of accelerations and liquidations? Our money’s on this line from a Moody’s report sent out to CDO noteholders on Tuesday:

If an acceleration were to occur, there is a very good chance that the most senior class would actually warrant an upgrade.
When a CDO triggers an Event of Default, its fate lies with the most-senior noteholders, who decide what to do with it. Hitherto those most senior classes have been very reluctant to liquidate. Look what happened to Adams Square - liquidation proved to be the wrong decision, wiping out every tranche and eating into even the super-senior investors’ positions.

In light of Moody’s comments, that’s clearly no longer seen as the case. In many CDOs, acceleration and liquidation have become viable options recently for the “most senior” noteholders because of who those “most senior” investors are. As we’ve reported before, they aren’t actually noteholders at all, but in many cases, counterparties to swap agreements on the CDO portfolio - known as super-senior positions. Super-seniors then, as swap holders have little compunction in pushing the liquidation button, because it gets them out of a unwanted commitment to failing CDOs.

There are, of course, big variances here, which Moody’s are keen to stress. For some, going into acceleration doesn’t mean imminent liquidation, but rather, the ability to postpone a decision and guarantee the position of the super-seniors. Such is the decision being taken by many super-senior counterparties - the bond insurers. Moody’s
Monolines, who do not typically apply mark-to-market accounting, may weigh the liquidation and acceleration choices differently. They are more likely to prefer acceleration as a post-EOD remedy whereby losses may be spread out over a longer period of time.

But where does all this acceleration and liquidation talk leave actual noteholders - AAA investors and the like? Moody’s again:

…it is also very likely that all other classes will be downgraded more severely than if acceleration were not to occur.

How severely remains to be seen. Factoring in termination fines in event of liquidation - which impact synthetic CDOs; 75 per cent of the CDO market - losses might be expected all the way up the capital structure, eating right into AAA notes, if not wiping them out.

Wednesday, January 02, 2008

Volatility? What Volatility?

While most would agree that the stock market has certainly been more volatile this year, putting it in perspective with the long term trend shows that by at least one measure, the S&P 500 was less volatile this year than its long term average.

The chart below summarizes the average absolute daily price change in the S&P 500 by year. In 2007, the average worked out to 72 basis points, which means that, on average, the S&P 500 had a daily move (up or down) of 0.72% versus an average of 0.75% since 1928. While this year was more volatile than the last three years, prior to those years, the last time the market was this 'placid' was in 1996.


Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.