Tuesday, September 30, 2008

A Safety Net for Investors in Money Funds

$50 Billion Insurance Plan
Covers Accounts as of Sept. 19,
If Fund Pays to Participate

The U.S. Treasury's $50 billion insurance plan for money-market mutual funds, unveiled Monday, lasts only for three months and covers investments made only through Sept. 19.

The effort aims to re-instill confidence in the $3.4 trillion money-fund industry -- a crucial cog in credit markets that broke down earlier this month. The Treasury program provides a financial backstop for investors in money funds that break the buck, or fall under the sacrosanct $1-per-share net asset value the funds seek to maintain.

Fund Checkup

How to monitor the health of a money- market fund:

  • Go to the company's Web site to learn if your fund is signed up for the program.
  • Check your fund's holdings at www.sec.gov under the Edgar section.
  • Call the fund firm to check assets in the fund versus few days ago.

The measures should help stem the big outflows from money funds that began this month after the once-venerable Reserve Primary fund collapsed due to its debt holdings in failed Lehman Brothers Holdings Inc. and a surge of investor redemptions. That was followed by the liquidation of the $12.3 billion Putnam Prime Money Market Fund (Institutional).

Funds are continuing to struggle, as evidenced by the announcement Monday by Northern Trust Corp. that it's increasing its capital support levels for its funds by $321 million, to $550 million.

To qualify for the government insurance, publicly offered funds must agree to participate and pay a fee. Fees are essentially higher for those that are having more trouble maintaining a $1-per-share value. Funds with share values of $0.9975 or greater as of Sept. 19 pay an upfront fee of 0.01% of assets. Meanwhile, funds with values between $0.995 and $0.9975 will pay 0.015%. That's small enough so that a lot of fund firms are anticipated to join in, if only to reassure their investors.

The plan covers all shareholders, retail and institutional, domestic and foreign, who had accounts as of Sept. 19. Unlike the Federal Deposit Insurance Corp.'s guarantee of bank deposits of up to $100,000 per person, per insured institution, there is no cap on the money-fund coverage.

The program will remain in place until mid-December. After that, Treasury can decide whether it wants to continue with the plans. The latest the program can be extend to is September of next year.

Managers are currently evaluating the details, but odds are that many money funds will opt for the coverage. Legg Mason Inc., with $187 billion in money-fund assets earlier this month, said on Monday that it intends to participate. The firm has been updating retail clients through its Smith Barney brokers and contacting institutional clients via letters and conference calls. Wachovia Corp. unit Evergreen Investments, BlackRock Inc. and Federated Investors Inc. also say they plan to apply to participate in the program but are still reviewing the information. (One complication: Citigroup Inc. is taking over Wachovia and doesn't intend to keep Evergreen.)

The Treasury payouts will be triggered if a participating fund sees its NAV fall below $0.995 a share. (A fund can break the buck if a big holding goes sour or if it suffers a rash of investor redemptions.) But that means the fund must be liquidated within 30 days, unless the period is extended by the Treasury. Covered shareholders will in turn receive $1-per-covered-share upon liquidation.

Given the terms, the program "is really a last-gasp measure," says Jay G. Baris, a partner at Kramer Levin Naftalis & Frankel LLP in New York.

The guaranty fund would not cover any additional investments in a money fund after Sept 19. For instance, if a shareholder had 100 shares in the fund as of Sept. 19, and a week later adds another 50 shares, he or she is insured only for the initial 100 shares. For the remaining 50 shares, the investor would get the fund's net asset value upon liquidation. If the number of shares held by an investor fluctuates, the investor will be covered for either the shares held as of Sept. 19, or the amount at the time of guaranty payment, whichever is less. So, if the investor had 100 shares on Sept. 19, and subsequently sold 50 shares and later bought 25 shares, he or she will be insured for 75 shares.

Investors can identify whether a fund participates by calling fund companies. Money-fund boards of directors are tasked with evaluating whether their offerings should participate in the program. Individual investors can't sign up for the coverage on their own.

For individuals who want to measure their fund's health, finding out about its redemptions recently can be a challenge. One tactic is to call the fund's shareholder-service line and ask for its assets currently versus a week ago. Also, iMoneyNet lists on its Web site the largest 15 money-market funds available to individual investors. It shows their assets, and the list is updated every Wednesday. See it at www.imoneynet.com/retail-money-funds/largest-retail.aspx.

How to suss out what a fund is holding? Some large fund companies like Charles Schwab Corp., Fidelity Investments and OppenheimerFunds Inc. have been frequently publishing a list of their money-fund holdings, or have posted frequently asked questions on their Web site.

For instance, Fidelity has a Q & A on its Web site in which it discusses its investments in financial companies that have been in the news lately, including American International Group Inc., which was recently seized by the U.S. government. Fidelity money funds own some investments issued by two AIG units, and the company says it is "confident that these holdings will pay full principal at maturity."

Investors can also call the fund's shareholder-services group to ask if their money fund owns securities from a specific company. Alternately, look up the fund's ticker on the Securities and Exchange Commission's Edgar Web site at: www.sec.gov/edgar/searchedgar/mutualsearch.htm. However, this may show only dated holdings, because some funds post their holdings only once a quarter.

The insurance, paid for using the $50 billion Exchange Stabilization Fund established in 1934, is part of the government efforts to bail out the nation's financial system, which include the Treasury's attempts to push through Congress its $700 billion bailout plan.

The Treasury worked closely with the Investment Company Institute, a fund-industry group, to develop the program. The plan is limited to accounts through Sept. 19 partly because of "grave concerns" the ICI raised about money-fund transactions. Institutional investors, which account for almost two-thirds of money-fund assets, had been making massive shifts out of general-purpose funds and into safer government funds. The worry was that without such a cut-off date, investors could all flock back into prime funds again, which could destabilize money markets.

After big outflows earlier this month, money-fund flows seemed to return to positive territory last week overall, according to researcher iMoneyNet. Investors put in more than $50 billion last week. But that figure masks a troublesome trend. Investors last week pulled out $53 billion from prime funds -- they often have significant short-term corporate debt, like commercial paper, which businesses need to operate -- while putting in $110 billion into safer government funds. That has made the commercial-paper market very iffy and threatens economic growth.

Because the Treasury won't back funds that broke the buck before Sept. 19, the Reserve Primary fund -- whose Sept. 16 meltdown set off tremors throughout global finance -- will not qualify. Other Reserve funds, however, could be eligible. On Monday, the Reserve listed offerings like the Reserve U.S. Government fund and several municipal money-market funds that continue to maintain a $1-per-share value. A Reserve spokeswoman declined to comment.

The Treasury program doesn't include so-called enhanced-cash funds, which are short-term debt funds that resemble money funds. This means offerings like the Schwab YieldPlus fund, which is down 30% this year, will not be able to participate. Nor will the Reserve Yield Plus fund, another big offering from New York-based Reserve Management Co. that is also not technically a money-market fund.

It's unclear whether the program could make fund firms less willing to put in their own capital to support troubled money funds as they've been doing for the past year. Money funds, which grappled with problem debt like structured investment vehicles last year, now are assessing recent risks like the bankruptcy filing of Washington Mutual Inc. -- and its takeover by J.P. Morgan Chase.

Money funds also are getting help from the Federal Reserve, which has begun extending loans to banks to finance their purchases of asset-backed commercial paper, or ABCP, from money funds. That should help the funds, which have had trouble selling the paper, to meet redemptions. Many firms seem to be tapping the facility. In the first three days of last week, a whopping $72.7 billion was already lent out.

Stocks Now 40 Percent Below Peak

This is what a real bear market looks like.

The Standard & Poor’s 500-stock index fell 8.8 percent today, its biggest one-day drop since 1987. But one-day drops can sometimes be erased the next day. The more relevant historical comparison looks back even further than the 1980s. Adjusted for inflation, stocks are now more than 40 percent below the highs they reached in 2000. (Share prices should be adjusted for inflation, just as any other price should.) That is the worst bear market since the 1970s, which was known as the “lost decade” for stocks.

To find another bear market worse than the current one, you have to go back to the Great Depression, when the index fell more than 80 percent from peak to trough, according to data compiled by Robert Shiller.

The S.&P. 500 still has not fallen back to its recent low. In late 2002, it briefly fell below 1,000, in inflation-adjusted terms, compared with 1,107 at today’s close. But it is getting close.

Monday, September 29, 2008

Corporate Bonds Worse Than Equities

Even though equity markets are down nearly 7% today, the corporate bond market is even worse. Below we highlight a price chart of an ETF that tracks an index of investment grade corporate bonds (LQD). As shown, the ETF is down nearly 10% today! Wall Street can't say it didn't warn Main Street. At this point, every tick lower is on Congress until something happens, because there's no way to know what the markets would have done had they approved the deal.


Biggest S&P 500 Declines

As it currently stands, the decline of 7.8% in the S&P 500 ranks 15th in terms of one-day losses going back to 1927. Below we highlight the 20 largest daily drops in the index sorted by decline and date. As shown, today is set to be the biggest drop since October 26th, 1987.

Update: the final tally for the day has the S&P 500 down 8.79%, making it the biggest decline since Black Monday in 1987.


Friday, September 26, 2008

Peter Thiel's Clarium Capital Shifts to Equities

Recently, we got word of what Clarium Capital is doing to navigate the rough waters. Clarium is a $6 billion global macro hedge fund run by Peter Thiel, the co-founder of PayPal. Assets under management had recently ballooned to the highest amount in Clarium's history and I noted that it would be interesting to see how effective Clarium would be at deploying this new capital. And, with his most recent investor letter, we see that he actually was adding to his leverage, rather than decreasing it. In the week prior to September 19th, he was borrowing 40 cents for every dollar. This past week though, he was borrowing $1.40 for every dollar. Although Thiel undoubtedly changes his leverage on a daily/weekly basis, it is still worth pointing out, given the massive deleveraging we've seen over the past months and most likely will see in the coming months.

As I wrote about in my August performance update of Clarium, we had heard Thiel was shifting out of commodities. And, it looks as though that is exactly what he has done. We now see that he actually has short positions in commodities, to the tune of about 14% of assets. Also, in my analysis of Clarium's portfolio holdings, I noted that he only had a very small percentage of assets invested in equities at the time. But, this time around, he's beefed up his equity positions. Around 71% of his assets are now in equities. And, it looks as if he has been incrementally adding to equities, as he had invested 36% of assets in equities just the week prior. And, year-to-date, he is still up 27.8%. If you want a little more background on Thiel & his investment style, I first wrote about him here.

Also worth noting, according to Morningstar, hedge funds in general saw nearly $12 billion of outflows in July. And, given the recent market activity/volatility, you'd expect that number to have increased in August and/or September.

Tumult Jars Bond-Tracking ETFs, Putting Their Values Out of Line

Exchange-traded funds that track bonds have been running into trouble trading at prices that match their underlying values, raising questions about one of their key promises to investors.

On Sept. 18, Barclays PLC's closed at a price 8.4% below the underlying value of its securities. The previous day the ETF closed at a discount of 3.2%. Two days earlier it was down 2.4% from its underlying value. While the fund has lately posted more accurate prices, investors that sold shares on any of those days may have taken a significant haircut.

"Because the market is so wild, some of these are trading like closed-end funds that drift from their NAVs," says Morgan Stanley ETF analyst Paul Mazzilli, referring to "net asset value," the industry term for the per-share value of a fund's holdings.

ETFs tracking investment-grade corporate bonds as well as other types of fixed income such as municipal bonds and preferred shares also had problems last week. In fact, of about 50 domestic fixed-income ETFs traded in the U.S., six missed their mark by 5% or more on at least one day. In all, 22 were off by 2% or more at least once. Moreover, while recent headline-grabbing events have exacerbated bond ETFs' problems, a number have been showing signs of trouble all year.

Wide swings away from their NAVs are supposed to be unusual for exchange-traded funds, open-end mutual funds that trade on an exchange like a stock. The vast majority of ETFs are index funds, designed to allow investors to buy baskets of stocks throughout the day at prices that closely reflect the values of their holdings.

How accurately do ETFs trade? One well-known fund, the SPDR Trust, Series 1, which tracks the Standard & Poor's 500-stock index, has missed its benchmark by more than 2% only twice in almost 4,000 trading days.

Fund companies point to the benefit in their advertising. "Precise in a world that isn't" is the slogan of one recent ETF ad. "Designed for better market tracking," reads the text of another.

That promise of certainty -- the result of a special mechanism that allows ETFs to create and eliminate shares to meet market demand -- has helped the funds collect more than $580 billion in assets from investors from individual investors to hedge funds. By contrast, closed-end funds, which don't have ETFs' special mechanism, have roughly half as many assets, despite having been around decades longer.

While ETFs still have a strong track record of accurately matching benchmarks, their reputation has occasionally been tarnished as ever more complex funds have hit the market. In 2007, ETFs that tracked crude oil came under scrutiny when the funds failed to keep up with rising oil prices.

Last week a pair of ETFs designed to help investors bet against financial stocks stopped functioning properly after the government restricted short selling.

Problems with bond funds could be more far-reaching, however, because many are meat-and-potatoes investments designed for the portfolios of small investors.

Investors should view bond funds' recent results as an exception, not the rule, says Noel Archard, head of U.S. iShares product development at Barclays. Amid last week's turmoil, ETFs continued to trade, even as markets for some of the risky bonds that the funds own all but froze, Mr. Archard says. That means ETF traders had to guess the securities' value, even as bond benchmarks reflected stale prices.

"It's a live estimate of where these should be valued," he says. In that sense, ETF prices are "more accurate" than market quotes for the funds' underlying values which are based on recent trading prices for individual bonds.

Bond funds are a relatively new addition to the ETF market, but one of the fastest-growing. A handful appeared in 2002, but no more were started until last year, when fund companies suddenly rushed out more than 40 new ones in an attempt to capitalize on ETFs' burgeoning popularity.

Thursday, September 25, 2008

Hedge funds move $100bn into safe havens

Hedge funds charging hefty fees for sophisticated trading strategies aimed at outperforming the wider market have collectively parked $100bn in simple money market funds typically used by investors seeking safe rather than spectacular returns.

Citigroup estimates that hedge funds have now placed $600bn in cash, and that $100bn of this is held in money market funds, normally seen as some of the safest places to invest cash.

However, last week, those money funds became embroiled in the wider financial crisis to the point that the US Treasury was forced to offer a blanket guarantee on them as part of its attempts to prevent the spillover of the financial crisis into the $3,400bn sector.

The extreme measures taken by the Treasury followed mounting fears that retail investors in the sector could be starting to panic and might withdraw funds on a large scale.

But some analysts say the extent of hedge fund investment in money market funds shows how scarce attractive investment opportunities and safe havens have become.

Pauline Modieski, president of Horizon Cash Management, a specialist cash manager, said: “In many cases there is effectively no daily transparency in money market funds. Surely investors as sophisticated as hedge funds should be asking if their cash is in a separately managed account or, as seems to be the case with these large allocations to money markets, a comingled account where the hedge fund has little or no control or knowledge of the underlying holdings on the money fund.”

In what analysts expect to be the first in a wave of potential lawsuits against money funds, Third Avenue Institutional International Value Fund, a fund of Third Avenue Management, a New York hedge fund, has filed a class action against The Reserve Management Company of New York.

The Reserve, meanwhile, last Friday filed with the Securities and Exchange Commission to suspend all of its redemptions and postpone the distribution date of payments for a period longer than seven days.

US mutual fund managers are also holding near to record levels of cash. The average actively managed stock fund has 5.4 per cent of its portfolio in cash, according to Morningstar. That is marginally below the record of 5.5 per cent at the end of 2007.

Ban on shorting financial stocks sends betting soaring

By Sean Farrell, Financial Editor

Fixed-odds betting on financial markets has surged in recent days as traders find ways to get around the ban on short-selling financial stocks.

BetsForTraders.com, a financial bookmaker, has reported volumes up by more than 400 per cent since last Thursday's ban, with almost all the increase in activity in bets against banking stocks.

Lloyds TSB is the most heavily bet-against bank share, with 84 per cent of open bets on the bank predicting its shares will fall following its agreement to buy HBOS. Other favourites for short betting include Royal Bank of Scotland, Barclays, Goldman Sachs and Morgan Stanley.

The Financial Services Authority (FSA) banned the taking of additional short positions on specified financial stocks last Thursday and requireddisclosure of existing positions starting from Tuesday. A raft of further disclosures was made yesterday, withAnglo Irish Bank, Aberdeen Asset Management and Bradford & Bingley among the most shorted stocks.

Ryan Kneale, the chief market analyst at BetsForTraders.com, said: "We are grateful to the FSA for the decision, as it has boosted our business a lot. Thanks to the ban, fixed-odds financial betting overnight became the only way of shorting a bank, and it was inevitable that traders would find this loophole as they scrambled to get around these protectionist rules."

Spread-betting firms have said they will stop offering bets against banks' share prices, but Mr Kneale said he had no intention of doing so. Individual accounts can go into six figures, he said. Hedge funds cannot place bets, but Mr Kneale said many of his company's clients work at hedge funds.

Unlike shorting stocks, placing bets cannot drive the share price down.

Wednesday, September 24, 2008

Tax-Free Money Fund Yields Top Taxables by `Record'

Tax-exempt money-market mutual funds yielded twice as much as taxable funds, as rates on variable municipal debt issued by borrowers including New York City more than tripled amid upheaval on Wall Street.

Tax-free money funds offered an average one-day annualized yield of 4.19 percent yesterday, compared with 2.08 percent for taxable funds, according to indexes from Crane Data. For income taxpayers in the top 35 percent federal bracket, the tax-exempt yield represents a taxable equivalent of 6.45 percent, or more than 1 percentage point higher than the yield on Pfizer Inc. bonds due in March 2018.

``I'll eat my hat if that's not a record,'' said Peter Crane, president of the money-fund research firm, based in Westborough, Massachusetts.

Yields on variable-rate demand notes, state and local government debt favored by money funds, rose as high as 10 percent as banks that set the interest daily or weekly seek to avoid being overwhelmed by inventories of unsold securities. Daily variable rates on New York City general obligation bonds whose remarketing agent is Citigroup Inc. rose as high as 9 percent today, up threefold from Sept. 15.

For variable issues with rates adjusted daily, yields of 9 percent were widespread today, while 10 percent rates were available yesterday, said Pam Tynan, senior portfolio manager for the $23.5 billion Vanguard Tax-Exempt Money Market Fund, the nation's largest.

Investor Withdrawals

Investors pulled a total of $13 billion from tax-free money funds on Sept. 19 and yesterday, even as taxable funds reported inflows, according to data from iMoneyNet, also of Westborough, after the U.S. government agreed to insure the investment vehicles temporarily against losses.

It wasn't until Sept. 21 that the Treasury Department clarified in a statement that tax-exempt money funds would be eligible for the program. The lag in clarification may have led some investors to avoid the tax-exempt funds in favor of taxable ones, Crane said.

The U.S. sought to assure investors in funds that are used as a place to park cash after Reserve Primary Fund, the oldest money-market fund in the country, became the first in 14 years to expose shareholders to losses by falling below $1 a share.

Lehman Brothers Holdings Inc.'s bankruptcy and Merrill Lynch & Co.'s forced sale last week prompted money funds to ``pare down their risk substantially,'' said Paul Brennan, who oversees about $12 billion in municipal bonds as portfolio manager at Nuveen Asset Management in Chicago.

Dealers aren't ``really willing to buy bonds and inventory them because they've got their own set of problems,'' so they are raising rates, Brennan said. ``Eventually, those high yields will attract more nontraditional investors, but that takes time. There's probably billions and billions that are going to have to be moved.''


Financial crises, bank implosions and chaos generally don't often inspire. But every debacle has a silver lining. One of those linings shows up these days in higher interest rate spreads. Investors willing to wade into the riskier realms of debt are being paid for their troubles, or so one could argue.

As our chart below shows, you get more for your money these days when buying high-yield bonds and Baa-rated corporates, the lowest tier of investment grade debt.

High-yield bonds (as per Citigroup High Yield Index) offered an 875-basis-point yield premium over a 10-year Treasury Note as of Monday's close. Meanwhile, the yield on Baa bonds (represented by Moody's Seasoned Baa Corporate Bond Index) closed at 378 basis points over the 10-year the same day. As the graph above relates, those are the highest risk premia in roughly six years.

But are they high enough? Do they fully compensate for the turbulence ahead? Since we don't really know what degree or type of hazards await, we must remain agnostic when it comes to proclaiming definitive answers. Common sense, however, suggests that there's still trouble afoot, and so one can't be fully confident that the elevated risk premia noted above will suffice. But they might.

The potential for capital losses that exceed the received yield is an ever-present risk, and perhaps more so than usual in the early days of autumn in these United States. At the same time, it's getting harder to ignore the rising spreads. It may be too early to make hefty bets about the future, but it's not too early to begin dipping one's investment toes into the riskier ranks of bonds. That's especially true for those with an existing multi-asset class portfolio, a long-term perspective and an underweight position in lower-grade fixed-income allocations.

There are no guarantees with investing, but you can count on variations in risk premia. Ignoring the variations is imprudent, but so is diving in head first at the first uptick in yields. Finding a middle ground is the goal, and arguably that middle terrain begins with a toe in the water now.

Yes, spreads may be higher down the road. Or not. We don't know, and neither does any one else. You can bet the farm one way or the other. Alternatively, you could make modest buys on occasion, when the odds seem at least moderately favorable. Might these be one of those times?

Paulson’s hedge fund targets UK banks

John Paulson, the New York-based hedge fund manager who made billions of dollars predicting the subprime implosion, emerged on Tuesday as the biggest short seller of British banks.

Mr Paulson, the founder of Paulson & Co, has bet against four of the five biggest British banks, according to filings made under a new regulatory regime on Tuesday.

Paulson took pre-emptive action to defend the short positions from what is likely to be a barrage of criticism from politicians and the popular media, saying the firm “empathises” with the tough position facing financial companies.

However, the scale of the positions taken by Paulson, including a £350m bet against shares in Barclays; £292m against Royal Bank of Scotland; and £260m against Lloyds TSB, is unlikely to mollify critics of short selling.

Among the disclosures of other short positions on British and Irish banks, Barclays Global Investors, part of Barclays, was revealed as a surprise holder of a £4m bet against the shares of St James’s Place, the wealth manager majority-owned by HBOS.

Short sellers aim to profit from falling prices, borrowing and selling shares in the hope of buying them back for less. Regulators have imposed restrictions on the practice around the world over the past week in an effort to stabilise markets, with the UK ruling that investors may not increase short positions.

The UK Financial Services Authority also demanded disclosure of shorts of more than 0.25 per cent of a company. In the US, hedge funds have managed to persuade their market regulator to delay a similar disclosure regime and are trying to get it scrapped.

Man Group, the biggest listed hedge fund manager, has asked the FSA to add it to the list of protected stocks, because it fears investors unable to short other financials are picking on it, according to people familiar with the talks. Man was opposed in principle to the list, they said.

Paulson said both its long and short positions were “based on extensive research on the company and its fundamentals, rather than short-term market movements”.

The FSA extended its list of protected stocks to cover Aberdeen Asset Management and F&C Asset Management. The New York Stock Exchange, which with Nasdaq was given authority for maintaining the US lists, added another 44 stocks.

New York-listed broker and asset manager JMP Group became the first company to opt out of the rules.

Sorry, RTC History Suggests Stock Market Not At Bottom


Merrill Lynch's David Rosenberg answers the question we were dying to know the answer to: What happened to the markets after the last huge government bailout--the RTC thrift deal in 1989?


Depends which market you're talking about. But unless you mean the bond market, which soared, the answer is "they kept going down."

Specifically, the stock market dropped for another year, the economy dropped for two years, and the housing market dropped for three years. So put the cork back in that champagne. Rosenberg:

The elusive bottom: Keep in mind, for all the bottom pickers out there, that after the RTC was
established in 1989 it took a year for the stock market to bottom, two years for the
economy to bottom, and three years for the housing market to bottom. And recall
that after the FSA in Japan was unveiled in 1997 the stock market didn’t bottom
for another five years and it’s an open question as whether the economy ever did
manage to stage a sustainable recovery. In the Swedish case of the early 1990s,
even with an effective government solution, the process of extinguishing the bad
debts via government intervention was painful – the equity market incurred a
28-month long bear market that saw Sweden’s major index decline 45% from
peak to trough and the economy undergo a 20-month recession that saw
domestic demand contract by 2-1/2%.

Prefer pictures to words? Here are some from David's most recent note.

Stock Market: Here's the S&P 500 from the late-80s to the early-90s. That little red dot is the RTC bailout deal:


Economy: Here's GDP. Again, that dot is the bailout.


Unemployment: Did the bailout put people right back to work? Not exactly.


Housing: Given that the RTC cleaned up the S&L mess, you might think housing bounced back right away. Nope.


The good news is that David notes that bonds were a great buy shortly after the RTC deal. He thinks the same thing will happen this time around:

Initial [bond] selloff turned into great buying opportunity. bond yields backed up initially as investors focused on the potential for a substantial increase in the supply of Treasuries. Yet, while the yield on the 10-year note yield backed up around 100 basis points (50 basis points in today’s terms) in response to the uncertain fiscal outlook at the time, the reality is that this selloff turned into one of the greatest buying opportunities in the past two decades. By the time the prolonged period of sub-par economic growth ended in late 1993, the 10-year note yield rallied more than 300 basis points from the post-RTC highs. bond yields backed up initially as investors focused on the potential for a substantial increase in the supply of Treasuries. Yet, while the yield on the 10-year note yield backed up around 100 basis points (50 basis points in today’s terms) in response to the uncertain fiscal outlook at the time, the reality is that this selloff turned into one of the greatest buying opportunities in the past two decades. By the time the prolonged period of sub-par economic growth ended in late 1993, the 10-year note yield rallied more than 300 basis points from the post-RTC highs.


Another way the Paulson Plan is hurting Main Street

Forget artificial stock markets. Here’s where the real market news is - in the turmoil rocking the world’s most liquid (non-sovereign) debt market.

The latest commercial paper yield numbers, from the Federal Reserve:

Fed CP issuance

Why the N.A.?

Trade data insufficient to support calculation of the 30-day AA nonfinancial, 60-day AA nonfinancial, 90-day AA nonfinancial, 90-day A2/P2 nonfinancial, and 90-day AA financial rates for September 22, 2008.

It looks as if the non-financial CP market - for anything with more than a two week maturity - has all but collapsed. Outstanding volumes of commercial paper in issuance are falling once more across the board, as they did this time last year.

Fed graph of CP outstanding

What does the collapse in non-financial lending mean? It’s a direct impact on corporates. Spreads have exploded outwards on non-financial CP - so even if corporates do manage to roll, they’ll pay for it. The credit crunch is indeed moving to main street.

The proximate cause for the distress in the market as a whole is the turmoil roiling money market funds - the CP’s chief buyers.

Things are worrying because the US government has promised a backstop to prevent any more of the funds doing a Reserve Primary and breaking the buck. That hasn’t stopped what appears to be a huge structural realignment of the money mutuals away from short-term paper. Nor has it stopped redemptions from those money market mutuals. US funds saw an estimated $197bn of outflows last week. To put that into context, in the whole month of July, just $27bn was withdrawn from them.

But - rather counterintuitively - firms are issuing more CP.

Total CP issuance last week jumped 17 per cent up from the week before. Two trends: the jump is principally in issuance of the very shortest term notes - with maturities of 1-4 days. And it’s mainly in financials.

The dollar volume of AA rated financial CP issued jumped from $7.2bn on Sep 19th to $14.6bn on Sep 22nd. On the face of things, that implies a return of confidence in financial issuers. But there’s a caveat: longer term issuance has continued its downward slope. No CP was issued with a maturity of more than 81 days this week.
That so much CP is being issued only on the very shortest maturities is hardly cause for celebration. The volume of 1-4 day issuance went from $5.3bn on the 19th to $12.4bn on the 22nd, which mirrors rather neatly the utter collapse of regular interbank lending captured in Libor. CP issuance, in other words, is perhaps rising not necessarily because of returning confidence, but perhaps because of collapsing interbank confidence.

Non-financial CP is in trouble because buyers are shifting out of it and into CP with an implicit government backing - financial CP.

Corporates are the ones left suffering.

From Morgan Stanley analysts this morning:

The authorities still have a couple of strings to their bow before resorting to non-market measures (see our notes from today and Friday on the Swedish banking crisis). These are: moral suasion to encourage term interbank lending; and official rate cuts. The scope for the former in current markets looks insufficient: the time for the latter, it seems, may be rapidly approaching.

Odds Of Government Bailout By End of Month at 80%

Leave it to Intrade to make a market in anything. The site now has a contract on whether or not Congress will approve a government bailout plan on or before September 30th. The last trade on the contract was at 80, which puts the Intrade odds at 80%. After listening to yesterday's hearings, these odds might be a bit high given the time frame attached to the contract. Hopefully Congress listened to Warren Buffett on CNBC this morning talking about how absolutely necessary it is to get this passed as quickly as possible.


Arbitrage disruption hits hedge funds

Arbitrage strategies at the heart of the hedge fund industry were decimated last week, as a combination of fire sales of assets from investment banks and worldwide restrictions on short selling hit their profits.

Convertible bond arbitrageurs had the worst performance of any hedge funds, according to investors, as large portfolios of bonds were dumped into the market – probably, said several managers, as Lehman Brothers’ proprietary trading desks closed.

The heavy losses for convertible arbitrage, coupled with the removal of the funds’ ability to lower the risk of holding bonds by short selling the linked equity, could make it much more expensive for companies trying to raise capital through convertibles, managers said. Convertible bond arbitrage involves hedging out the equity or credit risk, or both, often trying to profit by trading the value of the embedded option to convert the bond into shares.

So far this year, banks and other financial companies in the US have raised more than $35bn, one fund calculated, as the convertible bond market – which is dominated by hedge funds – remained one of the few still open at a reasonable price.

The average convertible fund lost more than 4 per cent, according to Hedge Fund Research’s daily indices, as the specialists had one of their worst weeks.

“Although they are not getting fall-off-your-chair hammered, they are among the worst out there,” said one investor in the sector, who said several large funds were down 7-8 per cent in the week.

Other arbitrage strategies have also had a terrible time as the combination of deleveraging and forced sales made common trades in the fixed income and equity markets go awry.

The same effects hit some event-driven funds, as common trades – such as the bet on Volkswagen’s share price versus its preference shares – were hit by forced sales and the fallout from the collapse of Lehman.

Computer-driven hedge funds, which use statistical arbitrage to look for small mispricings in shares, have also had a tough time, as the new short-selling rules forced them to scrap all or part of their models.

However, the biggest hedge fund sector, which follows equity long-short strategies betting both ways on share prices, ended the week down only 1-2 per cent, several investors said. The HFRX global index, including all hedge strategies, was down 1.4 per cent.

“Obviously nobody’s making money apart from the CTAs [managed futures traders], but in the long-short market nobody’s dead,” said another hedge fund investor.

Funds have just begun reporting weekly numbers so it remains unclear how badly the worst were hit and whether any switched their positions at the wrong time.

Some managed futures traders, who typically use computer models to follow short term or medium term trends in futures markets, did very well, several investors said, as did funds trading volatility.

Tuesday, September 23, 2008

Bloomberg's "No Short" Index

Bloomberg has recently created an index of US Restricted Short Sell stocks that measures the performance of stocks on the SEC's "No Short" list. As shown below, the index rose sharply (11.82%) on the first day of trading following the implementation of the short ban. Yesterday, the index declined by 6.3%, however, and it's down another 25 bps today. It will be interesting to follow this index over the next couple of weeks, and especially after the ban is eliminated on October 2nd.


Resolution Trust Corp vs Troubled Asset Relief Program

The Federal Reserve's program to help alleviate the stress in the credit markets has formally been called the TARP which stands for Troubled Asset Relief Program. Informally, though, many are hoping it turns out to be an RTC II, given the program's success in the late 80s and early 90s. Given the comparisons between that period and now, we looked to see how stocks and bonds were trading then versus now.

As shown in the charts below, there are several key differences between the two periods. For starters, back then stocks were in rally mode heading up to the formation of the RTC. Today, we're in a bear market. On the fixed income side, bond yields had fallen sharply leading up to the formation of the RTC in August 1989, while currently Treasuries are in a trading range. But the biggest difference for Treasuries between now and then is that in 1989, the Ten-Year US Treasury was yielding 8%. Last week, the yield on the Ten-Year spiked 40 basis points on news of the new bailout program. But even after that spike, it is yielding under 4%, which is less than half the levels it was trading at in 1989!


Eveillard Says Gold May Surge as Investors Seek `Insurance'

By Stewart Bailey

Sept. 23 (Bloomberg) -- Jean-Marie Eveillard says he has stashed $1 billion in gold in a vault near Times Square as insurance against ``extreme outcomes,'' like a market collapse or unintended consequences of the U.S. plan to avert one.

Eveillard keeps as much as 8 percent of his $22 billion First Eagle Global Fund in bullion or gold-mining stocks. He occasionally visits the vault in a building about 12 blocks from his Midtown Manhattan office, he said.

``Gold is insurance,'' Eveillard said in an interview yesterday. ``In most of those instances where things would get bad enough so you would get into equity bear markets, where economic and financial circumstances would be bad for a year or two or three,'' gold prices will rise.

Gold futures traded on the Comex division of the New York Mercantile Exchange have surged 19 percent since Sept. 12, the last trading day before Lehman Brothers Holdings Inc. filed for bankruptcy protection. The metal has gained for seven straight years, more than tripling in price, as the dollar declined.

Bullion rose $44.30, or 5.1 percent, to $909 an ounce yesterday.

Eveillard, a 68-year-old Frenchman, came out of retirement in March 2007 to resume managing the First Eagle fund after his successor, Charles de Vaulx, abruptly resigned. With Wall Street's turmoil forcing the U.S. toward a $700 billion plan to prop up the financial system, the dollar may plunge and inflation accelerate, Eveillard said.

Annual Returns

The First Eagle Global Fund, which he managed for 24 years before his first retirement, has returned 13 percent annually in the past five years, placing it in the 95th percentile of similar funds, according to Bloomberg data. The fund has dropped 8.2 percent this year.

U.S. officials led by Treasury Secretary Henry Paulson offered proposals during the weekend to avoid a credit freeze that could cripple the financial system and halt economic growth. The plan follows last week's bankruptcy of Lehman Brothers and the government's takeover of insurer American International Group Inc.

``I'm not expecting a disaster, and I acknowledge that the steps they took are probably helpful,'' Eveillard said. ``What I'm saying is, to the extent a price has to be paid, there will be unintended consequences, including the dollar looking shaky or inflation related to the ballooning budget deficit.''

`Creative Destruction'

The U.S. is unwilling to endure ``creative destruction'' that would rectify the market excesses caused by its debt-fueled boom, Eveillard said. Asian economies were forced by the U.S. and the International Monetary Fund to take their ``medicine'' after their market crises in the late 1990s, he said. The Japanese endured a decade of economic stagnation after the country's 1980s asset bubble burst, he said.

``The Asian solution would mean you correct the excesses and it's very painful for a year or two or three, or the Japanese solution is stagnation '' Eveillard said. ``They don't want the South Korean solution or the Japanese solution, so they come up with their own reflation.''

Financing the larger deficit by ``printing more money'' will drive inflation higher, increasing gold's appeal as a safe-haven asset and an alternative currency, Eveillard said.

Investors are buying treasuries as a haven in the debt crisis, he said. The Fed is likely to succeed in keeping companies able to borrow, which will prompt investors to switch from bonds to gold, he said.

Central banks and large investors would need to move a small portion of their money into gold to drastically boost the price because the bullion market is smaller than those for derivatives and currencies. He gave no exact target for gold's price.

``It's a small market, the market for gold bullion, so it could go very high, I presume,'' Eveillard said.

Blackrock's Doll on Markets: Signs of Capitulation

The worst may be over for markets, suggested Bob Doll, global chief investment officer of equities at BlackRock, on CNBC Tuesday.

"I think we saw lots of signs last week of capitulation -- that's what we need to clear this out -- I imagine we have to test those lows, but, absent three more names we know well disappearing, I think we've seen the lion's share of the downturn."

Of course, a major consideration is the bailout package being negotiated in Congress, he noted. And it's important for investors to know what the bailout does and doesn't do.

"This does not put a floor under housing prices," Doll said. "This does not prop up a weak economy. It's just a mechanism to create some liquidity, and, in doing so, to restore some confidence."

"I think we have to be thankful we have a guy like Hank Paulson sitting in that chair. He knows markets, he knows the players, he's reaching out, he's not a guy grabbing for power; he's trying to come up with some things that are going to make a difference in the middle of a crisis."

On Treasury bills going to zero, Doll said:

"We got down to 50 basis points in March; many of us thought that was ringing a bell, but, of course, we've now gone to zero. The other side of that trade is when you're desperate for owning safety, you're desperate to get out of risky things, and that's generally closer to a bottom, not a top, in risk assets."

Monday, September 22, 2008

How Much More Can Investors Take?

After a weekend that many on Wall Street wished would last forever, investors were hoping these volatile markets would show some signs of stability after last week's craziness. Better luck next week. With a decline of 3.27% today, the Dow just registered its fifth 3% day out of six trading days. Only the '87 Crash and the Great Depression saw such short-term volatility in the markets.


Crazy Move in Front-Month Crude

The difference between the front-month and next-month contract for crude is at a whopping 12%! The front-month contract rolls over today, so a massive short squeeze seems to be taking place. As shown in the second chart below, while very uncommon, this kind of spread has happened in the past. Just another crazy datapoint in a crazy market.



Crude Oil Back Above $110; Trading Halted

Crude oil was just halted on the NYMEX after trading up over 10%. Today's gain, if it holds, would be the 8th largest one-day gain going back to at least 1986.


Hedge funds spend big part of fees on middle and back office

Hedge funds spend 19% of revenue on operations, according to a survey by KPMG on behalf of PCE Investors. One out of 10 managers does not cover their costs with management fees, it also revealed.

PCE Investors, a hedge fund operations outsourcing platform, said the survey found that hedge fund managers on average spend 45% of their management fees on middle and back office. Eight out of 10 considered investors are placing more emphasis on the back and middle office.

When over 70% of a hedge funds manager's clients are institutional, the proportion spent on corporate control increased significantly, according to the survey.

"The landscape of managing a hedge fund business has become more complex. Investors are now driving the need for pertinent risk controls, efficient operational systems and studious compliance in a way that has not before been witnessed,” said George Cadbury, PCE Investors president.

“Managing the associated costs, however, are as important as managing the portfolio. PCE simplifies the complexities of running a fund business, enabling managers to focus solely on alpha generation," he said.

According to Andrew North, principal advisor, investment management, KPMG, "The portfolio of services managers are comfortable outsourcing is expanding; moving from traditional fund administration and IT, into the middle and back office as well as business support functions such as compliance."

The survey was commissioned by PCE Investors from KPMG. The participants were based in London and had combined assets under administration of $13 billion with a significant proportion under $1 billion. The survey looked at the structure of the cost base of small to medium sized hedge funds looking specifically at outsourcing and where costs are expected to change in the future.

Sunday, September 21, 2008

ABX: Extraordinary Value

Actions taken by the U.S. government aimed at stemming systemic risk have created a bottom in prices for cash and derivative segments of the asset-backed securities market.

“The actions taken this week and those that are forthcoming make it extremely likely that we have seen the bottom in ABS, ABX and non-agency MBS prices,” said Chris Flanagan, analyst at JPMorgan Securities. “Even after Friday morning’s sharp rally, we still see extraordinary value and move to overweight,” the analyst said in a report.

Friday, September 19, 2008

High Dividend Stocks and Preferreds Soar

A week like we have seen in the market provides so much information for analysis that it's hard to know where to start. There's no doubt that we now have boatloads worth of material to research, and we've clearly set a new bar for comparisons with future market moves. Two investments that have quickly turned higher following the drastic government measures to get the markets functioning again are preferreds and high dividend paying stocks. Below we highlight the performance of PEY (dividend ETF) and PFF (preferred stock ETF). As shown, PEY is up huge over the last two days, and it's up 65% since July 15th. PFF is up 23% from its recent low. Along with most corporate bonds, preferred shares, especially financial preferreds, were falling like nothing ever seen before earlier in the week. Now that the government is hoping to take all the bad debt off of these firms, it's not surprising to see their preferreds move higher.



Winners and Losers This Week

Below we highlight the performance of the ten S&P 500 sectors this week. As shown, only two sectors were up -- Energy and Financials. Utilities, Telecom, Consumer Staples and Health Care (all defensive) were down the most.


We also provide the best and worst performing stocks in the S&P 500 this week. As shown, MER was up the most, while AIG was down the most. The extremes of the moves on both sides below pretty much sum up the craziness of this week.



Oil Up $6 to $104

Somewhat lost in the mix today is oil's rise of $6 back above $100. As shown in the chart below, however, the commodity is still in a solid downtrend. For oil to break its downtrend, it needs to move and close above the $108-$109 level.


Global Equity Market Moves

Below we highlight the percentage changes that global equity markets have seen from their lows yesterday. As shown, Russia is currently up 20.2% today. Yes, the country's bear market has reversed and turned into a new bull in one trading day! Hong Kong is up the second most at 18.7%, followed by China, Singapore and the UK. Japan and Australia have seen the most muted gains at 5% to 6%.


Global Equity Market Moves

Below we highlight the percentage changes that global equity markets have seen from their lows yesterday. As shown, Russia is currently up 20.2% today. Yes, the country's bear market has reversed and turned into a new bull in one trading day! Hong Kong is up the second most at 18.7%, followed by China, Singapore and the UK. Japan and Australia have seen the most muted gains at 5% to 6%.


How much of troubled assets will government and/or dislocation investors have to buy in order to safe the financial system?

I have not seen a number yet but here is my quick and dirty calculation

Worldwide Credit Losses & Write Downs as per 9/19/2008............USD 516.7 bln

Capital Raised....................................................USD 362.8 bln

Capital Shortfall.................................................USD 153.9 bln

For this calculation I assume that financial institutions are leveraged by a

factor of 10. In reality I think the multiple may be even

higher. If we assume that equity capital markets for financial institutions

remain closed the existing capital shortfall of USD 153.9bln requires the sale

of (mostly troubled) assets in the amount of......................USD 1.539 trillion

Assuming that an estimated amount of USD 1.300 bln in total credit losses and

write downs will hold (risk is on the upside in my view) there are at least

another USD 783.30 bln (1.300 minus 516.7) to be realized which will result

in another........................................................USD 7.833 trillion

and in total

USD 9.372 trillion

to to be sold to:

- government(s)
- dislocation investors and/or
- remaining sound financial institutions (if any)

calculation as per September 19th 2009

Biggest Gap Higher Ever For SPY

In the table below, we highlight the biggest gap openings for the S&P 500 tracking SPY ETF since it began trading back in 1993. As shown, this morning's open of more than 4% will be by far the biggest gap higher in its history. The median change of the ETF from open to close after gapping up more than 2% has been -0.54%, indicating that the market typically sells off slightly throughout the trading day.


Unchartered Territory

Someone once said that you can tell a story is really important when the Wall Street Journal runs the lead headline across the entire front page. Well this week, we didn't get one day where the headline ran the entire front page, we got five! Whether or not you agree with the various actions taken this week, remember as much of it as you can, because whatever the outcome, good or bad, people will be talking about this forever.






Short Selling

...short selling should be forbidden for all times and a rule

should be imposed that former short sellers MUST buy if they

see a mismanaged company or they think future earnings go down.

Thursday, September 18, 2008

Cash is err, king

Lots of news recently that hedge funds are boosting their cash holdings.

FINalternatives reports:

Citigroup estimates that hedge funds have about 30% of their assets in cash, possibly their highest cash holdings ever. The bank said that hedge funds currently have about $600 billion in cash. Hedge funds held about 20% of their assets in cash prior to the outbreak of the credit crisis last year.

Meanwhile Merrill Lynch’s monthly global fund manager survey released yesterday showed a flight to cash - with 36 per cent of those surveyed net overweight on cash, compared with 34 per cent in August. The reason? They’re eschewing riskier assets like equities while seeking to meet increasing redemption requirements.

How safe is cash though, given that about 17 per cent of cash holdings are in money market funds, according to Citigroup.

With news of the $64.8bn Reserve Primary Fund breaking the buck, or falling below the level investors put in, those funds are starting to look a bit risky. That’s something decidely worrying, considering they were pitched to investors as safe - if not safer - than cash in the bank. Indeed, preventing a buck-break is so important that companies like Wachovia and Legg Mason have already poured billions into their MMFs to stop it happening. It takes surprisingly little to tip the funds over the brink - just $785m of exposure to Lehman Bros. defaulting commercial paper in Reserve Primary’s case.

As Sam notes in the previous post:

The real issue here though is the fear the collapse of LEH and Reserve Primary has created. If you were a money market fund - so absolutely sensitive to the tiniest changes in asset risk - would you be lending CP to Morgan Stanley or Goldman right now? Not likely.

There’s another impact here on the funds themselves. The whiff of MMF risk has already generated speculation there could be something of a run. Heightening the temptation to mass-exit, as Sean Corrigan at Diapason points out this morning, is the fact the funds carry no FDIC insurance. Maybe not that important given there’s a real possibility the FDIC could exhaust its own insurance line, but it certainly won’t help.

To see the "After the Crash Video" Click here:


Why aren't hedge funds failing as fast as banks?

Because they have different types of ownership,says. And that shows that the markets are not to blame for the financial crisis

The Western world faces the worst financial crisis since the 1930s. So they say. But they're wrong. To a large extent, the troubles that have claimed Lehman Brothers and Merrill Lynch, and may yet do for AIG, are not so much a financial crisis as an ownership crisis. It is not markets that have failed, but a peculiar form of ownership that we have taken for granted for decades - stock market-listed companies with dispersed shareholders.

To see this, consider the curious incident of the dog that hasn't barked - hedge funds. We have not (so far) seen a widespread collapse of these. Yes, a few have gone to the wall, but as there were thousands, this is barely more than normal attrition. And yes, their average returns have been poor. But they have not been a serious source of instability in the wider financial system. They might become victims of the crisis if their financing dries up, but they haven't caused it.

This is a surprise. Before the credit crunch started, countless experts warned us that hedge funds were a source of “systemic risk”. They were wrong.

Instead, the big dangers to the financial system have come from elsewhere. Fannie Mae and Freddie Mac - the guarantors of US mortgages - had to be nationalised. Three of Wall Street's big five investment banks have ceased to exist as independent entities. And the future of AIG, which helps to insure investors against defaults on bonds, is in doubt.

There's a pattern here. The biggest shocks to the financial system have all come from stock market-quoted companies. By contrast, hedge funds, which many expected to cause trouble, have been innocent bystanders. These are, generally, owned as private partnerships.

So, one form of ownership has caused a crisis, and another hasn't. The reason for this lies in what economists call the principal-agent problem, and what everyone else calls the difficulty of getting your employees to act in your interests rather than their own.

Big, quoted companies have been unable to solve this problem. Shareholders - often, ordinary people with pensions - have little control over fund managers. Fund managers have little control over chief executives. And chief executives have had little control over trading desks, partly because they just didn't understand the complexities of mortgage derivatives.

So traders were free to gamble with other people's money. They got multimillion bonuses if they did well, but faced almost no meaningful sanction if they failed: John Thain, Merrill Lynch's chief executive, is rumoured to be in line for an $11 million payout. The result was excessive risk taking.

In hedge funds, things have been different. Very often hedge fund managers invest their own money and take key decisions themselves, or at least closely watch those who do. Their incentives to take huge risks have been smaller. So these have at least survived.

What we're seeing, then, is the cost of separating ownership and control. In private firms, or partnerships - even limited liability ones - the two are closely aligned. In stock market-quoted firms, they are not.

Of course, Lehman Brothers tried to mitigate this problem by having employees hold shares; its chief executive, Dick Fuld, has lost more than $200 million this year as a result of Lehman's price collapse. But this was not good enough. No one at Lehman seems to have had sufficient control over Mr Fuld to rein in his pride, to tell him to admit failure and seek a rescue deal on any terms.

People have countless ways of losing money - greed, hubris and stupidity are always with us. Good organisations find ways to restrain these impulses. A lesson of this crisis is that firms with dispersed shareholders might not be best able to do this.

Although few have said this explicitly, investors know it tacitly. One reason why the markets rose last week, after the US Treasury nationalised Fannie Mae and Freddie Mac, was that investors realised that state ownership, for all its obvious faults, can be less dangerous than dispersed private ownership.

So, this is a crisis of a form of ownership, not of markets. This distinction might seem odd to those whose economic attitudes have not changed since the Cold War. The traditional Right defended markets and traditional ownership structures. The Left attacked both. But it's always been theoretically possible to defend markets while being sceptical of particular forms of ownership.

And it's more important to do this than ever before, as Robert Shiller, of Yale University, shows in his book, The Subprime Solution.

The solution to our troubles, he says, is more markets, not fewer. He proposes the introduction of markets in livelihood insurance, so that people can buy protection against job losses, and better markets in house-price futures, so we can insure against falling house prices.

Markets, then, can protect us from risks. So why haven't they done so?

Again, the answer lies in a failure of ownership. We've had more bad financial innovation - those mortgage derivatives - than good innovation (Shiller's ideas) because it's been easier to own the former. The investment bankers that thought up derivatives made fortunes selling them to other investment banks. Those who would gain from Shiller's ideas have shallower pockets. So it's hard to make money selling them even good products.

All this suggests that governments have a double role to play. They should help to encourage the development of Shiller-type markets and facilitate the transition from inefficient to less inefficient modes of ownership, as the US Treasury did with Fannie Mae and Freddie Mac.

Before we think about solutions, though, we should identify the problem - that ownership failure can be a bigger problem than market failure.

Wednesday, September 17, 2008

After the Crash - Part 1 - Wall Street Week Oct. 23, 198

Fear and Large VIX Spikes

We are starting to finally see some real fear today, for the first time in a long time.

Regarding fear and large VIX spikes, my thinking is that the setup for a big VIX spike comes only after market participants begin to believe that a bottom is in and a sharp move downward suddenly causes them to change their mind. The mind set switches from something like "it's finally safe to be long again" to something along the lines of "oh no, this is much worse than I though...and I am caught on the wrong side of it."

Part of the fear factor is the fear that something unknown and/or much larger than expected is at work.

The $85 Billion Check

Ottorock asks a question:

When a gov't cuts an $85Bn cheque, where do the funds come from?

John Jansen hazards a guess at the answer:

If the Federal Reserve Bank of New York plans to write an $85 billion check to AIG , then Treasury market participants should duck for cover. They will likely raise the money by selling Treasury debt from the System Open Market Account. I have no idea how they would do that but it would be the largest such sale of securities since the dawn of human history.

The real answer, however, is that there won't be any $85 billion check. AIG will draw down this liquidity facility only as and when it needs to, and indeed there's a substantial chance that now the liquidity facility exists, it won't get used at all.

At Libor + 850bp, the funds in the liquidity facility are very expensive, and AIG will tap them only as a last resort. What's more, it's now owned by the government, which means that it almost certainly won't default. (The Germans call this Anstaltslast.) As a result, AIG can probably find cheaper private funding elsewhere.

In other words, the headline cost of this bailout is $85 billion. But the practical cost might well be zero -- and the government's getting 79.9% of the world's largest insurer, to boot.

3-Month Treasuries Will Now Get You $4 on $10,000 Per Year

Three-Month Treasuries are now yielding an unbelievable 4 basis points. That means a $10,000 investment will get you a whopping $4 per year. Before equity markets opened today, the yield was at 0.23%, and it continued lower throughout the day. As shown below, the yield hasn't been this low since the 1930s. Investors have clearly lost faith in pretty much every asset class except for government-backed bonds. And who knows how long that faith will last.

In the bottom chart we highlight the yield curve, which was inverted at the start of 2007. Now the curve has moved back to the top of its historical range since the 1960s.



What's In Store For Munis?

With Wall Street in a free fall, investors are wondering if municipalities, especially in the New York region, will begin to suffer as local economies will surely struggle. One way to trade or just track the muni-bond market is through ETFs. iShares has an ETF for the national muni-bond market (MUB), the New York region (NYF), and California (CMF). As shown in the chart below, each of the ETFs have fallen in recent days, but the New York one hasn't gotten hit that hard. We'll see what happens in the coming months, however.


Multiple 4% Declines

The S&P 500 has now declined more than 4% in two of the last three trading days, and below we highlight all prior occurrences since 1928. As shown, the last time we had two out of three -4% days was during the '87 crash. Prior to that, it hadn't happened since 1948. The majority of the occurrences were during the Great Depression, where 3% and 4% moves were commonplace. Overall, the average performance of the S&P 500 on the day following the last -4% day has been 0.85%. Over the next week, the average performance has been 4.94%, and it has been 6.43% over the next month. Following the last 4 instances, the S&P 500 has been up the next day every time, but just 50% of the time over the next week and month.



With just two large investment banks remaining - Morgan Stanley and Goldman Sachs - questions are growing over who might step into the suddenly emptier playing field.

Many Wall Street watchers are pointing to the looming presence of large hedge funds and private-equity firms, which have been stealthily encroaching on many of Wall Street's traditional lines of business for years now.

"I think the new Wall Street is not going to be on Wall Street," said Ferenc Sanderson, a hedge fund researcher at Thomson Reuters. "The headquarters of Citadel is in Chicago," he said.

Indeed, the $20 billion Citadel Investment Group is more often compared to Goldman these days.

Last year, Citadel branched into providing administrative and technical support to other hedge funds, not unlike the investment banks. Citadel also has a unit that executes trades for retail brokerages, akin to market makers like Morgan Stanley and Merrill Lynch.

It's a far cry from the small operation Ken Griffin had when he founded Citadel with a modest $1 million in trading money in 1990.

Meanwhile, Steve Schwarzman's buyout firm Blackstone has been encroaching on traditional investment banking roles with its growing advisory business.

Blackstone also raised eyebrows by dispensing advice to blue-chip company Proctor & Gamble when it was looking to spin off units, and to Microsoft when it sought to buy Internet company Yahoo!.

But the new Wall Street players aren't necessarily any safer than their predecessors, people warn.

Firms like Blackstone, Fortress, Och- Ziff and KKR are or soon will be public companies that are tough to value and therefore vulnerable to the same crisis of confidence problems that befell Bear and Lehman - and nearly crippled Merrill Lynch, people say.

"It is all a matter of how much leverage they take on," said Scott Rothbort, finance professor at Seton Hall University's Stillman School of Business and president of LakeView Asset Management.

There're also growing concerns these new players are setting themselves up for the same mistakes by taking their stocks public, making them vulnerable to shareholders and encouraging them to take risks to boost the stock price.

Tuesday, September 16, 2008

Money market breaks the buck, freezes redemptions Reserve Primary Fund stung by Lehman collapse, investor withdrawals

One of the original and largest money market funds has put a seven-day freeze on investor redemptions after the net asset value of its shares fell below $1, in a rare instance in the fund industry of what is called "breaking the buck."
managed by New York-based money market fund inventor The Reserve, said late Tuesday that its $785 million holding of Lehman Brothers Holdings debt has been valued at zero.

As of 4 p.m., Eastern, the value of the fund's share was 97 cents. The Reserve said that redemption requests received before 3 p.m. will be paid out at $1 a share. The company said Primary Fund will continue to accept new money.
While Primary Fund's Lehman holding was small compared to the fund's overall size, the fact that it froze redemptions reflects a surge in redemption requests by investors.
The size and speed of the withdrawals was stunning. At 3 p.m. on Tuesday, Primary Fund's assets stood at $23 billion, a $40 billion hit from the $62.6 billion in the fund on Friday, a spokeswoman for The Reserve told MarketWatch late Tuesday.
"Effective today and until further notice, the proceeds of redemptions from The Primary Fund will not be transmitted to the redeeming investor for a period of up to seven calendar days after the redemption," The Reserve said in a prepared statement.
Retail account holders affected
Reserve Primary has both institutional and retail accounts. "This appears to be the first case where a retail investor will lose money in a money market fund." said Peter Crane, president of market research firm Crane Data in Westborough, Mass., though he called the situation "an anomaly."
Money market funds pride themselves on their liquidity and the safety of their investments. All money market shares are priced at $1 -- a figure so important to the industry that fund companies take losses to keep the share price from dipping below $1, which is known as breaking the buck.
"They didn't just break the buck, they shattered it," said Don Phillips, managing director at investment research firm Morningstar Inc.about The Reserve fund.
This is only the second time that a money market fund's net asset value has dipped below $1. In 1994, Denver-based Community Bankers U.S. Government Money Market Fund returned 96 cents on the dollar to investors when bad derivatives investments forced it to liquidate.
Phillips said the fact that The Reserve had to break the buck reflects the seriousness of its troubles. "People say that if you break the buck on a money market fund you're saying that you don't want to be in the money market business anymore."
Phillips speculated that because The Reserve is solely a money market shop, it didn't have the resources to bail out Primary Fund in the way a diversified mutual-fund giant such as Fidelity Investments, Vanguard Group or Evergreen Investments, which is owned by Wachovia Corp. , would be able.
Fidelity, other money fund giants reassure investors
Some of the largest money-market fund providers sought to calm investors in the wake of The Reserve's announcement.
Fidelity Investments said that its money market funds are sound. "We can state unequivocally that Fidelity's money market funds and accounts continue to provide security and safety for our customers' cash investments," said Anne Crowley, spokeswoman, in an email response.
She added: "We have been proactive in keeping our money market funds safe and in protecting the $1 net asset value, which has always been our number one objective in managing these funds."
Fidelity's taxable, general purpose money market funds have no exposure to any Lehman Brothers entity, Crowley said. The taxable money market funds do have "modest" exposure to two issuers that are subsidiaries of troubled American International Group she noted.
"Fidelity is confident that these holdings will pay full principal at maturity," she said.
Vanguard Group also issued a statement reaffirming the integrity of its money funds.
"We are confident in the stability of Vanguard's money market funds," spokesman John Woerth said in an email. "Our largest money market fund is Vanguard Prime Money Market Fund which currently holds more than half of its assets in Treasury and agency securities. In addition, Prime Money Market Fund and our other money market funds have no exposure to money market instruments issued by securities dealers, including distressed issuers like Lehman and AIG."
At Wells Fargo & Co. a spokesman also noted that its money market funds are secure.
"None of the Wells Fargo Advantage Money Market Funds hold securities issued by or guaranteed by Lehman Brothers or American International Group. The value of our money market funds continues to remain stable and the net asset value of the funds remains at $1 a share," he said in an email reply.
A spokesman for brokerage giant Charles Schwab & Co. said the company "does not own any Lehman securities in the Schwab Money Funds."
On Monday, Wachovia said it would pump money into three Evergreen money market funds. Evergreen would not disclose how much is being put into the funds.
While money market funds are supposed to be liquid, they are permitted by law to postpone payment of redemptions by up to seven days. Any further delays would require regulatory approval, however.
The Reserve was founded in 1970 by Bruce Bent, and launched the first money market fund soon after. As of Friday, the company had $127 billion in assets under management, according to a spokeswoman. The size of the money market fund industry is about $3.5 trillion, according to iMoneyNet.
Federated Investors which has about $270 billion in money market fund assets, declined all comment for this story, including whether the Reserve's troubles or fears surrounding Lehman debt had affected its own funds.
BlackRock Inc. sent a letter to its money market shareholders on Monday telling them that its funds had no Lehman debt.
"We do not have any holdings of Lehman Brothers paper, nor is Lehman a counterparty to any repurchase agreements in our 2a-7 registered money market funds," noted Simon Mendelson, managing director in BlackRock's COO global cash management group.
The credit crisis has put pressure on money market funds, several of which have had to take steps to prop up their funds as the value of their holdings -- which frequently included mortgage-backed securities -- has declined. According to money Crane Data, 20 fund companies in the past 13 months have had to pour their own money into their funds to prevent them from breaking the buck. End of Story

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.