Still Holding Back Jeremy Grantham, Chairman, GMO

	Monday, October 13, 2008

INTERVIEW Still Holding Back Jeremy Grantham, Chairman, GMO By LAWRENCE C. STRAUSS AN INTERVIEW WITH JEREMY GRANTHAM: His warnings against risk-taking fell on deaf ears. Now he says the biggest mistake might be buying too soon. FOR THREE YEARS, HE'S CAUTIONED INVESTORS TO AVOID RISK. Jeremy Grantham, chairman of institutional money manager GMO in Boston, was early, but eventually right. Grantham told Barron's in February of 2006 that "housing is a classic bubble" and that "this feels like the end of a cycle." Known for his insights on global investing, Grantham, 70, co-founded GMO, which has a value framework combining quantitative and fundamental analysis. It oversees assets of about $120 billion. For Grantham's latest views on the fallout from the financial crisis and what investment opportunities he sees, please read on. Shawn Henry "I can't say we are going to be in a great hurry, but our next move…will be back to emerging-market equities and small-cap international value." – Jeremy Grantham Barron's: How much will the recent $700 billion bailout plan approved by Congress help stabilize the economy and the financial markets? Grantham: It certainly doesn't hurt. It is an amazingly complicated situation. But I do believe we have passed the point where we have to worry about moral hazard. When Bear Stearns was in trouble, I used to worry about moral hazard. What is your sense of how this crisis has been handled by those in charge? It's been a haphazard response, and the next time something happens, you can't be sure what will happen. In one deal they protect the bonds, while in the next deal the bonds go. Then in the next deal they protect the foreign bonds but not the domestic bonds. My guess is that people will be nervous that they will be at the bad end of one of the tough deals, rather than one of the more gentle deals. Everyone is shaking in their boots. The awareness of risk has come back with a terrifying surge, and it is not going to go away too quickly. With the Fed and other central banks lowering rates last week, are you worried about inflation? My view is, "Forget inflation, guys." This is serious, the real McCoy, and you don't have to worry about little things like inflation. Global growth will slow down, commodities will be weaker for a while, and inflation is a thing of the past. Now we are talking about getting the financial machinery to work and just keeping [gross domestic product] grinding along. What was at the core of what got the financial system into this crisis? It was the belief by a lot of people who counted that financial bubbles did not have to addressed. The thinking was that...you could step in and, by scattering a bit of money around, ease the downside consequences. Therefore, you could let the tech bubble run amok and wait for it to burst and step in. And you could let the housing bubble run amok and step in. At the center of this crisis was a bubble in risk-taking. The risk premiums dropped off the cosmic scale, the lowest ever recorded. On our seven-year forecast data, we reckoned that between June of '06 and June of '07, people were actually paying for the privilege of taking risk. Our constant theme for the last three years was avoid risk, avoid risk, avoid risk. How much further do we have to go to get through this downturn? Great bubbles like the one in 2000 take a long time to wash through the system, and you shouldn't really expect a low much before 2010. The fair value on the [Standard & Poor's 500 index] is about 1025 [versus 910 late last week]. This was not only a monetary event, but it coincided with the first truly global bubble in all assets. You had inflated housing in almost every country in the world, except for Japan and Germany. You had overpriced stocks in every country in the world. And you had too much money and too-low interest rates. I was confident about very little, but I was confident that this would be different from anything we had seen before, and potentially more dangerous. It should have been treated with more care. Is this crisis playing out the way you thought it would? No. I threw in the towel three months ago, and wrote a quarterly letter saying I thought I was the bear around this joint. But this is much worse than I thought. All the fundamentals are turning out worse than I thought they would. All the competencies of the senior people at the Fed, Treasury and [firms like Merrill Lynch and Lehman Brothers] have turned out to be much less than I had expected; that's very disappointing. And, therefore, how could one's confidence that the senior people would get us through the storm be very high? Prior to three months ago, we were investing in emerging-market equities. Then we battened down the hatches, and I changed my view from avoid all risk except emerging markets to avoid all risk, period. The terrible thing -- after all this pain -- is that the U.S. equity market is not even cheap. You would imagine that, given the amount of panic, that it would be. But it started from such a high level in 2000 that it still has not yet worked its way down to trend, although it is getting close. But the really bad news is that great bubbles in history always overcorrected. So although the fair value of the S&P today may be about 1025, typically bubbles overcorrect by quite a bit, possibly by 20%. That is very discouraging. What about equities outside the U.S.? Things are getting cheaper. We score the EAFE [the Europe, Australasia and Far East Index] as absolutely cheap, and it's offering a 7% real annual return over seven years. Emerging-market equities are a bit cheaper, and we see a 9.5% annual real return over the same period. The problem, though, is that we have so much downside momentum, so many financial problems and so many interlocking relationships, that it is hard to imagine this crisis subsiding because stock prices are digging in their heels and approaching fair value. What happens to hedge funds in the wake of this crisis? A year ago, I said that half of all hedge funds would go out of business in five years, and I would certainly stand by that today. Unfortunately, like a lot of my dire projections, that may turn out to be conservative. I also said that at least one major bank will fail. I got a lot of grief for that, and now it looks like I could have said at least a dozen major banks will fail. As for the broad, typical opinion that we would muddle through this crisis, it just shows you what a dangerous optimistic bias the advisory business has built into it. Do you think we will learn anything from all of this turmoil? We will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent. Let's talk about your asset allocations. In a nutshell, we are as conservative as we can possibly get. One bet that has been very successful for us, touch wood, has been long high-quality, blue-chip stocks, particularly in the U.S., and short risky companies. We have been screaming against risk-taking for a long time, and in recent weeks, it has paid off enormously. What about looking ahead in terms of asset allocation? Going forward, you can think about slowly moving back into the cheapest pockets of global equities. So the next move that we make will be back to moderate neutral in emerging-market equities and small-cap international value. I can't say we are going to be in a great hurry, but that will be our next move. We had finished selling almost everything except emerging markets two years ago. We finished selling emerging-market equities three months ago. But the next move will be buying, and we are encouraged that there are a few pockets that are cheap on an absolute basis. We are not encouraged that they will rally immediately. But we will be looking to buy the cheap pockets of global equities as our next move some time in the next several months. Why emerging markets and small-cap international value? Just value and because they have been hit the most. Emerging equities are down almost 50% since late last year, and some of small-cap international is down more than 40%. That big a drop has this wonderful effect of making these categories look cheap pretty fast. You can buy, but it doesn't mean it is their low, and I strongly suspect it is not. The great trap is to buy too soon and, in the big move, to sell too soon. I've been saying since '98-'99 that my next major-league error will be buying too soon -- but we will not buy quite yet. But when we do, I suspect it will be too soon again. What do you see ahead for commodities? Commodities have a great long-term future, now that the long-term trend has shifted from falling commodity prices to rising commodity prices. Having said that, the next couple of years will be quite different. We are in a global slowdown, which I think will be worse than expected even today, and it will be longer than expected -- so this is not a healthy environment for commodities. Over a shorter horizon, I would be getting out of the way of commodities or I would be short commodities. I'm personally short oil; the firm is short copper. What about some other trades? I'm speaking for the asset-allocation unit at the firm. We have been substantially long the safe-haven currencies. We have been very long the yen and somewhat long the Swiss franc and short sterling, which is one of our favorite bets. We have been short the euro for three months, and slightly long the U.S. dollar. One of the paradoxes is, if the world is worse than people expect, the U.S. dollar will outperform. Why are you shorting the euro? It just ran too far. It went from 85 cents on the U.S. dollar to $1.60; it more or less doubled, which I don't think reflects reality. But the biggest lay-up of any idea over the last three or six months was shorting the pound. The U.K. housing market was dreadfully overpriced. I felt nearly certain that the U.K. housing market would come back to a more normal multiple of family income, which is a very big decline of 40% if you did it in a hurry -- or you can sit back for many years and wait for income to catch up. But you should really count on that market coming down over a couple of years painfully. Do you have any closing thoughts about how we got into this financial state? I ask myself, "Why is it that several dozen people saw this crisis coming for years?" I described it as being like watching a train wreck in very slow motion. It seemed so inevitable and so merciless, and yet the bosses of Merrill Lynch and Citi and even [U.S. Treasury Secretary] Hank Paulson and [Fed Chairman Ben] Bernanke -- none of them seemed to see it coming. I have a theory that people who find themselves running major-league companies are real organization-management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient, and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained -- but we end up with an army of left-brained immediate doers. So it's more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four-dozen-odd characters screaming about it are always going to be ignored. If you look at the people who have been screaming about impending doom, and you added all of those several dozen people together, I don't suppose that collectively they could run a single firm without dragging it into bankruptcy in two weeks. They are just a different kind of person. So we kept putting organization people -- people who can influence and persuade and cajole -- into top jobs that once-in-a-blue-moon take great creativity and historical insight. But they don't have those skills. Where do you see all of this going? I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don't. And I have no idea, really, how this will work out. I certainly wish it hadn't happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect. Sobering thoughts. Thanks, Jeremy.

Europe Just Got 16% Cheaper

The US Dollar index staged another sharp rally today and is now up 16.35% from its lows back in March. The Euro is down more than 16% from its highs earlier this year. For those that have plans to go to Europe anytime soon, at least it's 16% cheaper for now. Unfortunately for foreigners coming here, it's the reverse.

Comparing This Week To The '87 Crash

Most Dow stocks were down more this week than during the week of the '87 crash. As shown, GM was down 45%, AA was down 41%, BAC was down 39%, CVX was down 27%, and AXP was down 25%. Only two Dow stocks were down less than 10% this week: JPM (-9%) and GE (-0.32%). Maybe the most important takeaway is the returns these Dow stocks have had since the '87 crash. Who knows when, but we will go up again.

S&P 500 and Oil

Remember when the stock market moved in the exact opposite direction of oil a couple of months ago? As oil went up, stocks went down, as the impact of higher energy costs was supposed to weigh on the economy. That trade has now completely reversed.

The chart below highlights the change in the S&P 500 and oil this week. As shown, the two have moved in perfect tandem, and in fact, the correlation between the two on a minute-by-minute basis this week has been 0.97. That's about as high as it gets for asset classes. When markets are stable, asset classes are much less correlated. When panic sets in, correlation spikes sharply, and it turns into a diversification nightmare.

Stand and delever

Every credit market we turn to seems to be fracturing. Even the most fundamental.

Take a look at these numbers from jck at Alea:

Repos Fails
U.S. Treasury Securities
to receive:$2.5 trillion
to deliver: $2.3 trillion

There is a huge demand for US Treasuries among banks. But the main mechanism for providing those liquid treasuries - repo agreements whereby banks swap Treasuries for cash - is failing.

What the above numbers mean is that $2.5 trillion dollars of Treasury securities failed to arrive in the accounts of institutions when they were supposed to, and $2.3 trilllion of Treasury securities failed to leave the accounts of institutions when they were supposed to.

The numbers differ because only primary dealers report the figures. If a primary dealer is supposed to lend to another primary dealer, then both sides of the failed exchange show up - one reports a failure to deliver, the other a failure to recieve. But in a repo where a primary dealer lends to a non-primary dealer client, for example, only a failure to deliver would be reported.

The latest numbers then, point to the fact that Treasuries aren’t being returned to primary dealers. Putting it all into perspective, here’s a graph of historical repo failure rates from Michael Cloherty at Bank of America:

The ‘01 and ‘03 spikes wrought havoc in their own right. This week’s spike is catastrophic.

The bottom line is that financial institutions are hoarding cash or cash-like liquid securities. They’re anticipating a huge liquidity squeeze.

Today’s Lehman CDS auction is almost certainly the major driver of that.

Banks are thus not returning treasuries on time to the primary dealers. In return, that has the primary dealers cutting back on lending out the treasuries in the first place, exacerbating the problem.

That explains why the Fed’s money market operations aren’t being fully utilised. Primary dealers aren’t taking the Treasuries because they’re not lending them out.

The basic market for the world’s most liquid securities is falling into a terrifying liquidity trap.

With more huge CDS auctions looming, this won’t abate after Lehman’s auction today.

Early Results Published in Lehman Swaps Auction

Less than a dime on the dollar. Or 9.75 cents, to be exact.

That was the initial consensus about what a Lehman Brothers bond might be worth, judging from the early results of a highly anticipated auction to settle derivatives related to those bonds. Friday’s auction was intended to set the price for what is expected to be one of the largest payouts in the (relatively short) history of credit default swaps.

Hundreds of billions of dollars could change hands. Some have expressed concerns that the Lehman-related swap payouts could overwhelm some of the firms that are on the hook.

Wall Street’s biggest names entered bids in Friday’s auction, including Citigroup, Goldman Sachs, Morgan Stanley, Merrill Lynch and UBS, according a Web site run by Creditex Group and Markit Group, which are overseeing the auction.

What does this figure of 9.75 cents mean?

It means that the financial firms, hedge funds and insurance companies that were on the losing side of these Lehman credit default swaps — that is, the ones that must pay now that Lehman has filed for bankruptcy protection — would need to turn over about 90.25 cents on the dollar to the party on the other side of the trade. That’s $1 minus the agreed-upon value of the underlying bond.

That payout rate is a bit steeper than some might have expected. Lehman’s bonds were recently trading at about 13 cents or so, Bloomberg News reported, which would imply a net payout of 87 cents on the dollar.

The bidding process was scheduled to continue for a few hours, and the final settlement price could change.

More important than the price, though, will be learning the total amount of Lehman credit default swaps out there — and the names of the firms on the losing end of those contracts.

In part because there’s essentially no regulation of credit default swaps, these key points are still a mystery.

Hedge funds not bad at reading tea leaves finds new study

As we wrote in August, hedge funds seemed to be repositioning themselves for a down market. According to the Hennessee Group, average net (dollar) exposure had fallen from a high of around 55% in mid 2007 (the market peak) to 35% by mid 2008. Regardless of whether this means hedge funds can tel the future or not, shifting net exposure like that is obviously a useful skill. The mere fact that funds kept pushing down their net exposure does suggest some ability to read the tea leaves.

Now a new study seems to add credence to the argument that hedge funds have a statistically significant ability to time markets. Researchers from Citigroup and Athens University of Economics & Business found that there was a significant correlation between hedge fund market beta and market performance itself. In other words, hedge funds (specifically, “equity hedge” and “equity market neutral” hedge funds in the HFR database) became slightly more correlated with the market right before the market actually rose.

The authors set out to examine the behavior of three factors on hedge fund returns: value, momentum and “market”. But the market factor was the only one to show a significant relationship to future hedge fund returns.

As the table below shows, the correlation between the average market beta of hedge funds and the market’s returns is insignificant using the last month’s (”t-1″) market returns, is slightly higher using this month’s market returns and is relatively large (0.17) with next month’s returns. In other words, equity hedge funds seem to modestly ratchet up their market beta concurrent with rises in the market, but clearly ratchet up their beta in anticipation of a good month to come for the markets. Equity market neutral funds - although market neutral” also seem able to anticipate coming market “up months” (red circles below).

Quant strategies seemed to adjust their betas so quickly that they were able to ratchet-up their market exposure in the same month that the markets actually rose. Curiously, this market timing ability didn’t seem to exist for short sellers - arguably, the strategy most dependent on picking market directions.

To test the economic significance of their results, the authors calculated the trailing 24 month market betas for hedge funds since the turn of the century. Then they created a passive strategy that would invest in the market when this beta value ticks upward from one month to the next and sell the market when it ticks downwards. This passive strategy delivered a Sharpe ratio that blew the pants off that of the market itself.

The authors stop short of trying to explain the causality behind this correlation, but their conclusion is clear:

“…we find evidence that hedge fund managers adjust their ‘market’ betas in a way that exploits subsequent equity market return…According to the rolling correlation coefficients it appears that on average ‘Equity Hedge’, ‘Equity Market Neutral’ and ‘Quant Directional’ managers shift their betas at the - expost correct - expectation of a favourable market return in the next period.”

Forced Selling

I wouldn’t get cute with the technicals. All of the oversold indicators are broken. TWO stocks in the S&P 500 above their 50 dma? SEVEN above their 200 dma? And the VIX isn’t showing panic (trust me on this) because it ISN’T panic. It’s forced selling.

Whether it’s margin calls, hedge fund redemptions, mutual fund redemptions, or preparations for CDS settlement - doesn’t matter.

Here’s an example for those that might think this selloff has much to do with the fundamentals of the underlying economies.

Does anybody really think that the economic prospects for Brazilian companies improved tenfold in five years?

Does anybody really think that the Brazilian companies’ long-term economic prospects were cut by 90% in the last six months?

This is another one that’s setting up for a fantastic discretionary buy+hold, along with emerging markets in general and junk debt, the kind of stuff the good-lookin’, good-cookin’ Wifeykins might just pop in her self-directed IRA and forget about for year or three.

The forced selling will pass, just a matter of time. I plan on being around after it’s done, how about you? Sticking to plan, which for me is mechanical system trading.

10 Bullish Charts, Signals, Indicators

Earlier this week, we discussed several anecdotal pieces of evidence that suggested we were closer to the bottom then the top.

Today, we look at specific data and charts that can provide some insight as to how extreme these present levels are.

These suggest to us that we are increasingly close to a bottom that can be purchased for an upside trade of 20-30% from these levels.

NOTE: We scale in over time, in 10% increments, and recognize that the bottoming process can take several months to several quarters to complete. Hence, slowly buying in is the key.

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1. Relative Strength Indicator, SPX, 1928-2008

Ever since the beginning of the S&P500, the RSI's monthly indicator has only dropped below 30 on four occasions: 1929, 1973, 2002, and 2008. All 3 prior instances were very close to lows.

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2. SPX Losses

The S&P has given up nearly the entire gain from the 2002-03 period

This is a major correction that, like the many trading rallies int he 1970s, should set the stage for the next leg up. Note that these were not buy and hold rallies, but 6 - 18 month trades.

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3. Dow Components and the 200 Day Moving Average

All 30 Dow stocks are below their 200 day moving average -- a condition that has only occurred onmce -- the last time was right after the 1987 crash.

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4. Cash Allocation

Investors current allocation to Cash is well above its 21 year mean and are at the highest levels since ’02, ’98 and ’90 lows.

Chart courtesy FusionIQ

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5. 90/10 days

This week has seen three 90% downside days, reflecting massive liquidations.They can onluy continue for so long.

As noted above, we believe in scaling into long 0positions. We would become more aggressive buyers after the first 90% upside day. This has historically created a good entry for a 1 to 3 to 6 month holding period.

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6. Percentage NYSE over 200 Day MA

The percentage of stocks trading over their 200 day moving average is at multi year lows:

Yet another historically excellent entry point.

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7. Gold vs SPX

The cost of an ounce of Gold is now greater than the S&P500; This last occurred in the eraly phase of the 1982-2000 bull market -- around 1984.

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8. VIX Moving Average

The VIX (AKA the Fear Index) hit a multi-year high of 70.90, reflecting extreme levels of emotion in the markets. We like to look at this on a 50 day moving average

VIX Deviation From 50-Day Moving Average

Readings above 15 over the last 10 years have produced significant rallies. The present reading on this indicator is 26!

1998 Reading Market Up + 27 % (3 Months Later) and + 36 % (6 Months Later)
2001 Reading Market Up + 22 % (3 Months Later) and + 22 % (6 Months Later)
2002 Reading Market Up + 14 % (3 Months Later) and + 19% (6 Months Later)

If History bears out this should be a good buying opportunity with a 3 to 6 month horizon.

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9. S&P500 is down 47% from its peak level one year ago. Transports are down 38%. These are relatively rare degrees of loss, and suggest a near term upside move.

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10. The following two charts show the 2002 lows, and the current market. Can you tell them apart?

Highlight for answer: The first chart is 2002, the second chart is current as of 10/10/08

New York Stock Exchange Circuit Breakers

Given a decline of nearly seven hundred points at the open, it's a good idea to review the circuit breaker rules on the New York Stock Exchange. While we often hear that it takes a 10% decline for the first round of breakers to kick in, the numbers are actually set at the beginning of each quarter. At the start of this quarter, the Dow was at 11,000, setting the threshold for the first circuit breaker at 1,100 points. However, based on yesterday's close of 8,579, the Dow would need to fall 13% in order for the first round of circuit breakers to kick in. For the second round of circuit breakers to kick in, we would have to have a decline of 26%.

$700 Billion and What it Can Buy

Since the financial rescue package was signed into law last week, financial markets across the world have taken the pace of their declines to a higher gear. This has prompted people to ask what the Treasury is waiting for Yesterday afternoon in a press conference, Secretary Paulson said that it "will be several weeks before our first purchase." As shown in the chart below, when the TARP plan was first announced in September, that $700 billion was equal to less than 40% of the S&P 500 Financial sector's market cap. Today, that $700 billion represents over 55% of the sector's market cap. At this rate, by the time the Treasury opens up its wallet and starts spending that $700 billion, they might be able to buy the entire sector!

S&P 500 26% Below 200-Day Moving Average

Earlier today, the S&P 500 was trading 26% below its 200-day moving average. As shown in the historical 200-day moving average spread chart below, this has been an extremely rare occurrence in the S&P 500's history. The index got below 25% in July 2002, September 1974, May 1940, and multiple times in the late 1920s and the 1930s (not even the '87 crash saw the spread this low). As the chart highlights, spreads don't stay down at these levels for long, which means that while we might not go straight up from here, the sharp declines that we have been seeing are due to take a breather for at least a little bit.

“Why is the Fed Paying Interest on Excess Reserves?”

That’s the question that perplexes Alex Tabarrok. But he has a theory (which is endorsed by William Polley):

“Today the Fed starts to pay interest on reserves. The zero interest on required reserves was an opportunity cost to banks, a tax if you like, so paying interest lifts the tax…

“More interesting is why the Fed will pay interest on excess reserves. In the long run, there are again efficiency gains but why would the Fed want to make it more profitable for banks to hold excess reserves now when we want every dollar in the credit markets? My best guess is that the Fed wants to play more Operation Twist and in Brad DeLong's terms this gives them an additional tool to do it on the Pan-Galactic scale.”

Operation Twist refers to monetary policies deliberately aimed at manipulating the prices of particular assets. The idea is for the central bank to “buy” the targeted assets with central bank money—reserves—or short-term government debt. In the original instance of Operation Twist, the targeted assets were long-term government debt. In the present instance, the assets are presumably the various classes of illiquid private assets that have been targeted by various Federal Reserve lending facilities.

To me, that explanation is just a little too complicated. We like to make it clear that we here at macroblog do not speak for the Federal Reserve, but in this case the Federal Reserve (Board) spoke for itself in a questions and answers document on interest on reserves:

“Why does the Federal Reserve want to pay interest on excess balances?

“Paying interest on excess balances should help to establish a lower bound on the federal funds rate by lessening the incentive for institutions to trade balances in the market at rates much below the rate paid on excess balances. Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability. For more information about the implementation of monetary policy with the payment of interest on required reserve balances and excess balances, please see the Federal Reserve Bank of New York’s website at www.newyorkfed.org.”

A quick look at the data reveals pretty clearly why establishing the lower bound on the funds rate might be of particular interest at the moment. Below is a graph of the daily low in the effective federal funds rate since the end of April (when the federal funds rate target was cut to 2 percent, its current level)…

… and a graph showing the standard deviation of the daily rate over the same time period.

As these pictures clearly illustrate, since mid-September the daily effective funds rate lows have been consistently very low, often hitting zero, and the intraday volatility unusually high. This period corresponds to an accelerated use of the various Federal Reserve lending facilities—acquisitions of the Bear Stearns-related Maiden Lane LLC (ML), liquidity assistance to AIG, the Primary Dealer Credit Facility (PDCF), and the Money Market Mutual Fund Liquidity Facility (AMLF), in particular—which have expanded the reserves available to the banking system:

As noted at Real Time Economics…

“The change will encourage banks to leave more money on deposit at the Fed, and that’ll give the Fed more maneuvering room to lubricate the financial system and lend to troubled institutions without increasing the total supply of credit in the economy and pushing down the federal funds interest rate, the Fed’s key interest rate tool.”

This description is just another way of saying what the Federal Reserve said in its questions and answers document released yesterday: “Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.”

Sometimes the simple explanation is the best one.

Kass: The Tail Might Be Wagging the Do

Doug Kass

10/07/08 - 11:59 AM EDT

This blog post originally appeared on RealMoney Silver on Oct. 7 at 7:33 a.m. EDT.

The following observation is a thin-reed one and admittedly non-rigorous, but it might be more important than a lot of my fancy analysis and logic.

For what it is worth, this is what I have been seeing in the last week -- and, quite frankly, it makes me more optimistic.

As readers know, a constant theme of mine has been that the vortex (and continued supply) of selling from the hedge fund liquidations would serve as a significant headwind to any meaningful market advance.

Beginning last Monday, I began to see a number of big hedge funds in the S&P 500 futures pit, boldly selling futures to hedge their core long holdings. As the market dropped precipitously on both Friday afternoon and Monday afternoon, they got ever more aggressive -- according to my sources, more aggressive today than at almost any point in a decade or more.

If my observation is correct -- and we will get some sense of this on Friday afternoon when the size of the professionally hedged S&P futures positions are released; our thesis will be proven correct if there is a large increase in open interest -- it will be proof positive that those hedge funds are now shorting the hell out of S&P futures in order to hedge their cratering longs. Indeed, some of those hedge funds might now even be overhedged and short S&P futures, as it has been working.

This strategy is a classic tactic one sees at panic/capitulation lows as hedge-hoggers sell short what they can sell easily -- the S&P futures market is deep and liquid -- while they retain what they can't sell easily (i.e., large blocks of individual equities).

I have always been concerned about where the marginal buyer would come from, especially with the SEC ban, and, again, if I am correct, the momentum of a rising market into the all-important year-end could now cause a reverse panic to the upside as hedge fund managers that have overhedged their portfolio with futures buy them back and cover their positions just as fast as they sold them short.

ndeed, it is quite possible that those managers could lose both ways -- on the upside on their short futures positions (which some have overhedged because it's been working!) and as their core holdings fail to perform in line with an advancing market.

That's what I see happening recently in the S&P futures pit, and even if I am only half correct, those hedge-hoggers could be on a sinking ship without a life preserver as the stock market might have bottomed under the weight and intensity of their aggressive short selling of S&P futures.

In summary, investors and traders might now be looking for the answer to the market's recent drubbing in all the wrong places. The fundamental news is bad, but this is known and is arguably being cured by public and private sector initiatives. Rather, it could be that the recent behavior of hedge funds -- namely, their imperious and aggressive shorting of S&P futures -- is even worse than the fundamentals and might be a root cause for the precipitous market drop over the past 10 days.

Accordingly, my investment disposition is now turning sunny.

Google search look-up trends: "Great Depression"

Paulson Funds Rise During Difficult September

John Paulson continues to turn bad news for the markets into good news for his investors.

Amid what might have been the worst-ever month for the hedge fund industry, Paulson & Co.’s Advantage Plus Fund added another 4.3%, Bloomberg News reports. The fund, which returned better than 150% last year—one of several Paulson hedge funds to post triple-digit returns in 2007, helping its assets under management to balloon to $35 billion—is now up 24.6% on the year.

Another Paulson fund, the Advantage Fund, is also enjoying positive, if more modest, returns amid the market carnage. It rose 1.58% last month and is up 15% on the year.

Paulson has been betting against the banking sector, especially in the U.K.

Fed Balance Sheet Assets (Chart)

3% Days Becoming The Norm

The days of low volatility that occurred from '04-'06 are distant memories in the minds of traders these days. Oh what we all wouldn't give for just a week of sub-1% moves! Over the last month (23 trading days), the S&P 500 has seen 10 days where the index rose or fell (mostly fell) by more than 3%. You have to go all the way back to 1938 to find another one-month period where there were this many 3% days. As shown in the chart below, there were many multi-year periods between 1950 and 2007 where the S&P 500 didn't have even one 3% day. If you're not a regular market participant and someone that is tells you we are experiencing something that hasn't happened since the Great Depression, they're not joking!

Dow Intraday

Market commentators this afternoon seemed downright masochistic, as many of them complained that we needed to be down even more after falling close to 800 points today. Then, as the market rallied back in the last hour of the day, those interviewed on CNBC were complaining that it didn't mean capitulation was taking place. But who ever said that capitulation couldn't happen in the middle of the day? And since when was an 800 point drop and a VIX spike close to 60 not considered panic selling?

As shown in the chart below, while it still closed down significantly, the Dow rallied back nicely in the last hour of the day. Investors usually like to see the market sell off in the morning and rally into the close, as the "smart money" trades at the end of the day. It's hard to imagine being happy with a 300+ point decline, but looking at how bad it could have been, we'll take down 350 over down 800 any day.

Commodities and the Consumer

Cost Benefit of Higher Lower Commodities

The impact of commodity prices on consumer's wallets is now at its lowest levels of the year. With today's decline in oil and most other commodities (besides gold), the average consumer is now saving an average of 62 cents a day compared to the start of 2008. This is a complete reversal of the spike we saw early in the Summer when higher commodities were causing the average American to spend an extra $4.77 per day.

Contrary Cramer Buy Call ?

>

As I have said in the past, I don't like to harp on any one person. I also don't want to be a Cramer stalker. But DAMN if that headline doesn't smell like a giant buy signal.

The market down 30%, the VIX spiking to 56, and Cramer giving a panicky SELL on TV this morning. We have a 9,500 downside target, and the likelihood of an emergency action makes us want to get long -- at least for a trade . . .

We are putting a toe in the water here.

Jim Cramer: Top 10 Picks for 2008 - From January 2nd 2008

Jim Cramer listed his top 10 predictions for 2008 this week. Some of his forecasts are more likely than others, while others may just be wishful thinking.

The Cramer Crash?

What looked like just another bad day early this morning turned even worse when the opening bell rang today. As of 10:30 this morning, the S&P 500 was down over 7%. So what caused the acceleration in selling? Many have attributed the sell-off to hedge fund redemptions as well as comments Jim Cramer made on the Today Show before the open (that were later picked up on the Drudge Report) when he said, “Whatever money you may need for the next five years, please take it out of the stock market right now, this week."

We'll see how the market closes, but these type of hysteria comments to Main Street, America from a renowned bull may cause just the type of panic that we noted this market was currently lacking.

VIX at All Time High (18 yr history)

Dear Investor

We've got good news and bad news. Mostly bad news.

TPG Axon Investor Letter [PDF]

Tontine Investor Letter [PDF]

Cerberus Investor Letter [PDF]

Greenlight Capital Investor Letter [PDF]

And...

The following fell into our laps an hour or so ago. It is said to come from a credible source BUT WE HAVE NO IDEA. Obviously it has not been confirmed by the parties mentioned.

Tontine Partners
Sept 08
-59.30%
YTD
-66.70%

Copper River
Sept 08
-55.00%

Tontine Capital Partners
Sept 08
-38.50%
YTD
-31.50%

Maverick Levered
Sept 08
-35.50%

Tremblant Concentrated
Sept 08
-26.00%

Tracer
Sept 08
-21.40%
YTD
-9.20%

Maverick Regular
Sept 08
-19.50%
YTD
-21.30%

Tremblant
Sept 08
-19.30%
YTD
-28.00%

Yaupon
Sept 08
-19.20%
YTD
-19.30%

Cambrian Energy
Sept 08
-19.10%
YTD
-20.20%

Southpoint Millennium
Sept 08
-19.00%
YTD
-20.90%

TCS
Sept 08
-16.80%
YTD
-44.60%

Glenhill
Sept 08
-16.00%

Shumway Levered
Sept 08
-16.00%

Spindrift
Sept 08
-16.00%
YTD
-20.00%

North Run
Sept 08
-15.80%
YTD
-20.20%

Atticus Europe
Sept 08
-15.80%

TCI
Sept 08
-15.30%
YTD
-26.40%

Southport Energy
Sept 08
-15.10%
YTD
+8.60%

Lone Pine
Sept 08
-14.80%
YTD
-26.60%

Polygon
Sept 08
-14.50%
YTD
-19.00%

Springbok
Sept 08
-14.40%
YTD
-20.20%

Hayground Cove
Sept 08
-14.40%
YTD
-14.00%

Tiger Global
Sept 08
-14.30%
YTD
-13.70%

Kleinheinz
Sept 08
-14.00%
YTD
-31.00%

Southpoint
Sept 08
-13.60%
YTD
-20.30%

Galleon Buccaneers
Sept 08
-13.60%
YTD
-12.70%

Greenlight
Sept 08
-12.40%
YTD
-15.20%

Baypond
Sept 08
-11.80%
YTD
-22.50%

Eastside
Sept 08
-11.40%
YTD
-14.20%

Alson Signature
Sept 08
-11.10%
YTD
-19.50%

Bellman Walter
Sept 08
-11.10%

Third Pt
Sept 08
-11.00%
YTD
-17.90%

SAC Multi-Strat
Sept 08
-10.70%

Farallon
Sept 08
-10.50%

Conatus
Sept 08
-10.40%
YTD
-8.10%

Eminence
Sept 08
-10.30%
YTD
-15.30%

Tala
Sept 08
-10.30%
YTD
-27.80%

Weiss Multi-Strat
Sept 08
-10.00%
YTD
-2.60%

Corsair
Sept 08
-9.90%
YTD
-2.80%

Meditor
Sept 08
-9.40%
YTD
-3.90%

Whitebox High Yield
Sept 08
-9.30%
YTD
-8.90%

Jana Partners
Sept 08
-9.30%
YTD
-14.70%

Egerton
Sept 08
-9.30%
YTD
-20.60%

Coatue
Sept 08
-9.20%
YTD
-9.40%

Clovis
Sept 08
-9.10%
YTD
-15.40%

Gramercy Emerging Markets
Sept 08
-9.00%
YTD
-18.30%

Intrepid Multi Sector
Sept 08
-8.70%
YTD
-18.30%

Shumway Ocean
Sept 08
-8.60%
YTD
-9.00%

Coeus
Sept 08
-8.40%
YTD
-7.40%

Highbridge Long/Short Equity
Sept 08
-8.20%
YTD
-7.90%

Viking
Sept 08
-7.90%
YTD
+0.30%

Artis 2x
Sept 08
-7.80%
YTD
+13.50%

Royal
Sept 08
-7.80%
YTD
-7.00%

Intrepid
Sept 08
-7.70%
YTD
-13.00%

Valinor
Sept 08
-7.50%
YTD
-12.90%

Ivory Flagship
Sept 08
-7.50%

Taconic
Sept 08
-7.00%
YTD
-11.00%

Trilogy
Sept 08
-7.00%
YTD
-7.90%

Steel Japan
Sept 08
-6.80%
YTD
-19.50%

Seligman Technology
Sept 08
-6.80%
YTD
-3.30%

Abrams Bison
Sept 08
-6.50%
YTD
+1.40%

Kingdon
Sept 08
-6.10%
YTD
-12.40%

Camulos
Sept 08
-6.00%
YTD
-23.70%

Swiftcurrent
Sept 08
-5.80%
YTD
-12.00%

Cobalt
Sept 08
-5.60%
YTD
-2.90%

Highline
Sept 08
-5.40%
YTD
-6.00%

Davidson Kempner
Sept 08
-5.30%
YTD
-6.80%

Shannon River
Sept 08
-5.20%
YTD
-2.60%

Artis Partners
Sept 08
-4.30%
YTD
7.80%

PFM
Sept 08
-4.00%

Brant Point
Sept 08
-3.50%
YTD
-2.60%

Marea
Sept 08
-3.50%
YTD
-28.40%

PFM Tech
Sept 08
-3.40%
YTD
-6.00%

Artha
Sept 08
-3.30%
YTD
-12.80%

Alydar
Sept 08
-2.90%
YTD
-0.40%

SAB
Sept 08
-2.70%
YTD
-3.70%

Effissimo
Sept 08
-2.40%
YTD
-3.30%

Owl Creek
Sept 08
-2.30%
YTD
-9.50%

Axial
Sept 08
-2.30%

Affluential Hedge Funds Suffer in September

Oh how the mighty have stumbled. In a market where everyone is feeling the heat, even the well-respected, historical top performers are now finding it rough out there. We recently got some performance updates from numerous iconic hedge funds and found out that September was not kind to them. Let's take a look at some of the information.

• Moore Capital Management, a group of global macro hedge funds ran by notable risk manager Louis Bacon has seen three of its funds 'stumble' in the recent weeks, coming in -5% in September. You can view Moore Capital's equity portfolio holdings here.
• Maverick Capital, a $10 billion hedge fund ran by Lee Ainslie was -19.5% in the month of September alone and is now -21.2% year-to-date. As you can see, they were actually holding up pretty well all year until September hit them hard. Oh how one month can change things. Maverick's levered fund was -35.5% for the month of September. You can check out Maverick's most recent portfolio holdings here.
• Third Point Offshore, a fund ran by notable activist Daniel Loeb's Third Point LLC was -11% for the month of September and is now -18.4% for the year. You can check out some of Third Point's most recent holdings here.
• Paul Tudor Jones' Raptor Fund (Tudor Investment Corp) was -2% in the month of September and is now -12% year-to-date. Although Tudor employs a global macro strategy, the Raptor Fund is their equities fund. The Raptor Fund is currently run by James Pallotta; but, as I wrote about earlier, Pallotta is leaving Tudor to start his own equities fund. And, you can view Tudor Investment Corp's most recent equity holdings here.
• Greenlight Capital, the hedge fund run by David Einhorn, was -12.8% in September and is -16.4% for the year. You can check out some of Einhorn's portfolio holdings here.
• Lone Pine Capital, another 'tiger cub' fund managed by Stephen Mandel saw its Lone Cyprus fund -14.7% in September. That fund is -26.5% for the year. You can check out Lone Pine's recent activity here and portfolio holdings here.
• Timothy Barakett's Atticus Capital woes continue. His Atticus European Fund was -15.8% percent in September and his Atticus Global Fund -2.8% in September. Atticus European is now -42.5% for the year and Atticus Global is -27.2% for the year. You can view Atticus' most recent SEC filings disclosing their portfolio holdings here.
• Jeffrey Gendell's Tontine Partners wer -59.30% in September and are now -66.7% for the year... unreal. Here are Tontine's most recent portfolio holdings.
• Bret Barakett, brother of Atticus' Timothy Barakett, is also feeling the pain. His Tremblant Capital was -19.3% for the month of September and is -28% for the year. You can check out Tremblant's recent activity here and their portfolio holdings here.
• Shumway Capital's levered fund was -16% for September, and their Ocean fund was -8.6% for the month and is now -9% year-to-date. (Yet another case of one month doing extreme damage to a fund).
  
• Chris Coleman's Tiger Global was -14.3% for September and is now -13.7% for the year.
• Stephen Cohen's SAC Capital Multi-strat fund was -10.7% for September.
• Farallon Capital Management was -10.5% for the month of September.
• David Stemerman's Conatus Capital was -10.4% for September and is -8.10% year-to-date. Stemerman recently left Lone Pine Capital (referenced above) to start his own fund, which I wrote about here.
• Jana Partners was -9% for September and is -14.7% for the year
• Andreas Halvorsen's Viking Global, who I will be profiling next week, was -7.9% for September and is 0.30% for the year. (Wow, a fund that is actually still UP on the year).
• Bill Ackman's Pershing Square was 0.10% for the month of September and finds himself 1.9% for the year. (Another fund actually UP on the year).
• Ken Griffin has been hit hard as well. Citadel Capital's flagship fund was -15% for September and -18% for the year. The fund has lost around $2 billion.

80% Down For The Year

As of today's close, 80% of stocks in the Russell 3,000 are down year to date, and a whopping 17% are down more than 50%. In the chart below, we highlight the year to date change of each stock in the Russell 3,000 sorted by performance (100% to -100% scale). As shown, the red takes up much more area than the green, and it gets pretty ugly towards the tail end on the right side.

Lone Pine Capital stung by September losses

Lone Pine Capital, the $8bn (€5.6bn) hedge fund manager run by one of the industry’s most successful stock pickers, has posted an 11% decline in returns for its main fund during September—likely the worst month on record for hedge fund performance industry-wide.

Financial News has verified the returns for Lone Pine, run by Stephen Mandel, via a document obtained from a source familiar with the fund.

The performance of main fund Lone Cypress reflected the four weeks through September 26. Returns for Lone Cypress were down 24% for the year through September, according to the document.

Mandel’s Lone Cedar fund had made an average of just under 25% a year, net of fees, since its launch in December 1997, according to investors. The annual volatility of its returns over that period has been just under 12% per year. This is a better performance than almost any other long/short equity hedge fund.

An investor in hedge funds said about Mandel: “He is one of the brighter people around.”

Mandel previously served as a senior managing director with Tiger Management, the hedge fund manager known for its stock-picking expertise cultivated by founder Julian Robertson.

Lone Pine, based in Greenwich, Conn., focuses mainly on stock investment at a time when the S&P 500 has fallen more than 20% for the year to date. Market volatility spiked on Monday when the Dow Jones Industrial Average fell 7%, the most in a single day.

A spokeswoman for Lone Pine Capital said the company does not respond to press queries.

Lone Pine is just one of many hedge fund managers suffering a downturn in performance stemming from the liquidity crisis.

Losses also hit Maverick Capital, a Dallas-based long-short equity fund manager founded by Lee Ainslie, another former Tiger Management director.

The Maverick Fund declined an estimated 16% for the month through September 26 and the Maverick Levered fund fell 30% for the same period, according to documents from a source familiar with the fund.

The Maverick Fund fell 18% for the nine months through September and the Maverick Levered fund was down an estimated 36% for the same period.

Ainslie declined to comment.

A temporary ban on short selling has also affected hedge funds.

The Securities and Exchange Commission imposed the ban last month on companies in the financial sector following a steep drop in their share prices, which may have pushed some into bankruptcy such as Lehman Brothers, and spurred government rescues for insurer American International Group and mortgage lenders Fannie Mae and Freddie Mac.

In addition, the sudden transformation of Goldman Sachs and Morgan Stanley from investment banks into commercial banks and the level of the market downturn took the hedge fund industry by surprise, according to a fund of hedge funds manager.

The manager said: “It’s really bad. Almost everything is imploding… Not many hedge funds are making money."

The manager added that hedge fund managers have focused on raising cash to offset anticipated redemptions by investors. Funds of hedge funds are doing the same.

One hedge fund manager and short seller, John Paulson, defied industry trends with strong gains across his hedge funds this year. Paulson's hedge funds had returns of over 19% for the year through August.

A fund of hedge funds manager said if the two-week-old ban is allowed to expire on Thursday, Oct. 2, it would give back hedge fund managers the "most important tool in their toolbox."

The manager said: "No one knows what will really happen. If the market stabilizes and recovers, and if the short-selling ban is lifted, then there will be much fewer redemptions."

Ken Heinz, Hedge Fund Research president, said 7% to 10% of hedge funds could liquidate this year.

High Yield Spreads Near Record Highs

After surging more than 150 basis points in the last week, the spread between high yield bonds and comparable treasuries has surged to 1,096 basis points based on the Merrill Lynch Index of High Yield Bonds. Additionally, at current levels the spread is only 2% off its record high from October 2002. In other words, with the 10-Year US Treasury currently yielding about 3.75%, companies with 'junk' rated credit currently have to pay just under 15% to borrow money.

If you put in a redemption request, do you really want to redeem?

We are the first to admit that we are quick to criticize the hedge fund manager community when it comes to multiple issues ranging from fees to valuation. We've also been pretty harsh on the role of the administrator (what, me?? You want me to take responsibility for something???)

It is, of course, hardly fair if we don't highlight some of the weaknesses and contradictions of investor behavior.

Like many observers, we believe that many hedge funds will face significant redemption requests as of December 31. By the way, despite all the media talk of the September 30th deadline, most funds offer 90 day liquidity - you still have until tomorrow to get your paperwork in. Or you can wait for your 45 day notice funds in mid November.

The result of these redemption orders may very well be a broad swathe of managers adopting redemption gates. Indeed, if recent history is a guide, many funds may simply skip the redemption gate completely and suspend redemptions to progress a fund reorganization.

In the meantime, there is a risk that hedge funds raising cash in advance of year end redemptions will be forced sellers of securities. These sales could well drive down prices further, hurting fund performance still more, and thereby leading more investors to redeem their positions. We are all very familiar with the vicious circle in today's markets.

Against this background, the concept of the "provisional" redemption is toxic. Under this model, investors - and fund of funds are by far the worst culprits - will put in a redemption order "just in case". The investor may think that they will - probably - not need the redemption proceeds, but will put in the paperwork so that, closer to the redemption date they can decide whether they really want the money after all.

This is not exactly a good thing for managers at the best of times, but in the current environment is somewhere between extremely dangerous and just plain stupid. All this does is end up harming everybody involved: managers holding relatively illiquid portfolios may be forced to sell more of their positions (driving down prices) than they really need if investors don't reveal their "real" redemption plans in adequate time.

The solution would seem to be a prohibition on provisional redemptions. We've posted before that a hedge fund, from its side, should be able to honor its published redemption provisions. It's just as fair, therefore, to say that investors should live up to their side of the bargain and abide by those redemptions provisions, rather than try to find tricky ways round them.

The real problem here is, of course, the liquidity mismatch between fund of funds and their underlying hedge fund portfolios. As we have said before:

"There are certainly plenty of fund of funds which continue to offer monthly liquidity - in Europe, in particular, investors demand highly liquid fund of fund vehicles (even though this is with apparent disregard to what those fund of funds are actually invested in.) This may well be great but, ultimately, the laws of physics still apply - a portfolio invested in relatively illiquid assets cannot offer relatively liquid redemption terms. Sooner or later you'll lose at the game of chicken."

Good Financial/Bad Financial Divergence

The average stock currently in the S&P 500 was down 7.59% in the third quarter. But even though the Financial sector is right at the center of the storm, it's interesting to note that the majority of the best performing stocks last quarter were indeed Financials. Even though FNM, FRE, AIG, LEH, WM and WB pretty much went under, other banks like Wells Fargo (WFC), Bank of America (BAC), and JP Morgan (JPM) were all up more than 30% in Q3. As the credit crisis plays out, it's becoming apparent who the winners and who the losers will be.

Warren Buffett on Charlie Rose Tonight

11PM - PBS

Fund limits colleges' access to their money

2:12 pm, October 1, 2008

Some colleges and nonprofits in Ohio are trying to figure out how the termination and liquidation of a popular investment fund will affect them and when they might get back the money they have invested.

Wachovia Bank N.A. on Monday notified the institutions involved in the $9.3 billion Common Fund for Short Term Investments that, as trustee, it would be terminating the fund and distributing the assets. Commonfund of Wilton, Conn., manages investments for thousands of nonprofit institutions, including Baldwin-Wallace College, Oberlin College and the University of Akron.

Wachovia’s email to the institutions said the decision to terminate the Short Term Fund was one of several options officials at Wachovia and Commonfund had considered in recent months. The Short Term Fund will be terminated as of Dec. 31.

“Recognizing that the market for certain high quality, short-term debt instruments has become increasingly disrupted over the course of the past several months, and in order to ensure fair and equitable treatment of all investors in the Fund, Wachovia implemented the termination and liquidation plan this morning,” the email said. “Effective immediately, no further contributions to the Fund will be accepted.”

John Case, chief financial officer at the University of Akron, on Wednesday said the university does not have access at this time to the $750,000 it has in the Short Term Fund and he was not sure how that would affect the school.

“They’re coming back with information on how we get it back,” Mr. Case said. “It’s restricted now, so we can’t get it.”

Oberlin College has about $7 million invested in the Short Term Fund, but the school has access to other cash accounts, so it doesn’t need the money immediately, said Ronald Watts, chief financial officer for Oberlin.

But, Mr. Watts said, many colleges, especially smaller schools that might not have as much money spread around in various investments, could have difficulty making payroll or paying bills.

“For some schools, this could be a real nightmare,” said Mr. Watts, who noted that many colleges invested their money in the Common Fund because it was supposed to be “conservative and safe.”

Doling out the cash in dribs and drabs

According to a Sept. 30 statement by Commonfund, Wachovia on Friday, Sept. 26, restricted liquidity in the fund to 10% of each participant’s account value. That amount mirrored the value of maturing securities in the fund as of Monday, Sept. 29.

“The remaining 90% of the fund will be available to investors over the coming weeks and months as securities in the portfolio mature and as the fund’s advisers are able to sell underlying securities when markets return to normalcy,” the Commonfund statement said.

Commonfund said at least 26% of the fund is available today, Oct. 1, and 57% of the fund would mature by Dec. 31. So far, no securities in the Short Term Fund have defaulted and they continue to pay principal and interest.

The limited access to money in the Short Term Fund will be enough to enable Baldwin-Wallace, which has about $30 million in the Short Term Fund, to meet its operating obligations, said George Richard, assistant vice president and director of college relations at Baldwin-Wallace.

“It was operating cash and you don’t have loads of that laying around,” he said. “But, we’re fortunate.”

Mr. Richard said he expects Baldwin-Wallace to make changes in how it invests its money going forward, but it does not expect to lose what it has in the Short Term Fund. Though B-W’s endowment also is managed by Commonfund, he said the college does not expect that money to be affected by the termination of the Short Term Fund.

“Schools will get that money back, but they may have to wait for those investments to mature,” he said.

Problems with the Short Term Fund did not arise overnight. The statement from Commonfund said the Short Term Fund “has been exposed to significant price volatility since last spring as the credit crisis continued to unfold.”

New trustee hard to come by

The volatility over the last six months was mostly concentrated on 15% to 20% of the securities in the Short Term Fund, namely mortgage- and other asset-backed securities. The credit markets became frozen, however, after the recent failure of Lehman Bros., the federal government’s bailout of American International Group, and the failure of Congress to pass a bill to salvage the faltering financial market.

“Yesterday, virtually none of the non-government securities held in the fund could be sold at par, including the highest rated commercial paper with maturities of less than two weeks,” The Commonfund statement said.

As Commonfund waits for the market to stablize, it is trying to find ways to help its investors gain access to cash and have a place to put their Short Term Fund money once they have access to it. Those are proving to be difficult tasks.

Though Commonfund has asked several unidentified banks to extend credit to institutions who need immediate access to cash, it hasn’t had any takers, said Judson Koss, managing director of Commonfund.

Commonfund also hasn’t found a trust bank to act as a new trustee to succeed Wachovia in managing the Short Term Fund, he said. Commonfund has 60 days to find a new trustee.

“It’s not a good time to be in the banking business,” Mr. Koss said. “The candidate list of new trustees is pretty finite as organizations go belly up. We’re going to take our time.”

Quarter End Intra-Bank Lending Rate Still Frozen

Corporate Bonds Have Worst Month Since '80 as Lehman, WaMu Fail

Sept. 30 (Bloomberg) -- Investment-grade corporate bonds are headed for their worst month in almost three decades, losing 6 percent in September, after the failures of Lehman Brothers Holdings Inc. and Washington Mutual Inc. spurred losses.

This month's decline, the biggest since a 7.4 percent drop in February 1980, will also cap the worst quarter since a loss of 6.8 percent in the three-month period ended in September 1981, according to Merrill Lynch & Co.'s U.S. Corporate Master index. Daimler AG, the maker of Mercedes-Benz cars, was the only company among the 50 biggest issuers in the index to rise this month.

``There's no safety, the only thing you know is that if you don't buy anymore, you can't get hurt anymore,'' said Gregory Habeeb, who manages $8.5 billion of bonds at Calvert Asset Management Co. in Bethesda, Maryland.

The credit-market seizure led the Federal Reserve to pump an additional $630 billion into the global financial system this week as Congress prepares a second attempt at passing a $700 billion plan to help the financial industry shed devalued assets. The government's measures may fail to prevent a recession given the credit contraction, said John Lonski, chief economist at Moody's Capital Markets Group, who forecasts the economy will shrink in the fourth quarter and in the first quarter of 2009.

``It's been terrible in the financial markets because capital just won't flow,'' said Milton Ezrati, senior economist and strategist at Lord Abbett & Co. in Jersey City, New Jersey. ``People are just unwilling to lend or take any risk anywhere near a potential problem.'' Lord Abbett manages more than $40 billion in fixed-income assets.

Proceeding Cautiously

The extra yield, or spread, investors demand to own investment-grade debt instead of similar-maturity Treasuries widened to a record 4.65 percentage points yesterday from 3.17 percentage points at the end of August, Merrill data show. Investment-grade corporate bond sales have amounted to $82 billion in the past three months, the slowest quarter in a decade, according to data compiled by Bloomberg.

``If you're a business executive and you see this swelling of corporate credit risk premiums, how can you not respond by proceeding more cautiously?'' Lonski of Moody's said in an interview from his New York office. ``The near-term prognosis for the economy is: Poor.''

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke proposed the $700 billion plan to restore access to credit for individuals and businesses. The measure would give the U.S. Treasury authority to buy bad loans, including mortgages, from financial institutions.

`Insecure and Suspicious'

The credit markets have been a ``disaster,'' said Lord Abbett's Ezrati. ``The words are: Insecure and suspicious.''

Ezrati said the government bailout, if passed, will improve the tone in the market and increase available credit.

Bond investors are reticent to buy after being burned by what were once some of the highest-rated institutions. New York- based investment bank Lehman, rated A2 by Moody's Investors Service and A by Standard & Poor's until its collapse, filed for the biggest bankruptcy ever on Sept. 15.

The next day, New York-based American International Group Inc., the biggest U.S. insurer and rated A2 by Moody's and A- by S&P, was forced to obtain an $85 billion loan from the government in exchange for an 80 percent stake. Lehman's bonds have lost 86 percent on average this month, and AIG is down 37 percent, Merrill index data show.

Washington Mutual, the 119-year-old Seattle-based thrift, became the biggest U.S. bank to fail on Sept. 25. Its bonds have tumbled as much as 99.8 percent this month. Washington Mutual was rated investment-grade by Moody's until Sept. 11 and by S&P until Sept. 15.

Refocusing

Morgan Stanley recommends investors buy bonds of companies that don't need access to the capital markets in the near-term and whose earnings have held up as the economy slows. MDC Holdings Inc., the Denver-based builder of Richmond America Homes, is attractive because it doesn't have any maturities until 2012; and Hess Corp., the fifth-biggest U.S. oil company, offers a safe haven because the New York-based company's profit is still increasing, according to Morgan Stanley.

``In periods when sentiment is this bearish and when price action gets so dislocated and sloppy, we have to push back on the negativity,'' Gregory Peters, head of credit strategy at Morgan Stanley, said in a Sept. 26 report. ``We recommend focusing on companies which do not need to rely on capital markets for their survival, and those that can deliver quality earnings in the midst of all the economic turmoil.''

Risk of Being Wrong

Bonds of financial institutions fared the worst this month as investors dumped the debt on concern more banks will fail and as their access to capital in the short-term markets evaporated. The spread between yields on commercial paper due in 30 days sold by financial borrowers and those for industrial companies has widened to as much as 1.45 percentage points, the most since the Federal Reserve began compiling the data in 1997.

``Things are probably cheap but who can take on this kind of risk?'' said Calvert's Habeeb. ``The risk for being wrong is so substantial that institutions that were solvent institutions just two to three years ago are failing, and the risk is just deemed too great. That's what's precipitating this lack of buying and thus this freefall of prices.''

Financial company bond yields have jumped to a record 6.97 percentage points more than Treasuries on average from 3.64 percentage points at the end of August, Merrill index data show.

``My goodness that's unheard of,'' Lonski said. ``In all likelihood financial institutions and banks will tighten lending standards even further. That will have the effect of practically guaranteeing some reduction in economic activity.''