Wednesday 31 December 2008

Happy New Year

I get to close out 2008 on hospital room duty with my son. He's doing well - had his breathing tube out yesterday, is eating regular food, and slowly recuperating. He should be moved out of the ICU tomorrow and into a regular room. With some luck, he might be home by Monday the 5th.

The Unknown Wife and Daughter are going to a neighbor's house for a little New Year's cheer (the non-alcoholic kind, since Unknown Wife is expecting), and then home by about 10.

Here's hoping 2009 finds you healthy, prosperous, and happy.

Tuesday 30 December 2008

Asian Flu

In the past few days we have received confirmation that our thesis regarding Asia is playing out rapidly. The data come from Japan and Korea - both heavily industrialized exporters and relatively open societies. While we have been very bearish on Asian economies here at Financial Jenga, the rapid pace of the implosion even surprises us.

Japan will soon report 4th quarter GDP and the estimates are moving fast - an in a really frightening manner. Bloomberg reports that Barclays now is estimating that Japan's economy contracted at over 12% annualized in Q4. This would be the worst result since the Arab oil embargo of 1974. Korea reported a similarly disastrous result for November industrial production. The YoY decline of 14.1% was the worst on record - with data going back to 1970. Understand that the textbook definition of depression is a 10% fall in GDP - and both Japan and Korea are already on pace to do so in a year or less.

We do not yet have any numbers this bad from China but we should not expect to see them for some time. China's economy possessed tremendous momentum entering the current crisis and that will have to bleed off before the damage becomes apparent on a macro scale. Also, China's government is still rather secretive and probably will attempt to hide the extent of the declines. However, we are getting industrial production numbers showing that December was the fifth straight month of decline.


Once again, Bloomberg reports that industrial output is slowing and the pace of layoff is increasing. The problem is that order also continue to fall so this is not an inventory correction as the head of the People's Bank of China would suggest. This is a collapse of end demand driven by credit. The demand is nearly all external so China has no control over that. Since China's end consumer demand is small and even most of that is tied to export industries in some way, there really isn't any way out for them. The most fascinating quote from that article follows:

China’s economic growth may have slipped to 5.5 percent last quarter, the weakest pace in at least 15 years, according to Shanghai-based Industrial Bank Co.

Once again, numbers that would have seemed shocking a short time ago are now the expected. China will be fortunate indeed if their GDP continues to grow at all in the near future.

Monday 29 December 2008

Paddy Hirsch Explains Quantitative Easing

Yet another excellent whiteboard talk by Paddy Hirsch, senior editor at Marketplace. In this one, he explains "Quantitative Easing"

Quantitative easing from Marketplace on Vimeo.

How Do You Use Credit Default Swaps (CDS) To Create "Synthetic Debt"?

There's been a lot of talk in recent months about "synthetic debt". I just read a pretty good explanation of synthetics in Felix Salmon's column, so I thought I'd give a brief summary of what it is, how it's used, and why.

First off, let's start with Credit Default Swaps (CDS). A CDS has a lot of similarities to an insurance policy on a bond (it's different in that the holder of the CDS needn't own the underlying bond or even suffer a loss if the bond goes into default).

The buyer (holder) of a CDS will make yearly payments (called the "premium"), which is stated in terms of basis points (a basis point is 1/100 of one percent of the notional amount of the underlying bond). The holder of the CDS gets paid if the bond underlying the CDS goes into default or if other stated events occur (like bankruptcy or a restructuring).

So, how do you use a CDS to create a synthetic bond? here's the example from Salmon's column:

Let's assume that IBM 5-year bonds were yielding 150 basis points over treasuries. In addition, Let' s assume an individual (or portfolio manager) wanted to get exposure to these bonds, but didn't think it was a feasible to buy the bonds in the open market (either there weren't any available, or the market was so thin that he's have to pay too high a bid-ask spread). Here's how he could use CDS to accomplish the same thing:
  • First, buy $100,000 of 5-year treasuries and hold them as collateral
  • Next, write a 5-year, $100,000 CDS contract
  • he's receive the interest on the treasuries, and would get a 150 basis point annual premium on the CDS
So, what does he get from the Treasury plus writing the CDS? If there's no default, the coupons on the Treasury plus the CDS premium will give him the same yearly amount as he would have gotten if he's bought the 5-year IBM bond, And if the IBM bond goes into default, his portfolio value would be the value of the Treasury less what he would have to pay on the CDS (this amount would be the default losses on the IBM bond). So in either case (default or no default), his payoff from the portfolio would be the same payments as if he owned the IBM bond.

So why go through all this trouble? One reason might be that there's not enough liquidity in the market for the preferred security (and you'd get beaten up on the bid-ask spread). Another is that there might not be any bonds available in the maturity you want. The CDS market, on the other hand, is very flexible and extremely liquid.

One thing that's interesting about CDS is that (as I mentioned above), you don't have to hold the underlying asset to either buy or write a CDS. As a result, the notional value of CDS written on a particular security can be multiple times the actual amount of the security available.

I know of at least one hedge fund group that bought CDS as a way of betting against housing-sector stocks (particularly home builders). From what i know, they made a ton of money. But CDS can also be used to hedge default risk on securities you already hold in a portfolio.

To read Salmon's column, click here, and to read more about CDS, click here.

Thursday 25 December 2008

Bad News

We just got som bad news regarding the Unknown Son. As many of my regular readers already know, he's gone through a lot - he's a two-times cancer survivor.

In 2002 he was diagnosed with Neuroblastoma, a particularly nasty and resistant childhood cancer. After a great deal of chemotherapy, surgery, radiation, more chemotherapy, and experimental treatments (including an autologous (i.e. "self") stem-cell transplant, he went into remission in 2005.

In January of 2008, he was diagnosed with a Wilms' tumor (a kidney tumor), which resulted in the removal of his right kidney and, after more chemo, he was given another clean bill of health this summer.

Now it looks like he has another tumor - in the lower part of his right lung. We just found out about it two days ago as a result of routing follow-up scans. He's scheduled for more surgery this coming Monday (the 29th). He'll get the tumor removed, which will give us the best information as to what exactly it is. He'll probably have about a week-long hospital stay, and we'll then know if this is a recurrence of the Wilms, tumor or something else (it could be a recurrence of his neuroblastoma, but that's unlikely because there was no indication on his latest MIBG scan a couple of weeks back).

So, please keep us in your prayers.

If you're one of my "non-blogosphere" friends (or a regular reader who knows me by my real name) and you want to keep up with what's going on, we maintain a website that we use to keep family and friends abreast of the little guy's treatment. Drop me an email and I'll send it to you in case you want the url.

Monday 22 December 2008

Window Dressing and Other Mutual Fund Games

What do the following terms have in common?
  • Window Dressing
  • Painting The Tape/Banging The Close
  • Comparison Shopping
The answer is that they're all games that mutual fund managers play at the end of the year to make their portfolios' performance look better. The Investing section of today's Wall Street Journal has a short piece that describes these games:
  • Window dressing happens when the portfolio manager sells off securities just before the end of the reporting period so that they don't show up in the annual (or quarterly) listing o the portfolio's securities.
  • Painting the Tape (also called Banging the Close) occurs when a portfolio manager holding a security buys a few additional shares right at the close of business at an inflated price. For example, if he held shares in XYZ Corp on the last day of the reporting period (and it's selling at, say $50), he might put in small orders at a higher price to inflate the the closing price (which is what's reported). Do this for a couple dozen stocks in the portfolio, and the reported performance goes up. Of course, it goes back down the next day, but it looks good on the annual report.
  • Comparison Shopping could also be called "benchmark shopping". This refers to the idea that if a fund manager can't beat his benchmark, he just switches to a new benchmark that he can beat.
Read the whole thing here.

President Bush and The Military

I try to keep politics mostly out of Financial Rounds because it generally gets people far too worked up. Likewise, I try not to post too much about President Bush. But this piece in the Washington Post caught my eye.
For much of the past seven years, President Bush and Vice Prresident Dick Cheney have waged a clandestine operation inside the For much of the past seven years, President Bush and Vice President Dick Cheney White House. It has involved thousands of military personnel, private presidential letters and meetings that were kept off their public calendars or sometimes left the news media in the dark.

Their mission: to comfort the families of soldiers who died fighting in Afghanistan and Iraq since the Sept. 11 terrorist attacks and to lift the spirits of those wounded in the service of their country.

Read the whole thing here.

Regardless what else you think about President Bush, he clearly appreciates and honors the role the military plays and the sacrifices those soldiers have made for their country.

Saturday 20 December 2008

Awesome Explanation of the Economic Crisis

I didn't realize this, but every year Harvard's Kennedy School invites new members of congress for a three-day "briefing" by Harvard profs on various topics. This year, Jeff Frankel came up with a graphic explanation of the current economic crisis. Here it is:

Now that's what I call an information-rich slide.

Thursday 18 December 2008

Want To See Your Favorite Hedge Fund's Holdings?

You can't see all their holdings. But you can see quite a bit.

Section 13(f) of the Securities Exchange Act of 1934 requires all institutional fund managers with more than $100 million in assets to report their holdings each quarter to the SEC *(within 45 days of the end of the quarter). The hard copies of these filings go back 30 years, but they've been available for free online through the SEC's EDGAR database since 1999. The form name is (not surprisingly) "13F" or "13F-HR". Like many academics, I've used the electronic database of 13F filings put out by Thomson Financial (which has information back to the early 80s on electronic media, runs 5-10 gigabytes, and requires you to have some programming chops to access) in my research. But you can access a fund's data one filing at a time through the Edgar site.

It won't show things like derivatives holdings (at least usually not) or short sales. But if will give you an interesting look at the holding of the big boys. However, you might be looking at a portfolio as much as 45 days old. So, it's best for funds with a long-term (usually value-oriented) approach. As one example, here's the latest filing from Seth Klarman's Baupost Group.

And in case you're interested, here's one for Bernard L. Madoff Investment Securities LLC (I hear the founder has been in the news lately).

HT: World Beta who uses this information in an investment screening tool.

Wednesday 17 December 2008

When Worlds Collide: Spitzer Lost Money With Madoff

From Clusterstock.com: Elliott Spitzer Lost Money With Madoff:
Add the name Eliot Spitzer to the list of prominent people allegedly ripped off by Wall Street trader Bernard L. Madoff. Yesterday at Slate's holiday party Spitzer, who is writing a column for the online publication, confirmed that his family's firm had investments with a Madoff subsidiary.
I love it when two stories intersect (however loosely). It sounds like the Seinfeld episode "The Pool Guy"when George's girlfriend Susan starts being friends with Elaine.

HT: FinanceProfessor.com

The 12 Days of Global Warming

Whether you believe in global warming or not, this is pretty funny. At least I thought so. And besides--anything that makes fun of Al Gore is always worth a look just on general principles.


Note: If you want to receive updates, either sign up for email on the right sidebar, or add our RSS feed to your feed reader.

Tuesday 16 December 2008

It's All Done But The Grading (And The Bargaining)

I gave my last exam (to my MBA class) last night. I thought it was a pretty easy one, but as usual, there were three students (out of twenty eight) still working at the end of three hours' time. I've come to the realization that I could give four hours (or even five) for an exam, and there would STILL be a few people working to the bitter end. A few observations from the exam (none of them surprising):
  • My favorite student got the Terry Pratchett/Discworld references sprinkled on the exam, and one of my others caught a couple of 1980s movie references.
  • In between walking up and down the aisles, I wrote about a hundred lines of SAS code
  • One of my students already has sent an email asking if we can meet "to discuss his grade." Anyone want to guess how that'll play out?
Now all I have to do is grade them, set grades for the semester, and wait for the inevitable emails arguing for higher grades.

Oh wait - I already got one of those...

Monday 15 December 2008

Winner's (and Loser's) Curse with Swoopo.com

Winner's curse is the well-known phenomenon where the winner of an auction is often just the person who's most likely to have overpaid for the item in question. So, often the winner is the loser.

Then I heard about Swoopo.com. It's been called "pure distilled evil in a business plan". Here's their setup:
  • Bidding for an item starts at $0.15
  • Each bid raises the price by $0.15
  • Bids cost $0.75 to make.
  • Here's the kicker - a bid in the final seconds extends the auction for 15 seconds. So, auctions can go on and on.
Of course, they post the "savings" you would receive if you bought the item at the current price as a prod for people to continue betting.

They also hold "penny auctions" on their front page - a bid only increments the price by a penny. I recently saw a TomTom GPS sold for about $12. That means 1200 bids at $0.75 per bid, for revenue of $900, on something that costs them between $300 and $500. Not too shabby.

This is a behavioral economist's dream - it has bidders focusing on sunk costs (I have to make back my bids, and if I win, I get the savings), hubris, and endowment effects (the bidders start viewing the item as "theirs", and therefore value it more highly). And if I thought about it a bit, I could probably come up with other behavioral biases.

It has some similarities to a "dollar auction". In this setting, individuals bid on a dollar. But the catch is that the second highest bidder must also pay their bid, but without getting the dollar in exchange. So, the second place bidder continues to escalate to cut their losses. In Swoopo's setup, the 2nd place bidder isn't obligate to pay, but once they're in the game, they continue bidding to recoup their already-paid bids (that is, if they can get the item at a discount).

It's not a scam per se, because everything is disclosed up front - the rules are clearly stated. But the only advice I can give you about using Swoopo comes from War Games (the 1983 movie starring a very young Matthew Broderick):



UPDATE: Here's a perfect example of how the irrational bidding that can take place - a person "won" an auction for a Sharp 42 inch LCD TV. According to the website, it was "worth up to" $1,199. The "winning" bidder paid $3,360. Assuming that this was a "normal" auction with bid increments of $0.15, this means that Swoopo received total bids of (3,360/0.15) x $0.75 = $16,800 in total bids (including $1,512 from the "winner" alone), in addition to the winning bid of $3,360, for a total of $20,160 -- all for an item worth at most $1200.

UPDATE2: as pointed out by a reader, the auction above was a "fixed price" one where the "winner" got to purchase the item for $119. So, the buyer could have potentially gotten it for a very nice proice. However, they ended up spending over $1500 in bids, plus the $119 winning price, all for a TV that was worth at most $1200. So, the winner endend up overpaying by at least $400, and Swoopo made total revenue of almost $17,000 for the cost of a $1200 TV.

One part of me wishes I'd thought of this - in about a couple of days time I'd have made back all the money my retirement accounts lost this past year. But I'd feel a little bad getting that money from stupid people. Not to say I wouldn;t do it, but I'd feel a little bad.

Some Links On Distressed Debt Investing

One of my students is interviewing soon for an internship in an investment bank's fixed income department, and another is going to be starting soon in a credit analyst position, So, these pieces on distressed debt investing were pretty timely.

Michelle Harner over at the Conglomerate posted a very nice piece with some links about distressed debt investing. She highlights the difference between "vulture investing" and "investing for control" (basically traders vs. longer-term investors). She gives a couple of pretty good references. One, from Knowledge@QWharton lays out the basics of "distressed for control" investing:
Simply put, their line of work is to make a profit from companies that have failed to do so and are on the brink of bankruptcy. Unlike traditional hedge funds, however, their investment doesn't stop at buying significant portions of these companies' debt for pennies on the dollar, tidying up the balance sheet and then selling at a higher price. Instead, KPS and Matlin Patterson get in and stay in -- bringing in new managers, installing a new strategy, renegotiating labor and supplier contracts, and so on. (That's the 'control' part.) It's not an easy task, especially given the state of these companies when they step in.
Read the whole thing here.

She also cites some of her own research: a survey titled "Trends In Distressed Debt Investing: An Empirical Study of Investors' Objectives" (available on SSRN here).

Finally, Marketwatch gives us a look into the world of "vulture investors." It's a bit dated (April), but it shows how busy the world of distressed debt has become. One of the guys at my church's men's group is an analyst at a local distressed-debt hedge fund. He said he hasn't had this many good choices to buy since he can remember (luckily his firm is sitting on some cash).

I'm teaching the Level 1 Fixed Income material for CFA this spring, and will be teaching Unknown University's Fixed Income class in the fall. So, I'll probably be posting more on the credit market topics as time goes on (I tend to use this blog as a handy place to keep class-related stuff I want to remember).

Sunday 14 December 2008

It's Final Exam Time

I give my last final exam of the semester tomorrow to my MBAs. Just for the heck of it, I named all the companies and individuals in the problems after characters from Terry Pratchett's Discworld novels. I wonder if anyone in the class will notice?

If they do, I'll probably give them extra credit.

Bill Miller: The Stock Picker's Defeat

From 1991 to 2005, Bill Miller (superstar mutual fund manager for Legg Mason's Value Trust) beat the S&P every year - a record no other manager has ever come close to matching. Then, this last year the bottom fell out and his fund lost 58% (about 20% more than the typical fund.

The Wall Street Journal has a great interview of Miller, and here's the best line:
This meltdown has provided a lesson for Mr. Miller and other "value" investors: A stock may look tantalizingly cheap, but sometimes that's for good reason.
It's a very good piece for discussing in class, since it touches on a lot of issues related to market efficiency. Read the whole thing here.

Saturday 13 December 2008

Tuesday 9 December 2008

The Long-Run and International Evidence on the Value Premium

The term "Value Premium" refers to the empirical observation that firms with low price multiples (i.e Price/Book, Price/Earnings, Price/Cash Flow) have tended to have higher returns than their high-multiple counterparts - even after controlling for risk. People give a lot of possible reasons for this - we have a bad model for controlling for risk, there are behavioral biases, or it's simply a case of data diving.

I just came across a paper by a group known as the Brandeis Institute titled "Value vs. Glamour: A Global Phenomenon" that seems to rule out the data diving story. They examine the evidence for the value premium both across time (the mid 1960's to the present) and internationally. They found that
While the degree of outperformance of value stocks vs. glamour stocks varied across data sets, what strikes us as most significant was the consistency the value premium exhibited:
  • across valuation metrics, such as price-to-book, price-to-cash flow, price-to-earnings,and sales growth
  • across time, which in this study applies to the 1968-2008 period for U.S. stocks,and the 1980-2008 period for non-U.S. stocks
  • across regions, as the results indicated a value premium in developed markets in North America, Europe, and Asia
  • across market capitalizations, as the relative outperformance of value stocks to glamour stocks was evident among both large- and small-cap stock universes.
The paper has a lot of nice graphs that could be useful in class. You can read the whole thing here.

HT: CXO Advisory Group

Friday 5 December 2008

The Final Throes of the Semester

It's that time of the semester:
  • Only one meeting left for each of my classes.
  • My student-managed fund survive their end-of semester presentation to the advisory board
  • I've graded and handed back all assignments except for final exams
  • I've even given out and collected my evaluations
Now all I have to do is make up my finals, give them, and grade them.

The crop is almost in. And man, oh man is it about time.

One of the things I like about this career is that it has a rhythm to it - we have new "crops" each semester, and a feeling of accomplishment once the semester is done. But that final week or two is always a bit crazy.

So, to all my readers: If you're a student, good luck on your exams and projects. If you're faculty, hang in there - it's almost time for the break.

Wednesday 3 December 2008

New Blog on Markets

Al Roth (the George Gund Professor of Economics at Harvard) is extremely well known in the fields of game theory and market design. For just a few examples, he's published highly cited work on the market for donor organs, matching medical students with residencies, and matching public school children with schools. He also

Now he has a blog, titled (appropriately enough) Market Design. It's definitely worth a look-see.

HT: Marginal Revolution

Monday 1 December 2008

Credit Default Swaps and Arctic Expeditions

This weekend I posted a video of a "whiteboard" talk by Paddy Hirsch of Marketplace, in which he explains CDOs and the credit crisis. Here's another one where he explains Credit Default Swaps (CDS) using the analogy of an arctic expedition.

Since I'm teaching Fixed Income next year, I'm sure some of these will make their way into my class.

Sunday 30 November 2008

We've Had Some Budget Cuts

Yes, like most state schools, Unknown University had had some budget cuts - about 10% so far from the original budget. So these three strips by Scott Adams were pretty funny. A bit close to home, but funny.



Saturday 29 November 2008

One of The Best Explanations of the Credit Crisis I've Ever Seen

Every once in a while you come across an explanation that makes you realize that just really aren't all that good a teacher. Here's another one to add to the pile. In this video, Marketplace Senior Editor Paddy Hirsch gives one of the best explanations of CDOs and how they contributed to the current credit market woes that I've yet seen:


He's also got some other videos up on YouTube that I'll post in the next couple of weeks.



Thursday 27 November 2008

Happy Thanksgiving

Here's wishing a Happy Thanksgiving to you and yours from the Unknown Family. We've got a great, great many things to be thankful for - job, family, health, living situation, etc...). For now, we're off to the Unknown Sister-in-Law's house to engage in some extreme eating - three sisters in the family, and all (and Grandma, too) are great cooks.

Now go overdose on Tryptophan.

Wednesday 26 November 2008

(Bad) Governance at The University

For good corporate governance, it's important that the independent directors on the board are really independent. In particular, they shouldn't have business relationships with the company other their board service. If they did, it would make it hard for them to rein in the CEO, for fear that they'd lose the business.

There's been tons of work on this topic both in the academic and practitioner literatures. But I haven't seen much on similar relationships for universities. I'm sure that a lot's been done- I just haven't seen it.

Until now.

There's a good illustration in the Boston Globe of directors at Suffolk University (actually, trustees, which serve a similar role for a university) with significant business ties to the school. It turns out they just awarded the University president a 2.8 million dollar pay package. Of course, there were "good reasons" for doing so. Here's the lede from the story:

Boston lobbyist Robert Crowe was key among the Suffolk University trustees who made David J. Sargent the highest paid university president in the nation in 2006, with a $2.8 million compensation package. Less than a year later, Sargent renewed a $10,000-a-month contract with Crowe's lobbying firm to represent Suffolk's interests in Washington.

This month, as controversy flares over Sargent's pay, the job of publicly defending it falls on George Regan, himself a new appointee to the Suffolk Board of Trustees as well as the beneficiary of a $366,000 annual contract with the university.

Read the whole thing here.

Is this necessarily a bad thing? Not really - it could be perfectly innocent, and it's not surprising that trustees of a university might have significant business ties to the university. After all, they tend to be prominent alumni with a long history with the school. But, when you have those ties, a pay package like that is going to get far greater scrutiny than it would otherwise. Or as Ricky Ricardo would have said, "they got some 'splainin to do".

As an aside, if you want to see some excellent examples of affiliated directors in the corporate world (along with other examples of bad governance), there's no better place to go than Michelle Lederer's Footnoted.org. She's made a career out of scouring through company documents to find some truly outrageous examples of corporate mis-governance.

I think the president of Unknown University considered having some trustees with business ties to the school, but we didn't have enough money to pay the required graft.

Monday 24 November 2008

All The Monty Python You Could Ever Want

At this point in the semester, we're all tired, frustrated, and looking towards the end of the term. So things that make us laugh become even more important. Luckily, there's now a Monty Python YouTube Channel. Here's the announcement from the MP boys themselves:
For 3 years you YouTubers have been ripping us off, taking tens of thousands of our videos and putting them on YouTube. Now the tables are turned. It's time for us to take matters into our own hands.

We know who you are, we know where you live and we could come after you in ways too horrible to tell. But being the extraordinarily nice chaps we are, we've figured a better way to get our own back: We've launched our own Monty Python channel on YouTube.

No more of those crap quality videos you've been posting. We're giving you the real thing - HQ videos delivered straight from our vault.

What's more, we're taking our most viewed clips and uploading brand new HQ versions. And what's even more, we're letting you see absolutely everything for free. So there!

But we want something in return.

None of your driveling, mindless comments. Instead, we want you to click on the links, buy our movies & TV shows and soften our pain and disgust at being ripped off all these years.

Website: http://pythonline.com
For the lawyers, here's the disclaimer:
Warning- clicking on the link can result in hours of time wasted, a skewed perspective on life, and adoption of British accents.
Now go and enjoy.

HT: Barry Ritholtz.

Friday 21 November 2008

The NYU Finance Department Has a Blog!

NYU has one of the largest and best finance faculties around (most surveys place them squarely in the top 5 programs in terms of research output). It turns out that they now have a blog: Stern Finance.

It looks pretty promising. Although it's less than 2 months old (the first post was made on September 26), it already has a lot of high-quality content, with participation from a pretty large nuimnber of the faculty. Just this last month, it has posts by Viral Acharya, Marti Subramanyam, Edward Altman, and Joel Hasbrouk among others).

It's definitely one to add to your feed reader.

Tuesday 18 November 2008

Mark Cuban Charged With Insider Trading By SEC

Mark Cuban, HDnet founder and owner of the Dallas Mavericks was just charged with insider trading by the SEC. The commission alleges that Cuban received a call from tje Mamma.com CEO about a pending PIPE offering of Mamma's stock. The call was supposedly prefaced by a disclaimer from the CEO that the information was confidential. The SEC complaint alleges that Cuban then used this insider information to sell all his Mamma.com shares in after-hours trading, thereby avoiding a loss of about $750,000. In case you're interested, here's a link to the complaint.

It should make for an interesting case. Cuban has the resources to fight this thing pretty much as far as he wants (even potentially all the way to the Supreme Court), and is definitely stubborn enough to do exactly that. He's already posted a response to the complaint on his blog:
Mr. Cuban stated, “I am disappointed that the Commission chose to bring this case based upon its Enforcement staff’s win-at-any-cost ambitions. The staff’s process was result-oriented, facts be damned. The government’s claims are false and they will be proven to be so.”
Not surprisingly, Stephen Bainbridge has a very thorough legal analysis of the issue. After all, it's in his wheelhouse.

In the meanwhile, I have SAS programs to run and papers to write.

Thursday 13 November 2008

Weird Happenings on My Feeds

In the last few days, I've noticed big fluctuations in my feed readership along with a lot of strange things on Bloglines: all of a sudden, 200 new posts are listed for one blog or another. Is this happening to everyone, or just to me because of the last few political cartoons I posted?

Wednesday 12 November 2008

A Churchill Quote Relevent to the Current Economic Crisis

Compliments of Newmark's Door
In fact, my favorite Churchill story is the one about the time that Churchill was standing at the urinal in the men's room of the House of Commons. Atlee came into the room and stood at the urinal next to Winston's. Churchill looked up at him, zipped up, moved a couple of urinals farther down and resumed his business. "Why Winston, I had no idea you were so modest.", said Atlee. "It's not modesty, Prime Minister. It's only that every time you find something that is large and functions well, you try to nationalize it, and I thought it best not to take a chance!".
What will they nationalize next?

The Financial Crisis From A To Z

Tunku Varadarajan at Forbes has a pretty clever piece titled "The Financial Crisis From A-Z". Here are a few of the items that tickled my fancy:
C is for Credit Default Swaps, defined for me by a Wall Street watcher as: Risk whatever you want, and we insure it; risk too much, taxpayers insure it.

L is for leverage (a means of maximizing your losses), liar loans, Lehman (pronounced "lemon")--and the losses/liabilities that unite them all.

M is for where it all started: the mortgage (which, aptly, means death-pledge). Like the dog, it comes in a variety of breeds, "sub-prime" being a cross between a pit bull and a chihuahua.

Q is for quants, who forgot that, every so often, past performance is no indicator of anything at all.

S is for securitization, the process by which one passes off cat food as caviar.
The other 21 letters are pretty good too. Read the whole thing here.

HT: The Big Picture.

Monday 10 November 2008

New Blog

As a new blogger, Financial Rounds benefitted from a number of higher-profile bloggers mentioning it. So, I think it's important to pay the favor forward and highlight new blogs of note.

The latest new one is a put out by The Applied Portfolio Management Program at Washburn University.

Unlike other academic blogs, this one is unique in that material is contributed both by faculty and by students in the program.

Go check it out, and add them to your feed reader - it's been added to the blogroll. And if you come across any other ones, drop me a line.

Friday 7 November 2008

Professor Time vs. Grad Student Time


That reminds me - I have to check up on my grad assistant to see how he's doing on the assignment I gave him at the beginning of the semester.

Great Source For Financial Information

The student-managed investment fund class I teach is fortunate to be in a trading room with a lot of resources - because of a prominent alumni, we have access to everything from analyst reports to trade and quote data. But for those who don't have these resources, check out Tickerpedia - it has analyst forecasts, recommendations, SEC filings, a neat chart of ratios from various sources, and much more.

It's interesting how much the reported ratios change by data source. As one example, for GATX corp, the reported operating margin (trailing 12 months) ranged from 18.92% (reported on Reuters) to 46.7% (on Marketwatch).

HT: Jim Mahar at Finance Professor

Thursday 6 November 2008

Post Election Analysis From South Park

Compliments of South Park. Hey - I suspected it was an insidious plot of some kind all along.

Caution - may not be safe for work, unless you can close your office door and turn the audio WAY down.

Wednesday 5 November 2008

A Joke For The Science Nerds

Apropos of nothing:

Heisenberg gets pulled over by the cops for speeding. Cop walks up to his care and asks,"sir, do you have any idea how fast you were going?"

Heisenberg replies, "no, but I know exactly where I am."
Don't ask me why - I just thought it was funny.

Update: if you haven't managed to get your geek on, click here (hey - a couple of people asked, and I'm nothing if not accommodating).

Can I Bwing My Mommy? Puh-Weeze?

A new student (I'll call him SnowFlake from now on) walked into my office last week asking for advice on classes. He'd transferred to Unknown University from a private school (which, by the way, has a reputation for drastically inflating grades). He needed some advice on which classes to take, and since I'm listed as his advisor, I seemed like the right person to check with. But he also wanted some advice on how to study since he's flunking intermediate accounting, and "that's never happened in any of my classes before".

SnowFlake starts out by blaming the instructor (who, by the way, is one of the best in the college). After some questions and comments on my part like "Gee, that doesn't sound like Professor X at all. Are you sure?", it turns out that he hadn't been keeping up with the work, and hadn't worked more than a problem or two from the end of chapter material. Instead, he tried to cram for the first exam, and did poorly. Since that strategy worked out so well on the first exam, he decided to try it once more on the second exam for good measure. Lo and behold, the same approach yielded the same result (funny how that happens).

So, I gave Snowflake some standard advice on how to study, and then he asked if he could set up a time early this week to set up his classes for the next semester. We set a time (Monday morning at 10), and then came the kicker:

He asked if it was alright if his MOTHER came to the appointment.

I managed to keep my jaw off the floor, since he was a second-semester junior, and if you have hover-moms, they usually get cured of it by sophomore year (and they're almost non-existent in Business schools). But since I couldn't think of anything else to say (other than "You'll be all right once they drop", which didn't seem prudent at this juncture). I said, "Well, Precious, that's entirely up to you".

Monday morning comes around, and I'm running late for our 10:00 a.m. appointment. So, I have the secretary leave a note on my door saying I'd be a few minutes late, and hurry in to the office with visions of MomZilla running loose in the hallway and going on a rampage in the Dean's office.

I get there five minutes late, and there's no sign of either Snowflake or MomZilla. I hang out in my office for a few hours just in case, and it seems like a larger-than-usual number of faculty seem to filter by my office (they keep me off the beaten path, which is probably a good thing). I guess after hearing about Mom coming in, they just couldn't resist sneaking a peek.

In any event, I get a call late that morning from SnowFlake informing me that he had to be in traffic court that morning, had completely forgotten, and wanted to reschedule.

I guess I should have had his Mom remind him.

Tuesday 4 November 2008

We Voted

The Unknown Family just went to the polls and voted. Unknown Son went into the booth with me, and Unknown Daughter went in with the Unknown Wife. We let our kids fill out the ballots (they were paper ones), and then feed them into the machine.

It's pretty cool explaining how our political system works to an 8 year old and a ten year old. This year, I think I'll start working through the Declaration of Independence, the Constitution, and the Bill of Rights with them - it's never too early, and most people (myself included) don't know enough about these foundations of our country.

Sunday 2 November 2008

Submerging Market Update

note: This post was begun some time ago and the date-time stamp reflects the initial draft. The bulk of the data has been added since then.


China: The Collapse Begins
Chinese exports are collapsing and industrial activity with it.
Recent reports suggest that they are experiencing mass factory shutdowns with owners and manager absconding. According to the BBC, migrant workers from rural areas are returning to their homes in the countryside en masse. Those watching the media would think that an shocking collapse came out of nowhere in the last few weeks. Readers of Financial Jenga have known that this was not just possible but virtually inevitable for many months.

China could spend some of their dollars but they need to keep at least $1 trillion so the Yuan doesn't completely crash and burn. The interesting problem is the currency mismatch and "sterilization" issues. China's money supply growth is going to fall quickly as there will be fewer incoming dollars against which to issue new Yuan. Yes they will also be exporting fewer dollars to pay for raw materials but that doesn't matter to the unemployed citizens.

The mismatch issue is more critical. Everybody likes to talk about China's currency reserves. The problem is they've already been used up. Yes, they still have the dollars at the central bank but they've already issued Yuan against them as part of their "sterilization" operations. I.e. they cannot use the reserves to "stimulate" the domestic economy. They can SPEND them abroad, which will enable China to consume but will add production elsewhere, doing nothing for the production side of the Chinese economy. The mismatch problem is that they need more Yuan but what they have are Dollars. Much of the existing base of Yuan supply only exists because of the Dollar reserves. If they spend down the reserves, they either have to reduce their domestic money supply or simply print more money to make up the difference.

People like to point to China's dollar reserves but they've already had as much stimulative impact on China's economy as they ever will. Note that the Yuan is NOT a convertible currency. There is no large pool of Yuan outside of China that could be exchanged for dollars and spent in the domestic economy. Nor can they be lent out with the understanding that the loan be spent on Chinese goods (vendor financing). They have already done that indirectly by purchasing Treasury and Agency debt. Those looking for such an impact don't understand the structure of China's financial system.


Latin Cognates
Despite a vicious snapback, the trend is quite clearly down. Likely driven in part by the Fed's dollar swaps, these markets found support last week but it looks like a dead cat bounce. During that week a rally in their sovereign bonds of 200 basis points +/- 10 bp, left Mexico and Brazil debt trading 8.55% and 7.58% respectively. What this tell us is that the threat of immediate default has been averted by Fed imprudence but no one is willing to lend at anything less than a huge multiple of the 100 bp spreads we saw only a year and a half ago.

Latin economies are heavily dependent on natural resource extration. Thus they have had and continue to have a symbiotic relationship with the resource-eating black hole known as China. With consumption slowing worldwide and the initial feedback effects on the exporting countries, we are starting to see resource demand falling but the excess capacity created is collapsing commodity prices. The storm of demand destruction is roaring up the supply chain and spawning tornados that tear through individual sectors. The latest example comes from Brazil, where giant mining conglomerate Vale do Rio Doce is desperately cutting spending. The
big news is the cancellation of 12 giant ore carriers - which would have been built in new Chinese shipyards. At the same time, they are cutting ore production as demand falls.

An intersting question is how much demand for their own ore Vale just destroyed by cancelling the ship order. This is a vicious circle as the feedback loop in the symbiotic relationship turns negative. Rising expectations and optimism feed off themselves - until they don't anymore. Then ugliness always ensues. In this case the fall will be long and ugly - like that of Icarus, who flew too close to the sun. We have dubbed it the Universal Debt bubble as virtually every country and every industry was caught up in it. Countries like Brazil and China were some of the biggest beneficiaries of the UDB, yet those who advocated the Decoupling Theory essentially argued that the biggest beneficiaries of a trend would be hurt little if at all when it ended. The silliness of THAT position is now manifest for all to see.

Containment Breach
We've heard many times how the crisis would be "contained" to a specific industry or geographic region. The authorities making these countless claims were either lying, incompetent or both. We see now that it is and was global and across the board - thus UDB is very accurate. While we expect exporters and raw materials producers to suffer worse than most, the damage goes on elsewhere. German factory orders fell 8%. US durable goods spending fell 14.1% in the
3Q GDP report. Japanese auto sales have hit levels not seen since the 1970s, while US sales are Back to the Future of the 1980s. This is global and ugly friends. Please protect yourselves.

Saturday 1 November 2008

Some Key Questions

The most important question facing us today, both in the US and around the world is just how much of our supposed wealth is real and how much was part of the illusion generated by bubble-mania and the UDB. Most of the actions of various governments and CBs seem aimed at preventing us from answering this question accurately. In The Limits of Optimism we outlined the various elements of the capital structure and it should be immediately apparent why the stock market is the chosen instrument for conjuring chimeras. By coercing a larger and larger percentage of accumulated capital into stocks, Wall Street ensured a large pool of buyers to continue pushing prices higher in complete defiance of fundamentals. By allowing so much of our wealth accumulation to be attached to something so insubstantial, we have collectively ensured the destruction of much of that wealth. Something that falls as soon as anyone wants to sell isn't much of an investment.

Now we see some of the real world impacts of aggressively tying ourselves to the stock market. Once again, the secondary feedback effects may be greater than the primary impact. According to the
WSJ:

At the end of 2007, companies in the S&P 500 had a combined pension-plan surplus of about $60 billion, The market selloff in the nine months to late September turned that into a combined deficit of about $75 billion...



Of course that was before October even started and we all know that things didn't go so well during that month either. Double digit declines were the rule for the month - pretty much across the board. The pension obligation and attempt to meet it by speculating in the stock market are yet another example of companies tying their fortunes directly to stock market whims rather than fundamental performance. It worked well for a while - allowing them to report higher profits than justified by actual results as speculative profits allowed them to pay less into the pension funds than a sensible and stable plan would have required. The reverse is now occurring and it's going to be nasty. This is yet ANOTHER headwind for corporate profits as they are forced to pay cash in to make up for speculative losses.

The lesson that should be learned here is "don't gamble with retirement money" but I fear few will choose to learn it until all other avenues have been exhausted. People can usually be counted on to do the right thing after all else fails.


Confirmed Reservations

Occasionally, I will encounter a supercilious restaurant host who will haughtily ask if we have reservations. When the right mood strikes the answer will sometimes be "yes, but we're planning on eating here anyway." In much the same vein, our prior reservations about the export economies and China in particular have been confirmed with a vengeance recently. Reuters reports that China's PMI hit 44.6 in October - indicating clear and serious contraction in factory output. This now makes three of the last four months down. In addition, recent BBC reports suggest that half of the toy factories in China have shut down since the start of the year.

Keep in mind that we expect a crash and burn in China's economy even if exports stagnate, much less roll over. Government action can partially ameliorate this but only to a small extent. We laid out the full case four months ago in China Syndrome. All of the elements preliminary requirements have now been met for this scenario to play out. The US is desperately trying to prevent a meltdown across the submerging markets with swap lines to exchange valuable dollars for garbage currencies like the Mexican Peso and the Brazilian Real. The temporary availability of dollars in those imploding economies has relieved the pressure from capital flight for the moment and perhaps even caused a small short squeeze for those who were looking for reality to catch up to those nations' financial system. But the banking systems overseas cannot sustain their credit expansion in the face of falling external demand and especially the collapse of primary commodity prices on which their economies rely heavily.

Friday 31 October 2008

Happy Halloween

I usually don't post political stuff (because of the moonbat factor). But I just got this from a former student and it tickled me, so what the heck.

Tuesday 28 October 2008

Godspeed, Dean Barnett

I've always enjoyed Dan Barnett's writing and commentary, whether at SoxBlog, the Weekly Standard, or guesting on Hugh Hewitt's radio show. I just heard that he passed away after a long fight against Cystic Fibrosis. He was clearly one of the good guys. To get a small sense of the man, read this excerpt from his pamphlet "The Plucky Smart Kid With The Fatal Disease: A Life With Cystic Fibrosis"
As I grew sicker, I had what for me was an extremely comforting insight. I came to view serious and progressive illness as an ever constricting circle with oneself at the center. The interior of the circle represents the contents of one’s life. As the circle gets smaller, things that were inside get forced out. Some of these things are dearly missed; others that were once thought precious get forced to the exterior and turn out to go surprisingly unlamented.
t the innermost point of the circle are the things that really matter: family, faith, love. These things stay with you until the day you die. At the very end, because the circle has shrunk down to its center, they’re all you have left. But as we approach that end, we finally realize that all along, they were what mattered most. As a consequence, life often remains beautiful and worthwhile right up until the end.
A quick reminder: we're all born with a fatal ailment - it's called life, and no one gets out alive at the end. So without getting overly schmaltzy or preachy, we'd all do well to spend more time on that "inner circle" than Barnett wrote about.

To see a list of tributes to the man at the Weekly Standard, click here.

The Seven Deadly Sins of the Meltdown

Another thing for my "class" folder:

HT: The Big Picture

Monday 27 October 2008

Finance and Economic Courses on the Web on The Web

Increasingly, people are putting their lectures, teaching material, and (in some cases), entire courses on the web. Here are a few I've recently come across:

A Short Course In Behavioral Economics: Daniel Kahneman (yes, the Nobel Laureate) has recorded and posted videos of a two day conference called "Thinking about Thinking".

Robert Schiller's Spring 2008 Financial Markets Class at Yale
: Schiller has done a great deal of work in market efficiency, and also created the Case-Schiller Index of Home Prices.

While surfing through Yale's Open Classes, I also found a class titled Game Theory, by Ben Polak, a widely published economist. He seems to cover all the big topics: Nash (and other) Equilibrium concepts, Adverse Selection, Signalling, and even Evolutionary Game Theory.

If you know of other finance/econ classes on the web, let me know in the comments section and I'll post them here.

Sunday 26 October 2008

A Little Credit

That really is all that is available in the debt markets today and the consequences are obvious. At the same time, we'd like to claim a little credit for calling the direction and - to some extent the magnitude of this crisis. We felt that these (then pending) consequences were obvious 18-24 months ago. In fact, one of the first posts on this blog in August 2007 noted:

Today's actions by the European Central Bank and the Federal Reserve confirm that the real threat is DEFLATION - not inflation. Central Banks don't pump $150 billion dollars into the banking system because they are afraid of creating too much money.

Again this June:

That is where we are now. The Fed has failed. The Great Oz has been exposed a just a man behind the curtain. Prepare for severe credit deflation and falling asset prices in markets that traditionally use leverage to purchase or hold positions.

For years massive credit inflation raged unchecked and asset prices soared as the pool of buying power increased far faster than the assets available to absorb it. As the debt machine began to break down and collapse under its own weight, credit creation proved insufficient to continue propping up all asset prices. At this point the Universal Debt Bubble (UDB) began to falter selectively. First housing, then junk bonds, asset-backed securities, commercial real estate, equities, corporate bonds and sovereign debt all fell off the wagon in turn. By early 2008, the one asset class that had not yet been hammered was commodities - though in reality, that was also a fragmented market with the highest profile stuff still going up while nearly everything else was down.

Selected commodities proved to be the final bastion of credit-driven asset inflation - leading many analysts to mistakenly call for inflation when the exact opposite was looming. Credit creation has now fallen to such a low level that asset inflation is now dead virtually everywhere. Grains, metals and oil were the last holdouts of the UDB and they are now being hammered into the ground. The WSJ provides us with evidence and a salutary example of how demand destruction works in Metals Meltdown Burns Scrap Dealers:

Now demand and price are in a freefall. Does the Miami businessman sell his now high-priced inventory at basement prices, or wait for the market to recover?

...

But in the last six weeks, scrap steel prices have fallen nearly 60% to about $400 a ton. Prices for aluminum scrap has dropped 33%, copper 25% and nickel about 15%. Peter Marcus, metals analyst for World Steel Dynamics, says, "We aren't near the bottom yet."

For a while, the trend in price seemed to be in favor of commodity inflation. The reality was that the huge amount of "money" (really credit) created during the UDB has been running around looking for someplace, anyplace to hide and commodities were the last asset bubble it ran towards. But the economic function of bubbles is draw in such phantom "capital" and destroy it as if it had never been. The trend-followers and and performance chasers will never understand this as they are always late by definition. One has to take a systems analysis approach to understand how pulling a lever over here can impact things that have no obvious connection to the original stimulus.

The last bubble is over. Oil has collapsed from nearly $150 to less than half that. Grains are down 60% or more. Industrial metals are in worse shape than that. Deflation is now the order of the day. Governments will try to stop it but will fail repeatedly. They do possess the power to stop it before deflation runs its full, natural course but the price will be self-destruction and national suicide via devaluation and hyper-inflation. In this case the cure is much, much worse than the disease.

Wednesday 22 October 2008

You Get What You Pay For: Designing Incentive Compensation Plans

While I'm not currently working in that area, I try to keep on on topics related to compensation design and effects. One of the ongoing themes of this literature is that a program designed to incent employees to do one thing often has unintended consequences. As an example, the Unknown Wife put me through grad school working for a cell phone company. At one point, she was a commission auditor - the job was important because salespeople often tried to make their quotas by miscoding things rather than by just selling more (I'm shocked! Shocked, I say!). So, they needed people like her to check everyone's sales.

There's a great piece on this topic by Joel Sposky in Inc magazine.. Here's a choice snippet:
I'm always on the lookout for these incentive schemes gone wrong. There's a great book on the subject by Harvard Business School professor Robert Austin -- Measuring and Managing Performance in Organizations. The book's central thesis is fairly simple: When you try to measure people's performance, you have to take into account how they are going to react. Inevitably, people will figure out how to get the number you want at the expense of what you are not measuring, including things you can't measure, such as morale and customer goodwill.

...His point is that incentive plans based on measuring performance always backfire. Not sometimes. Always. What you measure is inevitably a proxy for the outcome you want, and even though you may think that all you have to do is tweak the incentives to boost sales, you can't. It's not going to work. Because people have brains and are endlessly creative when it comes to improving their personal well-being at everyone else's expense.
He's got some great examples illustrating this point. Read the whole thing here.

HT: Craig Newmark

Monday 20 October 2008

Are Hedge Funds Good at Reading The Market>

The tentative answer seems to be "Yes".

According to a new study "Unbundling Hedge Fund Betas" by by Ulloa, Giamouridis, Mesomeris, and Noorizadesh there's evidence that hedge funds increase betas prior to market upswings. Here's the abstract:
This article is concerned with the systematic exposures of equity hedge fund managers. In particular we seek common equity hedge fund systematic exposures through rigorous model selection techniques. We study their time variance to examine if equity hedge fund style characteristics are stable through time. Most importantly, we explore the informational role of manager decisions to shift their exposures to certain styles. Our results suggest that equity fund managers are exposed to three dominant style strategies, namely the 'market', 'value' and 'momentum'. We also discover that there is a considerable degree of variability in the factor exposures over time for the various dominant sources of systematic risk/return. Finally, we show evidence that managers vary their exposures to the 'market' in time to exploit favourable market moves. A similar pattern is however not observed for their 'value' or 'momentum' exposures.
Read the whole thing (downloadable copy at SSRN) here.

HT: All About Alpha

Thursday 2 October 2008

CP to FRB ICU ASAP!

The commercial paper market certainly appears to be critically wounded. The seasonally-adjusted amount of CP has fallen dramatically since mid-September. Per the Federal Reserve the declines over the last three weeks:

September 17: -$52.1 billion
September 24: - $61.0 billion
October 1: -$94.9 billion

Headlines emphasizing funding cutoffs to companies in the real economy, like Caterpillar and A&T are highly misleading. Non-financial CP took a single hit of $18 billion ($217 billion to $199 billion) two weeks ago and has hardly budged since. The REAL story is the collapse of CP issued by banks and other financial companies. Domestic financial paper is down by $93 billion ($590 billion to $497 billion); foreign financial paper fell $40 billion ($225 billion to $185 billion, down 20%!); asset-backed paper is off $55 billion ($780 billion to $725 billion).

We have seen record withdrawals from money market recently, which has led to falling demand for commercial paper - which is usually purchased by these funds. In order to stem the flight from MM funds and hide the losses in asset-backed CP, the Fed recently extended their alphabet soup yet again. The "Asset-backed commercial paper money market mutual fund liquidity facility" or ABCPM3FLC for short was instituted just two weeks ago. It's gone from zero to $152 billion in just days - $22 billion average last week, to $122 billion average this week, to $152 billion by 10/2/08. All data are from the
Fed's H.4.1 release.

Panic Lending

Actions of this magnitude clearly indicate that a major crisis is unfolding behind the scenes. The freeze in interbank lending, the explosion of LIBOR loan rates, the collapse of financial commercial paper and counter-measures taken by CBs around the world indicate that the final act of the Universal Debt Bubble may be upon us. The UDB rested entirely on confidence - and badly misplaced confidence at that. It allowed credit to be extended to those who were manifestly NOT credit-worthy and the temporarily elevated economic activity created the illusion of prosperity.

All of that is going in reverse now and the politicos don't like it. Well, unfortunately this is all necessary to return to a stable economic structure after the bankers deliberately destabilized it. One of our first blog entries was Legions of the Damned - wherein we pointed out:

Over the last several weeks, there has been a collective recognition of the inherent riskiness of using illiquid, volatile and hard to value paper as collateral for lending. The lenders are requiring either much more (paper) or better (cash) collateral to secure the loans. The result is the global "Dash for Cash" that we've seen recently. Cash is King again and the scramble to come up with it resulted in huge spikes in overnight lending rates. The injection of $150 billion into the system was designed to bring the rates back down to the ECB and Fed targets of 5.25% and 4.0% respectively.

Had the CBs not acted, there would have been massive forced selling of the illiquid paper, demonstrating it to be nearly worthless. Now that would only formally recognize a situation that already exists in reality but as long as the banks can pretend that it's worth face value, they can continue to make loans and prop up consumption. This is a classic example of Gresham's Law - to oversimplify "Bad money drives out good money." When dodgy paper assets are treated nearly the same as cash, nobody is going to put up cash.

As we surmised well over a year ago, the repricing of risk is ongoing and the current crisis is simply the big brother of the one we experienced last summer. The clearest indication of risk recognition is the explosion of spreads. Once again, according to the Fed's Commercial Paper Report, yield differentials between high-quality (AA) and lower-quality (A2/P2) commercial paper have blown out enormously - from 80 basis points (0.80%) just a few weeks ago to over 400 bp today. Then there is the spread due to implied higher risk just for being a financial company. The spread on financial vs non-financial paper has widened from 30 bp to 160 bp in just weeks. A risk that Financial Jenga readers have known about for a long time is now confirmed by the market.

Globo-shock
Inability to borrow in the US money markets helps to explain the severe dollar starvation overseas. It is this problem that the Fed is trying to fix with the their massive dollar loans (mischaracterized as "swaps") to foreign CBs. Less than a week ago, the Fed announced a
$330 billion expansion of these loans.

The results of the dollar starvation are manifest across Europe. Huge institutions like Dexia, Fortis and Bradford & Bingley have been fully or partially nationalized within the last few days. It does not help that the leverage ratios of European commercial banks are typically much higher than their American counterparts. Not only are the commercial paper markets closing to such banks but elevated LIBOR rates cut those same banks off from cheap dollar loans from other banks. The squeeze to dress up balance sheets to make them look good for the quarter-end reports undoubtedly contributed to it but the fact that pressures have not abated much yesterday and today indicates that much more than a seasonal problem is at work here.

The "dash for cash" is on. Despite the Fed lending as fast as it can, commercial credit is being drained from risky financial institutions faster than the Fed and other CBs can pump it in. Having seen Wachovia, WaMu and a half-dozen European banks fail in the last week, we see no near-term end to the pressures or the bank failures.

Monday 29 September 2008

The Limits of Optimism

The absurd actions of our financial authorities continue to impress with the sheer hubris and vast scale of their proposals - with today's bailout attempt being the latest and greatest of many attempts. Some of the government's contortions would be impressive even for Cirque du Soleil were they not such a blatant effort to distort the market. Our nation and the world at large seem to be living out the economic equivalent of a Kafka novel today. Yet even here we see the boundaries of government interference and the limits of (unjustified) optimism. As advocates of the free market and rule of law, we have been constantly appalled. A nominally Republican administration continually interferes with market forces and changes investment rules in the middle of the game. How did we come to such a sad pass?

Like many children, yours truly had a favorite word for much of his childhood - "Why?" Eventually, I stopped bothering Mother but never stopped asking the question. It is particularly pertinent now. How did we put ourselves in a position where using tax money to subsidize Wall Street's losses could even be considered? Well, the stock market is now considered key to the retirement of many Americans.

Why?
Er, most Americans now have a substantial part of their pension or 401(k) invested in stocks.

Why?
Well, the higher average rate of return on stocks allows us to say that retirement is fully funded with less up-front investment. This is especially important for corporate and government pension plans. For individuals it allows hope of the big score and a cushy retirement.

Did the pension managers decide that was a good idea, themselves?
Umm, not really. Remember, stocks are not bought - they are sold. Some smart salesmen on Wall Street started to push this in the late 1980s, just as the last people who lived through the Great Depression were retiring.


But what about the higher risk?
The salesmen could point to the superior long-term returns from equity, while glossing over the risk and the folks who remembered the risk in very visceral ways were gone. Even so, many pension managers objected but were overruled by their bosses who wanted to lay out less money for pensions so they could spend it elsewhere (government) or report higher earnings (corporate).

What about 401(k) plans?
The long bull market convinced many individuals that there was little risk in stocks. They certainly had produced high returns. Many people hitched their wagon the Wall Street.

Perpetual Motion Machine
With so much money from average Americans pouring in, stocks could hardly do anything else but rise. Eventually it became a self-fulfilling prophecy as money chased performance, while pushing the price up in turn. That reached its peak with the Tech Bubble, when completely worthless companies were valued in the billions. When that broke down, the Fed stepped in and created a new bubble - actually several bubbles, led by housing. The same self-reinforcing dynamic - as old as markets themselves played out again.

With so much money from the masses committed to the stock and housing markets, there is considerable support for ANY measure to bail out these markets and prop up asset prices. This is the end result of individuals and pension funds refusing to settle for the smaller but steady gains from lower-risk investments. Keep in mind that not long ago, most pension and endowment type funds invested almost exclusively in bonds. For the economic importance of this, let's examine the characteristics of each class of capital:

- Senior Debt (bonds or bank loans):
first in line for assets and cash
must be paid or the creditor can liquidate the borrower
reliant on total company cash reserves

- Junior Debt:
next in line but otherwise similar to Senior Debt

- Preferred Stock:
3rd in line for assets and cash
dividend can be suspended as stockholders CANNOT force liquidation
reliant on company cash flow

- Common Stock:
last in line for assets and cash
dividend has the least protection of any security
reliant on company profits
potential for speculative gains

Slouching towards Insolvency
Over time, asset allocations at all levels have become riskier, including pension funds. From an economic standpoint, investment results became more reliant on marginal financial activities. For example, bonds are tied to current and future corporate cash (reserves + cash flow), which tends to have a linear relationship with revenue. Preferred is reliant largely on cash flow. Common is tied to marginal profit and even to the growth rate of profit - the second and third derivatives of revenue. Investment results went from relying on the soundness of the companies, to their profitability and then to the growth rate of that profitability. Under these circumstances, it is no surprise that the emphasis shifted away from ensuring that companies remained sound and certain to survive and towards showing growth or even accelerating growth (a fourth derivative!) at almost any price.

The eventual price was to lever up companies far beyond what was prudent in the quest for "growth." It didn't matter if the growth was real or not, it just had to look real for the shareholders. Companies undermined their own capital base with stock buybacks that juiced EPS growth while consuming cash flow and in some cases requiring additional indebtedness. We pointed to this problem nearly a year ago in Tactical Nukes. The paradoxical result was a slew of companies that were "growing" rapidly but could not survive a downturn. By placing so much reliance on marginal outcomes, the system became easy to game as small movements in revenue could drive huge changes in "growth" rates. Eventually, growth became THE foundation of many investment strategies, making those folks dependent on them willing to support increasing distortions of free markets for financial gain.

Those distortions have been a large part of the discussion here at Financial Jenga since the very beginning. The collapse of the illusion of growth and the economic distortions that supported it have revealed the true state of the underlying economy for all to see and it's not a pretty sight. Such are the ironic outcomes of the Universal Debt Bubble.

Saturday 27 September 2008

Shadow Banks, Shadow Government

Here at Financial Jenga, we don't often comment directly on politics - being much more inclined towards economics. We are also equally skeptical of both groupthink and conspiracy theories - which tend to be opposite sides of the same psychological coin. However, the sheer scale of the current crisis and many of the proposed solutions make this problem inherently political. It would also appear that many of the "fixes" being bandied about won't actually fix anything but WILL benefit certain politically-connected parties.

There is considerable evidence that the proposed $700 billion bailout of Wall Street will do little to fix the credit problems. One of the key arguements used by supporters is that banks don't have enough money to keep lending. This is simply a lie. The latest
Fed H.3 report shows that excess reserves in the banking system were $68.8 billion as of 9/24/08. This is 1400% above any other datapoint for the past year and more than 2000% higher than the average for that time. In other words, the Fed has FLOODED the banking system with borrowed money (the excess reserves) and the banks STILL won't lend.

In the real world, you cannot conduct fully-controlled experiments to validate an economic theory. But to the extent that it can be, we have already tested the thesis that giving banks more money will cause them to lend more and found it to be flawed. The most likely outcome of the bailout appears to be many banks saved at taxpayer expense but we get a credit crash and recession-depression anyway and Main Street has even less money to struggle through it since it will have been given away to Wall Street. Basically, it redistributes the losses for past transgressions from the guilty to the innocent and does little to help the future. We therefore oppose the bailout on both economic and moral grounds.

Hitting the Panic Button
According to various media reports, the supposed experts threatened Congress with all sorts of terrible repercussions if the bailout was not passed immediately and without strings. From their public statements, our representatives have been told that failure to do so would result in an immediate end of credit, a stock market crash, massive layoffs and likely a new Great Depression. As regular readers here know, many of these consequences ARE likely but they do NOT stem from the lack of a bailout for Wall Street. They are the DIRECT result of the orgy of foolish lending that preceeded the bailout request. Paulson and Bernanke are using their control of information and the ignorance of the politicians to run a bluff. We are being threatened with consequences that are likely to come in any event and the bailout won't change that.

In many ways, the financial authorities are taking active measures to make the crisis worse. The Fed has been withdrawing liquidity from the financial system for over a week. According to
the Slosh Report, system liquidity topped at $190 billion on 9/18 and fell to $110, $110, $90, $65, $63 and $59 billion on subsequent days. With the Fed deliberately cutting prior support, it's no wonder the short-term stress has become overwhelming. One result has been the largest bank failure in history (Washington Mutual) followed within days by a shotgun marriage to prevent an even larger one (Wachovia). The WaMu failure itself is quite interesting. The FDIC ALWAYS buries failed banks on a Friday, in order to give themselves time to sort the mess out over the weekend. We've gone back and checked and it's been true for many years. Yet the WaMu failure was announced on a Thursday, the day after the President unveiled the bailout proposal. The FDIC's timing on WaMu looks suspiciously like an attempt to rachet up the pressure on Congress - as does the Fed's withdrawal of liqidity support from the system.

In many ways this power-grab resembles the cynical use of religion in primitive societies. It is well documented that the priesthood in many cases studied the heavens with great care. One benefit would be the ability to predict solar eclipses - one of the most terrifying astronomical events to our ancestors. In some cases, the religious leaders used that terror to wring offerings, greater control and even political power from a frightened populace. The events in Washington today are quite similar but even worse. The crisis is already pre-determined. But the current financial leaders helped to create the disaster and now demand power to end it. In contrast the shamans and witch doctors were merely opportunists. The crisis centered in the Shadow Banks is now being used to create a Shadow Government.