Much to the surprise of numerous market players, the Swiss National Bank yesterday (Jan. 15, 2015) dropped its commitment to peg the Swiss franc at 1.20 to the Euro. The Swiss franc suddenly rose some 20% in value, a price shift that clobbered anyone betting the peg would hold. Losses have been sudden and very sharp. A major foreign exchange broker, FXCM, has received an emergency $300 million bailout loan from Leucadia National. Another forex broker, Alpari UK, has entered insolvency proceedings. A new Zealand broker, Excel Markets, has been knocked out of business.
The Swiss National Bank's reasons for abandoning the peg aren't very clear. But the abrupt demise of the peg is reminiscent of the UK's withdrawal of the British pound from the European Exchange Rate Mechanism in 1992, after a large hedge fund shorted over 10 billion pounds on September 16, 1992. The Bank of England was trying to fight market forces that dictated a lower valuation for the pound, and in the end couldn't win that fight.
A news story reports that in December 2014, there was a very large capital inflow into the Swiss franc, with some 34 billion francs being bought up. See http://www.cnbc.com/id/102343957. This is about 10 times the monthly average. One can wonder whether this flood of capital was the result of a calculated move by one or a few big market players. While there has for some months been a flight to safety resulting from the EU's economic slowdown (and the likely de facto devaluation in the near future of the Euro via ECB quantitative easing), Vladimir Putin's banditry in Ukraine, and the never-ending turmoil in the Middle East, December's inflow is so abruptly large than one cannot exclude the possibility that it was a move made by a few powerful players. And if it was, they would have profited handsomely from the Swiss franc's recent price rise.
Showing posts with label hedge funds. Show all posts
Showing posts with label hedge funds. Show all posts
Friday, January 16, 2015
Saturday, July 21, 2012
Hedge Fund Money Managers
In Hedge Fund Market Wizards, author Jack D. Schwager explores the trading styles and techniques of 15 current or former hedge fund money managers. The book, provided without charge to this writer by publisher John Wiley & Sons, Inc., presents interviews with each trader featured, along with commentary by the author. The traders, whom the author believes to be highly successful compared to their peers, include some who are well-known in the financial community and others who are not. The interviewees are variously active in one or more of the major financial markets, including stocks, bonds, commodities, and derivatives. Some trade hundreds of times a day, holding positions for as a little as a few moments, while others are value investors, seeking in some cases to outsmart their peers by outlasting them.
The featured traders were asked to explain the keys to their success. Each has a different story. Some got their start as elementary school age kids. Others drifted into trading. Some manage billions of dollars of investor funds. Others deliberately limit themselves to tens of millions. Their ranks include academics, attorneys, accountants and college dropouts. While their paths to success varied greatly, all were persistent, patient, open-minded and willing to learn from mistakes, and loss averse. The last trait may be the one that the ordinary investors have the hardest time emulating. Each trader featured in the book has stringent ways of limiting losses, and learned to pull the plug on losers quickly, even if doing so meant admitting error and taking a few hits to one's ego. Most, perhaps counterintuitively, weren't terribly greedy. They would start taking profits without trying to score the maximum gain possible. Making some gains, and then looking for another good opportunity, is generally preferred over squeezing the last penny of profit from any given position (with its concomitant risk of overplaying one's hand).
Some of the traders employ rigorously defined parameters. Others apparently rely mostly on their intuition. But they weren't all numbers crunchers and screen watchers. One, perhaps not illegally, got some nonpublic information about a public company from a U.S. government agency. Another (mentioned but not interviewed), hoping to profit from the impending collapse of the real estate market in 2007-08, may have convinced an investment bank to create a derivatives based investment relating to real estate assets the trader suggested, believing those assets to be weak and to provide a good shorting opportunity.
Who would benefit from reading this book? Other traders, for one, just to get an idea of what their peers are thinking. Much of the material in the interviews is already well-known to money management professionals, but the ways that successful traders mix and match the kaleidoscopic inflow of information and ideas into the financial markets can be insightful. Of course, one cannot expect that the interviewees revealed everything they know and do. No good trader would do that. Not if he wanted to keep making money in the markets.
Potential hedge fund investors--in other words, accredited investors--would find the book helpful in revealing the enormous variety of money management styles and techniques. As author Jack Schwager emphasizes, you can't rely on past performance as a certain indicator of future performance. You have to look at investment approaches and risk management, and find a manager with whom you are comfortable.
Ordinary investors might find the book insightful, not because they could use most of the trading techniques discussed. Hedge fund managers do a lot of stuff that you shouldn't try at home. But reading the book can help crystallize an individual's thinking about his or her personal investment approach. As Mr. Schwager highlights, it's important to invest in ways that you find comfortable, to learn from your mistakes, to adjust to changes in the markets, to limit losses, and to find out how you personally can be successful.
The book presumes a considerable degree of financial literacy on the part of the readers. The author is an experienced money manager and tosses around many terms and concepts familiar to the cognoscenti that aren't defined in the book. Have a good Web browser handy if you don't know the lingo of the financial markets. In addition, very little math is presented in the book. But mathematical concepts underlie the financial markets. If you don't have a facility for arithmetic and a basic understanding of statistical analysis, you won't follow the discussion much of the time. Beginning investors should start their reading elsewhere.
One limitation of the book is that it casts little light on high speed computerized trading, which comprises the majority of today's stock trading volume. The impact of algorithmic trading by the millisecond, particularly on the perhaps decreasing number of live humans active in the markets, is a crucial question and problem as we look toward the future. Answers are difficult to discern, but badly needed. Humans can't possibly keep up with machines that trade faster than the blink of an eye, especially when the algorithms deployed are dynamic (i.e., they can change on the run). If Mr. Schwager can coax some high speed traders into talking for his next book, he might well do investors and the financial markets a considerable service.
The featured traders were asked to explain the keys to their success. Each has a different story. Some got their start as elementary school age kids. Others drifted into trading. Some manage billions of dollars of investor funds. Others deliberately limit themselves to tens of millions. Their ranks include academics, attorneys, accountants and college dropouts. While their paths to success varied greatly, all were persistent, patient, open-minded and willing to learn from mistakes, and loss averse. The last trait may be the one that the ordinary investors have the hardest time emulating. Each trader featured in the book has stringent ways of limiting losses, and learned to pull the plug on losers quickly, even if doing so meant admitting error and taking a few hits to one's ego. Most, perhaps counterintuitively, weren't terribly greedy. They would start taking profits without trying to score the maximum gain possible. Making some gains, and then looking for another good opportunity, is generally preferred over squeezing the last penny of profit from any given position (with its concomitant risk of overplaying one's hand).
Some of the traders employ rigorously defined parameters. Others apparently rely mostly on their intuition. But they weren't all numbers crunchers and screen watchers. One, perhaps not illegally, got some nonpublic information about a public company from a U.S. government agency. Another (mentioned but not interviewed), hoping to profit from the impending collapse of the real estate market in 2007-08, may have convinced an investment bank to create a derivatives based investment relating to real estate assets the trader suggested, believing those assets to be weak and to provide a good shorting opportunity.
Who would benefit from reading this book? Other traders, for one, just to get an idea of what their peers are thinking. Much of the material in the interviews is already well-known to money management professionals, but the ways that successful traders mix and match the kaleidoscopic inflow of information and ideas into the financial markets can be insightful. Of course, one cannot expect that the interviewees revealed everything they know and do. No good trader would do that. Not if he wanted to keep making money in the markets.
Potential hedge fund investors--in other words, accredited investors--would find the book helpful in revealing the enormous variety of money management styles and techniques. As author Jack Schwager emphasizes, you can't rely on past performance as a certain indicator of future performance. You have to look at investment approaches and risk management, and find a manager with whom you are comfortable.
Ordinary investors might find the book insightful, not because they could use most of the trading techniques discussed. Hedge fund managers do a lot of stuff that you shouldn't try at home. But reading the book can help crystallize an individual's thinking about his or her personal investment approach. As Mr. Schwager highlights, it's important to invest in ways that you find comfortable, to learn from your mistakes, to adjust to changes in the markets, to limit losses, and to find out how you personally can be successful.
The book presumes a considerable degree of financial literacy on the part of the readers. The author is an experienced money manager and tosses around many terms and concepts familiar to the cognoscenti that aren't defined in the book. Have a good Web browser handy if you don't know the lingo of the financial markets. In addition, very little math is presented in the book. But mathematical concepts underlie the financial markets. If you don't have a facility for arithmetic and a basic understanding of statistical analysis, you won't follow the discussion much of the time. Beginning investors should start their reading elsewhere.
One limitation of the book is that it casts little light on high speed computerized trading, which comprises the majority of today's stock trading volume. The impact of algorithmic trading by the millisecond, particularly on the perhaps decreasing number of live humans active in the markets, is a crucial question and problem as we look toward the future. Answers are difficult to discern, but badly needed. Humans can't possibly keep up with machines that trade faster than the blink of an eye, especially when the algorithms deployed are dynamic (i.e., they can change on the run). If Mr. Schwager can coax some high speed traders into talking for his next book, he might well do investors and the financial markets a considerable service.
Wednesday, January 25, 2012
Will Hedge Fund Returns Drop?
The last couple of years have seen aggressive enforcement of the insider trading laws by the U.S. Department of Justice and the SEC. The use of wiretap authority has given federal prosecutors a powerful tool not deployed in years past, and greatly amplified investigators' ability to uncover illegal tipping. It seems that, almost every month or two, another hedge fund or traders associated with hedge funds, plead guilty, settle civil charges or both. Entire networks of tipping and insider trading have been blown up.
Traders at surviving hedge funds have no doubt taken notice of the downfall of many of their peers. Those that were dancing at the edge of the curb, or beyond, may well be cooling their jets. Many phone lines on Wall Street are probably less busy these days.
Competitive pressures were doubtless a major reason for hedge funds to engage in insider trading. If a hedge fund that takes 2% of a customer's assets and 20% of gains wants to stay in business, it has to beat the S&P 500 by quite a lot. That's much more easily said than done in the secular bear market that has existed since the stock market downturn in 2000. Inside information offers an edge that can't be beat (as long as you're not caught), and many hedgies just couldn't resist the temptation have a soto voce telephone conversation or twenty-six.
However, explaining lame returns to dissatisfied investors is a lot better than sharing a cell with Bubba. Even if you lose your investors, you don't have to clean latrines used by a lot of other guys. With it likely that many fewer "just between you and me" conversations are taking place on the Street, one must wonder whether hedge fund returns will drop. If you're an accredited investor, or managing money for one, you naturally don't want your money involved in illegality. But you also might ask yourself what returns hedge funds might offer now that federal electronics are policing the markets. A guy who wants 2 and 20 needs to be pretty talented in order to legally make the returns that justify a hedge fund investment, especially with that industry crowded with firms competing for the special profits that economists call "rent" (meaning profits above the level that a competitive market would provide). Think carefully before locking up your money in a hedge fund.
Traders at surviving hedge funds have no doubt taken notice of the downfall of many of their peers. Those that were dancing at the edge of the curb, or beyond, may well be cooling their jets. Many phone lines on Wall Street are probably less busy these days.
Competitive pressures were doubtless a major reason for hedge funds to engage in insider trading. If a hedge fund that takes 2% of a customer's assets and 20% of gains wants to stay in business, it has to beat the S&P 500 by quite a lot. That's much more easily said than done in the secular bear market that has existed since the stock market downturn in 2000. Inside information offers an edge that can't be beat (as long as you're not caught), and many hedgies just couldn't resist the temptation have a soto voce telephone conversation or twenty-six.
However, explaining lame returns to dissatisfied investors is a lot better than sharing a cell with Bubba. Even if you lose your investors, you don't have to clean latrines used by a lot of other guys. With it likely that many fewer "just between you and me" conversations are taking place on the Street, one must wonder whether hedge fund returns will drop. If you're an accredited investor, or managing money for one, you naturally don't want your money involved in illegality. But you also might ask yourself what returns hedge funds might offer now that federal electronics are policing the markets. A guy who wants 2 and 20 needs to be pretty talented in order to legally make the returns that justify a hedge fund investment, especially with that industry crowded with firms competing for the special profits that economists call "rent" (meaning profits above the level that a competitive market would provide). Think carefully before locking up your money in a hedge fund.
Sunday, January 22, 2012
The Greek Debt Crisis and the Failure of Credit Default Swaps
The Greek debt crisis, from which the entire European sovereign debt morass arises, comes down to a dispute between the Greek government and a group of private investors who hold large amounts of Greek bonds. These investors, many of whom appear to be hedge funds, are refusing to swallow as much loss as the Greek government demands. The Greek government is threatening default. The investors respond by, in essence, saying, "Go ahead. Make my day."
If the Greek government defaults, the investors will turn to credit default swaps they bought to protect against losses on Greek bonds. These CDS's are like insurance coverage against a Greek default. The government wants the investors to "voluntarily" agree to concessions, which wouldn't trigger CDS payouts. The investors have bargained hard, apparently emboldened by the knowledge that they can turn to their insurers if negotiations fail and Greece defaults.
Although usually described as insurance, the CDS's in this instance are being used for speculative purposes. The hedge funds may actually profit more by forcing the Greek government to default, than by working toward a consensual resolution. A default could have severe consequences, triggering a credit crisis in Europe that could circumnavigate the global financial system at the speed of a broadband Internet connection and plaster the world economy with a major credit crunch. Economic dislocation and recession would surely ensue.
When an "insurance" contract turns out to encourage recklessness, it has failed. Insurance is meant to protect against outsized loss, not to encourage insureds to foster or instigate losses. CDS's appear to be motivating speculators to disrupt a nation's finances. That's undesirable, no matter how you look at it.
Regulators and the financial services industry have done little to prevent derivatives, and credit default swaps in particular, from wrecking the financial system, as happened in 2008. Now, derivatives again pose a similar danger. People who don't learn from their mistakes are doomed to make them again. A sense of impending doom is growing.
If the Greek government defaults, the investors will turn to credit default swaps they bought to protect against losses on Greek bonds. These CDS's are like insurance coverage against a Greek default. The government wants the investors to "voluntarily" agree to concessions, which wouldn't trigger CDS payouts. The investors have bargained hard, apparently emboldened by the knowledge that they can turn to their insurers if negotiations fail and Greece defaults.
Although usually described as insurance, the CDS's in this instance are being used for speculative purposes. The hedge funds may actually profit more by forcing the Greek government to default, than by working toward a consensual resolution. A default could have severe consequences, triggering a credit crisis in Europe that could circumnavigate the global financial system at the speed of a broadband Internet connection and plaster the world economy with a major credit crunch. Economic dislocation and recession would surely ensue.
When an "insurance" contract turns out to encourage recklessness, it has failed. Insurance is meant to protect against outsized loss, not to encourage insureds to foster or instigate losses. CDS's appear to be motivating speculators to disrupt a nation's finances. That's undesirable, no matter how you look at it.
Regulators and the financial services industry have done little to prevent derivatives, and credit default swaps in particular, from wrecking the financial system, as happened in 2008. Now, derivatives again pose a similar danger. People who don't learn from their mistakes are doomed to make them again. A sense of impending doom is growing.
Sunday, August 7, 2011
The Weird and Unknown From the U.S. Credit Rating Downgrade
We learned in a big way during the 2008 financial crisis that what we don't know can really hurt us. That would still be true today, after S&P lowered America's credit rating from AAA to AA+. We also know that weird stuff happens when the financial markets get a tummy ache. They seem likely to be queasy from the downgrade when the markets open tomorrow. The weird and unknown may surface soon.
Complex Trading. Major banks and hedge funds frequently trade esoteric investments in multi-investment positions involving U.S. Treasuries as hedges or otherwise. Quite often, these market players embrace leverage in playing this game, since it boosts potential profits. The downgrade shouldn't have come as a complete surprise, since the rating agencies have been loudly frowning at the U.S. debt situation for several months now. But the downgrade's timing was uncertain and its impact uncertain. Complex trading positions may become unhinged for unanticipated reasons. These large institutional traders may find their positions exposed, or may receive unexpected demands for collateral from brokers or counterparties, and then struggle to keep things on an even keel. If so, that could prove unsettling for the markets, especially if the exposures from such trading are directly or indirectly concentrated in one or two companies, a la AIG circa 2008. The reform of the derivatives market has proceeded slowly, if at all, and regulators likely have no idea if there exists the potential for another meltdown. So all we can do is wait and see what happens. If there is another AIG lurking out there, expect very bad consequences.
Housing Market Hassles. Fannie Mae and Freddie Mac provide almost all the financing in the residential real estate markets, primarily because their debts are effectively 100% guaranteed by the U.S. government. It's logical to expect that Fannie and Freddie will be downgraded, since their sugar daddy was just downgraded. This could make mortgage loans harder to get. Not necessarily because interest rates would rise, because the U.S. Treasury downgrade could trigger a flight to safety that ironically would increase demand for U.S. Treasuries (there being few alternatives). But a Fan/Fred downgrade would make it harder to find investors for the mortgage backed securities that Fan/Fred backed loans go into. Investors in those securities are the true source of liquidity for the mortgage market, and may demand higher quality borrowers than current already stringent credit standards require. The housing market could slip on yet another banana peel in its path.
Chinese Communists Strengthened. China's Communist government has been coming under increasing domestic political pressure, because of rising unemployment, poor protection of consumers, sporadic protection of the environment, corruption and co-optation by China's capitalist plutocracy. The S&P downgrade of U.S. Treasuries, however, highlights the fundamental strength of the Chinese economy and its levitating currency, the yuan. That makes the Communist government look good, at a time when it needed some positive spin. Of course, S&P wasn't trying to influence internal Chinese politics. But the law of unintended consequences is the supreme authority in the world of finance.
Obama-Boehner in 2012? Increased factionalism in both political parties is stretching current party delineations close to the breaking point. The Republican Party is held hostage by a limited number of Tea Party ideologues. Respected mainstream conservative voices have labeled Tea Partiers "hobbits, " which, albeit an affront to hobbits, captures the fantastical quality of the thinking on the far right. At the same time, the fissure between President Obama and liberal Democrats has been outed. Emotions are red hot. Ralph Nader publicly, and likely others nonpublicly, predict a primaries challenge to President Obama next year. No one is naming names yet. The most obvious challenger, Secretary of State Hillary Clinton, has publicly said she isn't running for elective office again. Neither a liberal left agenda, nor a Tea Party-style conservative platform, will win the White House in 2012. Both Obama and Boehner know that. Their problems with their parties will increase, because the debt ceiling deal creates a bipartisan committee to squabble more about deficit reduction, giving all factions many opportunities for further raucousness. With so many shouting past each other instead of having a dialogue, the conditions for a realignment of parties are ripening. It's impossible that Obama and Boehner would actually team up to run in 2012. But the pressures for a functioning U.S. government come from powerful forces in the financial markets and the economy. We're no longer debating political philosophy or ideology over beer and pretzels or coffee and Danish. Lots of jobs, careers, wealth, and retirements are on the line. The will of the people is for a functioning government, and ambitious politicians will find a way to give them one. Current party alignments may be endangered.
Complex Trading. Major banks and hedge funds frequently trade esoteric investments in multi-investment positions involving U.S. Treasuries as hedges or otherwise. Quite often, these market players embrace leverage in playing this game, since it boosts potential profits. The downgrade shouldn't have come as a complete surprise, since the rating agencies have been loudly frowning at the U.S. debt situation for several months now. But the downgrade's timing was uncertain and its impact uncertain. Complex trading positions may become unhinged for unanticipated reasons. These large institutional traders may find their positions exposed, or may receive unexpected demands for collateral from brokers or counterparties, and then struggle to keep things on an even keel. If so, that could prove unsettling for the markets, especially if the exposures from such trading are directly or indirectly concentrated in one or two companies, a la AIG circa 2008. The reform of the derivatives market has proceeded slowly, if at all, and regulators likely have no idea if there exists the potential for another meltdown. So all we can do is wait and see what happens. If there is another AIG lurking out there, expect very bad consequences.
Housing Market Hassles. Fannie Mae and Freddie Mac provide almost all the financing in the residential real estate markets, primarily because their debts are effectively 100% guaranteed by the U.S. government. It's logical to expect that Fannie and Freddie will be downgraded, since their sugar daddy was just downgraded. This could make mortgage loans harder to get. Not necessarily because interest rates would rise, because the U.S. Treasury downgrade could trigger a flight to safety that ironically would increase demand for U.S. Treasuries (there being few alternatives). But a Fan/Fred downgrade would make it harder to find investors for the mortgage backed securities that Fan/Fred backed loans go into. Investors in those securities are the true source of liquidity for the mortgage market, and may demand higher quality borrowers than current already stringent credit standards require. The housing market could slip on yet another banana peel in its path.
Chinese Communists Strengthened. China's Communist government has been coming under increasing domestic political pressure, because of rising unemployment, poor protection of consumers, sporadic protection of the environment, corruption and co-optation by China's capitalist plutocracy. The S&P downgrade of U.S. Treasuries, however, highlights the fundamental strength of the Chinese economy and its levitating currency, the yuan. That makes the Communist government look good, at a time when it needed some positive spin. Of course, S&P wasn't trying to influence internal Chinese politics. But the law of unintended consequences is the supreme authority in the world of finance.
Obama-Boehner in 2012? Increased factionalism in both political parties is stretching current party delineations close to the breaking point. The Republican Party is held hostage by a limited number of Tea Party ideologues. Respected mainstream conservative voices have labeled Tea Partiers "hobbits, " which, albeit an affront to hobbits, captures the fantastical quality of the thinking on the far right. At the same time, the fissure between President Obama and liberal Democrats has been outed. Emotions are red hot. Ralph Nader publicly, and likely others nonpublicly, predict a primaries challenge to President Obama next year. No one is naming names yet. The most obvious challenger, Secretary of State Hillary Clinton, has publicly said she isn't running for elective office again. Neither a liberal left agenda, nor a Tea Party-style conservative platform, will win the White House in 2012. Both Obama and Boehner know that. Their problems with their parties will increase, because the debt ceiling deal creates a bipartisan committee to squabble more about deficit reduction, giving all factions many opportunities for further raucousness. With so many shouting past each other instead of having a dialogue, the conditions for a realignment of parties are ripening. It's impossible that Obama and Boehner would actually team up to run in 2012. But the pressures for a functioning U.S. government come from powerful forces in the financial markets and the economy. We're no longer debating political philosophy or ideology over beer and pretzels or coffee and Danish. Lots of jobs, careers, wealth, and retirements are on the line. The will of the people is for a functioning government, and ambitious politicians will find a way to give them one. Current party alignments may be endangered.
Wednesday, May 11, 2011
Hedge Funds: Is the Sun Setting on the Raj?
It's not surprising the jury today found Raj Rajaratnam guilty of 14 felony counts stemming from accusations of insider trading. After all, the government had him on tape. Prosecutors love tapes. What the tapes show is that: (a) the defendant and alleged tipper actually had a conversation--it wasn't just chit chat with a secretary; (b) the conversation took place at a time when the defendant could have taken advantage of any nonpublic information he received to trade profitably; and (c) the conversation wasn't just about the Mets, or the best recipe for mac and cheese, or the latest on the width of ties; and (d) the conversation involved the company whose stock the defendant allegedly traded on the basis of inside information. Defense lawyers can and will strenuously argue about what the parties to the taped conversations meant when they said whatever they said, and whether or not that information was already public, etc. But the tapes remove a lot of the doubt prosecutors need to overcome in order to get a guilty verdict.
Rajaratnam has promised to appeal. Apparently, he's going to argue something along the lines that the government can use its wiretap authority to nab old guys who walk around Brooklyn in bathrobes, but not Wall Street guys who live at fancy addresses in Manhattan. At least, that's how the argument on appeal might end up sounding. Would the judges in the appeals court be seen as traitors to their class if they uphold the verdict? Rajaratnam reportedly is rolling in dough, so he has little to lose by appealing ad infinitum. But convicted criminal defendants don't have a high rate of success on appeal. Maybe Bernie Madoff will some day have a neighbor with whom he can talk shop.
More importantly from a systemic standpoint, this verdict may contribute to a downturn for the hedge fund industry. It's not an accident that the current wave of insider trading cases, and the last big wave of insider trading cases, both took place during eras of market stagnation. The Dennis Levine-Ivan Boesky-Michael Milken string of cases had its origins in the insipid stock market of the 1970s and early 1980s. When a market is devoted mostly to flatlining, buying-and-holding and other such investing-for-Main Street mantras don't work. They need a rising market to provide returns. What can be highly profitable in such circumstances is insider trading. Dennis Levine, one of the first high-profile Wall Streeters to be nabbed, turned about $40,000 into $12 million in some eight years. Even if you don't adjust for inflation, that's impressive. (The inflation adjusted figures are an initial investment of about $137,000 becoming roughly $24,467,000.) Insider trading pays, as long as you're not caught.
Since the spring of 2000, the stock market has, adjusted for inflation, dropped. Okay, it's bounced down and up and down and up again. But adjusted for inflation, it hasn't returned to its 2000 peak. In such circumstances, with investors having high expectations for hedge fund results (appropriately so, given the steep management and performance fees they face), hedge fund managers are under the gun to deliver. But things haven't been like the 1990s, when a cow that bought and held would have made a lot of money. Thus, the temptation to seek out and trade on inside information.
The recent spate of insider trading cases, most of which seem to involve wiretaps, confirm that the allure of inside information remains strong. For quite a few defendants, it's proven to be a siren call. Hedge fund managers, whatever they may have been up to, will probably cool their jets. Some phone calls may not be answered; others not returned. Swapping tips to make some money today isn't worthwhile if the true price is you end up a guest at a federal facility, swapping tips with Bernie Madoff. Hedge fund returns could droop.
Hedge fund investors may start to yank their money. Most don't want to be associated with even a whiff of scandal. Moreover, if a fund they invest in is caught up in insider trading, they might have to return some of the distributions they receive so other investors, injured by the insider trading, can obtain recompense. This is what happened to some of Bernie Madoff's investors, who received distributions exceeding their investments and had to return some of the money.
Even if a hedge fund hasn't been charged or isn't rumored to be under investigation, its returns might diminish because managers stop having some of the edgier conversations they've had in the past. Not to say that they were or will do anything illegal, but not all risks are worth having to bunk with Bubba. The lower returns, though, may lead their investors to seek greener pastures elsewhere.
Money has surged into the hedge fund industry during the past year, with investors trying to recoup losses from the recent financial crisis. The hedgies have done well, since the Federal Reserve keeps shoveling shiploads of cash off its loading dock to boost stock and commodities prices. Hedge fund managers have reigned supreme while investment banks battled increased regulation. But the Fed is being circumspect about how long it will keep its money printing presses rolling. Inflation is rising. Asian and European economies are slowing. Commodities prices have suddenly ebbed. There are plenty of market-related reasons to think that asset prices may have peaked. Then consider that federal wiretapping is probably cutting off the flow of inside information to some of the more brazen hedge fund managers, and chances are growing that the sun may be setting on the hedge fund industry, at least for another market cycle.
Rajaratnam has promised to appeal. Apparently, he's going to argue something along the lines that the government can use its wiretap authority to nab old guys who walk around Brooklyn in bathrobes, but not Wall Street guys who live at fancy addresses in Manhattan. At least, that's how the argument on appeal might end up sounding. Would the judges in the appeals court be seen as traitors to their class if they uphold the verdict? Rajaratnam reportedly is rolling in dough, so he has little to lose by appealing ad infinitum. But convicted criminal defendants don't have a high rate of success on appeal. Maybe Bernie Madoff will some day have a neighbor with whom he can talk shop.
More importantly from a systemic standpoint, this verdict may contribute to a downturn for the hedge fund industry. It's not an accident that the current wave of insider trading cases, and the last big wave of insider trading cases, both took place during eras of market stagnation. The Dennis Levine-Ivan Boesky-Michael Milken string of cases had its origins in the insipid stock market of the 1970s and early 1980s. When a market is devoted mostly to flatlining, buying-and-holding and other such investing-for-Main Street mantras don't work. They need a rising market to provide returns. What can be highly profitable in such circumstances is insider trading. Dennis Levine, one of the first high-profile Wall Streeters to be nabbed, turned about $40,000 into $12 million in some eight years. Even if you don't adjust for inflation, that's impressive. (The inflation adjusted figures are an initial investment of about $137,000 becoming roughly $24,467,000.) Insider trading pays, as long as you're not caught.
Since the spring of 2000, the stock market has, adjusted for inflation, dropped. Okay, it's bounced down and up and down and up again. But adjusted for inflation, it hasn't returned to its 2000 peak. In such circumstances, with investors having high expectations for hedge fund results (appropriately so, given the steep management and performance fees they face), hedge fund managers are under the gun to deliver. But things haven't been like the 1990s, when a cow that bought and held would have made a lot of money. Thus, the temptation to seek out and trade on inside information.
The recent spate of insider trading cases, most of which seem to involve wiretaps, confirm that the allure of inside information remains strong. For quite a few defendants, it's proven to be a siren call. Hedge fund managers, whatever they may have been up to, will probably cool their jets. Some phone calls may not be answered; others not returned. Swapping tips to make some money today isn't worthwhile if the true price is you end up a guest at a federal facility, swapping tips with Bernie Madoff. Hedge fund returns could droop.
Hedge fund investors may start to yank their money. Most don't want to be associated with even a whiff of scandal. Moreover, if a fund they invest in is caught up in insider trading, they might have to return some of the distributions they receive so other investors, injured by the insider trading, can obtain recompense. This is what happened to some of Bernie Madoff's investors, who received distributions exceeding their investments and had to return some of the money.
Even if a hedge fund hasn't been charged or isn't rumored to be under investigation, its returns might diminish because managers stop having some of the edgier conversations they've had in the past. Not to say that they were or will do anything illegal, but not all risks are worth having to bunk with Bubba. The lower returns, though, may lead their investors to seek greener pastures elsewhere.
Money has surged into the hedge fund industry during the past year, with investors trying to recoup losses from the recent financial crisis. The hedgies have done well, since the Federal Reserve keeps shoveling shiploads of cash off its loading dock to boost stock and commodities prices. Hedge fund managers have reigned supreme while investment banks battled increased regulation. But the Fed is being circumspect about how long it will keep its money printing presses rolling. Inflation is rising. Asian and European economies are slowing. Commodities prices have suddenly ebbed. There are plenty of market-related reasons to think that asset prices may have peaked. Then consider that federal wiretapping is probably cutting off the flow of inside information to some of the more brazen hedge fund managers, and chances are growing that the sun may be setting on the hedge fund industry, at least for another market cycle.
Friday, August 20, 2010
What the Smart Money is Doing in the Financial Markets
If you want to find out what the smart money is doing, look at money managers. Not wealthy people, some of whom put their money with Bernie Madoff. But people who have successfully managed money for wealthy people.
This past week, Stanley Druckenmiller, a long standing hedge fund maven, announced he would return investor money from his firm, Duquesne Capital Management LLC, and close up shop. He was followed a couple days later by Paolo Pelligrini, a former sidekick of John Paulson who help to engineer the mother of all short sales--the 2007 thumbs down on the mortgage market--that made Paulson billions (and Pelligrini mucho millions). Pelligrini had left Paulson and set up his own fund. But now he, too, has decided to return investor money and manage only his own money.
There are a shipload of supposed experts on Wall Street who will tell you to do this or that with your investments. But just about all of them are looking for a way to pocket some of your money. Investors circa 2010, suffering from battered portfolio syndrome, have learned to be wary of people with sales agendas. Druckenmiller and Pelligrini are doing the exact opposite. They're returning investor money they currently manage--the anti-sales maneuver.
That's a sign of the times. One can infer that Druckenmiller and Pelligrini don't see a lot of low hanging fruit in the financial markets. Neither said they were ditching their personal portfolios and going to cash. But it's not hard to imagine that they expect to play more defense than offense in the foreseeable future. It's hard to explain to investors the pedestrian returns that playing defense produces. But the markets don't always cooperate when people want home runs. Sometimes, strong winds blow in from the outfield bleachers. A couple of home run hitters just took themselves out of the game. That may be a hint to be cautious about swinging for the fences.
Sunday, August 22, 2010: today comes the news that one of Warren Buffett's premier stock pickers, Lou Simpson, is going to retire soon. See http://www.cnbc.com/id/38807185. This is a guy who's usually beaten the S&P 500. And now he's opting for a retirement watch. One starts to get the impression that people who know where the top is are getting out at the top.
This past week, Stanley Druckenmiller, a long standing hedge fund maven, announced he would return investor money from his firm, Duquesne Capital Management LLC, and close up shop. He was followed a couple days later by Paolo Pelligrini, a former sidekick of John Paulson who help to engineer the mother of all short sales--the 2007 thumbs down on the mortgage market--that made Paulson billions (and Pelligrini mucho millions). Pelligrini had left Paulson and set up his own fund. But now he, too, has decided to return investor money and manage only his own money.
There are a shipload of supposed experts on Wall Street who will tell you to do this or that with your investments. But just about all of them are looking for a way to pocket some of your money. Investors circa 2010, suffering from battered portfolio syndrome, have learned to be wary of people with sales agendas. Druckenmiller and Pelligrini are doing the exact opposite. They're returning investor money they currently manage--the anti-sales maneuver.
That's a sign of the times. One can infer that Druckenmiller and Pelligrini don't see a lot of low hanging fruit in the financial markets. Neither said they were ditching their personal portfolios and going to cash. But it's not hard to imagine that they expect to play more defense than offense in the foreseeable future. It's hard to explain to investors the pedestrian returns that playing defense produces. But the markets don't always cooperate when people want home runs. Sometimes, strong winds blow in from the outfield bleachers. A couple of home run hitters just took themselves out of the game. That may be a hint to be cautious about swinging for the fences.
Sunday, August 22, 2010: today comes the news that one of Warren Buffett's premier stock pickers, Lou Simpson, is going to retire soon. See http://www.cnbc.com/id/38807185. This is a guy who's usually beaten the S&P 500. And now he's opting for a retirement watch. One starts to get the impression that people who know where the top is are getting out at the top.
Tuesday, December 11, 2007
We've Got Bailouts. How About Fixing the Banking System?
Just in time for the holiday season, the federal government is trying to climb down the chimney with bailouts in hand. It's brought a rate freeze for some mortgage borrowers, a super conduit for SIV-bedeviled banks, and another interest rate cut courtesy of the Federal Reserve Board. There have been many of the usual holiday-season reactions to these gifts. Many borrowers claim that the rate freeze doesn't benefit enough homeowners, and the stock market threw a hissy fit today when the Fed's interest rate cuts felt too much like anthracite from a stocking. Unfortunately, regifting isn't possible here.
The government has only been treating symptoms. If things go well, it might stabilize the situation. But all of the government's announced measures simply re-allocate the mammoth risks and losses from the mortgage mess. The rate freeze benefits some borrowers and hurts banks and investors. The super conduit will provide liquidity to certain SIVs and their affiliated banks, but at risk to the investors in the super conduit and its commercial paper. The Fed's latest interest rate cut, like all its other rate cuts, benefits banks and reckless speculators while shifting some of their losses onto savers and other holders of capital. Re-allocating losses, often in seemingly arbitrary or random manner, does little to promote rational future behavior. It might, indeed, exacerbate the credit crunch as holders of capital simply avoid the asset-backed investments that have given rise to the current financial mess.
That points to the missing piece of the government's response to the mortgage crisis and credit crunch. Securitization of loans is big business today. Most types of loans that banks made and held 25 or 30 years ago are now bundled into investments with various alphabet soup acronyms and sold to investors. These include home mortgages, home equity lines of credit, credit card balances, auto loans and corporate loans. Those things called "banks" are in many respects just administrative functionaries that screen borrowers' creditworthiness (we hope) and process paperwork associated with loans. But actual loans are made by investors. The real bank is the securitization process.
Asset backed securities, as we all know, are not protected by federal deposit insurance. That's much of the reason for the credit implosion this past summer. Investors, who functionally speaking are depositors, were frazzled by mortgage losses and tried to offload their mortgage-related exposure. Cash values of these investments plummeted or became unavailable. Hedge funds and other investment vehicles shut down. If you step back, it all has an uncanny resemblance to the financial panics and bank collapses of the pre-FDIC world. That shouldn't be surprising, since the asset-backed securities market is now a crucial de facto segment of the banking system.
Neither J.P. Morgan nor Jimmy Stewart is around to calm the panic. Federal insurance of asset-backed securities wouldn't fly, for both political and practical reasons. The $100,000 limit on federal insurance of bank accounts is a trivial amount in the multi-millions and billions world of asset-backed securities. A higher amount would look like a bailout of the wealthy, and would probably result in federal examiners moving into the offices of the investments banks peddling these investments in order to prevent undue risk to the U.S. Treasury.
There are ways to improve the asset-backed securities market and thereby strengthen the true banking system:
1. Simplification and standardization. Many asset-backed investments, such as CDOs, are a witch's brew of different loans, including mortgages, credit card balances, auto loans and corporate debt. An important reason why these things can't find cash buyers right now is because a cash buyer would need a supercomputer to analyze the constituent components of the asset pool and calculate a value. On Wall Street's trading desks, buy and sell decisions are often made in seconds. There's no time to dally around with complex, hinky derivatives of derivatives. Simplifying and standardizing asset-backed investments, such as limiting them to just one type of loan--e.g., home mortgages with a first lien, auto loans for new cars, or credit card balances with credit ratings of at least a certain minimum--would go a long way to ensuring that they can find a ready market. Overpaid financial engineers have mixed and matched too many different kinds of debt in a now discredited effort to squeeze AAA ratings out of risky investments. Their cleverness and a half has been costly for all of us.
2. Margin Regulations for Derivatives. Much of the reason for the sudden and severe losses of the past six months is the mainlining of leverage by the investment community. The reckless lending by banks and reckless borrowing by money managers magnified every flaw in the securitization process, and rubbed vats of salt into the wounds suffered in the financial crisis. Borrowing with abandon to buy stocks was one of the reasons for the stock market boom of the 1920s and the flood of margin calls that aggravated the stock market crash of 1929. The Fed has successfully regulated margin lending on stocks ever since. It should get and exercise regulatory authority over margin lending on derivatives.
3. Regulation of Hedge Funds and Derivatives Trading. One of the major reasons for the make-it-up-as-you-go-along quality of the government's response to the financial crisis is that regulators don't know much about the problems. Getting firm information about the full extent of derivatives holdings and trading has apparently been extremely difficult or impossible. It's really hard to formulate effective policy if you can't see the complete contours of the problem. Federal regulators don't effectively regulate either hedge funds or derivatives trading, partly because of a lack of inclination and partly because of questions about their lawful authority. Both of these problems can and should be fixed. Given the hundreds of billions of dollars of losses that now appear certain, there remains no excuse for a regulatory void. The regulation need not overstep reasonable bounds--the crucial things are to be able to gather information about who holds what, who has sustained what losses, and what the trading activity has been.
4. Listed Markets for Asset-Backed Securities. A logical corollary to the preceding measures would be the creation of exchanges or similar markets for asset-backed securities with publicly displayed price quotations and transaction reports. Nothing would instill public confidence and investment interest as much as an open and readily observable market. That's exactly what happened with stocks and bonds. It can happen with asset-backed securities.
The securitization process isn't going to go away. The regulatory structure of the formal banking system, with its risk-based capital requirements, will continue to subtly push banks to offload credit risk. And the securitization process is a primary means of accessing the vast amount of capital it takes to fund banks' lending activities. Back of the envelope bailout proposals won't make the banking system truly functional. Only meaningful reform can accomplish that.
School News: parents with high school age kids, rethink your plans to move to Montpelier. www.wtop.com/?nid=456&sid=1307882.
The government has only been treating symptoms. If things go well, it might stabilize the situation. But all of the government's announced measures simply re-allocate the mammoth risks and losses from the mortgage mess. The rate freeze benefits some borrowers and hurts banks and investors. The super conduit will provide liquidity to certain SIVs and their affiliated banks, but at risk to the investors in the super conduit and its commercial paper. The Fed's latest interest rate cut, like all its other rate cuts, benefits banks and reckless speculators while shifting some of their losses onto savers and other holders of capital. Re-allocating losses, often in seemingly arbitrary or random manner, does little to promote rational future behavior. It might, indeed, exacerbate the credit crunch as holders of capital simply avoid the asset-backed investments that have given rise to the current financial mess.
That points to the missing piece of the government's response to the mortgage crisis and credit crunch. Securitization of loans is big business today. Most types of loans that banks made and held 25 or 30 years ago are now bundled into investments with various alphabet soup acronyms and sold to investors. These include home mortgages, home equity lines of credit, credit card balances, auto loans and corporate loans. Those things called "banks" are in many respects just administrative functionaries that screen borrowers' creditworthiness (we hope) and process paperwork associated with loans. But actual loans are made by investors. The real bank is the securitization process.
Asset backed securities, as we all know, are not protected by federal deposit insurance. That's much of the reason for the credit implosion this past summer. Investors, who functionally speaking are depositors, were frazzled by mortgage losses and tried to offload their mortgage-related exposure. Cash values of these investments plummeted or became unavailable. Hedge funds and other investment vehicles shut down. If you step back, it all has an uncanny resemblance to the financial panics and bank collapses of the pre-FDIC world. That shouldn't be surprising, since the asset-backed securities market is now a crucial de facto segment of the banking system.
Neither J.P. Morgan nor Jimmy Stewart is around to calm the panic. Federal insurance of asset-backed securities wouldn't fly, for both political and practical reasons. The $100,000 limit on federal insurance of bank accounts is a trivial amount in the multi-millions and billions world of asset-backed securities. A higher amount would look like a bailout of the wealthy, and would probably result in federal examiners moving into the offices of the investments banks peddling these investments in order to prevent undue risk to the U.S. Treasury.
There are ways to improve the asset-backed securities market and thereby strengthen the true banking system:
1. Simplification and standardization. Many asset-backed investments, such as CDOs, are a witch's brew of different loans, including mortgages, credit card balances, auto loans and corporate debt. An important reason why these things can't find cash buyers right now is because a cash buyer would need a supercomputer to analyze the constituent components of the asset pool and calculate a value. On Wall Street's trading desks, buy and sell decisions are often made in seconds. There's no time to dally around with complex, hinky derivatives of derivatives. Simplifying and standardizing asset-backed investments, such as limiting them to just one type of loan--e.g., home mortgages with a first lien, auto loans for new cars, or credit card balances with credit ratings of at least a certain minimum--would go a long way to ensuring that they can find a ready market. Overpaid financial engineers have mixed and matched too many different kinds of debt in a now discredited effort to squeeze AAA ratings out of risky investments. Their cleverness and a half has been costly for all of us.
2. Margin Regulations for Derivatives. Much of the reason for the sudden and severe losses of the past six months is the mainlining of leverage by the investment community. The reckless lending by banks and reckless borrowing by money managers magnified every flaw in the securitization process, and rubbed vats of salt into the wounds suffered in the financial crisis. Borrowing with abandon to buy stocks was one of the reasons for the stock market boom of the 1920s and the flood of margin calls that aggravated the stock market crash of 1929. The Fed has successfully regulated margin lending on stocks ever since. It should get and exercise regulatory authority over margin lending on derivatives.
3. Regulation of Hedge Funds and Derivatives Trading. One of the major reasons for the make-it-up-as-you-go-along quality of the government's response to the financial crisis is that regulators don't know much about the problems. Getting firm information about the full extent of derivatives holdings and trading has apparently been extremely difficult or impossible. It's really hard to formulate effective policy if you can't see the complete contours of the problem. Federal regulators don't effectively regulate either hedge funds or derivatives trading, partly because of a lack of inclination and partly because of questions about their lawful authority. Both of these problems can and should be fixed. Given the hundreds of billions of dollars of losses that now appear certain, there remains no excuse for a regulatory void. The regulation need not overstep reasonable bounds--the crucial things are to be able to gather information about who holds what, who has sustained what losses, and what the trading activity has been.
4. Listed Markets for Asset-Backed Securities. A logical corollary to the preceding measures would be the creation of exchanges or similar markets for asset-backed securities with publicly displayed price quotations and transaction reports. Nothing would instill public confidence and investment interest as much as an open and readily observable market. That's exactly what happened with stocks and bonds. It can happen with asset-backed securities.
The securitization process isn't going to go away. The regulatory structure of the formal banking system, with its risk-based capital requirements, will continue to subtly push banks to offload credit risk. And the securitization process is a primary means of accessing the vast amount of capital it takes to fund banks' lending activities. Back of the envelope bailout proposals won't make the banking system truly functional. Only meaningful reform can accomplish that.
School News: parents with high school age kids, rethink your plans to move to Montpelier. www.wtop.com/?nid=456&sid=1307882.
Tuesday, August 7, 2007
Stock Market Volatility and How It Bailed Out the Fed (This Time)
Anyone with even a passing interest in the stock markets has noticed the surge in volatility in recent months. The Dow Jones Industrial Average seems clinically manic-depressive, flying in the stratosphere one day and bungee jumping with a frayed rope the next day. Daily movements of 200 or even 300 points have become commonplace. Antacid manufacturers and therapists are celebrating.
Where does the volatility come from? There's no way of knowing all of the reasons. As discussed in an earlier blog, there are unknown factors that probably will never be known. http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html. But not everything is unknown. Here are a few thoughts to chew on.
1. The Managed Money Problem. The greatest threat to professional money managers is the index fund. Most money managers can't beat the S&P 500, and many don't even do as well. If a money manager can't beat the S&P 500, why would his or her clients not simply move their money to an index fund? Many index funds have low fees and expenses, and are relatively tax efficient. Money managers feel the pressure to step away from traditional stock picking and try out other strategies in order to get even a tiny increment ahead of the overall market. For example, one can trade futures contracts for the S&P 500. This is a game for bigtime money managers and institutional investors. Individual investors should not try this at home. If a money manager senses that the stock market is likely to fall, he could sell S&P 500 futures contracts in an effort to hedge his stock holdings, or simply to bet on the price drop. Alternatively, he could buy S&P 500 put options, which would hedge his losses if the S&P 500 drops.
If the market begins to sink after the money manager has sold S&P 500 futures contracts or bought S&P 500 put options, the counterparty to that transaction will begin to sell the S&P 500 stocks to hedge its exposure (or do some sort of derivatives trade with another counterparty, who will start to sell stock). Either way, sell pressure is added to the market at a time when it is teetering. Financial history buffs will recall that portfolio insurance had a similar effect in the 1987 market crash.
2. Yen carry trade. Interest rates in Japan have been extremely low ever since the Tokyo stock markets rose in the 1980's and then crashed in 1989. The Nikkei 225 fell from an all-time high around 38,900 to the 7,000 to 8,000 level and has risen to around 17,000 today. The Japanese stock market bubble was accompanied by a real estate bubble so extreme that the Japanese imperial palace was said to be worth more than the entire value of all the real estate in America. Some Japanese home buyers took out 100-year mortgages (that's some inheritance for your kids). Needless to say, the Japanese real estate bubble also popped. Between the stock market crash and the real estate bubble popping, Japan's banks were saddled with such enormous loan losses that they very possibly were insolvent. In order to bail out the banks, the Japanese central bank lowered interest rates to virtually zero (which meant the banks could take deposits and otherwise borrow money for almost no cost). These rates have been kept more or less around zero until recently.
The extraordinarily low interest rates in Japan gave rise to a trading strategy called the "yen carry trade." You borrowed yen at the very low rates available in Japan, converted it into dollars, and invested in the U.S. Because U.S. interest rates and other returns were quite a bit higher than your borrowing costs, you made some easy money fairly quickly. There's nothing like easy money. Many Japanese have been using this strategy. So have many other investors, from places like the U.S., U.K., Australia and New Zealand. Anyone who can borrow yen--and in today's globalized financial system, that means almost anyone who can borrow--can do the yen carry trade.
The catch--remember, in all investment schemes, there's a catch--is that currency exchange rates fluctuate. If the dollar drops in value against the yen, the dollar denominated investment gains you get will be reduced by your losses in the dollar. In the last year or so, the dollar has been dropping against the yen. While the drop has been fairly gradual, it's been enough to make yen carry traders nervous.
Then, the stock market fell, sometimes abruptly, in the last two and a half weeks. That's been enough to make a lot of yen carry traders throw in the towel. They've ditched their U.S. investments, and reconverted their money into yen.
3. Hedge Funds. You knew hedge funds would be mentioned sooner or later, and here they are. Hedge funds that invested in subprime and other mortgages (another thing you knew would come up) have been receiving many withdrawal requests from nervous investors who believe too much of what they read in the newspapers. In the case of one Bear Stearns sponsored hedge fund, the fund simply ceased honoring withdrawal requests. But many other hedge funds have been trying to accommodate these nervous Nellies who have a complex about retiring with only Social Security.
The hedge funds have a minor problem, though. There aren't many people paying cash for CDOs these days. Some CDOs, when put up for auction, apparently aren't getting any bids at all. You can't honor a withdrawal request with zero. So, hedge funds have been liquidating other investments, like other debt securities. The private equity debt and junk bond markets have been particularly hard hit by these liquidations, and spreads between these securities and Treasuries have widened sharply. It's also likely that some of the selling in the stock markets has also been hedge funds raising cash to meet withdrawal requests, or just hoping to avoid losses.
4. Short Sellers. Short sellers are viewed by many as a scourge. They are disliked for profiting from misfortune and scorned for scavenging. However, they may assist the pricing function of the market, pushing the price toward its true equilibrium.
Some short sellers have no doubt been shorting the market (through derivatives that allow them to trade the equivalent of the S&P 500 or other broad market indexes). This probably has added to the downward pressure on the market. However, the shorts can also fuel some of the upward pops in the market. When the market begins to rise, the shorts start to take losses on their positions. As their losses increase, the counterparties with whom they traded (in order to assume their short positions) will often ask for cash collateral. If the shorts don't or can't provide cash collateral, or simply want to cut their losses, they'll buy stock to cover their shorts. This "short covering" is fast and intense, and may account for the laughing gas quality of some of the recent upswings in the market.
5. Derivatives Market? The increasingly tattered state of the derivatives market may account for some of the increased market volatility. There's no way to know for sure, since the derivatives market is unregulated and seriously opaque. But many players that might write derivatives contracts to protect holders of stocks from downswings could be inclined to demure these days. They may have taken losses in the subprime and corporate debt markets, and be unable to take on additional equity risk. They may simply be skittish, not knowing how bad things are, and prefer a quiet game of croquet.
Derivatives are said to moderate volatility by shifting risk to parties willing to take it. There's some truth to that. The problem is one of success--they proved so good at risk shifting that more players began investing in risky contracts, with expectation that they'd shift the risk to someone else. That was a clever strategy until it created such a large amount of risk that the mortgage market belly flopped. We discussed these unintended consequences in http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html.
If some of the participants in the derivatives market have stopped playing in that particular sandbox, others seeking to hedge their stockholdings may be unable to lay off their downside equity risk. In that case, they'd have to take old fashioned action to protect themselves--like sell. As the derivatives market pulls back, it won't damp volatility as much.
There may be many other causes of market volatility, although these are probably enough for anyone who owns stock. The past few years have been unusually calm ones for the markets. But an unduly large amount of risk may have been heedlessly created because of the Panglossian perception fostered by that calm. The concern now is that this change in financial climate may have created the conditions for larger and more frequent hurricanes. Let's hope the levees hold.
A Fed Bailout: in the vein of cat-saves-people-from-fire stories, we noted in the preceding blog (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html) that the stock market was hoping the Fed would give the market a little boost at its meeting today. In anticipation of some dispensation, the Dow rose 287 points on Monday (8/6/07), the day before the meeting. With a handicap like that, it was easy for the Fed not to indulge the market, hold interest rates steady and maintain that its primary concern is controlling inflation. The Fed gave the market a bit of a doggy treat by noting the problems in the credit and real estate markets, and the stock market's volatility. But it gave no real indication that an interest rate cut would be forthcoming at any predictable time in the foreseeable future. The Dow closed up 35, apparently satisfied with the crunchy chicken and beef flavor of its treat.
Animal News: you can't take hardly any liquids on board a plane, but if it's a monkey . . .
www.wtop.com/?nid=456&sid=1212487.
Where does the volatility come from? There's no way of knowing all of the reasons. As discussed in an earlier blog, there are unknown factors that probably will never be known. http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html. But not everything is unknown. Here are a few thoughts to chew on.
1. The Managed Money Problem. The greatest threat to professional money managers is the index fund. Most money managers can't beat the S&P 500, and many don't even do as well. If a money manager can't beat the S&P 500, why would his or her clients not simply move their money to an index fund? Many index funds have low fees and expenses, and are relatively tax efficient. Money managers feel the pressure to step away from traditional stock picking and try out other strategies in order to get even a tiny increment ahead of the overall market. For example, one can trade futures contracts for the S&P 500. This is a game for bigtime money managers and institutional investors. Individual investors should not try this at home. If a money manager senses that the stock market is likely to fall, he could sell S&P 500 futures contracts in an effort to hedge his stock holdings, or simply to bet on the price drop. Alternatively, he could buy S&P 500 put options, which would hedge his losses if the S&P 500 drops.
If the market begins to sink after the money manager has sold S&P 500 futures contracts or bought S&P 500 put options, the counterparty to that transaction will begin to sell the S&P 500 stocks to hedge its exposure (or do some sort of derivatives trade with another counterparty, who will start to sell stock). Either way, sell pressure is added to the market at a time when it is teetering. Financial history buffs will recall that portfolio insurance had a similar effect in the 1987 market crash.
2. Yen carry trade. Interest rates in Japan have been extremely low ever since the Tokyo stock markets rose in the 1980's and then crashed in 1989. The Nikkei 225 fell from an all-time high around 38,900 to the 7,000 to 8,000 level and has risen to around 17,000 today. The Japanese stock market bubble was accompanied by a real estate bubble so extreme that the Japanese imperial palace was said to be worth more than the entire value of all the real estate in America. Some Japanese home buyers took out 100-year mortgages (that's some inheritance for your kids). Needless to say, the Japanese real estate bubble also popped. Between the stock market crash and the real estate bubble popping, Japan's banks were saddled with such enormous loan losses that they very possibly were insolvent. In order to bail out the banks, the Japanese central bank lowered interest rates to virtually zero (which meant the banks could take deposits and otherwise borrow money for almost no cost). These rates have been kept more or less around zero until recently.
The extraordinarily low interest rates in Japan gave rise to a trading strategy called the "yen carry trade." You borrowed yen at the very low rates available in Japan, converted it into dollars, and invested in the U.S. Because U.S. interest rates and other returns were quite a bit higher than your borrowing costs, you made some easy money fairly quickly. There's nothing like easy money. Many Japanese have been using this strategy. So have many other investors, from places like the U.S., U.K., Australia and New Zealand. Anyone who can borrow yen--and in today's globalized financial system, that means almost anyone who can borrow--can do the yen carry trade.
The catch--remember, in all investment schemes, there's a catch--is that currency exchange rates fluctuate. If the dollar drops in value against the yen, the dollar denominated investment gains you get will be reduced by your losses in the dollar. In the last year or so, the dollar has been dropping against the yen. While the drop has been fairly gradual, it's been enough to make yen carry traders nervous.
Then, the stock market fell, sometimes abruptly, in the last two and a half weeks. That's been enough to make a lot of yen carry traders throw in the towel. They've ditched their U.S. investments, and reconverted their money into yen.
3. Hedge Funds. You knew hedge funds would be mentioned sooner or later, and here they are. Hedge funds that invested in subprime and other mortgages (another thing you knew would come up) have been receiving many withdrawal requests from nervous investors who believe too much of what they read in the newspapers. In the case of one Bear Stearns sponsored hedge fund, the fund simply ceased honoring withdrawal requests. But many other hedge funds have been trying to accommodate these nervous Nellies who have a complex about retiring with only Social Security.
The hedge funds have a minor problem, though. There aren't many people paying cash for CDOs these days. Some CDOs, when put up for auction, apparently aren't getting any bids at all. You can't honor a withdrawal request with zero. So, hedge funds have been liquidating other investments, like other debt securities. The private equity debt and junk bond markets have been particularly hard hit by these liquidations, and spreads between these securities and Treasuries have widened sharply. It's also likely that some of the selling in the stock markets has also been hedge funds raising cash to meet withdrawal requests, or just hoping to avoid losses.
4. Short Sellers. Short sellers are viewed by many as a scourge. They are disliked for profiting from misfortune and scorned for scavenging. However, they may assist the pricing function of the market, pushing the price toward its true equilibrium.
Some short sellers have no doubt been shorting the market (through derivatives that allow them to trade the equivalent of the S&P 500 or other broad market indexes). This probably has added to the downward pressure on the market. However, the shorts can also fuel some of the upward pops in the market. When the market begins to rise, the shorts start to take losses on their positions. As their losses increase, the counterparties with whom they traded (in order to assume their short positions) will often ask for cash collateral. If the shorts don't or can't provide cash collateral, or simply want to cut their losses, they'll buy stock to cover their shorts. This "short covering" is fast and intense, and may account for the laughing gas quality of some of the recent upswings in the market.
5. Derivatives Market? The increasingly tattered state of the derivatives market may account for some of the increased market volatility. There's no way to know for sure, since the derivatives market is unregulated and seriously opaque. But many players that might write derivatives contracts to protect holders of stocks from downswings could be inclined to demure these days. They may have taken losses in the subprime and corporate debt markets, and be unable to take on additional equity risk. They may simply be skittish, not knowing how bad things are, and prefer a quiet game of croquet.
Derivatives are said to moderate volatility by shifting risk to parties willing to take it. There's some truth to that. The problem is one of success--they proved so good at risk shifting that more players began investing in risky contracts, with expectation that they'd shift the risk to someone else. That was a clever strategy until it created such a large amount of risk that the mortgage market belly flopped. We discussed these unintended consequences in http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html.
If some of the participants in the derivatives market have stopped playing in that particular sandbox, others seeking to hedge their stockholdings may be unable to lay off their downside equity risk. In that case, they'd have to take old fashioned action to protect themselves--like sell. As the derivatives market pulls back, it won't damp volatility as much.
There may be many other causes of market volatility, although these are probably enough for anyone who owns stock. The past few years have been unusually calm ones for the markets. But an unduly large amount of risk may have been heedlessly created because of the Panglossian perception fostered by that calm. The concern now is that this change in financial climate may have created the conditions for larger and more frequent hurricanes. Let's hope the levees hold.
A Fed Bailout: in the vein of cat-saves-people-from-fire stories, we noted in the preceding blog (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html) that the stock market was hoping the Fed would give the market a little boost at its meeting today. In anticipation of some dispensation, the Dow rose 287 points on Monday (8/6/07), the day before the meeting. With a handicap like that, it was easy for the Fed not to indulge the market, hold interest rates steady and maintain that its primary concern is controlling inflation. The Fed gave the market a bit of a doggy treat by noting the problems in the credit and real estate markets, and the stock market's volatility. But it gave no real indication that an interest rate cut would be forthcoming at any predictable time in the foreseeable future. The Dow closed up 35, apparently satisfied with the crunchy chicken and beef flavor of its treat.
Animal News: you can't take hardly any liquids on board a plane, but if it's a monkey . . .
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