The CFTC is focusing on the swap market, which is currently for the most part unregulated in comparison to the exchanges (see Financial Times article). Currently, swap dealers receive exemptions for speculative positions limits that may apply to other speculators in the commodities markets. In essence, swaps are private contracts between investment banks and investors that allow for exposure to commodity prices without investing directly in the futures that backed the assets. This does allows one to take a speculative position without posting the same margin or abiding by the same position limits that one would encounter on a futures exchange such as the Nymex. A CFTC survey found that of the 550 clients of swap dealers, at least 18 were above the exchange limits as a result of using swaps. Closing this path, or at least imposing the same limits, would put these traders more in-line with current exchange requirements. Whether this curbs speculation to a noticeable degree, beyond affecting the 18 or so mentioned clients, will have to be seen.
Interesting Telegraph (London) article regarding a decision by News Corp. (NWS) to consider pulling out of Russia after learning that the offices of its outdoor advertising firm were raided. As stated by Rupert Murdock,
"The more I read about investments in Russia, the less I like the feel of it. The more successful we'd be, the more vulnerable we'd be to have it stolen."As Russia continues to generate crude oil revenues, capital available for investment will grow, as will interest in investment opportunities. Yet, experiences such as the one encountered by News Corp, along with recent confrontations with Georgia, will certainly cause some to questions the risk-reward of any such investments. As more companies consider managing risk, including political risk, the BRIC may start to become the BIC. Regardless of opportunities, companies are nervous about taking on any unnecessary risk. The News Corp decision may be just the beginning, with more countries than Russia being affected.
Thursday, the investment-grade CDX North America Index rose from 130 bps to above 150 bps in a little over a month (see Financial Times article). The Counterparty Risk Index of the 15 leading dealers in the credit derivative markets rose almost 30 bps to rise above 210 bps, sending the CRI to its highest level since the March 14 pre-Bear Stearns Federal Reserve bailout (ie, sale to JPMorgan). The recent Lehman Brothers issues are certainly shaking the market once again, as each new proposal by Lehman to stay afloat is rejected by the market, driving the prices of Lehman down further. Swaps measuring the difference between three-month dollar Libor and the Federal Reserve’s overnight rate for the next three months was trading near 85 bps, just below the 90 bps peak last April. The increase in Libor is signaling rising concerns over counterparty risk. The market has been waiting for the next shoe (financial company) to drop, expecting that Bear Stearns was not the end of the story. Whether a Lehman sale, or failure, will signal a turning point in the level of fear that is continuing to be priced into the credit derivative markets should be known shortly. If not, additional banks and financial institutions may be placed under the liquidity microscope.
Yet another article about how poorly hedge funds are doing this year, with the average fund losing more than 4 percent to date (see NY Times article). Compared to the general markets, not terrible, but certainly not what many investors in hedge funds are looking for when making such investments. The term 'hedge fund' has come to mean a number of things over the years. It will be interesting to see if the recent market troubles will cause some to go back to the basics of hedging and protecting assets. Protecting capital, in addition to generating alpha, may come back in vogue again, offering even more opportunities for those with both investment and risk management expertise.
Update: Of course, this is not as easy as it seems. As also reported recently in a New York Post article, funds with a "simple and traditional" long-short strategy are also down 3.2 percent, with some down over 20 percent. Good managers are still in short supply, and even the good ones get it wrong every now and then.
During Jim Chanos's recent appearance on CNBC, the famous short seller mentioned that financial stocks have probably seen the worst and that his fund now has fewer short positions in financial stocks than it did in the recent past (see Reuters article). He also feels that most of the bad news is already known and priced into the financials. As an alternative, Chanos is now shorting companies involved in commodities, in particular "... companies that might depend on cement prices or steel prices going up." Certainly not good news for the automotive, infrastructure, and housing markets.
As pension funds look for ways to increase return, and adjust to the changing markets, the GAO is recommending more guidance as they begin to invest more in alternative investments, such as hedge funds and private equity (see Reuters article). While there is always worry of over-stepping when Congress gets involved, the trends are real and will most likely cause more concern going forward given the lower level of transparency for alternative investments. Whether future restrictions and regulations will impose a greater cost burden on such funds is yet to be seen. Of interest, data shows mid- and large-size funds to have between 21 and 27 percent investment in hedge funds, and more than 40 percent in private equity. These trends are not unlike those seen at various academic endowments (see previous post). It would not surprise me if more individuals begin exploring these investment areas as related products start to become available to retail investors.
Commodity index investors (ie, speculators) sold $39 billion worth of crude oil futures between the July market peaks and September 2nd, a time that saw a rapid sell-off in crude oil prices (see Independend.ie article). The analysis was once again done my Michael Masters, president of Masters Capital Management, who recently blamed speculators for driving up prices. The drop also comes at time when the IEA is forecasting lower demand, and pension and hedge funds are unwinding commodity positions, each of which have put pressure on prices. In the end, such debate may be academic as to whether we call those selling speculators (be it hedge funds, pension funds, index funds, or individual traders). Given the exposure we all have to pensions and index funds (even us retail money mortals), we all might be classified as speculators, notwithstanding the evil mustache-twisting monopoly banker image. Of course, all this talk says nothing as for whether speculators are even inherently bad for the markets in whole (see US News & World Report blog). After all, who is going to take the other side of the position when a company is looking to hedge its risk? If the market is rising or falling, will there always be the perfect number of textbook farmers and bakers on the other side of the wheat contract? Probably not. How many companies will show higher profits, or at least less loss, due to placing proper hedges? Raising margins to decrease leverage and unhealthy exposure is one thing, but making it more difficult for the market to even function is another. If we eliminate all trades and traders that don't actually plan to buy or sell the commodity, liquidity will decrease. If this does happen, individuals may find themselves living in a much riskier world, even if the price of crude seems a little less volatile day-to-day.
OPEC's recent decision to cut production may not have the impact that is usually expected (see NY Times article). Reports are that Saudi Arabian officials have assured world markets that they would ignore their own cartel members and continue to pump oil. While agreeing with the recent decision of OPEC to cut production, the Saudi's are concern that higher oil prices will not help the world economy, possibly causing a recession that would not only cause oil prices to collapse even further, but also speed-up the development of alternative energy sources. The 13 nations in OPEC control roughly 40-45 percent of the world's oil production (and hold roughly two-thirds of reserves), yet some large non-OPEC players in the space, such as OECD members and Russia, produce approximately 24 percent and 15 percent, respectively. The impact of the OPEC decision, especially when one of its members may be breaking ranks, may be less than might be expected, but with close to half of all production their impact is still worth paying attention to. Nonetheless, when an asset is selling-off, even on good (or at least bullish) news, then this also must be noticed. Oil is nearing the psychological $100 a barrel level once again. If this level is broken with any conviction, even in the face of possible production cuts, this would certainly be an interesting development for the entire market. Further selling pressure seems to be more of a reality at the moment, especially given the de-leveraging of commodity assets by various pension and hedge funds. Then again, as current markets have illustrated on a near daily basis, they have a tendency to change their mind pretty quickly, causing the shorts to also be quite nervous, regardless of their current bias. It is probably safe to expect continued volatility, but at this point it is not clear whether the recent decision by OPEC can reverse the recent sell-off.
Update: As a follow-up, the Times of London is also reporting that OPEC is continuing to work with Russia on oil production, scheduling another meeting for next month. Together, OPEC and Russia would produce about 50 percent of the world's oil, and could exert more influence when working together.
Update: Hurricane Ike is moving into the Gulf. A number of rigs and platforms are already being affected. Friday price action before the weekend should be interesting. Gasoline prices are jumping on the refinery impacts.
Berkshire Hathaway is apparently telling one of its subsidiaries, Kansas Bankers Surety Co., to stop insuring bank deposits above the amount guaranteed by the federal government (see WSJ article). The move will prevent banks from offering "bank deposit guaranty bonds," often used as a way to attract the business of wealthy customers. The decision stems from the fact that when banks are acquired, the company purchasing the bank may not take on the larger deposits beyond what is insured by the government, causing potential losses for those companies that have insured these extra deposits. The current move would help Berkshire reduce future losses that may occur as more banks fail or are purchased. Unfortunately, the move also signals worry by Buffett and Berkshire that more bank failures and consolidation could be expected in the future. This is certainly not the news the markets need right now.
Nothing too earth shattering here, and the Buffett interview is rushed as he on the baseball field at Boston to throw out the first pitch, but it nonetheless highlights how we all are in the same situation. When asked about the uncertainty of the markets, whether housing will recover, or whether Fannie and Freddie will be expensive to taxpayers, he basically says, "I don't know." Probably the most honest statement yet, and an illustration of how were are all just feeling around in the dark with regarding to the housing and credit crisis. There will be winners and losers in the end, as there already have been with Fannie and Freddie, but hope is still entering into the equation. Just ask Lehman.
Source: Wall Street Journal Online Video
The recent move by the Treasury to place Fannie and Freddie into conservatorship amounts to the equivalent of bankruptcy in the credit derivatives market, generating defaults, and causing dealers in unwind various credit default swaps (see Financial Times article). The move once again highlights some of the problems with the CDS market, as no one really knows the real level of exposure. The notional protection outstanding is expected to be significant, but again, the exact amount is difficult to estimate. Settlement and trading procedures, as well as general transparency, needs to be improved. While the Fannie and Freddie related CDS issues may have less concerns, given that the value of the agency debt is still high and is currently backed by the U.S. government, the next Bear Stearns-like default may not provide as clear an exit plan. The powers to be need to act fast given that the growth of the CDS market is outpacing the current trading infrastructure, while the need for hedging credit risk has never been greater.
In a effort to reduce the number of investors withdrawing money and going elsewhere, some hedge funds are cutting their fees in an attempt to retain investors (see WSJ article). Camulos Capital for one is reducing its management fees from 2 to 1.25 percent, and its fee on profits from 20 to 10 percent. Other funds are offering sliding fee scales based on time in the fund, or lower fees for agreeing to longer lock-up periods. Ironically, such a move could hurt hedge funds in more ways than just losing income. For one, it may make it more difficult to retain top talent who are often paid from fees. Second, it may make it more difficult for funds to attract new money. With higher fees often comes higher prestige, and the expectation of good talent with a track record of returns. A lower fee structure actually seems desperate to some, and may cause investors to look to other funds that appear to have a less difficult time raising capital. As fee structure are reduced, hedge funds begin to look more like mutual funds, causing fee and return expectation to change. Higher fees can actually help to differentiate the funds, delineating the expected level of risk and reward. As with human nature, we often want what we cannot have, and are even willing to pay up to get it. Of course, a few years of negative returns changes everything, even human nature.
Driven by a declining housing market, and aided by the Treasury Secretary's recent decision, hedge funds that bet against Fannie and Freddie racked up big gains on Monday (see Reuters article). Hedge fund Seabreeze Partners, run by short-seller Doug Kass, was short both companies. Kass's big bet has helped his fund to be up over 25% this year. William Ackman's Pershing Square Capital Management has also made money betting against Fannie and Freddie. Short-sellers have often been vilified, but now they have reason to gloat, causing one hedge fund manager to state: "I don't know how they could get it so wrong. There were so many red flags. I feel sorry for them." One trader that was not as fortunate was Legg Mason manager, Bill Miller, who had increased his holding in Freddie to 79.8 million shares, causing his fund to be off 31 percent for the year. Miller had previously beaten the S&P 500 for 15 years. Some speculate that the Freddie Mac losses may put pressure on Miller to step aside. The old saying, "So what have you done for me lately" never seemed so brutal.
Year-to-date, volatility hedge funds rose 7.3 percent according to data from the Newedge Volatility Trading Index (see Bloomberg article). The average equity fund fell 8.38 percent during the same time. Corporate fixed-income funds declined 4.00 percent YTD, and energy and basic- materials stock funds are down 6.36 percent over the same time frame. The 50 or so hedge funds that investing in volatility have been able to profit from the swings caused by the subprime and Fannie/Freddie news without trying to pick a direction for the market. New funds focusing on volatility are continuing to be developed nearly everyday (see previous post). This year the S&P 500 has fluctuated by more than 1 percent on 71 trading days, making this the most volatile start since 2003 and surpassing the 61 day annual average since 1928. The index is on pace to have its most volatile year since 2002, a time when there were 125 swings of more than 1 percent. The CBOE Volatility Index (VIX) also reached a five year high of 32.24 on March 17 of this year (the day after the Bear Stearns bailout), and has been 33 percent higher than in 2007, averaging 23.12 this year. Some analysts are expecting elevated volatility for the next couple of years. Nonetheless, even if volatility remains above historic levels, it is worth noting that the VIX has fallen 31 percent from its five-year high in March. As such, it appears that even trading volatility can be a volatile (and risky) move.
In yet another example of the credit crisis migrating down the food chain, lenders are now giving out smaller and more expensive lines of credit to retailers than they were just last year (see Financial Week article). Not surprisingly, retailers are securing less asset-based loans, which traditionally used real estate, inventory, and other assets as collateral. By the end of August of this year, major retailers had received 16 loans valued at $4.6 billion, compared to 40 loans worth about $8.8 billion during the first eight months of 2007. Why the falloff? For one, less retailers have been taken private, thereby lowering the number of retailers and firms that are seeking out asset-based loans for leveraged buyouts. The rates charged have also increased, going from 125 bps over Libor to 225 bps over Libor on the low end. Finally, advanced rates, or the percentage of collateral that is advanced to the borrower, have been cut. Previously, advanced rate were between 95-100 percent. The rates are now closer to 85 percent as real estate and inventory values have declined.
Of interest is that the rise in borrowing costs and lower advanced rates have changed the types of companies that are seeking out and getting loans. Stronger companies that previously may have taken advantage of lower rates and the tax advantages of borrowing are shying away from asset-based loans. Now, on average, the companies that appear to be taking out such loans are those that are often being forced to secure financing, and may themselves be in a less stable situation. Given recent weak retail sales data, not to mention lower consumer borrowing (and subsequently lower consumer spending - see Bloomberg article), the number of companies (especially the speciality retailers) that need to agree to less friendly loan terms may be on the rise. Credit terms, and even the need to secure financing itself, may be one more indicator that traders and investors can use to identify those companies that are most likely to weather the current credit storm.
As of now, the Fannie and Freddie story is pretty well known, and has been looked at from a number of different angles (see various articles and posts here, here, here, and here). Now we find out that the auto industry is set to press Congress for $50 billion in low-interest auto loans (see CNN Money article). The government loans are expected to be used to help modernize plants and help the car companies make more fuel efficient vehicles. Congress had already authorized $25 billion in loans last year, but apparently that is now not enough. It is believed that the loans would have rates between 4-5 percent. Even though market rates are fairly low already, the credit ratings of both Ford and GM have fallen below investment grade, making it difficult to borrow anywhere near 5 percent.
This of course makes one wonder at which point all of this stops. Sure, it is important to keep Fannie and Freddie and the general housing mess from bringing down the financial markets, but at what cost? Starbucks has fallen on hard times. Should they get some type of bailout or support? What about Sears Holdings, with the struggling Sears and K-Mart retailers? Is it time for the airlines to go back to the well? The argument of course is usually attached to the financial sector, talking about things like contagion, or national interest, for industries such as defense and manufacturing. But where is the consistency? Just as loans are being requested to help build hybrids, electric cars, and other alternatives, other measures to increase low cost electricity or reduce our energy independence are met with resistance. Even more unsettling is that by choosing to bailout Fannie and Freddie, we (the taxpayers) are now all investors in the mortgage markets, whether we choose so or not. To add insult to injury, we can even lose more than our initial investment.
Of course the real issue of concern may not be whether or not a specific industry or company is receiving low interest loans or a nice government contract, or whether we are being forced to invest in risky companies against our will, but whether the trend of privatizing profits and socializing risk is really good for free markets. As readers know, I often discuss the need for risk management, but unfortunately for many companies their idea of risk management is simply letting the government take the reins when things go bad. Again, the point is not specifically about the current problems or plan proposed by Secretary Paulson. It appears that he had no other choice, and as he stated on CNBC: "played the hand he was dealt." Yet, should it have gotten to this point?
As is now obvious, banks kept making loans without worry of whether homeowners would pay them back. They could simply sell the loans off to Fannie and Freddie, sponsored in part by the government. While Fannie and Freddie were indeed "just" sponsored entities, there was always a "wink-wink" understanding that the government would step up in times of need. As such, both risk and return were adjusted accordingly. Yet, this was part of the problem. By having in place what amounted to a zero deductible insurance policy, Fannie and Freddie could go off and look for ways to juice returns by creating portfolios that really had no purpose other than to help meet quarterly numbers and make Wall Street and shareholders happy - all the while knowing that if things got bad, Uncle Sam was there to save the day. Well, that day has come, and now the government is left with few options, tax payers are left with more risks and unwanted investments, and the free-markets are a little less free. Where does it stop?