We have heard the old computer adage "garbage in - garbage out" to highlight how even a sophisticated computer program will produce nonsensical output if provided nonsensical input. The world of risk management is no different. The quants on Wall Street that are hard at work developing the next best trading and risk management systems are not perfect, but their job and measured performance becomes even more difficult when they are given bad information (see NY Times blog article).

On the surface, the goal of the risk management quants seem simply - tell me how much of the portfolio is at risk, and then tell me how much I need to sell, or how much capital I need to set aside so that I can sleep at night. In a sense, prepare me for the 100 year flood. Yet the 100 year floods seem to be occurring more often. Why is this? One possible reason is the "garbage in - garbage out" phenomenon, the problem of which is exacerbated as the markets continue to become more complex. Recent case in point, Lehman Brothers. As talk continued about a potential failure with Lehman, it became almost impossible to tell what their exposure was. Who are the counterparties? What are the default rates? What are the recovery rates? And most frightening of all, was does this new product even do? If companies cannot even understand the products they are selling, how can one expect to develop an adequate risk management system to help protect against the 100 year flood when it is not clear that water damage is even the problem, or that the strength of the levees is even important?

There is no doubt that some systems on Wall Street were provided optimistic data and assumptions, or had smoothed-out historical data in order to reduce the number of times the warning bells sounded, ultimately keeping companies from scaling back positions or redeploying capital to less profitable areas. But I suspect that there was an equal number of firms that diligently tried to provide the best information possible, but were simply in the dark. Why is this the case? There are no doubt a number of reasons, many of which are financial, but the separation between those that develop such risk management systems from those that develop products that need to be managed is not helping the situation. The information gap most likely goes both ways as the financial engineers are unaware of the workings of the risk management systems, while the risk managers are blind to the real exposures of the complex structured products that are being purchased and sold.

As more retail investors enter the markets, institutional trading continues to rise, and the securitization and engineering of products increases, both volatility and the values at risk will continue to affect markets. As new products are offered to the markets, it is essential that those who develop such products are on the same team as those who manage the risk. Risk management truly needs to be an enterprise-wide proposition, with incentives in place to reward those who properly managing risk, just as they are in place for those who engineer and sell the latest structured product. Performance on Wall Street is measured in money. If risk managers start to become rewarded in a similar manner, or if the risk management of new products begins to influence how new products are rewarded, we may then begin to find that the garbage provided to risk managers will begin to smell a little better.

The Bank of Buffett

Posted by Bull Bear Trader | 9/18/2008 09:22:00 AM | , | 0 comments »

As reported in a recent Bloomberg article, Warren Buffett's telephone has been ringing off the hook. As the credit markets seize-up, more distressed sellers are looking to Omaha as the last source for funding. As mentioned in the article, "Buffett right now is probably about the only money in the world, in the billions of dollars range, that the check will clear overnight." This has some analysts bullish on Berkshire Hathaway stock. Buffett is known as a value investor, and the market is certainly on sale right now. The combination of his deep pockets allowing him to buy just about whatever he wants, and his liquidity and reputation allowing him to set the terms, makes it likely that he will be able to add value to Berkshire. Of interest in the article is how the price of Berkshire stock has been rising as the TED spread (bank borrowing cost) has been increasing. As usual, market corrections have a way of separating the wheat from the chaff.

The SEC is looking to force hedge funds to disclose their short-sale positions, and further plans to subpoena hedge fund records (see Bloomberg article). Why stop there? Why not just make it more difficult to even short a stock? Oh, never mind (see Reuters article). I suspect that if as much attention was paid to making sure that companies were not leveraging over 50-1 as is being given to finding coordinated short selling (which may be impossible to prove BTW, even with disclosure), that short-sellers might be getting their hat handed to them in a more natural way. By the way, if you know that a famous and successful short seller with deep pockets is taking a short position in a certain company, are you more likely to go long or short? Could extra transparency even cause more traders to jump on the pile, making things worse? Would seeing that multiple funds are short a stock make you assume the stock is being manipulated in a coordinated manner, or would it give you more reason to think the stock had issues? The law of unintended consequences may raise its ugly head once again.

Where Are The Big Hedge Fund Failures?

Posted by Bull Bear Trader | 9/18/2008 09:22:00 AM | , , | 0 comments »

There is an article in the Times Online asking the question of why we are not hearing about more hedge fund failures as the current credit crisis has intensified over the last few weeks. The author believes the reason is that the current problems are due less to a credit crisis problem and more to an ownership problem - the real problem is the divergence between listed companies and their dispersed shareholders. While hedge funds have done poorly, and some will no doubt fail as a result of the current market issues, the numbers to date are not much different than normal attrition in the industry. Since hedge funds are private partnerships, it is believe that they will therefore continue to not have the same ownership problems that are plaguing the market.

Of course, besides ownership differences, hedge funds also have some other unique attributes. For one, hedge funds can keep their investors from withdrawing money, unlike listed companies. A run on the fund is less likely, at least right after a major event, unlike shareholders of listed companies who can sell their shares in mass right now. Also, hedge funds do not have to publicly mark-to-market all their assets and disclose all their underwater positions, allowing them to hold positions that may currently have irrational prices. Many (not all) also seem to take hedging and risk management into consideration, or at least are able to use their flexibility to respond to the market a little quicker. Some hedge funds will no doubt fail as a result of the current issues in the market, but I suspect that poor risk management, poor decisions, over-leverage, greed, stupidity from numerous stakeholders, and the inability to ride out the storm (due to mark-to-market or other liquidity issues) have more to do with recent failures than ownership issues.

As reported in a recent Financial Times article, accounting experts that were brought together by the International Accounting Standards Board have stated in a draft paper that they expect no let-up in the use of fair market values for bank holdings, even in illiquid markets. Of interest is the following quote from a partner at Ernst & Young:

“The key point is that the paper does stress that you cannot default to some ‘fundamental value’. You are required to find an estimate for the current price. That price might be thought to be irrational, exuberant or completely depressed but this makes it clear that is what you must use.”
In other words, the price can be totally wrong and irrational, but you have to use something. I realize that the issue is not clear-cut, that standards must be set and followed, and that any value that is used will be questioned, but there has to be a better way. I am sure the standards board and other groups will continue to examine this issue.

According to research by State Street Global Markets, fund managers in Europe are paying less attention to sell-side analysts than in the past (see Financial Times article). Data from Bloomberg also showed that the accuracy of earnings forecasts made by US sell-side analysts has fallen to its lowest level in over a decade, with analysts being accurate only 6.7 percent of the time. As for the sell-side analysis, State Street found that the pattern of analysts upgrades and downgrades matched institutional investment flows on just 2 of 11 sectors in Europe. For the other sectors, institutional investors were either withdrawing money despite analysts upgrades, or increasing their investments in sectors that were downgraded. As stated by Andrew Capon of State Street:

"The buy-side and the sell-side disagree to such extent that when fund managers receive recommendations they then tell their traders to do exactly the opposite. For many sectors there is a complete bifurcation between flows and sell-side earnings forecasts.”
Of course, if the crowd is now taking a contrarian view of analyst recommendations, should we begin to do the opposite and actually follow them? Maybe it is time to get the dart board back out. Then again, in this market the target keeps moving.

Just as crude oil hits a seven month low, closing a little over $91 a barrel yesterday, Petrobas announced that it broke its own monthly record for domestic production, now producing almost 1.9 million barrels per day in August (see Business Week article). No word yet whether George Soros had lighten up on his initial $811 million stake in the company after it was down 28 percent on recent falling crude oil prices (see previous post). If crude oil prices continue to fall (they are rallying back this morning), the expensive off-shore oil production may begin to generate fewer profits than expected, even with production increases.

The current market environment is producing difficult decisions for those with both long and short positions. As reported in a recent Reuters article, hedge fund manager and short seller Douglas Kass has been cutting back on his positions. As mentioned by Kass: "It is a dangerous time for the longs and for the shorts. This is a time to watch and not a time to play. It is time to move to cash." Kass has recently said he was still short Fannie and Freddie, even after the government takeover. Watching and not playing may end up being good advice as it certainly is a difficult and dangerous time for both the longs and shorts. As with any panic and sell-off, there is always a desire to lighten up, yet always the worry of selling at the bottom. I must say that it kind of amazes to me that we have not sold off more given some of the news hitting the street, especially when you consider large sell-offs from the recent and not so recent past, such as the 22% sell-off in the DJIA in 1987. No doubt this was a different situation, circumstance, computer network trading system, and general market psychology, but it was also a situation that did not see they types of buyouts and failures (and potential failures) that we have seen with Lehman Brothers, Merrill Lynch, AIG, and Fannie and Freddie, not to mention the on-going housing and credit crisis and previous Bear Stearns failure. Not sure if that means we have responded better this time, or whether the real pain is yet to be felt. The VIX is signaling panic again as it moves significantly above 30, but it did so back in March as well. Time will tell.

Liquidity or Solvency? Its Complicated.

Posted by Bull Bear Trader | 9/15/2008 11:01:00 AM | , , , , , | 0 comments »

The current problems with Lehman Brothers, AIG, and Merrill Lynch are uncovering a number of issues that will no doubt change the way we look at the health, valuation, of operations of businesses going forward. Of interest is how the current environment has resulted in Lehman Brothers being a company with liquidity that is not solvent, compared to AIG that may be solvent (for now), but has a liquidity issue. Just last week the WSJ Deal Journal blog highlighted some of the various anomalies between Lehman's valuation and its apparent asset values as its stock price plummeted. As of Friday, the closing price of Lehman put the market capitalization of the company at around $3 billion. Yet, many analysts highlighted that the current price reflected little on the true value of the company. Analysts expected the company to receive about $3 billion for a 55% stake in Neuberger Berman - as much, if not more than the value of all of Lehman. The bonus pool for Lehman's 24,000 employees itself was estimated to be around $3 billion. On the other hand, the company has $25-30 billion in toxic real estate assets to deal with, and there-in lies the issue for Lehman. How much is the exposure, how much are they worth, and what are the potential losses? Even with the ability to spin off the real estate into another company, and further inject it with $5-7 billion in liquidity, solvency was still not guaranteed. As Ken Lewis, the CEO of Bank of America stated today, the difference between the balance sheets of Merrill and Lehman was "night and day". Time will tell on BAC's move on Merrill. In the mean time AIG is scrambling to find capital to sure up its balance sheet and keep from getting a ratings downgrade, and subsequent higher cost of capital - as if selling off assets was not a high enough cost. The Fed window may stay closed to AIG, but funds might travel out the back door before all is said and done (New York is already granting permission to access $20 billion in capital from subsidiaries, see WSJ article).

So, are the issues with Lehman, AIG, and even Merrill a result of bad risk management, lack of good regulation, poor accounting rules, circumstance, or some combination of each. The easy answer is some combination of each, but the situation is of course more complicated than that. Good risk management should help us to avoid failure, if not excessive loss when circumstances go against us, but there are no guarantees. Regulation can force us to set aside risk capital, even when we don't want to, but again, it could be argued that a good risk management system that is actually both honest and honestly followed could serve a similar purpose (whether it does and would be followed, and whether that is why regulations exist in the first place is another issue and debate). That leaves of course accounting, and I suspect this area in particular will receive a lot of attention in the coming months, especially with regard to mark-to-market. The questions of whether each of these companies would have the same liquidity issues if accounting rules were different will certainly get some play, causing it to be a busy fall, possibly followed by an busy winter, spring, and summer. For all the regulators and agencies tasked with these problems, they may come to question the validity of the old proverb: "may you live in interesting times." Right now, something a little more boring would be nice.

Update: On another site a reader responded that leverage was the problem, and any new regulations will probably overstep. I could not agree more. Just looking at things a little down stream. In fact, the mark-to-market issues may be nothing more than an identification / realization of the leverage problem. Nonetheless, I suspect the regulators will be busy trying to prevent a similar problem. Hopefully, any changes will be measured and focused with few unintended consequences.

It should once again be an interesting week for crude oil. It appears that Hurricane Ike shutdown 19 percent of refining capacity, causing analysts to predict that gasoline may once again rise to $4 per gallon on average if the outages start to approach a month or longer (see Bloomberg article). While some refineries escaped damage, extensive power outages and closed transportation and shipping lines will make it difficult to return to normal operations quickly. While gasoline prices were on the rise late last week, the effect on crude oil was a little less certain. On Friday, as the storm was still in the gulf, crude oil traded below $100 a barrel for a short time before finally closing above $102 a barrel. Crude oil has recently been looking for reasons to go down as it has sold off after reaching prices in the $140s a just a few months. Whether the current disruptions in the gulf and the recent breaking and bouncing of crude oil prices off the psychological barrier of $100 will help to reverse the slide in crude oil (which has been selling-off even on good news), should become a little more clear as the week progresses. Rumors of funds liquidating various commodity positions, aided by speculators now taking short positions (see previous post), have been given as reasons for the recent slide in crude oil and commodities in general. This week may give an indication of how strong the selling is, and whether some funds will take any run-ups in crude prices as an opportunity to sell into strength. Taking some production off-line, even a small amount, should help to signal the current level of strength of the crude oil market. If this current development is shaken-off in short order, crude oil bears may in fact see the $80 a barrel price they have been predicting. This week should provide a little more clarity, but then again, with crude oil this seems to be a popular refrain.

As reported at the WSJ, the assets and liabilities of Fannie and Freddie will not be placed onto the federal books for now, even after the recent takeover by the government. This decision seems odd given that one of the main reason for the takeover was to instill confidence that the government was there as a backstop. Even CBO director Orszag thought that both companies should be incorporated into the federal budget. Given that it is an election year, it is not surprising that Washington would not want increase the size of government, or at least the appearance of doing so. The reason given for keeping Fannie and Freddie off the budget is apparently the need to take "... into account the degree of federal control of the companies, the economic risk to the taxpayer, and the temporary nature of the government's arrangement with the companies." Yet, the federal budget has always considered revenue and outlays of various programs and activities that the government has some control over, even if they do not run them directly.

So in the mean time, both Fannie and Freddie will have their combined $1.5 trillion of debt placed in a separate category and not added to U.S. publicly held debt - kind of like a Special Purpose Vehicle for taxpayers. Now if we can only get the companies moved to the Cayman Islands, maybe we could also reduce our tax burden. Then again, pledging up to $200 billion of capital for $1 billion in equity may generate a tax loss savings in the future, so maybe we should keep our options open. Of course, with both hands in the cookie jar, this may end up being nothing more than just another case of robbing Peter to pay Paul. I just haven't figured out which one I am yet (but I have a good guess).