Here is the link to the recent New York Times Warren Buffett Op-Ed (free subscription required). Worth a read if you have not already come across it.
Banks are continuing to ask for more collateral to back past hedge fund lending, causing more funds to liquidate their positions (see WSJ article). When added with investor redemption, bank-induced liquidation is forcing hedge funds to step-up their deleveraging. Such selling is continuing to put pressure on the market, generating more requests for bank collateral and investor redemption, in what amounts to a catch-22 that continues to spiral the market downward. Such selling has been occurring for a while, as funds have been unwinding exposure to financial and energy stocks, both of which continue to suffer as crude oil continues to drop, and the credit crisis continues to unfold. While Hedge Fund Research recently reported that the level of hedge fund market exposure has decreased by one-third over the last year, I suspect that this still may not be enough. As mentioned by Antonio Munoz-Sune, head of the U.S. for fund of funds EIM: "The combination can take anyone down." Unfortunately, it is difficult to tell where we are in the hedge fund closing and deleveraging process, with many hedge funds still appearing to use every rally as an opportunity to sell. I suspect that until we see the VIX approach more normal sub-30 levels, stop seeing the DJIA and S&P 500 Index post intra-day percent swings in the high single digits, and see crude oil stop falling in price, it is unlikely that the market will stop feeling the effects of hedge fund selling, allowing for a long-term and lasting rally. Like most bottoms, we won't know for sure that it has occurred until we see it in the rear-view mirror, but I will be watching the VIX, the price of crude oil, and the Dow Jones and S&P 500 index percent swings for clues.
The EU is once again looking for ways to not only deal with the results of the financial crisis, but also some of the potential root causes of the problems (see Financial Times article). EU regulators in Brussels voted to accept changes made by the International Accounting Standards Board that will give banks more leeway in how they value certain assets whose value has dropped excessively. The changes can be applied to third quarter results, and essentially allow banks and institutions to move assets from their trading books to their banking books. This change will allow the assets to be reported at "amortized" cost, spreading cost over a number of years, as opposed to "fair" market value, which in some cases is too low or simply unknown.
Are the days of the financial lottery over? Is the excitement (and at times envy or disdain) of seeing a CEO or hedge fund manager make a killing a thing of the past? A new era of public ownership, and subsequent public oversight, may be signaling the end of the financial superhero (see WSJ article). The involvement of the Treasury in nearly every aspect of the financial system certainly means more oversight, more regulation, and more required regulatory capital: and of course, lower returns and paydays. The end result may be a slow stumble to the middle. Boring may in fact turn out to be better in the long-run, but suffering through another post-excess 1930s or 1970s market while Wall Street once again finds its way is not going to generate the page turning excitement of reading about your favorite superhero (or villain).
The drumbeat continues for adopting some type of central clearing house for the complex derivative products that are current causing issues in the marketplace (see Financial Times article). Such a move has been discussed for some time now (see posts here and here), but recent failures are certainly expected to cause the interest in creating such a clearing house to increase. Unfortunately, such an implementation, which I would support, would not be perfect, nor would it cover every existing type of over-the-counter product. Not everything can be perfectly standardized to allow for an efficient clearing. OTC trading will still be necessary for those specialized products that are offered to not only create investment banking fees, but also hedge a specific risk that a company is worried about. The ability to create these products is necessary to encourage both financial innovation, and reasonable risk taking.
So how would you guard against unreasonable risk taking? The same way as before: regulatory capital. The difference this time is that I suspect that the amount of risk capital that companies will be asked to set aside will have as much to do with both the complexity and liquidity levels as it does with the expected default rates and levels of exposure. Products that cannot be traded on exchanges or through a special clearing house will no doubt be too complex and/or too illiquid to make a market. As such, to better insure that these hard to sell and hard to understand assets are properly covered for counterparty risk, required regulatory capital will increase. If excessively complex, the level of regulatory capital may become so extreme that such "self insurance" could prevent such products from even being developed. Hopefully this will not be the case, or the intent. Responsible financial engineers (I know, that sounds like an oxymoron anymore) need to be able to continue to structure products that will allow for the off-loading of risk on both sides of the transaction. Otherwise, financial innovation and reasonable risk taking will slow down, along with the returns the markets desire. Hopefully regulators will find a "reasonable" balance that will still allow for innovation and risk management. While a flat and less volatile market sounds pretty good right now, eventually risk-taking and an expectation of return will come back to the market. Hopefully future regulation and intervention will allow it.
Many fund companies are expected to take a hit over the next quarter as a result of investors pulling money out of funds and parking their cash in money markets or Treasuries (see WSJ article). Mutual fund generate a large share of their revenue from fee income that is based on a percentage of assets under management. The market decline over the last month alone (recovered some yesterday) has reduced stock mutual fund AUM by $2 trillion, reducing a large chuck of fee generating capital. To add insult to injury, firms that generate a large portion of income from overseas are seeing even lower fees as the dollar strengthens.
Yet, everything may not be bad for mutual funds, hedge funds, and other forms of active management. As the market has declined, ETFs, which are often indexed to the S&P 500, DJIA, Nasdaq Composite Index, Russell 2000, or other subset of the market have seen their performance fall with the market, in many cases more than other funds under active management. While indexers will certainly point to the benefits of buying and holding for the long-term, individual investors looking at their financial statements and comparing returns to the ubiquitous lists of "star" mutual fund and hedge fund performance will no doubt begin to wonder whether it is worth giving up some return in order to have a professional actually manage the portfolio. Just as mutual funds were forced in some cases to lower fees in the 1990s as the market rallied and everyone felt they were a market genius (and index-based ETFs posted stellar gains by just riding along), the recent market downturn may have a reverse effect as investors realize they don't really understand the market or know what they are doing and need to pay-up to get professional management and stock selection. Ironically, the same funds that are being questioned for charging outrageous fees may be the same ones investors turn to for guidance and management.
Market uncertainty is causing some hedge fund managers to stay on the sidelines (see WSJ article). Steven Cohen, John Paulson, and Israel Englander have move much of their funds into cash. In addition to general market uncertainty, many hedge funds are also worried about stricter regulatory requirements and short selling limits, the rules of which appear to be changing nearly every day. While it is not unusual for managers to not trade when they feel they do not currently understand the market, it is also not unusual for them to begin trading quickly once conditions improve and market dynamics are more clear. Unfortunately, even once the markets start to enter steadier waters, navigating the regulatory environment will no doubt continue to be a challenge going forward as the debate continues in earnest on how to prevent similar problems in the future. Funds may find that hedging such risk is just as important as guarding oneself against market risk.
Money continues to flow into gold assets and gold ETFs (see Time Online article). The SPDR Gold Trust has expanded its holdings by 26 percent since the Lehman Brothers failure. South Africa has temporarily run out of krugerrands, and the US Mint has also temporarily suspended sales of American Buffalo bullion coins (American Eagle coins were already halted in August). Maybe this is a contrarian sign. The market action today certainly is promising.
There was an interesting article at the AllAboutAlpha blog a few weeks ago that discusses a recent working paper that considers a new method for measuring the systematic risk to the financial system that results from the level of hedge fund leverage. The report considers both funding leverage and instrument leverage (i.e., leverage to increase returns directly, such as buying on margin, compared to leverage that results from the product itself, such as buying an option contract). Of interest is that the study uses techniques from hedge fund replication research in order to determine the level of leverage a fund was using. Fascinating stuff for someone interested in developing hedge fund replication models. Nonetheless, given the recent issues with marketing to model when data is limited, the models developed will no doubt need to be improved a little before the Bank for International Settlements incorporates it into the next version of the Basel accord.