There has been increased talk recently about the relationships between energy prices and demand levels for crude oil, natural gas, electricity, diesel, and gasoline. Even as prices have hit record levels, global demand has not fallen as sharply, or in some cases, even at all, putting into question the traditional relationship between the levels of price and demand. As it turns out, many countries are subsidizing the energy demands of their citizens, causing many users of energy to not directly feel the effects of higher energy prices, and therefore have no reason to curb their energy usage.
Recently, some of these countries are being singled out in the ever growing and popular game of assigning blame for higher energy prices. Just ask SUV drivers, President Bush, the Saudi King, congress, the Iraq war, speculators, supply-demand relationships, environmentalists, emerging markets, Mother Nature, and even alternative fuels, such as ethanol. Each has had its turn as the energy boogie man. As a sign of increasing pressure, the Wall Street Journal is reporting that China is now lifting energy prices for domestic consumers, raising prices for gasoline (by 17%), diesel (by 18%), and electricity (by 4.7%). As a comparison, this will raise gasoline prices in China to the U.S. equivalent of just over $3 a gallon. China has also stated that some of the gains in global energy prices that are realized will be passed on to consumers.
Ironically, the raising of prices may actually increase demand, and subsequent prices, as profits return for Chinese refiners. Refiners are currently buying crude oil on the open market at recent high prices, yet are limited as to how high they can price their refined products. As prices rise to meet and exceed their raw material costs, refiners will begin making more gasoline, resulting in more crude oil being purchased. Price controls have created fuel shortages in some parts of China since last year, and the level of pent-up demand is strong. The United States ran into similar problems in the 1970s as shortages developed and volatility increased when price controls were implemented.
Yet, the question still remains - will this have any impact on the global price of energy? Probably little, unless more countries follow suit. China currently consumes about 10% of all global oil. Significant, but small changes in China may have less of a global impact than hoped. Furthermore, the economies of China and other emerging countries continue to grow at high single and double digit rates. Small changes are therefore unlikely to slow growth enough to reduce demand, and as seen with the refiners, could have the opposite effect.
As the U.S. presidential election approaches, and an new president is elected, expect to begin hearing more about cap-and-trade for reducing carbon emissions. Both presidential candidates support some form of cap-and-trade, and the Congress at this point seems inclined to proceed. Fortunately for the U.S., Europe implemented cap-and-trade for carbon in 2005, and their experiment offers a number of lessons that hopefully U.S. lawmakers and regulators will learn from.
As reported in an International Herald Tribune article, emissions from factories and plants that trade pollution permits actually rose 0.4% between 2005 and 2006, and 0.7% between 2006 and 2007. It appears that the initial problem developed when the market was created, as some EU governments allocated too many trading permits to polluters. The flood of permits caused their value to be cut in half, and raised questions about the validity of the permit market. The overall allocation not only allowed polluters to keep polluting, but also allowed companies to sell excess permits into the market, profiting from their sale while reducing their value along the way. Prices have since rose after reforms were put in place.
Another problem with the system is the catch-22 of not enough, yet too much government intervention. Without government intervention it is unlikely that industry would impose such a system on themselves, yet with too much intervention, the market is not allowed to operate as it probably should. Of course, government intervention also gives lawmakers opportunities to do one of the things they do best - look out for businesses and industries within their own states and districts. Not that this is inherently a bad thing, but in this case it does not facilitate the problem at hand - reducing carbon emissions.
Careful consideration also needs to be made as to the type of system put in place. While the cap-and-trade systems created in the 1970s and modified in the 1990s to reduce acid rain did have some success, and is now being seen as a framework to build on for carbon trading, the environment at the time - pardon the pun - was different. The acid rain problem was somewhat localized, at least the part we were interested in. Carbon emissions are more of a global problem, and being consider as such. While a cap-and-trade system could possibly help to reduce U.S. emissions if successfully implemented, a U.S. system may do little to curb overall global emission levels, even with the large levels of emissions generated by the U.S. If developing and fast growing countries are not on-board or forced to participate in a similar market system, especially larger countries such as India and China, then the global benefits will be small. Furthermore, making business operations more expensive for small companies and developing countries makes it more likely that companies will either go out of business, pass costs on to consumers, relocate, or look for ways around the regulations. Developing countries will find it more difficult to lift their citizens out of poverty. If not probably designed, and we simply dive in for the sake of political expediency, then the only thing regulators and lawmakers will have achieved is to reduce U.S. competitiveness, and make it more difficult for countries to increase the quality of life and standard of living of its citizens - the very thing such regulation is trying to achieve. If done right, there is potential, but various outcomes must be considered first.
Market solutions may in fact be the answer to reducing carbon emissions, but increased regulation and government interaction often make it less likely that markets can operate efficiently. Ironically, high crude oil and gasoline prices, a result of market forces already in place (be it supply-and-demand and/or speculation driven), may do more than even cap-and-trade could for reducing carbon emissions. As carbon-based energy sources continue to rise in price, the marketplace will look for cheaper, and often cleaner, alternatives. We are already seeing this with the increased interest and investment in solar and wind energy (and even the government mandated ethanol - which has its own carbon footprint). While each does have various forms of government incentives for investment, the market is still being allowed for the most part to operate as its should. Maybe in the end we don't need another market to solve our problem. Maybe what is needed is a little patience, a little incentive, a little trust in the markets, a little faith in American business and ingenuity, and a lot of political courage.
A recent Financial Times article discusses timetables for U.S. businesses to manage the move from domestic accounting rules to the International Financial Reporting Standards (IFRS). Five years is being discussed as a good time frame in that it is short enough to get people interested now, but long enough to give them time to successfully implement the standards. The SEC is still considering proposals and time frames. Foreign companies are already allowed to file international financial reporting standards without converting them to GAAP (generally accepted accounting principles). IFRS is already being used by over 100 countries, including China and India, and members of the European Union. U.S. acceptance would essentially make it the chosen standard for other countries still on the fence.
Given the increased level of globalization, and the increased interest in international investment, the move to a global standard would on the surface make it easier for investors to analyze international companies. Yet there are issues to be resolved and worked out, such as inventory issues, dealing with extraordinary items, depreciation of existing assets, lease issues, derivatives, and numerous tax issues, among others. Details of the differences can be found in a report from Price Waterhouse Coopers. In another report, described in an article from Accountancy Age last August, an analysis by Citigroup found 426 reconciliation differences. The biggest areas of difference included the general areas of tax, pensions, goodwill and intangible assets, and financial instruments. Of additional interest is that moving to IFRS would allow some U.S. companies to boost some of their numbers. The Citigroup study found that 82% had higher net income under IFRS, while book value was lower for 70% of the sample. Overall returns on equity were also higher under IFRS. Nonetheless, it is felt that over time these differences would be worked out.
One potential drawback of moving to an international standard is that it could make it more difficult for the U.S. to maintain flexibility without additional regulation when dealing with reporting issues that present themselves unexpectedly. Nonetheless, the positives and environment currently seem to outweigh the negatives, even with the initial inconsistencies, so it is likely that such a move will be made. While it is hopeful that investors and companies will benefit in the long-term, there is no doubt that consultants and accountants will see some short-term benefit as well, at least in terms of increased business. As transitions are never as smooth as originally planned, investors and traders relying on fundamentals can only hope that the makers of headache medicine and antacids also do not see an increase in business as they wade through the new standards.
Companies are expected to shift investment over the next five years from the U.S. to BRIC countries according to KPMG International, as reported at Financial News Online. As a result of the shift in investment, by the year 2014 China is expected to be the leading recipient of corporate investment worldwide, rising to 24%, while the U.S. falls to 23%. Of the BRIC countries, India is expected to have the largest shift in corporate investment during the next five years, going from 8% to 18% of worldwide corporate investment. Part of the shift is explained not only by the emergence and growth of the BRIC economies, but also by a desire for corporations (and investors in corporations) to diversify and take on greater international exposure.
There is an interesting article at the Financial Times Online about how Deloitte & Touche is helping Goldman Sachs restructure their SIVs without direct help from the US Treasury supported SuperSIV scheme for purchasing SIV assets. The proposed restructuring is too involved to detail here (see the article), but the advantage to Goldman and others is that it would allow these firms to keep the assets long enough to hopefully avoid fire sales prices. The Deloitte/Goldman model is expected to be rolled out for orphaned SIVs within Goldman (those in receivership that were unable to be restructured quick enough), and could be used as a model for other companies.
In short, the principle used to restructure the SIVs is similar to those used to restructure debt-laden companies. First, the claims of the junior creditors are wiped-out allowing the senior creditors to control the assets. The assets are then reorganized into a new framework, which may involve additional restructuring and recapitalization. The main difference lies in the valuing of the assets, which is more difficult given that it is hard to get creditors to agree on valuations. While not transferable to all companies, if successful the structure could help to reduce the burden on the government and taxpayers, while also allowing firms to eventually sell assets for more reasonable prices.
An article in The Bond Buyer discusses how investment and commercial banks that originate municipal bonds are having a difficult time determining how to put their risk capital to work. Many are pricing securities to sell, thereby keeping less inventory and less securities on their books. Firms in general are reluctant to put capital at risk, and therefore are beginning to leave the municipal origination business. With approximately half of all muni bonds on a typical balance sheet insured by the bond insurers (who have their own problems), companies are feeling the effects of the on-going credit issues as many of these bonds have fallen 30% or more. Given the desire to unload positions, electronic trading platforms that sell munis are playing a larger role, with electronic trading up 40% over the last year.
Less origination by the large firms is also having an effect on trading operations. Traditionally, new underwritten securities give traders something to sell, while also providing products to clients serviced by the wealth management groups. UBS, which recently exited the origination business, is transferring some of its municipal securities unit back to the wealth management business, effectively shifting this business to a new profit center. By using an electronic platform for trading, UBS feels it will still give clients "... access to a broad supply of both new issues and secondary securities." For UBS and others, it is unclear who will be providing the new securities. Once possible source are regional firms that are already looking to fill the void generated by larger firms exiting the origination business. The shift back to regionals is already taking place as displaced brokers from the larger firms are already making the move.
Regionals do have the advantage of understanding the local environment better, be it economic, legal, regulatory, or political issues. Whether the shift from more to less capitalized firms is good for the credit markets is yet to be seen. There is no guarantee that smaller firms will also not get into trouble in the future by putting too much capital at risk. Many regionals would not be classified as "too big to fail," and will therefore be more difficult to justify bailing out unless a larger scale "saving-and-loan type" of contagion presents itself. The ramifications of this would certainly be further reaching and worse overall than bailing out another Bear Stearns.
As reported in a recent WSJ article, small hedge funds (those with less than $1 billion in assets under management) are struggling to not only beat the market, but also stay in existence. The impact is seen below in a chart from the WSJ article, by way of Hedge Fund Research, Inc.
At the end of 2007, 87% of all hedge fund money was in funds with $1 billion or more assets under management, and 60% was in funds with at least $5 billion in assets. Furthermore, while the number of hedge funds has grown to over 8,000 from only a few hundred just 10 years ago, only 1,152 new funds were launched in 2007. While 1,152 is still a large number, this figure is down 50% from the 2005 peak. When you also consider all the funds that were either merged or went out of business, the net number of new funds was even lower at 589.
The shift towards larger funds appears to be occurring for a number of reasons. For one, smaller firms are having difficulty borrowing funds, making strategies that utilize leverage much more difficult to employ. Some lower cost mutual funds are also beginning to act like hedge funds using various replication strategies, thereby giving investors other options. Institutions and pension funds, which are increasingly looking for alternative investment opportunities, are also choosing to allocate capital to larger hedge funds, which many believe are safer, given their larger capitalization and risk management (i.e., hedging) practices. The more flexible smaller funds have at times generated higher returns, but given the current market environment, larger funds with better risk management have made up for their lack of flexibility. Given that some smaller funds can spend up to $1 million or more a month for staff salaries and expenses, along with the reality that it may be a while before some hit their high water marks and can begin capturing 20% or more of profits, it is becoming more difficult for these funds to contend with current cash burn rates. As a result, don't be surprised if more smaller funds either change strategies, close down, or merge with the larger funds as the credit problems continue to unwind, and new capital continues to get allocated to hot markets, such as commodities and energy.
Recently there was an interesting article at Spiegel Online regarding the faces of commodity speculation, as told by a farmer, baker, banker, and hedge fund manager. The use of the futures market by both the farmer and baker (hedging against falling and rising prices, respectively) are well known, as is the interest by both investment bankers and hedge funds, but the perspectives offered by the participants are interesting nonetheless.
While the article highlights only four individuals/institutions, and is somewhat anecdotal, it does offer a few observations. For instance, the following quote from the farmer is telling: "Farmers who don't have supply contracts at the moment are now calling the shots." This particular farmer, who had not yet signed a contract, is planning to sell only half of his crop to the cooperative at the end of July at the current price. He then plans to store another 50% until at least October in silos in the hope that prices will rise further. He admits that farming is becoming more speculative and that he is willing to take the risk. Quiet a turn of events and roles.
The baker on the other hand is worried about speculation and the associated risk, and is still worried that his raw material costs will be too high. As prices have increased, he is being forced to pass cost increases on to his customers, and is worried that the markets he must now operate in are too unpredictable. Since the EU has abolished intervention prices - which had helped to regulate the market he operates in, prices are now set at the CME, which he worries is being driven by speculators.
The investment banker is, not unexpectedly, trying to take advantage of the market by offering new products, such as certificates whose value rises or falls along with the price of food commodity contracts on the CME. Of interest from the investment banker is the quote of how they want to "provide each private investor with a toolkit he can use as if he were a hedge fund manager worth millions." This brings back memories of people quitting their day jobs in the late 1990s to trade stocks online at home, only to see the market correct violently. As has been pointed out by others numerous times before, when the average investor begins talking about securities and markets that he or she never talked about before (day trading tech stocks before, commodities and futures this time around), it is usually the sign that a top in the market is near.
Finally, a hedge fund manager was interviewed and pointed out that he no longer trades crude oil futures (ironically, since they are too speculative), but continues to watch them closely, since at the moment "... oil futures are the measuring stick for everything." Whether trading in oil futures or not, the fund manager needs to know how high crude oil might go given that its price has such a strong impact on the stocks he trades. Many other traders have also expressed how crude oil is affecting nearly every other asset, and how crude oil itself is becoming the new global currency. Right now that currency is in an uptrend, but volatile, and worrying market participants of a correction.
As reported at Arab News, and commented on at Bloomberg, United Nations Secretary General Ban Ki-moon is saying that Saudi Arabian King Abdullah "... acknowledged that the current oil prices are abnormally high due to speculative factors and he is willing to do what he can to control it.”
Saudi Arabia had previously offered to increase production in June by 300,000 barrels, and may now increase production by 500,000 barrels in July. Given that Saudi Arabia is one of the few countries that has idle capacity and can actually raise production, this could certainly help in the short-term.
Nonetheless, even with the news of increased production, crude oil prices were still up sharply this morning in futures trading. While the crude oil markets are volatile and seem to have a mind of their own, the current news may be a reflection of a few realities. First, there is only limited idle capacity that can be brought to market. If the world were to suffer another shock, given a political or weather-related oil field or pipeline shut-down, it may be difficult for the markets to make-up reduced capacity in short-order, quickly putting pressure on prices. Second, the increased crude oil that is being placed on the market is not the light sweet crude that is demanded and driving price.
Of course, prices may also be reacting to recent calls by analysts, CEOs, and speculators, such as the one made by the CEO of Gazprom (see Bloomberg article), forecasting $250 a barrel for crude oil in the "foreseeable future." The call is more of a worst case scenario, and certainly is not unbiased, but does reflect the current mood of the crude oil market. T. Boone Pickens recently called for crude oil to reach $150 a barrel over the summer (when it was around $120), only to see the price spike higher. Recent calls such as this bring back images of the dot.com bubble in the late 1990s. During this rush, all things technology and Internet-related were doubling on a regular basis, with many stocks reaching new analyst annual forecasts in a matter of weeks. A $100 stock that was forecast to reach $180 over the next year often found its market price close to the new $180 target in just a few trading days. While I am still a skeptic as to how much speculators and not supply and demand are driving the crude oil market, calls such as the one recently made by the Gazprom CEO are not helping to stabilize the market, and are certainly enticing some momentum traders to take positions and enter the market.
2nd Notice: Given that the weekend link summaries are a little dated, in the future I will just post the shorter summaries as I write them in an effort to make them a little more timely.
After a short hibernation, the Microsoft-Yahoo saga is back in the news (for the time being I am taking the ! off the Yahoo name given that the excitement is now gone). Per the Wall Street Journal, Microsoft and Yahoo have decided to give up their plan courtship, but of course, each leaves open the right to form some type of partnership in the future. Yahoo then went right out and got engaged to Google (which it can back out of with a change in leadership - i.e., Yahoo decides later it really prefers Microsoft).
To be honest, it is all a little boring anymore. Like many merger agreements and talks, value usually gets destroyed instead of created. This certainly seems true for Microsoft, given that Yahoo is now partnering with their main rival Google. For their troubles, Microsoft left with nothing but a bruised ego and a stronger main competitor. Microsoft stock did pop on the news, as investors were glad that the distraction was gone, at least for now. Eventually they will realize they lost this part of the Internet, and will begin scratching their heads and wondering what to do next - as well as praying that the Xbox 360 numbers are better than expected, and that Vista is not really that bad. Sigh.
Of course, Yahoo really did not fair much better. For a company that built itself on search, they have essentially farmed-out the business to their main competitor. Exactly how this is good in the long-run is difficult to understand. But as Yahoo CEO Jerry Yang mention, this will bring $800 million in annual revenue through improved monetization. No mention was made of loss of market share. Sigh.
And of course, there are the billionaires - Icahn, Pickens, and Cuban. Cuban will not get his board seat, and Icahn and Pickens, well, they will not get richer - at least not yet. I am sure they will be fine. As for the other Yahoo investors, some of which were invested through funds, well, they did not fair as well. Each may have a wait a while before seeing Yahoo at the proposed $35 a share price. Sigh.
Any winners? The same winner before everything was put into motion - Google. Without really doing too much it was able to chop a leg out from under and weaken the behemoth Microsoft, who while inept in search and the Internet, still has a lot of money to throw around. At the same time it took its next closest competitor and put a leash on it. Not bad for six months of press releases and the extension of a previous beta test agreement with a competitor.
In the end, nothing much has changed. Microsoft continues to trip over itself when it comes to the Internet, Yahoo continues to destroy value, the billionaires are still rich, small investors still absorb the lost capital, and Google continues to dominate search. Myself? I just feel a little hung-over.
Given all the bad news written about the U.S. economy, in particular energy and food prices, credit problems, financial failures, higher unemployment, and the housing crisis, it would be nice to finally hear some good news. As reported in a Financial Times article, the good news came in the form of the Rand Corporation announcing that the U.S. remains the dominant global player in science and technology. Among all industrialized nations, the Rand study finds that the U.S. still accounts for 40% of global spending on scientific R&D and 38% of patented inventions. A total of 75% of the world’s leading universities are in the United States. A total of 70% of the world’s Nobel prize winners also work in the U.S.
Of course, everything is not rosy, as expected. Policymakers worry that lower standards and decreased spending on research could hurt the economy and threaten national security. The Rand Corporation also warns that more college educated scientists and engineers now graduate in the European Union and China every year, compared to the U.S. As a member of academia who has taught in both engineering and finance departments, the increase of domestic students choosing to enter the work force after graduation as opposed to entering graduate school has been apparent for years. Unfortunately, at this point it is hard to see how the trend can be reversed quickly, even with our continued good standing regarding undergraduate and graduate science, engineering, and technology education. The difficult part is convincing domestic students that the hard work they put in now will pay dividends in the future. Unless we continue to support investment in all kinds of technology (be it biological, energy, computer/electronic, etc.), and give companies the business environment they need to continue to innovate and attract the best and the brightest, this may continue to be a hard sell. But if we can continue to do the right things, and provide the proper environment, there is reason to be optimistic.
As recently discussed at bullbeartrader.com, and followed-up today with another article from Bloomberg, heavy rain is causing corn prices to reach record levels. Prices have essentially risen for 6 straight days after Bloomberg first reported how heavy rains would cut the corn crop estimates. Global inventories are forecast to fall to a 24-year low as prices head higher for the fourth straight year. As reported in the recent article:
Corn's yield potential falls unless plants have emerged from the ground before the end of May in most of the Midwest. Corn planted in wet, cool soils develops shallow roots, increasing the threat of damage from hot, dry weather in July and August. About 60 percent of the corn crop in the U.S., the largest exporter of the grain, was in good or excellent condition as of June 8, down from 63 percent a week earlier, and 77 percent a year earlier, the USDA said June 9 in a report. An estimated 89 percent of the corn crop had emerged from the ground as of June 8, compared with 98 percent a year ago and the five-year average of 89 percent, the USDA said.As the U.S. summer heat begins to increase in July and August, there is an expectation that the USDA will cut its crop estimates even further. Wheat (up 48%), rice (up 62%), and soybeans (up 64%) have also all been rising over the last year.
The Financial News is reporting how the current methodologies for non-exchange dark pools may be resulting in volumes being reported higher than they should be. Guidelines exist for reporting volume, but there is not a standard way for calculating them. Currently, both the buyer and seller volume are being counted, resulting in a form of double counting. This has been standard practice, but now smart-order routing is causing many sellside brokers and independent pools to count routed volume as well. For instance, by using smart-order routing, an order sent to a dark pool could be matched in the pool, or routed to another dark pool, causing volume to be counted two or three times. When it is match in the second dark pool, it is counted once again, possibly even two more times.
Double counting is often used as a standard practice, many times for no other reason than for marketing purposes in order to show the liquidity offered by a particular dark pool. Nonetheless, not everyone is following the same rules-of-thumb, making it difficult to compare dark pools, and more importantly, get a good read on the real level of trading volume. Some brokerages, such as Merrill Lynch, are choosing to not publish volume data given the industry-wide inconsistencies. To correct the problems, some are reporting both "volume" and "pass through." While using "pass through" to measure routing volume would seem to be an easy fix, it is not quite as simple as it seems given that some pass through trades are "not matched," some or "not eligible for matching," and some are just "touched."
To complicate matters, the exchanges are not free and clear when it comes to dark pools. While the exchanges have seen some trade volume move to the dark pools, and the non-exchange dark pools have generated criticism for their secretive nature, the exchanges are also involved in similar activities. In fact, exchange dark pools not only exist, but have been increasing as the exchanges try to fend off threats from non-exchange dark pools. Approximately 10-20% of consolidated volume occurs on Bats Trading, Nasdaq OMX, and the NYSE Arca exchange-based dark pools. As mentioned by Brian Hyndman, senior vice-president of Nasdaq transaction services: "We have the ability to break our non-displayed liquidity from our displayed liquidity. We are the largest exchange in terms of volume in the US and the largest for non-displayed volume." Such a badge of courage may make Nasdaq investors happy in the short-term, but may also cause problems in the future as regulators begin to look into dark pools and their affects on liquidity and price discovery. Given the recent talk of speculation in the commodities markets, in particular the crude oil markets, any discussion of lack of price discovery, even in a different non-commodity market such as the equity exchanges, may generate un-welcomed attention. The uncovering of increased dark pool activity may be something that not only results in embarrassment, but also causes investors to increase selling volume and execute their own method of price discovery.
The Financial Times and Reuters are reporting that Icap, the interdealer brokerage, is launching a new survey-based reporting of one and three month unsecured bank funding cost. The poll will be released at 10 AM New York time. The move is yet another attempt to find solutions and/or provide alternatives to Libor - which has come into question recently and has been something we have talked about extensively (last article), including proposed alternatives.
The 10 AM reporting for the Icap value will occur when the eurodollar deposit market is the most active. Only rates, and not contributing banks, will be reported - thereby reducing signaling effects. Currently, more than two dozen institutions are involved in reporting for Icap. The British Bankers Association (BBA) is already meeting to discuss alternatives and ways to return confidence to Libor reporting. Moves like the one recently made my Icap will certainly help speed up the process.
As reported from Reuters, the CEO of Potash has recently stated that he believes that the next five years could be "the greatest period of growth" for the company in its history. He goes on to say: "We have a lot of pricing power. We're nowhere near peak pricing." Given recent fertilizer price increases, demand, and stock price activity, this certainly seems like a bold statement. As seen in the daily and weekly charts below (from stockcharts.com), the price activity for Potash has been outstanding. The weekly chart shows a nearly perfect 45 degree line uptrend for both the weekly price and its 50 and 200 week averages.
Charts like this are both exciting and scary. While the chart looks good technically, logic tells us that what goes up must surly come down - or at least take a breather. While not apparent on the weekly chart, the daily chart does show some consolidation before moving back up, albeit somewhat volatile. If the stock can hold above the $210-215 level, then investors may have a little more confidence that the uptrend will continue. Recent comments from the Potash CEO should certainly help provide some short-term buying interest in the stock. If he is correct, and fertilizer prices truly are going up and demand does stay strong, than Potash and its competitors (Mosaic and Agrium) should continue to outperform.
As reported in Bloomberg and elsewhere, a group of 17 banks have come together to create a clearinghouse system to move credit default swap (CDS) trades and cover a failure by one of the market-makers. While the amount of potential CDS loss is closer to $2 trillion, and not the entire $62 trillion in notional value that often gets reported, the possible market exposure is still significant and should be addressed. Just a little over a week ago we discussed the CDS counterparty risk issue in an article that mentioned how regulators and the Fed were looking for ways to limit the exposure from a counterparty failing to meet its obligations.
Of concern is not so much the failure of one bank or counterparty, but the possible systematic risk that would be felt by the entire financial system. The new system will allow the market to trade against the central counterparty, mitigating the consequences of failure by a major institution. In addition to systematic risk, the system should also help prevent a Bear Stearns-type of failure since there will be less need to make a run on a specific institution.
Other benefits of the clearinghouse will be increased liquidity and transparency. Providing a clearinghouse will encourage more swap trading, and larger volume will allow for a more efficient market and more reliable mark-to-market process. This will make it easier for investors to have a better idea of the true exposure that a company is taking, allowing for a better valuation and more efficient stock price. Currently, it is difficult for companies to even know what their credit risk exposure is given that the CDS market is thin and delayed, not to mention opaque at best. The new center counterparty system is a good step towards helping to shine light on the CDS market by reducing credit risk, and allowing for more real-time price discovery.
Unfortunately, it will not be enough to suffer losses from just regular credit default swaps (CDS) and collateralized debt obligations (CDO). As reported in the WSJ, additional pain from synthetic CDO losses may be just around the corner. Synthetic CDOs have been around for a while, but have become popular in the last few years as a way for insurance companies, banks, and funds to invest in a diversified portfolio of companies without directly purchasing the bonds of the companies. While many of the problems with CDOs linked to mortgage debt have been uncovered and are currently being felt, problems with CDOs linked to regular corporate debt are now raising the interest of rating agencies.
Unlike normal CDOs, synthetic CDOs do not contain actual bonds or debt. In order to provide the normal income stream generated by CDOs, synthetic CDOs provide income by selling insurance against debt default. Each synthetic CDO typically has numerous companies with good to high "investment-grade" credit ratings. Like a normal CDO, different tranches, or levels of risk and return are sold. The tranche structure allows some investors to receive higher returns (while taking higher risk), while making it possible for others to take much less risk, but also receive lower returns. Again, much like a normal CDO, it is possible to create a higher investment grade asset (tranche) out of lower quality securities. Additional details regarding collateralized debt obligations can be found here.
Insurance companies typically purchase the higher rated senior and mezzanine tranches, while hedge funds, looking for higher return, yet willing to bear or hedge the additional risk, typically invest in the lower-rated or unrated equity tranches. As with any CDO, in order to increase the returns of the equity tranche, the banks that created the CDOs can simply include lower-grade (higher return) debt. As the credit crunch progressed, more of these lower-grade companies have defaulted on their debt, causing the CDO losses to move up to the higher tranches. Given the synthetic nature of the CDO, rating companies are now being forced to develop new methodologies that will allow them to examine synthetic CDOs.
New downgrades will surely result from this closer examination, forcing additional selling of already distressed securities, putting further pressure on the markets. Combined with higher energy costs, this should prove to be a challenging time for some companies and investors, as well as the market in general. The old saying, "may you live in interesting times," will certainly get tested as we move into the dog days of summer.
Richmond Federal Reserve Bank president Jeffery Lacker is warning about consequences from the decision of the Fed to lend to securities dealers. Of concern is how investment banks are not subject to the same level of regulation and oversight as are commercial banks. Paraphrasing, Lacker points out that the effect of the recent credit extension on the incentives of financial market participants might induce greater risk-taking, and that this increased risk-taking could give rise to more frequent crises - the classic case of moral hazard.
Robert Eisenbeis from Cumberland Advisors points out that some of the Fed officials may be having "buyers remorse" with regard to going down the path of opening-up securities lending to investment bank. As a result, some are starting to discuss potential problems in public, possibly in an attempt to begin sending a message to the market that this is not something that the investment banks can always rely on. Many economist have pointed out that once the Fed bailed out Bear Stearns and opened up the discount window, they let the cat out of the bag and will have a difficult time getting it back in. As other investment banks run into trouble, they will no doubt be expecting similar treatment, including cheap borrowing and a market for illiquid assets.
Eisenbeis mentions possible ways to begin correcting the perception, including preventing investment banks from being prime dealers - in effect preventing them from being a conduit for implementing Federal Reserve policy. The Fed could also force the investment banks to change their charter, allowing the Fed more flexibility to take necessary actions to secure the assets available for borrowing. Nonetheless, any changes will be difficult. Since it is unlikely that the Fed will make any formal declarations, the market will no doubt have to wait until the next potential failure before it will know for sure what actions the Federal Reserve is willing to take. Hopefully this will not come sooner than later.
Given that the weekend link summaries are a little dated, in the future I will just post the shorter summaries as I write them in an effort to make them a little more timely.
