In an attempt to profit from the recent increases in volatility, an ex-Merrill Lynch trader is planning to start a volatility hedge fund (see Bloomberg article). The fund will try to profit by buying and selling option contracts linked to currencies, commodities, and global equities. Year-to-date, volatility funds are up 7.3 percent (see previous post), allowing them to outperforming other hedge funds. The trend in offering such funds seems to be increasing given that earlier this month CQS launched a Global Volatility Fund (see previous post), and other new funds are also raising capital. The new proposed funds are also coming at a time when the VIX has recently rose to its highest value since 2002. Could this be a contrarian signal, indicating lower volatility going forward? Possibly, but given new regulations and changing market rules, it is likely that volatility levels will be elevated for the foreseeable future.

As reported at a Financial Times Alphaville blog post, hedge funds are looking for new ways to short securities, including everything from shorting index funds and then buying back every security in the index except one, to restructuring swaps to have the same exposure as a short position. Both techniques will no doubt have an affect on market volatility as more stocks become actively traded. Ironically, derivatives such as swaps, which had their own role in the current financial crisis, are now being used to help get around restrictions imposed as a result of the very same crisis. Where there is a will, there is a way. Innovation and financial engineering never sleeps.

The global federal-induced short-squeeze is now going global, as countries from Australia, Taiwan, and the Netherlands join the U.S. and U.K. in prohibiting some short selling (see WSJ article). Potential problems with the short-sell ban are already becoming evident as those needing to hedge positions, or those making a market in derivative products, are finding it difficult to comply. During the last order the SEC had already considered some restrictions on market makers who need to short stock when making a market in put options. Now, the SEC is also considering allowing short-selling to be used in some cases as a hedge - it is expected that they will allow such shorting.

Of course, where do you draw the line? What about hedge funds that actually hedge their positions? Will they be excluded? What about convertible bond and arbitrage positions? What about allowing investors to hedge their investments when companies raise money in a rights offerings? What if the sale is for risk management purposes? If risk management is considered a viable reason for shorting, couldn't everything be considered risk management to some degree? Isn't shorting an overvalued company a way to take the risk of the overvalued stock out of the marketplace? Yes, this argument is a little much, but the points is that once again it is difficult to know where to draw the line when making exceptions, which only becomes more difficult as the unintended consequences start becoming worst than what the order was hoping to accomplish in the first place.

While the order did seem to stem the selling tide last week, it ultimately makes the stock market more inefficient. If now less efficient, does this mean that the market is in fact now more risky, given that prices are more artificial than before, and that any snap-backs could be worse in the long-run (if the order is removed)? These are questions that will no doubt only be clear with 20-20 hindsight. Extraordinary times do often require extraordinary measures, but eventually we are going to come to regret interfering with a market structure and mechanism that was put in place to keep us all honest, and keep prices as efficient as possible. Finally, I do find it ironic that for the last year or so we have continued to complain about how the prices of all the various credit default swaps and CDOs were difficult to price, making it even more difficult to know their current value and a company's true level of exposure for holding such securities. One can argue that we are now starting to make transparency mistakes with our equities.

The latest SEC rule change that restricts the short selling of financial stocks is causing many hedge funds to reconsider some of the models they use (see WSJ article). As an added pressure, some pension funds that invest in hedge funds are asking fund managers if they have strategies that rely on shorting, causing some less diversified pension funds to consider withdrawing hedge fund investments. Many smaller hedge funds with less sophisticated back office operations are also now finding it more difficult to comply with the new SEC regulations and still respond to the market, continuing the recent trend of challenging times for small funds (see previous post). The new rules, if successful in reducing the selling pressure on stocks, may also affect hedge funds that have been profiting recently from volatility (see previous post), although the last short-squeeze and trend reversal was short-lived (yet the rule affected less than 20 companies). Are funds eager to get back to shorting? Of interest is the following:

"Now the market is popping big time, and it's going to frustrate people. Are the short sellers wishing today that they could be shorting at these levels? Yes, they are."

No doubt that some will take this quote as a further indication that the shorts simply want to drive the markets down at the expense of everyone else. Others will see this as further proof that the markets are still over-valued. Of course, such a quote could just be an admission that the new rules have in fact created an artificial SEC-induced short-squeeze. If the natural tendency is towards a reversion to market efficiency, the new rules certainly don't help us achieve this goal over the long-run, even if they do slam the brakes on what some believe might have been an over-reaction in the opposite direction.

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.

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.

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.

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).

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.