In another example of "unintended consequences," some bond holders are beginning to avoid companies such as General Motors, after the recent moves by the Obama administration to short-change its creditors (see Bloomberg article). Companies with strong unions or extensive medical and pension legacy cost, similar to those at GM, may find it difficult in the future to obtain the funding they need from those labeled by the administration as "speculators". Even those that are still willing to lend will now do so only on their financing terms, which will most likely involve higher rates to compensate for the added credit risk each investor is now taking for the possibility of being "leapfrogged in a bankruptcy," according to those at Schultze Asset Management. In addition to the other automakers, including Chrysler and Ford Motor, companies such as AMR are also being shunned. The irony is that each of the car companies will probably be looking for financing in the future to help fund new energy efficient technology, such as hybrids and more efficient engines, yet they may find the terms offered in the markets unacceptable for making a profit. This of course will no doubt result in Joe tax payer once again making up the difference.

Just as the media and regulators continue to discuss the use of alternative investments and the active trading of hedge funds in contributing to the downfall of the economy and the stock market, many private investors are seeing each as a way to help protect themselves from recent market uncertainty (see New York Times article). While a more conservative trading mentality has been the norm for high net worth investors, many are now questioning its usefulness in the current market environment. Many investors who in the past have relied on a simple mix of stocks, bonds, and cash, and now turning to managed futures, financial futures, hedge funds, funds-of-funds, mutual hedge funds, currencies, commodities, and other avenues for gaining exposure to alternative investments.

Maybe even more interesting is how these same investors are becoming aggressive in moving away from a strict buy-and-hold approach, and instead are looking to take advantage of short-term trading opportunities - a move that indicates in part that such investors are not only opportunistic, but also worried about placing longer-term bets on the markets. As mentioned by Paul Speargas, senior client at WMS Partners:

“The buy-and-hold strategy, which was almost universally accepted by the investment and academic community over the past several decades, is no longer the sole investment strategy to be employed in order to deliver solid investment returns. A thoughtful balance between long-term investing and short-to-intermediate term trades is likely the recipe for investment success in the volatile years ahead.”

Given the interest by clients to still utilize hedge funds, commodities, futures, and alternative investments, not to mention the desire of the Fed and Treasury to have investors step-up and provide capital to purchase distressed assets, it might be good to pause and reflect before slapping or over-regulating the trading hands that are still willing to check the temperature of the investment waters.

Even while equities were rallying over the last few months, some well-known hedge funds were increasing their exposure to gold (see WSJ article). Some of those buying gold, gold futures, and shares of gold producing companies include Greenlight Capital, Paulson and Company, Eton Park Capital Management, and Blue Ridge Capital Holdings, among others. Yet, instead of providing a hedge against a market correction, the move appears to be motivated more by a worry of excess spending and borrowing by the government, resulting in an eventual spike in inflation, and rally in gold prices. While the recent market run has scared some away from the trade, many others are staying long, and even adding to positions, with current gold-related hedge fund investments coming in on average around 5 percent of assets. With gold still holding above $900 an ounce, there is some worry that a crowded trade will keep the shiny metal from moving much higher in the short-term. Nonetheless, for those with a longer investment horizon, there is still an expectation that the excessive printing of money will eventually cause the chickens to come home to roost, validating those who continue to stay long gold.

The market rally off its recent lows is paying off for some contrarian investors (see WSJ article). While contrarian investing can mean many things, it often involves buying out-of-favor and beaten-down stocks, or selling those that are over-extended after a nice, and often too-far, too-fast, rally. Essentially, contrarian investors often go against the grain of market sentiment. Of course, given the massive sell-off, some could argue that the markets had no were else to go but up, but timing is important, and hindsight is 20-20. Whom among us was 100 percent certain late last year that the markets were not going lower, or for that matter, were going to recover at all anytime soon, even for a quick bear rally? Even successful contrarian investors such as Warren Buffett, Bill Miller, and David Dreman had a difficult 2008, with Buffett himself adding to down investments prematurely. While those with less than perfect timing may eventually be proven to once again beat the market if held long enough (often a requirement for contrarian investors who have low levels of turnover and high levels of patience), those that are most successful understand both timing and value. It is important to remember that beaten down companies can go lower, or even fail, while those running up too fast can keep soring as the markets remain irrational longer than your ability to remain solvent. But now, in the mists of a nice bear (or new bull) rally, it is easy to once again have stars in our investing eyes. Yet while we dream, contrarian investors may already be looking for those stars that are ready to fall back to earth after a nice, and possibly unjustified, run. After all, summer is often a good time for spotting shooting stars, which are really not stars at all, but bits of dust and rock burning up as they fall from the sky. Maybe now is the time to start enjoying the show.

As the current administration continues to scold hedge fund "speculators" and blame them for potentially forcing Chrysler into bankruptcy for not accepting a deep discount on their debt (before they finally relented), those same firms may now hold more keys to the success of some of the programs being pushed by the same folks doing the scolding (see Bloomberg article). While smaller in numbers and size than just one year ago, hedge funds are still in many instances those with the most capital and risk tolerance to participate in programs such as the TALF and PPIP. Yet, while hedge funds like making money, they hate losing it even more, especially when those losses are driven in part by the rules of the game being changed. Given the recent move to ignore and subordinate more senior debt to a status lower than other parties, hedge funds may be more cautious with future investments opportunities.

Such program participation may soon get another test as hedge funds weight their options as GM goes through its own restructuring. Holders of GM bonds have just a few weeks to decide if they want to swap their debt for a 10 percent equity stake in the company - while the government and the United Auto Workers union-run health care funds get 50 and 39 percent, respectively. While not only getting the short end of the stick, those debt holders who also hold CDS contracts would most likely favor a bankruptcy filing (see Financial Times article). Estimates have investors holding $34 billion in CDS on GM, with profits on the order of $2.4 billion if GM were to default. In what is not much of a surprise, current CDS prices are indicating that a bankruptcy filing is likely. The complicated and extensive lines of debt and derivatives will make both a GM bankruptcy, and any strong arm tactics, much more difficult to execute. Given less of an incentive to participate in the next restructuring, hedge funds may find others offering a little more cooperation, and maybe even a seat at the table going forward. At some point, you cannot keep slapping the hand that may save you.

In the wake of some hedge funds pulling back risk, participants at a recent Investing Summit in Asia feel that private equity, boutique firms, institutions, and sovereign wealth funds will begin buying distressed debt (see FinanceAsia.com article). Many of these firms are expected to enter the secondary market for distressed assets given the opportunity to buy them at large discounts. Nonetheless, participants at the conference worried that all the "distress" was not currently in these assets, and that there was no reason to rush into buying them. Ed Altman, Professor of Finance with the NYU Stern School of Business, agrees, and predicts that the assets and the bargains will be available for another 6-12 months.

As we move into May, we are once again hearing the common refrain of "Sell in May and go away." Robert Maltbie, managing director of Singular Research, feels that while the refrain may hold, he expects that investors will need to be more selective (see WSJ video below). In particular, Maltbie feels that the rule of thumb works best after a nice run-up in stocks. Without that run-up, there is less downside to not selling. Of course, we have had a nice rally recently, but are still quite a bit off the highs, so even this rule of thumb has a layer of subjectivity to it this year. As for stocks and industries that have probably run-up, Maltbie highlights the consumer stocks, some banks, and some casinos. On the other hand, investors may want hold positions in infrastructure and green investment, due to the stimulus spending, and micro-small caps, due to their prices having been driven down too far.

The Grail American Beacon Large Cap ETF is now being offered to the public. While this would normally not be a big deal, this ETF is unique in that it is being billed as the first actively managed ETF (see WSJ article). There have been other active ETFs that diverged from a specific index, but the stocks choices for the fund were generated by computer models, as opposed to having a manager pick the stocks. In the tradition of lower fees for ETF, fees will be 0.79%, lower than a mutual fund, but still higher than a typical straight index fund ETF. Like other ETFs, the funds holdings will be made public daily, similar to mutual funds. Whether the ETF will be successful will depend on whether the company can avoid front-running of large public positions, and whether or not investors, who are already skittish and getting conservative, will be willing to invest with a product and a manager with an unknown track record. If history is any indication, the outlook is not good, especially given the timing.

The Worlds' Largest Hedge Fund (yes, that one, the one owned by you and I, the U.S. taxpayer) may now be adding additional securities to its portfolio. According to a recent Bloomberg article, the Fed is considering expanding the Term Asset-Backed Securities Loan Facility (TALF) to include loans for the purchase of Commercial Mortgage Backed Securities (CMBS). As you may recall, the TALF was developed to provide low-cost Federal Reverse loans that would be used to buy securities backed by consumer debt - essentially using taxpayer money to provide debt to help other taxpayers purchase the debt of still other taxpayers that took out too much debt [Yes, I know, using debt to solve a problem caused by too much debt does not really make sense, but I digress]. Anyway, since the TALF has previously been used to purchase securities tied to automotive debt and credit cards by offering three-year loans, why not try it now using five-year loans for commercial real estate? After all, it has been so successful for the auto and credit card industries (GM, Chrysler, and a White House Presidential scolding of credit card executives, notwithstanding - tongue in cheek, of course).

All kidding aside, it is hoped that such loans will create buying pressure for CBMS, thereby decreasing yields - many of which are near junk levels, making it unprofitable for banks to make new loans at such high yields. The down fall, of course, is that with such loans having a five instead of three year maturity, it will be even harder for the Fed to timely withdraw money from the system in later years, just when inflation is likely to creep back with a vengeance as the economy begins to hopefully recover. While maybe too late, at some point we are going to have to ask, are we preventing collapse and saving entire industries, or are we simply, and needlessly, juicing the system in order to save a few select companies, all the while unnaturally speeding-up the recovery? If the later, we may want to start planning for the hangover now.

Bank stress tests are now being delayed until the end of next week, not Monday, May 4th, as originally planned (see Bloomberg article).

Source: CFA Smart Brief
The delay is apparently being made as bank executives debate the findings of the tests with examiners. Initial talk was for banks to have tangible common equity equal of about 4 percent of a bank’s assets, with Tier 1 capital coming in about 6 percent. The goal of some regulators is to have common equity to be the dominant element in the bank's primary capital. Regulators are now worried that disclosure of poor results could cause the stocks of the weaker institutions to fall. Really? Is this a surprise? To add insult to injury, banks with low equity will be pressured to add capital, either by raising funds from private investors or taxpayers, or by converting government-held or privately-held preferred shares to common equity. Such a move will dilute existing shares and is sure to produce an undesirable downward spiral, one of which could further weaken banks which have scored low on the stress tests - which will no doubt result in some other type of assistance. Apparently, the government now needs a little more time to untangle the web they have weaved.

The Treasury Department will need to borrow $361 billion in Q2, a record for the April-June quarter (see Investment News article), making for three straight quarters of record borrowing. The Treasury is also estimating it will need another $515 billion in Q3. The projected federal deficit for the year ending Sept. 30 will come to $1.75 trillion, another record, and quadruple the previous $454.8 billion deficit set last year - which was also a record. The national debt is currently at $11.1 trillion, but new limits will be raised to $12.1 trillion to account for the increased spending and borrowing.

The numbers are simply staggering, and make the recent proposal by the President to reduce the budget by $100 million seem to be just a drop in the bucket (see Washington Post article). In fact, regardless of your views on the $100 million, and spending cuts in general, a recent Youtube video gives you an idea of the size of the current budget, borrowing, and deficits, and shows you just how much (or little) $100 million amounts to (see YouTube video). Staggering indeed.

In the video below, Jim Cramer makes the case that hedge funds, and others for that matter, should consider going long select names given the recent positive (or less negative) macroeconomic data.

The flood of borrowing in the U.S. is eventually going to force us to pay the piper, with some arguing that the bill may come sooner than later. Others have argued for continued deflation over the next 12-18 months (see previous post). Fortunately, or unfortunately, depending on your perspective, the move from deflation to inflation might not be as sharp as expected (see Bloomberg article). As it turns out, rising home vacancies across the U.S. are depressing rents, the largest item in the consumer price index released by the labor department. Home and apartment rents, as well as owners' equivalent rent, make up 30 percent of the CPI. As of the third quarter of 2008, the number of empty homes stood at 19 million, signaling that deflation may be here to stay for a while - or at least worries of inflation can wait until 2010, at the earliest. While not a perfect scenario, an environment with lower inflation will allow the Fed some extra time before it needs to start raising rates, thereby giving lower rates more time to do their magic without the threat of stagflation.

ETF Securities is launching an exchange for ETFs that includes a consortium of over 15 global banks and asset managers (see Hedge Fund Review article). The structure allows each exchange member to be able to participate in trading, market making, and index replication activities while allowing counterparty risk to be spread among multiple exchange members. By concentrating liquidity in a single location, ETFs that would normally be unavailable due to low demand and liquidity issues, can now be created and used for more specific purposes, such as hedge fund replication, without the same trading and credit worries. Certainly an interesting idea during a time when many are concerned about those on the other side of the transaction, especially when specialized, low liquidity securities are involved. This may be one way to help reduce both counterparty and liquidity risk for those researching and implementing hedge fund replication products.

Just yesterday I wrote a post about how the IMF is predicting that toxic debt will increase to nearly $4 trillion worldwide. Now, a recent report released by the Congressional Oversight Panel - those in charge of overseeing the TARP - indicates that $700 billion may be just the beginning in the U.S. (see ABC News article). To date, the TARP, Fed, and FDIC have set aside, lent, or spend more than $4 trillion.

New forecast from the International Monetary Fund are predicting that toxic debt will increase to nearly $4 trillion, due in part to the forecast of toxic assets in the U.S. rising from $2.2 trillion to $3.1 trillion (see Times Online article). Toxic assets across Europe and Asia will increase the total by another $900 billion. Given that "only" about $1.3 trillion has already been accounted for, the size of the money hole may be considerably larger than expected, requiring governments to bury more cash in an attempt to fill it up. As some have predicted (see Dealbook article), after the mortgage write-downs, banks will start unloading loans on the commercial side, and non-mortgage loans, such as auto and credit card loans, on the retail side. At some level governments are going to get spending fatigue and see increased levels of taxpayer revolt, or at least reach a level where saving the patient begins to bankrupt the caretaker and no longer makes sense.

There is an interesting article by Andrew Ross Sorkin over at the Dealbook blog (see article here), discussing how the FDIC is justifying its participation in the Public-Private Investment Program (PPIP). In effect, the FDIC is insuring the PPIP in the name of mitigating systemic risk. While the FDIC is not suppose to guarantee obligations of more than $30 billion, for the PPIP it is not considering total obligations, but contingent liabilities, or what it expects to lose - which conveniently, they project to be nothing. This form of logic essentially allows them to lend an unlimited amount of money. Yet under the PPIP plan, the public-private pool will be financed at a ratio of 6-to-1 public-to-private money, with half of the "1" coming from the private buyer, and the other half coming from the Treasury. With this debt being non-recourse and guaranteed by the government, the risk to the government (i.e., tax payers) would be significant and fully felt. In some ways, it appears that the program will either work wonderfully, or end horribly. Maybe I am missing something, but this sounds like as risky a leveraged bet as I have ever heard. Regrettably, this appears to be just another example of solving a problem caused by taking on too much debt and risk by, you guessed it, taking on too much debt and risk. Why does the term "double down" come to mind? I don't know about you, but I am hoping we hit 21. Otherwise, it may be a long bus ride home.

Vanguard is offering a small cap international ETF which tracks the FTSE Global Small Cap ex-U.S. Index (see Index Universe article). The fund considers both developed and emerging countries. While both "small cap" and "emerging" hint of increased risk, the ETF holds 2,100 different companies, providing broad exposure. The ETF also has a relatively small expense ratio at 0.38%, providing an inexpensive and diversified way to take on some international and emerging growth exposure.

In the wake of a nice bear rally, the SEC is once again discussing the reinstatement of the uptick rule, or some version of it (see Financial Times article). The rule was abolished in July 2007, but now various politicians are writing to SEC chairwoman, Mary Schapiro, asking that the rule be reinstated in order to produce an “unambiguous commitment to promulgate and enforce regulations that put an end to naked short selling”. Of course, naked short selling is already not allowed. While selling on a down-tick may have facilitated naked short selling, reinstating the uptick rule will not by itself rid the market of naked short-sellers. Enforcement of current rules might actually be the place to start. Until the SEC gets serious about investigating delivery failures, naked short selling will continue, regardless of changes in the uptick rule.

In addition politicians, the largest US exchanges have also recently written to the SEC asking that some version of the rule be put back into place, and further suggest that the new rule only allow short selling to be initiated by posting a quote for a short sale order that is priced more than the prevailing national bid. While such a change seems slightly different from the requirement of selling only on a new plus-tick or previous plus-tick (the current price being the same as the last, which was up), the change is significant. A value higher than the bid can still be below the ask. Not only are the prices lower than a plus tick (which is not that difficult to find for highly liquid stocks, even during a sell-off), selling between the bid and ask also makes the transaction less transparent. To make matters worse, the exchanges don't stop here, but also suggest that as an added precaution (guess for who), that a new type of circuit breaker be used that would initiate the rule only when the stock had a precipitous decline - defined as 10 percent. No more killing a stock in one or two days. Now it will take you at least 10 days. Not sure this is much of an improvement.

As for the motivation of the exchanges, you cannot really blame them for being proactive. While it is essential to keep the hedge funds and other drivers of order flow happy, helping to convince individual investors that it is safe to wade back in the waters will also be good for trading and revenue generation. I am sure that it is also hoped that any collaboration will make it more unlikely that the SEC will temporarily change the rules at a later date, selectively deciding what can and cannot be shorted. As for the SEC, they send the message that the days of the wild-west are over, and politicians get to take credit for putting pressure on the regulators and exchanges to look out for the little guy. Yet the changes will be ineffective at best - since naked short selling is not really directly addressed, and will most likely get worse given that shorting on a price higher than the bid is no improvement at all, but simply helps to mask the underlying transaction.

When I began to see the increased focus recently on finally bringing back the uptick rule, my initial thought was that if the rule was so vital, why has it taken this long to get back on the books? Looking at the latest collaborative effort, a little more delay might be in order.

A new proposed product from Macroshares will allow investors to purchase Up and Down ETF shares based on the movement of the S&P / Case-Shiller Composite Index (see WSJ article). Unlike some other similar ETFs, the proposed shares will not be backed by the physical asset, such as you might see with gold ETFs. Therefore, there will not be a specific artificial commodity bull market as the physical asset is bought to cover the demand for new shares (too bad for all those homeowners underwater). Here, the cash is put into government securities to ensure liquidity, creating a kind of zero-sum game as cash is moved from one account to another as housing prices, and the Case-Shiller index, move up and down in price. Obviously, if there is more demand for one type of share, this side of the bet is likely to trade for more than its net asset value, while the other side will trade at a discount. The zero-sum game structure also places a cap on profits since a positive move of 100 percent all but clears out the down shares, causing an automatic liquidation of shares.

While such a vehicle will get some attention given its tie in to the Case-Shiller index, not to mention offering a new and more liquid method for taking on housing exposure, it is likely that only a select set of builders and highly mobile executives on the coast who are looking to hedge their risks will find much use for this specific ETF (see article for past failed housing products). Speculators, of course, will be looking for significant daily liquidity before stepping their toes into the water. Time, and a potential housing recovery (or further bust), is probably needed before people will be encourage to bet with or against housing in this manner.