With banks trading at historically cheap valuations, private equity firms are now looking not only for bargains in the sector, but also for ways to get around regulatory hurdles (see FT article). Currently, federal rules prevent investors from holding more than 24.9% of a bank if they own other companies. The reason for the rules were to keep larger companies and conglomerates from buying banks simply to fund their other businesses. This has been a sticking point in the past given that many private equity funds like to have the flexibility to take large, and at times controlling positions. Furthermore, anytime you own a bank there is also the possibility that regulators will come in and require additional risk capital to be set aside, further reducing investment returns.
However, funds are looking for ways around regulations, and indications are that some are succeeding as regulators are starting to show flexibility. Some funds are launching new funds with different names and no direct ties with the home fund, allowing the isolated fund or investors to take a controlling stake in the banks. Can anyone say SIV? Other companies have been able to take stakes that are slightly larger than the 14.9% benchmarks that in the past have usually resulted in regulatory disapproval. Both moves seem to go against safety and transparency, and indicate not only more flexibility with the regulators, but maybe also a little desperation as well. Given the decrease in SWFs for being the capital provider of last resort for U.S. companies (see previous post regarding decreased sovereign wealth funding), some regulators may be forced with a choice between less regulation and transparency, or flat-out insolvency. Sometimes you just need to look for more choices. This may be one of those times.
Deutsche Bank is now offering ETNs that tracks the Benjamin Graham Intelligent Value indexes (see IndexUniverse article). The indexes are based on the value-based investment philosophy of the well-known and revered economist and investor for which the ETNs are named. Three value-oriented funds are being offered, broken down into total market, large-cap, and small-cap segments as follows:
- Benjamin Graham Large Cap Value ELEMENTS (NYSEArca: BVL)
- Benjamin Graham Small Cap Value ELEMENTS (NYSEArca: BSC)
- Benjamin Graham Total Market Value ELEMENTS (NYSEArca: BVT)
The WSJ has a nice article summarizing the auction-rate security mess, along with a short primer on what auction rate securities are, as well as how they are bought and sold through auction. Definitely worth the read for those interested in what has recently become a larger Wall Street focus. Auction-rate securities are essentially a form of debt issued by municipalities, student-loan organizations, and others interested in borrowing for the long-term, but doing so at short-term interest rates. How is this achieved? By auction, of course. Every 7, 28, or 35 days, depending on the product, banks will hold auctions in what amounts to a resetting of the interest rates as the securities are passed on to the new security holders (or reset for existing holders that want to stay long).
As reported, UBS, Merrill Lynch, and Citigroup alone have committed to buying back more than $36 billion of the securities. The problem that each of these companies find themselves in, among others, is that at times the auction-rate securities may have been promoted as being similar to short-term CDs, but with higher returns. Unfortunately, as credit problems increased, the auction-rate security market also began to freeze up, making it difficult for these securities to be re-priced. Many investors were left with bank statements that simply listed a "null" placeholder where their security prices were once quoted, implying that liquidity was poor enough that a reliable price could not be provided. To complicate matters, apparently the liquidity issue has persisted for a while, even as more securities were being marketed and sold, causing many banks to prop-up the market by issuing their own bids. The WSJ reports that UBS alone may have submitted bids in just under 70% of its auctions between January 2006 to February 2008. Allegations against Merrill Lynch imply that they gave the false impression that demand was high, driven in part by dark pools of liquidity in the auction market (see previous posts here, here, here, and here on dark pools of liquidity).
As recourse, and a way for UBS to hopefully reduced the intensity of this recent black eye (how many eyes does UBS even have?), the company has agreed to buy back from investors nearly $19 billion of auction-rate securities, starting with individuals and charities this October, all the way to institutional clients in mid-2010. It is worth noting that while UBS plans to start buying back securities in October, the actual purchase could take longer. As reported in a Barron's article back in May, and discussed in a previous post, how much money investors get back from auction-rate securities depends on who originally issued the securities. The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will probably have to wait a little longer. If you or one of you investment funds purchased auction-rate securities sold by a CDO or student-loan trust, well, you may be waiting a while to get your money back, possibly many years.
The auction-rate security issues once again highlight the need for better due diligence and a better understanding of risk. As we often forget, higher reward is almost always accompanied by higher risk - I dare say 100% of the time, but someone will always find exceptions in an inefficient market. If you look for more return, you need to understand the risk. Auction-rate securities based on CDOs should have raised red flags for some. Deception is one thing, but offering a blind-eye is another. Furthermore, the way we talk about risk also probably needs to change. For instance, have you ever noticed that we seem to be having "100 year floods" every other year, or how the metaphorical "perfect storm", whether in finance, insurance, or other fields seems to occur with more regularity? Anecdotal? Sure. But eventually simply stating that the recent event was the prefect storm or a once-in-a-lifetime event will not cut it. There are only so many times that you can cry wolf before no one cares about the real danger lurking in the woods. Maybe auction-rate securities and their current issues provide another one of those warning calls we need to listen to, regardless of its eventual magnitude and implications in the current market.
Reuters reports that while the failure of Bear Stearns would have likely triggered a series of counterparty failures in the credit default swaps market had the Fed not come to the rescue, CDS securities have actually held up pretty well and remained relatively liquid even while other financial markets have had their challenges. To date, since the market for credit derivatives has come into being, there has not been a default from a major dealer or bank. Ironically, the Bear Stearns issues themselves may have helped bolster the CDS market since not only did the Fed prevent potential counterparty failures associated with Bear, but they also gave the impressions that other major derivative counterparties were too big to fail.
Other markets have not fared as well. Recent credit problems and housing related losses have reduced the flow of capital in the mortgage-backed security, CDO, auction-rate security, corporate bond, and preferred shares markets. On the other hand, liquidity in the CDS market, especially for 5-year duration securities, has been better than other markets, even though it too has experience less dealers, lower liquidity, and wider bid-ask spreads than normal. Yet, it is still functioning and allowing investors with illiquid corporate bond exposure to buy protection with credit derivatives.
Of interest for traders is that in some instances CDS securities have weakened ahead of stock prices, giving traders some clue as to what equities are a cause for concern. As an example, the CDS spreads for Bear Stearns widened by 10 times over two months last summer, significantly under-performing the stock and giving some insight into potential problems. Shortly near the end of the two month period, two Bear Stearns hedge funds collapsed from bad mortgage bets. The traders that were focused on credit risk hedged their exposure in the CDS market long before problems became evident to the equity market. Something worth noting as we hear of new activity in the credit derivative markets going forward.
Since 2007, sovereign wealth funds have spent almost $80 billion to buy stakes in U.S. companies, in particular banks that were desperately in need of a capital infusion. Now, the International Herald Tribune is reporting that the lender of last resort may be having second thoughts. Even though most SWF don't have to report mark-to-market losses in public, they still want to make a return, and some high profile investments, such as those in Merrill Lynch (MER), are not turning out as expected. Many SWF are now entering "south-south" trades, or in other words, simply investing in other emerging economies. While the moves are being made to not only look for higher return, south-south trades also prevent emerging economies (many of which got their start-up capital from the West) from simply recycling their funds back into these same economies. Oil-exporting countries for one are looking to hedge against oil price fluctuations by becoming underweight assets correlated with oil prices, i.e., just about everything U.S. based. If this trend persist, then many small, medium, and even large companies may start depending more on alternative forms of capital, such as the hedge fund lending discussed in a recent post.
Here is the link to an interview on CNBC between Maria Bartiromo and Freddie Mac Chairman and CEO Richard Syron. There has been a lot of talk in the blogosphere about whether the NY Times piece was a hit job or not. While the interview was not very convincing, the CEO did seem to initially focus on the company, and less on himself, until asked later in the interview about the allegations (part 2, not linked here).
The New York Times has an article today about how the CEO at Freddie Mac ignored the warnings signs of potential problems, in particular its financing of questionable loans that threatened its financial health. Not necessarily news, and you can decide who you want to believe, but it once again stresses the need for not only implementing a risk management system within companies, but actually listening to the recommendations offered by the chief risk officer. Insiders at Freddie Mac say that the CEO of Freddie Mac, Richard Syron, made things worse by repeatedly ignoring recommendations from the chief risk officer at Freddie, David Andrukonis, regarding poor underwriting standards that were becoming too weak and too risky.
Andrukonis is quoted as saying:
“The thinking was that if something really bad happened to the housing market, then the government would need Freddie and Fannie more than ever, and would have to rescue them. Everybody understood that at some level the company was putting taxpayers at risk.”Moral hazard at is best, or ugliest. Of course, this comment is not quite as telling as the one made by CEO Syron, who contends:
“If I had better foresight, maybe I could have improved things a little bit. But frankly, if I had perfect foresight, I would never have taken this job in the first place.”While none of us has 20-20 business vision, the need for better insight is exactly why companies need to utilize some type of risk management. Although not a perfect science (far from it), risk management can at least provide managers some of that needed foresight. While the future cannot be forecast at a level that makes it easier to sleep at night, risk management can at least provide scenario analysis supported with statistics and various risk measures, among other techniques, that will give managers some idea of where potential problems lie so that safeguards can be taken (such as increasing capital or laying off risk) and corrective action can be planned and anticipated.
It appears that Wall Street and Corporate America are getting the message as companies struggle to educate themselves on enterprise risk management, implement risk management systems, and hire employees with the proper risk management skills. Understanding credit risk, market risk, operational risk, Value-at-Risk, Basel II, RAROC, and GARCH volatility modeling are causing businesses to seek out universities and consultants as they rush to receive the needed education and training. Of course, like TQM in the 1980s and 1990s, it is up to businesses to actually practice what they preach, or at least practice what they put in place. Fortunately, for those interested in risk management, challenges and job security will be available as innovation and capital growth offer new problems for businesses. Hopefully, it will not take another Bear Stearns, Freddie, or Fannie in a few years to once again drive the point home.
Hedge funds have traditionally invested in banks, but now some funds are actually acting as the banks themselves. As discussed in a recent Business Week article, hedge funds are turning out to be a lender of last resort for some companies as the credit crisis unfolds. In particular, small businesses that are unable to secure loans, and simply do not have the cash resources to ride the credit storm out, are turning to hedge funds for the necessary capital to continue operations. According to the Commercial Finance Association, a trade organization of asset-based lenders, the demand for such funds is on the rise.
Why are hedge funds interested? The loan terms, of course. Unlike traditional loans which may be offered for 2-3% over prime, so called "asset-based loans" can carry double digit interest rates (as high as 14% with fees for one example provided), along with double digit early payment penalties. Should you be worried about the risk as a hedge fund investor? Possibility, but often the loans are only given out to the most credit-worthy companies with a good business plan, and often only after performing a level of due diligence that would make a venture capitalist proud (in fact, some actually do deals that include options or equity stakes). As the name implies, asset-based loans require some type of asset to back the loan, be it hard assets such as inventories, or accounts receivable. In fact, some hedge funds actually require documentation and/or send people to check out the assets for themselves. Imagine that! Maybe the banks should take note.
The New York Mercantile Exchange is planning to introduce a futures contract that is based on U.S. Midwest market prices for hot-rolled steel coil (see WSJ article). The steel contracts are expected to be offered later this year in the fourth quarter, and be settled against an index developed by CRU Indices Ltd. The futures contracts offer a new way to price steel, which is typically bought through direct negotiations. The move comes at an interesting time considering that many in Congress and elsewhere are blaming speculators in part for the recent moves in crude oil price. Some steel company executives have also resisted steel futures since they too feel that the new futures market will only benefit speculators. On the other hand, a futures market will allow for more consistent pricing and less dumping into competitive markets. The futures market may also keep companies from bidding against themselves, not to mention allow smaller companies without negotiating power to work on a more level playing field.
Of course, beyond helping to eliminate the dumping of steel, a futures market will open up the potential for companies to hedge their steel cost. Given the increased costs of the energy, coking coal, and other raw materials needed to produce steel, the ability the hedge steel cost could not come at a better time for the automobile makers, aerospace industry, and other large users of steel. Therefore, while a potentially good development for companies such General Motors (GM), Ford (F), and Boeing (BA), the move towards steel futures is probably less good news for larger steel makers, such as U.S. Steel (X), Arcelor Mittal (MT), and Nucor (NUE).
There is an interesting article in the WSJ regarding recessions and productivity numbers. As seen in the figure below, the last six recessions have occurred at a time when productivity numbers were decreasing (although the numbers were still positive for the last two recessions, and productivity was relatively strong during the most recent recession in 2001).
While productivity has averaged 0.8% over the last six recessions, it is currently growing at an annual average rate of 2.5%. This is important since high productivity numbers allow the Federal Reserve to keep interest rates lower than normal since higher prices are being matched with higher productivity, at least to some extent. As an example, if workers are making x% more of a product in the same amount of time, then wages can increase by the same x% and the per unit labor cost will stay the same. Simplistic, but you get the idea. Productivity gains were the key to the 1990s, and one of the reasons Alan Greenspan was often espousing the benefits of high productivity, providing yet another reason to keep interest rates low, sub-prime notwithstanding.
Of course, higher productivity can allow you to keep from hiring new workers, or even allow you to reduce headcount, since now you can do more with less. Furthermore, the current high productivity numbers may just be an artifact of the recent environment. Housing, which is a less productive industry, is currently being shifted out of while higher productivity industries, like those exporting, are increasing in emphasis. The weak dollar is also having an effect in amplifying the export-based productivity numbers. Given that the U.S. is trading overseas more now than in the past, the higher export productivity numbers make sense.
So, if productivity is not cooperating for those talking recession, what about other numbers in comparison to previous economic conditions, such as the stagflation days of the 1970s that many analysts are comparing the current conditions to? Given higher energy costs, producer price increases for finished goods are worse now than during the 1970s, causing lower consumer confidence and higher levels of consumer credit as a percentage of GDP. The savings rate is down, as it has been for a while, and the number of vacant homes is increasing.
Yet, all is not bad, or falling off a cliff. The ISM index is hovering about the benchmark contraction / expansion levels, and disposal income has still not collapsed, even with increasing job losses. Industrial production, while flat, is also not severely contracting. Furthermore, core CPI (without food and energy) is not excessive, nor is core PPI. The unemployment rate, while rising, is also not yet close to approaching high single and low double digit levels. High productivity is keeping unit labor cost down (as discussed before), and wages have stayed in check for corporations. After-tax corporate profits as a percentage of GDP are also still good, and long-term Treasury yields are not excessive in comparison to the stagflation years.
So in short, is the picture rosy? No. But are we heading for another decade of stagflation with sustained lower growth and high inflation? Right now the data does not point to this conclusion, regardless of the continued comparisons. Housing and crude oil still seem to be ruling the day, the fallout of which is affecting nearly everything in the economy. When the former finally turns around, and the later sells off with conviction, we may be able to finally get rid of both the "stag" and "flation".
It looks like a number of hedge fund who were doing well betting against the banks and betting with commodities are finally starting to get their comeuppance as the easy money shorting the banks is decreasing, and commodities have begun to correct, at least short-term over the last month. As a result, hedge funds as a whole are on pace to turn in their worst monthly performance since July 2002, down 2.8% for the month, based on data from the group Hedge Fund Research that looked at the returns from 60 hedge funds. Some managers are now down more than 20% for the year. When corrections occur on short notice, even for those funds that are actually hedged somewhat (not all hedge funds are), you simply don't have enough time to adjust delta, especially for the larger funds, resulting in stories like the recent one in the WSJ. As they say, live by the sword, die by the sword.
As reported at the Financial Times and the WSJ, discussions have progress to the point that larger banks and dealers should have a central clearing house for credit derivatives by later this fall. The market for credit derivatives is currently near $62 trillion in notional value after being less than $5 trillion as little as five years ago. The goal of the clearinghouse will be to reduce the systemic risk that results from inefficient trading and uncertain counterparty exposure, both of which have increased as the market expanded. Automated trade-matching and electronic processing in other OTC derivatives market was also discussed. Credit derivatives in particular have caused concern as their rapid grown has made it more difficult to both track and measure the exact level of exposure being taken.
Recent credit problems have highlighted the need to better understand counterparty exposure. A central clearing house for credit derivatives should help in this area given that the clearing house will take the risk of a market participant's failure. Any failure would then be absorbed by the clearing house members, reducing the need for the Federal Reserve or Treasury to get involved, and possibly preventing the type of failure that was experienced with Bear Stearns. Like other clearing houses, trades are also likely to be better scrutinized when made, such as making sure that margin requirements are enforced and trades are verified and recorded.
To date the levels of electronic derivative trading in the various markets has been mixed. Currently, about 90% of credit derivatives are traded electronically. The interest-rate derivatives market, which is larger and potentially more worrisome, has also increased electronic trading and now sits at about half of all trades. Equity derivatives trading is bringing up the rear with only about one quarter of all trades executed electronically. Depending on the success of the credit derivative clearing house, plans could be expanded to also include the equity and interest rate markets.
One current hitch for the credit derivative clearing house is the need to make sure that the entire CDS market is integrated and electronic. To facilitate the move, dealers have agreed to reduce the total value of outstanding CDS trades, and to help sort out corporate defaults by incorporating a cash settlement mechanism into CDS documentation. Of note is that the market in many cases would still be private, but more centralized.
Although the details of the clearing house are still being worked out, such as what exactly the dealers and exchanges will control, any move is certain to benefit the exchanges as they will now have a direct link to the lucrative CDS market, while the large investment banks that currently control the credit derivative market will need to start sharing some of the billions of dollars of revenue. For some banks, this line of revenue has been significant. Companies that my be positively impacted include the CME Group (CME) and NYSE Euronext (NYX). Investment banks that may be negatively impacted, at least with regard to losing some of their current credit derivative revenue stream, include Deutsche Bank (DB), Goldman Sachs (GS), and Morgan Stanley (MS).
In another interesting move, Bloomberg is reporting that the U.S. Agricultural Department will not allow farmers to withdraw from a land-conservation program without penalty next year. The move has the effect of further limiting the acreage available for planting corn at the exact time that corn prices have come off record highs, demand is strong, and flooding has caused crop losses. While a win for environmentalists, the move will reduce the additional acres that many were expecting to be available next year. Not surprisingly, corn prices rallied on the news. Recently, corn prices had sold off, causing the margins for ethanol production to become attractive again. The current margins, along with the news of less than expected acreage increases are sure to have a bullish effect on corn prices. While there is most likely more to the story (there usually is), the fact that you would mandate something and then reduce your ability to produce or develop the raw material seems wrong on so many levels. Of course, this says nothing of how such moves will also continue to keep food prices artificially high as corn continues to be converted to fuel. If history is any indication, there is no doubt that as corn prices rise and more traders move back into this market, speculators will be blamed for the high prices hitting consumers, launching yet another formal inquiry.
Why should institutional investors and hedge funds have all the fun in the current credit crisis? Now you too can join in. Societe Generale is offering a new product that provides exposure to the credit default swaps (CDS) of speculative-grade companies. The new product is linked to the number of defaults in the iTraxx five-year Crossover Index, which is comprised of 50 European companies which Moody’s has forecast to remain below long-term average and market implied default rates.
As reported in an article at Structured Products, the product is designed to give investors an IRR up to 14.25%, provided of course that none of companies in the index suffers a credit event during 5 years of the product’s life. Events include bankruptcy, default, or restructuring. The notes can be purchased at 54-55% of face value and are redeemed 100% at maturity. They are also designed such that when each constituent experiences a credit event, 2% is subtracted from the total portfolio value. Estimates are that even if 17 of the 50 companies in the portfolio experience a credit event, the IRR would still be around 5.2%, above the 5 year European Interbank Offered Rate. Sounds good, but just remember that when major events do occur, certain assets will start to become more correlated very quickly.
As reported in the Financial Times, Blue Coast, a unit of the German insurer Allianz, is now selling catastrophe bonds that break down losses from hurricanes by the county in a state, instead of at the state level itself. The $120 million issue is the first to bring the event down to the county level. Whether this will encourage local municipalities along with states themselves to cover their catastrophe risk is difficult to tell. It will no doubt certainly allow investors more transparency as to the exact risk they are taking, at least from a location perspective, and could facilitate pricing and valuation.
For those unfamiliar with catastrophe bonds, they are similar to normal bonds in that you invest a principal in return for periodic coupons. Once the bond matures, you receive your principal back - hopefully. As with other bonds you have the risk of losing your principal, but for cat bonds it is less about credit risk, and more about catastrophic risk. In most cases this is a binary proposition. If there is no event, you get all your money back. If there is an event, you do not get anything back. In return you get a nice coupon to compensate for the risk you are taking. Cat bonds have returned over 33% from 2005 to this May, ahead of the 19.1% offered by the Lehman High Yield Corporate Bond Index over the same time frame. After Hurricane Katrina one cat bond tranche was offered by Swiss Re with an annual coupon of near 40%. An additional benefit of cat bonds, beyond the high yields, is that their returns are often uncorrelated with the returns of other equity or fixed income investments, providing another vehicle for diversification.
A little over a month ago I wrote a post discussing a Barron's article on the subject. At the time a reader who worked in the industry made some interesting comments, one of which discussed the recent growth of cat bonds. It was mention that over the last 10 - 15 years the market for cat bonds had went through some abrupt growth periods which typically followed weather events like Hurricanes Katrina and Andrew, and other events like 9/11, but then growth usually stagnated in between. What is interesting now is that the current growth is not really being triggered by recent events. What could be driving the growth? As it turns out, hedge funds are initiating funds that invest in cat bonds given their low beta risk, high yield, and attractive Sharpe Ratios. Since both supply and demand has been strong, even without events increasing, the cat bond yields have stayed attractive.
The worry is that higher yields will cause more hedge funds to enter this asset class without really understanding the nature of the risk, driving down yields and increasing exposure. Furthermore, unlike for bankruptcy, or even credit risk, investors will have a more difficult time evaluating something like a catastrophe which can be both severe and unexplainable. This usually leads to a post-event attempt to assign blame to others with no hand in the event. Investors who put their toe in the water during the year of the event could lose their entire principal before they ever earn the high yields. The fear is that when the event does happen, the product, and those that offer it, may end up being the scapegoat, thereby forcing the government (and John Q taxpayer) to cover the losses. Imagine. A scenario where investors buy something they don't fully understand, capture the benefits of attractive terms, but have the government and taxpayers cover the risk when things go bad. Never mind. That would never happen.
There is an interesting article at the International Herald Tribune about how forecasting on Wall Street is getting "too wild," and how forecasts are getting less accurate. Data from Thomson Reuters finds that analysts correctly predict earnings only a fifth of the time. Approximately two-thirds of quarterly earnings beating estimates, with the remaining estimates being too low. This is not surprising since many companies attempt to managing earnings by reducing expectations and then delivering better-than-expected results. This year, only about 10% of companies matched expectations. Again, probably a combination of poor forecasting and earnings management by companies.
As mentioned in the article, "Even the collective wisdom of the marketplace has been wrong time and again. The stock market, that weathervane for corporate profits and the economy, keeps swinging from fear to greed and back. A glance at the major stock indexes over the past year reveals a host of false bottoms and fools' rallies." In fact, just looking at a Citigroup (C), General Motors (GM), Ford (F), JPMorgan (JPM) and other similar companies gives a picture of stocks that are relatively flat over the last month or so, even though price action during this time has made some significant moves up and down.
Of interest is that just as the markets become almost too difficult to forecast, due to market conditions and headwinds that reduce clarity going forward and prevent past trends from being trusted, is the exact time investors are looking for guidance, hanging on every forecast - and, in some instances, trading on that guidance as well. The recent moves also have the feel of the late 1990s in which new yearly price forecasts were meet in a day to two as retail investors piled in and bid up prices in an attempt to board the train before it left the station. Things have not gotten that extreme yet in the opposite direction, and the circumstances are certainly different, but the faith and need for guidance from Wall Street, or anyone for that matter, is reaching interesting levels. Whether this signals a reversal, as it did in early 2000 (but in the opposite direction), is difficult to tell. Furthermore, even if it does, it may take a while to see the effects. After all, Greenspan gave his "irrational exuberance" speech in December 1996, over three years before the market finally corrected and came to its senses.
As reported at the Financial Times, unsolicited bids for companies are running at their highest level in nearly a decade as companies use built-up cash, and in some cases a weaker dollar to acquire other companies. Data from Dealogic shows that since the start of the year, unsolicited bids have accounted for 19% of global mergers and acquisitions. This is the highest this number has been since 1999. As mentioned by the co-head of global M&A at Deutsche Bank, “The lack of credible white knights and activist shareholders pushing for quick resolutions and financing available for strategics is also fueling the high number of unsolicited bids”. Of interest is that the success rate of hostile deals has also increased, with only 31% of such deal failing in 2008, compared to an average failure rate of 42% since 1997. Apparently, activist like Carl Icahn are having an impact, Microsoft-Yahoo notwithstanding. On the other hand, given issues in the credit market, it could be that current deals going forward are more likely to have financing already in place and only include stable companies, thereby making a successful deals more likely. This news certainly provides a little better risk-reward for those trading on M&A news.
As somewhat expected, it is being reported at Reuters, the WSJ, and elsewhere that the SEC is planning to extend the temporary curbs on short-selling set to expire Tuesday. Plans are also being made to extend the curbs to cover additional equities, beyond the original 19 financial stocks. New curb limits could now include insurance, housing, and additional financial stocks. The SEC is also apparently considering making the rules permanent, but that would require later finalization, not to mention changes in the way shares are borrowed in order to speed up and automate the process beyond making phone calls for authorization.
Some on Wall Street, including executives and hedge fund participants, are lobbying the SEC in an attempt to get them to reconsider. I would suspect that if the curbs were extended, increased to cover more stocks, or made permanent (which I would assume would include all stocks), then we may get another SEC induced rally that now obviously includes more than just the financial stocks. Or will we? Some, even in the hedge fund industry, have mentioned that it is still easy to borrow anything you want. Others say that while borrowing is still possible, the cost of borrowing has increased, and is having an impact. Due to their size or frequency of trading, the real impact may be on smaller firms and those using programmed trading.
Markets certainly get nervous when regulators start getting more involved, but on the surface this seems more like a way to enforce what should have been done in the first place. Of course, that does not mean it will not impact a market that is used to borrowing now and worrying about that messy back office stuff later, or that it will not negatively affect those that need to provide liquidity to the market (the SEC is already considering market maker exemptions). A more automated system for borrowing will also need to be implement if the rules are extended and expanded. The worst thing would be for the SEC to continue to micro-manage the current sectors in trouble. Where does this end, and is it really the sign of a healthy market, rally or not?
There is a article worth reading at the MarketSci Blog about how the VIX may not be as magical as some make it out to be. The blog post is responding to another on the subject written by Mark Hulbert, whose opinion I agree with on this subject. BTW, the article is also discussed at the Daily Options Report, and there is a good exchange of comments with Bill Luby at the VIX and More site (also worth the read, as usual). The article does a pretty good job illustrating how the VIX is like any other indicator - it is just another tool in the toolbox, albeit useful and better than some.
While the VIX is based on a somewhat complex algorithm of implied volatility, it is not a perfect model in the strict sense of the term for how it is being used in that it has not been fine tuned with the optimal parameters or the best inputs in order to measure something other than, as discussed by Hulbert, "... the volatility that options traders are expecting the stock market to experience over the subsequent 30 days." The fact that we use the market sentiment implications of the VIX for timing market turning points, or by assigning relatively arbitrary benchmarks (like the market will rally when the VIX is above 30), makes it no more or no less a better indicator in my opinion, or more importantly, a specific model for the purpose we are using it for. Assigning a heuristic is helpful in that it starts to get us interested, but it does not make it any more predictive.
Like many indicators, the VIX may be just another way to measure an oversold market. Helpful, yes, and something I look at, but it should not come as any surprise that it is not anymore accurate than 3/4th of the time, and even then, timing is not exact. In fact, if it was nearly 100% accurate, with good timing, then I would not be writing this article, and you would not be reading it. Instead, a few lucky traders who spotted it first would be sitting on a private island somewhere, while a second group sometime later would have made a some money and garnered some fame writing about its use (with some nice historical relationships provided as support). Meanwhile, the indicator's predictive ability would have probably self-destructed, causing the rest of us to end up disappointed as its widespread use has now caused the indicator to simply tell us what we already know ........ while nicely giving us approximately 3/4th direction accuracy with less than perfect market timing.
Again, please keep in mind that I am not saying the VIX is useless. I look at it everyday, and find that when it starts spiking I need to start paying attention a little more to what is occurring in the market. My issues are from two areas: 1.) assuming that once it reaches a benchmark (30 for most), something is going to happen soon; and 2.) from taking something that was not really designed for how it is being used (market timing), adding a heuristic or two, and then assuming it is a model to be trusted. Rightly so, none of the authors mentioned and linked to in the article states this, or puts absolute faith in heuristic turning points. Like them, I believe the VIX is a good tool in the toolbox, as long as your toolbox contains more than one hammer, and as long as you are convinced that not everything is a nail.
There is an interesting article over at the Economist regarding hedge fund returns. As pointed out in the article, hedge funds had a great first half of 2008 when compared to standard benchmark indexes, outperforming Wall Street by 12%. On the other hand, given that the market lost slightly more than this on average, you could also say that hedge funds did poorly during the first six months, producing what amounted to their worst return on record. So which is it? It really depends on your perspective. Interestingly, if your mutual fund beat the market by 12%, even in a losing year, you would probably feel pretty lucky. Yet with hedge funds we expect more. We want that 30% per year, regardless of the market. After all, that is why we pay the 2-20, in good times and bad. We want returns that are uncorrelated, regardless of the market return (yes, I know, it does not always make sense).
Also of interest in the article, and something talked about before, is the pruning of hedge funds, or at least a slowdown in the net growth of new funds. The trend of the bigger getting bigger is continuing. The question is whether this will be good in the long run. As more and more pension, retirement, and endowment funds invest in hedge funds, the tendency to invest in more "stable," i.e., larger hedge funds will increase. Not only will fund-of-funds increase as institutional clients enter the industry, but this trend will produce a combination of fees upon fees, along with large diversified portfolios producing more mediocre returns. After all, a nice $500 million hedge fund can focus investments in, say, small or mid-cap banks, looking for opportunity and then taking a large position compared to totals assets. This is more difficult for the larger funds, resulting in more diversification and mediocre returns. As funds start looking and performing like mutual funds with flexibility (shorting, leverage, etc.), justifying the 2-20 may become even harder for some funds.
