The Inside Scoop feature at Barron's (see article) is reporting on how Warren Buffett has increased his position in Burlington Northern Santa Fe (BNI). Earlier this week, Buffett bought another 825,000 shares, bring his total position to about 19% of the company. Not only does this recent transaction put approximately one-fifth of the company in strong hands, but Buffett has also recently sold 5.5 million puts in October, with strike prices ranging from $75-$80. The put position effectively places a floor on the stock, since if the past is any indication, the position implies that Buffett is comfortable being a buyer at these strike price levels.

As with the rest of the market, Burlington has fallen over the last month, but not as much as some of its biggest competitors. Since Burlington hauls a higher percentage of coal and fertilizer, as well as other domestic goods, analysts believe they will most likely not be hit as hard by a global recession. Furthermore, any return to higher fuel costs, which will impact global growth, could also help Burlington weather any further downturn as companies continue to shift from trucking to the rails for transporting their goods. As the chart below shows (from BigCharts.com), BNI, the DJIA, and the Dow Transports (DJTA) have diverged somewhat since the beginning of the year.

Source: BigCharts.com

Often the DJIA will follow the transports, but in this case the market sell-off in October has caused the transports to catch-up on the downside with the general market. BNI fared a little better during this time. Each has gained over the last week. Of interest is how the transports are bumping up against resistance levels in place since January, whereas BNI has actually found some support at these levels. If the market can break these levels and continue to build a bottom in November (or even begin to rally), and the six months from November to April do turn out to be bullish after the heuristic-based "sell in May and go away - until November" trades are unwound, than BNI may not only be a potential recession play, but it may also help to lead the market over the next year. Nothing is fool proof, but with the winds of Buffett, energy (coal), and ethanol (fertilizer) at your back, the profit trains could start rolling again for BNI stock holders.

It appears that stars of the hedge fund world, such as Cohen, Einhorn, and Signer are not having any problem raising money at a time when other funds are seeing mass redemption (see Bloomberg article). For established managers, there are a couple of intriguing reasons to raise money at this time. For one, equity prices are depressed, creating opportunity for managers with capital on hand. In addition, the recent sell-off has placed existing clients significantly under their high-water marks, meaning that it may be a while before managers can capture the normal 20% of future profits. New money, on the other hand, is starting fresh, allowing future profits to generate normal fees right away. Apparently, reputation and performance do still matter. Then again, in a down market, performance is all relative. As one person on CNBC was recently quoted as saying "small losses are the new gains." Only during a bear market, and only on Wall Street, would such a statement make any sense.

The Treasury and FDIC are considering a plan to guarantee about $500 billion of bad mortgages in an attempt to reduce the total number of foreclosures, with an estimated cost of about $50 billion to be paid by the bailout package - i.e., you, Joe and Jane taxpayer (see Bloomberg article). The plan would allow banks to restructure as many as 3 million loans into ones that homeowners would actually be able to afford (imagine that). In other words, the mortgages would be restructured based on a borrower's ability to repay, and not their ability to afford the home. If homeowners also took out a home equity line of credit, no problem. The plan being considered would also cover these second mortgages as well. I guess that will teach those of you that recently bought a home within the last year or two and actually put down the "required" 20% down payment. If you live in Florida, California, or Nevada, that 20% is probably gone. Your neighbor, who put nothing down, will now end up paying back what you have left on your loan, which is about 80% of the original value, or 100% of the current value. Their repayment amount could possibly be even less than you if their ability to repay is still not sufficient. I hoped you learned your lesson. Next time buy a bigger house. And of course, don't forget to remodel the kitchen and bathroom while you are at it.

Fortunately, the plan is still being discussed, so hopefully some steps will be put in place to reduce moral hazard, such as having rates and payments increase as the borrower becomes better able to make payments, or allowing taxpayers to recover some or all of the lost and forgiven loan principal once prices recover and loan to equity values become more favorable. Otherwise, no matter how good the intentions are, or how necessary the plan is, the unintended consequences of rewarding bad behavior and poor decision making will cause confidence in the banks and the housing market to take much longer to recover.

The success of the Yale and Harvard Endowments has cause many to consider trying to mimic their asset allocation models (see article, and previous posts here and here). Unfortunately, this offers a few problems. For one, small investors do not have as easy access to alternative investment, whether it be private equity, hedge funds, venture capital funds, or certain types of real estate. Even those that do find that performance suffers when funds that were suppose to be hedged were not. Furthermore, many of the alternative asset classes turn out to be more correlated than expected, especially during market sell-offs.

Studies are also showing that adding the diversification of alternatives to your portfolio may turn out to not reduce volatility in ways normally expected. Morgan Stanley examined the risk and return characteristics of a hypothetical endowment model portfolio that had 40 percent allocation to alternative investments. While the portfolio outperformed a traditional portfolio allocating 60 percent equities / 40 percent for bonds, it did not materially reduce volatility. The performance of US equities alone explained 94 percent of the return.

Another problem is that private investors do not have the same tax advantages of endowments, many of which have access to top-tier funds and other tax-exempt groups. In some cases, seeking an pre-tax return of 10 percent would require an average hedge fund to return 14.5 percent in order to overcome the fees. For a fund of funds, the return is even higher, at 17.1 percent due to the extra layer of fees.

Those of us in the academic world often hear the common retrain from our industry colleagues, "Well, that just the academic theory. Things are different in the real world." At least for mimicking endowment funds, the refrain may ring true.

New York Magazine is reporting that cardiologist in New York are receiving 20% more complaints regarding chest pain - the highest levels since 9/11. “One patient said that every time he sits at his desk he feels chest tightness.” Gastrointestinal doctors are also experiencing more business. Given this market, maybe buying stock in Pepto Bismol maker P&G or Prilosec maker AstraZeneca are the smart investment choices as a sympathy volatility play. Can I sell options on heartburn?

There is an interesting article in the Telegraph UK about how thousands of hedge funds are on the brink of failure as the global crisis unfolds. Emmanuel Roman, chief executive of GLG Partners, and Nouriel Roubini, New York University Professor and long-time predictor of financial doom, have made the recent forecast for the industry. Of interest in the article, beyond the prediction of massive hedge fund failures, is the following quote:

"It's like we're walking blind in a minefield," said Prof Roubini. " Every situation has become risky and no one can trust each other. The banks are too big to be allowed to fail, but they're also too big to be saved."

Unfortunately, the "too big to fail, but too big to save" perspective may be more true than we want to believe or admit. The trust issue is certainly being played out from all directions. Of additional interest is the belief that recent events and a protracted recession will end the financial dominance of the US. While I believe the end of this story is still yet to be written, you have to wonder, "What if this is true?". Who will step into the leadership role of the US? Economies that are still developing and emerging? Economies that reply on crude oil revenues? The European Union? Furthermore, are any of these economies really decoupled? Rocked back on its heels? Definitely. Loss of leadership? Not so sure.

Japan is the latest country to consider trying to stabilize its markets by banning short selling (see MarketWatch article). The move is being considered after the Nikkei 225 has fallen to its lowest level in 26 years. While potentially propping up the market, the long-term consequences of limiting information, hampering risk management, reducing liquidity, and prevent overall market efficiency may prevent the Japanese markets from reversing anytime soon what has become a generational decline in the Nikkei.

It appears that short selling levels have receded at both the NYSE and Nasdaq in the first two weeks of October, falling 8.3 percent on the NYSE and 10.5 percent on the Nasdaq (see WSJ article). As quoted in the article:

"This decline in short interest, particularly the decline in brokerage stocks, is a continuation of a 12-week trend. Shorts have been large net buyers and therefore stabilizing these stocks, calling into question the rationale behind the SEC's ban on shorting."

You ban short selling and it results in less shorting and more short covering. Is this a surprise? As for refuting the rationale behind the SEC decision, I am not sure the trend is really calling the ban into question. If anything, the trend supports the decision (even if for other reasons it was short-sighted - no pun intended, see previous posts here and here). Of course, one could argue that the ban was lifted October 8th, therefore the second week of short interest declines shows that the ban was not necessary to reverse the trend. Yet given the SEC's recent proclivity to change the rules at the drop of a hat, not to mention the significant market decline (and recovery and decline) over the last few weeks, it appear likely that only a few brave traders would take such a position, even if it seems to make sense. I suspect that someday rationality will re-enter the picture, but it probably will not happen until the short selling cuffs are taken off the invisible hand of the free-markets and thrown away for good.

According to a Financial Times article, a European commission examining the credit derivatives industry is asking CDS traders to reduce risk. Ah, if it was only that easy. Kind of like asking someone running a garage sale in the 1980s to sell their old eight-track player for what they paid for it. For one, you are not going to get your original value back, and two, very few people are interested in buying something that may be worthless tomorrow. It is also kind of ironic how we need to reduce risk on the very item we were using to reduce risk in the first place. At some point you cannot just keep passing risk along. Someone has to bear it - which is unfortunately where the government steps in when such exposure is contagious. Fortunately, besides asking for the obvious (and possibly impossible), the commission is forcing its hand a little, stressing how they want a clearinghouse for credit derivatives - otherwise legislation could be introduced. If that is not enough to put the fear in the industry, I am not sure what else is.

What is the hot new hedge fund strategy? Convertible Arbitrage? Distressed Debt? Emerging Markets? Event Driven? Macro? Long / Short, Risk Arbitrage? Quant? No, if a new hedge fund by a former Columbia professor is any clue, it is value (see Bloomberg article). The new company, called the Van Biema Value Partners, plans to invest in no more than 20 small Asian managers that follow value investing principles. When people start losing significant amounts of money, it is interesting how Buffett and Templeton start to appearing wise again.

Recently, high volatility is causing some option strategies, such as selling strangles, to look appealing again (see WSJ article). A strangle is an option strategy where you buy out-of-the-money puts and calls, as opposed to a straddle where both options are at-the-money. For those buying the position, you are hoping for volatility - with movement in either direction. Right now, as a result of higher volatility, the strategy is more expensive than it has been in the past, offering opportunity for those who sell the position. Typically, selling the strategy is safer when the straddle options are deeper out-of-the-money, but of course, deep out-of-the-money options do not usually generate as much premium - until now. The higher volatility has increased premiums to the point that deep out-of-the-money options, even for those tied to historically lower volatility stocks, are looking attractive. Each position needs to be considered carefully for risk and reward, but those with the stomach to sell option are seeing new opportunities and possibilities.

As hedge fund investors find it difficult to unload their shares (often due to missing redemption deadlines, or not wanting to wait through their holding period), some are utilizing the secondary market to sell their shares (see WSJ article). Hedgebay Trading Corp., which began business in 1999, operates a secondary market to match buyers and sellers of hedge fund stakes. Initially, when hedge funds were doing well, Hedgebay would have buyers paying a premium in order to take a stake in an attractive fund that may have been closed to new investors. As the market has turned, investors are now offering their shares at a discount, with the average discount recently doubling to 3.5%. Clients include individual investors, funds of funds, pension companies, and endowments. Funds of funds in particular have been aggressively utilizing the site and have actually redeemed more money than they need out of fear that when they do need the money, the individual hedge funds will put up redemption gates. JPMorgan has estimated that there will be up to $100 billion in redemption requests from funds of funds in Q4. The secondary market has even generated new opportunities for Permal Group, which is launching a $500 million fund that buys distressed priced hedge fund stakes, with shares coming from Hedgebay and existing relationships. Just another example of how capitalism does amazing things when it is allowed to operate. Now if only some private entity can do this efficiently with credit default swaps and credit derivatives, investors might actually be able to once again sell attractive hedge fund stakes for a premium.

According to a Dow Jones Financial News article (subscription required) and data from Hedge Fund Research, equity market neutral hedge funds made 0.3 percent so far this month (to October 20th). Equity market neutral funds look to profit from the markets regardless of their direction, putting equal positions on share prices rising and falling, leaving the portfolio as a whole uncommitted to the general direction of the market. Market neutral hedge funds are also up 0.4 percent total for the year. Given that market neutral funds are one of the few funds that actually seem to employ hedging, it is often considered by some to be a pure play, or true hedge fund. Imagine that. A hedge fund that hedges, doing the best when the market is volatile. Then again, being flat is a little boring (albeit nice when the market is tanking).

As if the credit markets did not have enough problems with actual credit default swaps (CDS) and collateralized debt obligations (CDO), now it has to worry about their synthetic relatives (see WSJ article). While synthetic CDOs have been talked about for a while, additional pain from synthetic CDO losses may be on its way, possibly setting back any recovery in the credit markets.

Synthetic CDOs essentially allow banks, hedge funds, and insurance firms to invest in a diversified portfolio of companies without directly purchasing the bonds of the companies. Unlike normal CDOs, synthetic CDOs do not contain actual bonds or debt. In order to provide the normal income stream generated by CDOs, synthetic CDOs provide income by selling insurance against debt default. Each synthetic CDO typically has numerous companies with good to high investment-grade credit ratings (often AAA or AA). Like a normal CDO, different tranches, or levels of risk and return are sold. Insurance companies typically purchase the higher rated senior and mezzanine tranches, while hedge funds, looking for higher return, yet willing to bear or hedge the additional risk, might invest in the lower-rated or unrated equity tranches. As the credit crunch progressed, many CDOs had exposure to financial companies, such as Lehman Brothers. Such exposure has caused previous AAA-rated products to now trade for 50 cents on the dollar, falling from 60 cents just a few weeks ago. The resulting hedge fund liquidation is pushing up the cost of default insurance, which in turn is raising the cost of borrowing, and putting more pressure on the credit markets.

Specialized funds, such as Constant Proportion Debt Obligations (CPDO) are also causing problems. If you felt that CDOs were not complex or risky enough, no problem. CPDOs juice returns by adding leverage, as much as 15 to 1. Of course, such leverage is risky, so many CPDOs have safety triggers that force them to exit their investment if their losses reach a certain level. Unfortunately, many are starting to reach their trigger levels. Some companies that sell protection on credit derivatives, called Credit Derivative Product Companies (CDPC) or Derivative Product Companies (DPC), have made matters worse by leveraging as high as 80 to 1. The CDPCs are similar to the monoline financial guarantee companies (remember Ambac, MBIA, etc.), except they do not have the burden of regulation (ah, remember the days). In order to stabilize company returns and ironically help secure a AAA rating, such companies would not post collateral, since posting collateral on trades could force collateral calls on losing trades and force portfolio selling. Of course, now, many firms are learning what forced selling is all about, or even worse, insolvency.

Hindsight is usually 20-20 (except when you still don't understand the product or exposure), but you still have to wonder how things were allowed to get so out of control. As an analogy, does it really make sense for me to be able to take out insurance on my neighbor's house, as well as mine? Should every neighbor on my street be allowed to insure against my house burning down? Or even better, on a house that does not even exist? Apparently so. Greed and common sense are not always close friends.

There is an interesting article today in the WSJ regarding the recent short selling ban, along with its unintended consequences. While the effects on hedging, volatility, and widening bid-ask spreads have been discussed at length, what often gets lost in the discussion is the effect on market efficiency (see previous post). As quoted in the recent article:

"Why would regulators ban short selling in nearly 1,000 companies, effectively banning accurate information from the markets? By targeting short sellers as a way to prop up share prices, regulators clearly panicked. This in turn panicked financial professionals and individual investors who saw regulators losing faith in the system they oversee."

In a sense, by trying to stabilize stocks, current actions have made them more volatile. Even worse than affecting individual stocks, such bans have destabilized the confidence and structure of the market itself, and made information flow less transparent. Individual stocks can recover, or can be sacrificed, but confidence must be built. Market structure must be consistent and trusted. Hopefully we have learned our lesson over the last few weeks as we continue to watch greater than 5% daily swings, not to mention material market moves (often down) every time someone from Washington shows up at a press conference.

There is an interesting article over at the All About Alpha site regarding the impact of the short selling bans on 130/30 funds. While the article discusses the obvious challenge of maintaining a 30 percent short position when many stocks cannot be shorted, it brings up an interesting point about data and quantitative modeling. As quants go forward with model development, they will need to be careful when back testing their models given the periods of time in the market when short selling was either restricted or tightened for various equities. As one expert was quoted as saying:

"Managers with quant models for generating trades will probably have their heads in their hands. Not only will the quant models have to be redeveloped, but the managers will lose months if not years worth of model evolution, back-testing and intellectual investment. I can predict a few horror scenarios where code and expertise in these models may have been lost.”

There is no doubt that many non-quants or retail investors will say "big deal, isn't it just a bunch of traders taking the hit? Why should I care?" Yet, they should. Besides attempting to make a profit and generate abnormal return, quant funds, like many other strategy based funds, seek to profit from inefficiencies in the market, which ironically helps to keep the market more efficient. When this ability is hampered, as it is when short sale rules are not only changed, but selectively changed, you just add more inefficiency and market volatility (have you seen the VIX lately?).

Sure, naked short selling is wrong, and bans need to be enforced, but interfering with the normal market checks and balances could take months to sort out, even after short selling rules are returned to normal (or at least consistent for more than two weeks at a time). Until then, risk management, arbitrage, and finding someone to take the other side of the trade will be more difficult. All the while, day traders will continue to enjoy the volatility, while retail investors will continue to get nauseous, wondering if things will ever calm down.

Here is the link to the recent New York Times Warren Buffett Op-Ed (free subscription required). Worth a read if you have not already come across it.

Banks are continuing to ask for more collateral to back past hedge fund lending, causing more funds to liquidate their positions (see WSJ article). When added with investor redemption, bank-induced liquidation is forcing hedge funds to step-up their deleveraging. Such selling is continuing to put pressure on the market, generating more requests for bank collateral and investor redemption, in what amounts to a catch-22 that continues to spiral the market downward. Such selling has been occurring for a while, as funds have been unwinding exposure to financial and energy stocks, both of which continue to suffer as crude oil continues to drop, and the credit crisis continues to unfold. While Hedge Fund Research recently reported that the level of hedge fund market exposure has decreased by one-third over the last year, I suspect that this still may not be enough. As mentioned by Antonio Munoz-Sune, head of the U.S. for fund of funds EIM: "The combination can take anyone down." Unfortunately, it is difficult to tell where we are in the hedge fund closing and deleveraging process, with many hedge funds still appearing to use every rally as an opportunity to sell. I suspect that until we see the VIX approach more normal sub-30 levels, stop seeing the DJIA and S&P 500 Index post intra-day percent swings in the high single digits, and see crude oil stop falling in price, it is unlikely that the market will stop feeling the effects of hedge fund selling, allowing for a long-term and lasting rally. Like most bottoms, we won't know for sure that it has occurred until we see it in the rear-view mirror, but I will be watching the VIX, the price of crude oil, and the Dow Jones and S&P 500 index percent swings for clues.

The EU is once again looking for ways to not only deal with the results of the financial crisis, but also some of the potential root causes of the problems (see Financial Times article). EU regulators in Brussels voted to accept changes made by the International Accounting Standards Board that will give banks more leeway in how they value certain assets whose value has dropped excessively. The changes can be applied to third quarter results, and essentially allow banks and institutions to move assets from their trading books to their banking books. This change will allow the assets to be reported at "amortized" cost, spreading cost over a number of years, as opposed to "fair" market value, which in some cases is too low or simply unknown.

Are the days of the financial lottery over? Is the excitement (and at times envy or disdain) of seeing a CEO or hedge fund manager make a killing a thing of the past? A new era of public ownership, and subsequent public oversight, may be signaling the end of the financial superhero (see WSJ article). The involvement of the Treasury in nearly every aspect of the financial system certainly means more oversight, more regulation, and more required regulatory capital: and of course, lower returns and paydays. The end result may be a slow stumble to the middle. Boring may in fact turn out to be better in the long-run, but suffering through another post-excess 1930s or 1970s market while Wall Street once again finds its way is not going to generate the page turning excitement of reading about your favorite superhero (or villain).