Selling by hedge funds is still putting pressure on the market (see WSJ article). As we have discussed over the last month (see posts here and here), many redemption requests by hedge fund investors are now meeting their waiting periods, causing many funds to sell assets in order to raise cash. As quoted by Gregory Horn, president of Persimmon Capital Management:

"In mid-October, redemption levels were in the 5% range but all of a sudden now it's cranking up to as high as 25% for some funds."

Certainly not good news for hedge funds, but maybe even worse news for the market. With continued forced selling, it is unlikely the market will quit trying to find a bottom. Hedge funds will continue to sell every rally, increasing volatility. As long as the VIX continues to spike and stay at elevated levels, and we continue to see the "punch-in-the-stomach" late day sell-offs after nice rallies (both of which I suspect are indications of further hedge funds selling), we will continue to be in a volatile holding pattern between 850 and 1,000 on the S&P. Unfortunately, it is difficult to know exactly when the selling will quit, as the selling and redemption requests are tied together in what is becoming a volatile catch-22 pattern that is feeding upon itself. The other day I heard an analysts say it was "too late to sell, but too soon to buy." Until hedge fund investors believe the former, it is unlikely any investors will quit believing the latter.

Trend following managed futures funds have outperformed hedge funds this year, gaining 8.9 percent year-to-date (see WSJ article). Hedge funds have lost almost 19 percent during the same time frame. Managed futures funds often use quantitative trading algorithms to spot market trends, at which point a long or short position is quickly taken in futures or other derivatives. Managed futures underperformed between 2003 to 2007 when volatility was lower, but have since done better as volatility increased. The ability to quickly initiate an "unemotional" short selling signals has also added to recent gains. Ironically, the reduction of risk by some traders and hedge funds has resulted in less liquidity and larger price swings, both of which have allowed managed futures to outperform hedge funds who have traded in many of the same markets.

For the first time since 1993, credit card companies were unable to sell bonds backed by customer payments (see Bloomberg article). Top-rated credit card-backed securities maturing in three years are selling at spreads of 475 basis points over Libor, compared to a spread of only 50 basis points less than a year ago. Given higher unemployment, leading to potentially higher credit card use and an inability to pay, lenders are expecting higher default rates for 2009. American Express is already accessing the Fed commercial facility program, as well as cutting 10 percent of its work force. Bank of America, JPMorgan, and Citigroup all rely on the debt market to fund their credit card portfolios, and could also subsequently be impacted by higher spreads and lower liquidity.

It appears that efforts by the central bank to encourage investors to purchase corporate debt are not having much success (see CNN Money article). While it is often the case that companies are hesitant in the fourth quarter of a fiscal year to purchase debt for fear of creating problems on their balance sheets, this year the policy decisions of the Fed also appear to be having an impact. Currently, the Fed is offering a much lower borrowing rate than the market, with rates as low as 1.55 percent for three-month paper. The market is offering closer to 2.6 percent for similar debt. Until the market rates are lower, or the Fed rates become higher, it is not likely that investors will take the extra risk of buying corporate debt.

In a seemingly unrelated story, automakers are apparently unhappy with the $25 billion in loans they are set to receive for making more fuel efficient cars, with paperwork and administrative hurdles delaying the money (see Reuters article). As a result, the industry is continuing to burn through cash at a faster pace, causing GM to warn that the industry is now "near collapse," requiring further assistance. New aid is now being demanded, possibly up to another $25 billion in loans. The difference is that now these loans would come with no strings attached, with the expectation is that the companies would use the money to pay retiree health care obligations.

As the current financial crisis continues to unfold, one can expect that similar market circumstances (interest in cheaper Fed debt) and stimulus requests (taxpayers covering operating costs) will continue. At some point the response to such request will have to be no, and the results of such decision will have to be felt. Unfortunately, the longer that requests are accepted and government intervention occurs, that longer it will take to separate business from government and allow the free markets to get back to doing what they do best - rewarding with cheaper capital those companies that are managed well and properly positioned, while punishing those that aren't.

A recent New York Times article follows up on a previous discussion (see blog post) regarding modeling and risk management. While financial engineering and quants will continue to receive some criticism for the recent problems in the markets, along with development of generally inadequate risk management models, the NY Times article further explores whether it was the models or human failure that are to blame for the current financial situation. There is no doubt that some models, especially black box models, have created some of the problems, but we cannot really fix the problem until we know the root causes. Is it simply a matter of not having sophisticated enough modeling techniques, or are poor assumptions, inadequate data, and lack of oversight also to blame?

Research at the IMF found that quantitative methods underestimated defaults for subprime borrowers, at times often relying on computerized credit-scoring models instead of human judgment (then again, I am not sure Moody's or S&P were much better or more timely, but I digress). On the other hand, economists at the Fed concluded that risk models had correctly predicted that a drop in real estate prices of 10-20 percent would be bad for subprime mortgage-backed securities (not a surprise), but that analysts themselves assigned a very low probability of this happening. In fact, the Fed study might be at the heart of the problem - human behavior.

As mentioned in the article, asset prices depend on not only our belief, but the belief of others. In an "efficient" market the participants expect that the true (or near true) price is reflected, even if the belief of one person is far from the efficient value. Of course, it is hard to model the beliefs of the market, so often the beliefs, hopes, or profit motives of one person may come into play, with at times disastrous results. The problem is compounded when risk management models are assumed to follow some natural law, when in fact both the theory that defines the model, and the inputs provided to the models, are more stochastic in nature.

As I have argued before, we need risk models, even those based on imperfect mathematics and assumptions, but we must always take into consideration what could happen if we are wrong. If our assumptions are too optimistic or too pessimistic, what is the fallout? We should be asking ourselves how confident we are in mathematics used AND the assumptions made. Are there assumption scenarios that could bring a company to its knees? What models are best to help understand all the possible outcomes that we should be worried about? These are the questions risk managers need to continue to ask. Yet in many instances blind black box models with fixed assumptions were trusted. Unfortunately, I suspect that even with the recent problems and consequences hanging over our heads, asking which models and assumptions point to the highest profits or lowest levels of regulatory capital will once again start to be considered. After all, its just human nature. Of course, avoiding pain is also a natural human instinct. Maybe there is a lesson to be learn there as well when the next bailout is voted on.

As reported at the Deal Book blog, the total size of credit default swaps outstanding on corporate, government, and asset-backed securities is "only" $33.6 trillion, smaller than the previous estimates of +$50 trillion. The largest CDS dollar amounts were written against debt for Merrill Lynch, Goldman Sachs, Morgan Stanley, GE Capital, Countrywide, GMAC, and government debt in Turkey, Italy, Brazil, and Russia. Nonetheless, much of the notional value has been reduced through hedging. The weekly reports are being offered by the Depository Trust and Clearing Corporation, and are expected to also include trade volume and turnover in future reports. Expect more transparency going forward. A little sunlight is the best disinfectant.

Nassim Nicholas Taleb, author of the Black Swan, is using the impact of extreme events mentioned in the Black Swan to help the hedge fund he advises, Universa Investments L.P., benefit in October (see WSJ article). Separate funds in the Universa's Black Swan Protection Protocol were up between 65 percent to 115 percent in October alone. The fund has a strategy of buying far-out-of-the-money put options on stocks and stock indexes. Most of the time the fund will take small loses when nothing unusual happens, but occasionally a black swan even occurs (such as the recent 20% market decline in one month), causing the gains to be extraordinary. In addition to using deep out-of-the-money puts, the fund has a strategy of keeping more than 90% of its assets in cash or cash equivalents, and is believed to break even or only incur small losses while waiting for the next black swan event. The fund recently made huge profits buying cheap puts on the S&P 500 and AIG, with the S&P puts increasing in value over 50-fold. While profitable during times of extreme volatility changes, one has to wonder how often such changes and moves will occur. Even a previous fund that Taleb was involved with had to shut down in 2004 after lower volatility caused returns to suffer and investors to flee. But then again, a 50-fold increase in a few trades gives you time to wait for the next event. You just need to be patient, and of course, know where to look as you wait for the worst to happen. Easier said than done.

An recent article in the WSJ discusses the AIG risk models developed by Gary Gordton (note, Gorton, not Gordon as originally posted), a professor at the Yale School of Management. The headline of the article boldly states "Behind AIG's Fall, Risk Models Failed to Pass Real-World Test." Yet, did the models really fail? Gordton's models were developed to gauge the risk of AIG's credit default swaps, but according to the article, "... AIG didn't anticipate how market forces and contract terms not weighted by the models would turn the swaps, over the short term, into huge financial liabilities." The quote is interesting in that it highlights what may be at the heart of AIG's problems. As a result of its ignorance on whether the short-term collateral risk needed to be considered, or its belief that such risk was not something to be worried about, AIG made a decision to not have Gordton assess these threats - even stating later that it knew his models did not consider such risk. So this begs the question once again. Did the models really fail (as approached by Gordton and approved by AIG), or was it more of a lack of understanding of the very products they were modeling? I know some will ask what's the difference - in the end the models were incomplete - but the distinction is significant.

In hindsight, it is easy to point fingers and wonder exactly what risk AIG was even trying to manage. But the real problem here seems to be less about one particular modeler getting it wrong, or developing incomplete models, and more about management ignoring to consider some risk while putting faith in the very same models that were not designed to give the level of confidence or enterprise-wide coverage that is being used to engender confidence. Even the WSJ article (in the body of the story) mentions how "Mr. Gordton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances." Of course, this did not keep AIG from trading as though it did, and therein lies the problem. The failure here is less about modeling, or even risk management, and more about corporate management and decision making. Yet, the perception that the problem is with modeling is widespread. Even Warren Buffett is quoted as saying "All I can say is, beware of geeks .... bearing formulas." But what is the alternative? Shall we abandon all risk modeling and simply use our gut instincts? Should we just take risk off the table completely? I don't believe so. While better risk management models should continue to be developed, maybe a little humility is a good place to start. Understanding a company's limitations is key to uncovering its strengths and protecting against its weaknesses.

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.