Economic data is pointing towards a worsening global recession in 2009. The scale of the slowdown in economic activity, the damage done to the banking system, the losses accumulated in residential real estate and the impairment of household balance sheets call for extraordinary policy measures. A more or less global though not entirely concerted policy for dealing with the ailing banking system is already underway. It is not working as well as expected or intended. Similarly, monetary policy has become more accommodative globally in an effort to revive rapidly slowing economies. Monetary policy on its own is insufficient as it addresses the ability and not the intention to spend or invest. At the extreme, monetary policy has direct inflationary consequences.
In a slowing economy, it is individually rational to increase saving at the expense of consumption, and to cut back on investment in capacity, even though it is collectively irrational to do so. Enter government. Governments will have to spend and invest on behalf of households and companies to stabilize economic growth. This approach addresses demand directly but is not without its risks. Developed markets now operating below full potential output, are less at risk of direct crowding out. Inflationary risks are another matter and may raise funding rates to cause de facto crowding out.
There are several ways to fund fiscal deficit spending. Taxation is one. Developed world taxation is already high and the scope for increases is limited. It is risky to argue that increased economic activity may result in increased tax receipts. More immediately, cutting taxes may be necessary. Raising taxes on the rich has limited use as the rich are a marginal taxpayer given globalization and the prevalence of tax arbitrage. Borrowing through the issuance of public debt is another avenue. This can create the so called crowding out of private investment. A third way, is seignorage, which is of course inflationary and historically untenable. Enterprise and investment, a technique established in the form of sovereign wealth funds is another way. It is unlikely that deficits will be funded by taxation in the middle of a recession. If so, it might take the form of highly targeted taxation, or cosmetic taxation, such as an increase in top rate marginal taxes. If anything, marginal tax rates on consumption and lower income earners is likely to be reduced on the rationale that the marginal propensity to consume out of income decreases with increasing income and wealth. This would have a negative impact on tax receipts.
Financing deficit spending through the printing of money is directly inflationary but has the advantage of immediately supporting asset prices. The cost is in a weaker currency both internally and externally. The inflation cost can be high and depending on the prevailing inflationary conditions might not be viable. The natural route is financing deficit spending through borrowing, effectively from future generations. This is the most likely approach most nations will take. The impact in the US for example is higher interest rates. Once again, the crowding out effect is unlikely to bite as the US economy is clearly below potential.
Inflation is a risk. We have seen the path of the oil price rising from 20 USD per barrel in 2001 to 147 USD per barrel in the summer of 2008 before falling below 50 USD again. Similar patterns are seen in coal, metals, agricultural commodities, soft commodities, energy. Markets overshoot on both the upside and downside. The equilibrium price ex speculators, that it paid for by people who would like to burn the oil is probably in the 60 – 70 USD range. At these prices, inflation does not decline as much as policy makers would hope. Alternative sources of energy are not commercial once development costs are included. US CPI inflation would probably settle at around 4% while PPI inflation might be slightly higher from 4 – 6%. These levels are not overly concerning but they are not low by any means. (As an aside, if inflation does increase, the need for pensions and endowments to meet their obligations will likely bring them back into the market for risky assets). All this assumes of course that in the course of fiscal reflation, banking bailouts and other extraordinary measures, governments do not debase their currencies.
If currencies are debased, such as in banking bailouts or where fiscal deficits are funded by printing money, for example, inflation pressures will be exacerbated. The likely candidates where this scenario is likely can be found by an examination of public finances. This is a different analysis from looking at public balance sheets. Developed countries with budget deficits will likely be in this group. They will likely face weakening currencies and inflationary pressures. This could lead to a vicious cycle of rising commodity prices and rising inflation. Where the public sector balance sheet is weak, quantitative easing is not feasible as it is highly inflationary.
Monetary policy across the globe is currently extremely loose, and, given the expected depth of the slowdown, interest rates are likely to be driven further down to zero. This is likely to result in steep yield curves as public debt issuance is increased and inflation expectations are revived. Generally, the market expects little to no inflation and there are even expectations for deflation risk. It is likely that there will be volatility at the long end of the curve. The likely evolution is an early 1980’s yield curve as the expectations oscillate between inflation and recession.
Apart from developed countries where economic dogma eschews the direct allocation of credit by a central planner, developing countries do have the option to lend directly where their banking system may be paralyzed. In particular, in Communist countries operating market economies, the banking system can be directed to lend. Without the burden of economic dogma, certain countries have full freedom to deploy a host of economic tools to revive their economies. They can spend on behalf of consumers, they can put cash in the hands of consumers, they can invest in place of companies, they can print money to finance fiscal deficits, they can borrow to create a normalized yield curve and provide the banking system with a carry trade, they can tax selectively and tactically to synthesize inflation, if it was called for, they can invest in infrastructure, in improving the capital stock, in improving the knowledge base, in human capital. These measures may terrify the free marketer, but ever since the slew of blanket bail outs and ad hoc rescues in the West, criticism is unlikely to arise from those quarters.
Current policy remains short term and focused on disaster control. In the medium to longer term, disaster control policies are inappropriate. The time to be reactive has passed and it is now time to be pre emptive. The current policy of encouraging credit creation on a grand scale needs moderation and fine tuning. Failure of the policy is a poor outcome. Success of the policy risks the reflation of the credit conditions that precipitated the crisis in the first place. Quantitative easing can be highly inflationary. Some economies will have little choice but to print money to fund fiscal deficit spending.
If as we expect, policy remains inflexible and continues down the simple reflationary path, a real economy recovery would precipitate the need for central banks to shrink their balance sheets, reduce credit lines and raise interest rates in reaction or risk hyperinflation. History has shown that such action would have a strong negative impact on asset values. The various scenarios and options are indicative of further uncertainty and thus volatility in asset values.
Further implications:
It is impractical to have a macro view without considering the social impact of economic recessions and their policy responses. Globalization has created a complex web of relationships linking the economies of developed and developing nations. This creates correlation in economic growth, employment and prices across nations. Unemployment driven by the global financial crisis is likely to result in social unrest across the globe. Less diversified economies with concentrations in particular industries are particularly at risk. In some countries, there may be military solutions (China); in others there may be anarchy (India, Russia.)
Emerging market proactive solutions are likely to take the form of some sort of nationalization of substantial parts of industry either explicitly or implicitly. Such measures may not be acceptable in developed capitalist economies. There may, however, be little choice in the face of social turmoil except for government to become the employer of last resort in de facto nationalizations. Sovereign risk will be highly differentiated and priced.
The US auto sector is an example of a possible manifestation of this theme. The financial sector, and in particular the banking system is also likely to become regulated as utilities. Protectionism is a likely consequence. If large swathes of economies become nationalized, they will take on a new political dimension and will influence trade policy. Globally, agriculture is a dire example.
Return on investment is likely to suffer in industries facing de facto or formal nationalization. An example is the banking industry where it is likely that in recovery, banks will come to be regulated as utilities and returns are likely to converge to those of utilities.
Thursday, 22 January 2009
Tuesday, 6 January 2009
Inflation Deflation
In my post of 11 Aug 2008, I said that recession was the greater concern over inflation, at a time when US CPI was 5% and PPI 14%. Today there are fears of deflation. Looking forward, the risk to inflation is on the upside.
In late 2006, the oil price was in the range 60 – 70 USD which is regarded by Purvin and Gertz an energy consultancy as the market clearing price based on demand and supply from industry, that is ex financial speculation for 2009. The gap between headline CPI and core CPI was running at about 2% at the time. Assuming now that economic growth slows further and that we end up in a late 2002 situation where US Core CPI was at about 1%. Energy prices back at 60 – 70 USD could add another 1.5 – 2% to inflation taking it to 3 -3.5%. All this assumes that the US and other developed economies, which are mostly those running budget deficits, do not debase their currencies as they try to fund further bail outs and fiscal reflationary policies. The risk, I believe, is that in 12 months time, an expansionary China and India, competing for resources, and being inefficient users of resources, bid up the price of cyclical commodities and food, and drives prices to the point where inflation begins to pick up in the developed world.
With the debasing of currencies, this could result in CPI in the 5-6% range. Not disastrously high, but not disinflationary either. In fact, it might be a comfortable range to be in, supporting long term bond yields and maintaining the term structure.
More interestingly, investors who were happy to sit on cash will find that strategy eroded by inflation, and will at the least have to find inflation hedges, mostly found in risky assets.
Now, if countries like the US start printing money, all bets are off. Inflation then becomes a case of a shrinking yardstick (purchasing power of money), and could be unbounded.
In late 2006, the oil price was in the range 60 – 70 USD which is regarded by Purvin and Gertz an energy consultancy as the market clearing price based on demand and supply from industry, that is ex financial speculation for 2009. The gap between headline CPI and core CPI was running at about 2% at the time. Assuming now that economic growth slows further and that we end up in a late 2002 situation where US Core CPI was at about 1%. Energy prices back at 60 – 70 USD could add another 1.5 – 2% to inflation taking it to 3 -3.5%. All this assumes that the US and other developed economies, which are mostly those running budget deficits, do not debase their currencies as they try to fund further bail outs and fiscal reflationary policies. The risk, I believe, is that in 12 months time, an expansionary China and India, competing for resources, and being inefficient users of resources, bid up the price of cyclical commodities and food, and drives prices to the point where inflation begins to pick up in the developed world.
With the debasing of currencies, this could result in CPI in the 5-6% range. Not disastrously high, but not disinflationary either. In fact, it might be a comfortable range to be in, supporting long term bond yields and maintaining the term structure.
More interestingly, investors who were happy to sit on cash will find that strategy eroded by inflation, and will at the least have to find inflation hedges, mostly found in risky assets.
Now, if countries like the US start printing money, all bets are off. Inflation then becomes a case of a shrinking yardstick (purchasing power of money), and could be unbounded.
Government bonds versus Corporate bonds
All the bail outs and helpful measures that governments are undertaking to reinvigorate the economy amount to a transfer from the government to the private sector.
Government balance sheets must suffer. Corporate balance sheets must improve. Short US Treasuries and treasuries of governments that are already running deficits, thus Europe and the UK, and Long their corresponding corporate bonds.
Another way of looking at it is that governments are in a sense guaranteeing the private sector. Therefore one should take on private sector credit risk and hedge it by buying protection in sovereign CDS.
Government balance sheets must suffer. Corporate balance sheets must improve. Short US Treasuries and treasuries of governments that are already running deficits, thus Europe and the UK, and Long their corresponding corporate bonds.
Another way of looking at it is that governments are in a sense guaranteeing the private sector. Therefore one should take on private sector credit risk and hedge it by buying protection in sovereign CDS.
Wednesday, 17 December 2008
Madoff is not representative of the hedge fund industry
The Madoff Fraud is bound to have investors running from hedge funds. However, one should realize that Madoff was not structured as a typical hedge fund. The Madoff structure was unique, and allowed ample latitude for fraud.
Investors in Madoff:
-Did not buy shares in an offshore entity advised or managed by Madoff.
-Did invest in an offshore entity which in turn placed funds in a brokerage account.
-Had the said brokerage account held at Madoff Securities.
-Therefore had their assets custodied, managed, executed and reported by Madoff Securities.
-Lost an independent source of information and were thus vulnerable to fraud among other things.
The typical hedge fund is structured as follows:
-investors buy shares in an offshore entity.
-the entity would appoint an independent custodian to hold its assets.
-the entity would appoint an independent administrator to manage it on a day to day basis, such management to include the calculation and determination of the gross and net asset values.
-an investment manager would manage the assets of the entity.
-the investment manager would execute trades through independent third party brokers.
-the investment manager would not be able to operate the bank accounts of the company or limited partnership without the involvement of the third party, independent administrator.
-the company or limited partnership would engage reputable and independent third party auditors.
It is sad that a long standing and prominent member of the hedge fund community has succumbed to fraud. The reputational impact to the industry is significant, however, with time it is hoped that investor faith will be restored.
It is likely that the Madoff Fraud will precipitate certain changes in the industry. Whether these changes are useful or not is not the issue.
-Investors will lean towards having managed accounts.
-This will allow them to use service providers and counterparties of their choice, or at least influence the choice of service providers and counterparties.
-A managed account will provide investors better transparency as well confidence.
-This will allow them to live test the portfolio from time to time, albeit at a cost.
-Bespoke mandates eliminate style drift and allows better segregation of risk factors.
-Places control back in the hands of the investor.
Investors in Madoff:
-Did not buy shares in an offshore entity advised or managed by Madoff.
-Did invest in an offshore entity which in turn placed funds in a brokerage account.
-Had the said brokerage account held at Madoff Securities.
-Therefore had their assets custodied, managed, executed and reported by Madoff Securities.
-Lost an independent source of information and were thus vulnerable to fraud among other things.
The typical hedge fund is structured as follows:
-investors buy shares in an offshore entity.
-the entity would appoint an independent custodian to hold its assets.
-the entity would appoint an independent administrator to manage it on a day to day basis, such management to include the calculation and determination of the gross and net asset values.
-an investment manager would manage the assets of the entity.
-the investment manager would execute trades through independent third party brokers.
-the investment manager would not be able to operate the bank accounts of the company or limited partnership without the involvement of the third party, independent administrator.
-the company or limited partnership would engage reputable and independent third party auditors.
It is sad that a long standing and prominent member of the hedge fund community has succumbed to fraud. The reputational impact to the industry is significant, however, with time it is hoped that investor faith will be restored.
It is likely that the Madoff Fraud will precipitate certain changes in the industry. Whether these changes are useful or not is not the issue.
-Investors will lean towards having managed accounts.
-This will allow them to use service providers and counterparties of their choice, or at least influence the choice of service providers and counterparties.
-A managed account will provide investors better transparency as well confidence.
-This will allow them to live test the portfolio from time to time, albeit at a cost.
-Bespoke mandates eliminate style drift and allows better segregation of risk factors.
-Places control back in the hands of the investor.
Strategies for 2009
Strategies for 2009
Distressed Asian Convertible Bonds
Long only and unlevered
Closed end fund format
Asia has performing assets at distressed prices
Distressed investors, not distressed issuers
List of quasi sovereign issuers – which can later be hedged with sovereign CDS when counterparty risk is settled
Currently poor liquidity – market likely to return albeit smaller than before
Full exposure to credit default risk
Distressed Convertible Bonds
Long only and unlevered
Closed end fund format
Distressed investors purging convertible portfolios has created distressed pricing
Currently poor liquidity – market likely to return albeit smaller than before
Full exposure to credit default risk
Bond Basis
Long cash bond long credit protection through CDS
Closed end fund format
Wholesale deleveraging from cash bond investors has created arbitrage opportunity
Open to CDS counterparty default risk
Distressed Debt
Long biased
Closed end fund format
Recession has accelerated default rates
Technical selling pressure has created distressed pricing across performing and non performing assets
Capital Structure Arbitrage
Long Short
Closed end fund format
Technical selling has created arbitrage opportunities intra issuer
Long senior short sub – positive jump to default at low to non negative cost / no negative jump to default at positive carry
Capital Structure Arbitrage Distressed
Closed end fund format
Long short
Recession has accelerated default rates
Long fulcrum security – converts to equity
Short most senior non recoverable to hedge non-default spread duration
Trade finance
Open ended fund
Senior secured, over collateralized, liquid collateral, commodities or commoditized goods only
Acute shortage of capital has improved margins
Secondary market opportunities
Particularly attractive in emerging markets
Receivables finance
Open ended fund
Acute shortage of capital has improved margins
Shorter duration assets
Structured with limited recourse
Obligor / credit risk arbitrage
Deep value equity
Long biased / Long only
Open ended with lock up
Wholesale de-risking has created attractive valuations even under recessionary assumptions
Strategy variant: buy out (which would require either a closed end or long lock up fund)
Strategy variant: activist (financial restructuring)
Merger Arbitrage
Open ended with lock up
Value is available and there is a good proportion of corporates with cash
ROE and valuation differentials encourage cross border deals
Developed world acquirers, developing nation targets
Cross border skills required
Most of the above strategies would not survive a run on the fund situation and hence require a closed end structure. They are also vulnerable to mark to market divergence and thus should not be leveraged with a prime broker on standard terms. Many of these strategies could be leveraged if one could term finance the trade bundles and lock in financing rates.
Strategies I would be less inclined to recommend:
Convertible arbitrage – gamma or carry
Needs borrow that may be hard to get
Needs leverage that is hard to get
CBs are trading through their bond floors – no gamma
Risk Arbitrage - traditional in country
LBO deals are dead
There is no finance to leverage the large private equity buy out deals
Equity/Credit market neutral
Valuations not supportive of shorting
Broken business models in industries at risk of bailout
No liquidity in other shorts
Longer duration direct lending
Cyclical strategy – cash flow predictability is poor
Although spreads are highly attractive
Attractive only if it is the intention to acquire the collateral
Default rates likely to rise
Volatility – Long Biased
Long vega game is unlikely to continue to pay
Long gamma is opportunistic
Distressed Asian Convertible Bonds
Long only and unlevered
Closed end fund format
Asia has performing assets at distressed prices
Distressed investors, not distressed issuers
List of quasi sovereign issuers – which can later be hedged with sovereign CDS when counterparty risk is settled
Currently poor liquidity – market likely to return albeit smaller than before
Full exposure to credit default risk
Distressed Convertible Bonds
Long only and unlevered
Closed end fund format
Distressed investors purging convertible portfolios has created distressed pricing
Currently poor liquidity – market likely to return albeit smaller than before
Full exposure to credit default risk
Bond Basis
Long cash bond long credit protection through CDS
Closed end fund format
Wholesale deleveraging from cash bond investors has created arbitrage opportunity
Open to CDS counterparty default risk
Distressed Debt
Long biased
Closed end fund format
Recession has accelerated default rates
Technical selling pressure has created distressed pricing across performing and non performing assets
Capital Structure Arbitrage
Long Short
Closed end fund format
Technical selling has created arbitrage opportunities intra issuer
Long senior short sub – positive jump to default at low to non negative cost / no negative jump to default at positive carry
Capital Structure Arbitrage Distressed
Closed end fund format
Long short
Recession has accelerated default rates
Long fulcrum security – converts to equity
Short most senior non recoverable to hedge non-default spread duration
Trade finance
Open ended fund
Senior secured, over collateralized, liquid collateral, commodities or commoditized goods only
Acute shortage of capital has improved margins
Secondary market opportunities
Particularly attractive in emerging markets
Receivables finance
Open ended fund
Acute shortage of capital has improved margins
Shorter duration assets
Structured with limited recourse
Obligor / credit risk arbitrage
Deep value equity
Long biased / Long only
Open ended with lock up
Wholesale de-risking has created attractive valuations even under recessionary assumptions
Strategy variant: buy out (which would require either a closed end or long lock up fund)
Strategy variant: activist (financial restructuring)
Merger Arbitrage
Open ended with lock up
Value is available and there is a good proportion of corporates with cash
ROE and valuation differentials encourage cross border deals
Developed world acquirers, developing nation targets
Cross border skills required
Most of the above strategies would not survive a run on the fund situation and hence require a closed end structure. They are also vulnerable to mark to market divergence and thus should not be leveraged with a prime broker on standard terms. Many of these strategies could be leveraged if one could term finance the trade bundles and lock in financing rates.
Strategies I would be less inclined to recommend:
Convertible arbitrage – gamma or carry
Needs borrow that may be hard to get
Needs leverage that is hard to get
CBs are trading through their bond floors – no gamma
Risk Arbitrage - traditional in country
LBO deals are dead
There is no finance to leverage the large private equity buy out deals
Equity/Credit market neutral
Valuations not supportive of shorting
Broken business models in industries at risk of bailout
No liquidity in other shorts
Longer duration direct lending
Cyclical strategy – cash flow predictability is poor
Although spreads are highly attractive
Attractive only if it is the intention to acquire the collateral
Default rates likely to rise
Volatility – Long Biased
Long vega game is unlikely to continue to pay
Long gamma is opportunistic
Tuesday, 16 December 2008
Madoff
Last week Bernard Madoff decided to throw in the towel on his own Ponzi scheme and confess to one of the largest cases of alleged fraud in the hedge fund industry, known to date. The list of direct investors includes astute and reputable investors. The details of the scheme are as yet unknown but the opportunity for fraud and the vulnerability of the structure of the fund is immediately apparent and indeed has been apparent to investors since inception. In fact, the fund documents are transparent as to all the structural weaknesses of the fund.
How does one invest in a fund managed by Madoff? Unless one has a sufficiently large checkbook, the only way to invest is through a feeder fund. Madoff’s business model is based on scale and to this end, rather than have in house distribution and marketing, Madoff uses intermediaries to raise capital in what is sometimes known as white labeled or private labeled products. An intermediary sets up a fund and raises capital for that fund. This fund then invests substantially all of its assets in a ‘fund’ or more accurately in the case of Madoff, a managed account managed by Madoff. Typically in a white labeled agreement, a feeder fund invests in a master fund. That is, an investor puts money in the feeder fund. The feeder fund then invests that money in the master fund. Corporate governance requires that each fund will have its own investment advisor, independent administrator, prime brokers, custodian banks, auditors. In the case of Madoff, the feeder funds did have their own investment advisor, independent administrator, prime brokers, custodian banks, auditors. The master accounts with Madoff Securities, unfortunately, did not.
In the typical structure of a Madoff run fund, the white labeled fund into which the end investor puts their money would have a reputable independent administrator, custodian, auditor (usually one of the big 4). The investment advisor would be the sponsor (and marketer) of the fund. The fund, however, would establish an account at Bernard L Madoff Investment Securities Inc, a registered broker dealer it should be noted, who would trade the account. The prime broker and custodian of the fund would also be Bernard L Madoff Investment Securities Inc. And here the independence is lost. Without independent oversight, the opportunity for fraud became abundant. One should note that the structure itself was not the fraud, it was the weakness in control that the structure introduced that provided the opportunity for fraud.
The marketing materials of many of these white labeled funds would often refer to the transparency that they were getting from Madoff Securities, and there is no reason to doubt this claim, however, one should question the value of receiving said transparency from a custodian which was a connected party to the fund manager.
In a sense, the white label sponsors were conspirators after the fact since it would have been very difficult to perpetrate a fraud without their involvement. An investor investing directly with Madoff, had there been such a fund offering would have seen the weakness of not having an independent custodian, let alone prime broker, let alone administrator. The auditors would have had to face individual investors for each and every round of due diligence. Too often, an end investor gaining access through the white labeled fund would have seen only the service providers of the white labeled fund and been satisfied with the quality of these service providers without delving further and asking the same questions of the managed account at Madoff.
At the heart of the problem is NOT a failure of due diligence, since the weaknesses of the structure were fully disclosed in fund due diligence materials and offering memoranda. There was no effort to misrepresent the structure or to cover it up. Investors therefore invested with full information or at least access to sufficient information to make an informed judgment. Why would reputable sponsors attach their reputations and fortunes to a deficient structure, and why did end investors knowing invest?
How does one invest in a fund managed by Madoff? Unless one has a sufficiently large checkbook, the only way to invest is through a feeder fund. Madoff’s business model is based on scale and to this end, rather than have in house distribution and marketing, Madoff uses intermediaries to raise capital in what is sometimes known as white labeled or private labeled products. An intermediary sets up a fund and raises capital for that fund. This fund then invests substantially all of its assets in a ‘fund’ or more accurately in the case of Madoff, a managed account managed by Madoff. Typically in a white labeled agreement, a feeder fund invests in a master fund. That is, an investor puts money in the feeder fund. The feeder fund then invests that money in the master fund. Corporate governance requires that each fund will have its own investment advisor, independent administrator, prime brokers, custodian banks, auditors. In the case of Madoff, the feeder funds did have their own investment advisor, independent administrator, prime brokers, custodian banks, auditors. The master accounts with Madoff Securities, unfortunately, did not.
In the typical structure of a Madoff run fund, the white labeled fund into which the end investor puts their money would have a reputable independent administrator, custodian, auditor (usually one of the big 4). The investment advisor would be the sponsor (and marketer) of the fund. The fund, however, would establish an account at Bernard L Madoff Investment Securities Inc, a registered broker dealer it should be noted, who would trade the account. The prime broker and custodian of the fund would also be Bernard L Madoff Investment Securities Inc. And here the independence is lost. Without independent oversight, the opportunity for fraud became abundant. One should note that the structure itself was not the fraud, it was the weakness in control that the structure introduced that provided the opportunity for fraud.
The marketing materials of many of these white labeled funds would often refer to the transparency that they were getting from Madoff Securities, and there is no reason to doubt this claim, however, one should question the value of receiving said transparency from a custodian which was a connected party to the fund manager.
In a sense, the white label sponsors were conspirators after the fact since it would have been very difficult to perpetrate a fraud without their involvement. An investor investing directly with Madoff, had there been such a fund offering would have seen the weakness of not having an independent custodian, let alone prime broker, let alone administrator. The auditors would have had to face individual investors for each and every round of due diligence. Too often, an end investor gaining access through the white labeled fund would have seen only the service providers of the white labeled fund and been satisfied with the quality of these service providers without delving further and asking the same questions of the managed account at Madoff.
At the heart of the problem is NOT a failure of due diligence, since the weaknesses of the structure were fully disclosed in fund due diligence materials and offering memoranda. There was no effort to misrepresent the structure or to cover it up. Investors therefore invested with full information or at least access to sufficient information to make an informed judgment. Why would reputable sponsors attach their reputations and fortunes to a deficient structure, and why did end investors knowing invest?
Monday, 15 December 2008
Some investment strategies for 2009
Closed end funds:
Fund structure mitigates investor risk
Suitable for arbitrage strategies
Suitable for relative value strategies
Suitable for distressed and private equity strategies
Lends itself to efficient and risk controlled deployment of leverage
Technically complex strategies which rely on multiple trade legs
Distressed investing:
Current cycle is attractive for distressed investing
Distressed assets and distressed pricing in developed markets
Distressed pricing and performing assets in emerging markets
Recovery strategies:
Distressed strategies are a subset
Deep value equity
Deep value credit
Direct lending:
Dearth of credit, easy or otherwise
Banks are retrenching from the market
Spreads and margins are priced for distress despite strong and performing obligors
Bespoke deal structures to mitigate specific risks
Trade finance
Stale strategies:
Short or market neutral credit
Short or market neutral equity
Long volatility - vega
Systematic global macro
Fresh strategies:
Long equity
Long credit (including CBs and private CBs)
Capital structure arbitrage
Distressed investing: control over asset
Factoring, receivables finance, trade finance
Fixed income arbitrage
Risk arbitrage – cross border strategic
Fund structure mitigates investor risk
Suitable for arbitrage strategies
Suitable for relative value strategies
Suitable for distressed and private equity strategies
Lends itself to efficient and risk controlled deployment of leverage
Technically complex strategies which rely on multiple trade legs
Distressed investing:
Current cycle is attractive for distressed investing
Distressed assets and distressed pricing in developed markets
Distressed pricing and performing assets in emerging markets
Recovery strategies:
Distressed strategies are a subset
Deep value equity
Deep value credit
Direct lending:
Dearth of credit, easy or otherwise
Banks are retrenching from the market
Spreads and margins are priced for distress despite strong and performing obligors
Bespoke deal structures to mitigate specific risks
Trade finance
Stale strategies:
Short or market neutral credit
Short or market neutral equity
Long volatility - vega
Systematic global macro
Fresh strategies:
Long equity
Long credit (including CBs and private CBs)
Capital structure arbitrage
Distressed investing: control over asset
Factoring, receivables finance, trade finance
Fixed income arbitrage
Risk arbitrage – cross border strategic
Wednesday, 3 December 2008
Convertible Bonds
An opportunity exists today for a long only buy and hold strategy. The strategy is vulnerable to further mark to market losses but a strategy of investing in CBs from a credit point of view, as opposed to an equity arbitrage point of view yields interesting opportunities. Things could get cheaper next year, and indeed the way economic fundamentals are deteriorating this seems likely, but current pricing is already very attractive for the investor who can buy and hold.
Note that the classic convertible arbitrage construction doesn’t really work and one has to take on both the open equity and credit risk. Neither can one lever the portfolio, not that one needs to. Stock borrow, restrictions on shorting, terms of borrow make delta hedging a potentially futile exercise. Some converts are trading distressed to the extent that while a non zero delta has re emerged, convexity is no longer positive. Credit hedging the CB runs into all sorts of prime broker counterparty risk, and the correlation between CBs and straight bonds let alone CDS is broken at the moment. This makes life simpler, actually, since if one has the resources in credit analysis, there is no need to hire a hedge fund manager.
Note that the classic convertible arbitrage construction doesn’t really work and one has to take on both the open equity and credit risk. Neither can one lever the portfolio, not that one needs to. Stock borrow, restrictions on shorting, terms of borrow make delta hedging a potentially futile exercise. Some converts are trading distressed to the extent that while a non zero delta has re emerged, convexity is no longer positive. Credit hedging the CB runs into all sorts of prime broker counterparty risk, and the correlation between CBs and straight bonds let alone CDS is broken at the moment. This makes life simpler, actually, since if one has the resources in credit analysis, there is no need to hire a hedge fund manager.
Tuesday, 2 December 2008
A Currency Call
Commodity prices are overly depressed. See post 27 Nov 2008, A Quick Macro Overview.
Buy AUD, sell USD.
Sunday, 30 November 2008
Central Planning
Why is it a bad thing for a central planner to allocate resources in an economy? The Soviet experience is one example. Underlying it is the lack of alignment of interest between principal and agent. If one does not reap the benefits of one's investment decisions, those decisions are bound to be less than optimal. A central planner will never offer a better solution than rational independent agents making private decisions.
In my previous posts, I have argued that the setting of interest rates by central banks is already a dangerous compromise to the principle of a free market. So, given that we have made that compromise, and the moral hazard that resulted has taken us in no small part to where we are today, a financial crisis feeding and fed by economic recession, lets ask a couple of silly questions.
Why is it a bad thing for a central planner to lend directly to private consumers and private enterprise? From our initial premise, it is equivalent to allocation of resources, in this case financial capital. It presupposes that the central planner has sufficient information and motivation to act in the best interest of the collective (always a dangerous concept), and isn't too clumsy as to make too many mistakes.
Today, however, credit spreads have widened to acutely high levels, despite central banks liquefying the banking system. Banks which previously lent in greed, now withhold credit in fear. We know that a central planner is sub optimal compared with rational agents and their private decisions, but what about timees when agents are irrational? (again calls for a very tenuous definition of rational and irrational.)
When government chose to bail out the financial system in the Fall of 2008, it had already abandoned the idea of free market solutions. It must have concluded that a climate of irrationality, or, where individual rationality conflicted with collective rationality, existed. Its efforts included a massive liquefication of the banking industry, an effort that has so far proved futile as banks have saved the liquidity and placed the capital back with the central banks. The intention to get the banking industry to lend once again has been foiled.
If the premise remains that a climate of irrationality, or ,where individual rationality conflicted with collective rationality, exists, central planners should be happy to extend their abandonment of market solutions.
Lend directly to private individuals and enterprise.
That is the conceptual argument. The devil is in the details. More on this later.
Thursday, 27 November 2008
A quick macro overview
Economic data is pointing towards a global recession deepening in 2009. The scale of the slowdown in economic activity, the damage done to the banking system, the losses accumulated in residential real estate and the impairment of household balance sheets call for extraordinary policy measures. A more or less global though not entirely concerted policy for dealing with the ailing banking system is already underway. It is not working as well as expected or intended. Similarly, monetary policy has become more accommodative globally in an effort to revive rapidly slowing economies. Monetary policy on its own is insufficient as it addresses the ability and not the intention to spend or invest. In a slowing economy, it is individually rational to increase saving at the expense of consumption, and to cut back on investment in capacity, even though it is collectively irrational to do so. Enter government. Governments will have to spend and invest on behalf of households and companies to stabilize economic growth. This approach addresses demand directly but is not without its risks. Developed markets now operating below full potential output, are less at risk of direct crowding out. Inflationary risks are another matter and may raise funding rates to cause de facto crowding out.
There are several ways to fund fiscal reflationary efforts. Taxation is one. Developed world taxation is already high and the scope for increases is limited. It is risky to argue that increased economic activity may result in increased tax receipts. More immediately, cutting taxes may be a necessary element in fiscal deficit spending. Raising taxes on the rich has limited use as the rich are a marginal taxpayer given globalization and the prevalence of tax arbitrage. Another way of financing fiscal deficit spending is of course borrowing through the issuance of public debt. This can create the so called crowding out of private investment. A third way, is seignorage, which is of course inflationary and historically untenable. This may not be the case today and a range of options may be a more appropriate approach. There is another way, which is enterprise and investment, a technique established in the form of sovereign wealth funds. It is unlikely that deficits will be funded by taxation in the middle of a recession. If so, it might take the form of highly targeted taxation, or cosmetic taxation, such as an increase in marginal taxes on the rich. If anything, marginal tax rates on consumption and lower income earners is likely to be reduced on the rationale that the marginal propensity to consume out of income decreases with increasing income and wealth. This would have a negative impact on tax receipts. Financing deficit spending through the printing of money is directly inflationary but has the advantage of immediately supporting asset prices as well. The cost is in a weaker currency both internally and externally. The inflation cost can be high and depending on the prevailing inflationary conditions might not be viable. The most natural route is financing deficit spending through borrowing, preferably from future generations. This is the most likely approach most nations will take. The impact in the US for example is higher interest rates. Once again, the crowding out effect is unlikely to bite as the US economy is clearly below potential.
A word about inflation ex policy. We have seen the path of the oil price rising from 20 USD per barrel in 2001 to 147 USD per barrel in the summer of 2008 before falling below 50 USD again. Similar patterns are seen in coal, metals, ags, softs, energy. Markets overshoot on both the upside and downside. The equilibrium price ex speculators, that it paid for by people who would like to burn the oil is probably in the 70 – 80 USD range. At these prices, inflation does not decline as much as policy makers would hope. Alternative sources of energy are not commercial once development costs are included. US CPI inflation would probably settle at around 4% while PPI inflation might be slightly higher from 4 – 6%. These levels are not overly concerning but they are not low by any means. (As an aside, if inflation does increase, the need for pensions and endowments to meet their obligations will likely bring them back into the market for risky assets). All this assumes of course that in the course of fiscal reflation, banking bailouts and other extraordinary measures, governments do not debase their currencies.
If currencies are debased, such as in banking bailouts or where fiscal deficits are funded by printing money, for example, inflation pressures will be exacerbated. The likely candidates where this scenario is likely can be found by an examination of public finances. This is a different analysis from looking at sovereign balance sheets. Developed countries with budget deficits will likely be in this group. They will likely face weakening currencies and inflationary pressures. This could lead to a vicious cycle of rising commodity prices and rising inflation. Currently this is a contrarian view. A little inflation, however, is a good thing. Deflationary recessions maintain and inflate the real value of debt.
Monetary policy across the globe is currently extremely loose, and, given the expected depth of the slowdown, interest rates are likely to be driven further down to zero. This is likely to result in steep yield curves as public debt issuance is increased and inflation expectations are revived. Generally, the market expects little to no inflation and there are even expectations for deflation risk. It is likely that there will be volatility at the long end of the curve. The likely evolution is an early 1980’s yield curve as the expectations oscillate between inflation and recession.
Apart from developed countries where economic dogma eschews the direct allocation of credit by a central planner, developing countries do have the option to lend directly where their banking system may be paralysed. In particular, in Communist countries operating market economies, the banking system can be directed to lend. Without the burden of economic dogma, certain countries have full freedom to deploy a host of economic tools to revive their economies. They can spend on behalf of consumers, they can put cash in the hands of consumers, they can invest in place of companies, they can print money to finance fiscal deficits, they can borrow to create a normalized yield curve and provide the banking system with a carry trade, they can tax selectively and tactically to synthesize inflation, if it was called for, they can invest in infrastructure, in improving the capital stock, in improving the knowledge base, in human capital. These measures may terrify the free marketer, but ever since the slew of blanket bail outs and ad hoc rescues in the West, criticism is unlikely to arise from those quarters.
A global recession seems unavoidable given the scale of leverage and excess as the global economy drifted into 2007. However, there exist the tools to soften the blow. Most of these tools run counter to the prescriptions of free market economics. The challenge will be the restoration of order and a proper market mechanism once conditions normalize. One of the failings of the system that was at least in part, and possibly in large part responsible for the excesses of the past few years has been the moral hazard created by the US Fed in particular in underwriting the economy and asset markets. More generally, one can extend the critique to the existence of an institution that unilaterally determines the price of money, the central bank, undermining the concept of an efficient money market. Unfortunately, the rescues that are mounted today move us further from a free market and therefore entrench the regulators where in fact the regulators should have their powers diminished. This is likely to create new and greater imbalances and thus sustained uncertainty and volatility in the future. In certain cultures, however, there is the concept that uncertainty is the mother of opportunity.
There are several ways to fund fiscal reflationary efforts. Taxation is one. Developed world taxation is already high and the scope for increases is limited. It is risky to argue that increased economic activity may result in increased tax receipts. More immediately, cutting taxes may be a necessary element in fiscal deficit spending. Raising taxes on the rich has limited use as the rich are a marginal taxpayer given globalization and the prevalence of tax arbitrage. Another way of financing fiscal deficit spending is of course borrowing through the issuance of public debt. This can create the so called crowding out of private investment. A third way, is seignorage, which is of course inflationary and historically untenable. This may not be the case today and a range of options may be a more appropriate approach. There is another way, which is enterprise and investment, a technique established in the form of sovereign wealth funds. It is unlikely that deficits will be funded by taxation in the middle of a recession. If so, it might take the form of highly targeted taxation, or cosmetic taxation, such as an increase in marginal taxes on the rich. If anything, marginal tax rates on consumption and lower income earners is likely to be reduced on the rationale that the marginal propensity to consume out of income decreases with increasing income and wealth. This would have a negative impact on tax receipts. Financing deficit spending through the printing of money is directly inflationary but has the advantage of immediately supporting asset prices as well. The cost is in a weaker currency both internally and externally. The inflation cost can be high and depending on the prevailing inflationary conditions might not be viable. The most natural route is financing deficit spending through borrowing, preferably from future generations. This is the most likely approach most nations will take. The impact in the US for example is higher interest rates. Once again, the crowding out effect is unlikely to bite as the US economy is clearly below potential.
A word about inflation ex policy. We have seen the path of the oil price rising from 20 USD per barrel in 2001 to 147 USD per barrel in the summer of 2008 before falling below 50 USD again. Similar patterns are seen in coal, metals, ags, softs, energy. Markets overshoot on both the upside and downside. The equilibrium price ex speculators, that it paid for by people who would like to burn the oil is probably in the 70 – 80 USD range. At these prices, inflation does not decline as much as policy makers would hope. Alternative sources of energy are not commercial once development costs are included. US CPI inflation would probably settle at around 4% while PPI inflation might be slightly higher from 4 – 6%. These levels are not overly concerning but they are not low by any means. (As an aside, if inflation does increase, the need for pensions and endowments to meet their obligations will likely bring them back into the market for risky assets). All this assumes of course that in the course of fiscal reflation, banking bailouts and other extraordinary measures, governments do not debase their currencies.
If currencies are debased, such as in banking bailouts or where fiscal deficits are funded by printing money, for example, inflation pressures will be exacerbated. The likely candidates where this scenario is likely can be found by an examination of public finances. This is a different analysis from looking at sovereign balance sheets. Developed countries with budget deficits will likely be in this group. They will likely face weakening currencies and inflationary pressures. This could lead to a vicious cycle of rising commodity prices and rising inflation. Currently this is a contrarian view. A little inflation, however, is a good thing. Deflationary recessions maintain and inflate the real value of debt.
Monetary policy across the globe is currently extremely loose, and, given the expected depth of the slowdown, interest rates are likely to be driven further down to zero. This is likely to result in steep yield curves as public debt issuance is increased and inflation expectations are revived. Generally, the market expects little to no inflation and there are even expectations for deflation risk. It is likely that there will be volatility at the long end of the curve. The likely evolution is an early 1980’s yield curve as the expectations oscillate between inflation and recession.
Apart from developed countries where economic dogma eschews the direct allocation of credit by a central planner, developing countries do have the option to lend directly where their banking system may be paralysed. In particular, in Communist countries operating market economies, the banking system can be directed to lend. Without the burden of economic dogma, certain countries have full freedom to deploy a host of economic tools to revive their economies. They can spend on behalf of consumers, they can put cash in the hands of consumers, they can invest in place of companies, they can print money to finance fiscal deficits, they can borrow to create a normalized yield curve and provide the banking system with a carry trade, they can tax selectively and tactically to synthesize inflation, if it was called for, they can invest in infrastructure, in improving the capital stock, in improving the knowledge base, in human capital. These measures may terrify the free marketer, but ever since the slew of blanket bail outs and ad hoc rescues in the West, criticism is unlikely to arise from those quarters.
A global recession seems unavoidable given the scale of leverage and excess as the global economy drifted into 2007. However, there exist the tools to soften the blow. Most of these tools run counter to the prescriptions of free market economics. The challenge will be the restoration of order and a proper market mechanism once conditions normalize. One of the failings of the system that was at least in part, and possibly in large part responsible for the excesses of the past few years has been the moral hazard created by the US Fed in particular in underwriting the economy and asset markets. More generally, one can extend the critique to the existence of an institution that unilaterally determines the price of money, the central bank, undermining the concept of an efficient money market. Unfortunately, the rescues that are mounted today move us further from a free market and therefore entrench the regulators where in fact the regulators should have their powers diminished. This is likely to create new and greater imbalances and thus sustained uncertainty and volatility in the future. In certain cultures, however, there is the concept that uncertainty is the mother of opportunity.
Wednesday, 26 November 2008
Trading and Investing
You cannot do it solely for the money. If you do, one day it will hurt you so badly you can't go on.
You have to deal the cards as a meditation. It can't be done for profit, it can't be done for respect. It's done to find the answers, to discover the sacred laws of chance.
You have to deal the cards as a meditation. It can't be done for profit, it can't be done for respect. It's done to find the answers, to discover the sacred laws of chance.
Tuesday, 14 October 2008
Relief Rally
In 1997, when the Asian Crisis broke, equities tumbled in a flurry of panic selling. Markets were down between 60 - 70% in the first downdraft. When Asian governments rushed to bailout their banks and corporates the market found its footing and rallied between 50 - 100% as disbelief was converted to relief.
All the financial engineering and arm twisting could not address the broader more deep rooted causes of the crisis and with time markets began to price in fundamentals. Asian market made new lows, between 20 - 50% lower than the 1997 lows.
2008 is a bit different. The scale is different. The world economy is in a synchronized slow down. But the psychology that drives markets is pretty much the same. Complacency, fiddling while Wall Street burns, somewhere there is a whiff of smoke, it turns to panic, the panic spreads, soon the fire is the least of concerns as a stampede for the exit begins, the fire is put out, order returns, people cheer, and then somebody looks at the ruins. Eventually, however, the rebuilding begins.
As an aside, in 1997, as Asian governments nationalized parts of their economies, forced consolidation upon the banks, spent the public coffers on bailout plans, the IMF, the developed world and every academic worth his publications condemned these non market solutions that would doom the region to failure after failure.
All the financial engineering and arm twisting could not address the broader more deep rooted causes of the crisis and with time markets began to price in fundamentals. Asian market made new lows, between 20 - 50% lower than the 1997 lows.
2008 is a bit different. The scale is different. The world economy is in a synchronized slow down. But the psychology that drives markets is pretty much the same. Complacency, fiddling while Wall Street burns, somewhere there is a whiff of smoke, it turns to panic, the panic spreads, soon the fire is the least of concerns as a stampede for the exit begins, the fire is put out, order returns, people cheer, and then somebody looks at the ruins. Eventually, however, the rebuilding begins.
As an aside, in 1997, as Asian governments nationalized parts of their economies, forced consolidation upon the banks, spent the public coffers on bailout plans, the IMF, the developed world and every academic worth his publications condemned these non market solutions that would doom the region to failure after failure.
Friday, 3 October 2008
Hedge Fund Redemptions Dec 2008
Hedge funds will face massive redemption requests for 31 December 2008 as investors seek to reduce risk across the board. This is an unprecedented position for the industry. Hedge funds often face liquidity mismatches in that there are positions with longer duration than the redemption intervals offered by these funds to their investors. They can therefore only meet a portion of redemptions should everry investor redeem fully from the fund. In case redemptions exceed a certain proportion of total assets under management, hedge funds have mechanisms which limit redemptions (called Gates), or have the right to suspend redemptions. Another failsafe is the right to meet redemptions in kind, that is delivering securities held in the portfolio, to redeeming investors.
Fund of hedge funds are in a similar if not worse liquidity mismatched position as hedge funds.
As investors redeem from funds of funds, they in turn are forced to redeem out of the hedge funds they invest in.
Hedge funds provide liquidity on a monthly, quarterly or annual basis. Some have lock ups ranging from 1 year to 5, but few have more than 3. 10 years ago, most hedge funds provided monthly liquidity. Today, most funds have at best quarterly liquidity and the number with lock ups has also increased.
The industry is today caught in a Prisoner's Dilemma. Performance of the hedge fund notwithstanding, the expectation of redemptions incentivizes investors to redeem. Stable holders aim to redeem ahead of weak holders so that individually rational decisions lead to collectively irrational outcomes. Extrapolation leads to the conclusion of mass redemptions leading to closure.
For the hedge fund manager who has performed poorly, there is no escape, and closure is inevitable. Their security strategy, is to do nothing, face the flood of redemptions requests and either gate the fund or suspend redemptions.
For the hedge fund manager who continues to perform well, there are various options. Their best strategy is to communicate with their investors and to manage the investor base.
For too long, hedge fund managers have neglected the management of their investor base. For a company structured with variable capital, this is a necessary and crucial part of risk management since capital can be withdrawn. Leverage is a function of capital and can increase precipitously if capital is withdrawn.
For the hedge fund manager, a prudent strategy would be to communicate with their investors so that the majority of their capital can be secured. This should be done before assets begin any substantial decline, before any substantial redemptions are submitted. The investors, in effect shareholders, should be presented with a strategic plan for either supporting the fund as a going concern, or an orderly liquidation. In any case, a suspension of redemptions would be a likely feature of the plan, as well as time line for which to either lift the suspension or liquidate the fund. A number of hedge funds have done this, albeit when their assets have declined severely, and redemption orders have flooded in. A pre-emptive coordination with investors preserves the reputation and franchise of the hedge fund manager.
Fund of hedge funds are in a similar if not worse liquidity mismatched position as hedge funds.
As investors redeem from funds of funds, they in turn are forced to redeem out of the hedge funds they invest in.
Hedge funds provide liquidity on a monthly, quarterly or annual basis. Some have lock ups ranging from 1 year to 5, but few have more than 3. 10 years ago, most hedge funds provided monthly liquidity. Today, most funds have at best quarterly liquidity and the number with lock ups has also increased.
The industry is today caught in a Prisoner's Dilemma. Performance of the hedge fund notwithstanding, the expectation of redemptions incentivizes investors to redeem. Stable holders aim to redeem ahead of weak holders so that individually rational decisions lead to collectively irrational outcomes. Extrapolation leads to the conclusion of mass redemptions leading to closure.
For the hedge fund manager who has performed poorly, there is no escape, and closure is inevitable. Their security strategy, is to do nothing, face the flood of redemptions requests and either gate the fund or suspend redemptions.
For the hedge fund manager who continues to perform well, there are various options. Their best strategy is to communicate with their investors and to manage the investor base.
For too long, hedge fund managers have neglected the management of their investor base. For a company structured with variable capital, this is a necessary and crucial part of risk management since capital can be withdrawn. Leverage is a function of capital and can increase precipitously if capital is withdrawn.
For the hedge fund manager, a prudent strategy would be to communicate with their investors so that the majority of their capital can be secured. This should be done before assets begin any substantial decline, before any substantial redemptions are submitted. The investors, in effect shareholders, should be presented with a strategic plan for either supporting the fund as a going concern, or an orderly liquidation. In any case, a suspension of redemptions would be a likely feature of the plan, as well as time line for which to either lift the suspension or liquidate the fund. A number of hedge funds have done this, albeit when their assets have declined severely, and redemption orders have flooded in. A pre-emptive coordination with investors preserves the reputation and franchise of the hedge fund manager.
September 2008 and Beyond
Short Term:
· The consensus expectation is for recession and a hard landing particularly in US and Europe with a protracted trough before recovery. There is some disagreement over the outlook for emerging markets but sentiment is beginning to deteriorate. The short term, however, is a poor guide for the medium to long term.
· All markets are trading on liquidity and not on fundamentals. Opportunities abound for the unlevered investor.
· Market attention was focused on the proposed Troubled Asset Relief Program, a 700 billion USD bailout of the US banking system. The substance and material impact of the Program is limited and the majority of its utility was in shoring up confidence in the financial system. Debating the Program and delaying it has blunted its signaling value.
· The hedge fund industry is facing large scale redemptions starting first from investors exiting funds of funds, and funds of funds redeeming from their hedge funds to meet their redemption needs. Most funds have calendar quarter redemption dates and the September redemptions have been known for some time. Aggregating the outflows from the annual redemption funds with those that are quarterly and monthly, implies that December will be a highly risky month for hedge funds and the markets in which they invest, as gross exposures are reduced in large scale. It is expected that a significant number of hedge funds may not survive.
· A large number of hedge funds will be suspending redemptions. A Prisoner’s Dilemma situation now exists where strong holders need to redeem ahead of weak holders. Hedge funds will not have the liquidity to meet the expected volume of redemptions.
Medium Term:
· Falling stock prices and house prices will have knock on effects on consumer confidence and thus consumption plans.
· Increased credit spreads have raised the cost of debt and will impact corporate profitability going forward. Availability of credit from cash strapped banks will also be reduced. Demand for credit will be impacted by expectations of consumer confidence and exports which will be dampened by slowing economic growth elsewhere.
· Economic data from around the world are indicative of a severe economic slowdown. Inflation is unlikely to be a problem at least in the developed world.
· The influence of liquidity will remain for a time. However, as the velocity of capital outflow slows, asset prices will come to be driven more by fundamentals than by momentum.
· Regulatory changes almost always follow large dislocations in financial markets and recessions. One can expect the financial sector to be regulated as a public good. There is much uncertainty here as regulators do not have the best access to information, can make errors in policy, are often driven by politics before economic efficiency, and plan over different time horizons.
· The CDS markets, and more generally the OTC markets, are likely to be regulated and moved on exchange.
· Investors will take some time to regain their risk appetite. As they do, they are likely to realize the risks in liquidity mismatches inherent in various investment vehicles from hedge funds, to structured products, to banks. Many hedge fund strategies which are sound and logical, fail because of liquidity mismatches. The closed ended fixed term fund, the investor vehicle of choice in private equity, is well suited to many hedge fund strategies. One could argue that with greater certainty of outcome than private equity, and with greater certainty of maturity in arbitrage, such investor vehicles are even more appropriate for hedge fund strategies. Examples of such structures arose in 2005 in the structured credit markets, triggered by the credit ratings downgrades in the US auto sector.
· Investors are likely to be wary of highly leveraged investments and will scrutinize more closely the magnitude and structure of levered investments. Many credit hedge fund strategies are levered implicit providers of capital to the economy. Leveraged provision of credit is a strategy that has most visibly failed not only in hedge funds, but banks as well. Here lies a two fold opportunity. For the Asset Based Lender, a beleaguered banking industry provides them the opportunity to take market share and to grow in scale. For businesses, Asset Based Lenders are an efficient source of credit, providing more responsive client service, bespoke financing solutions and thus more flexible pricing. For the investor, Asset Based Lending Funds provide the opportunity to participate in the new banks, lending institutions without the excessive leverage, complex and opaque proprietary trading books, sprawling organizations and overall operational and financial complexity.
· The face of hedge fund investing will change. Before Aug 2007, hedge fund analysis focused on the skill, talent and integrity of the manager, the operational infrastructure and mostly investment issues. While the astute investor scrutinized the investor base, the importance of this consideration in the greater scheme of things was not as high as it will be going forward. Henceforth, the stability of the equity base and of funding will be a major consideration. For established funds with a long list of legacy investors, this analysis is complicated, more so than for a small or medium sized fund with an anchor seeder that has stable capital and can offer marketing support to strategically build the asset base. Risk management will include policies, limits and guidelines for funding as well as for the investor base. Transparency to the structure, if not the identities, of the investor base will be important.
· The consensus expectation is for recession and a hard landing particularly in US and Europe with a protracted trough before recovery. There is some disagreement over the outlook for emerging markets but sentiment is beginning to deteriorate. The short term, however, is a poor guide for the medium to long term.
· All markets are trading on liquidity and not on fundamentals. Opportunities abound for the unlevered investor.
· Market attention was focused on the proposed Troubled Asset Relief Program, a 700 billion USD bailout of the US banking system. The substance and material impact of the Program is limited and the majority of its utility was in shoring up confidence in the financial system. Debating the Program and delaying it has blunted its signaling value.
· The hedge fund industry is facing large scale redemptions starting first from investors exiting funds of funds, and funds of funds redeeming from their hedge funds to meet their redemption needs. Most funds have calendar quarter redemption dates and the September redemptions have been known for some time. Aggregating the outflows from the annual redemption funds with those that are quarterly and monthly, implies that December will be a highly risky month for hedge funds and the markets in which they invest, as gross exposures are reduced in large scale. It is expected that a significant number of hedge funds may not survive.
· A large number of hedge funds will be suspending redemptions. A Prisoner’s Dilemma situation now exists where strong holders need to redeem ahead of weak holders. Hedge funds will not have the liquidity to meet the expected volume of redemptions.
Medium Term:
· Falling stock prices and house prices will have knock on effects on consumer confidence and thus consumption plans.
· Increased credit spreads have raised the cost of debt and will impact corporate profitability going forward. Availability of credit from cash strapped banks will also be reduced. Demand for credit will be impacted by expectations of consumer confidence and exports which will be dampened by slowing economic growth elsewhere.
· Economic data from around the world are indicative of a severe economic slowdown. Inflation is unlikely to be a problem at least in the developed world.
· The influence of liquidity will remain for a time. However, as the velocity of capital outflow slows, asset prices will come to be driven more by fundamentals than by momentum.
· Regulatory changes almost always follow large dislocations in financial markets and recessions. One can expect the financial sector to be regulated as a public good. There is much uncertainty here as regulators do not have the best access to information, can make errors in policy, are often driven by politics before economic efficiency, and plan over different time horizons.
· The CDS markets, and more generally the OTC markets, are likely to be regulated and moved on exchange.
· Investors will take some time to regain their risk appetite. As they do, they are likely to realize the risks in liquidity mismatches inherent in various investment vehicles from hedge funds, to structured products, to banks. Many hedge fund strategies which are sound and logical, fail because of liquidity mismatches. The closed ended fixed term fund, the investor vehicle of choice in private equity, is well suited to many hedge fund strategies. One could argue that with greater certainty of outcome than private equity, and with greater certainty of maturity in arbitrage, such investor vehicles are even more appropriate for hedge fund strategies. Examples of such structures arose in 2005 in the structured credit markets, triggered by the credit ratings downgrades in the US auto sector.
· Investors are likely to be wary of highly leveraged investments and will scrutinize more closely the magnitude and structure of levered investments. Many credit hedge fund strategies are levered implicit providers of capital to the economy. Leveraged provision of credit is a strategy that has most visibly failed not only in hedge funds, but banks as well. Here lies a two fold opportunity. For the Asset Based Lender, a beleaguered banking industry provides them the opportunity to take market share and to grow in scale. For businesses, Asset Based Lenders are an efficient source of credit, providing more responsive client service, bespoke financing solutions and thus more flexible pricing. For the investor, Asset Based Lending Funds provide the opportunity to participate in the new banks, lending institutions without the excessive leverage, complex and opaque proprietary trading books, sprawling organizations and overall operational and financial complexity.
· The face of hedge fund investing will change. Before Aug 2007, hedge fund analysis focused on the skill, talent and integrity of the manager, the operational infrastructure and mostly investment issues. While the astute investor scrutinized the investor base, the importance of this consideration in the greater scheme of things was not as high as it will be going forward. Henceforth, the stability of the equity base and of funding will be a major consideration. For established funds with a long list of legacy investors, this analysis is complicated, more so than for a small or medium sized fund with an anchor seeder that has stable capital and can offer marketing support to strategically build the asset base. Risk management will include policies, limits and guidelines for funding as well as for the investor base. Transparency to the structure, if not the identities, of the investor base will be important.
September Round Up
The credit crisis that first broke in August 2007 deteriorated very quickly in September 2008. The month was dominated by bank failures and bailouts, a dysfunctional LIBOR market, free falling equity markets, failing credit markets and a general crisis of liquidity. Equities, bonds and commodities all sold off simultaneously as investors sought to reduce risk in any way shape or form. Below is a quick time line of the key events in September as the US financial system lurched precariously to the edge, where at the time of this writing, it remains.
- September 7: Federal takeover of Fannie Mae and Freddie Mac.
- September 14: Bank of America takeover of Merrill Lynch over fears of a liquidity crisis.
- September 15: Lehman Brothers files for Chapter 11 bankruptcy protection.
- September 17: Federal Reserve rescue finance of 85 billion USD extended to support AIG.
- September 19: Treasury Secretary Paulson announced the proposed "Troubled Asset Relief Program."
- September 19: The US SEC leads a number of regulators around the world in establishing a ban on short selling.
- September 25: Washington Mutual is placed under receivership of the FDIC and its assets sold to JP Morgan.
- September 28: Fortis NV partially nationalized.
- September 29: Congress votes down the "Troubled Asset Relief Program."
· Money market stress increased to unprecedented levels with the TED spread widening from 1.09% at the end of August to 3.42% at the end of September. 3 month US T bills traded briefly with negative yield.
· Currency markets gyrated significantly, with the EUR starting September at 1.463, weakening to 1.399, rebounding to 1.4866 and closing the month at 1.409. Similar trading patterns were seen in GBP and CHF. JPY traded from 109 to 104 then to 106.
· Equity markets were broadly weaker, the US markets losing between -6 to -10% depending on your benchmark. Small caps were more resilient as the sell off was driven by capital flows. European markets saw greater damage with European indices losing between -6 to -20%. Asia experienced even heavier losses, with Japan losing -14%, HK -19%, and various markets losing of the order of mid teens. Similar losses were recorded in Lat Am.
· In fixed income, the Lehman Aggregate lost -2% in the month. Credit spreads widened sharply in the final weeks of September, US AAA’s widening 1.6% on average, AA’s 1.9%, A’s 2.4%, Baa’s 3.2% and High Yield an alarming 9.5%.
· Commodities also fell as pricing started to reflect recession expectations. Crude futures fell -16%, driving the whole energy complex down by similar amounts. Base metals, softs and ags were all sharply weaker. Only gold was higher at +4.8% over August purely reflecting the degree of risk aversion in the markets.
- September 7: Federal takeover of Fannie Mae and Freddie Mac.
- September 14: Bank of America takeover of Merrill Lynch over fears of a liquidity crisis.
- September 15: Lehman Brothers files for Chapter 11 bankruptcy protection.
- September 17: Federal Reserve rescue finance of 85 billion USD extended to support AIG.
- September 19: Treasury Secretary Paulson announced the proposed "Troubled Asset Relief Program."
- September 19: The US SEC leads a number of regulators around the world in establishing a ban on short selling.
- September 25: Washington Mutual is placed under receivership of the FDIC and its assets sold to JP Morgan.
- September 28: Fortis NV partially nationalized.
- September 29: Congress votes down the "Troubled Asset Relief Program."
· Money market stress increased to unprecedented levels with the TED spread widening from 1.09% at the end of August to 3.42% at the end of September. 3 month US T bills traded briefly with negative yield.
· Currency markets gyrated significantly, with the EUR starting September at 1.463, weakening to 1.399, rebounding to 1.4866 and closing the month at 1.409. Similar trading patterns were seen in GBP and CHF. JPY traded from 109 to 104 then to 106.
· Equity markets were broadly weaker, the US markets losing between -6 to -10% depending on your benchmark. Small caps were more resilient as the sell off was driven by capital flows. European markets saw greater damage with European indices losing between -6 to -20%. Asia experienced even heavier losses, with Japan losing -14%, HK -19%, and various markets losing of the order of mid teens. Similar losses were recorded in Lat Am.
· In fixed income, the Lehman Aggregate lost -2% in the month. Credit spreads widened sharply in the final weeks of September, US AAA’s widening 1.6% on average, AA’s 1.9%, A’s 2.4%, Baa’s 3.2% and High Yield an alarming 9.5%.
· Commodities also fell as pricing started to reflect recession expectations. Crude futures fell -16%, driving the whole energy complex down by similar amounts. Base metals, softs and ags were all sharply weaker. Only gold was higher at +4.8% over August purely reflecting the degree of risk aversion in the markets.
Monday, 29 September 2008
Paulson’s address at the Shanghai Futures Exchange March 2007:
The continued large role of non-market factors that influence both state-owned enterprises and private enterprises - including financial services companies - stifles the dynamism of economic decision-making and the strength of regulatory integrity. Increasing the pace of privatization of state-owned enterprises would be beneficial.
the reality of the situation is that an open, competitive, and liberalized financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention.
Thursday, 25 September 2008
Short Selling and Market Efficiency
A few interesting findings about short selling:
1. There is evidence in short selling activity consistent with information leakage and front-running. (Do Short Sellers Front-Run Insider Sales? Khan and Lu, June 2008.)
2. Short selling restrictions tend to be effective against negative skewness at market level but not at individual stock levels. (Efficiency and the Bear: Short Sales anad Markets around the World, September 2004, Bris, Goetzmann and Zhu.)
3. Where short sales are possible, aggregate stock returns are less volatile and there is greater liquidity. When countries start to permit short-selling, aggregate stock price increases, implying a cost of capital. There is no evidence that short-sale restrictions affect either the level of skewness of returns or the probability of a market crash. (A Study of Market-Wide Short-Selling Restrictions Jan 2005, Caroenrook and Daouk.)
4. While short-sellers take larger positions in stocks with recent price declines than in stocks with recent price increases, when the analysis is conditional on accounting-based measures of fundamental value, the positions of short-sellers in stocks with price declines are concentrated in stocks that are overvalued relative to fundamentals. (Does short-selling amplify price declines or align stocks with their fundamental values? May 2008, Curtis and Fargher.)
5. Stocks with limited lending supply and high borrowing fees respond more slowly to market shocks. Second, short-sale constraints have a small impact on the distribution of weekly stock returns. Limited lending supply is associated with higher skewness, but not with fewer extreme negative returns. Third, stocks with limited lending supply and higher borrowing fees are associated with lower R2s on average. (Price Efficiency and Short Selling, January 2008. Saffi and Sigurdsson.)
Point 1 above is interesting. It implies that someone somewhere has asymmetric (superior) information and at least some of these are short sellers.
Points 3, 4, 5 all point to greater market efficiency where short selling is permitted.
Point 2 implies that short selling has some negative impact on market returns but not on efficient pricing at the stock level. Measures that slow the momentum of short selling may correct some of the negative skewness without taking away too much from the market efficiency. An uptick rule would likely widen bid offer spreads as well as encourage smaller but more frequent trades.
1. There is evidence in short selling activity consistent with information leakage and front-running. (Do Short Sellers Front-Run Insider Sales? Khan and Lu, June 2008.)
2. Short selling restrictions tend to be effective against negative skewness at market level but not at individual stock levels. (Efficiency and the Bear: Short Sales anad Markets around the World, September 2004, Bris, Goetzmann and Zhu.)
3. Where short sales are possible, aggregate stock returns are less volatile and there is greater liquidity. When countries start to permit short-selling, aggregate stock price increases, implying a cost of capital. There is no evidence that short-sale restrictions affect either the level of skewness of returns or the probability of a market crash. (A Study of Market-Wide Short-Selling Restrictions Jan 2005, Caroenrook and Daouk.)
4. While short-sellers take larger positions in stocks with recent price declines than in stocks with recent price increases, when the analysis is conditional on accounting-based measures of fundamental value, the positions of short-sellers in stocks with price declines are concentrated in stocks that are overvalued relative to fundamentals. (Does short-selling amplify price declines or align stocks with their fundamental values? May 2008, Curtis and Fargher.)
5. Stocks with limited lending supply and high borrowing fees respond more slowly to market shocks. Second, short-sale constraints have a small impact on the distribution of weekly stock returns. Limited lending supply is associated with higher skewness, but not with fewer extreme negative returns. Third, stocks with limited lending supply and higher borrowing fees are associated with lower R2s on average. (Price Efficiency and Short Selling, January 2008. Saffi and Sigurdsson.)
Point 1 above is interesting. It implies that someone somewhere has asymmetric (superior) information and at least some of these are short sellers.
Points 3, 4, 5 all point to greater market efficiency where short selling is permitted.
Point 2 implies that short selling has some negative impact on market returns but not on efficient pricing at the stock level. Measures that slow the momentum of short selling may correct some of the negative skewness without taking away too much from the market efficiency. An uptick rule would likely widen bid offer spreads as well as encourage smaller but more frequent trades.
Friday, 19 September 2008
Economic Consequences of the Paulson Plan
In the US:
The consumer is quite broke. Unemployment is rising. Firms have no access to credit. And now the government is quite broke too. The cost of cleaning up the banking system will fall on the government first. A budget deficit would imply austerity and a severe limitation to government fiscal spend as well as possibly higher taxes down the road.
The Fed will have to cut rates or face deep recession. Normally this is highly inflationary but given that the BRICs are slowing down as well, inflation is likely not to be a problem.
The USD will come under pressure improving terms of trade and providing some relief to the economy in the form of export growth. This will be limited by the synchronized slow down in Europe and Asia.
The recovery will take multiple years depending on the approach taken. If the scale of the bailout is big enough and the time frame is short and decisive enough, this could take a further 2 years or so to work through.
Equity markets should begin to price this in earlier but no further than 1 year in advance. Credit markets may react more quickly.
This is the good case scenario.
The consumer is quite broke. Unemployment is rising. Firms have no access to credit. And now the government is quite broke too. The cost of cleaning up the banking system will fall on the government first. A budget deficit would imply austerity and a severe limitation to government fiscal spend as well as possibly higher taxes down the road.
The Fed will have to cut rates or face deep recession. Normally this is highly inflationary but given that the BRICs are slowing down as well, inflation is likely not to be a problem.
The USD will come under pressure improving terms of trade and providing some relief to the economy in the form of export growth. This will be limited by the synchronized slow down in Europe and Asia.
The recovery will take multiple years depending on the approach taken. If the scale of the bailout is big enough and the time frame is short and decisive enough, this could take a further 2 years or so to work through.
Equity markets should begin to price this in earlier but no further than 1 year in advance. Credit markets may react more quickly.
This is the good case scenario.
Market Manipulation, Nationalized.
The Fed and Treasury are putting their heads together to find a solution. They need to figure out first what the problem is beyond the symptoms we see. It is, however, a first step. Managing expectations at a time like this is as important as material policy.
It looks like they propose a system wide solution since their ad hoc measures are not working and the fairness of their process or lack of it has been called into question. It doesn’t mean that ad hoc solutions won’t be found for Goldman Sachs and Morgan Stanley. It certainly buys them time for a more orderly solution.
On the subject of bailouts, the US cried foul when Malaysia established currency controls, when HK spent 15 billion USD (1997 prices, in a much smaller market than it is today), to fend of the speculators, when Malaysia’s Khazanah bailed out the banks by buying their assets.
Academic purity reacts to all this by pointing out that:
Singapore did nothing during the 1997 crisis but emerged from recession ahead of Malaysia.
Bailouts sew the seeds of the next crisis.
The Greenspan put which was responsible in great part for the current crisis is now replaced by the Paulson put.
The intentions of the current plan look highly domestically focused and internationally myopic.
The intentions of the current plan look highly market focused and economically myopic.
The reality is that:
-Singapore was a sound economy and Malaysia wasn’t. Malaysia emerged stronger than Thailand which took the IMF’s prescribed hard medicine.
-Bailouts sew the seeds of the next crisis if lessons aren’t learnt. Bailouts are necessary so that there is enough residual industry to face the next crisis.
-The Paulson put has higher theta and omicron compared to the Greenspan put.
-It is likely that any bailout plan will be negative for the USD which would be positive for terms of trade
-It is likely that any bailout plan will be inflationary.
On the subject of banning shortselling, it will have the effect of:
-Impairing market efficiency by limiting the feasible set, this is mostly an academic objection.
-Forcing investors to sell long positions to scale risk instead of hedging whenever they want to reduce market exposure. This will have practical consequences.
-Making it hard for option holders and writers to hedge positions. The uncertainty that the restrictions introduce to derivative markets is significant.
-Lowering liquidity in the markets at a time when market liquidity is an important factor in the crisis.
Some conjecture:
The creation of some agency to purchase distressed assets from financial institutions has to be paid for. It will have to be paid for by the government. The government will have to raise cash. They will have to issue debt. Who will buy this debt? They could just auction new debt and see what the free market thinks of US sovereign risk. Given that the faith of the US government in the free market is not all that strong these days, its likely that they will need a backstop. Foreign investors may not be willing to take USD risk. US investors whether healthier corporates or individuals through asset management companies may not be willing to take that risk either. The financial institutions in receipt of aid may be asked to be that backstop resulting in a de facto swap of US Treasuries for risky assets. System wide, this would only defer the liabilities, not crystallize them. It would, however, reflate the financial institutions, providing them income bearing risk free assets in exchange for toxic waste, without relying on external price discovery.
It looks like they propose a system wide solution since their ad hoc measures are not working and the fairness of their process or lack of it has been called into question. It doesn’t mean that ad hoc solutions won’t be found for Goldman Sachs and Morgan Stanley. It certainly buys them time for a more orderly solution.
On the subject of bailouts, the US cried foul when Malaysia established currency controls, when HK spent 15 billion USD (1997 prices, in a much smaller market than it is today), to fend of the speculators, when Malaysia’s Khazanah bailed out the banks by buying their assets.
Academic purity reacts to all this by pointing out that:
Singapore did nothing during the 1997 crisis but emerged from recession ahead of Malaysia.
Bailouts sew the seeds of the next crisis.
The Greenspan put which was responsible in great part for the current crisis is now replaced by the Paulson put.
The intentions of the current plan look highly domestically focused and internationally myopic.
The intentions of the current plan look highly market focused and economically myopic.
The reality is that:
-Singapore was a sound economy and Malaysia wasn’t. Malaysia emerged stronger than Thailand which took the IMF’s prescribed hard medicine.
-Bailouts sew the seeds of the next crisis if lessons aren’t learnt. Bailouts are necessary so that there is enough residual industry to face the next crisis.
-The Paulson put has higher theta and omicron compared to the Greenspan put.
-It is likely that any bailout plan will be negative for the USD which would be positive for terms of trade
-It is likely that any bailout plan will be inflationary.
On the subject of banning shortselling, it will have the effect of:
-Impairing market efficiency by limiting the feasible set, this is mostly an academic objection.
-Forcing investors to sell long positions to scale risk instead of hedging whenever they want to reduce market exposure. This will have practical consequences.
-Making it hard for option holders and writers to hedge positions. The uncertainty that the restrictions introduce to derivative markets is significant.
-Lowering liquidity in the markets at a time when market liquidity is an important factor in the crisis.
Some conjecture:
The creation of some agency to purchase distressed assets from financial institutions has to be paid for. It will have to be paid for by the government. The government will have to raise cash. They will have to issue debt. Who will buy this debt? They could just auction new debt and see what the free market thinks of US sovereign risk. Given that the faith of the US government in the free market is not all that strong these days, its likely that they will need a backstop. Foreign investors may not be willing to take USD risk. US investors whether healthier corporates or individuals through asset management companies may not be willing to take that risk either. The financial institutions in receipt of aid may be asked to be that backstop resulting in a de facto swap of US Treasuries for risky assets. System wide, this would only defer the liabilities, not crystallize them. It would, however, reflate the financial institutions, providing them income bearing risk free assets in exchange for toxic waste, without relying on external price discovery.
Subscribe to:
Posts (Atom)
