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Wednesday, June 23, 2010

Why Don't Corporations Want to Save Money On Their Swap Transactions

As someone that worked for years marketing derivatives transactions to corporations for use in hedging one element of the debate over financial services reforms mystifies me (well actually one of many). It is how corporations have lined up with the banking community in opposition to a clearing house and transparent pricing in derivatives products.

nyt gives an overview

Currently, the only way to trade many derivatives is to call up various dealers and ask for the price at which they are willing to buy or sell. The securities dealer profits from the difference between the prices at which it buys from one party and sells to another. Investors rarely, if ever, see details on the other side of the trade. Wall Street has signaled that it can live with a clearinghouse approach, but it is strongly opposed to exchange trading of derivatives, which would introduce price competition and lower the profits

The ostensible argument is that in a clearing house arrangement companies would be obliged to tie up capital in posting margin. But the margin can be posted with treasury bills and earn interest and should the swap value move in favor of the corporation there would be extremely small margin requirements. So the cost of posting margin would be minimal. Furthermore as descibed below the lack of collateral requirement means there is a cost for credit extension built into the pricing.

It's not hard to understand why the swaps dealers would oppose the clearing house. The increased transparency would allow end users to easily compare prices and thus cut the margins on their transactions massively. As someone who was involved in the early days of some interest rate and currency derivatives I can assure you that once there was a bloomberg page giving transparency to pricing the gravy train of profits on the transactions ended, The products became commoditized the profits slashed and the "rocket scientists" were off to invent a new product that would be harder for clients to value.

There seems to be little doubt that the clearing house and transparent markets on swaps would slash margins and reduce the cost of swaps for corporations by hundreds of millions of dollars far in excess of any costs related to margin. Yet these corporations are on the side of those very dealers that are trying to preserve a market structure that puts the corporations at a gross disadvantage.

an ex Goldman VP Walter Turbevikke who blogs writes an informational advantage in a non transparent market  is crucial to large profits for the dealers:

 A trader views these advantages(better access to the markets and information than corporate counterparties) as central to his or her livelihood. Fairness, a level playing field and social utility are not important considerations to a trader. In fact, for a trader to perform the functions that are desirable, such as accurate pricing of commodities, this is appropriate.

An additional factor is counterparty risk. With swaps as currently structured should the counterparty go bankrupt the institution on the other side of the contract would be holding a worthless piece of paper as was the case for Lehman and would have been the case for AIG had the Fed not stepped into the lurch.

In contrast there was not a single failed transaction on the billions of derivative contracts traded on the Chicago Mercantile Exchange. Why was that ? because there is a central clearing house, contracts are marked to market every evening and adequate margins must be posted before trading opens the next day. The prices on the instruments traded there: fully transparent with extremely narrow bid/ask spreads. No surprise that those very banks arguing for non transparent markets for swaps trade tens of millions of dollars on the world's futures markets every day.

Experience with corporate treasury departments leads me to suspect there is another factor at work in the corporate campaign for a non transparent market that will cost them $100s of millions. The savings from moving to a transparent maket is an opportunity gain. It never shows up on an income statement or a balance sheet.

On the other hand the new proposal will include mark to market rules for all transactions. In other words even though under current accounting rules changes in value on hedges don't hit the income sheet, financial reports andevery and balance sheets will show the values of these swap transactions and they will be more transparent to financial analysts and shareholders.. While ostensibly the swap transactions will offset exposure to other price movements (exchange rates or interest rates) the increased scrutiny may make things a bit uncomfortable for corporate treasurers on the wrong side of the market. Without market to market it might have been possible to obscure this. With mark to market....impossible.

Could it be that management of these corporations in joining hands with the banks that peddle them derivatives are more interested in income and balance sheet management than in creating shareholder value ?
It wouldnt be the first time.

Wallace Turbeville  has an interesting piece that gives another accounting angle on derivatives. Currently when a bank offers a derivative to a corporation without margin requirements it is effectively making a credit extension, it must tie up capital in the event of client default.  The credit doesn't show up as a loan but is priced into the derivative transaction. The economic impact of the credit extension being part of the swap price or a loan or a loan made to the corporation to post derivative would be the same. Furthermore the lack of a clearing house and the credit extension embedded in the derivative is more likely to tie the corporation to a particular financial institution putting it at a pricing disadvantage. But this credit extension unlike a straight loan shows up nowhere on financial statements. He argues:
• the financial statements of a company that borrows money from a bank to post collateral on a derivative should look the same as
• the financial statements of a company that has an agreement with a counter party to forgo posting collateral.
While I have not reviewed the accounting treatment of every end user and every arrangement, it is certain that in a number of situations, foregone collateral credit arrangements are not treated as balance sheet debt. It may be that these transactions are misunderstood. It would be unfortunate if the end user exemption became a mechanism for continuing this practice.
Is it the bottom line of possible real dollar savings in a more transparent swaps market or the accounting optics that drives these corporations to line up their lobbyists with those of the options dealers ?

As for the Washington view at this point the House bill incorporates exemptions from the clearinghouse requirement for some non financial firms (as the corporate lobbyists favor). A key person behind the house bill is Cong Jim Himes of CT an ex Goldman Sachs banker. His argument for the exemptionas reported by the Connecticut Mirror:

Moreover, Himes said, there are really two kinds of derivatives, one good and one bad.
The good ones include those in which a farmer wants to lock in a price on his wheat at the beginning of the year so he can plan properly, or IBM tries to protect itself from fluctuations in the yen when selling billions of dollars worth of goods to Japan.

To which I would reply:

Most farmers use the commodity exchanges with clearinghouses to hedge their exposure to price fluctuations.

The foreign exchange market is transparent already due to the existence of the futures market and the easy access to price data. The spreads on simple hedging transactions in foreign exchange are minimal. The new reforms would drastically reduce those on more complex transactions.

In fact those two examples are a bit of a red herring, the focus of the legislation is the swaps market.

When more exotic swaps transactions are moved to a clearing house the transparency will increase, the spreads (markups) to end users will collapse, and the counterparty risk will be eliminated. So if some derivatives are "good" when they are used by  exporters or farmers because they reduce risk, then they will become better (no counterparty credit risk) and cheaper under the proposed reforms. The only persons really hurt would be the Congressman's former colleagues on Wall Street.

Monday, June 14, 2010


Sometimes the poor logic in investing columns is so blatant it is startling. Such was the case in the NYT's "fundamentally" column on investing
my comments in blue

Don’t Let the Euro Dictate Your Portfolio

FOR Americans with significant exposure to foreign stocksthe euro’s 16 percent decline against the dollar this year may lead to second thoughts.
... the currency’s fall to $1.21 last week from $1.43 at the start of the year has only exacerbated those losses....
But before investors start changing their portfolios because of concerns over currency risk, market strategists advise them to consider several things...
Perhaps the best case for maintaining overseas holdings, though, is that exposure to different currencies has been shown to make a portfolio more stable, and not more volatile, in the long run.
How is that possible?
Stock markets around the world have grown more correlated, thanks to the effects of globalization. In fact, there is now a correlation level of about 0.9 between movements in the Standard & Poor’s 500 index of domestic stocks and the EAFE. (A correlation of 1.0 would indicate that two investments were in perfect sync.)
So the only possible conclusion from the above is that adding European stocks to a US stock portfolio  adds virtually no diversification to a portfolio.
The only real correlation comes from holding the foreign currencies outright not by holding the European stocks:
But Peng Chen, president of Ibbotson Associates, the investment advisory firm, notes that currency fluctuations are one aspect of foreign investing that has been shown to be essentially unrelated to movements in the S.&P. 500. In fact, over the last 20 years, the correlation between movements in European currencies and the S.& P. 500 has been just a negative 0.07, he said.
 Owning  european stocks is bad way  to get diversification.  Even though Mr. Lim tells his readers to hold onto stocks to get diversification.

The way to get diversification is to own foreign currencies. Lim presents the data but makes the wrong recommendation (holding onto the stocks)
better to follow this advice not advocated by the author but included in the article: 
MICHELE GAMBERA, head of quantitative analysis at UBS Global Asset Management in Chicago, says that even if foreign stocks no longer zig when domestic shares zag, one reason that these asset classes don’t always post similar returns each year is the currency effect.
“By having even some passive exposure to different currencies, you are adding diversification,” he said.
Interestingly the WSJ has a nice review of various ways to get currency exposure without entering the dangerously leveraged futures and cash currency markets

There are No Geniuses ....Bond Market Division

I have written before about the largest actively managed bond mutual fund in the world: Pimco Total Return. Although the firm and many analysts categorize it as a "core" bond holding I argue that since it can literally move anywhere in the realm of fixed income it is more of a bet in its manager "bond guru" Bill Gross. The investor in the fund never really knows what Pimco Total Return is holding and the market view and hence allocation of the manager can change radically. While Mr. Gross may indeed be a very bright man a core bond holding, as I have argued before, should consist of an etf or index fund where when knows exactly the maturity and credit quality of the holdings at all time.

As for the sharp changes in market view and strategy at Pimco Total Return. This from a Bloomberg article on the bond market

Lower Treasury yields may also reflect investor demand for a haven amid concern Europe’s debt crisis will slow the global economy.(Bill) Gross, who manages the $228 billion Total Return Fund, called the U.S. the “least dirty shirt” in a “world full of dirty shirts in terms of excessive debt.”
‘Significant Haven’
“A 30-year Treasury bond at just mildly above 4 percent is not a great value, but it’s a significant haven of storage, so to speak, for investors,” Gross, the co-chief investment officer at Newport Beach, California-based Pacific Investment Management Co., said in a radio interview June 4 on Bloomberg Surveillance with Tom Keene. “It’s attractive from the standpoint that inflation, in a new-normal economy, stays in the 1 to 2 percent area.
Gross boosted his fund’s investment in U.S. government- related debt in April to the highest level in five months. A month earlier he said in a separate Bloomberg Radio interview that “bonds have seen their best days.
Total return ytd for TLT (long term treasury etf) is 10.3% for PTTAX (Pimco Total Return Bond Fund)  it is 4.12%
 chart is below

Friday, June 11, 2010

Inflation or Deflation Redux

I wrote on March 5 that those predicting inflation in the near term needed to revisit their macroeconomic 101 textbooks. Monetary easing doesnt cause inflation if it occurs at a time of weak demand, excess capacity,an excess of available labor and slow velocity of now.

From today's WSJ

Deflation Fears Stir in Developed Economies


Worries about consumer price deflation are resurfacing in the world's developed economies after weeks of financial-market turmoil driven by Europe's fiscal crisis.
The fears are most pronounced in Europe, where policy makers are under pressure to reduce large budget deficits now, before durable recoveries emerge. A combination of spending cuts and tax increases could weigh on economic growth and feed into deflation, which is a broad decline in consumer prices.
Officials fret about deflation because it is hard to stop. Interest rates are already near zero in the U.S. and elsewhere, so policy makers can't use the traditional tool of rate cuts to spur growth and stop deflation.
That's an acute worry today. In addition to government debt, U.S. households are still trying to work off large debt burdens built up in the last two decades. 

Mr. Market is speaking as well
In one sign of rising alertness to the threat, yields on 10-year Treasury bonds—which fall when inflation worries recede and rise when inflation worries increase—have dropped from nearly 4% in early April to about 3.3%.
...And the lack of lending = low velocity of money is present as well.
"There are clear warning signs of deflation," Anthony Sanders, a George Mason University professor, warned at a Federal Reserve conference about housing in Cleveland Thursday. "My friends at the [Federal Reserve] may not agree with me. If the banks don't lend, we will get deflation."

And Mr. Market is speaking in the market that offers the most certain inflation protection; TIPS. I'll leave it to others to explain the massive gold rally.I'm with Chairman Bernanke yesterday who observed the gold price is unhinged from any other inflation indicators in the market.:
Fed chief Bernanke noted Wednesday that even though gold prices have been soaring—a potential indicator of inflation fears—many other inflation indicators are going the other way, including yields on U.S. Treasury bonds and prices for commodities.

And here is what Mr. Market is saying in the TIPS market:

Financial markets suggest investors are torn about inflation risks too. Prices for gold—which some investors buy as an inflation hedge—have soared, suggestion inflation worries are mounting. But expectations as measured in the market for Treasury Inflation Protected Securities, or TIPS, have been mostly stable and softened a bit in recent weeks. Yields on these instruments imply investors expect 2.7% inflation five years from now. This is down from 3.1% seen in April.

more on the unusual combination of higher long term bond prices (lower yields) and higher gold prices here.

Once Again....A Down Market = Losses In Hedge Funds "Absolute Return" ? Not So Much

The volatile and negative month of May in the overall markets generated similar and often larger losses in hedge funds. Once again the claim that hedge funds are a distinct "asset class" that can provide "absolute return" generating positive results in both up and down markets has proven to be a myth. In fact rather than showing savvy in managing risk the hedge funds seemed to have been hit much worse in the "flash crash " of May 6 than indexers are conventional money managers without such active trigger fingers on the trading terminals.

The FT reports

May proves the cruelest month for hedge funds

By Sam Jones, Hedge Fund Correspondent

On May 6, days after the EU moved to implement a huge €750bn bail-out package and on the eve of the UK's knife-edge general election, traders at the world's biggest hedge funds watched as wonderland numbers flickered across their screens.

Indeed, to some hedge fund traders eyes, the way individual names moved during the now infamous May 6 movements in the Dow was disconcertingly similar to the events of August 2007 - when previously imperceptible subprime jitters in the credit markets translated into a mass computerised dumping of stocks by the giant quantitative hedge funds AQR, Renaissance Capital and Goldman's Global Alpha fund.
Though no explanation was forthcoming for the causes of the flash crash, it was, in the days that followed, painted as a freak event - idiosyncratic and technical.
Scant comfort was available for many hedge funds, though. On the Thursday and Friday of the first week of May, some lost billions.
From its newly opened offices in Geneva, traders for BlueTrend - the $10bn quantitative fund run by Brazilian financial engineer Leda Braga, saw the flagship portfolio dive 7.5 per cent - a loss of nearly a billion dollars - in the first week of May alone. BlueTrend closed May down 8.5 per cent, unable to recover.
For some funds, May was not merely on a par with, but worse than October 2008.

Reflect upon the consequence of the information above. Despite the market turmoil of October 2008 and the massive losses the hedge funds have not engaged in any strategies to reduce their exposure to sever market movements. Either they adopted new risk management strategies that failed or they simply did nothing new to manage risk.....amazing

One of my fundamental beliefs is that there are no geniuses in investing meaning managers that consistently generate market beating returns particularly when adjusted for risk. Naseem Taleeb in his brilliant book Fooled By Randomness writes of the common tendency to confuse luck with skill by making conclusions based on a very short period of manager performance. Here's a case in point:

According to Hedge Fund Research information published yesterday, the average hedge fund lost 2.26 per cent in May. Every single hedge fund strategy lost money during the month. And in many cases, it was the biggest and best-known hedge funds - such as BlueTrend - that suffered the most.
Paulson & Co - perhaps after its phenomenally successful shorting of the US subprime market in 2007 and 2008, the best known hedge fund in the world - was among those hit hard. The firm's flagship Advantage fund, which alone manages close to $7bn, closed the month down 4.8 per cent. Worst hit, however, was the manager's Recovery fund - set up in early 2009 to capitalise on the bounce back of the global economy. The $7bn fund dropped 8.7 per cent in May, though it remains up 14.35 per cent so far this year.

The hedge fund behavior in May fit the pattern we have seen repeatedly it almost reads like a textbook description: 

  1. Large leveraged positions entered into trend following trades, the trades becoming "crowded" as all the supposed geniuses of the investment world ape each others strategies.
  2. A Market shock
  3. Panic and deleveraging of the positions put on during the period of overconfidence.
  4. Large scale reversal by managers of the same positions pushing
  5.  A feedback as more and more selling generates more losses on leveraged positions and more forced liquidations
  6. Underperformance by most hedge funds compared to unleveraged investors and indices during the period of turmol.
  7. Disapointment by hedge fund investors who expected diversification and absolute return from the hedge fund "asset class" only to find their hedge fund investments simply magnified the losses on their other holdings as they were highly correlated to their other risk assets. 
The FT article describes the May action

The losses are noteworthy not so much for their size, or the concern they might have caused investors, but rather, because they caught so many off guard, and were so widespread.
The first half of the month was marked by a growing panic from many of the largest funds to delever and unwind their biggest positions. April had caught many off guard. During that month, funds had grown increasingly confident of their positions and outlook in global markets - not least as far as the eurozone was concerned. For many, April was a month to hammer home their advantage by bulking up their positions.
For macro funds, whose ambit is to trade on global economic imbalances, the eurozone's difficulties were a godsend. Funds piled into "differentiation trades" - typically short the euro, and long Asian or Latin American currencies and equities. They were undone by the size of their positions.
"As problems in Europe grew, many market participants including banks and hedge funds began to try and de-risk the other leg of their short euro trade - the large, long emerging markets positions and they all rushed out at once," says Jamil Samaha at CQS, a large London credit hedge fund.
The effect was a sudden fall in Asian markets that triggered a vicious cycle of de-risking. Losses on macro funds long-Asian plays far outstripped gains on their short-euro positions.
Some global macro funds were able to staunch the losses, others were not. Brevan Howard, Europe's largest macro hedge fund, saw its flagship vehicle down 0.7 per cent as of May 21. Paul Tudor Jones' BVI Global fund closed the month down 2.26 per cent. Moore Capital, however, saw its flagship fund lose 7.7 per cent.
"There were movements in credit during May that were greater than anything we saw after Lehmans," says a manager at one of the world's biggest credit traders. "The banks were panicked. They were marking positions to the bone and we were marking some big losses mid-month."
The effect cycled into the bond markets. Hedge funds specialising in convertible arbitrage were hit hard, according to brokers. As funds looked to hedge their risks, they bought CDS protection en masse, forcing spreads wider and only further exacerbating the cost of hedging. The only choice was to dump the underlying instruments.
In the words of one hedge fund manager, May was "a wilderness of mirrors" - when the many uncertainties and unknowns of an overstretched market became impossible to square.
What is surprising is not that the above occurred but that the story is so similar every time

More Not so Common Sense Advice From James Stewart

 This week James Stewart shows how not to invest in and analyze  mutual funds and etfs.

He expresses concern over the BP oil spill and the European credit crisis, and it prompts him to look under the hood of an investment he has held in his portfolio. Incredibly he,a financial journalist offering investment advice, had no idea what the holdings were in an etf he owned: My comments in blue

I don't directly own shares in BP or any European financial institutions, and I've been avoiding both while following the depressing news about the environmental disaster in the Gulf and the latest permutations of the European debt crisis, which last week segued to Hungary....

I've been avoiding European bank stocks for another reason: Who knows where the exposure to shaky sovereign debt really lies?

Stewart goes on to state that he owns a european etf
 BLDRS Europe 100 ADR Index Fund...—which has dropped recently in line with European markets. I bought it for broad-based exposure to developed Europe, part of what I consider a prudent diversification strategy 

incredibly this author of a common sense investment column didnt due the most minimal research on the etf information one could find with two clicks of a mouse

. I'd never really examined the actual securities in the fund, so I decided to see just what was in it.
You can imagine my dismay when I discovered that its biggest holding is a European bank—HSBC Holdings—and its second biggest is BP. Spain's Banco Santander is also in its top 10 holdings, and financial companies make up 21% of the portfolio. So much for my illusion that I owned no BP or European banks.

He then moves to a specious way of researching holdings of mutual funds. Although he uses the only tool possible to find fund holdings he fails to mention that the data is not current since the funds report quarterly in arrears.In fact no one has any idea in real time what an actively managed fund owns.

In his search for an alternative european holding he comes up with a strange choice given that he seeks diversification. His choice a single country fund the etf for

 Stewart winds up with an etf probably a decent choice and at least this time he checks the holdings but his reasoning is curious he picks a single country fund based on the industry breakdown, He gets better industry diversification but takes a concentrated single country exposure. It has no BP and minimal exposure to energy(although I am not sure why the BP spill would lead one to avoid all energy shares a persuasive case could easily be made for building a portfolio of energy companies ex BP at this point). I don't know that it does much for his desire to avoid european financials

The best bet for my strategy may well be a Germany ETF. The iShares MSCI Germany Index ETF is filled with big exporters like Siemens (10% of the portfolio), SAP and ThyssenKrupp. It does contain Deutsche Bank (5% of the portfolio) but no energy companies among its top 25 positions.
The simple lesson in this exercise is to look at the portfolios of your mutual funds and ETFs. They do offer diversification—but also some unwanted major holdings.

I'm not sure that diversification is a great attribute of this fund. Like many single country funds it is highly concentrated 39% of its assets are in its top 5 holdings. And it's allocation to financials is 20.1% based on ishares fact sheet  That's basically indistinguishable than the   the 21% in the bldrs europe. which he views as overweighted in financials. And as for risk even though Germany is certainly the stongest economy in Europe it doesnt mean it is better to have all one's  holdings in european financials cocnetrated solely in Germany.

In sum in terms of diversification as is often the case single country funds seldom make the grade particularly as an alternative to a broader regional portfolio,

A little more research would have yielded the conclusion that there is a better alternative in a low cost european investment that holds not shares in BP ( UK not being part of the EMU). It offers country and industry diversification much broader than the single country fund.

The ishares emu etf (EZU)  is of course geographically diversified since it invests in all of the euro zone countries. where the top 5 holdings make up only 15% of assets.This etf probably  make a better choice  for a single European investment. It's largest sector is financials at 23.4%. higher than the Germany fund but diversified across several countries.The holdings are concentrated in the stronger european economies with the notable exception of spain:

Top Countries as of 5/28/2010
France 31.22%
Germany 25.57%
Spain 11.66%
Italy 9.20%
Netherlands 9.14%
Finland 3.64%
Belgium 3.27%
Luxembourg 1.51%
Austria 1.08%


Mr. Stewart might also have been better off solving his problem with european banks BP by purchasing a broad developed market index like VEA.

In any case rather than common sense advice and analysis Mr.Stewart comes down to recommending a narrowly focused single country fund as a way to diversify internationally.

Monday, June 7, 2010

What I'm Watching For A Buying Opportunity

I am not much of a market timer. I don't think I can pick tops and bottoms and under current circumstances I am pretty much comfortable holding my long term asset allocation along with the vxx and vxz "black swan" hedges. Actually at this point I wouldn't even call them black swan hedges. A black swan is a large disruptive unforecastable event. I think the outlines of a severe crisis caused by more deterioration in Europw are clearly visible. It may be impossible to put a firm probability on it but if it occurs I can't see how any observer could say it was unforseen. So the vxx and vxz are hedges but not black swan hedges.

One thing we do know is that markets overshoot in times of financial crises. It is certainly highly risky to try to pick bottoms in the equity markets. In the fixed income markets, the risk/reward for entering into positions in the midst of a crisis are far different.  The yield spreads between investment grade corporates and treasury bonds and the high yield/treasury spreads inevitably move to extreme levels in the midst of financial crises.

For the long term investor this represents an excellent opportunity to enter these markets. The spreads inevitably tighten giving both a capital gain and the high yield. Should the investor enter the trade early the downside is relatively inconsequential, the spreads will eventually tighten and he will only have the opportunity cost of not picking the exact best timing. Entering into long positions in intermediate term investment grade corporate bond etfs like (LQDor VCIT) as well as high yield bond etfs (JNK, HYG) at levels close to previous extremes in yield spreads offers an attractive risk/return. Of course traders will enter into this as a spread trade (short the treasuries and long the credit bonds) even on a leveraged basis, I'll leave it to others to venture there.

In 2009 LQD returned 8.5%, HYG 28.6%

I don't think that we are quite at the point to enter these trades as seen by the charts that show recent history for the spreads. I dont think we are done with the Europe related crisis. But the time will come and I will be ready.

This chart is LQD over IEF (inter treasury erf)the extreme at the high of the 2008 crisis was around 3% right now we are at
The second chart is HYG/IEF the extreme in 2008 was around 8%

current yields
lqd =5.29%
hyg= 9.65%
ief =3.81%