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A FOOL AND HIS MONEY
Investing has many similarities to poker. For example: A small minority of professionals take the lion’s share of profits. The house takes its cut from all comers with ironclad regularity. Odds allow for confidence, but never certainty – there is no hand that cannot be beaten, no hand that cannot win. Both games are heavily influenced by luck in the short run, yet dominated by skill and consistency in the long run. And success is rarely the result of any one large decision; it is rather the result of countless small decisions, built into an accumulated edge over time.
The typical poker player reverts to the style he or she is most comfortable with in live play. This lack of variation gives the professional an edge, highlighting the best way to take the amateur’s money. Poker predators usually assign one of three classifications to their prey: Maniac, Rock, or Calling Station. Of these three, the Calling Station is prized as the most reliable source of funds. The Maniac is dangerously aggressive, and often too hot; the Rock is notoriously tight-fisted, and usually too cold; but the lukewarm Calling Station is just right. A passive aggressive type, the Calling Station has no grasp of strategy, yet feels compelled to participate. He or she is happy to call the majority of bets, rarely raising or taking control of the hand. Analysis is minimal, actions robotic. The Calling Station’s attitude can be summed up as, “I don’t really know what I’m doing, but I’m just glad to be here.” A streak of good cards will occasionally reward this hapless style of play, but odds inevitably prevail over time. The Calling Station thus provides a steady stream of revenue for those who understand the importance of strategy and put it to use.
On Wall Street, the investing equivalent of the Calling Station is the Passive Indexer – the individual who seeks to unthinkingly mimic the performance of the Dow Jones or the S&P 500. Like his poker equivalent, the Passive Indexer is either unaware that strategy exists or unconvinced of its necessity – just happy to be a part of the action, hoping that luck or providence will provide a decent retirement. (Of course, the Passive Indexer is frequently encouraged to believe that providence is all he needs. This is rather like wolves encouraging sheep to believe the forest is safe.) By contrasting the modest returns of passive indexing with the subpar returns of mutual funds, index touts pull off a neat trick: they make the bad look good by comparing it to worse. Adding insult to injury, many large mutual funds are actually “closet” indexers, charging for active management yet hugging the benchmarks anyway. This is like starting at the bottom and digging a hole.
In essence, passive indexing is the equivalent of a dog chasing its own tail. Selected companies grow larger as sums of indexed money robotically swell their market caps. As valuations rise, the indexers are encouraged by the boost. The process repeats in round robin fashion, with little thought for the objective worth of the companies receiving these blind inflows. Few question this puzzling lack of logic, thanks to a triumph of circular reasoning: the Efficient Market Hypothesis assumes that all valuations are intrinsically self-justified.
Those who defend passive indexing invariably point to stocks’ historical uptrend. But like the Calling Station on a temporary winning streak, indexers overlook the cyclical tendencies of the market, putting too much emphasis on an extraordinary run of good cards. As the Rydex chart shows, the market actually spends more time going nowhere than going up, with the typical bear cycle measured in decades. Whether things work out in the long run is a moot point for those with retirement needs close at hand. As Lord Keynes famously noted, in the long run we are all dead.
Alternative asset managers – who pursue absolute returns rather than relative ones – are required to post the prominent disclaimer “PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS,” or some variation of such, on their investment materials. Ironically, the Passive Index claque relies on just such an outlawed guarantee to make their case. They want you to believe that buy and hold is safe as milk. Worse still, the indexers lean on history for support without actually consulting it. Ignoring the ramifications of market cycles proves fundamentally dishonest. A more rational assessment, assisted by the chart above, would go something like this: “If historical market patterns offer guidance, we are probably heading into a period of sideways to down markets that could easily be ten years or more in duration – hardly the time to be passive.”
Is there ever a time to seek general exposure to stocks? Certainly. When valuations are low, pessimism is high, and interest rates and inflation have hit cyclical peaks, it is probably a good time to be a broad market bull. In the stagflated seventies, the PE Ratio for the S&P 500 flirted with single digits, inflation ran rampant, and a determined fed chairman took interest rates to sky-high levels. Here in 2005, we are at the opposite end of the spectrum. Price stability is crumbling. The twin specters of inflation and deflation lurk. Government expenditures are skyrocketing. A long-term sideways to down cycle is required. But the news is not all bad. There will be plenty of opportunity afoot, even with the broad markets going nowhere. Savvy investors made good money in the ‘30s and the ‘70s, and they will have similar opportunities in the coming cycle. It will be a stock picker’s market, and very much a trader’s market … but not a passive indexer’s one.Link here.
THE HOUSING BUBBLE REVISITED
If there has been any doubt that a housing bubble really exists, recent news should have changed that. In early July, word got out that trailers in a mobile home park in Malibu were selling for over $1 million. Well, granted, it is not your ordinary trailer park – scenically located at Point Dume and close enough to the houses of the stars that you can wave Barbra Streisand goodnight. Whoever cannot afford an 8-digit Malibu mansion moves into a mobile home; even celebs like Minnie Driver have been reported to own one. The downside: what you get for your $1+ million is just the mobile home itself; the land it sits on does not come with the deal. Which leads to downside number 2 – the fact that trailer owners at Point Dume are paying up to $2,500 “space rent” per month to stay in their domiciles.
Critics may object that this is one of those typical Tinseltown fads and not representative for the “real world”. Not true, as a glance to the other coast shows. In Florida, buy-and-flip real estate investors are outbidding each other for rickety trailers on postage stamp-sized lots, framed by chicken-wire fences and often littered with debris from the last hurricane. Currently sellers rake in up to $500,000, especially if the property happens to be located in the Keys. Of course it is not the trailers but the land that is so valuable to investors – in fact, as the Miami Herald reported, the price of moving the trailers often exceeds their value by so much that most are being demolished on-site by their proud new owners who no doubt already envision a nice townhouse or cottage on the premises.
We can only shake our heads in wonder … and figure that, even though we have covered the housing bubble previously, the latest developments warrant an update. In a nutshell: the news is not good. Take housing affordability, for example. According to the National Association of Realtors, in 2002, the median price for an existing single-family home was $158,100. In June of this year, that figure stood at $218,600, nearly a 40% increase. That is pretty heady, but it might be okay if incomes were keeping pace. They are not. Over the same period, median family incomes rose from $51,680 to $57,115, a gain of only 10.5%.
What is really sobering is the fact that during that same period, the monthly payment (P&I) required to finance a median-value home jumped from $804 to $1,016, up over 26%. And that despite the fact that average mortgage interest rates dropped from 6.55% to 5.71%. Take the NAR’s Housing Affordability Index, which shows the percentage of American households that can afford a median home (based on a 25% qualifying ratio of monthly housing expense/gross monthly income). A year ago, that index stood at 57. Now it is 50 and falling. This means that only one out of two families in the country can now afford an average dwelling. In superheated markets, the situation is far worse: a mere 17% of California families can afford that same house.
The rental market, in contrast, has remained relatively stable. So what is happening? For one thing, folks are spreading themselves exceedingly thin. For another, those buying houses are increasingly uninterested in a place to live. Soured on the stock market, they are trying to make their fortunes by speculating in real estate. According to an article in the Wall Street Journal, in the first four months of 2005 investors accounted for 9.9% of home mortgages, a better than 60% increase since 2001. In addition, another 7.2% of mortgages went for second homes, vs. a mere 2.2% in 2001. These two groups are largely driving the red-hot market, and they are not stable home owners. They will sell at the first hint of a price peak. No one knows, of course, when that will happen, but it will. History teaches that no asset class continues to appreciate indefinitely. What goes up must come down.
Compounding the problem has been the ominous rise in the incidence of non-traditional financing, which Fed Chairman Alan Greenspan commented on in June, saying that “the apparent froth in housing markets may have spilled over into mortgage markets.” There is no “may have” about it. What Greenspan is talking about are such high-risk propositions as interest-only mortgages – which in their early years require only interest payments, often leading borrowers to choose a higher-priced house than they can actually afford; and option ARMs, which are, if possible, even scarier. Option ARMs have teaser rates as low as 1% and give borrowers four different choices of how much to pay every month. The minimum-payment option is so low that it may not even cover all the interest due. Whatever is not paid gets added to the principal, a phenomenon called “negative amortization”. Even though that is the kind of speculation resembling Russian Roulette, buyers are proceeding to take these big risks, in ever-increasing numbers. Nationally, for example, a staggering 31% of mortgages were interest-only in 2004, and in the hottest markets, the ratio was much higher.
Taken together, all these numbers indicate a teetering house of cards. Is a crash inevitable? No, but a decline is, and that decline could take a different form than an outright plunge. Prices could drop in fits and starts, with any number of fool’s rallies punctuating the trip to the bottom. Or there could be a long, steady fall, as has happened in Japan, which before the present U.S. boom boasted the most overpriced market in history. Since their peak in 1991, Japanese property prices have dropped for 14 consecutive years, with a cumulative loss of more than 40%.
Our advice regarding how to protect yourself and your family in this climate is the same as it has been for quite a while now. Get the lowest fixed-rate mortgage you can negotiate, and sit on it; avoid gimmicky interest-only and option ARMs like the plague. Do not speculate in real estate; you may miss the top, but you will not get hurt when the downturn comes. Do not borrow against your property’s present value. What this all boils down to is merely adopting a more traditional mindset about your home. It is the place where you intend to live.Link here.
Black Horsemen, White Knuckles
Financial bubbles are like great parties. They are fun … too much fun. No one wants to leave too early, so almost everyone stays much later than prudence would permit. Hangovers are no fun, but they are quickly forgotten … which is why we will eagerly attend the next party. Financial bubbles, though they resemble parties, can impart far more dire consequences than a mere hangover. Indeed, sometimes the consequences seem almost Apocalyptic in magnitude, as Adam Smith, author of The Money Game, explains: “We are all at a wonderful party, and by the rules of the game we know that at some point in time the Black Horsemen will burst through the great terrace doors to cut down the revelers; those who leave early may be saved, but the music and wines are so seductive that we don’t want to leave, but we do ask ‘What time is it? What time is it?’ Only none of the clocks have any hands.”
Yes, that is it exactly. Financial bubbles are an Apocalyptic cocktail party. Over in the housing market, the cocktails have been flowing for a good, long while. Not surprisingly, therefore, most housing bubble participants have become a bit light-headed, especially the mortgage lenders. Intoxicated by their good fortune, the mortgage lenders have become increasingly reckless. They have been mixing up potent cocktails like “interest-only” mortgages and “no doc” mortgages (where the income of the borrower is not verified). Some lenders have also concocted 40-year mortgages. Fannie Mae, the barfly of our metaphor, loves them all. This government-sponsored mortgage lender recently announced that it would accept 40-year mortgages as “conforming loans” – meaning she will buy them. This all but assures we will see more of them – if the bubble can hold it together a little longer. All of these innovative new “lending programs” enable homebuyers to borrow more and more money against less and less equity.
But the Black Horsemen will arrive at some point. As the credit cycle turns “EZ credit” to not-so-EZ credit, the housing bubble might deflate very rapidly. Some banks have been partying harder than others. So these doomed revelers are likely to feel the Horsemen’s cold steel across their vulnerable necks sooner than others.
In a new report, Standard & Poor’s “stress tested” various banks against the possibility of a housing bust. While the authors of the report conclude that most banks would not suffer losses that would result in ratings downgrades, several high-profile lenders would suffer such losses. We are most interested in these feeble members of the herd, as they would seem to offer good bets (as short sales) on the end of the housing bubble.
“Operating in bubble markets,” James Grant observes, “many people lose their bearings. They become disoriented, financially or morally. As most investors shrugged at the preposterous high-tech valuations of early 2000 (they had become used to them), so they are prepared to explain away the risk-fraught mortgage-lending practices of 2005.” The mortgage bubble looks every bit the equivalent of the insanity achieved in the late 1990s tech-bubble. And Countrywide, the nation’s largest mortgage lender, is one of the best pure bets on the bubble’s collapse.
S&P assumes a 20% decline in housing prices over a two-year period. The report also makes reasonable assumptions about default rates by using historical episodes of housing market busts. For example, housing prices declined 30% in the 1980s in Texas – and nearly 16% of Houston’s housing market entered foreclosure between 1982-87. S&P chief economist David Wyss believes a 20% fall in average price would consist of something like a 30% drop on the coasts and a 10% drop in the Midwest. The top five booming markets, according to the FDIC, are Los Angeles, New York, Boston, Washington, D.C and San Diego. We can infer that these markets, and the institutions that serve them, would be more vulnerable than Midwest counterparts.
With the widespread acceptance of unconventional and riskier mortgages on an unprecedented scale, there is a further wild card in the mix. A real full-scale housing bear market has not yet tested these products. In any event, these tables (here and here) may provide fresh new candidates for those looking for plays on the housing bubble finding its pin. If only those clocks had hands!Link here (scroll down to piece by Chris Mayer).
Fee Fi Fo … Fannie
How do you best a giant? Well, as the famous children’s story Jack and the Beanstalk illustrates, hand-to-hand the size of a Honda combat ain’t gonna get the job done. Instead, like Jack, you slowly chip away at the structure the ogre climbs to reach the top, until the fateful day when his weight tumbles the whole thing to the ground. And, from fairytales to the world of finance, that is exactly what is been happening to the mortgage giant Fannie Mae over the past two years: Regulators swung their axes into the trunk that took the company to the stars:
From March-July 2004 when the Bush Administration and Congress demanded a “complete regulatory overhaul” of the mortgage behemoth, including restructuring, reductions in borrowing capacity, greater financial disclosure and constraints … to this month Federal Reserve chairman Alan Greenspan issues a heightened warning against Fannie Mae, explaining: “Their debt raises the potential danger to the U.S. financial system.”
At this point, we would be wary if a butterfly landed on Fannie’s feeble foundation. “Look out below!”, however, often means squat if there was not a very enthusiastic “Look out before!” at some earlier time. Which begs the question: What if someone told you three years ago – when Ms. Mae’s shares were orbiting an all-time record high and Franklin Raines was coined “America’s most confident CEO” – that Fannie was about to fall on its fanny? As it were, “someone”, namely the March 2002 Elliott Wave Financial Forecast, did. In our words:
“When social mood turns down, Fannie Mae, ‘the government sponsored enterprise’ that has pushed home ownership into the depths of the populations, will be extremely vulnerable. Fannie will probably be testifying before Congressional Committees for years to come. To stay on top of this debacle, keep an eye on Fannies’ stock price (FNM). A final burst to one more new high would complete a longer-term, five-wave advance from the early 1990s. After that, it will be downhill.”
Fact Check: From April 2002 to late July 2002, Fannie Mae stock plunged 30%. Since then, the market has made a series of lower lows and lower highs, bringing the total loss of FNM as of September 22, 2005 to 40%. Today, prices stand a bean’s-throw away from an 8-year low. As for days spent before Congress, Fannie’s clocked in overtime. Widely regarded as the “linchpin”, “bedrock”, and/or “bellwether” of strength in the U.S. housing sector, whether Fannie can rebuild its bean-STOCK in time before facing a fatal fall is the trillion-dollar question.Elliott Wave International September 23 lead article.
Tokyo land prices have first gain in 15 years.
Land prices rose in central Tokyo for the first time since 1990 and spread to outlying districts of the city as Japan’s economic recovery and demand from property trusts and funds helped boost values. Commercial and residential real estate in the capital’s 23 wards gained for the first time since 1990 in the 12 months ended July 1, the Ministry of Land, Infrastructure and Transport said in a report, supporting an Aug. 1 assessment by the National Tax Agency. Land zoned for commercial use rose 0.6% and residential areas were up 0.5%, while the decline in nationwide values slowed.
Tokyo acquisitions by domestic real estate investment funds and foreign investors that include Morgan Stanley and Lone Star Funds are boosting values in Tokyo’s 23 wards, where land prices rose 0.9% in 2004, according to the National Tax Agency. The rise is supporting gains elsewhere in the capital and in other Japanese cities. “The turnaround in real estate prices is broadening out from a few places in a few major cities to a more general stabilization,” said Richard Jerram, chief economist for Japan at Macquarie Securities Ltd., before the report was released. “The positive macroeconomic effect is becoming more significant.”
Nationwide, commercial and residential land prices dropped for a 14th year, the ministry report showed, with declines of 5% and 3.8% respectively, compared with 6.5% and 4.6% a year earlier. “It is now clear that land prices are bottoming out,” said Hiromichi Iwasa, president of the Real Estate Companies Association of Japan and chief executive of Mitsui Fudosan Co. “The property market is heading for a healthy transformation.”Link here.
Real estate brokers feel they are under unjustified attack.
These days, it seems like open season on real-estate brokers … and the brokers are not happy about it. With more than 1.2 million members of the National Association of Realtors (NAR), that is a lot of frustration. “I just feel like we’re taking it on the chin again,” said Robert Ellis, a Coldwell Banker broker in Florida.
Critics of brokers say the industry needs to be more competitive, paving the way for lower commissions than the standard 6% most realtors charge. As real estate prices have soared, so have commissions, with Americans paying out more than $70 billion last year. A recent suit brought by the Department of Justice challenges a policy by NAR that governs individual broker’s ability to “opt out” of broadly displaying their listings on the Internet. This summer, the Justice Dept. went after rules in Kentucky and South Dakota that limited brokers’ ability to lower their fees. The DoJ won those cases.
For many brokers, the latest “opt-out” suit is much ado about nothing. “I don’t know a single agent who will not allow their listings to be shown on other Web sites,” said Dan Haynes, who runs a RE/MAX agency in Fenton, Missouri. Cheryl Ramos, another Missouri broker, said, “Opting out is not to our advantage or the sellers’.” Ellis said he knows of no Florida broker who chooses to opt-out and blames the housing boom for bringing extra attention on the industry. “The real-estate business is so hot that the media is focused on it,” he said.
Spokesman Steve Cook of NAR said that the association does not discourage competition. A new study by Penn State professor Steve Sawyer backs that up. “Selling real estate is intensely competitive. Consumers have more information, they demand more services, and they have more agents and business models to choose from than ever before,” wrote Sawyer in the report. Still, it is tough to argue that the industry is as competitive as it could be. In other businesses, such as travel-booking and stock trading, fees dropped precipitously after the Internet spawned new business models.Link here.
U.S. DOLLAR: THE LITTLE ENGINE THAT COULD
Much like the Little Engine That Could, the U.S. dollar is again moving up the mountain that it looked too weak to climb. Such has been the case for most of 2005. Still, the Dollar Index did see a sell-off in the summer months. At the end of August, news accounts reflected a grim assessment of the greenback: an AP story on August 31 said, “The 12-nation euro gained against the U.S. dollar Wednesday amid continued concerns over high oil prices in the wake of Hurricane Katrina.” By September 5, Reuters was reporting that still-deeper declines in the dollar had come “on worries that the Federal Reserve may pause in its dollar-supportive monetary tightening as the United States counts the cost of Hurricane Katrina. The dollar hit its lowest level since May 18 against a basket of major currencies.”
Thus you can look at declines in the dollar – which are supposed to be “bad” – and in turn look around for news that is also “bad”. Since there was plenty of bad news at the end of August, the cause and effect with the dollar appeared all too compelling.
But wait. You could also look at the dollar’s trend and say the news headlines are 100% irrelevant to what prices have done or will do. Instead, you could say that the 4-month decline has almost exhausted itself; you could even say the pattern is about to turn. And this is precisely what the Short Term Update claimed on Friday, September 2. It showed subscribers a chart with the caption, “The Dollar Index: Nearing the End of the Downward Correction.” The commentary also said that “prices should bottom in, or very close to our cited support. This is what we are looking for next week.” The following Monday, the Dollar Index did indeed hit the 4-month low, but then reversed higher that very day – prices have rallied handsomely in the two weeks since. This is the difference between looking at the market, and looking someplace else.Link here.
NO SLACK LEFT
Energy prices gyrate, up goes the trend. Infrastructure rots, down go the levies and the responses are neither adequately fast nor appropriately full. Gulf Coast flood waters and GDP forecasts recede, up go the equity markets. This is the celebration of the positive, the hoped for, the best case scenario in an economy that has forgotten how to do anything else. Wishful thinking has replaced prudent assessment in situations with no systemic slack to call upon.
We are stretched tight, beyond tight. There are no savings, credit card required minimum monthly payments are doubling, from 2% to 4% of balance. Payment percentages are doubling as adjustable rate interest payments are, and will, continue to be on the rise. Median weekly incomes in the U.S. did not rise in 2003 or 2004. Not to worry, we will borrow the difference, continue spending and cash out bubble gains in frothy real estate.
The slackless economy is defined by a total absence of reserve for the forecast rain. As climatologists and meteorologist forewarned authorities in Washington D.C., Baton Rouge and beyond, so economic theory and history scream out to us. The message is simple, things that can not go on forever do not. But we believe they do because we have to. Nothing else is so reassuring. There is no place for full spectrum risk consideration, no time for downside planning and no cushion to fall on.
Slack is gone from refining, pipelines, production and storage. Auto makers stayed reliant on huge, gas inefficient vehicles to retain profitability. In 2003 these vehicles passed the 50% threshold and now account for well over half of all vehicles on US roads. Light trucks, SUVs, and minivans are financed with debt and slurp gas. One might see them as microcosms of the slackless economy. They were bought with borrowed money, cost a lot to own, are easy to roll-over, a poor investment and more dangerous than we like to think. These vehicles are piloted longer and longer distances to larger and larger homes packed with energy hungry appliances.
Our international position offers no high ground amid rising waters. Massive structural trade imbalances require us to attract $3 billion in foreign capital per day and assure that we will run net imports at or above $700 billion per year. We are a debt driven economy that dis-saves. This is not set to change for the better. As the average price of oil in the forward markets adjusts upward and knowledge jobs are outsourced, the direction of change is mysterious only to those yet to examine the direction of America’s external balances over the last 15 years. Rising energy costs, distressed consumer finances, trade deficits, budget deficits and imbalance fragility are as predictable and devastating as storm surges and flood waters. We have dodged a direct hit for a long time. Our defenses are down. There is very little slack in the system.Link here.
RISING COST OF DEBT MUCH MORE DANGEROUS
For years, even through the terrorist attacks in September 2001, consumer spending has continued to rise. Interest rates remained low, and credit has been easily available. Home prices soared. Debt – and leverage through debt – became an accepted way of life. Savings disappeared. Soon, very soon, we are going to have to pay for our folly.
You do not need government statistics to tell you that prices are rising. In fact, for some items, prices are rising at an even faster rate than the 0.5% increase in the Consumer Price Index in August. Without food and energy increases, the CPI rose only 0.1%, but I do not know anyone who exists without food and energy for a month! There are other components of the CPI that tend to minimize the impact of higher costs. The CPI’s housing component is figured at the rental-equivalent cost. But with so many people buying homes, rental demand has eased, so rents have been held down. If you are a senior consuming health services, your cost of living is certainly rising at a more rapid rate than the index. Ditto if you are the parent of a college student. And ditto in spades if you are a first-time home buyer.
Rising prices are a symptom of inflation. But the real definition of inflation is the excess creation of money, which destroys the value of the money we hold. And that process of inflation is directly related to the actions of the Federal Reserve Bank. The Fed has been fighting the possibility of inflation for well over a year, raising interest rates and tightening up on the money supply in a less-noticed attempt to wring the inflationary potential out of the economy.
The banking system had been awash in low-interest, easy money following the Fed’s easing going into the year 2000 transition, and in its efforts to stem the potential impact on the economy after Sept. 11, 2001. If the Fed keeps tightening up on the price and availability of credit, consumers will have to start making choices. Rising energy costs, not only for gasoline but home heating oil and natural gas, will take a toll on other consumer spending. In the 1970s, the Fed tried to accommodate both higher energy costs and war by creating more, not less, availability of credit. The result was inflation. They are not likely to make that mistake again.
Consumers have been attempting to maintain their lifestyles in spite of rising energy prices, but they do it at a huge hidden cost. Our savings rate as a nation has fallen into negative territory. That means that in an attempt to keep up with rising prices, we have been paying for our lifestyles with mortgage loans and credit cards. Even worse, we have been spending money abroad in record amounts to buy foreign goods to the tune of $770 billion a year. Stuck with the dollars, foreigners have been reinvesting them in Treasury securities at a rate of around $65-$70 billion a month. If foreign central banks ever stop finding those Treasury bills attractive, interest rates would have to go much higher to attract lenders to finance our debt. Global oil producers would demand more of those less-valuable dollars to pay for the oil they ship. And then the house of cards that we call consumer debt would fall faster than any hurricane winds.
The gold market recognizes the danger, with recent price rises. That potential loss of confidence in the dollar is why the Fed must raise rates in spite of the government’s need to borrow money to help the rebuilding effort. The Fed recognizes reality – and so should you. If you are living on the edge with credit-card debt or an adjustable-rate mortgage, wake up to the new reality. Debt has suddenly become much more dangerous.Link here.
ASYMMETRICAL RISKS OF GLOBAL REBALANCING
The disparity between current account deficits and surpluses is now closing in on a record 5% of world GDP. Behind this imbalance lurks an important and potentially dangerous asymmetry: Deficits are heavily concentrated in one economy whereas surpluses are spread out widely over a large number of nations. This mismatch could well exert a very destabilizing influence on the coming rebalancing of the global economy.
By our reckoning, America’s record current-account shortfall should account for about 70% of the total deficit positions in the global economy in 2005. By contrast, the incidence of surpluses is far more diffused: It takes some 10 economies to account for 70% of the total global current-account surplus in 2005. While our estimates suggest that Germany and Japan should collectively account for nearly 30% of the world’s total current-account surpluses this year, the remainder of the global surplus is widely distributed into a broad cross-section of countries around the world.
Current account imbalances are really nothing more than saving-investment gaps. A country such as the U.S. runs a current account deficit because its domestic saving falls short of investment. It must then import surplus saving from abroad in order to maintain such “under-funded” investment. Conversely, a country such as Japan runs a current account surplus when its investment falls short of domestic saving. There are no guarantees that there will be a synchronous rebalancing in the mix of global saving – that a U.S. saving increase will be accompanied by declining saving rates elsewhere in the world. To the contrary, there is good reason to fear a further widening of the disparity in global saving and current account positions over the next couple of years. While there is a growing and welcome possibility of some saving reduction in the major surplus economies, that constructive trend could well be more than offset by a sharp deterioration on the U.S. saving front.
America’s national saving outlook is in the process of going from bad to worse. Deterioration is likely in all three major components of domestic saving – for households, the government sector, and for businesses. Consequently, it appears quite likely that the world’s dominant current-account deficit economy, the saving-short U.S., is about to put an even larger claim on the world’s pool of surplus saving. There is an important new reason to believe this could be a serious problem for world financial markets and the global economy: Surplus economies are finally on the road to recovery. That is true in Japan and could well be the case in Germany, as well. Moreover, China – the 4th largest surplus saver in the world (possibly moving up to #3 by year-end 2005) – is very focused on stimulating domestic private consumption.
There is a certain irony in these prospective developments. For the last few years, Washington politicians have been quick to label America’s current account and trade deficits as a foreign problem – an outgrowth of persistently sluggish growth in the rest of the world. The rest of the world finally is starting to break the shackles of sluggish growth. And in doing so, recoveries seem likely to be concentrated amongst three of the world’s four biggest savers – namely, Japan, Germany, and China. In the meantime, America has not only failed to correct its record saving deficiency, but it appears to be on a course that will depress its domestic saving rate even further over the next year or so. This puts more tension on the global rebalancing framework.
Today’s unbalanced world is in an extremely delicate state of equilibrium. The asymmetrical distribution of current account deficits and surpluses around the world means global rebalancing will involve an equally asymmetrical realignment in the mix of global saving. This is potentially a “hair-trigger” result for an already unbalanced world. There is much greater urgency for the U.S. to raise its record low domestic saving rate than there is for any one country – or group of countries – to draw down surplus saving. Yet a U.S.-centric rebalancing is very much a double-edged sword for a lopsided world: An increase in U.S. saving would also crimp the major engine on the demand side of the global economy. Depending on the path of the saving adjustment – gradual or abrupt – the outcomes could range from a sustained shortfall in global growth to a sharp worldwide recession.
This is where the asymmetries in the mix of global saving have the clear potential to become a serious problem. If the U.S. goes even deeper into deficit at the same time the world’s surplus economies start to absorb their domestic saving, America’s ever-mounting external financing pressures are likely to be vented in world financial markets. This, of course, is the stuff of a classic current-account adjustment – the case for a weaker dollar and higher U.S. interest rates. As long as the non-U.S. world was in an excess saving position, a major re-pricing of dollar-denominated assets could be avoided. But now, with an asymmetrical shift in the mix of global saving increasingly likely, it could well become all the tougher for the U.S. to avoid this treacherous endgame.Link here.
SO LONG, DENNIS KOZLOWKSI …
Fare thee well, Dennis Kozlowski. We will miss you. We will miss you each and every day of your 8 1/3 to 25 year sentence. We only regret that we will not have the opportunity to miss you for longer. Yesterday, a bailiff slapped handcuffs on Kozlowski and led him out of a New York City courtroom to begin serving his multi-year sentence. The judge also ordered Kozlowski to pay nearly $200 million in restitution and fines. We will miss you, Dennis Kozlowski.
We will miss your beaming mug on the cover of sycophantic business journals. We will miss the adoring columns about your “can do” management style. We will miss your bravado, tinged with condescension, that wowed the press and cowed your critics. We will miss your ostentatious misuse of stolen funds: your $6,000 shower curtain, your $17 million apartment, and your $2 million dollar birthday parties – complete with ice sculptures of Michelangelo’s David spewing vodka from his private parts. In short, we will miss your pathetic caricature of capitalism.
Dennis Kozlowski used to be the embezzling CEO of Tyco International, a company once hailed as the “Next GE” by a widely read business magazine. Now he is a convicted felon. Justice is served. Tyco was not the next GE, nor was it ever going to be. But he was a marvelous imposter. Dennis “the Menace” was not a capitalist, he was merely a thief. His masquerade cost millions of investors billions of dollars. But he did not fool everyone. Jim Chanos, a legendary short-selling hedge fund manager here in Manhattan, identified Tyco as a questionable corporate entity, long before the rest of the world recognized that fact.
Eventually, Tyco’s mysterious accounting became less mysterious. The English language, helpfully, provides a word to describe Tyco’s accounting. The word is “fraud”. The same word aptly describes Dennis Kozlowski. He is a fraud … a preposterous fraud. So long, Dennis Kozlowski. We will miss you. You do not have to break the law to get rich. …Link here.
WHAT IS A CREDIT SCORE? CONSUMERS STILL NOT SURE
More consumers are learning about credit scores, but there is still considerable confusion surrounding the three-digit number which largely determines a consumer’s borrowing power, a new survey has found. For example, three-quarters of Americans now believe they are entitled to a free peek at their credit score every year. They are not. Apparently consumers are confused about their new right to a free look at their credit reports, which does not include access to credit scores.
Credit scores and credit reports are different, but the survey suggests consumers are blurring the two. Credit reports contain a consumer’s entire financial past, listing payment histories for credit card accounts, car loans, mortgages, and other accounts. Any late payments and defaults are highlighted. A credit score is a number generally ranging from 300-850 that is generated at a lender’s request. The score, which is calculated through secret formulas that take into account items on the credit report and other factors, attempts to rate the likelihood a consumer will honor future debt payments. The importance of credit scores has spiked in recent years, as many lenders now only look at credit scores – skipping a chance to see the full report – when making credit decisions. Poor scores can also impact a wide range of consumer activities. A low score can limit a person’s eligibility for home insurance, raise the price of auto insurance, and even effect the outcome of a job interview.Link here.
HEALTH AND LIFE INSURANCE … AND THE STOCK MARKET
When it comes to health and life, most people assess risk based on what is possible, not on what they think is probable. Yet, when it comes to investing, most individuals in the market do the opposite: They assess risk based on what they think is probable, not on what is possible. The point about health and life hardly needs explanation. You probably will not be badly injured or die in the next week, month, or year. But your assessment of life’s risks tells you that such misfortunes are possible, which is why you are among the millions of people who have health and life insurance. What is more, your insurance policy is a contract that reduces monetary risk by stipulating how much money it will pay out. Alas, the point about investing does need an explanation, if the behavior of most market participants is any guide. By way of example, consider this brief conversation.
Q: Dude, I heard you just snagged 500 shares of XYZ Company. Did you do any kind of risk assessment?
A: Well, I assessed the risk, and I think this puppy’s going up. Have you looked at XYZ? It’s a serious winner.
Q: I know what everyone’s been saying, but hasn’t XYZ been going up for a long time? What are you gonna do if it starts heading down? It is possible …
A: C’mon man, “going up” is what got my attention. Hey, a small decline is possible, just before the big gains start up again. So you should really get in on it now.
Q: Yea, I hear you. Just one other thing: If XYZ does turn south, how far should you let it fall before you sell?
A: I haven’t EVEN thought about that. Look, here’s my broker’s card. At least email him. The address is on there. It’s okay to mention me.
Yes, this is a fictional conversation. Yet when it comes to performance chasing, crowd psychology, and hope, this exchange reflects the rule – not the exception. Markets are patterned because crowd behavior is patterned. The turns and trends are NOT random. The price patterns even offer measurements and ratios that define risk and reduce uncertainty.Link here.
IS COPPER POPPING ITS TOP?
A few months ago I had the gall to disagree with the resident metal heads about the direction of copper. They were long-term bullish every one, so, natch, I was bearish. My argument was pooh-poohed with several dismissive waves, which I interpreted as middle fingers sandwiched between superfluous digits – and why not? After all, what the hell do I know? My “expertise” is small-, micro-, and nano-cap equities, not commodities! But that is precisely the point: To paraphrase Socrates, I know one thing, and that is that I know nothing. Even with my so-called area of “expertise”, I always rely on research to guide my opinion, not opinion to guide my research. And when my small-cap research takes me, as it often does, into unfamiliar territory, that scientific approach – the idea that there is no such thing as knowledge in investing, that the best we can hope for is a preponderance of evidence, that theories are constructed to be destroyed, etc. – is imperative.
As is always the case, my bearish inclination toward copper – indeed most base metals (except for nickel and zinc) – was primarily a function of disdain for the consensus opinion. Momentum strategies work short-term, but over the long-term, investors are much better served by taking the road less traveled, which would not describe the present commodities environment. My earlier opinion vis à vis copper holds true months later.
Since then, the price of copper has added roughly 20 points, but warehouse levels have risen by three-fold as demand has fallen 2.1% year-over-year, while copper production has increased 5.1%. My suggestion was that the confluence of higher energy prices, slowing demand, and increased production would result in a copper surplus was met with derision, but just a few months later, copper market analysts are no longer asking if there will be a surplus but how much that surplus will be. Of course, the bigger message in all this is that we as investors always do well to at least question conventional wisdom – if not dismiss it entirely – because conventional wisdom is almost always wrong. That is something you can bank on – at least until it becomes conventional wisdom.Link here (scroll down to piece by Carl Waynberg).
I’m your wicked Uncle Ernie,
I’m glad you won’t see or hear me
As I fiddle about, fiddle about, fiddle about!
– Tommy, The Who (1969)
Interest rates are dialed by central banks worldwide into the black box that we call the global economy. The main vocation of central bankers is fiddling about with interest rates. You and I are trapped in this black box, for our lives exist in the real world, not in a conceptual intellectual exercise driven by interest rates. Central bankers have forgotten entirely about the real world. They are absorbed with their wizard-like mastery of both short-term and long- term rates.
It is commonly known in finance that short-term interest rates are sculpted through individual central banks setting their respective countries’ discount rates. Long-term rates too are under central bank management, but they moderated by global central bank cooperation. Both ends of the yield curve, long and short term, are under management to common global interests. Long rates are exposed to the risk of derivatives and follow-on failures of settlement. These rates are the beast, the dragon or chimera with which our central bank wizards are most concerned. The global economy – the economic black box we are talking about – works. But perhaps it only just sort of works, maybe, for now.
Nobody really knows how the black box works. It is commonly known, however, that as central banks fiddle about, jobs pop up in one place and disappear elsewhere, troops are deployed, oil gets pumped, people get fed, cars get built, and paper pushers everywhere falsely believe they are doing something productive. This fiddling allows China to sell labor. It enables Japan to extract profit on its domestic savings surplus. Fiddling about allows people in the U.S. to enjoy a wealth effect evidenced by relatively high per capita levels of consumption. Economic exchange systems are a question of who gets what.
Because of common interests, a tacit policy exists between central banks to cooperate in the matching of savings and debt. While the central bank of each country tries to manage the output of the global economic black box to further its own objectives, some of these objectives are common. Watch out when interests diverge. The present cooperation in the setting of long interest rates also keeps the various international flavors of paper currency in relative value bands to each other. The currency we carry around in our pockets, or digitized in a savings account, differs not from a treasury bond. Paper fiat money currency has many derivative forms, many flavors. Interest rate curves and fiat paper currency are synonymous.
Central bankers are so used to getting the desired result that they think they can control the global economic black box. They forget that the black box may not be understandable. By fiddling about, central bankers are trying to command the economy, such command being a failed technique used in the mismanagement of communist allocation systems. Command economies are always full of distortions because rigid control of an overly complex system can be nothing but an untenable exercise.
At the time of this writing, great distortions exist in the interest rate yield curve. Capital labor and asset flows are skewed to an artificial command model. The improper setting of yield has enabled asset bubbles to take hold. War has broken out – a sign that economic distortions are failing to reconcile and adjust naturally. The U.S. does not want to become poorer, China wants to retain political stability and job growth, and Japan wants continued access to Middle East oil. Whatever the U.S. central bankers decide, I fear that the black box of our global economy will yield unanticipated, unpredictable and unwelcome results.Link here.
CASTLES IN THE AIR
First, the Chinese have not given up their determined pursuit of scarce energy assets. Chinese National Petroleum Corp. – China’s biggest oil producer – succeeded in its $4.2 billion bid to buy Petro Kazakhstan. Petro Kazakhstan is a Canadian company, but most of its 150,000 barrels of production per day come from Kazakhstan, which is considerably closer to China than Canada. This is simply Round 2 of China securing energy reserves closer to its borders. The CNOOC bid for Unocal was first, and failed. But the Chinese strategy has not changed. The second, successful, bid is more evidence that the bull market in resources is being driven as much by national strategy as it is by economic scarcity. And in winning the bid, the Chinese beat out their Indian rivals on the subcontinent. It is bad news for India, because China has an additional $700 billion in currency reserves with which to conduct its global campaign for resource security.
While the Chinese patiently execute their strategy for economic competition with the U.S., I would be remiss if I did not note the joint military exercises conducted by China and Russia in August, dubbed “Peace Mission 2005”. Over 11,000 Russian and Chinese forces coordinated a mock invasion of a restive country. The exercises took place on eastern China’s Shandong Peninsula, which is well north of Taiwan. But make no mistake about the several messages being sent by both China and Russia. First and foremost is always Taiwan. One way of viewing the exercises with Russia is as a reminder that the communists in Beijing are willing to turn any domestic instability into an excuse to attack Taiwan.
However, I am sure the Chinese would prefer not to attack Taiwan militarily, at least not yet. And the Chinese would prefer to put diplomatic and economic pressure on the U.S., not spark a military conflict. China recognizes it is in a long-term, nonmilitary conflict with the U.S. for scarce economic resources. China has gone about securing resources through careful alliances and agreements. Of course, China also does a great deal of business with U.S. consumers. But in the long term, China sees the U.S., and perhaps rightly so, as its chief global economic rival. All of the actions of the Chinese government indicate this is the case, and that the government will do all it can to win this low-intensity economic war. While China takes the reality of peak oil production seriously, the second important news item from August shows that Americans are still behaving as if it were possible to get rich buying houses from one another. However, the news on the housing front was mixed.
A study by National City Corp. showed housing prices in at least 53 American cities were “extremely overvalued.” But let me just give you some insight from here on the ground in Superior, Colorado. My older brother and his wife live at the end of a cul-de-sac in a relatively new neighborhood that has grown up near the enormous FlatIron Crossing shopping center outside Denver. It is nearly a perfect example of the consumption economy at work. People buy expensive houses with low interest rates, cash out some equity, and head to the mall.
The only problem is house prices are not inevitably going up. A flier from a local real estate agent showed the list and final sale prices for a dozen new homes in the areas. Only two of the 12 homes sold for the original list price. The “Cabernet” and “Chardonnay” models seemed to fare the worst. One “Chardonnay” model, a four-bedroom, four-bathroom, 3,100-square-foot monster, originally listed at $525,000. Its final sale price was $397,500 – a hefty 24% discount to the list price. Still, nearly $400,000 for a home is not exactly cheap. Yet this is further evidence that the frothy mentality that has sent home prices to the boiling point may finally be cooling off.
In a low-interest rate-driven economy, rampant speculation, not patient wealth building, becomes the name of the game. As easy as the money came with low rates, I fear it will go away just as easily with high rates. All of which means that owning the right stocks – companies with durable competitive advantages and pricing power and good management – is more important than ever.Link here (scroll down to piece by Dan Denning).
CHINA LEARNS JAPAN’S PLAZA ACCORD LESSON
Exactly 20 years ago Japan volunteered to raise the value of the yen, touching off a sharp appreciation that fueled a boom and bust in asset prices that ushered in more than a decade of stagnation and deflation. China is determined not to make the same mistake. As Washington keeps up pressure on Beijing to let the yuan rise more quickly, Chinese policy makers are acutely aware of the lessons from the landmark meeting of finance ministers and central bank governors from the Group of Five industrial nations at New York’s Plaza Hotel on September 22, 1985.
Differences in income levels, technological progress and the government’s control over the economy and capital flows make the parallel between Japan then and China now a rough and ready one. But the similarities are striking. Then, as now, the U.S. administration was alarmed by a high and rising current account deficit that was destroying jobs and fanning protectionism. In 1985, Japan was in the dock because the U.S. Treasury thought its big trade surplus warranted a much stronger yen. In 2005, Washington is telling China its 2.1% revaluation on July 21 was a good start but that the yuan remains far too cheap.
Avinash Persaud, chairman of Intelligence Capital Ltd., believes China should firmly say no to a big rise in the yuan if the issue comes up at this week’s meeting in Washington of the Group of Seven rich nations plus five big emerging market economies. “Large revaluations of the Chinese currency could have a huge negative impact on China, could plunge China into a deflationary environment, could bring about the Japanification of China and will have no impact on global imbalances,” Persaud told a recent foreign-exchange conference in Shanghai. The fact that Japan’s current account surplus withstood a surge in the yen in the years following the Plaza Accord shows that the answer to global current account imbalances is to change savings and investment behavior, Persaud said. And surge the yen did …Link here.
S&P 500 HITS 4-YEAR HIGH, WHILE WAL-MART HITS 6-YEAR LOW
We heard all about it when the S&P 500 hit a four-year high this past July, and again when the index approached that same level earlier this month. But yesterday (Sept. 21), the company which accounts for nearly 10% of the entire retail sector saw its share price hit a 6-year low, and not only were there no banner headlines, I could not even spot a mention of it in the small print.
I am talking of course about Wal-Mart shares. Prices recently broke beneath a multi-year trading range, down into a region last seen back in 1999. This major low in a very big stock – and the virtual news silence about it – may remind you of a couple of other “non-stories” I have recently mentioned, about another behemoth enterprise: Fannie Mae. In fact, when it comes to size and weight, Fannie’s importance to the housing industry is even greater than that of Wal-Mart’s to retailing. And if you are wondering about the latest unreported news regarding Fannie Mae, it is that share prices this week hit an 8-year low.
The next question is, what does the trend in these two giants say about their respective sectors, and the economy overall?Link here.
INSURANCE CARRIERS REEL FROM WAVE OF DISASTERS
With powerful Hurricane Rita churning its way toward landfall, the insurance industry is bracing for yet another major financial hit in a year that suddenly has become the worst ever for catastrophic losses. The well-capitalized industry has plenty of assets to pay out the projected billions of dollars in damage claims and is expected to come through the hurricane season largely intact, although reinsurance premiums appear likely to rise and a few smaller, mostly regional carriers might struggle to survive.
But the appearance of another menacing hurricane so soon after Katrina underscores the fact that insurers are facing a new cycle of increasingly large, frequent and costly disasters. “We don’t know the exact cause or reason, but it’s certainly clear when you look at the worst-ever catastrophic event, which it looks like Katrina will be, we’re in a different world, and it’s a much more risky world for catastrophic events,” said Kurt Karl, chief economist for Swiss Re, the giant reinsurer.
The terrorist attacks of Sept. 11, 2001, introduced a new level of man-made risk for insurance companies, and then came last year’s wave of four hurricanes that swept through Florida and other southeastern states, which caused massive property losses. Even before the impact of Rita the devastation left by Katrina means that since the turn of the century the nation’s property and casualty insurers have experienced three of their four worst years on record, each with more than $27 billion in losses from major disasters. That compares with an average of $8 billion a year in disaster-related claims in the relatively quiescent period of 1995-2000.
“The question of whether this is a trend or an anomaly is one that is not yet answered,” said Pennsylvania Insurance Commissioner Diane Koken. “A one-year or two-year impact in the insurance world does not a trend make. It has to be something that continues over a much longer period of time.” But while damage claims have been outsized over the past several years, man-made and natural catastrophes have been occurring around the world more frequently – and with greater severity – since about the mid-1980s, said Karl.
The reasons are not completely understood, although the insurance industry clearly is facing greater exposure especially in the U.S. because of growing affluence, population and property development along the nation’s coasts, where property is most exposed to the risks of hurricanes and earthquakes.Link here.
Rita is coming ... but what did stocks do during Katrina?
Another grim weather story dominated the news today. In turn, given that the Dow Industrials were down more than 100 points, lead sentences like this one were inevitable: “Stocks slid for the third straight day Wednesday as Hurricane Rita, which was upgraded to a Category 5 storm, moved into the Gulf of Mexico and crude-oil prices jumped higher.”
Now, I for one pray that every living soul gets out of the storm’s path. But on this page we talk about financial markets. People whose short-term memory is 3rd grade level or above (which will exclude most of the financial press) do not need to see the chart below, yet I cannot resist. It shows the S&P 500 and CBOE Oil Index both trending higher from August 26 through September 9. If “oil moves stocks”, then this chart shows higher oil means higher stocks. And by the way, this period also includes the day Katrina came ashore, plus the week that followed, when it became dreadfully obvious that the damage was catastrophic – estimates of 10,000 fatalities were frequently repeated in major news outlets. Remember?
What would you think if I made a straight-faced argument that Hurricane Katrina’s landfall made the stock market go higher? Yet with this same logic, the media would have investors believe that Hurricane Rita “explains” today’s decline in the stock market.Link here.
SAUDI LEADER REJECTS OIL SHORTAGE IDEA, SAYS PRICES SHOULD DROP TO $40-45
Saudi Arabia’s foreign minister rejected suggestions of an oil shortage and said prices should drop to $40 to $45 a barrel from well over $60. “The oil industry does not suffer from a lack of oil,” Prince Saud al-Faisal said in an interview with the Associated Press. He cited a lack of refineries in the U.S. “We are adding barrels of oil on the market,” Saud said. “The price of oil will go down.”
Many energy analysts say two forces are behind a global market where oil prices soar if anything unusual happens: tight supply with little excess production capacity and growing demand, especially in China. Oil prices climbed as a result of disruptions in the Gulf Coast caused by Hurricane Katrina; further problems could come from Hurricane Rita this weekend. Saud, in the interview, predicted prices would decline significantly by next summer. OPEC once viewed a price range of $20 to $28 a barrel as its goal to maintain revenue and global economic stability.Link here.
CREDIT CARD COMPANIES TO INCREASE MINIMUM PAYMENTS
Consumers who make only minimum payments on their credit cards are in for a shock. Spurred by a new federal mandate, card companies over the next three months plan to raise – in some cases double – the amount card holders must pay each month. A consumer carrying a $10,000 balance may see a minimum payment jump from $200 to $400.
The new minimums are designed to prevent consumers from being hobbled for decades by credit card debt. An estimated one-third to one-half of American families carry credit card debt, with many making only minimum payments. “Many credit card borrowers don’t realize that if they just pay the minimum monthly payment, they may never pay off their card,” said Mike Peterson, vice president of the Salt Lake City-based credit counseling group, American Credit Foundation. It would take a consumer making only the minimum monthly payment nearly 30 years to pay off a $2,000 credit card balance at 18% interest. Total interest payments over that period would be about $5,000, Peterson said. Increasing the monthly payment from 2% to 4% of the outstanding balance will require only 10 years and $1,100 in financing costs to pay off the same amount.
“This is a positive for consumers,” Peterson said. “They won’t be able to carry as much debt and they will get out of debt faster.” While long-term benefits of the change are clear, Peterson and others worry about how families will react in the short term. Increased payments certainly will catch most families by surprise. And short-term costs may be more than many low to moderate-income families can bear, said Glenn Bailey, executive director of Crossroads Urban Center, a low-income advocacy group in Salt Lake City.Link here.
DERIVATIVES: POPULAR, RISKY, SCRUTINIZED
Credit derivatives, complex investments based on the value of corporate bonds, have soared in popularity on Wall Street, sparking regulators to step up their scrutiny of this rapidly growing marketplace. Derivatives are investments that derive their value from something else, such as stock options that trade based on the price of an underlying stock. Credit derivatives are bought by investors as protection against a possible default on an underlying bond. One of the most common credit derivatives, a credit default swap, calls for the seller to pay if the underlying bonds get downgraded or if the issuer defaults. The swaps are akin to insurance for investors, and supporters say they help spread and manage risk.
The credit derivatives market overall was worth about $8.4 trillion last year, and has roughly doubled in each of the last three years, according to the International Swaps and Derivatives Association, an industry group. Helping to fuel the rapid growth: hedge funds that specialize in bonds that have become big players in the derivatives space. The way that a hedge fund can profit is by selling credit default swaps to a bank, for example. If the underlying bonds go into default, the hedge fund covers the bank’s losses. But if there is no default, the hedge fund profits.
Regulators want to ward off trouble in the rapidly growing market by making sure the sellers of these contracts are stable and have sufficient funds to meet their obligations. “Risk transfer through derivatives is effective only if the parties to whom risk is transferred can perform their contractual obligations,” Federal Reserve Chairman Alan Greenspan said in a speech last spring. “These parties include both derivatives dealers that act as intermediaries in these markets and hedge funds and other nonbank financial entities that increasingly are the ultimate bearers of risk.”
Greenspan also acknowledged the benefits of derivatives, noting their risk-management features were “key factors underpinning the greater resilience of our largest financial institutions.” But regulators have also raised concerns. Last week, the Federal Reserve Board of New York met with several Wall Street firms to discuss its worries that the contracts are not being processed in a timely way, the Fed announced. The regulators worry that a series of big corporate defaults, while unlikely, could nevertheless pose substantial risks to financial markets – with ripple effects on interest rates and the broader economy. When General Motors and Ford debt first got cut to junk status last spring, many hedge funds and proprietary trading desks at banks reportedly lost hundreds of millions of dollars.
Tanya Azarchs, a managing director in the financial institutions ratings practice at Standard and Poor’s, noted several concerns about the rapid growth in derivatives. First, many hedge funds and other investors move so quickly that a big default or downgrade could trigger simultaneous sell signals, causing everyone to head for the exits at once. Another problem is with how trades are settled, Azarchs said, adding it was troubling to see that back-office operations of many players in credit derivatives markets were in disarray. Lastly, if trades do not get processed accurately after a default or series of defaults, there could be flood of lawsuits that can become “really messy and difficult for the court system” if the paperwork is in disarray, she said.Link here.
HEDGE FUND-RUN BROKERAGES, A LA BAYOU MANAGEMENT, NO RARITY
It is a bit late in the game for the wealthy investors allegedly fleeced by Bayou Management, but securities regulators have moved to shut down the scandal-tarred hedge fund’s affiliated brokerage firm. On Sept. 8, two weeks after news broke about the alleged $300 million fraud at the Connecticut hedge fund, the NASD suspended Bayou Securities’ membership for failing to pay an undisclosed sum to a former employee who filed a 2004 arbitration claim against the small brokerage.
From a practical standpoint, the suspension means little to Bayou’s 100 or so investors. The hedge fund and brokerage essentially ceased operating in July, when manager Samuel Israel III suddenly announced he was closing down the seven-year-old fund. Investors have yet to get their money back. But in the wake of the fraud allegations, some critics claim Bayou’s reliance on an in-house brokerage to process its trades should have been an obvious red flag to investors about the potential for abuse. In particular, there was the $16,000 in regulatory fines the brokerage paid for infractions ranging from failure to keep records of customer complaints to permitting unregistered individuals to make trades.
The trouble is, in the $1 trillion hedge fund world, it is more common than investors think for a hedge fund to maintain its own brokerage. And the payment of fines for regulatory sins is not that rare, either. In fact, some of the biggest hedge funds in the nation have affiliated brokerages through which they either execute trades, or borrow and lend stock in order to finance their activities. One of those is the $12 billion Citadel Investment Group, one of the world’s largest hedge funds. The brokerage arm of Ramius, a $7.5 billion hedge fund complex, has paid $85,000 in fines since 2001. One of the fines imposed on Ramius Securities included a 10-day suspension from trading in certain securities.
There is no doubt that an in-house brokerage arm at a hedge fund can be abused. The most obvious danger is self-dealing, where a hedge fund manager might drive up commission costs through random trading and pocket the money. Bayou’s managers recognized the potential for this abuse and even warned investors of the potential conflict of interest in its marketing materials. In retrospect, Bayou’s managers should have gone a step further and simply admitted that is what they planned to do.
But some say there is legitimate reasons for hedge funds to maintain their own brokerages. If used properly, an in-house brokerage can reduce trading costs. It also can be used to lower a hedge fund’s borrowing costs by striking its own stock lending deals with other financial institutions.Link here.
BIG CASH, SMALL GROWTH, STOCK BUYBACKS?
Stock analysts and economists have talked all year about corporate America’s “strong earnings”, most of the time to argue that, in turn, stocks will go higher. Though the notion that “earnings drive stocks” is complete fiction, it is true that corporate profits and cash flow have been healthy this year. S&P 500 companies have amassed more than $634 billion in cash so far for 2005 – that is a 54% increase over the past two years, and a 92% increase from five years ago. Yet, have you noticed what the talking heads have not talked about when it comes to earnings – namely, what corporations are actually doing with the money?
The economic data makes what they are not doing clear enough. From Q3 of 2001 through Q1 of 2005, after-tax corporate profits surged by more than 80%, yet business investment increased only by about 15%. They are not aggressively hiring, increasing wages, or adding to their productive capacity. Which is to say, the business sector overall reflects none of the rapid growth that characterized this stage of previous economic recovery/expansions.
Still, the earnings are going somewhere, and indeed in a very large way: More than half of the S&P 500 companies announced stock buyback plans in the first half of 2005, to the tune of $126 billion. This is 76% more companies than did so over the same period in 2004. What does it mean?
Well, in an economic environment where the usual choices appear too risky, perhaps corporate stock buybacks appear less so. No doubt many decision-makers suppose that, if demand stays constant, reducing the “supply” of stocks will help bump prices higher. Hmmm … nice logic in Economics 101, except today’s stock market is not a textbook. In truth, nearly all traditional valuation measures show that the market remains historically overvalued. So irony of ironies, if the stock market does what it has always done when it is this far overpriced, what seemed like a conservative means of spending corporate earnings will prove to be most reckless and risky course of all.Link here.
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