Saturday, August 11, 2007
Friday, August 10, 2007
We're not down in the double digits of percentage return this week, or this month. We hold large-cap, S&P500 equities, and call options thereon.
We don't sell calls. We don't sell puts. We don't buy or sell on margin. We don't try to hedge different instruments, in hopes of taking advantage of relationships which are, in general, predictable, but perhaps not so during times of financial uncertainty. We buy no bundles of mixed securities, such as mortgage CDOs, or other CDOs, nor do we buy or sell them in pairs, to hedge their returns.
A few weeks ago, as I spent several days with my daughters at a well-known amusement park in the next state, I mused about how my behavior at that park was rather like the investment behaviors my partner and I evince in the equity markets.
Since we only deal in listed US equities, or call options for them, that means we eschew some very unpredictable instruments which lend themselves to pricing and demand irregularities with frightening frequency.
Similarly, I don't take my children to just any amusement park. Some are rather lax in their admissions security checks and general behavior requirements. Others are less well-known, and subject to my concerns about the safety of some of their rides.
For instance, my daughters and I love to ride roller coasters. We are addicted. Thus, we've spent at least a few days during each of the last few summers at Hershey Park. As I am being rocketed around one of the older, more exciting wooden coasters, I regularly consider how little would be left of all of us if the cars left the track. You basically have no chance of survival whatsoever. None.
Thus, while I engage in the, to some, risky behavior of riding roller coasters, I only do it at a park where I trust the management to operate totally safe roller coaster rides. I never worry about boarding any ride at Hershey. Between the park's long reputation for cleanliness and safety, and the related food operations of the parent, I am confident the company's management of the park brooks absolutely no lapses which could lead to any fatalities or serious injuries on the rides.
Each year, there's a story about someone dying while riding and, falling out of or from, some ride at some amusement park somewhere in the US. But never Hershey.
The lesson I draw from my amusement park behavior, and apply to my investment behavior, is that it is important to set hierarchical, conditional criteria for risk.
We don't invest in instruments other than large-cap, US equities, and the purchase of options thereon (calls in markets expected to remain strong, puts in markets expected to remain weak).
Having set that initial criterion, we remain invested through market turmoil such as these past few weeks. My partner and I monitor the conditions that affect the companies whose equities we may purchase, but we don't worry unnecessarily about the trouble other investors create for themselves through injudicious trading and investing in various esoteric instruments.
That is very germane to this week's market activity. Although some extremists, such as Jim Cramer or Gary Shilling, believe there is a global liquidity and capital contraction which is of systemic proportions, I do not share that view.
Global economic growth and corporate activity remain healthy and robust. Profits are up. Most financial instruments- equities, corporate debt, Treasuries- are in good shape.
The genesis of the current financial volatility and perceived liquidity problems lie primarily with those parties who have chosen to buy, hold, and/or depend upon other parties with positions in relatively high risk instruments involving sub-prime residential US mortgages.
Just a week ago, James Cayne, Chairman of Bear Stearns, got the denial ball rolling by alleging that this is the 'worst debt market in twenty years.'
Only if you happen to dabble significantly in the riskiest, least creditworthy, shallow and illiquid parts of it. Which Bear did.
By Tuesday of this week, other scorched trading and portfolio players, also guilty of expecting constant profit from sub-prime debt, echoed Cayne's claim that the market was unraveling, and, therefore, they had not done anything extreme, greedy or unwise. They were merely victims of a bad market.
Someone would have to fix that bad market. Oh, yes, and, in the process, bail out those who chose to play with that brand of fire labelled 'sub-prime.'
As the French swung into action yesterday, with Paribas' idiotic suspension of redemptions in several of its sub-prime-related funds, and the EuroBank loudly announced its provision of liquidity to their markets, the panic began. Cayne, Cramer & Co. had accomplished their objectives, by causing sufficient uncertainty that counterparties to known holders of sub-prime-related issues stampeded out of positions.
As my partner has pointed out, the actual expected loss on sub-prime mortgages, were they simply to be written off, is far, far less than the total amount of market value destruction seen over the past week in the global financial markets.
Over very, very short periods of time, like the past few weeks, the mass of mediocre, poorly-informed and -reasoning investors, analysts, money managers and pundits can cause temporary market behaviors to depart radically from what more reasoned, informed market participants believe is warranted.
As such, as we have seen recently, volatility can soar, and assets can appear to lose even their intrinsic values. But this is a purely short term effect when there is no serious, structural economic problem underpinning the behavior.
Right now, being in US large-cap equities and options has insulated our portfolio from egregiously magnified losses of those experienced in the S&P500. We still have risk exposure, but we feel it is far, far less than that of investors who have engaged in complex, hedged positions which rely on modeled behavior of prices for esoteric, thinly-traded debt instruments.
Thursday, August 09, 2007
"Over the time period stretching from mid-2003 to mid-2006, my selection process had selected companies in these sectors which returned a total of 4.8%. By July of last year, however, the process had rinsed mortgage lending and homebuilding out of the portfolio."
Further reading of the Journal article reveals that these guys simply couldn't accept slowing growth. So, they did what financial executives nearly always do in a slowing market- they cut standards and stoked higher-risk growth. Hand in hand with the mortgage banking industry, the homebuilding executives thought that that, as so many before them, could repeal the laws of Schumpeterian dynamics, and continue to grow their revenues and unit volume forever. Soon, these companies began to resume practices they swore off some years ago, including buying large amounts of land, instead of optioning it, as they claimed they had, prudently, now learned to do.
Wednesday, August 08, 2007
It's important to note how such large compensation packages affect the behavior of management at such a firm. Neither Cayne, nor Spector, was going to go homeless if whatever their equity interest in the firm became worthless. Even the lack of many more years of such compensation isn't exactly becoming poor.
So, if anyone thinks that financial consequences would ever figure in supplying some sense of risk awareness and prudence to either Cayne or Spector, think again. Folks at that level are motivated more by power and prestige than by money. The former are provided by others, as a function of staying in power, while the latter becomes a non-motivator pretty quickly at those sums.
Thus, we find both Cayne and Spector, laughably, attending a bridge tournament during a key week in July, when the fortunes of their firm were souring. You cannot make this stuff up.
It's debatable whether Spector, or anyone else, can do much about Bear's position. Let me make some conjectures.
First, the problems stem from rather exotic debt instruments which are not always traded. See this post , from yesterday, for some more details on how this works. Perhaps some forms of credit derivatives are also involved.
How do you price instruments which are either seldom traded, individually tailored, over the counter, and/or based upon exotics? Well, without much confidence is the answer.
As a one-time partner of mine, B, who built a well-known Street mortgage business, used to tell me,
"A model can tell me what something was worth yesterday, or may be worth tomorrow. But the only way I know what it is worth today is to take a piece and offer it, and see what the bid is."
Just so. And very scary, since if the bid is much lower than the carried value by the firm, the difference in value must be marked down.
Now, if these instruments were hedged, with credible counterparties, then one reasons that the damage would be contained, right? For limiting upside profit, a downside loss could be minimized.
What do you want to bet very few of Bear's positions were hedged? Because, after all, limiting profits limits bonus pools and, therefore bonuses. And who wants that? The firm pays out bonuses from those profits. It never allocates the losses to the traders.
With such a handsome asymmetric payoff matrix, why would the traders or their managers hedge much of the risk? Besides, the models probably assumed they could simply sell problem instruments when needed, per my earlier post.
So, it's not hard to imagine Bear having held, unknown to the senior managers who didn't really want to, or know how to, ask many piercing questions, that, in mutual funds and/or on proprietary trading desks, there has been substantial, unhedged exposure to some thinly-traded, esoteric debt.
That Cayne would so callously and dangerously declare the current debt markets to be the 'worst in 20 years,' is a measure of the depth of Bear's desperation and situation. By attempting to make the system and market the problem, he hopes to deflect observers from the truth- that Bear got into this mess on its own.
Fortunately, quite a few pundits, and Ben Bernanke, have vocally disagreed with Cayne's view, since his over the top comments in last week's conference call.
As Herb Greenberg, of Marketwatch, noted, this is one case where the retail investor dodged the bullet, because the class of instrument which has disintegrated is too complex and inaccessible for most of them. The institutions which have been brought down or damaged- mortgage companies, fund managers, brokerages- all knew what they were doing.
Typically, every decade has its financial debacle. It usually features young, inexperienced traders and risk managers who believe they have everything under control. More senior managers, with prior experience during financial market meltdowns or major problems, are typically further from detailed knowledge of the risk management and positions, and better insulated, financially, from damage, should the firm go under.
Bear's senior executives, Cayne and Spector, deserve to lose their jobs. Bear, as a firm, probably deserves to be bought or acquired by a better firm. In the final analysis, the company finally seems to have run afoul of its buccaneering attitude and less-than-adequate risk management, losing
Tuesday, August 07, 2007
Here we are, amidst a turbulent credit market that is spooking the equity markets. There's a tension between bailing out institutions that made bad decisions in credit markets, and holding the lid on inflation.
So, who does CNBC have on their Fed watch segment? John Rutledge? Larry Kudlow? Mike Holland? Any of the former Fed Governors who appear from time to time?
They have the Marx Brothers of finance- Jim(my) Cramer, Steve Leisman, and Ron Insana.
Cramer is, as I wrote here recently, an unabashed shill for his trading desk friends on the Street. Leisman is the networks uncredentialed, nonsensical, self-impressed 'senior economics reporter.' He is regularly bested by their Chicago on-air correspondent, the excitable but wise Rick Santelli.
Finally, we have Ron Insana. A former CNBC correspondent and anchor of no particular talent who managed to lose at least one prime-time afternoon slot due to his lack of presence and knowledge. Now, we are told, he is a guest commentator, and managing partner of Insana Capital Partners.
Oh. How impressive.
Does anybody else but CNBC know this guy at all?
So, for one of the most anticipated Fed meetings in memory, we have three clowns moderated by the earnest, but underappreciated Erin Burnett. More farce than analysis or sense.
For Murdoch, constructing a network to put CNBC out of business should be like shooting fish in a barrel.
Recruit the better anchors away- Kernen, Quick, and Burnett. Use the Wall Street Journal to fuel content. And add distinguished guest commentators, making sure they are available for breaking news events, like today.
Simple enough. And it should help send GE's stock further down under Immelt's lackluster stewardship, as even the media group loses yet another opportunity.
"When is a market not a market?"
There are two fundamental assumptions which, when they fail, effectively turn a market into something that is not a market- and does not function like a market. Those two assumptions are: that buyers and sellers always exist for each other, and that pricing is continuous.
These failed in 1987, according to a then-friend of mine who was a very successful asset manager at a major firm. They failed three times in early 1987, on the way up, when the market was peaking, and fills took place at prices higher than those thought to be the execution price. As he wryly noted, nobody complained at that time.
Then, in October of that year, they failed again, this time on the way down. Way down.
People traded, not knowing for days what the actual price at which they sold was. And prices didn't move in small increments, as specialists deserted their functions.
Prices skipped downward, discontinuously.
Further, in panics, markets fail in terms of liquidity. There are not buyers and sellers present to 'make' the market. Again, specialists in equities step back. And in debt markets, bids simply vanish.
The whiz kids of today don't recall LTCM in 1998, much less the crash of 1987. They do not realize that, in a crisis, a panic, the "market," as we conceive of it, vanishes.
Bids fail to materialize. Prices do not move continuously, especially for esoteric, non-listed instruments.
This is, in my opinion, key. So much of the trouble invariably begins with thinly-traded instruments and/or derivatives thereof. One-off CMOs, CDOs, their derivatives, derivatives based upon some proprietary index.
It seems that many trading desks, risk managers, and hedge fund managers either were unaware of, or forgot these phenomena. When markets stop being markets, and become something else, all hell has effectively broken loose in the OTC market where so many esoterics trade, as well as in the more thinly traded listed instruments.
Happy to book profits on originating, distributing and/or trading these esoterics, Wall Street firms suddenly realize how risky they can be at times of lessened liquidity.
In my opinion, this is where a number of interacting phenomena combine to cause major problems.
Few traders remain traders into their forties. Thus, most on a desk at any given time may have no more than ten years' experience. Risk managers are likely similar. Promotions for both tend to lead them off the floor, into senior management, or into other firms, perhaps at hedge funds.
Thus, with each new crisis, the frontline troops are largely untested, and the experienced managers are slower to see the new problem unfold, and are often unfamiliar with the details of the source of the latest debacle. Thus, when all is well on the way 'up,' managers don't think to ask or check that a desk trading mortgage CDOs is in a position to be passively hedged, in the event of a meltdown, so that losses are minimized without the need to trade through non-market periods in which bids vanish or skip around.
Besides, hedging limits profits. Who wants that? It puts a lid on bonuses, doesn't it?
And there you have your new financial instrument crisis. The new whiz kid traders, risk and fund managers think they have it all controlled via quantitative programs. But they fail to account for the inability to even trade a portfolio during the time when asset values are plummeting, if there is a recent market value at all.
And this is, in my opinion, how and why we repeat these types of instrument-based financial market failures every decade. It simply doesn't pay for the adults to bother building in safeguards because, as the Wall Street Journal noted in an article lately, bonuses are short term, but the risks held in portfolio are longer term.
When individuals are paid upwards of $3-4MM annually, the loss of net worth due to the decline of their firm's stock's value is a lot less painful than most people realize. Coming atop a cushion of tens of millions of past compensation, it simply isn't a sufficient incentive to curb current excesses- ever.
Monday, August 06, 2007
There really isn't all that much to say about the move. Oh, there are the obvious aspects.
Having drawn the ire of many shareholders through his overpaid failure to earn respectable returns at Home Depot, being CEO for a small group of private owners removes that problem this time.
But looking more deeply, one wonders why Cerebrus would choose a cost-cutter to save a firm whose major problem is developing, building and selling cars people will actually pay list to buy. Plus, they've given the sack to at least one Chrysler executive, and a former Cerebrus advisor on automotive units.
Since I don't believe Cerebrus made a good deal buying Chrysler to begin with, putting Nardelli in charge simply adds to my scepticism about this situation.
Many people, including some pundits, believe that, as the Wall Street Journal cited today, Ford's Alan Mullaly and, now, Chrysler's Nardelli will, together, bring a radical new perspective to union negotiations, and magically eliminate the two firms' cost disadvantages relative to firms like Toyota.
Let's just say, I remain to be convinced that; a) this will happen, and b) it will matter in the long run.
Yes, it's "risk week." I will be writing posts about various aspects of the recent activities in the debt and equity markets, and risk, and its management.
To begin my posts, I want to discuss Jim Cramer's outrageous comments last week on CNBC while speaking one afternoon (Thursday?) with Erin Burnett.
He set himself up as a sort of God of the markets, claiming various Wall Street trading desk personnel were beseeching him to tell Ben Bernanke how bad the credit situation is. Cramer alleged that these traders told him,
'You're the only one they'll listen to. You can get through to them....'
Nice try, Jim. But you're just a shill for your trading desk and hedge fund friends. They are using you the same way you used to use CNBC and The Wall Street Journal when you managed a hedge fund, as you have admitted.
What is going on now is not a general credit market meltdown. And in no way is it remotely as bad as Bear Stearns Chairman, Jim Cayne, alleged, saying it is the worst credit market in 20 years.
All that is happening is that some investment banks and hedge funds have made poor risk management and investment decisions. They hold more sub-prime mortgage paper than is prudent, if holding any at all is, at this point. These institutions would love to have the market bail them out. Rather than admit they have made costly mistakes, they would prefer that others believe, instead, that the credit markets are in crisis.
Thus, as Cramer was shilling the other day, Ben Bernanke must cut rates. Damn inflation, let's rescue some overpaid, underperforming traders and fund managers!
There is no crisis. What there is, is a case of some greedy, opportunistic, short-sighted managers at some firms being caught with heavy losses on bad investments.
It pains me to see CNBC allow Cramer to openly shill for his friends, and other industry insiders. At least this morning, several commentators directly contradicted Cramer, though not naming him specifically. They simply reiterated my position, that this is not a credit market crisis, it's a problem for some firms.
What most people fail to grasp is that these traders and fund managers will do anything to escape the losses they now face for injudicious decisions. If crying "fire" in a market, and getting others to stampede and believe the market is in crisis, so be it. So long as it leads to the Fed cutting rates, pushing debt prices up, then these traders and hedge fund managers will be relieved of some of their losses. And can rapidly dump their trash onto the market before others catch on.
The truth is, credit market problems primarily lie with a sub-species of the collateralized mortgage obligations market. Not corporate debt, or Treasuries. Not equities. It's a weakness confined to those players who knowingly bought sub-prime mortgages, or sub-prime-based paper, knowing the greater risk these mortgages bore.
I don't think it merits a general hand-wringing over the credit, or equity markets. And it certainly does not merit Jim Cramer anointing himself God of the market, and imploring Ben Bernanke to quit doing his job as Fed Chairman, and just loosen the monetary spigots to bail out some overpaid Wall Street traders, fund and risk managers.
Tomorrow: when a market is not a market, and why that surprised this generation's risk management whiz kids on Wall Street.