Wednesday, April 29, 2009

Robert Arnott: Bonds: Why Bother?

Here is the conclusion of the popular article from Index Universe "Bonds: Why Bother?" written by Robert Arnott and published on April 20, 2009:

We manage assets in an equity-centric world. In the pages of the Wall Street Journal, Financial Times and other financial presses, we see endless comparisons of the best equity funds, value funds, growth funds, large-cap funds, mid-cap funds, small-cap funds, international equity funds, sector funds, international regional funds and so forth. Balanced funds get some grudging acknowledgment. Bond funds are treated almost as the dull cousin, hidden in the attic.

This is no indictment of the financial press. They deliver the information that their readers demand, and bonds are—at first blush—less interesting. The same holds true for 401(k) offerings, which are overwhelmingly equity-centric. If 80–90 percent of the offerings provided to our employees are equity market strategies, is it any surprise that 80–90 percent of their assets are invested in stocks? And is it any surprise that they now feel angry and misled?

Many cherished myths drive our industry’s equity-centric worldview. The events of 2008 are shining a spotlight, for professionals and retail investors alike, on the folly of relying on false dogma.

* For the long-term investor, stocks are supposed to add 5 percent per year over bonds. They don’t. Indeed, for 10 years, 20 years, even 40 years, ordinary long-term Treasury bonds have outpaced the broad stock market.
* For the long-term investor, stock markets are supposed to give us steady gains, interrupted by periodic bear markets and occasional jolts like 1987 or 2008. The opposite—long periods of disappointment, interrupted by some wonderful gains—appears to be more accurate.
* For the long-term investor, mainstream bonds are supposed to reduce our risk and provide useful diversification, which can improve our long-term risk-adjusted returns. While they clearly reduce our risk, there are far more powerful ways to achieve true diversification—and many of them are out-of-mainstream segments of the bond market.
* Capitalization weighting is supposed to be the best way to construct a portfolio, whether for stocks or for bonds. The historical evidence is pretty solidly to the contrary.

As investors become increasingly aware that the conventional wisdom of modern investing is largely myth and urban legend, there will be growing demand for new ideas, and for more choices.

Why are there so many equity market mutual funds, diving into the smallest niche of the world’s stock markets, and so few specialty bond products, commodity products or other alternative market products? Today, investors are still reeling from the devastation of 2008, and the bleak equity results of this entire decade. They have already begun to notice that there were opportunities to earn gains, sometimes handsome gains, in a whole panoply of markets in the past decade—most of which are still difficult for the retail investor to access.

We’re in the early stages of a revolution in the index community, now fast extending into the bond arena. In the pages of this special issue of the Journal of Indexes, we see several elements of that revolution. In the months and years ahead, we will see the division between active and passive management become ever more blurred. We will see the introduction of innovative new products. The spectrum of bond and alternative product for the retail investor will quickly expand. We will shake off our overreliance on dogma. And our industry will be healthier for it.

Read full article

Post Factum... Jim Chanos: "We Need Honest Accounting"

As you know, the FASB approved relaxation of Mark-to-Market accounting rules despite protesting voices. But those voices must be remembered. Publishing post factum Jim Chanos arguments.

We Need Honest Accounting
Relax regulatory capital rules if need be, but don't let banks hide the truth.


Mark-to-market (MTM) accounting is under fierce attack by bank CEOs and others who are pressing Congress to suspend, if not repeal, the rules they blame for the current financial crisis. Yet their pleas to bubble-wrap financial statements run counter to increased calls for greater financial-market transparency and ongoing efforts to restore investor trust.

We have a sorry history of the banking industry driving statutory and regulatory changes. Now banks want accounting fixes to mask their recklessness. Meanwhile, there has been no acknowledgment of culpability in what top management in these financial institutions did -- despite warnings -- to help bring about the crisis. Theirs is a record of lax risk management, flawed models, reckless lending, and excessively leveraged investment strategies. In the worst instances, they acted with moral indifference, knowing that what they were doing was flawed, but still willing to pocket the fees and accompanying bonuses.

MTM accounting isn't perfect, but it does provide a compass for investors to figure out what an asset would be worth in today's market if it were sold in an orderly fashion to a willing buyer. Before MTM took effect, the Financial Accounting Standards Board (FASB) produced much evidence to show that valuing financial instruments and other difficult-to-price assets by "historical" costs, or "mark to management," was folly.

The rules now under attack are neither as significant nor as inflexible as critics charge. MTM is generally limited to investments held for trading purposes, and to certain derivatives. For many financial institutions, these investments represent a minority of their total investment portfolio. A recent study by Bloomberg columnist David Reilly of the 12 largest banks in the KBW Bank Index shows that only 29% of the $8.46 trillion in assets are at MTM prices. In General Electric's case, the portion is just 2%.

Why is that so? Most bank assets are in loans, which are held at their original cost using amortization rules, minus a reserve that banks must set aside as a safety cushion for potential future losses.

MTM rules also give banks a choice. MTM accounting is not required for securities held to maturity, but you need to demonstrate a "positive intent and ability" that you will do so. Further, an SEC 2008 report found that "over 90% of investments marked-to-market are valued based on observable inputs."

Financial institutions had no problem in using MTM to benefit from the drop in prices of their own notes and bonds, since the rule also applies to liabilities. And when the value of the securitized loans they held was soaring, they eagerly embraced MTM. Once committed to that accounting discipline, though, they were obligated to continue doing so for the duration of their holding of securities they've marked to market. And one wonders if they are as equally willing to forego MTM for valuing the same illiquid securities in client accounts for margin loans as they are for their proprietary trading accounts?

But these facts haven't stopped the charge forward on Capitol Hill. At a recent hearing, bankers said that MTM forced them to price securities well below their real valuation, making it difficult to purge toxic assets from their books at anything but fire-sale prices. They also justified their attack with claims that loans, mortgages and other securities are now safe or close to safe, ignoring mounting evidence that losses are growing across a greater swath of credit. This makes the timing of the anti-MTM lobbying appear even more suspect. And not all financial firms are calling for loosening MTM standards; Goldman Sachs and others who are standing firm on this issue should be applauded.

According to J.P. Morgan, approximately $450 billion of collateralized debt obligations (CDOs) of asset-backed securities were issued from late 2005 to mid-2007. Of that amount, roughly $305 billion is now in a formal state of default and $102 billion of this amount has already been liquidated. The latest monthly mortgage reports from investment banks are equally sobering. It is no surprise, then, that the largest underwriters of mortgages and CDOs have been decimated.

Commercial banking regulations generally do not require banks to sell assets to meet capital requirements just because market values decline. But if "impairment" charges under MTM do push banks below regulatory capital requirements and limit their ability to lend when they can't raise more capital, then the solution is to grant temporary regulatory capital "relief," which is itself an arbitrary number.

There is a connection between efforts over the past 12 years to reduce regulatory oversight, weaken capital requirements, and silence the financial detectives who uncovered such scandals as Lehman and Enron. The assault against MTM is just the latest chapter.

Instead of acknowledging mistakes, we are told this is a "once in 100 years" anomaly with the market not functioning correctly. It isn't lost on investors that the MTM criticisms come, too, as private equity firms must now report the value of their investments. The truth is the market is functioning correctly. It's just that MTM critics don't like the prices that investors are willing to pay.

The FASB and Securities and Exchange Commission (SEC) must stand firm in their respective efforts to ensure that investors get a true sense of the losses facing banks and investment firms. To be sure, we should work to make MTM accounting more precise, following, for example, the counsel of the President's Working Group on Financial Markets and the SEC's December 2008 recommendations for achieving greater clarity in valuation approaches.

Unfortunately, the FASB proposal on March 16 represents capitulation. It calls for "significant judgment" by banks in determining if a market or an asset is "inactive" and if a transaction is "distressed." This would give banks more discretion to throw out "quotes" and use valuation alternatives, including cash-flow estimates, to determine value in illiquid markets. In other words, it allows banks to substitute their own wishful-thinking judgments of value for market prices.

The FASB is also changing the criteria used to determine impairment, giving companies more flexibility to not recognize impairments if they don't have "the intent to sell." Banks will only need to state that they are more likely than not to be able to hold onto an underwater asset until its price "recovers." CFOs will also have a choice to divide impairments into "credit losses" and "other losses," which means fewer of these charges will be counted against income. If approved, companies could start this quarter to report net income that ignores sharp declines in securities they own. The FASB is taking comments until April 1, but its vote is a fait accompli.

Obfuscating sound accounting rules by gutting MTM rules will only further reduce investors' trust in the financial statements of all companies, causing private capital -- desperately needed in securities markets -- to become even scarcer. Worse, obfuscation will further erode confidence in the American economy, with dire consequences for the very financial institutions who are calling for MTM changes. If need be, temporarily relax the arbitrary levels of regulatory capital, rather than compromise the integrity of all financial statements.

Mr. Chanos is chairman of the Coalition of Private Investment Companies and founder and president of Kynikos Associates LP.

(from WSJ, March 23, 2009)

At Least Six of the 19 Largest U.S. Banks Require Additional Capital

At least six of the 19 largest U.S. banks require additional capital, according to preliminary results of government stress tests, people briefed on the matter said.

While some of the lenders may need extra cash injections from the government, most of the capital is likely to come from converting preferred shares to common equity, the people said. The Federal Reserve is now hearing appeals from banks, including Citigroup Inc. and Bank of America Corp., that regulators have determined need more of a cushion against losses, they added.

By pushing conversions, rather than federal assistance, the government would allow banks to shore themselves up without the political taint that has soured both Wall Street and Congress on the bailouts. The risk is that, along with diluting existing shareholders, the government action won’t seem strong enough.

“The challenge that policy makers will confront is that more will be needed and it’s not clear they have the resources currently in place or the political capability to deliver more,” said David Greenlaw, the chief financial economist at Morgan Stanley, one of the 19 banks that are being tested, in New York.

Final results of the tests are due to be released next week. The banking agencies overseeing the reviews and the Treasury are still debating how much of the information to disclose. Fed Chairman Ben S. Bernanke, Treasury Secretary Timothy Geithner and other regulators are scheduled to meet this week to discuss the tests.

Geithner has said that banks can add capital by a variety of ways, including converting government-held preferred shares dating from capital injections made last year, raising private funds or getting more taxpayer cash. With regulators putting an emphasis on common equity in their stress tests, converting privately held preferred shares is another option.

Firms that receive exceptional assistance could face stiffer government controls, including the firing of executives or board members, the Treasury chief has warned.

Geithner today endorsed legislation before Congress that would tighten oversight of credit card fees, interest rates and penalties, saying banks should view the pending legislation as a sign of what lies ahead.

“This is a very important signal,” Geithner told reporters after a meeting at the Treasury. “I think it’s important that we see that affect behavior.”

Also today, Bank of America Corp. shareholders re-elected the entire 18-member board including Chairman and Chief Executive Officer Kenneth Lewis, according to a person familiar with the matter.

The directors were re-elected by a “comfortable margin,” according to the person, who declined to be identified because the results hadn’t been made public. While Lewis has been at the helm, the bank has received $45 billion in government aid.

Lewis said earlier this month that the Charlotte, North Carolina-based bank “absolutely” doesn’t need more capital, while adding that the decision on whether to convert the U.S.’s previous investments into common equity is “now out of our hands.”

Citigroup, in a statement, said the bank’s “regulatory capital base is strong, and we have previously announced our intention to conduct an exchange offer that will significantly improve our tangible common ratios.”

Along with Bank of America and New York-based Citigroup, some regional banks are likely to need additional capital, analysts have said.

SunTrust Banks Inc., KeyCorp, and Regions Financial Corp. are the banks that are most likely to require more capital, according to an April 24 analysis by Morgan Stanley.

By taking the less onerous path of converting preferred shares, the Treasury is husbanding the diminishing resources from the $700 billion bailout passed by Congress last October.

“Does that indicate that’s what the regulators actually believe, or is it that they felt politically constrained from doing much more than that?” said Douglas Elliott, a former investment banker who is now a fellow at the Brookings Institution in Washington.

Geithner said April 21 that $109.6 billion of TARP funds remain, or $134.6 billion including expected repayments in the coming year. Lawmakers have warned repeatedly not to expect approval of any request for additional money.

Some forecasts predict much greater losses are still on the horizon for the financial system. The International Monetary Fund calculates global losses tied to bad loans and securitized assets may reach $4.1 trillion next year.

Geithner has said repeatedly that the “vast majority” of U.S. banks have more capital than regulatory guidelines indicate. The stress tests are designed to ensure that firms have enough reserves to weather a deeper economic downturn and sustain lending to consumers and businesses.

He also said there are signs of “thawing” in credit markets and some indication that confidence is beginning to return. His remarks reflected an improvement in earnings in several lenders’ results for the first quarter, and a reduction in benchmark lending rates this month.

Financial shares are poised for their first back-to-back monthly gain since September 2007. The Standard & Poor’s 500 Financials Index has climbed 18 percent this month, while still 73 percent below the high reached in May 2007.

Finance ministers and central bankers who met in Washington last weekend singled out banks’ impaired balance sheets as the biggest threat to a sustainable recovery. Geithner has crafted a plan to finance purchases of as much as $1 trillion in distressed loans and securities. Germany has proposed removing $1.1 trillion in toxic assets.

(from Bloomberg, April 29, 2009)

Ron Grassi Takes on Standard & Poor’s, Moody’s Investors Service and Fitch Ratings

Ron Grassi says he thought he had retired five years ago after a 35-year career as a trial lawyer.

Now Grassi, 68, has set up a war room in his Tahoe City, California, home to single-handedly take on Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. He’s sued the three credit rating firms for negligence, fraud and deceit.

Grassi says the companies’ faulty debt analyses have been at the core of the global financial meltdown and the firms should be held accountable. Exhibit One is his own investment. He and his wife, Sally, held $40,000 in Lehman Brothers Holdings Inc. bonds because all three credit raters gave them at least an A rating -- meaning they were a safe investment -- right until Sept. 15, the day Lehman filed for bankruptcy.

“They’re supposed to spot time bombs,” Grassi says. “The bombs exploded before the credit companies acted.”

As the U.S. and other economic powers devise ways to overhaul financial regulations, they have yet to come up with plans to address one issue at the heart of the crisis: the role of the rating firms.

That’s partly because the reach of the three big credit raters extends into virtually every corner of the financial system. Everyone from banks to the agencies that regulate them is hooked on ratings.

Debt grades are baked into hundreds of rules, laws and private contracts that affect banking, insurance, mutual funds and pension funds. U.S. Securities and Exchange Commission guidelines, for example, require money market fund managers to rely on ratings in deciding what to buy with $3.9 trillion of investors’ money.

State regulators depend on credit grades to monitor the safety of $450 billion of bonds held by U.S. insurance companies. Even the plans crafted by Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Timothy Geithner to stimulate the economy count on rating firms to determine how the money will be spent.

“The key to policy going forward has to be to stop our reliance on these credit ratings,” says Frank Partnoy, a professor at the San Diego School of Law and a former derivatives trader who has written four books on modern finance, including Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Times Books, 2003).

“Even though few people respect the credit raters, most continue to rely on them,” Partnoy says. “We’ve become addicted to them like a drug, and we have to figure out a way to wean regulators and investors off of them.”

Just how critical a role ratings firms play in the health and stability of the financial system became clear in the case of American International Group Inc., the New York-based insurer that’s now a ward of the U.S. government.

On Sept. 16, one day after the three credit rating firms downgraded AIG’s double-A score by two to three grades, private contract provisions that AIG had with banks around the world based on credit rating changes forced the insurer to hand over billions of dollars of collateral to its customers. The company didn’t have the cash.

Trying to avert a global financial cataclysm, the Federal Reserve rescued AIG with an $85 billion loan -- the first of four U.S. bailouts of the insurer.

Investors, traders and regulators have been questioning whether credit rating companies serve a good purpose ever since Enron Corp. imploded in 2001. Until four days before the Houston-based energy company filed for what was then the largest-ever U.S. bankruptcy, its debt had investment-grade stamps of approval from S&P, Moody’s and Fitch.

In the run-up to the current financial crisis, credit companies evolved from evaluators of debt into consultants.

They helped banks create $3.2 trillion of subprime mortgage securities. Typically, the firms awarded triple-A ratings to 75 percent of those debt packages.

“Ratings agencies just abjectly failed in serving the interests of investors,” SEC Commissioner Kathleen Casey says.

S&P President Deven Sharma says he knows his firm is taking heat from all sides -- and he expects to turn that around.

“Our company has always operated by the principle that if you do the right thing by the customers and the market, ultimately you’ll succeed,” Sharma says.

Moody’s Chief Executive Officer Raymond McDaniel and Fitch CEO Stephen Joynt declined to comment for this story.

“We are firmly committed to meeting the highest standards of integrity in our ratings practice,” McDaniel said in an April 15 SEC hearing.

“We remain committed to the highest standards of integrity and objectivity in all aspects of our work,” Joynt told the SEC.

Notwithstanding the role the credit companies played in fomenting disaster, the U.S. government is relying on them to help fix the system they had a hand in breaking.

The Federal Reserve’s Term Asset-Backed Securities Loan Facility, or TALF, will finance the purchase by taxpayers of as much as $1 trillion of new securities backed by consumer loans or other asset-backed debt -- on the condition they have triple-A ratings.

And the Fed has also been buying commercial paper directly from companies since October, only if the debt has at least the equivalent of an A-1 rating, the second highest for short-term credit. The three rating companies graded Lehman debt A-1 the day it filed for bankruptcy.

The Fed’s financial rescue is good for the bottom lines of the three rating firms, Connecticut Attorney General Richard Blumenthal says. They could enjoy as much as $400 million in fees that come from taxpayer money, he says.

S&P, Moody’s and Fitch, all based in New York, got their official blessing from the SEC in 1975, when the regulator named them Nationally Recognized Statistical Ratings Organizations.

Seven companies, along with the big three, now have SEC licensing. The regulator created the NRSRO designation after deciding to set capital requirements for broker-dealers. The SEC relies on ratings from the NRSROs to evaluate the bond holdings of those firms.

At the core of the rating system is an inherent conflict of interest, says Lawrence White, the Arthur E. Imperatore Professor of Economics at New York University in Manhattan. Credit raters are paid by the companies whose debt they analyze, so the ratings might reflect a bias, he says.

“So long as you are delegating these decisions to for- profit companies, inevitably there are going to be conflicts,” he says.

In a March 25 report, policy makers from the Group of 20 nations recommended that credit rating companies be supervised to provide more transparency, improve rating quality and avoid conflicts of interest. The G-20 didn’t offer specifics.

As lawmakers scratch their heads over how to come up with an alternative approach, the rating firms continue to pull in rich profits.

Moody’s, the only one of the three that stands alone as a publicly traded company, has averaged pretax profit margins of 52 percent over the past five years. It reported revenue of $1.76 billion -- earning a pretax margin of 41 percent -- even during the economic collapse in 2008.

S&P, Moody’s and Fitch control 98 percent of the market for debt ratings in the U.S., according to the SEC. The noncompetitive market leads to high fees, says SEC Commissioner Casey, 43, appointed by President George W. Bush in July 2006 to a five-year term. S&P, a unit of McGraw-Hill Cos., has profit margins similar to those at Moody’s, she says.

“They’ve benefited from the monopoly status that they’ve achieved with a tremendous amount of assistance from regulators,” Casey says.

Sharma, 53, says S&P has justifiably earned its income.

“Why does anybody pay $200, or whatever, for Air Jordan shoes?” he asks, sitting in a company boardroom high over the southern tip of Manhattan. “It’s the same. People see value in that. And it all boils down to the value of what people see in it.”

Blumenthal says he sees little value in credit ratings. He says raters shouldn’t be getting money from federal financial rescue efforts.

“It rewards the very incompetence of Standard & Poors, Moody’s and Fitch that helped cause our current financial crisis,” he says. “It enables those specific credit rating agencies to profit from their own self-enriching malfeasance.”

Blumenthal has subpoenaed documents from the three companies to determine if they improperly influenced the TALF rules to snatch business from smaller rivals.

S&P and Fitch deny Blumenthal’s accusations.

“The investigation by the Connecticut attorney general is without merit,” S&P Vice President Chris Atkins says. “The attorney general fails to recognize S&P’s strong track record rating consumer asset-backed securities, the assets that will be included in the TALF program. S&P’s fees for this work are subject to fee caps.”

Fitch Managing Director David Weinfurter says the government makes all the rules -- not the rating firms.

“Fitch Ratings views Blumenthal’s investigation into credit ratings eligibility requirements under TALF and other federal lending programs as an unfortunate development stemming from incomplete or inaccurate information,” he says.

Moody’s Senior Vice President Anthony Mirenda declined to comment.

Sharma says it’s clear that his firm’s housing market assumptions were incorrect. S&P is making its methodology clearer so investors can better decide whether they agree with the ratings, he says.

“The thing to do is make it transparent, ‘Here are our criteria. Here are our analytics. Here are our assumptions. Here are the stress-test scenarios. And now, if you have any questions, talk to us,’” Sharma says.

The rating companies reaped a bonanza in fees earlier this decade as they worked with financial firms to manufacture collateralized debt obligations. Those creations held a mix of questionable debt, including subprime mortgages, auto loans and junk-rated assets.

S&P, Moody’s and Fitch won as much as three times more in fees for grading structured securities than they charged for rating ordinary bonds. The CDO market started to crash in mid- 2007, as investors learned the securities were jammed with bad debt.

Financial firms around the world have reported about $1.3 trillion in writedowns and losses in the past two years.

Alex Pollock, now a resident fellow at the American Enterprise Institute in Washington, says more competition among credit raters would reduce fees.

“The rating agencies are an SEC-created cartel,” he says. “Usually, issuers need at least two ratings, so they don’t even have to compete.”

Pollock was president of the Federal Home Loan Bank in Chicago from 1991 to 2004. The bank was rated triple-A by both Moody’s and S&P. He says he recalls an annual ritual as he visited with representatives of each company.

“They’d say, ‘Here’s what it’s going to cost,’” he says. “I’d say, ‘That’s outrageous.’ They’d repeat, ‘This is what it’s going to cost.’ Finally, I’d say, ‘OK.’ With no ratings, you can’t sell your debt.”

Congress has held hearings on credit raters routinely this decade, first in 2002 after Enron and then again each year through 2008. In 2006, Congress passed the Credit Rating Agency Reform Act, which gave the SEC limited authority to regulate raters’ business practices.

The SEC adopted rules under the law in December 2008 banning rating firms from grading debt structures they designed themselves. The law forbids the SEC from ordering the firms to change their analytical methods.

Only Congress has the power to overhaul the rating system. So far, nobody has introduced legislation that would do that. In a hearing on April 15, the SEC heard suggestions for legislation on credit raters. Some of the loudest proponents for change are in state government and on Wall Street. But no one’s agreed on how to do it.

“We should replace ratings agencies,” says Peter Fisher, managing director and co-head of fixed income at New York-based BlackRock Inc., the largest publicly traded U.S. asset management company.

“Our credit rating system is anachronistic,” he says. “Eighty years ago, equities were thought to be complicated and bonds were thought to be simple, so it appeared to make sense to have a few rating agencies set up to tell us all what bonds to buy. But flash forward to the slicing and dicing of credit today, and it’s really a pretty wacky concept.”

To create competition, the U.S. should license individuals, not companies, as credit rating professionals, Fisher says. They should be more like equity analysts and would be primarily paid by institutional investors, Fisher says. Neither equity analysts nor those who work at rating companies currently need to be licensed.

Such a system wouldn’t be fair, says Daniel Fuss, vice chairman of Boston-based Loomis Sayles & Co., which manages $106 billion. An investor-pay ratings model may give the biggest money managers a huge advantage over smaller firms and individuals because they can afford to pay for the analyses, he says. “What about individuals?” he asks.

Eric Dinallo, New York’s top insurance regulator, proposes a government takeover of the rating business.

“There’s nothing wrong with saying Moody’s or someone is going to just become a government agency,” he says. “We’ve hung the entire global economy on ratings.”

Insurance companies are among the world’s largest bond investors. Dinallo suggests that insurers could fund a credit rating collective run by the National Association of Insurance Commissioners, a group of state regulators.

“It would be like the Consumer Reports of credit ratings,” Dinallo says, referring to the not-for-profit magazine that provides unbiased reviews of consumer products.

Turning over the credit ratings to a consortium headed by state governments could lead to lower quality because there would be even less competition, Fuss says.

“I would be strongly opposed to the government taking over the function of credit ratings,” he says. “I just don’t think it would work at all. The business creativity, the drive, would go straight out of it.”

At the April 15 SEC hearing, Joseph Grundfest, a professor at Stanford Law School in Stanford, California, suggested a variation of Dinallo’s idea. He said the SEC could authorize a new kind of rating company, owned and run by the largest debt investors.

All bond issuers that pay for a traditional rating would also have to buy a credit analysis from one of these firms.

SEC Commissioner Casey has another solution. She wants to remove rating requirements from federal guidelines. She also faults investors for shirking their responsibility to do independent research, rather than simply looking to the grades produced by credit raters.

“I’d like to promote greater competition in the market and greater discipline,” she says. “Eliminating the references to ratings will play a huge role in removing the undue reliance that we’ve seen.”

Sharma, who became president of S&P in August 2007, agrees with Casey that ratings are too enmeshed in SEC rules. He wants the SEC to either get rid of references to rating companies in regulations or add other benchmarks such as current market prices, volatility and liquidity.

“Just don’t leave us the way it is today,” Sharma says. “There’s too much risk of being overused and inappropriately used.”

Sharma says that even with widespread regulatory reliance on ratings, his firm will lose business if investors say it doesn’t produce accurate ones.

“Our reputation is hurt now,” he says. “Let’s say it continues to be hurt; it never comes back. Three other competitors come back who do much-better-quality work. Investors will finally say, ‘I don’t want S&P ratings.’”

S&P will prove to the public that it can help companies and bondholders by updating and clarifying its rating methodology, Sharma says. The company will also add commentary on the liquidity and volatility of securities.

S&P has incorporated so-called credit stability into its ratings to address the risk that ratings will fall several levels under stress conditions, which is what happened to CDO grades. The company has also created an ombudsman office in an effort to resolve potential conflicts of interest.

Jerome Fons, who worked at Moody’s for 17 years and was managing director for credit policy until August 2007, says investors don’t have to wait for a change in the rating system. They can learn more about the value of debt by tracking the prices of credit-default swaps, he says.

The swaps, which are derivatives, are an unregulated type of insurance in which one side bets that a company will default and the other side, or counterparty, gambles that the firm won’t fail. The higher the price of that protection, the greater the perceived risk of default.

“We know the spreads are more accurate than ratings,” says Fons, now principal of Fons Risk Solutions, a credit risk consulting firm in New York. Moody’s sells a service called Moody’s Implied Ratings, which is based on prices of credit swaps, debt and stock.

In July 2007, credit-default-swap traders started pricing Bear Stearns Cos. and Lehman as if they were Ba1 rated, the highest junk level. They pegged Merrill Lynch & Co. as a Ba1 credit three months later, according to the Moody’s model.

Each of those investment banks was stamped at investment grade by the top three credit raters within weeks of when the banks either failed or were rescued in 2008.

Lynn Tilton, who manages $6 billion as CEO of private equity firm Patriarch Partners in New York, says she woke up one morning in August 2007 convinced the banking system would collapse and started buying gold coins.

“I predicted the banks would be insolvent,” Tilton says. “My biggest issue was credit-default swaps. When the size of that market started to dwarf gross domestic product by six or seven times, then my understanding of what defaults would be in a down market became clear: There’s no escaping.”

Investors like Tilton watched as the financial firms tumbled while credit raters held on to investment-grade marks.

“If the ratings mandate weren’t there, we wouldn’t care because the credit-default-swap markets can tell us basically what we want to know about default probabilities,” NYU’s White says. “I’m a market-oriented guy, so I’m more inclined to be relying on the collective wisdom of the market participants.”

While credit-default-swap traders lack inside information that companies give to credit raters, swap traders move faster because they’re reacting to market changes every day.

San Diego School of Law’s Partnoy, who’s written law review articles about credit rating firms for more than a decade and has been a paid consultant to plaintiffs suing rating companies, says raters hold back from downgrading because they know the consequences can be dire.

In September, Moody’s and S&P downgraded AIG to A2 and A-, the sixth- and seventh-highest investment-grade ratings. The downgrades triggered CDS payouts and led to the U.S. lending AIG $85 billion. The government has since more than doubled AIG’s rescue funds.

“When you get into a situation like we’re in right now with AIG, the rating agencies are basically trapped into maintaining high ratings because they know if they downgrade, they don’t only have this regulatory effect but they have all these effects,” Partnoy says.

“It’s all this stuff that basically turns the rating downgrade into a bullet fired at the heart of a bunch of institutions,” he says.

Sharma says S&P has never delayed a ratings change because of potential downgrade results. He says his firm tells clients not to use ratings as triggers in private contracts.

“We take action based on what we feel is right,” Sharma says.

While swap prices may be better than bond ratings at predicting a disaster, swaps can also cause a disaster.

AIG, one of the world’s biggest sellers of CDS protection, nearly collapsed -- taking the global financial system with it -- when it didn’t have enough cash to honor its swaps contracts. Loomis’s Fuss says relying on swap prices is a bad idea.

“The market is not always right,” he says. “An unregulated market isn’t always a fair appraisal of value.”

Moody’s was the first credit rating firm in the U.S. It started grading railroad bonds in 1909. Standard Statistics, a precursor of S&P, began rating securities seven years later.

After the 1929 stock market crash, the government decided it wasn’t able to determine the quality of the assets held by banks on its own, Partnoy says. In 1931, the U.S. Treasury started using bond ratings to analyze banks’ holdings.

James O’Connor, then comptroller of the currency, issued a regulation in 1936 restricting banks to buying only securities that were deemed high quality by at least two credit raters.

“One of the major responses was to try to find a way -- just as we are now with the stress tests and the examination of the banks -- to figure out how to get the bad assets off the banks’ books,” Partnoy says.

Since then, regulators have increasingly leaned on ratings to police debt investing. In 1991, the SEC ruled that money market mutual fund managers must put 95 percent of their investments into highly rated commercial paper.

Like auditors, lawyers and investment bankers, rating firms serve as gatekeepers to the financial markets. They provide assurances to bond investors. Unlike the others, ratings companies have generally avoided liability for errors.

Grassi, the retired California lawyer, wants to change that. He filed his lawsuit against the rating companies on Jan. 26 in state superior court in Placer County.

The white-haired lawyer discusses his case seated at a tiny wooden desk in his small guest bedroom, with files spread over both levels of a bunk bed. Grassi says in his complaint that the raters were negligent for failing to downgrade Lehman Brothers debt as the bank’s finances were deteriorating.

The day Lehman filed for bankruptcy, S&P rated the investment bank’s debt as A, which according to S&P’s definition means a “strong” capacity to meet financial commitments. Moody’s rated Lehman A2 that day, which Moody’s defines as a “low credit risk.” Fitch gave Lehman a grade of A+, which it describes as “high credit quality.”

“We’d like to have a jury hear this,” Grassi says. “This wouldn’t be six economists, just six normal people. That would scare the rating agencies to death.”

The rating companies haven’t yet filed responses. They’ve asked the federal court in Sacramento to take jurisdiction from the state court.

S&P and Fitch say they dispute Grassi’s allegations. “We believe the complaint is without merit and intend to defend against it vigorously,” S&P’s Atkins says.

Fitch’s Weinfurter says, “The lawsuit is fully without merit and we will vigorously defend it.”

Mirenda at Moody’s declined to comment.

S&P included a standard disclaimer with Lehman’s ratings: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

Grassi isn’t deterred.

“They’re saying we know you’re going to rely on us and if you get screwed, you’re on your own because our lawyers have told us to put this paragraph in here,” he says.

The companies have defended their ratings from lawsuits, arguing that they were just opinions, protected by the free speech guarantees of the First Amendment to the U.S. Constitution.

McGraw-Hill used the First Amendment defense in 1996 after its subsidiary S&P was sued for professional negligence by Orange County, California. S&P had given the county an AA- rating before the county filed for the largest-ever municipal bankruptcy.

Orange County alleged in its lawsuit that S&P had failed to warn the government that its treasurer, Robert Citron, had made risky investments with county cash.

The U.S. District Court in Santa Ana, California, ruled that the county would have needed to prove the rating company’s “knowledge of falsity or reckless disregard for the truth” to win damages.

The court found that the credit rater couldn’t be held liable for mere negligence, agreeing with S&P that it was shielded by the First Amendment.

Sharma says rating companies shouldn’t be responsible when investors misuse ratings.

“Hold us accountable for what you can,” he says. He compares the rating companies to carmakers. “Look, if you drove the car wrong, the manufacturer can’t be held negligent. But if you designed the car wrong, then of course the manufacturer should be held negligent.”

The bigger issue is whether the credit rating system should be changed or even abolished. From California to New York to Washington, investors and regulators are saying it doesn’t work. No one has been able to fix it.

The federal government created the rating cartel, and the U.S. is as dependent on it as everyone else. So far, the legislative branch hasn’t cleaned up the ratings mess.

“This problem really is like a cancer that has spread throughout the entire investment system,” Partnoy says. “You’ve got a body filled with little tumors, and you’ve got to go through and find them and cut them out.”

As the U.S. has spent, lent or pledged about $12.8 trillion in efforts to revive the slumping economy, and as President Barack Obama and Congress have worked overtime to find a way out of the deepest recession in 70 years, no one has taken steps that would substantially fix a broken ratings system.

If the government doesn’t head in that direction, all of its efforts at financial reform may be put in jeopardy by the one piece of this puzzle that nobody has yet figured out how to solve.

(from Bloomberg, April 29, 2009)

Tuesday, April 28, 2009

Recent Survey on the State of the Hedge Fund Industry

from Jamie Murray, Director at Broadgate Alternatives -

Recent survey run with HFM Week on the state of the hedge fund industry

Damon Vickers Wins with Trend Following

Analysis and discussion with Damon Vickers of Nine Points Capital Partners and Phil Dow of RBC Wealth Management.

We short weakness, we buy strength...

Marc Faber: "We shouldn't underestimate the money printing"

In-Depth Look - Gloom, Boom Or Doom?

Marc Faber predicts that the market will return to November 2008 lows and then will start rising. Not because of the economy doing better but because of the money printing.

(from Bloomberg, Apr. 27, 2009)

Zell Speaks at Milken Conference

Global Leaders Gathered in Los Angeles to Address Unprecedented Economic Challenges and Search for Solutions at 2009 Milken Institute Global Conference

Samuel Zell
Born: September, 1941, Chicago, Illinois
Occupation: Chairman and Chief Executive of Tribune Company and Equity Group Investments
Net worth: US$3.0 billion (2009)

Saturday, April 25, 2009

BNP Paribas on Equities Bubble

In a note issued late on Thursday, the credit analysts at BNP Paribas argued that “despite a close to 5o per cent drop in equity valuations, equities look not only rich but are significantly mispriced and are a bubble waiting to be pricked.”

Moreover, they contend that equity analysts are “ignoring the tremendous value embedded in investment grade credit.”

Here are some highlights, which include quite a lot of snickering at the “unfathomable” bullishness of equity types:

Over the past equity bubble decade, it has become fashionable for equity analysts to concentrate on Operating earnings as opposed to As Reported earnings, which factor in write-offs and restructuring charges (Charts 1 and 2). While the difference between the two measures was insignificant until the internet bubble, that difference has grown significantly to the extent that operating earnings look like numbers plucked out of thin air with little resemblance to economic reality. As credit analysts, we are taught that, for a given revenue base, rising costs lower profits, raise leverage and lower creditworthiness. How equity analysts can ignore this fundamental credit analysis is unfathomable to us.

Using current valuations, if one were to calculate the P/E multiple on 2009 earnings, one lands up with 14x using operating earnings and 30x using as reported earnings. We will leave investors to make their own judgment but P/E multiples of 30x certainly scream bubble to us.

As for the use of earnings yield, which they deplore as “another false measure”, equity analysts, using the operating earnings measure have also made the argument that earnings yield are significantly higher than 10-year US Treasury yields and hence equities offer value. This relative value comparison is fundamentally flawed on two counts. Firstly, as we have pointed out, operating earnings are not true earnings and secondly the relative value comparison, should be made to corporate bond yields not treasuries, which would be an appropriate apples to apples comparison. Using this measure, clearly it again illustrates the tremendous value in investment grade credit as opposed to equities.

BNP Paribas chart of expected earnings yield with S&P 500 at 850

Every bull and bear cycle is usually characterized by a significant event that anecdotally indicates over or under valuation in equities. The 2007 top was characterized by the generosity of Blackstone, which thought it fit to share its profits via an IPO, the equity piece of a highly leveraged entity and a known liquidity extractor.

The recent secondary offering by Goldman Sachs, could well mark the top of this bear market rally because GS, we believe would only issue equity at these valuations for two reasons, namely because it needed to as losses on its highly illiquid Level 3 assets continue to mount, or because it saw its equity valuation as being grossly overpriced.

The lack of institutional participation and endorsement of this deal, radio silence from Mr. Buffett, who, as a consequence of this deal got diluted and with both Moody’s and S&P maintaining their Negative Outlook despite the equity injection, it points to GS being very opportunistic in exploiting its equity overvaluation and having the need to build a buffer for future losses.

Time will tell, how significant this GS top will be but for now it makes us very wary of equities, especially US financials, as they have become the playground of day-traders.

They also the purported green shoots in mortgage applications - “not a sign of new home purchases but simply refinancing”.

As for commodities and trade, we will simply let the hard data and the charts do the talking here as commodities and the Baltic Dry index continue to show a “U” or “L” shaped recovery with no sign of “V”.

For the record, they’re expecting a “U” shaped recovery.

(from, April 24, 2009)

Friday, April 24, 2009

Kapitall Blog Defends Goldman Sachs Against Conspiracy Theory

People keep sending me articles about some Goldman Sachs proprietary trading conspiracy that is responsible for recent market advances. (Most notably, Zero and the seriously angry Specifically, they blame program trading and quantitative trading.

I was the head of program trading at Morgan Stanley from 1996 to 2002 (both Global and U.S.), which, at the time, was the NYSE volume leader. And while I always enjoy a good conspiracy, in this case I find little evidence of one. As the managing director in charge of a trading desk and an ex-rival of Goldman Sachs I'd love to trash them, but I cannot. I find myself defending them.

First, the numbers in the ZeroHedge article shows an increase in program trading volume and Goldman Sachs' position at the top of the list as an indication of market manipulation pushing the market up. Program trading volume on a proprietary basis can come from many things, but all of which make pushing the entire market higher difficult to nearly impossible.

1. Quantitative (black box) trading:

Basically, most black box strategies involve something called mean reversion. This means when a stock moves too much relative to the stocks to which it is normally correlated the strategy buys the stocks that have have moved higher the least (or lower the most) and does the opposite with everything else. Actually, it is way more complicated than this and requires loads of academic explanations and complex statistical mathematics. But I hope you get the idea. Days of great volatility and fast market moves (like last week) provide lots of market dislocations (black box trading volume). Almost no black box strategy creates net buys or sells (every stock bought is offset by another that is sold.)

2. Index Arbitrage:

Index arbitrage is the risk neutral trading of index futures (like the S&P500) and stocks. In the case of last week, selling overpriced futures and buying stocks. While the program trading reports show Goldman reporting zero in this category, the complex NYSE rules on the subject of what kind of trading fall into which category leave the reporting firm lots of leeway on interpretation. Thus, much of what could be reported as index arbitrage by one firm is reported as principal trading by another.

3. Customer Facilitation:

The vast majority of customer facilitation occurs after the close and in the form of something called an EFP (Exchange for physical) in which a basket of stocks is exchange for an equal value of futures. Customers are typically pension funds, foreign government investment funds, index funds and other mutual funds. These can run in the billions of dollars at times - but with both sides relatively hedged. The unwind of these transactions by the facilitator is slow, lasting several days as the investment bank liquidates stock and futures positions. This dual liquidation doubles the initial EFP. Technically, these are proprietary trades not reported as customer facilitation but as principal.

4. ETF Creation:

In the normal course of providing liquidity to Exchange Traded Fund (ETF) investors, a market maker must trade a basket of the underlying stocks in order to create and sell and ETF. These transactions are generated electronically and very quickly in order to keep the ETF market efficient. Buyers of ETFs (as I expect last week) creates buyers of baskets of stock.

Now imagine all of these activities, mostly quantitative trading and index arbitrage, being done by several different departments at the same time (but in different ways) in a volatile and fast moving market. None of these activities create a net bias by Goldman Sachs to either be net long (buyer) or net short.

The only thing that can drive a market higher is buyers willing to pay more than current market prices. Buyers can include pension funds, corporations, mutual fund investors, speculators like hedge funds and individuals. These buyers use many instruments other that direct buying and all of them eventually find their way into stock prices. Futures, options and ETFs most notable among them.

Among the many financial market abuses that have occurred in the past few years, portfolio (program) trading is not among them.

(Excerpt from David Neubert's post in Kapitall Blog, April 13, 2009)

Thursday, April 23, 2009

IBM Stream Computing: 5 Million Pieces of Options Trading Data per Second

When Riswan Khalfan, chief information officer at TD Securities, set out to improve the performance of the bank's options-trading system last year, he couldn't find ready-to-use technology suitable for the job. So he agreed to let his company become a test subject for a research project at IBM called "stream" computing. The technology, developed over half a decade by a team of 70 scientists and engineers at IBM Research, allows companies to analyze data as it's being received—rather than having to place it first in a database.
In TD Securities' case, stream computing lets it handle 5 million pieces of options trading data per second, analyze them on the fly, and make automated trading decisions. That compares with the 1 to 2 million per second rate the bank typically handles on its current trading system. "In this business, quicker decisions are better decisions," says Khalfan. "If you fall behind, you're dealing with stale data and that puts you at a disadvantage." The bank is now considering switching its entire trading system to the new technology.

Hedge Funds Underperformed Broader Markets in the Bear Rally

Hedge funds failed to take advantage of the sharp rally in equities in March as their generally defensive stance meant the average fund across all investment strategies gained less than 2 per cent even as the benchmark S&P 500 index rallied by more than 8 per cent.

Some hedge fund strategies completely missed the upside of the equity markets in what many analysts were describing as a bear market rally.

Many hedge funds have taken a step back from directional bets on the stock markets against the backdrop of the heightened volatility that has accompanied the financial crisis.

Many are under pressure for funding and have been subject to a wave of redemptions by investors. Some have invested large amounts in cash, while many multi-strategy funds have focused on opportunities beyond the equity markets, particularly in distressed debt and special situations.

According to figures from Hedge Fund Research, a weighted composite of hedge fund strategies rose 1.8 per cent in March. The S&P 500 rose 8.5 per cent over the same period while the Nasdaq Composite index rallied almost 11 per cent.

Many hedge funds posted negative returns for the month. For example, the HFR macro hedge fund index was down 1.2 per cent for the month. The best-performing hedge fund strategy groups were those focusing on energy and basic materials. But even these funds failed to the match the gains in the broader equity market, rising about 5 per cent for the month.

March began with a challenging week for equity markets in which the benchmark S&P reached a 12-year low and fell to 57 per cent below its October 2007 peak.

But positive news regarding the early-year revenues from Citigroup and other financial institutions sparked three weeks of sharp rallies in the leading US equity market indices.

These were accompanied by similarly powerful equity rallies across the globe and were given further momentum by positive revenue announcements from other troubled banks as well as the US government’s proposal to buy toxic assets from financial institutions and other upbeat indicators.

Long/short equity managers, the largest strategy group in the hedge fund business, displayed a wide dispersion in performance as many were defensively positioned going into the rally.

Their overall performance of 2.3 per cent was low as a result compared with the broader equity markets. Not surprisingly, the HFR dedicated short bias index was down 4.9 per cent for the month, after staging two strong months in January and February. Multi-strategy funds captured upside participation with a return of 1.6 per cent for the month.

(from FT, April 9, 2009)

Wednesday, April 22, 2009

Structural Logic Macro Update

Today's macro recap courtesy of John Bougearel at Structural Logic.
Use "Toggle Full Screen" button in the upper right hand corner for reading.

Tuesday, April 21, 2009

One On One With Stanford

Allen Stanford of Stanford Financial swears he did nothing wrong. CNBC's Scott Cohn sat down with him in an exclusive interview.

(from, April 20, 2009)

In-Depth Look - Allen Stanford vs The SEC - Bloomberg

Sunday, April 19, 2009

Top Hedge Fund Managers in 2008

Rank: 1
James Simons
Renaissance Technologies
Est. 2008 earnings: $2.5 billion
Est. 2007 earnings: $2.8 billion

Rank: 2
John Paulson
Paulson & Company
Est. 2008 earnings: $2 billion
Est. 2007 earnings: $3.7 billion

Rank: 3
John D. Arnold
Centaurus Energy
Est. 2008 earnings: $1.5 billion
Est. 2007 earnings: $480 million

Rank: 4
George Soros
Soros Fund Management
Est. 2008 earnings: $1.1 billion
Est. 2007 earnings: $2.9 billion

Rank: 5
Ray Dalio
Bridgewater Associates
Est. 2008 earnings: $780 million
Est. 2007 earnings: $400 million

Rank: 6
Bruce Kovner
Caxton Associates
Est. 2008 earnings: $640 million
Est. 2007 earnings: $100 million

Rank: 7
David Shaw
D.E. Shaw & Company
Est. 2008 earnings: $275 million
Est. 2007 earnings: $210 million

Rank: 8
Stanley Druckenmiller
Duquesne Capital Management
Est. 2008 earnings: $260 million
Est. 2007 earnings: Not available

Rank: 9 (tie)
David Harding, left
Winton Capital Management
Est. 2008 earnings: $250 million
Est. 2007 earnings: $225 million

Rank: 9 (tie)
John Taylor Jr., right
FX Concepts
Est. 2008 earnings: $250 million
Est. 2007 earnings: Not available

Rank: 9 (tie)
Alan Howard, not pictured
Brevan Howard Asset Management
Est. 2008 earnings: $250 million
Est. 2007 earnings: $245 million

Source: Alpha Magazine

As major markets and economies careened downward last year, 25 top managers reaped a total of $11.6 billion in pay by trading above the pain in the markets, according to an annual ranking of top hedge fund earners by Institutional Investor’s Alpha magazine, which comes out Wednesday.

James H. Simons, a former math professor who has made billions year after year for the hedge fund Renaissance Technologies, earned $2.5 billion running computer-driven trading strategies. John A. Paulson, who rode to riches by betting against the housing market, came in second with reported gains of $2 billion. And George Soros, also a perennial name on the rich list of secretive moneymakers, pulled in $1.1 billion.

Of course, their earnings were not unscathed by the extensive shakeout in the markets. In a year when losses were recorded at two of every three hedge funds, pay for many of these managers was down by several million, and the overall pool of earnings was about half the $22.5 billion the top 25 earned in 2007.

The managers’ compensation, which was breathtaking in the best of times, is eye-popping after a year when hedge funds lost 18 percent on average, and investors withdrew money en masse.

Government scrutiny, over Wall Street pay and the role all kinds of institutions play in the financial markets, is also mounting. Hedge funds are facing proposals for new taxes on their gains, and on Tuesday, Treasury Secretary Timothy F. Geithner said he would seek greater power to regulate hedge funds.

Some people on the list disputed Alpha’s calculations, which are estimates that include the increase in value of personal investments the managers made in their funds. But none offered different values for their bonuses or the soaring wealth in their funds.

To make the cut this year, a hedge fund hotshot needed to earn $75 million, down sharply from the $360 million cutoff for 2007’s top 25. Still, amid the financial shakeout, the combined pay of the top 25 hedge fund managers beat every year before 2006.

“The golden age for hedge funds is gone, but it’s still three times more lucrative than working at a mutual fund and most other places on Wall Street,” said Robert Sloan, managing partner of S3 Partners, a hedge fund risk management firm. “But this shouldn’t pop up on the greed meter. They made money. That’s what they’re supposed to.”

In an interview, Mr. Paulson — whose lofty 2008 earnings were down from the $3.7 billion that Alpha estimated he earned in 2007 — said his pay was high in large part because he is the biggest investor in his fund. In fact, he said he receives no bonus. The pensions, endowments and other institutions that invest in his fund do not mind the hefty cut of profits he and his team take, he said.

“In a year when all their other investments lost money, we’re like an oasis,” Mr. Paulson said.

“We have investors who were invested with Madoff, and they can’t thank me enough,” he added, referring to the disgraced financier Bernard L. Madoff.

Even as the spotlight intensifies, these hedge fund managers and others who made it through last year with cash on hand are the sort of investors the federal government hopes will step in and buy troubled assets from banks. The richest managers are also in the best position to take advantage of the distressed environment to build their wealth.

“The guys who own the future are the guys like John Paulson and the others on the Alpha list,” said Keith R. McCullough, the chief executive of Research Edge, a firm in New Haven that provides trading analysis for hedge funds. “Ironically enough, we’re going to go beg for capital from the very people we’ve been trying to vilify.” Mr. Paulson, though, said he did not plan to participate in the new public-private investment program.

One hedge fund manager on the list, Paul Touradji, said he understood the public outcry against people who are paid regardless of whether they earned money for their clients. “Wall Street should get paid only when they reward their clients,” he said. “For every dollar we made, our clients earned multiples.”

Mr. Touradji, $140 million richer than in 2007, according to Alpha, said he gave his investors advice by sharing strategies — something rare in the black-box hedge fund world. Last year, for instance, he spotted the commodities bubble early and warned his investors, which include pension funds and endowments, to reshuffle their other holdings, saving them from losses.

Some hedge funds made so much that they had two people on the list. While Mr. Simons of Renaissance Technologies landed the No. 1 spot, one of his partners, Henry B. Laufer, is also on the list with earnings of $125 million.

A spokesman for Mr. Simons declined to comment.

John D. Arnold, an energy trader in his early 30s who was third on the list, with $1.5 billion, did not respond to a request for comment. A spokesman for George Soros, Michael Vachon, said his boss gave away more than half his earnings in 2008. A spokesman for Raymond T. Dalio, who is said to have earned $780 million, said his boss had made so much money because he anticipated the crisis.

Two of the three managers who tied for ninth, at $250 million, are based in Britain: David Harding of Winton Capital and Alan Howard of Brevan Howard Asset Management. A second employee of Brevan Howard, Christopher Rokos, also made the list.

Mr. Harding, who runs Winton, said his success last year was part luck, part knowledge from 25 years of hard work in which he often struck a solitary path in a type of trading that had many naysayers. “It is nice to have a golden life and a purpose to engage in, a reason to go to work,” said Mr. Harding, who doubted that many people would be willing or able to do his job. “Obviously I wouldn’t have set out to be a futures trader if I hadn’t wanted to make a lot of money.”

John R. Taylor, the third hedge fund manager who tied as ninth on the list, said even winning hedge funds should acknowledge that they had benefited from the government’s bailout of the banking system. “Thank God for the government, because if they hadn’t intervened, we wouldn’t have had anybody to trade with,” said Mr. Taylor, who has run his currency fund, FX Concepts, since the 1980s.

But he said he was not grateful to be on Alpha’s list, which he said overestimated his pay by a multiple of five. The last time he received lots of publicity, Mr. Taylor said, was in 1993, and that preceded his worst year ever.

“This is bad luck with the trading gods,” Mr. Taylor said. “We’re doomed next year if you write about us.”

(from NYT, March 25, 2009)

Global Currency in Development at G20

A single clause in Point 19 of the communiqué issued by the G20 leaders amounts to revolution in the global financial order.

"We have agreed to support a general SDR allocation which will inject $250bn (£170bn) into the world economy and increase global liquidity," it said. SDRs are Special Drawing Rights, a synthetic paper currency issued by the International Monetary Fund that has lain dormant for half a century.

In effect, the G20 leaders have activated the IMF's power to create money and begin global "quantitative easing". In doing so, they are putting a de facto world currency into play. It is outside the control of any sovereign body. Conspiracy theorists will love it.

It has been a good summit for the IMF. Its fighting fund for crises is to be tripled overnight to $750bn. This is real money.

There is now a world currency in waiting. In time, SDRs are likely evolve into a parking place for the foreign holdings of central banks, led by the People's Bank of China. Beijing's moves this week to offer $95bn in yuan currency swaps to developing economies show how fast China aims to break dollar dependence.

Hedge funds deemed "systemically important" will come under draconian restraints. How this is enforced will determine whether Mayfair's hedge-fund industry – 80pc of all European funds are there – will continue to flourish.

It seems that hedge funds have been designated for ritual sacrifice, even though they played no more than a cameo role in the genesis of this crisis. It was not they who took on extreme debt leverage: it was the banks – up to 30 times in the US and nearer 60 times for some in Europe that used off-books "conduits" to increase their bets. The market process itself is sorting this out in any case – brutally – forcing banks to wind down their leverage. The problem right now is that this is happening too fast.

But to the extent that this G20 accord makes it impossible for the "shadow banking" to resurrect itself in the next inevitable cycle of risk appetite, it may prevent another disaster of this kind.

The key phrase is "new rules aimed at avoiding excessive leverage and forcing banks to put more money aside during good times." This is more or less what the authorities agreed after the Depression. Complacency chipped away at the rules as the decades passed. It is the human condition, and we can't change that.

(from Telegraph, April 7, 2009)

Akerlof and Shiller: "There was nothing rational, well ­informed or unemotional about the behavior that has all but collapsed the economy"

Look around you, George A. Akerlof and Robert J. Shiller say. The second coming of the Great Depression is, like the original, a direct result of animal spirits. If only we had factored those turbulent emotions into economic theory, we might not be repeating the earlier tragedy.

Akerlof, a Nobel laureate, and Shiller, a good bet to become one, are prominent mainstream economists. They don’t deviate easily from orthodox theory, with its allegiance to the proposition that people are essentially rational, well informed and unemotional in the numerous transactions that shape the economy. But in “Animal Spirits,” they have deviated — and they have done so just as mainstream theory self-destructs.

There was nothing rational, well ­informed or unemotional about the behavior that has all but collapsed the economy. That leaves most of America’s economists without a believable framework for explaining how we got into this mess. Akerlof and Shiller are the first to try to rework economic theory for our times. The effort itself makes their book a milestone.

Keynes performed a similar service in the 1930s — mainly by making the point that market economies could suffer long periods of high unemployment and low output unless government stepped in to supply the necessary demand. Barack Obama’s $787 billion stimulus program reflects his insight.

But another aspect of Keynes’s thinking did not fare well. He also introduced the world to “animal spirits,” coining that phrase to describe a range of emotions, human impulses, enthusiasms and misperceptions that drive economies — and ultimately unwind them. The economists who interpreted Keynes “rooted out almost all of the animal spirits — the noneconomic motives and irrational behaviors — that lay at the heart of his explanation for the Great Depression,” ­Akerlof and Shiller declare.

Addressing this wrong, the authors attempt to restore animal spirits to economic theory. They do this by drawing on the greater understanding of human psychology that exists today, and which Akerlof and Shiller, along with other economists, have incorporated into the relatively new field of behavioral economics.

Until now, behavioral economics has focused mainly on a variety of disparate traits that chip away at the assumption of rationality embedded in mainstream ­theory. A young person, for example, fails to join a 401(k) plan, even one subsidized by his employer, although if he were ra­tional and fully informed, he would certainly sign up.

What Akerlof and Shiller do is to highlight this sort of finding, packaging it with numerous other psychological insights into a half-dozen broad maxims that permanently alter the concept of rational behavior. And their book takes their case not just to economists, but also to the general reader. It is short (176 pages of text) and easy enough for laymen to understand (most of the time).

Above all, they challenge the reigning free-market ideology of the past 30 years or so, from the rise of Margaret Thatcher and Ronald Reagan to the abrupt arrival of the present crisis late last year. That ideology held that markets should operate free of government because they were rational. But if animal spirits influence behavior, then government must play a broad, disciplinary role, and do so permanently.

Akerlof and Shiller spent five years writing “Animal Spirits” and honing that conviction. They are concerned that once we enter a revival, pressure will inevitably build — just as it did in the late 1970s, more than a generation after the Great Depression — to give the markets free rein again. Akerlof and Shiller intend their book as an obstacle to that ever happening.

“The system of safeguards developed from the experience of the Great Depression has been eroded,” they write. “It is therefore necessary for us to renew our understanding of how capitalist economies — in which people have not only rational economic motives but also all kinds of animal spirits — really work.”

Both men are old hands at prodding their fellow economists into recognizing exceptions to mainstream theory. Akerlof, a professor at the University of California, Berkeley, shared a Nobel Prize in 2001 for his work on “asymmetric information,” which means that some parties to a transaction know more about the deal than others, like the used-car salesman who knows more about the shortcomings of the vehicle he is trying to sell than the customer he is pitching. Lemon laws, protecting consumers, grew out of such findings. Akerlof has long believed that in most market situations a government role can improve the outcome. “Animal Spirits” brings that view to a high boil.

Shiller, a Yale professor, originated the phrase “irrational exuberance” before Alan Greenspan made it famous, and in his research he has documented the rise and fall of home prices going back decades, to demonstrate that the latest surge was far and away the greatest in American history. The bubble will burst with very unpleasant results, Shiller warned, well before that actually happened.

What are these animal spirits that drive the American economy? Confidence is one. Far from dispassionately weighing and analyzing all the options, people act on the confidence, or overconfidence, that a home they are about to buy will be worth more a year later. Confidence drove up stock ­prices in the 1920s and again in this decade, far more than corporate balance sheets and pure reason would justify, and now lack of confidence, spreading like a contagious disease, is exacerbating the sell-off.

Fairness also shows up as an animal spirit, influencing thousands of decisions in ways that part company with standard theory. Out of a sense of fairness, for example, bosses often pay their employees more than the market demands. “Considerations of fairness are a major motivator in many economic decisions,” Akerlof and Shiller write, “and are related to our sense of confidence and our ability to work effectively together.”

Corruption, too, is an animal spirit. This includes the propensity to produce not just what people really need but what they think they need, like the mortgage-backed securities, “a modern form of snake oil,” the authors declare.

In their list of animal spirits, the two economists pay special attention to the tendency of people to think in terms of narratives or stories. “High confidence tends to be associated with inspirational stories, stories about new business initiatives, tales of how others are getting rich,” the authors write. On the other hand, ­stories about the Great Depression shape our narrative of what is happening now, and our behavior.

So what is to be done? Animal spirits are human emotions; they can’t be turned off. Unchecked, they drive the economy into misbegotten booms and disastrous busts. Tempered by government, on the other hand, they are a great source of entrepreneurial energy, safely channeled into a healthy capitalism. Keynes came to that conclusion, and Akerlof and Shiller, in “Animal Spirits,” push hard in the same direction — prodding their colleagues to follow their lead in revamping economic theory to deal with a market system that, quite irrationally, failed to govern itself.

(from NYT, April 17, 2009

Stiglitz Interview on U.S. Banks: TARP as a Strange Partnership and Hidden Subsidy

Nobel-prize winning economist Joseph Stiglitz talks with Bloomberg's Kathleen Hays about the U.S. government's Troubled Asset Relief Program for banks. Stiglitz, former chief economist at the World Bank and a professor of economics at Columbia University, also discusses the government's stress tests for banks and the Obama administration's strategy to bolster banks’ balance sheets to spearhead a recovery in an economy facing its longest recession in at least a quarter century.

Watch Stiglitz Interview

Why Joseph Stiglitz doesn't like the TARP

What strikes me about the TARP is that the banks choose which assets to dump. Therefore, the taxpayers will hold the worthless assets.

The Obama administration’s bank-rescue efforts will probably fail because the programs have been designed to help Wall Street rather than create a viable financial system, Nobel Prize-winning economist Joseph Stiglitz said.

“All the ingredients they have so far are weak, and there are several missing ingredients,” Stiglitz said in an interview yesterday. The people who designed the plans are “either in the pocket of the banks or they’re incompetent.”

The Troubled Asset Relief Program, or TARP, isn’t large enough to recapitalize the banking system, and the administration hasn’t been direct in addressing that shortfall, he said. Stiglitz said there are conflicts of interest at the White House because some of Obama’s advisers have close ties to Wall Street.

“We don’t have enough money, they don’t want to go back to Congress, and they don’t want to do it in an open way and they don’t want to get control” of the banks, a set of constraints that will guarantee failure, Stiglitz said.

The return to taxpayers from the TARP is as low as 25 cents on the dollar, he said. “The bank restructuring has been an absolute mess.”

Rather than continually buying small stakes in banks, the government should put weaker banks through a receivership where the shareholders of the banks are wiped out and the bondholders become the shareholders, using taxpayer money to keep the institutions functioning, he said.

Stiglitz, 66, won the Nobel in 2001 for showing that markets are inefficient when all parties in a transaction don’t have equal access to critical information, which is most of the time. His work is cited in more economic papers than that of any of his peers, according to a February ranking by Research Papers in Economics, an international database.

Financial shares have rallied in the past month as Goldman Sachs Group Inc., JPMorgan Chase & Co., Citigroup Inc. all reported better-than-expected earnings in the first quarter. The Standard & Poor’s 500 Financials Index has soared 91 percent from its low of 78.45 on March 6.

The Public-Private Investment Program, PPIP, designed to buy bad assets from banks, “is a really bad program,” Stiglitz said. It won’t accomplish the administration’s goal of establishing a price for illiquid assets clogging banks’ balance sheets, and instead will enrich investors while sticking taxpayers with huge losses, he said.

“You’re really bailing out the shareholders and the bondholders,” he said. “Some of the people likely to be involved in this, like Pimco, are big bondholders,” he said, referring to Pacific Investment Management Co., a bond investment firm in Newport Beach, California.

Stiglitz said taxpayer losses are likely to be much larger than bank profits from the PPIP program even though Federal Deposit Insurance Corp. Chairman Sheila Bair has said the agency expects no losses.

“The statement from Sheila Bair that there’s no risk is absurd,” he said, because losses from the PPIP will be borne by the FDIC, which is funded by member banks.

Andrew Gray, an FDIC spokesman, said Bair never said there would be no risk, only that the agency had “zero expected cost” from the program.

“We’re going to be asking all the banks, including presumably some healthy banks, to pay for the losses of the bad banks,” Stiglitz said. “It’s a real redistribution and a tax on all American savers.”

Stiglitz was also concerned about the links between White House advisers and Wall Street. Hedge fund D.E. Shaw & Co. paid National Economic Council Director Lawrence Summers, a managing director of the firm, more than $5 million in salary and other compensation in the 16 months before he joined the administration. Treasury Secretary Timothy Geithner was president of the New York Federal Reserve Bank.

“America has had a revolving door. People go from Wall Street to Treasury and back to Wall Street,” he said. “Even if there is no quid pro quo, that is not the issue. The issue is the mindset.”

Stiglitz was head of the White House’s Council of Economic Advisers under President Bill Clinton before serving from 1997 to 2000 as chief economist at the World Bank. He resigned from that post in 2000 after repeatedly clashing with the White House over economic policies it supported at the International Monetary Fund. He is now a professor at Columbia University.

Stiglitz was also critical of Obama’s other economic rescue programs.

He called the $787 billion stimulus program necessary but “flawed” because too much spending comes after 2009, and because it devotes too much of the money to tax cuts “which aren’t likely to work very effectively.”

“It’s really a peculiar policy, I think,” he said.

The $75 billion mortgage relief program, meanwhile, doesn’t do enough to help Americans who can’t afford to make their monthly payments, he said. It doesn’t reduce principal, doesn’t make changes in bankruptcy law that would help people work out debts, and doesn’t change the incentive to simply stop making payments once a mortgage is greater than the value of a house.

Stiglitz said the Fed, while it’s done almost all it can to bring the country back from the worst recession since 1982, can’t revive the economy on its own.

Relying on low interest rates to help put a floor under housing prices is a variation on the policies that created the housing bubble in the first place, Stiglitz said.

“This is a strategy trying to recreate that bubble,” he said. “That’s not likely to provide a long-run solution. It’s a solution that says let’s kick the can down the road a little bit.”

While the strategy might put a floor under housing prices, it won’t do anything to speed the recovery, he said. “It’s a recipe for Japanese-style malaise.”

Even with rates low, banks may not lend because they remain wary of market or borrower risk, and in the current environment “there’s still a lot of risk.” That’s why even with all of the programs the Fed and the administration have opened, lending is still very limited, Stiglitz said.

“They haven’t thought enough about the determinants of the flow of credit and lending.”

(from Bloomberg, April 17, 2009)

Roubini’s Read on the Recession

The solutions and government interventions that need to be tackled in order to take the economy and financial system off of life support, with Nouriel Roubini, chairman/NYU Stern School of Business professor and Arianna Huffington, Huffington Post. Nouriel Roubini shares his views on the ongoing global recession on CNBC Squawk Box. He is much more bearish than the consensus.

Roubini's Read on the Recession
Roubini's Read on the Recession

Wednesday, April 15, 2009

Calpers Seeks to Buy TARP Holdings

The California Public Employees’ Retirement System said it’s seeking opportunities to buy assets of Citigroup Inc. and other financial companies tied to the U.S. government’s $700 billion Troubled Asset Relief Program.

Calpers, as the largest U.S. public pension manager is known, said today it’s setting aside “billions of dollars” amid the credit crunch and is ready to deploy capital. It added that there’s a “glimmer of hope” in the stock market.

The pension fund is seeking to buy “some of the assets of these financial companies such as Citi and the others, assets that they’re trying to get off their balance sheets,” Henry Jones, a Calpers board of administration member, said in an interview after a speech in Seoul.

Calpers’s cost of managing its investments declined to the lowest level since 2004 after the value of fund holdings fell 27 percent this fiscal year, and it projects its investment costs will fall to $817 million in the 12 months that begin July 1, down from $1.04 billion last year, according to a report that will be presented to the fund’s governing board. That is the lowest since the fund spent $523 million in the fiscal year that ended June 30, 2004.

Calpers has broadened its asset allocation ranges to ensure more flexibility and plans to hold its investment review in May, about 18 months ahead of schedule, Jones said in the speech.

“The assumptions that we used 18 months ago no longer fit the present market,” he said. “There’s still a tremendous ocean of toxic debt out there. Even if we didn’t buy it, it’s done enough damage to our banks to affect all of us on Wall Street.”

The pension fund lost more than a quarter of its value in the first seven months of its current fiscal year, led down by stocks, real estate and commodities, according to its most recent investment activity report.

The MSCI World Index jumped 12 percent in the past one month as governments around the world stepped up efforts to stimulate their economies. The gauge has pared losses this year to 6.6 percent after last year’s 42 percent slump when the global economy sank into recession.

Calpers, with $175 billion in assets as of April 13, reached a record high of $260 billion in October 2007. The fund provides pension and health benefits to 1.6 million government workers, retirees and their families.

“Credit is still tight in the markets, but we’re able to raise enough cash to still make good deals and position ourselves for an eventual market turnaround,” Jones added.

The Sacramento, California-based fund invests 7.6 percent of its funds in cash, a category that calls for no allocation under targets established in December 2007, according to its Web site. The fund’s bond investments represent 24.8 percent of the total, more than the 19 percent target. It’s underinvested in equities, with 53.5 percent allocated there compared with a target of 66 percent.

Calpers has $500 million invested in South Korea, including a $100 million investment with Lazard Asset Management Plc last year, Jones said.

(from Bloomberg, April 15, 2009)

Sunday, April 12, 2009

Pension Funds And Recession

Participating in the meeting with CalPERS in February 2009, I learned how CalPERS work with hedge fund managers. The hedge fund strategy is written into the contract and serves as an input into the calculation of the entire CalPERS risk management model. To change the strategy, the fund manager must have the approval from the CalPERS. Understandingly, the fund manager strives to maintain CalPERS funds under the management and faces the dilemma of achieving the best performance versus maintaining the funds.

I felt that hedge fund managers don't have enough flexibility to adjust to the market conditions and take advantage of fast changes to maximize their performance. New CalPERS CIO Joseph Dear proposes to revisit the structure of management fees to achieve better alignment between the CalPERS partners and investors interests. He also agrees with the need for the market regulation and stresses, that the believe in markets self regulation is colossally expensive mistake.

George Soros Disagrees with Geithner's Way of Helping Banks

George Soros is a big supporter of Obama. However, he disagrees with Geithner's way of helping banks. In his interview to "For the Record" on Bloomberg he answers a wide range of questions covering the health of financial system, housing crisis, credit default swaps regulation, hedge fund reporting, strength of dollar, stock market propensity to deviate from equilibrium and re-enforce the deviation, bear rally, and many more.

China’s New Lending and Money Supply Surged to Records in March

China’s new lending and money supply surged to records in March, adding to signs that government stimulus efforts are reviving the world’s third- largest economy.

Loans jumped more than sixfold from a year earlier to 1.89 trillion yuan ($277 billion) and M2, the broadest measure of money supply, grew 25.5 percent, the central bank said on its Web site yesterday.

Premier Wen Jiabao said China’s economy showed better-than- expected changes in the first quarter after the government adopted a 4 trillion yuan spending plan, the official Xinhua News Agency reported, citing an interview in Thailand yesterday. China’s lending boom contrasts with the struggle in the U.S. to rid banks of illiquid assets and efforts by central banks from Switzerland to Japan to unfreeze credit.

“China is unusual in that it has this incredible capacity to mobilize all its institutions -- central government, local governments and the entire banking system -- to boost government-influenced investments,” said Vikram Nehru, the World Bank’s Washington-based chief Asia economist.

The growth in money supply was the fastest since Bloomberg began compiling data in 1998 and exceeded the 21.5 percent median estimate in a survey of 12 economists.

Economic growth cooled to 6.8 percent in the fourth quarter, the slowest pace in seven years. The first-quarter figure is due April 16.

China’s banks, which are mostly state-owned, have already met the bulk of the government’s target of at least 5 trillion yuan of new loans this year. Lending may top that level by as much as 3 trillion yuan, according to JPMorgan Chase & Co.

The explosion in credit since the central bank dropped lending restrictions in November prompted the nation’s banking regulator to warn this month that lenders face a “severe” challenge in managing their risks.

“The central bank had to ensure it did enough to reflate the economy,” said Kevin Lai, an economist with Daiwa Institute of Research in Hong Kong. “The question now is whether it has done more than is needed.”

A concentration of loans in infrastructure projects is a potential hazard for banks, China Banking Regulatory Commission Vice Chairman Jiang Dingzhi wrote in the April 1 edition of China Finance, a magazine affiliated with the central bank. Unusual growth in discounted bills, which are used for working capital and dilute banks’ lending profits, “deserves high attention,” Jiang said.

“The biggest dangers to China’s economy and financial system come from within, not from outside,” Jiang Zhenghua, former vice chairman of China’s parliamentary standing committee, said at a financial conference in Beijing yesterday. “The biggest of these hidden dangers is the degree of bad loans in China.”

China Merchants Bank Co., the nation’s fifth-largest by market value, said on April 9 that providing money for infrastructure projects will improve the quality of its book by adding more medium- to long-term loans.

Besides the risk of bad loans, the credit boom may inflate asset prices and increase the likelihood of inflation making a comeback. The benchmark Shanghai Composite Index of stocks has climbed about 34 percent this year.

“Some of the money has gone to the property market, some to the stock market,” said Lai at Daiwa Research. “It is not what the central bank wants to see.”

Excessive loan growth may “lead to inflationary pressure in the medium term, exacerbate credit risk and could potentially contribute to higher volatility in the economy,” said Ma Jun, chief China economist at Deutsche Bank AG in Hong Kong.

Signs of nascent economic recovery include a 26.5 percent jump in urban fixed-asset investment in the first two months. Manufacturing expanded in March for the first time in six months, according to a government-backed index, while automobile sales rose to a record 1.08 million vehicles, Xinhua reported.

Consumer demand grew “steadily and relatively rapidly” while imports and exports rose month-on-month in the first quarter, Xinhua cited Premier Wen as saying in an interview with Hong Kong and Macau reporters during the aborted Association of Southeast Asian Nations summit in Pattaya.

“With loan growth rates exceeding official targets, bank regulators may urge more restraint, to guard against excessive liquidity,” Jing Ulrich, head of China equities at JPMorgan Chase & Co. in Hong Kong, wrote in a report yesterday.

China’s banking regulator is examining whether it needs to curb lending after new bank loans surged to a record in March, the Shanghai Securities News reported on April 8, citing unidentified people.

Still, exports fell a record 25.7 percent in February, Chinese steel prices have dropped this year, and industries face “great difficulty,” according to Ou Xinqian, a vice minister of Industry and Information Technology.

China’s trade surplus shrank 45 percent to $62.5 billion in the first quarter, from $114.3 billion in the previous quarter. The country’s foreign-exchange reserves grew by the least in eight years to $1.9537 trillion, the central bank said yesterday.

Macquarie Securities Ltd. on April 8 raised its forecast for China’s growth this year by 1 percentage point to as much as 8 percent. China International Capital Corp. raised its estimate to as much as 8 percent from a previous forecast of 7.3 percent.

from Bloomberg, April 11, 2009