Bear Stearns

The FED and LIBOR – The Biggest Manipulator of Them All


Thursday, July 5th, 2012

 

by Peter Tchir, TF Market Advisors

The Fed does everything it can to keep Libor low

This chart says it all.

The Fed cannot affect LIBOR directly, but in general LIBOR trades in line with Fed Funds. You can see that historically as Fed Funds was changed, LIBOR responded appropriately. There was typically some small premium to reflect the “credit risk” of banks versus the Fed, but it was relatively small, and fairly stable. 3 Month LIBOR would deviate a bit as rate cuts and hikes were anticipated in the market, but in general, it was a fairly stable game.

That all started to break down in 2007. We saw the first real signs of LIBOR deviating from its normal spread to Fed Funds in the summer of 2007. The Fed responded by cutting the “penalty” rate for using the discount window, and in fact encouraged banks to use the discount window (I still can’t shake the mental image of someone sitting in a dark basement with a green eye-shade doling out money to banks that request it). Then the crisis got worse. Bear needed to be rescued. Facilities such as the Term Auction Facility that had been put in earlier were increased in size. The Fed backstopped some portfolios that JPM acquired as part of the Bear Stearns deal.

As the crisis re-ignited in the late summer of 2008 and peaked after Lehman and AIG, the Fed took step after step to reduce borrowing costs. The Fed was blatantly clear that it wanted borrowing costs to go down. They had the obvious tool of reducing Fed Funds to virtually zero, but when LIBOR didn’t follow, the Fed took further action. The Fed did not want bank borrowing costs to be high.

They increased dollar swap lines so foreign banks could borrow. The Fed stepped into the commercial paper market so banks wouldn’t have to use money to meet drawdowns on revolvers. TALF was another creation to take pressure of bank lending.

The FDIC allowed banks to issue bonds with FDIC backing (so not quite Fed program, but who is going to quibble).

Fears that MS and GS and GE would topple the banks were alleviated by making them banks.

The list goes on. The Fed has done a lot and trying to control LIBOR as a key borrowing rate is one of the things they have worked on, both directly and indirectly.

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Killing Vampires, Werewolves, and Zombie Banks (Tchir)


Thursday, June 7th, 2012

 

by Peter Tchir, TF Market Advisors

We all know how to kill a vampire and a werewolf. For vampires you need to either trap them in sunlight or drive a wooden stake through their heart. For werewolves, you need a silver bullet. Or at least you did before the Twilight series came out. But killing a zombie bank isn’t necessarily as easy.

We all get caught up in the moment. Every tick down in the stock market adds to the fear and anxiety. Every tick up sends waves of relief through the economy. The reality the stock market and economy move at dramatically different speeds, and that is the case for bank failures as well.

While it is true that occasionally banks or companies default overnight or in very short order, that isn’t the norm. Even Lehman was a known problem for ages. Its debt traded very wide off and on for a year ahead of the eventual default. It was on the cusp when Bear Stearns got saved. Lehman got saved that time without a dime being given to it. It squandered its chance and failed to raise money in the 6 months after Bear, but it did last a long time.

Weak banks can linger for a long time, especially if someone is willing to provide them liquidity at non market (stupid) rates. Rescap affectionately known as Rescrap, although not a bank is a great example.

A solvency problem can’t be solved by liquidity, but if there is a lender willing to provide as much liquidity as it takes, and rates that make no sense for the risk, the default can be pushed off for a long time. It can be delayed much longer than we think and in some cases, avoided all together. While Rescap finally met its fate it should probably have met in 2007 or 2008, MBIA seems to have turned the corner.

MBIA has lasted this long because it didn’t require much funding and time has given it the chance to earn carry and avoid payouts.

While neither Rescap nor MBIA are banks they are decent examples of how long it can take to play out.

In the U.S. only Lehman and Washington Mutual failed. At the last moment Bear Stearns and Merrill were “saved”. Others have lingered along in various states of disrepair for a long time with full government support.

That is the key when looking at the crisis in Spain or at Bankia in particular. A solution of lots of fresh equity capital tomorrow would be ideal. But just because we don’t see capital injections tomorrow doesn’t mean it is about to default or go into full unwind mode. Unlimited 3 month LTRO and other ECB and Spanish facilities can keep it alive for quite some time, so expecting it to be an immediate catalyst to a huge down move is as likely to be true as those that hope for some magic plan from the ESM to make it all better.

Time is the key, and horrible headlines aside, it is easier to kill a vampire or werewolf than it is to kill a bank with an unlimited supply of cheap money.

Central Bank Activity

Our scorecard from yesterday continues to fill in. We didn’t get global swap lines, but we did get a China rate cut, so +1. We didn’t get a rate cut, so -1/2, but they did mention some members had voted for a rate cut, so take that as a zero, with a running total of +1.

Unlimited 3 month LTRO, wasn’t on our list but call that a +1/2. 3 year would have been better, but the focus on unlimited was good. So we are at +1.5 so far in total.

Away from that, the ECB didn’t really do much else, but Germany or someone floated a rumor that the EFSF or ESM could lend to some Spanish entity other than Spain which could then recapitalize the banks. I don’t know the source and it is so convoluted that it is unlikely to work, yet convoluted enough it seems likely some politician is really looking at it. Call that +1/2 max, but when coupled with further rumors that ESM will either get a banking license or have a lots of ECB support, lets call all the rumors and “wink wink” signals as a +1 in total. That gets us to 2.5.

The ECB did put it back on the politicians, but not as belligerently as they could have so only -1/2.

Extremely dovish Fed comments added back at least +1, giving us a current total of +3 heading into Bernanke’s testimony.

After yesterday’s comments, by Yellen in particular, it is hard to imagine anything other than an actual announcement by Ben doing a lot for the market and he could easily undo the work done by Yellen.

Still Targeting May 11th Prices

In addition to the central bank push encouraging risk on, and the overreaction to the Spanish banking crisis, I was surprised that the Spanish sovereign debt auction got done. I suspect that the banks were told to buy and some CDS short covering bids were put in, but it is still a minor positive and far better than pulling the auction.

I was also surprised just how short the market seemed to trade. I thought we were oversold, but the market traded even more short than I would have guessed.

I think the banks can be a catalyst for yet another leg higher. Clearly I’m getting nervous back up at these levels, but I think we can achieve the May 11th prices. Everyone again seems to be fading this rally or too bitter that we are moving up on a Chinese rate cut. No one has embraced the trade off the lows and too many funds seemed to have gotten whipsawed that the pain of this up move isn’t quite over.

Look for a continued bounce in HY and EM debt denominated in dollars. U.S. treasury rates aren’t going up any time soon, the search for yield will resume, and high yield will benefit from a sluggish, but stable economy, and EM will benefit from the “reflation” trade the central bankers so desperately want to see happen.

 

Copyright © TF Market Advisors

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“Lehman 2.0″ Imminent Warns John Taylor


Thursday, February 16th, 2012

By John R. Taylor, Jr. Chief Investment Officer FX Concepts

Lehman 2.0

Global investors either have extremely short memories or they are far too concrete, as my wife the psychologist would say. Saying that Greece is not a bank but a country means nothing. Almost all Europeans argue that a default by the Greek government would now be more straightforward and not as significant as the collapse and bankruptcy of Lehman Brothers in September 2008, especially since the Eurozone, under the influence of the surplus countries, has effectively ‘ring-fenced’ Greece from the other 16 members. Lehman was not a very large factor in the global banking scene with less than one quarter the capital of the biggest US banks and with assets below those of more than 100 banks around the world. Greece might represent less than 3% of the GDP of the Eurozone, but when lined up against Lehman, Greece stands larger in its relevant market. Anyone can read the newspapers, blogs, and Internet scribblings before the Lehman collapse and see that the impact of its collapse was not expected to be significant. Tim Geithner, then head of the New York Fed, worked to arrange the emergency liquidation of Lehman’s assets and there were expectations that the company could be sold to Bank of America or Barclays, but the Bank of England vetoed a sale to Barclays and the US government refused to lend any support to Bank of America in its effort to buy Lehman.

Rereading the documents and remembering the situation as I set out for a weekend cruise on the Chesapeake, the world was not worried. The market had already seen the rescues or restructuring of Washington Mutual, Countrywide, Fannie Mae, and Freddie Mac, so no one was worried. This looked like another Bear Stearns, a manageable problem but this time the Bush administration was not interested in getting involved – ‘let the market solve this, don’t throw good money after the bad.’ So, what is the difference now? The world is as blasé about a Greek default or departure from the euro as it can be – credit spreads are dropping, the other weak Eurozone sovereigns are financing themselves easily, and everyone thinks the LTRO has solved the problem for the next year or two. Why should we worry about Greece? Who cares if their unemployment is 20.9% and climbing very fast, or that it is now in its fifth year of declining GDP? Let’s teach them a lesson!

Hubris is at the heart of this. Everyone says this cannot happen – we won’t allow it. Says who? The EU says: if it is written in an agreement, it must be totally correct, unchangeable, and followed at all costs. New realities can’t intervene and no slippage is allowed. Why the Germans are so sure that they know the future is beyond me. They are fallible too, but they won’t admit it, and the Greeks can’t make them budge. Haven’t they looked around? Santorini has a different economic and social cost structure than Wiesbaden. Humanity (and common sense) seems totally lacking in the negotiations with the Greeks and a violent backlash would be totally understandable. Why the countries that have been fattening up their current account surpluses selling products to Greeks, whom they should have known were basically broke – just as they always have been – should be paid 100% on the euro is beyond me. Major losses should apply not only to sovereign borrowings but also to accounts receivable for cars, electronics, and other consumer goods. The market has not opened its eyes to the impact this Greek unraveling will have. The Eurozone will be mortally wounded and the world will suffer a significant recession – maybe as deep as 2008. European banks will lose much of their capital base and many should be bankrupt, but just as in the Lehman aftermath, the governments will try to save the banks and the banks’ bondholders, solvent or not. As the bank appetite for Eurozone sovereign paper will be decimated, austerity will probably follow shortly, followed by deflation and uncontrollable money creation. The European recession should be one for the record books.

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Penny Wise and Euro Foolish (Hussman)


Sunday, October 23rd, 2011

Penny Wise and Euro Foolish

by John P. Hussman, Ph.D., Hussman Funds

Among the effects of the recent and now renewed credit strains in the global economy is that investors have lost touch with relative magnitudes. For example, a billion dollars effectively represents about $3.20 for every adult and child in the U.S., while a trillion dollars represents about $3,200 dollars per person. From our standpoint, among the most important research coordination that government provides comes from the National Institutes of Health (NIH), which funds basic medical research in cancer, diabetes, multiple sclerosis, Alzheimer’s, autism, and other conditions, and where the total annual budget is about $31 billion annually (roughly $1,000 per American). Add in just over $7 billion in research through the National Science Foundation, and about $1,200 per citizen a year is spent by the government on essential medical and non-military scientific research through these agencies. These figures pale in comparison to the amounts that are increasingly demanded in order to make bondholders whole on their voluntary, bad investments. The Federal Reserve provided an amount equal to the entire NIH budget simply to backstop the rescue of Bear Stearns, which allowed Bear Stearns bondholders to receive 100 cents on the dollar, plus interest. In return, the Fed got questionable assets that it pouched into a shell company called “Maiden Lane,” which were later reported to have “underperformed.”

Incomprehensibly large bailout figures now get tossed around unexamined in the wake of the 2008-2009 crisis (blessed, of course, by Wall Street), while funding toward NIH, NSF and other essential purposes has been increasingly squeezed. At the urging of Treasury Secretary Timothy Geithner, Europe has been encouraged to follow the “big bazooka” approach to the banking system. That global fiscal policy is forced into austere spending cuts for research, education, and social services as a result of financial recklessness, but we’ve become conditioned not to blink, much less wince, at gargantuan bailout figures to defend the bloated financial institutions that made bad investments at 20- 30- and 40-to-1 leverage, is Timothy Geithner’s triumph and humanity’s collective loss.

The most depressing display of math-illiteracy by investors last week was the excitement over a report suggesting that France and Germany had agreed to a 2 trillion euro bailout package for Europe, which triggered a “risk-on” tone for the rest of the week, even after the report was retracted as inaccurate. It was almost beyond belief that investors took that report seriously, but people have become so tolerant of unbelievably large figures that virtually any bailout number can now be tossed out without triggering the least bit of scrutiny. Notably, 2 trillion euros is more than the GDP of France, and is half the GDP of Germany and France combined. Moreover, Europe has just gone through a tooth-pulling process just to approve 440 billion euros for the European Financial Stability Fund (EFSF) from all EU members combined.

So barring new dedicated funds from Germany and France, which had zero chance of being forthcoming, the only way you could morph 440 billion euros into 2 trillion euros was for each of those 2 trillion euros to really be only 22 euro cents of protection. In other words, you could only say that the EFSF would “protect” 2 trillion euros in European debt by limiting the protection to about 20% of face value, without using any of the funds to recapitalize banks or deal with much deeper probable losses on Greek debt (50-60%). Those losses alone will gulp down a large chunk of the EFSF (not to mention post-default needs to stabilize Greece over the longer-term, which the Troika estimates at another 450 billion euros).

Last week, the yield on one-year Greek debt closed at 183%, a new record, and up from 169% the prior week. Yet on Friday, the market rallied on hopes of a comprehensive “solution” to the European debt crisis, and took heart that part of an 8 billion euro hold-over loan to Greece was approved. The 1-year Greek yield pushed 3 percentage points higher. As I’ve noted before, this limited amount of immediate relief is needed to buy time preparatory to a default. A clean solution to the European debt problem does not exist. The road ahead will likely be tortuous.

The way that Europe can be expected to deal with this is as follows. First, European banks will not have their losses limited to the optimistic but unrealistic 21% haircut that they were hoping to sustain. In order to avoid the European Financial Stability Fund from being swallowed whole by a Greek default, leaving next-to-nothing to prevent broader contagion, the probable Greek default will be around 50%-60%. Note that Greek obligations of all maturities, including 1-year notes, are trading at prices about 40 or below, so a 50% haircut would actually be an upgrade. Given the likely time needed to sustainably narrow Greek deficits, a default of that size is also the only way that another later crisis would be prevented (at least for a decade, and hopefully much longer).

Gradually, but eventually, European leaders are beginning to recognize that you can’t solve a sovereign debt crisis by expanding the quantity of sovereign debt, when even the strongest countries are already bloated with it. You can’t get “Out” by walking through yet another door marked “In.” The markets aren’t quite to that realization, hoping for some easy “final” resolution that will simply make the problem go away, but that dawn will come.

The Troika report released over the weekend notes that “the situation in Greece has taken a turn for the worse … Deeper PSI [private sector involvement - i.e. loss-taking], which is now being contemplated, also has a vital role in establishing the sustainability of Greece’s debt*. To assess the potential magnitude of improvements in the debt trajectory, and potential implications for official financing, illustrative scenarios can be considered using discount bonds with an assumed yield of 6 percent and no collateral. The results show that debt can be brought to just above 120 percent of GDP by end-2020 if 50 percent discounts are applied… *Footnote: The ECB does not agree with the inclusion of the illustrative scenarios concerning a deeper PSI in this report.”

That footnote is interesting – it’s not that the ECB disputed the deeper loss-taking scenarios – it just didn’t want to include them in the report.

My guess is that European leaders will force a bank recapitalization within days – probably 100 billion euros, preferably 200 billion, but the larger number is doubtful because at present market values, European banks would have to sell new shares in nearly the same quantity as their current outstanding float in order to acquire the new capital. Yet Stratfor correctly notes that even in the event of a 200 billion recapitalization, a 50% haircut on Greek debt “would absorb more than half of that 200 billion euros. A mere 8 percent haircut on Italian debt would absorb the remainder.” So a good chunk of the present EFSF could end up recapitalizing banks, especially if too little is raised from private investors. This would leave little ammunition against any further strains, should they develop.

Of course, Europe wouldn’t need to blow all of these public resources or impose depression on Greek citizens if bank stockholders and bondholders were required to absorb the losses that result from the mind-boggling leverage taken by European banks. It’s that leverage (born of inadequate capital requirements and regulation), not simply bad investments or even Greek default per se, that is at the core of the crisis.

The bottom line is a) European leaders will likely initiate a forced bank recapitalization within days; b) Greece will default, but the new hold-over funding may give the country a few more months; c) the EFSF will not be “leveraged” by the European Central Bank; d) banks are likely to take haircuts of not 21%, but closer to 50% or more on Greek debt; e) much of the EFSF will go toward covering post-default capital shortfalls in the European banking system following writedowns of Greek debt; f) the rest will most probably be used to provide “first loss” coverage of perhaps 10% on other European debt, which may be sufficient to limit contagion provided that implied default probabilities on Italian and Spanish debt don’t breach that level and the global economy stabilizes; g) uncertainty following a Greek default is likely to create significant financial strains, even in the absence of a recession; h) all bets for stability are off if the global economy deteriorates markedly from here, which is unfortunately what we continue to expect.

Shenanigans

On the subject of bank capital, I can’t stress enough that the proper approach is for government to restrict even temporary, fully-collateralized assistance only to those institutions that are clearly solvent, and to promptly restructure the other institutions. What the global economy needs most is not bank bailouts, but to establish and enforce a legal and regulatory structure that allows the streamlined bankruptcy of insolvent institutions (Title II of Dodd-Frank addresses this with a more comprehensive policy than existed in 2008, but it doesn’t read as a “clean” solution in my view – putting too many cooks in the kitchen – particularly the Fed and the Treasury).

Again, again, again, the “failure” of a financial institution only means that the institution fails to pay off its own bondholders. Depositors typically lose nothing. For example, “saving” Bear Stearns meant primarily that Bear Stearns’ bondholders would be made whole. Saving Dexia a few weeks ago meant the same thing for Dexia’s bondholders. The key is not to prevent “failure,” but to prevent disorderly failure and piecemeal liquidation. Washington Mutual was a seamless, and therefore nearly unmemorable “failure.” Lehman was disorderly and jarring. The difference was that there was a legal and regulatory structure to quickly cut away stockholder and bondholder liabilities in the Washington Mutual instance (which was handled by the FDIC), while there was no similar way to restructure non-bank financials like Lehman in 2008.

From my perspective, weak regulation of bank leverage, inadequate capital requirements, and the need for prompt, streamlined restructuring for insolvent banks are among the most urgent problems that the global economy faces. Consider this. The Financial Times reported on Friday that in 2008, Dexia lent 1.5 billion euros of its capital to two institutional investors, who used the cash to buy newly issued shares in … wait for it … Dexia. Remember that as a bank, Dexia operated at leverage of about 50 times its tangible shareholder equity (see last week’s comment ). So Dexia’s maneuver made it possible to meet regulatory capital standards and take on a huge amount of additional leverage, without actually raising any bona-fide capital. As FT noted, “The unorthodox funding move, which roused Belgian regulators’ concern at the time, amounted to Dexia borrowing money from itself to finance a capital increase. This is illegal in most jurisdictions and is now banned in the European Union, but did not break Belgium’s existing laws.”

On a similarly outrageous note, Bloomberg reported last week that ” Bank of America , hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits… The Federal Reserve and the Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by the counterparties. The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC is objecting. The bank doesn’t believe regulatory approval is needed.” Well, other than that it goes against Section 23A of the Federal Reserve Act , but then, the Fed can make an exemption whether the FDIC likes it or not . And that’s what we’ve come to – government of the banks, by the banks, and for the banks (because banks are people too) .

The Bloomberg report continued, “B ank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA [the FDIC insured entity], according to the data, which represent the notional values of the trades. That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives.”

Note that the figures are in trillions, not billions (U.S. GDP is $15 trillion). That said, the vast majority of the “notional value” of derivatives in the financial system represents multiple fully-hedged links in a long chain between final users who actually take the risk, so Bank of America’s true risk is most probably a tiny fraction of that notional amount. Unless those derivatives include unhedged short positions in credit default swaps on Greek debt (which we can’t really rule out), it’s not clear that the derivatives themselves are underwater. The real problem, in my view, is that the transfer is clearly driven by the intent to get around capital adequacy regulations, and runs precisely opposite to the right way to create a good bank and a bad bank . It saddles the good bank – the taxpayer insured one – with the questionable liabilities, while “giving relief” to the holding company. This is really preposterous.

As a final note, it’s worth observing that a number of banks reported positive “earnings surprises” last week. If you look at those results for any of the major banks, it is immediately clear that the bulk of the earnings were of two sources: further reductions in reserves against potential loan losses, and an accounting gain known as a “Credit Valuation Adjustment.” Those two items, for example, were responsible for nearly 90% of Citigroup’s reported “earnings.” The Credit Valuation Adjustment (CVA) works like this: as the bond market has become more concerned about new financial strains, the bonds of U.S. banks have sold off significantly in order to reflect higher default probabilities. Under U.S. accounting rules, bank assets are no longer marked to market, but happily for the banks, the decline in the market value of their bond liabilities means that the banks could technically “buy their bonds back cheaper.” So the decline in the bonds, despite being due to an increase in investor concerns about bank default, actually gets reported as an addition to earnings! Surprise, surprise.

Market Climate

As of last week, the Market Climate for stocks remained hostile, with a clearly negative expected return/risk profile. Strategic Growth and Strategic International remain tightly hedged. That said, we’re beginning to see some emerging speculative elements in our analysis of market action. When there is ample negative news to smack speculators back to reality, it’s difficult for speculation to get “legs,” but speculation can take on a life of its own even in overvalued markets when there is a pause in flow of fresh concerns. Given our continued expectations of oncoming recession, and the likely inadequacy (from the market’s perspective) of bailout provisions in Europe, my impression is that further speculation is likely to be quickly smacked, but I won’t impose that impression on the objective evidence. While we would expect to retain a tight line of put option protection in any event, measurable improvement in market internals over the next few weeks would likely provoke us to accept a small positive exposure by covering some of our short index calls – at least until overvalued, overbought conditions are joined by overbullish sentiment. I doubt that we’ll observe even that modest constructive shift in the data, but am keeping an open mind. More often, overbought rallies in negative Market Climates (as we observe today) simply fail.

I continue to view economic evidence as consistent with oncoming recession. While there was some enthusiasm over the pop in the Philly Fed index to 8.7%, it’s useful to remember that the Philly Fed index also popped from negative levels in August 2007 to 8.6% in November 2007 (the month our Recession Warning Composite turned negative and the economy went into recession). Meanwhile, the Conference Board’s index of leading indicators places nearly half of its weight on the yield curve and M2, which reduces its robustness compared with broader methods. The slight positive reading last month was driven by those monetary components. As Babson Capital has noted, the non-monetary components of the LEI have historically had a 94% correlation with the index, with much more noise from the monetary components. In fact, in recent years, the monetary components have become negatively correlated with the economic components, so that improvements in the monetary components typically occur despite true economic deterioration. For example, I suspect that last month’s rise in M2 was largely due to investors switching from large money market funds (which have substantial holdings in European bank debt) and into Certificates of Deposit at U.S. banks – hardly an indication of robust economic prospects. Even the Conference Board conceded a very high probability of oncoming recession last month.

Notably, the ECRI Weekly Leading Index growth rate dropped to a fresh low of -10.1% last week, and unlike 2010, the deterioration is matched by weakness in a much broader set of evidence. Suffice it to say that leading data is leading data, and there is typically a gap between the point that the leading evidence turns down decisively and the point where coincident and lagging indicators confirm the deterioration. As for stocks, recession-linked bear markets don’t end before the recession even begins.

In bonds, yield levels are still depressingly low, but given the likelihood of recession and further credit strains, there is some potential for a renewed flight to safety in Treasury securities. That prospect combines moderately positive return possibilities with significant risks, so the return/risk potential is fairly limited, but improves somewhat as yields rise. Accordingly, we would be inclined to move slightly out in duration on further upticks in long-term yields. Presently, Strategic Total Return continues to carry a duration of about 1.5 years, with about 18% of assets in precious metals shares, and less than 4% in utilities and foreign currencies.

Copyright © Hussman Funds

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Reducing the Risk?


Thursday, June 2nd, 2011

Roger L. Martin, dean of the Rotman School of Management and author of Fixing the Game: Bubbles, Crashes and What Capitalism Can Learn from the NFL, writes in the Ottawa Citizen, Reducing the risk (HT: Bill Tufts):

In the wake of the spectacular 2008 financial markets crash, much has been made of the fact that no one has been held to account. Life has returned to near normal, and other than the failures of Lehman Brothers and Bear Stearns, little has changed in reaction to the mortgage meltdown.

The too-big-to-fail banks received hundreds of billions in bailout funds. Compensation for corporate executives is back on the upswing -by 11 per cent in 2010, according to the Wall Street Journal. Citigroup’s Vikram Pandit, almost turfed back in the darkest days of the crisis, just received a nearly $17-million bonus package aimed at keeping him in his job through 2015.

But the most concerning number for many pundits is zero. That’s how many corporate executives have been charged, indicted or convicted of malfeasance related to the crisis. It seems unimaginable -billions of dollars in wealth wiped away through risky, profit-maximizing deals and not one individual crossed the line into illegality.

This outcome has had many clamouring for greater regulation of the financial markets -more oversight, tighter controls and new regulations on complex derivatives. Unfortunately, those clamouring for greater accountability for private sector firms are fighting the wrong battle. As just one small player in a global economy, there is precious little Canada can do in the way of regulation in the financial markets to prevent another crash.

But, instead of ineffectually regulating at the margins, we can take clear and decisive action on one of the real root causes of the meltdown: the 2&20 formula.

The 2&20 formula is shorthand for the way in which hedge funds and other large market makers are compensated. They receive a base fee of two per cent (or three per cent or five per cent) of assets under management, plus 20 per cent (or 30 per cent or sometimes more) of any upside returns -called “carried interest.” This fee structure is almost identical to the stock-option compensation models that came into vogue in Silicon Valley in the late 1990s. Those kinds of stock options fell into disrepute when it became clear that allupside options give executives precisely the wrong kind of incentives.

Give a CEO a good base salary and significant stock options, and you’ve given her a mandate to swing for the fences, taking on huge risk in hopes of accruing huge rewards. If the risks don’t pan out, the CEO can fall back on that base salary, even as the company takes substantial losses. If the risks do pan out, however, the CEO gets massively rich.

The same structure applies to a hedge fund with a 2&20 formula. The fund gets two per cent of assets under management no matter what. So downside losses aren’t terribly worrisome when balanced against the potential reward of a huge home run on the upside. Hedge funds are therefore incented to take massive, risky gambles in the market. And the nature and size of those risks have the effect of actually increasing the volatility of our capital markets.

Of course, hedge funds aren’t going anywhere, and the Canadian government would have a limited capacity to regulate a massive global industry regardless. So, what can we do to better regulate and de-risk our financial markets?

Simple: We can better regulate some of the hedge funds’ biggest customers -public sector pension funds and endowments. Canada’s public sector pension funds are incredibly sophisticated and many, notably the CPP Investment Board, are exceptionally well run. But far too many have fallen under the thrall of “alternative investments” -which run directly counter to the best interests of their pensioners. The funds, whether university endowments or public sector union pension plans, should have incentive to generate long-term, steady growth in order to meet their future commitments. Yet those same funds have been chasing the high-risk, massively volatile, all-or-nothing returns promised by hedge funds.

This misalignment came into stark relief in 2008. In the lead-up to the crisis, pension funds began chasing higher and higher returns, wary of being found in an underfunded position relative to future commitments. Soon, they were caught up by promises of supernatural returns and public sector funds found themselves holding toxic and worthless alternative vehicles from funds of funds and the like. As the market declined, the pension funds lost billions. My own university’s endowment fund lost more than a quarter of its value in fiscal 2009, as it unwound its alternative investment strategy.

Clearly the public sector funds were chasing returns, and they used hedge funds and risky investments to do so. They need clearer direction about the appropriate risk profile for the investment of public pension funds. They need clearer regulations to prevent them from heeding the siren call of hedge fund investing. In short, they need to be banned from investing with any firm that uses a 2&20-type formula.

Public pension funds should be permitted to invest only in funds that charge either an asset fee or a carried interest, but not both. The funds in which they invest must have some downside risk along with the investor.

Only under this structure would the needs of pensioners be better aligned with the incentives of their money managers.

Mr. Martin makes an excellent point on hedge funds becoming large asset gatherers, collecting 2% management fee and ignoring the 20% performance fee. When hedge funds have more sales staff than investment professionals, run away, they’re not aligning their interests with their investors who are looking for high risk-adjusted returns (that means you protect the downside).

But Mr. Martin is completely wrong blaming hedge funds and public pension funds who invest in hedge funds and alternatives as the root cause of the financial crisis. You can blame greedy bankers, but not the hedge funds or private equity managers. By throwing the baby out with the bathwater, he demonstrates his ignorance on hedge funds.

While 2&20 can be a problem when assets explode, the truth is it aligns interests with investors because the best managers focus on delivering high risk-adjusted returns. Unlike mutual fund managers and bank prop traders, hedge fund managers have ther own personal wealth in the fund – - skin in the game which is why they focus on minimizing downside risk.

Admittedly, the bulk of hedge funds are just selling beta as alpha, but there are plenty of managers that are generating real alpha. Should we do away with management fees? Maybe after a hedge fund passes a critical asset threshold. The other option is to use managed accounts and negotiate lower fees. This is where more and more of the large pension funds are heading because it allows them to have full control of their hedge fund investments, allowing them to control liquidity and operational risk.

I disagree with Mr. Martin. Public pension funds should be investing and even seeding hedge funds, but they should be going about it in an intelligent way, using managed accounts. Only then will they be truly aligning their interests with their stakeholders. Finally, as far as Mr. Martin’s university endowment fund and other endowment funds, I know for a fact they took stupid risks that had nothing to do with the alternative investments they invested in (like asset-backed commercial paper).

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Harbinger is a Harbinger of Things to Come: Goodbye Phil, You are Just the Start


Thursday, November 11th, 2010

In the purest definition of nomenclature irony, Harbinger has now become a harbinger of what is in store for the whole hedge fund industry as a whole. And for those who may have missed yesterday’s news, Phil Falcone’s multi-billion hedge fund is now essentially finished. As William Cowan said yesterday, “you may be seeing right before your eyes the unwinding of this hedge fund” and he proceeds to compare Harbinger to the two Bear Stearns hedge funds whose unwind was the key catalyst to the end of the credit bubble. Goldman’s redemption of its $120 million interest in Falcone is merely the start of the avalanche for the once perceived as flawless Falcone, and now has become the butt of jokes in the hedge fund industry. Today we read that both Blackstone and the NY Pension fund are pulling their money as well, which means the liquidation run has commenced. Yet what is happening with Harbinger is just an indication of what will happen to all hedge funds at the end of the year who are underperforming the S&P, or heaven forbid, negative for the year. After all, the news that Falcone was “misappropriating” locked up funds was public in March – Goldman’s pull using that as an excuse is merely a strawman to get out of losing positions. Which is why the beta leveraged ramp is about to hit desperation levels, as not one fund can create alpha. In other words, if something happens to Apple in the next 5 weeks, the next leg of the depression is about to take off.

But back to Harbinger, where in FinAlternatives we read that Goldman’s pull out was just the start:

Goldman Sachs and the Blackstone Group may redeem their investments in Harbinger Capital Partners’ flagship after the hedge fund’s founder said he borrowed more than $100 million from another fund to pay his taxes.

Both firms filed redemption notices with the New York-based hedge fund, which has about $9 billion in assets under management. The New York State Common Retirement Fund also plans to pull $41 million from the Harbinger Capital Partners Fund, which is down 15% this year.

And William Cowan’s take on the imminent unwind of what as recently as 4 years ago was seen as the Paulson and Co. of that time.

Oh well, the biggest winner in all of this is Lisa Falcone, who, as she herself said previously, “Eighteen years and no prenup means family office.” The question of what happens to the spoils as the office is liquidated is now a very unpleasant one for Phil.

http://advisoranalyst.com/glablog/wp-content/uploads/HLIC/21de83ca1b28d656771a31b4c7ae3d89.jpg

Here are Falcone’s top stocks (not that many – the fund is mostly involved in bonds and a crazy plan to take over the world via some zany wireless company scheme) which will soon be force liquidated. Position appropriately, especially since many of these are very illiquid.

(click image to enlarge)

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Andrew Maguire Re-Emerges: Ex-Goldman Trader Exposes JPMorgan, HSBC In Latest Silver Price Manipulation Class Action Lawsuit


Tuesday, November 9th, 2010

via ZeroHedge.com

Just as in fraudclosure, the PM manipulation lawsuits are now coming daily… Soon – hourly. From the just filed lawsuit by Eric Nalven, which references Andrew Maguire‘s series of whistleblowing emails: “In connection with its acquisition of Bear Stearns in March 2008, defendant JPMorgan acquired massive short positions in the silver futures market. Thereafter, JPMorgan, with HSBC, artificially depressed the price of silver dramatically downward.

The conspiracy and scheme was enormously successful, netting the defendants substantial illegal profits. The conspiracy and scheme has been corroborate by a 40-year industry veteran and former employee of Goldman Sachs (the “Informant”) who was told by representatives of the defendants about the conspiracy and scheme. The Informant has stated that he had been told first hand by traders at JPMorgan that JPMorgan manipulates the silver market. The JPMorgan traders would brag to the Informant about how much money they were making as a result of such manipulation.

The informant reported the defendants’ activities to the CFTC which has opened an investigation into the manipulation of the silver market.”

Stick a fork in it – JPM’s manipulation reign is over. And, for the record, this is the same HSBC, whose vaults “hold” the 1,300 tonnes of “gold” owned by GLD. Good luck collecting.

Full lawsuit (pdf) – read cover to cover.


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h/t SilverIsKing

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Rosenberg: “Greece Is The Same Coalmine Canary As Thailand Was To LTCM And As New Century Was To Lehman”


Tuesday, May 11th, 2010

David Rosenberg is out with some very fitting analogies of the current sovereign crisis. If he is proven prescient, which we have no doubt he will, the Greek near-default will have massive repercussions to the entire developed world when all is said and done.”In my opinion, Greece is the same canary in the coal mine that Thailand was for emerging Asia in 1997, which ultimately led to the Russian debt default and demise of LTCM; the same canary in the coal mine that New Century Financial in early 2007 proved to be in terms of being a leading indicator for the likes of Bear Stearns and Lehman. So, the most dangerous thing to do now is to view Greece as a one-off crisis that will be contained.” Furthermore, as he makes all too clear, if a $1 trillion bailout can only buy 400 points in teh Dow, Europe, aside from all the other fundamentals which confirm the same, is doomed, and even the ever-optimistic market now realizes it. Lastly, should Europe pursue the required austerity measures, the hit to European GDP will be massive, and is certainly not being priced in European stocks, but certainly not in US stocks, whose primary export market is about to disappear.

From today’s Breakfast with Dave.

Well, I think the turbulent global events of the past few weeks underscore the reason why I have maintained a cautious investment approach for the past year, notwithstanding the massive recovery in risk assets we saw from the March 2009 lows, which from my lens bore a huge resemblance to the bungee jump in the market back in 1930. In fact, at one point two weeks ago, at the highs, the stock market had already achieved, in barely more than a year, what took five years to accomplish in the 2002 to 2007 bull market, and at least that market wasn’t being fuelled by unprecedented government intervention in the economy and incursion into the capital markets.

The dramatic government stimulus was global in nature, and this was the primary prop behind the rally in equities over the past year and change, and the message coming out of Greece, and not just Greece but many other governments in the European Union and across the globe, is that governments are probing the outer limits of their deficit finance capacities. History does indeed show that it is quite common to see sovereign default risks follow on the heels of a global banking crisis, which was the story for 2007 and 2008; it took a respite in 2009 and we are now in a new chapter of this prolonged debt deleveraging story. These cycles of balance sheet repair, alternating between the private and public sector, typically lasts 6 to 7 years. We are barely into year three, and what is extremely important in this roller coaster ride is to focus on capital preservation strategies that minimize the volatility in the portfolio, which is one reason why I have favoured long-short income and equity strategies.

In my opinion, Greece is the same canary in the coal mine that Thailand was for emerging Asia in 1997, which ultimately led to the Russian debt default and demise of LTCM; the same canary in the coal mine that New Century Financial in early 2007 proved to be in terms of being a leading indicator for the likes of Bear Stearns and Lehman. So, the most dangerous thing to do now is to view Greece as a one-off crisis that will be contained. Even with this new and aggressive EU-IMF financing arrangement that has managed to trigger a wild short covering rally yesterday, the risks are still high that the contagion spreads to countries like Portugal, Spain, Italy and even the U.K., which has already received some warnings from the major rating agencies and is gripped with political gridlock in the aftermath of last week’s uncertain election results.

The problem of there being far too much debt on balance sheets globally has not gone away and in many cases has become worse, and the ability to service these debts especially in countries that have weak economic structures like Greece, Portugal and Spain has become seriously impaired. It remains to be seen how Greece and the other problem countries in the euro area will manage to cut their deficits without, at the same time, controlling their monetary policy and their currency, which of course we were able to do here in Canada during the 1990s but with the help of a 30% currency devaluation.

Speaking of Canada, the downdraft in our market and our dollar shows once again that we can be doing everything right, and in terms of fiscal policy we still look good on a relative basis. However, being a small open economy sensitive to commodity prices, this is one of those times where sudden shifts in global economic sentiment can hit us disproportionately.

Even before this latest leg in the European financial crisis, China was already tightening monetary policy aggressively to lean against what appears to be a property bubble in various urban centers. One has to consider what the outlook is for the global economy in general, and near-term prospects for the resource sector in particular, when the Shanghai equity index is down more than 20% from the nearby highs; yet something else to add to the concern list.

Recall that we headed into this latest round of turmoil with the equity markets priced for a return to peak earnings as early as next year, bullish sentiment on the stock market and institutional investor cash ratios at levels we last saw in late 2007 when the market was just rolling off its highs, and measures of volatility at extremely low levels, the VIX index was a mere 15 as an example, a sign of widespread complacency. It is at times like that, when all the good news is priced in and then some, and the exact opposite of what was happening at the lows just over a year ago, that the markets are most susceptible to a pullback.

With the benefit of hindsight, it is clear that the time to start to wade into the risk asset pool was a year ago after a 60% plunge in equities. However, 80% later on the upside, it’s time to get more defensive and less cyclical with a keen eye towards taking advantage of this crisis if it presents opportunities in the equity market as the panic in the corporate bond market presented to us back in early 2009. I, for one, am looking forward to having my temptation level tested if this market heads back into undervalued or even fair-value terrain, which it only managed to achieve for a few months early last year.

While the coincident economic indicators, such as employment, have improved in recent months, many of the leading indicators have begun to roll over. In fact, these indicators are pointing towards a discernible slowing in economic and earnings growth in the second half of the year and into 2011 when we will see the stimulus shift to significant fiscal restraint in both Canada and the U.S., and the lagged impact of the Chinese policy tightening.

In addition, while the periphery of Europe received a financial lifeline package, the conditions for accessing the funds will require massive fiscal tightening and it will be interesting to see how countries like Spain, let alone Greece, can cut spending and raise taxes at a time when the unemployment rate is at a sky-high 20%. Remember, 20% of the global economy is going to be slowing down going forward, the question is by how much and this in turn will impact North American exports. On top of that, the equity and debt cost of capital, which had been on a declining path for much of the past year and has very supportive of risk appetite, is now going on the opposite path. This is not necessarily a double-dip recession scenario, but I would not rule it out.

What’s important from an investor standpoint is that the uncertainty surrounding the macro outlook is much wider now than it was before. Over the near term, there is still more downside but the main message is that one should be prepared to take advantage of the springtime selling by using cash and near-cash as part of a tactical asset allocation strategy because one of the best way to make money in this tumultuous environment is not to lose it, but to have it ready to put to use once things get really cheap.

At the same time, we are confronting a deflationary shock at a time when most measured rates of underlying inflation in most parts of the world, especially the U.S. are already extremely low, barely 1%, and in such an environment, having an income theme as a core component of the portfolio makes a whole lot of sense.

As for the GDP impact on Europe now that all the dirty laundry is out int he open, here is why it will get very ugly:

We did some in-depth analysis on how the economies of the “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) countries (and the rest of Europe) would fare if deficit-to-GDP ratios were to revert back to the Maastricht criteria of 3%. The adjustment will be painful for Europe in general, slicing off about 1% GDP growth annually over the next three years, and very painful for the PIIGS specifically. If these countries’ fiscal ratios were return to 3%, Ireland would see four percentage points (ppts) shaved off nominal GDP annually over the next three years, Greece 3.5ppts, Spain 2.8ppts, Portugal 2.2ppts and 0.8ppt for Italy.

It would not be a picnic for the rest of Europe, where many countries were running deficits greater than 3% of GDP in 2009. We estimate that fiscal cuts will shave about 1.5ppts off France’s nominal growth, 1.0ppt for Belgium, and 0.8ppt for the Netherlands. Austria and Germany would only have to endure 0.2ppt and 0.1ppt lower GDP growth, respectively, to bring their ratios back in line with targets. Finland is the only country with a GDP deficit under 3% (using 2009 data). Note that the starting point for our analysis was 2009 — the adjustment could be more painful as deficit-to-GDP ratios look to have deteriorated further in 2010.

Lastly, it appears that even Rosie has had it with the unbearable hypocrisy of our “leaders.”

Maybe it’s all about false pride. The need to counter-attack those who would dare to attack the Euro. How interesting was it to see the sharpness of the political rhetoric over the weekend from the European political elite. Please, fund our lifestyle, Mr. Market, but don’t hold us to our commitments:

“ … a battle of the politicians against the markets. I am determined to win” (German Chancellor Angela Merkel).

“… unfounded off-the-wall suggestions and speculation” (EC President Jose Manuel Barroso).

“… confront speculators mercilessly … know once and for all what lies in store for them” (French Present Nicolas Zarkozy).

It is a sad deflationary reality when a trillion dollars can only buy you 400 points on the Dow. What can the politicos do for an encore?

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David Rosenberg: “Bonds Have More Fun”


Wednesday, May 5th, 2010

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This article is an excerpt from David Rosenberg, Gluskin Sheff, in today’s Breakfast with Dave, May 5, 2010.

Market Thoughts

Head for the hills! James Paulsen on CNBC today uttered the Bernanke-ism “contained” twice in one sentence to describe his view of the risks in Europe. Yikes! Jason Trennert then went on to describe the positive fallout from all this because the events overseas will keep the Fed on hold for longer (well, the Bear Stearns collapse forced the Fed to actually cut rates — we should have all been extremely bullish in the opening months of 2008 based on that logic).

It was quite the session yesterday. The VIX index soared another 20% to an 11-week high. The equity market suffered its worst pounding in three months (pharmaceuticals was the best performing sector as investors rotate to defensives from cyclicals), though the S&P 500 did find late-day support as it bounced off the key 50-day moving average. We shall see if this technical level holds but investors are now seeing that the market is in fact not a game of straight-up as has been the case for the better part of the past year.

The U.S. bond market has caught fire — just six weeks after receiving a death sentence from the intellectual elite as the yield on the 10-year T-note, back then, made yet another unsuccessful run at the 4% mark (just days after my debate with Jim Grant). Today, the 10-year note is sitting at 3.57% and the long bond is at 4.40%, both setting lows for 2010.

BONDS HAVE MORE FUN

Make no mistake, investors are getting hit far worse on their long-put positions on Treasuries right now than their long-call positions in equities (we haven’t even seen the big short squeeze yet in bond-land — this should get exciting). So far this year, it looks to as though total returns on long Treasuries are bordering on 5% — over 14% in Euro terms too!

Incredibly, in Canada, the yield curve steepened as the front end rallied to levels prevailing before the “hawkish” Bank of Canada policy report last month as two tightenings were taken out of the market (and the Canadian dollar paying the price as it finally heads toward its fair-value estimate of 93-94 cents). The Canadian bond rally got an extra boost from “dovish” comments out of Finance Minister Flaherty regarding stubbornly high unemployment.

Source: David Rosenberg, May 5, 2010

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Mobius: Bear Stearns – The Bear That Started It All


Tuesday, March 23rd, 2010

This article is a guest post by Dr. Mark Mobius, Franklin Templeton Asset Management.

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Mark MobiusIt is now two years since the Bear Stearns bail-out, which set the stage for the global financial crisis triggered by the collapse of Lehman Brothers, another established name in the business.

I was in our office in Shanghai, China, on March 15, 2008, when I heard about the Bear Stearns’ fire sale to JP Morgan Chase. My initial reaction was that the timing around the Bear Stearns decision was probably unfortunate. I thought that the deed was sudden and done in a moment of panic. It would have been ideal for the government to have allowed for a more orderly process so that clients and related parties of Bear Stearns who had legitimate interests and holdings would not be disadvantaged.

One lingering concern of mine is that some of the key issues that led to the global financial crisis still remain unresolved, and could potentially give rise to future problems. I do feel that the governments have not done enough in general; and we are in a situation where we have not sufficiently learned the lessons of the previous crises. While perhaps not popular, I believe it is necessary for governments to insist on a separation of investment banking and regular banking and to ensure complete transparency and liquidity of all derivatives. There is currently over $600 trillion of derivatives outstanding, which is more than 10 times the total global GDP.[1]

That said, I believe that emerging markets have come out of this crisis in relatively strong shape. Some emerging markets now have more foreign reserves, in absolute terms, than some developed countries. In 2005, some emerging markets began to grow foreign reserves faster than developed markets and now we have the situation where China is the largest holder of foreign reserves in the world – over US$ 2 trillion. Russia and Taiwan each have over US$ 300 billion; India, Korea, Hong Kong and Brazil have over US$ 200 billion and so forth. The U.S. has only slightly more than US$ 70 billion in reserves while U.K. and Germany have around US$ 45 billion each. [2] Many Asian governments’ emphasis on fiscal prudency, and the Asian banks’ high cash reserve ratios, were borne out of the Asian Financial Crisis in 1997. As a result, the debt levels and banking systems of some Asian economies are in a better shape currently as compared to some of their Western counterparts. We are optimistic about the growth of emerging markets and the rising financial strength of those markets. This should help them avoid some of the past mistakes.

As I pointed out before, I think that bull markets tend to last longer than bear markets. Hence, if we allow fear to keep us from the markets, we will be sitting on cash (currently yielding less than 1%) and not making much money. Our savings would gradually be eroded by the cost of inflation.

[1] Source: BIS, as of Sep 2009.

[2] Source: EIU, IMF, as of Jun 2009.

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