Four Paths Forward for the Euro

Monday, July 2nd, 2012

From what seemed like a very low bar on expectations, last week’s summit headlines surprised modestly on the upside, even if the details remain far from clear – and implementation even murkier. Political talk of wanting to break the link between sovereign and banking risk was well-received by markets – but we remind all that talk-is-cheap with these Euro-pols. As Goldman noted this weekend, “we do not see the outcome as a game changer”, rather can-kicking until one of four possible endgames are realized. The absence of any explicit commitment to plans for fiscal or political integration; the lack of reference to any pan-European deposit insurance; and Ms. Merkel’s limited concessions (to ensure passage of the growth compact) to the terms on which the existing pool of EFSF/ESM resources are offered leaves the underlying issue – the terms on which mutualisation of financial risk is offered by Germany in return for mutualization of control over fiscal decisions throughout the Euro area – remaining inharmonious. German tactical concessions at the summit do not change their basic position on this issue: that discipline, reform and consolidation must be achieved and cemented first before mutualization of financial obligations is possible. Looking to the future Goldman sees four paths for the Euro are from here – and short-term too many crucial issues are left unresolved.

Huw Pill, Goldman Sachs: European Views

Looking to the future, we see four paths (albeit ones that are connected by cross streets) for the Euro area from here, around which scenarios for the market outlook can be developed:

• The Cultural Revolution. While unlikely, it is possible that European politicians recognize the error of their previous ways and collectively jump to a more constructive approach, exploiting the strengths of the consolidated Euro area in pursuit of a solution, rather than focusing on the weakness in individual countries that represent obstacles to one. In short, the European leadership could start to ‘think continental’ (to use a phrase originated by Alexander Hamilton in not dissimilar circumstances). In principle, this would offer a rapid and effective resolution of the crisis. But the likelihood of this outcome is low. The European authorities are inevitably in thrall to their national political constituencies (which, after all, elect them): thinking national rather than continental is the therefore the most likely result.
• The Long March. More realistically, one can characterize the June EU summit as another step forward in the long and slow process of necessary adjustment and governance reform in the Euro area, bringing national constituencies along in a step-by-step manner. Announcement of plans for banking union can be seen (for good reason) as part of the development of the new institutional architecture needed to make the Euro area workable. But however necessary, these measures are far from sufficient. Only over time will successive summits, each resulting in individually modest forward steps, lead to an accumulation of institutional advances sufficient to underpin the Euro adequately. The slow cumulative construction of a workable governance structure has been (and will remain) initially under-appreciated by the markets, but eventually be recognized, leading the market to support convergence rather than divergence across economies within the Euro area. Of course, aside from the politics of institutional reform, this ‘long march’ is likely to prove economically challenging: economic activity in the periphery will be hamstrung by the lack of a more comprehensive resolution, especially as the underlying necessary adjustments to competitiveness, external imbalances and public finances will proceed slowly, if at all, in this environment.
• The Great Leap Forward. We are skeptical that either financial markets or domestic political constituencies will have the patience for a ‘long march’ lasting as long as a decade (as Ms. Merkel has repeatedly predicted). More realistically, intensifying market pressure is likely to short-circuit this process, forcing Europe to an earlier decision point. For example, should Spain be denied market access and be forced into an explicit external financing program, additional fiscal demands will be placed on the rest of the Euro area, weakening the public finances of Italy and, via a domino effect, France and ultimately Germany. Relying on a slow, cumulative improvement in governance is inadequate in these circumstances. The ‘Big 4’ countries will quickly be presented with the question of whether or not they are prepared to take the steps necessary to underpin the Euro. Measures will need to be taken quickly and aggressively: acting outside the existing institutional framework will be required. Germany and France will have to decide to whether they are prepared to take substantial steps forward in economic and political integration in order to preserve the Euro. Muddling through will no longer suffice. In these circumstances, we think such a ‘great leap forward’ is the most likely response.
• Disintegration. That said, we cannot rule out the possibility that, faced with an ‘existential threat’, the political process does not allow such a ‘great leap forward’ to be taken. At that point, Monetary Union would become untenable—and a rapid and costly unraveling of the Euro area would result.

Using these four paths as a framework, we see the most likely scenario going forward as follows:

the European authorities continue their ongoing ‘long march’ of cumulative reform until, at some point—probably not imminently, but over the coming one to three years—market and/or political dynamics force the choice of whether to make a ‘great leap forward’ on the key Franco-German axis that has driven European integration since the 1950s.

Sketching this baseline scenario raises two questions:

• When will the Euro area switch from the slow, cumulative path of the ‘long march’ to confronting the pressing question of whether to take a ‘great leap forward’? We believe Euro area can continue on its current ‘long march’ for some time yet. The institutional machinery of monetary union—notably the balance sheet of the ECB and the ability of its TARGET2 balances to accommodate intra-Euro area cross-border stresses elastically—has proved remarkably robust to market pressure: by its nature, monetary union has greater resilience than the fixed exchange rate systems with which it is often compared. Moreover, for different reasons, the key players are not facing immediate pressures: ample liquidity in the Euro area is keeping French government bond yields at close to historical lows, while the German economy continues to show resilience at the lowest level of unemployment seen n for a generation. And procrastination is the path of least resistance for European politicians, lending inertia to the process. This makes a continuation of slow, incremental reform—rather than a comprehensive and rapid resolution of the crisis—more likely. But this approach does not come without its own costs. Macroeconomic performance in the periphery is set to deteriorate further in 2012H2, as market dislocation continues to weigh on credit creation and economic activity. And market participants are losing patience with the slow pace of adjustment: this adds to the tensions in financial markets.
• When facing the existential choice of whether to take the ‘great leap forward’, will France and Germany be prepared to do so? Yet ultimately we doubt that the ‘long march’ can be pursued to a conclusion. Other forces—such as a fiscal policy mis-step in France that undermines investor confidence or a populist political shock in the Italian elections—would force an ‘existential crisis’ for the Euro. At that point, we believe Germany and France will demonstrate the courage and commitment to move forward. Failing to do so in those circumstances would not merely imply acquiescence with the status quo, but rather a disintegration of the Europe built over the past 60 years, something neither country is likely to countenance. Yet making this step will not be without its own political challenges, especially in Germany where taxpayers are understandably reluctant to take on yet greater burdens that such a leap forward would imply.

Viewed in this light, the decisions taken at last week’s EU summit are best seen as part of the cumulative and incremental process of institutional reform inherent to the ‘long march’. While elements were surprisingly positive and important in themselves, in our view these decisions do not represent the ‘great leap forward’ required to resolve the crisis. They leave too many crucial issues—not least, the central question of how mutualization of financial risk and the debt overhang is traded off against loss of national fiscal sovereignty to German-inspired Euro area-wide fiscal and regulatory institutions—still unresolved.

Source: Goldman Sachs

Tags: Concessions, Constructive Approach, Cross Streets, Cultural Revolution, Deposit Insurance, Endgames, European Politicians, Explicit Commitment, Financial Obligations, Financial Risk, Four Paths, Goldman Sachs, Looking To The Future, Market Outlook, Ms Merkel, Pan European, Political Integration, Pols, Scenarios, Sovereign
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What a Potential Greek Exit Means for Investors

Friday, June 1st, 2012

by Michelle Gibley, CFA, Director of International Research, Schwab Center for Financial Research

Key points

• The risk of a Greek exit has increased, although the timing is uncertain.
• In the meantime, we believe more market turmoil is likely, because most of the major tools to stem the crisis have political and legal barriers.
• We prefer underweighting Europe at this time because the potential for downside risks has increased and there is the likelihood of high levels of ongoing volatility.

In national parliamentary elections on May 6^th, many Greeks swung their support away from mainstream parties and toward anti-austerity fringe parties, increasing the chance of an eventual Greek exit from the euro. This has led a lot of Schwab clients to ask some key questions—namely, if and when Greece could exit the euro, and what this would mean for investors. One word of caution before we start: It’s unusually difficult to predict a resolution to this crisis, given the number of different scenarios and political decisions involved. Here are some of the questions we’ve heard most frequently:

• When would a potential Greek exit happen?
• If Greece is small, why would a Greek exit matter?
• What does Europe need to stem contagion?
• Could the ECB re-use prior tools?
• Will the Federal Reserve of the United States act?
• What are the arguments for keeping Greece in the euro?
• What are the implications for investors?

When would a potential Greek exit happen?

Because the May election didn’t give any party the majority of the parliament, and a coalition government failed to emerge, Greeks go back to the polls on June 17. This election could create the conditions for a fast exit if austerity measures to be implemented by June 30 are outright rejected. While Greece’s next quarterly bailout funding is due August 30, observers are concerned that Greece could run out of money as soon as July, as tax collection revenues are likely coming in below expected levels.

We believe an exit in the short-term is less likely because Europe doesn’t yet appear to have mechanisms in place to deal with the aftereffects, or contagion. A Greek exit could begin to infect other countries, threatening their ability to issue debt at reasonable rates and potentially pushing them closer to an eventual exit from the eurozone, and spark a flight of capital from banks in other peripheral countries. Measures to stem contagion will likely need approval—either parliamentary or by the general public—before they can be enacted. Therefore, Europe is likely to again kick the can down the road and buy time, even if a coalition of hard anti-austerity parties forms a government in Greece.

We believe the probability of a Greek exit increases as the year progresses and over the next several years. Greece is likely to need continual relaxation of bailout targets, which will become increasingly unpalatable to the electorate in financially stronger countries.

If Greece is small, why would a Greek exit matter?

We believe that markets are focused on Greece primarily because of the risk of contagion to Spain and Italy. While even last fall there was hope that Greece’s problems could be “ring-fenced,” or contained, the risk of contagion has become increasingly apparent.

Italian and Spanish bonds move somewhat in tandem

Source: FactSet, iBoxx. As of May 29, 2012.

Spain’s problems are complicating the situation. In Spain, the fiscal deficit has been revised negatively and the health of its banking system has been deteriorating. The Spanish fiscal deterioration, combined with the inaction of the European Central Bank (ECB) at its April monetary policy meeting, helped to increase yields on the government debt of an entirely different country—Italy. Italian and Spanish government bonds continue to move somewhat in tandem, even though you could argue that Italy’s financial position is stronger than Spain’s.

Tags: Austerity Measures, Bailout, Caution, Cfa, Coalition Government, Contagion, Downside Risks, Europe Need, Federal Reserve, Greeks, Legal Barriers, Likelihood, Major Tools, Market Turmoil, National Parliamentary Elections, Observers, Political Decisions, Scenarios, Schwab, Volatility
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The Put Spread Collar

Thursday, April 26th, 2012

by Randy Frederick, Managing Director of Trading and Derivatives, Schwab Center for Financial Research

Key points

• Collars combine a covered call and a protective put.
• Collars help you cost effectively protect a position that you’re not ready to sell—but they limit your upside potential.
• A put spread collar is a sophisticated strategy for experienced option traders that can allow for more upside profit potential if you’re willing to take a little more risk on the downside.

A collar is a risk-management strategy that combines a covered call and a protective put. An investor who establishes a collar is usually concerned with protecting a position in a cost effective way. While a collar can provide short-term protection against a downturn in the stock, it also limits upside return.

But what if you only need some downside protection—for example, if you think a potential downturn will be limited and not catastrophic in scope. Or, what if you want more upside potential, but without spending any additional money?

If either of these scenarios applies to you, consider a put spread collar.

What is a put spread collar?

As with a traditional collar, a put spread collar is usually set up so that both the long (protective) puts and the short (covered) calls are out of the money, but with the same expiration date. However, with the put spread collar, the long put position can be purchased much closer to the money than the short call position and the difference in price is offset by the sale of a farther out-of-the-money put position.

This structure allows for greater upside potential, with less downside risk when there is only a small decline in the price of the stock. However, if there is a big decline, downside losses could be significant. A put spread collar is essentially a covered call combined with a bearish put spread.

An example of a put spread collar

To illustrate this strategy, let’s assume that a couple of months ago, you purchased 1,000 shares of XYZ at a price of $26 and since then the stock price has risen to $28.30. You are optimistic about the long-term prospects of XYZ, so you don’t want to sell it, but in the short term you’re concerned about a possible small pullback. No matter what happens though, you believe there will not be a large decline.

You only have a 2.30 unrealized gain in this stock so you would like to limit your immediate downside risk as much as possible without spending a lot of money. However, because you’re bullish you’d like to leave a fair amount of room for the upside too.

The solution may be to establish a put spread collar as follows:

This position ensures that you won’t lose more than 0.80 unless XYZ drops more than 3.30 points. However, you can make 6.70 points if XYZ rallies. Your only out-of-pocket expense would be the commission charges. Let’s take a look at this strategy (as of expiration date) on a profit and loss graph.

Profit and Loss for a Put Spread Collar

Source: Schwab Center for Financial Research.

As you can see in the chart above, based on the starting price of 28.30, your profit, loss and breakeven thresholds at expiration are:

• Below $25 there is downside risk to zero. The maximum loss is 25.80 or -$25,800 if XYZ drops all the way to zero.
• From $25 to $27.50, the loss is limited to .80 points or -$800.
• From $27.50 to $28.30, the loss will range somewhere between -$800 and $0.
• From $28.30 to $35, the gain will range from $0 to $6,700.
• At $35 or above, the gain is capped at a maximum of $6,700.

Like a traditional collar, with a put spread collar you can specify how long you need the protection. One nice feature is that the costs should not change materially based on the length of time holding this strategy, because time value affects all the options similarly and the option premiums essentially cancel each other out.

Depending upon the price of XYZ at expiration, some of the options could expire worthless, get assigned, or be exercised, so in order to reach the profit and loss scenarios described above, let’s compare the put spread collar to a similarly structured (zero cost) traditional collar.

The table below identifies exactly what takes place at each price point. For comparison purposes, let’s assume all positions are purchased when XYZ is at the current market price of $28.30.

How Do They Stack Up? A Traditional Collar vs. a Put Spread Collar

Source: Schwab Center for Financial Research.

In the table, you can see that the traditional collar and the put spread collar have essentially the same initial cash outlay (not including commissions) and gains and losses at prices between $25 and $29.

However, at prices below $25, losses will not exceed $800 on the traditional collar but will continue to get worse as the stock drops on the put spread collar. Because the put spread collar is short 25 puts, they will need to be closed out in the market, and the farther the stock drops the more expensive this will be. The maximum loss on the put spread collar is -$25,800. Essentially the downside protection on the put spread collar ends if XYZ drops below $25.

At prices above $29, gains will not exceed $700 on the traditional collar but will continue to grow on the put spread collar until a price of $35. At all prices above $35, the maximum gain on the put spread collar is $6,700. This additional $6,000 of potential upside opportunity is the trade-off for the extra risk taken below 25.

The bottom line is that a put spread collar is only appropriate when you are trying to protect against a modest decline in price—not a severe decline.

What to keep in mind

A put spread collar is a unique strategy, suited for specific situations so I’d like to conclude with a summary of its benefits and risks:

Benefits

• Provides limited downside protection at very low or potentially zero cost.
• Allows for greater upside profit potential versus a traditional collar.
• If the stock stays within the range of the call option and the higher strike put, the cost is zero or very low and all options expire worthless.

Risks

• While this strategy does limit risk somewhat, if the stock declines below 25 your losses could be quite significant.
• Anytime you sell a call, you have established a maximum selling price for your stock. While this strategy does allow for greater upside potential, if the underlying stock moves substantially above the short call strike price, your profit potential will still be limited.
• If your short calls go in-the-money, you could be assigned at any time.
• All options eventually expire, and the benefit of this strategy ends at expiration.
• Because a put spread collar is a spread, you have to be approved for spread trading in order to utilize this strategy.

For additional information on this strategy or for assistance with other options strategies, please contact a Schwab Trading Specialist at 800-435-9050.

Important Disclosures

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. With long options, investors may lose 100% of funds invested. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any option transaction. Call Schwab at 800-435-4000 for a current copy.

With long options, investors may lose 100% of funds invested. Multiple-leg options strategies will involve multiple commissions. Spread trading must be done in a margin account. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received. Writing uncovered options involves potentially unlimited risk.

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

Past performance is no indication (or “guarantee”) of future results. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve.

Tags: Covered Calls, Decline, Derivatives, Downside Protection, Downside Risk, Downturn, Expiration Date, Investor, Losses, Managing Director, Nbsp, Option Traders, Puts, Risk Management Strategy, Scenarios, Schwab, Scope, Sophisticated Strategy, Spread Collar, Xyz
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Technical Take: Bulls Lose Enthusiasm

Sunday, April 22nd, 2012

by Guy Lerner, The Technical Take

The “dumb money” indicator has become more neutral suggesting that the bulls have lost enthusiasm for this bull market.  As can be seen in figure 1 (below), the indicator has dropped below the upper trading band (green arrow).  From this perspective, the playbook becomes real simple.  If the indicator moves back above the upper trading band, then investors are putting risk back on, and all in likelihood, this would represent the last gasp of speculation in an aging bull market.  This would be worth playing for.  The other option and the next best time to buy equities would be when there are too many bears (i.e., bull signal), and this occurs when the indicator drops below the lower trading band (red arrow).  The best and most efficient way for this scenario to develop is by having lower prices.  Period.  With the indicator neutral, the bulls have lost their mojo and there is little edge.

As a reminder, the 2011 market top took over 6 months to develop.  The S&P 500 traveled in a narrow 75 point range before dropping 20% over a 4 week perid.  The top can best be described as a period of discussion.  Is the economy sputtering?  Will the European contagion effect the US economy?  Will the fiscal cliff be realized?  And of course, the #1 topic of discussion and the only one that matters: will there be QE3?  This all sounds familiar.

The “Dumb Money” indicator (see figure 1) looks for extremes in the data from 4 different groups of investors who historically have been wrong on the market: 1) Investors Intelligence; 2) MarketVane; 3) American Association of Individual Investors; and 4) the put call ratio. This indicator is now neutral. The data shows that the optimal sign to sell is 1 week after the indicator crosses below the upper trading band. But these are optimal scenarios, and I should caution that optimal and stock market are rarely spoken of in the same sentence. The market is just too unpredictable. Who saw the May, 2010 “flash crash” or the 20% drop over 3 weeks in 2011 coming? If you hang around too long, you could be one of those casualties. Alas, there are no right answers or guarantees. These are just signposts that help us better understand the price action.

Figure 1. “Dumb Money”/ weekly

Figure 2 is a weekly chart of the S&P 500 with the InsiderScore “entire market” value in the lower panel. From the InsiderScore weekly report: “An Industry Buy Inflection, our strongest quantitative signal of positive sentiment, was triggered in the Russell 2000 last week as buyers outnumbered sellers for the first time since the final week of November 2011. It was the first time an Industry Buy Inflection was triggered since August 2011, when insiders bought at their most aggressive pace since the multi-year market bottom of March 2009. Qualitatively the activity within the Russell 2000 is similar to what we witnessed in June 2011 when an Industry Buy Inflection was also triggered.”

Figure 2. InsiderScore “Entire Market” value/ weekly

Figure 3 is a weekly chart of the SP500. The indicator in the lower panel measures all the assets in the Rydex bullish oriented equity funds divided by the sum of assets in the bullish oriented equity funds plus the assets in the bearish oriented equity funds. When the indicator is green, the value is low and there is fear in the market; this is where market bottoms are forged. When the indicator is red, there is complacency in the market. There are too many bulls and this is when market advances stall. Currently, the value of the indicator is 65.34%. This is the second week in a row that the indicator has turned down week over week. Values less than 50% are associated with market bottoms. Values greater than 58% are associated with market tops. It should be noted that the market topped out in 2011 with this indicator between 70% and 71%.

Figure 3. Rydex Total Bull v. Total Bear/ weekly

Copyright © The Technical Take

Tags: American Association Of Individual Investors, Best Time, Bulls, Contagion Effect, Dumb Money, Extremes, Figure 1, Green Arrow, Guy Lerner, Last Gasp, Likelihood, Market 1, Marketvane, Mojo, Playbook, Put Call Ratio, Red Arrow, Reminder, S&P500, Scenarios, Speculation, Stock Market
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Synthetic CDO’s – When Risky Isn’t Risky – Or Free Equity

Wednesday, April 4th, 2012

by Peter Tchir, TF Market Advisors

Synthetic CDO ‘First Loss’ tranche safer than ‘Second Loss’ Tranche

In the past few weeks there has been some more noise from regulators and the rumor mill related to synthetic CDO’s.  It hasn’t hit the frenzy surrounding the Abacus deal last year, but the questions are starting to pop up again.  Who was long what?  Who was short what?  Who picked the portfolio?  Etc.

While all that is important, I figured now is a good time to trot out one of my favorite pieces.  In many cases the ‘first loss’ or ‘equity’ or ‘unrated’ tranche was actually safer than the ‘second loss’ or ‘mezz’ or ‘rated’ tranche above it.  Does this make any sense?  On the surface, NO!  An investor would expect the more senior tranche to underperform the ‘equity’ in good scenarios and outperform in bad scenarios.  That makes sense, yet many of the synthetic CDO’s were created in such a way that there was almost no scenario where the second loss tranche outperformed the equity tranche.  Bizarre, but true.

It’s important to understand this phenomenon as it helps explain a lot of the strategies that were employed and also why the defense of ‘I owned the equity’ is not a very strong defense.  I will now try and walk you through how this paradox is possible.

Cash CDO vs Synthetic CDO

The best way to demonstrate ‘safe’ or ‘free’ equity is to show how we got there and why its unique to the synthetic CDO’s.  Free equity does not exist in the cash CDO world (maybe that’s why that market was a fraction of the synthetic one?).

I will walk through 2 hypothetical examples that illustrate the point.  The example is more similar to a corporate CDO than a mortgage backed one, but the principals remain the same, and in reality, the trade first appeared in the credit referenced world and then moved to the mortgage world as that market developed.

For a cash CDO, let’s assume we have 100 bonds each paying T+150, each with a maturity of 5 years.  Let’s assume that the 5 year treasury yields 4.5% (reasonable at the time most of these deals were created).  So we have a portfolio of 100 bonds paying 6% each.

For a comparable synthetic CDO, let’s assume we have 5 year CDS on the same 100 bonds (issuers) and each CDS pays 100 bps.  That’s a reasonable ‘basis’ where the 5 year bond pays T+150 and the CDS to the same maturity is 100 bps.  Its simplified for our purposes, but realistic.

If each position is $10 million, then the $1 billion bond portfolio generates annual income of $60 million.  The $1 billion CDS portfolio generates $10 million of annual income.

Now let’s assume a simple capital structure.  A 3% ‘first loss’ tranche, a 10% ‘mezz’ tranche and a 87% ‘super senior’ tranche.  Again, this is simplified, but not out of line on a 5 year corporate structure to have the mezz as BBB and the Super Senior as AAA.

Let’s assume that the senior tranche of the cash deal gets T+60 or 5.1%.  They get less than the average since there is so much subordination.  Assuming a ‘basis’ of 50 bps, the synthetic deal would pay 10 bps on this tranche.  Lets assume the mezz tranche earns T+300 or 7.5%.  They are receiving a premium to the average because although they have second loss, they do have leverage once losses start hitting that tranche.  That mezz tranche for the synthetic would pay 2.5% keeping the 50 bps basis.

So here is what we have:

So in a no default case, the returns look reasonable for the risk.  The funded returns are higher, but that does reflect the use of cash.

The key element here, the driver of the free equity, is the income versus cost of the senior tranches.  In a cash deal, 86% of the income is used pay the interest due on senior tranches.  For a synthetic deal, only 34% of the income is needed to pay the senior tranches.  This excess income, and how little of an impact any individual default has on the income stream of a synthetic deal, is what creates free equity.

Now let’s take what might be an extreme case, but is great at illustrating the difference between the cash deals and synthetic deals.  Let’s assume 20 defaults occur, all with 0 recovery.  This would generate $200 million of losses.  It should wipe out the equity, the mezz, and eat into the super senior.  Where it gets interesting, is when you look at the residual income.

With $200 million of assets gone, the cash deal would only generate $48 million of income.  This would be enough to pay the full interest due on the senior tranche, but not enough to cover the ‘mezz’ tranche and nothing left for the equity.  That makes sense to me.  It’s on the synthetic side that you get a very interesting dynamic.  The residual income would be $8 million.  Not only is that enough to continue to paying the interest on the senior and mezz tranches, but it leaves $4.6 million for the ‘first loss’ tranche which is 15% per annum on the notional!

It all comes down to the ‘waterfall’ of how the interest is distributed.  On the cash deal, its easy to see that with 20% default, on day 1, with 0 recovery, that the equity would be wiped out, the mezz would be wiped out, and even if there were no waterfall/cashflow restrictions, there would be no distributions to the first loss holder.

On the synthetic side, the story is very different.  The equity would be wiped out, but receive $23 million over the 5 year deal in residual interest flows if there were no more defaults.  The mezz tranche would be wiped out but receive $7.5 million in interest over 5 years.  So the mezz loss would be 92.5/100, or 92.5%.  The first loss piece would lose 6.9/30 or only 23%.  It seems amazing, but the first loss loses less than the second loss in a synthetic cdo with a straight waterfall.

To make matters worse, the mezz tranches were often structured so that they stopped receiving their interest payments on any portion of their tranche that had been used to cover a default.  In the above example, that $2.5 million per annum would have then gone straight to the first loss holder.  The second loss would have received 0 in income and had to pay for the $100 they lost.  The so-called first loss piece would actually receive 7.1 millon per annum (24%) and over the life receive 35.7, so even after paying away $30 in losses, they would have received a positive return, while the tranche above them, the more senior tranche, the IG rated tranche, would have lost 100% and even the super senior would have had a negative return!

Scary but true.  And yes you could argue over the time value of money, and you can argue over capital structure, and you can argue that individual spreads were be different and in all likelihood higher spread names would default first, all of which make the ‘free’ equity less free, but its almost impossible to argue that the equity is as risky as you would think.  The risk/reward that exists does not match what you would expect.

If there are no defaults, it’s clear that the first loss portion will outperform the mezz tranche.  Its now also clear that under extremely adverse conditions, the first loss outperforms the tranche above it, which is truly bizarre.  At least, maybe, there is something in the middle ground, that salvages the mezz tranche?

How about there are 10 defaults on day 1, each with a 70% recovery.  This is fairly unrealistic, but should be an example skewed against the first loss tranche.  The 10 defaults each losing 30% means a total loss on the portfolio of 3% so the first loss would have to pay out that amount.  The mezz tranche would have no losses.  The mezz tranche would receive the $2.5 million a year its entitled to.  Even with 10 defaults, the residual income to the first loss tranche would be 5.63 million.  A total of 28.2 million over 5 years.  So a slight net loss of $1.8 million or an annualized loss of just over 1%, compared to a gain of 2.5% for the mezz tranche.  Yes, in this case the mezz moderately outperformed, but any additional defaults would primarily impact the mezz so the outperformance would disappear quickly.  And this is the most harmful case I can think of where mezz receives all that it is entitled to and the equity receives the bare minimum.

There were deals where the equity was getting large ‘guaranteed’ interest payments, sometimes in excess of 20%, so more than the amount at risk over the life of the trade.  Guaranteed coupons this high were a sign of how unrisky the risky tranche was.

One European dealer created a structure, where, by using a reserve account to build up excess cash flow, they got the rating agencies to rate the ‘first loss’ tranche HIHGER than the tranche above it!  Boggles the mind that the rating agencies did it, but more proof that the concept is real.

How could this happen?

One of Wall Street’s biggest flaws seems to be complacency when something is working.  The CDO structure had worked with bonds and loans and other cash instruments as the underlying.  The flows made sense.  The first loss did very well in good times, but underperformed the more senior tranches in times of high default rates.  There really was no reason to suspect that the dynamics of a synthetic CDO changed all that.  On the surface it seemed the same.  Heck, it even got a similar ratings profile to the cash deals.  The relative value paid to senior investors in synthetics seemed in line with what investors demanded on the cash side.  People had Guassian Copula models attributing the spread to various tranches ‘fairly’.  Though I remain convinced that the quants just liked the word copula because it reminded them of copulation.

Another reason it happened, is because have you ever tried to explain to risk management that the first loss tranche is safer than the second loss tranche?  How the unrated tranche is less risky than the BBB rated tranche?  It’s so counterintuitive it’s not an easy argument.  The first time someone told me it existed, I shook my heading thinking they were missing something.  It just doesn’t seem right, but it is.

This happened primarily for the early deals.  As people became more aware of the issue, bells and whistles were added to protect the senior investors (at their request).  After defaults, cash flows to the first loss would stop, or at least some portion would stop, to build up a reserve or cushion against future defaults.  It helped and seemed fair.  Over time the product evolved and in the later credit deals, the risk/rewards had gone back to being more in line with expectations.

As a market developed for single name CDS on the mortgage side, synthetic CDO’s backed by them were also created.  For better or worse, mainly for worse, most Wall Street firms seemed to have a mortgage department that was in direct competition with their credit department.  In chasing P&L and accolades, the amount of communication between the desks was often minimal.  Investors, who probably understood the concept of ‘free’ equity less than the street, also tended to run their investments in credit cdo’s separately from their mortgage backed cdo investments.  I believe that this allowed many of the early mortgage deals to create the same sort of free or low risk equity that had existed in the early days.  There is nothing wrong with it, it just skews the risk reward and means that you have to be careful when making the claim that the equity holder was taking the real risk.

Have you ever wondered why so many bears were either long the ‘equity’ tranche or seemed willing to be long?

Well, wonder no more.  You now know that depending on structure, the first loss, or equity, was actually very well protected.  Deals could be structured in such a way that by owning the first loss and shorting more senior tranches, the base case was high teens returns, the best case were massive gains as big losses hit the super senior, and the scenarios that caused a loss were minimal (if not non-existent).  These are complex deals.  I have simplified the analysis to make a point, but the math works, and it does help explain why there are few stories about how hard it was to place the equity of synthetic cdo’s and why many of the people most bearish the underlying markets were long them and were short higher up the ‘capital’ structure.

So, if we get another round of discussion about the CDO market, like we did surrounding Abacus, at the very least I hope this makes you question what the parties are saying and spend more time figuring who had what risk, based on the documentation and the math, rather than just the name of the investment.

Copyright © TF Market Advisors

Tags: Bizarre, Fraction, Frenzy, Good Time, Hypothetical Examples, Investor, Mezz, Mortgage World, Nbsp, Paradox, Phenomenon, Principals, Regulators, Rumor Mill, Scenarios, Synthetic Cdo, Tf, Tranche, Unrated, World Market
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A Not as Bullish Take on Apple (AAPL)

Friday, March 30th, 2012

While I don’t agree with every comment in this analyst’s letter, it is always good to see both sides of a trade.  I think in part the writer focuses too much on the U.S. market (and capacity) rather than global, but in terms of the impact Apple (AAPL) has on indexes and how it’s market capitalization has grown and the effects, it’s salient.  As an aside I read a story yesterday saying 1 out 4 adults polled expected to buy an iPad – that number was shocking to me.

If you are curious the firm putting this out is an RIA out of Colorado.

As to stock price, Apple simply cannot continue its current pace – it is up around 50% year to date.  Google on the other hand is barely up for the year – I know two different companies but just offering a contrast.  I scanned yesterday for stocks that are the most extended from their 50 day moving averages and that list is usually chock full of names with buyout offers, a recent earning report, or “small/mid cap momo stock of the week” ideas.  Apple was actually on that list yesterday which is startling.  The only thing I can compare this to is the move in Cisco Systems in 1999 during a bubble as both were the largest companies in the universe at the time.  At some point Apple will need to either (a) digest / consolidate / go sideways or (b) pullback substantially.  When it does (either of those scenarios) it will be interesting to see what the rest of the market does as it’s over 4% of the S&P 500 and 10% of the NASDAQ.  Even with today’s weakness the stock has not pulled back to even its 10 day moving average.

Apple Conundrum

Copyright © Market Montage

Tags: Aapl, Amp, Cisco, Cisco Systems, Conundrum, Different Companies, Earning Report, Google, Indexes, Ipad, Market Capitalization, Moving Averages, Nasdaq, Nbsp, Pace, Pullback, S Market, Scenarios, Small Mid Cap, Stock Price
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Is Apple a $17,000 Stock? (Bespoke)

Tuesday, February 14th, 2012

by Bespoke Investment Group

Of course not.  While there are no $17,000 price targets for shares of AAPL (yet), with the stock topping $500 per share on Monday, there is a vigorous debate as to what price the stock should realistically trade at.  Is the current price overvalued, undervalued, or fairly valued?  At times like this, it often helps to compare the stock in question to similar stocks to see how they are valued.  To that end, in the table below, we have listed the P/E ratios (based on the current year’s expected earnings) of comparable stocks to Apple and then calculated where shares of AAPL would trade if the stock had a similar valuation.

At a current price of $502.50, AAPL trades at 11.8 times this year’s expected earnings.  The S&P 500 now trades at 13.5 times earnings on a weighted basis, while the average P/E ratio of the 500 stocks in the index on an unweighted basis is 17.7 times earnings.  Given the fact that AAPL has one of the highest individual growth rates of any stock in the S&P 500, it isn’t too much of a stretch to assume that the stock should have a ‘market’ multiple.  To get there, though, AAPL would need to rally to just under $574 per share, while an average P/E ratio would send the stock to $752 per share.  Within its peer sector, the average stock in the S&P 500 Technology sector trades at 17.1 times earnings, which would equate to $728 per share.  While AAPL is a member of the S&P 500 Technology sector, it is often considered one of the best retailers in the country as it boasts one of the highest sales per square foot of any chain.  The average retailer in the S&P 500 trades at 16.4 times earnings, and based on that multiple, AAPL would be worth $698 per share.

The scenarios outlined above are based on the multiples of groups and sectors that AAPL is often considered part of, but what about individual stocks?  In the middle section of the table we have listed the earnings multiples of eight high profile ‘old guard’ Technology stocks.  As shown, the average multiples of these stocks ranges anywhere from 10.8 (INTC and CSCO) to 18.9 (YHOO).  Applying these multiples to AAPL would equate to a share price of anywhere from $459.80 to $803.70.  So, compared to the multiples of CSCO, INTC or MSFT, AAPL would be modestly overvalued, while a multiple similar to any of the other stocks would imply that the current price of AAPL is too low.

Now we move on to the fun part.  Let’s just assume that given its phenomenal growth rate, that AAPL were to trade at a valuation similar to the Technology/Web stocks in the S&P 500 with the highest multiples.  Currently, the three stocks in similar sectors to AAPL with the highest P/E ratios are Amazon (AMZN), Salesforce (CRM), and Netflix (NFLX).  These stocks have multiples ranging from 78.8 times earnings (AMZN) to 422.5 times earnings (NFLX).  If AAPL were to trade at a multiple similar to any of these names, the stock would currently be massively undervalued.  Based on AMZN’s multiple, AAPL would trade at more than $3,300.  If it had CRM’s multiple, the stock would trade at more than $4,000 per share.  Finally, if AAPL had a multiple similar to NFLX, the stock would trade at just under $18,000 per share!

Obviously, AAPL is not likely to trade at a multiple similar to the ones that NFLX, CRM, or AMZN currently have.  In the case of NFLX, not even the Fed can print enough money to cover a price that high.  From the law of large numbers, competition, and questions over the sustainability of its recent track record of torrid growth, there are legitimate factors keeping AAPL’s multiple where it is.  That being said, when you compare the stock’s multiple to that of its peer groups and peer stocks, arguing that the stock is wildly overvalued just because of its $500 share price seems to lack much in the way of credibility.

Tags: Aapl, Amp, Apple, Earnings, Investment Group, Price Targets, Ratios, Sales Per Square Foot, Scenarios, Sectors, Stock Investment, Stock Market, Stock Trade, Stock Valuation, Stocks, Technology Sector, Trade Stock, Trades, Vigorous Debate
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Ray Dalio Shares his Principles and Investment Outlook (Rare in-Depth Interview)

Sunday, September 18th, 2011

From WSJ:

Ray Dalio runs the biggest hedge fund (approx. $125-billion) in the universe. And he’s making money this year. A lot of it. So how does he do it?

“If you are playing the role of the casino… that’s where you are going to make money,” Dalio told the Bloomberg Markets 50 Summit on Thursday.

Basically, the hedge fund guru was suggesting that winning portfolios in this market are ones built on all kinds of non-correlated and diversified bets. In effect, if you’ve got the whole casino, rather than just playing a few games, there’s a better chance you are going to win – and you can avoid “Russian roulette scenarios.”

It served Dalio well in early August, as equity markets were plummeting. In a one week period, Dalio’s Bridgewater Associates LP scored gains of more than $3.5 billion, or about 5%, in its flagship hedge fund in a one week period. The gains helped the fund keep its place as one of the top-performers of the year.

23 minute video – email readers will need to come to site to view

Here is the full transcript of this rare interview (use full screen to enlarge):

Ray Dalio Bloomberg 50 Sept 15 2011 Transcript

Finally, Ray Dalio’s Principles if you care to learn from a real master of the universe: DOWNLOAD

Hat tip Reformed Broker.

Tags: Bets, Better Chance, Bloomberg, Bridgewater Associates, Depth Interview, Early August, Flagship, Full Transcript, Hat Tip, Hedge Fund, Investment Outlook, Master Of The Universe, Outlook, Portfolios, Rare Interview, Ray Dalio, Russian Roulette, Scenarios, Top Performers, Video Email, Wsj
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What if 8% is Really 0%?

Tuesday, June 21st, 2011

by Leo Kolivakis, Pension Pulse

Mebane Faber of Cambria Investment Management sent me an excellent paper he authored, What if 8% is Really 0%? Pension Funds Investing with Fingers-Crossed and Eyes Closed:

It is well known that pension funds in the United States are underfunded even if they achieve their projected 8% rate of return. The scope of pension underfunding increases to an astonishing level when more probable future rates are employed. A reduction in the future rate of return from 8% to the more reasonable risk-free rate of approximately 4% causes the liabilities to explode by trillions of dollars. As bond yields declined over the past twenty years, pension funds moved toward more aggressive equity-based portfolios in an attempt to reach for this 8% return.

By investing in a portfolio with uncertain outcomes, pension funds could experience increasingly volatile and even negative returns. Paradoxically, in an effort to chase the universal 8% rate, pension funds may be laying the groundwork for returns even lower than the risk free rate.

In an effort to offer an empirical basis for this possibility, we conclude the paper with a relevant comparison – the return of a hypothetical Japanese pension for the past two decades. We believe that pension funds need to at least prepare for the unfathomable: 0% returns for 20 years. Most pension funds, regrettably, have not adequately stress tested their portfolios for these scenarios.

So how does a pension manager get 8% in the current environment? Mr. Faber writes:

With government bonds yielding about 4% plan sponsors must invest in other outperforming assets to bring the cumulative return to 8%. The problem with allocating assets away from the risk-free rate is that they are, by definition, risky and uncertain. If a pension manager is employing the benchmark 60% stock/40% bond allocation, the 60% in equity or diversifying assets must return approximately 11% to achieve 8% total returns.

The second major problem outlined in this paper is that pension managers, in an attempt to deal with the realities of underfunding, may be tempted to chase higher performing and riskier asset classes, and may end up compounding the underfunding problem even more through exposure to these risky asset mixes.

Interestingly, according to Biggs, the targeted equity allocation does not correlate with projected return. Even worse, as shown in Exhibit 1 (above), funds using the highest return assumptions have the most underfunded pensions, a scenario that could be called, “fingers crossed and eyes closed”

Mr. Faber goes on to write:

The focus on illiquid assets (private equity, venture capital and timberland investments, for example) made the Endowment Model particularly attractive to funds that in theory have long time horizons, such as endowments and pensions.

Yet, as real money investors sought diversification through the same methodology, their portfolios were, in fact, becoming more correlated to each other while portfolio risks were becoming more concentrated and increasingly dependent upon illiquid equity-like investments.

Most real money funds were not prepared for the following stress scenario to their portfolio:

• US and Foreign Stocks declining over 50%
• Commodities declining 67%
• Real Estate (REITs) declining 68%

The figures above are the peak drawdowns from the bear markets of 2008-2009, and, importantly, they all occurred simultaneously. It is critical that pension funds – especially funds pursuing high equity allocations – consider all possible stresses to portfolio viability.

Mr. Faber then asks a simple question:

Are funds prepared for a lengthy bear market in equities like when stocks declined nearly 90% in the 1930’s? Are funds prepared for both raging inflation of the 1970’s and 1980’s and sustained deflation like Japan from 1990 to the present? It is our opinion that most funds do not consider these outcomes as they are seen as extraordinary and beyond the scope of either feasible response or possibility.

He’s absolutely right, the majority of pension funds are hoping — nay, praying — that we won’t ever see another 2008 for another 100 years. The Fed is doing everything it can to reflate risks assets and introduce inflation into the global economic system. Pension funds are also pumping billions into risks assets, but as Leo de Bever said, this is sowing the seeds of the next financial crisis, and when the music stops, watch out below. Pensions will get decimated. That’s why the Fed will keep pumping billions into the financial system. Let’s pray it works or else the road to serfdom lies straight ahead. In fact, I think we’re already there.

Below, Mebane Faber talks about the benefits of the ETF he manages, Cambria Global Tactical ETF (NYSE:GTAA). I thank him for sharing this paper with me.

Tags: Assets, Astonishing Level, Bond Allocation, Bond Yields, Cambria, Commodities, Cumulative Return, Empirical Basis, Faber, Fingers, Government Bonds, Groundwork, Investment Management, Liabilities, Pension Funds, Plan Sponsors, Portfolios, Rate Of Return, Scenarios, Trillions, Twenty Years
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Opportunities in the Bad News?

Monday, August 30th, 2010

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors.

There’s been plenty of bleak news coming out of the equity markets and the U.S. economy as a whole. Are there opportunities hidden within that bad news? Are we now in one of those “blood in the streets” scenarios that Rothschild (and many investors after him) found so appealing?

If you believe in the cyclical nature of markets, the chart below from Stifel Nicolaus may be of interest. This chart shows the 10-year rolling return of the S&P Stock Market Composite going back nearly two centuries—current performance (inside the circled area) is at low levels only seen during the Great Depression.

The negative news flow keeps many investors on the sidelines waiting for sunnier days, while those who believe that what goes down eventually comes back up may see an opportunity to snap up equities at bargain prices.

A similar story line may be created for the next chart, which was produced by Old Mutual insurance company. The MSCI World Index is a measure of stock market performance across the world (including the U.S.).

The chart shows how the growth rate can swing wildly based on global events, but what’s clear is that the negative rolling 10-year growth since 2008 is unmatched in the past four decades. Markets have always bounced back, and as you can see on both charts, the best gains tend to be posted early in the turnaround.

One more data point—over the past decade, Treasury bonds have outperformed U.S. equities by nearly 90 percent. This is the widest margin of such outperformance over a rolling 10-year period in more than a century.

J.P. Morgan points out that history shows equities eventually reversing that trend, and when they do, they on average climb more than 250 percent over 10 years—a compounded annual growth rate of 13.6 percent.

The persistent bad macroeconomic news makes another round of “quantitative easing” (i.e., money injection) by the Federal Reserve increasingly likely. This could be good for equities by lowering long-term interest rates, stimulating the economy and boosting valuations.

It’s often said that hope is not an investment strategy, and that’s certainly true. It’s also true that hopelessness is also not an investment strategy. History and cycles are not perfect predictors, but it’s worthwhile to pay attention to these indicators.

I would also invite you to take our G-20 flag quiz—not only is it fun, it also teaches you a little about one of the most important global economic groups. If you have already done the quiz, try it again—you can always increase your speed and accuracy.

Copyright (c) U.S. Global Investors

Tags: Bad News, Bargain Prices, Chief Investment Officer, Cyclical Nature, Federal Reserve, Frank Holmes, Global Events, Great Depression, J P Morgan, Macroeconomic News, Msci World Index, Mutual Insurance Company, Negative News, Outperformance, Rothschild, Scenarios, Sidelines, Stock Market Performance, Treasury Bonds, U S Global Investors
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