Category: capital-markets

It Was a Wonderful Life – And Then Came Securitization

Via Money Morning:

There are two major problems with securitization.

First, in modern securitization markets, nobody is really responsible for the credit risk. Instead of taking loans onto their own balance sheet, and losing money if they default, mortgage companies merely sell the loans they originate to Wall Street, pocketing a fee for doing so. Wall Street, in turn, retains very little of the resultant mortgage packages: It sells them on to investors, who can hardly expect Wall Street to be responsible for each individual mortgage.

Thus, all the parties involved in originating the transaction became salesmen. Since it was no longer necessary to have a balance sheet to originate mortgages, mortgage brokers became pure sales operations.  The sales business being what it is, the more unscrupulous and aggressive the sales operation, the more business it did.

That’s how we ended up with so-called “Liar Loans.”

In newly unveiled draft legislation, the U.S. Treasury Department has proposed to reduce this problem by making securitization originators keep 5% of the resultant credit risk. This seems a sensible move, and should help matters considerably, even if it does reduce the attraction of the more-exotic securitizations.

A second problem with securitization, highlighted by the Massachusetts court decision, is that of documentation.  As I can testify from experience, securitizations are by far the most tiresome of all Street transactions to document, with a non-standard securitization creating incalculable costs while taking 18-24 months to complete.

You can see why the more complex transactions were complicated: Hundreds – or even thousands – of mortgages were being bundled and sold as a bundle to maybe tens of thousands of investors.

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Credit Default Swaps Should Not Be Banned

Via zero hedge:

The bottom line is: in every trade there is a buyer and a seller. What needs to happen is the risk skew has to be eliminated and everyone has to be on equal footing. If an AIG or Goldman is aware that they can sell CDS in a company X all the way to zero because if the bet goes against them, they will be “rescued” by a moral hazard encouraging Federal Reserve. In doing so they will squeeze the natural market to a point where enough opposite bets emerge in order to arrive at some imbalanced equilibrium. The imbalance would disappear if Goldman were to realize that it has the same risk/return profile as a Carl Icahn or any other CDS player. If you want to have an efficient CDS market, remove the government backstops of its core players: AIG some years ago, which was more an implicit understanding of their TBTF status, and Goldman Sachs and all the TBTF banks currently, courtesy of explicit guarantees by the government. That is the first and critical step to making CDS trading sensible.

Even with a myriad of cons, CDS has its pros. Credit Default Swaps provide the most liquid and effective mechanism to express a directional bias. With equity volumes ransacked courtesy of HFT systems and various algos that have taken the equity market to unsustainable valuations all with the administration-backstopped desire to provide the “image” to the retail public (and their 401(k) holdings) that things are ok, it is next to impossible to hedge positions for the downside, as every equity short gets run over (courtesy of the Fed), and purchased puts expire worthless: in essence the equity market is broken from a hedging perspective. This only leaves fixed income as some semblance of providing a hedging opportunity. This of course excludes cash bonds (good luck finding borrow to offset long bonds anywhere even close to 1:1), thus leaving asset managers with only CDS as a natural hedge to any and every risk imaginable: from corporate, to duration, to interest rate, to counterparty.

All those who would see CDS extinguished, should consider that without this most liquid product, there will practically be no way to express bearish opinions on the most critical part of the  capital structure. And as we live in a valuation vacuum and true enterprise values are well below the equity tranche for the bulk of corporations (yet above 0, we hope), CDS is precisely the principal and only way to express a valuation bias for such time as the Fed decides to stop fighting the market and tightens (which may or may not happen in our lifetimes). Absent CDS, we will revert to the day when the mutual funds could only go directionally long, and when selling begins, look out below with no natural bids on the way down. A CDS ban is to the fixed income market, as a shorting ban is to equities…

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Why Markets Make Mistakes

Via Simoleon Sense:

Introduction (Via SSRN):

The research described in this article calls into question the assumptions of rationality, transparency, efficiency, and homogeneity on which many models of markets are based (see for example Samuelson 1948; Bass 1969; Fisher and Pry 1971, Malkiel 1973). The classic models assume, at least implicitly, that decision makers understand the structure of the market and how it produces the dynamics which can be observed or might potentially occur. Are these models acceptable simplifications, or can they be seriously misleading?
This article explains why markets routinely and repeatedly make “mistakes” that are inconsistent with the simplifying assumptions and often produce disastrously wrong business decisions. The undesirable outcomes could include vicious cycles of investment and profitability, market bubbles, accelerated commoditization, excessive investment in dead-end technologies, giving up on a product that becomes a huge success, waiting too long to reinvent legacy companies, and changes in market leadership. The article illuminates the effects of bounded rationality, imperfect information, fragmentation of decision making, and extrapolating past trends.

Click Here To Learn Why Markets Make Mistakes

What We Talk About When We Talk About the Efficient Market Hypothesis

Via The Curious Capitalist:

Eugene Fama said that in order to test whether markets were efficient in this sense you needed an economic theory of how prices were determined. He chose the Capital Asset Pricing Model, devised a few years before by Jack Treynor, Bill Sharpe and John Lintner. It said risky stocks would outperform less-risky ones, with the risk that mattered being something called beta—the correlation of a stock’s movements to those of the overall market.

Roll started pointing out issues with CAPM in the 1970s, and Fama and French concluded in 1992 that the conjunction of CAPM and the EMH simply didn’t match the data. They chose to jettison CAPM, not the EMH (Fischer Black made more or less the opposite choice). But without an economic theory of how stock prices should move, there’s no way of testing the claim that markets are efficient in the “price is right” sense. Pricing models like the arbitrage pricing theory or the Fama-French factor models simply assume that prices are right, then extrapolate from that what the relevant risk factors must be that determine prices. But this assumption that prices are right is now based on no empirical evidence at all. In fact, both Fama and Roll have said that there’s just no way to tell whether prices are right or not.

That leaves us with an efficient market hypothesis that merely claims, as John Cochrane puts it, that “nobody can tell where markets are going.” This is an okay theory, and one that has held up reasonably well—although there are well-documented exceptions such as the value and momentum effects. But if “we can’t tell where the markets are going” was all the finance professors had to offer, they wouldn’t have had much influence.

The price-is-right combo of EMH and CAPM allowed finance professors to say much more than “we dunno.” They may not have known exactly where a stock’s price was headed, but thanks to CAPM they could confidently predict the bounds within which it would move. Thus armed they went on to conquer the world, eventually transforming MBA curricula, legal thinking, corporate governance, financial regulation and many aspects of investment practice. It’s admirable that finance scholars—especially Fama, since it was his theory in the first place—kept sniffing around and eventually concluded that the EMH/CAPM combo didn’t match the evidence. It’s not so great that some of them now pretend that the price-is-right version of the efficient market hypothesis never existed, and fail to fully confront what its demise means for a lot of the other things taught in finance and investment classes.

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Size Really Does Matter…for ETFs

Via Abnormal Returns:

We are no strangers to the world of ETFs, but the following observation took us by surprise.  A single fund, the iShares MSCI Emerging Markets Index Fund (EEM) generates some $240 million in revenue per annum for its sponsor.  Ian Salisbury at WSJ goes on to note how lower trading costs have kept EEM on top against its much thriftier competitor the Vanguard Emerging Markets Stock ETF (VWO).  In short, size matters in the ETF industry.  And by industry, we mean industry.

There certainly are benefits to size in the ETF world, but there is a downside as well. Funds that were originally thought to be niche products have in some cases have seen explosive growth.  This growth has put pressure on their ability to produce the returns they set out to generate.  Therefore owning an ETF that invests in gold, commodities, or junk bonds is not the same thing as holding the underlying asset(s).

In some of these cases the ETF industry has tried to take something that is complex and make it seem simple.  Unfortunately something can get lost in the translation.  In addition the issuance of an ETF can change the dynamics of a market, something not always contemplated prior to a fund launch.

That is not to say that being too small in world of ETFs is not a problem as well.  We have written about the risks of so-called orphan or “zombie ETFs” that are too small and illiquid.  One need not look far to see that a broad swath of the ETF industry is potentially on the chopping block.

…ETFs can be a wonderful tool for investors, but ETFs are also a business.  A big business.  If you want to continue playing in the ETF sandbox make sure you know the distinction between a good ETF and a bad ETF.  Because the ETF sponsors are not going to tell you which is which.

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Markets After the Age of Efficiency

John Kay writing in the FT:

As anyone who has taken Finance 101 knows, there are three versions of the efficient market hypothesis. The strong version claims that everything you might know about the value of securities is “in the price”. It is closely bound up with the idea of rational expectations, whose implications have dominated macroeconomics for 30 years. Policy interventions are mostly futile, monetary policy should follow simple rigid rules, market prices are a considered reflection of fundamental values and there can be no such things as asset-price bubbles.

These claims are not just empirically false but contain inherent contradictions. If prices reflect all available information, why would anyone trouble to obtain the information they reflect? If markets are informationally efficient, why is there so much trade between people who take different views of the same future? If the theory were true, the activities it purports to explain would barely exist.

Yet although efficient market theory is not true, it may nevertheless be illuminating. The absurdities of rational expectations come from the physics envy of many economists, who mistake occasional insights for universal truths. Economic models are illustrations and metaphors, and cannot be comprehensive descriptions even of the part of the world they describe. There is plenty to be learnt from the theory if you do not take it too seriously – and, like Mr Buffett, focus on the infrequent inefficiency rather than the frequent efficiency.

…The strong version of the efficient market hypothesis is popular because the world it describes is free of extraneous social, political and cultural influences. Yet if reality were shaped by beliefs about the world, not only would we need to investigate how beliefs are formed and influenced – something economists do not want to do – but models and predictions would be contingent on these beliefs. Of course, models and predictions are so contingent, and an understanding of how beliefs form is indispensable. Economics is not so much the queen of the social sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies. The future of investing – and economics – lies in that more eclectic vision.

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Further reading: Culture and Prosperity: Why Some Nations Are Rich but Most Remain Poor

How ETFs Are Like Mortgage-Backed Securities

Via FT Alphaville:

Bedlam Asset Management takes a look at exchange traded funds in its latest market commentary. Specifically, at how — largely because of greed — a sound concept has once again potentially been bastardised by the financial industry.

As Bedlam notes, ETFs started off as a simple and good idea. They were convenient for investors, easy to understand, affordable, the natural successor of earlier market structures  like futures.

But then — unhappy with the ETFs’ solid but low returns — the industry turned to financial rocket scientists to try and beef up the ETF game. Or as Bedlam observes:

Like alcoholics, investment bankers can never have enough, but in the ETF markets they had made a mistake. For the annual management charges and the dealing commissions were set at a low, thus fair, price to make them attractive.

Having established these precedents, it proved hard to raise the profitability for their managers and thus skin the investor. Banks really dislike steady, recurrent low fee income from low-risk products as they can never cover their bloated overheads; so they consulted their rocket scientists.

They invented the ‘Almost as Safe ETF’, but with a much higher fee base. Some started using derivatives and other opaque financial instruments to offer an increase in value twice that of the price gain of the underlying gold or other commodity. These attracted more trading and higher fees too.

The next phase, as Bedlam notes, was similar to the development of asset-backed mortgage securities. The industry thinking appeared to be:

Why not have gold ETFs not backed by gold at all but say by gold shares, with price differences smoothed out through ever-liquid derivatives and hedges?

And the risk (and fees) just kept getting greater:

The ability to play around globally in multiple types of listed paper generated even more commissions; and because these vehicles were far more complex — but still very safe — management fees charged could be higher for enhancing the rise or fall relative to the underlying commodity. The die was cast. As it worked so well, and profitably, for bullion and then hard commodities why not apply it to others such as sugar, cocoa or coffee? Why not to anything not nailed down? So ETFs spread like a virus; the market went fissile. Having dredged most commodities — yes, there are even lean hog ETFs over which you can buy an OTC put — investment bankers took the final leap of taking it back into actual listed companies.

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Financial Innovation Under Fire

Peter Coy writing in BusinessWeek:

Leave it to Wall Street to give innovation a bad name. Americans prize out-of-the-box thinking in technology and culture, but they fear it in finance—understandably, thanks to innovative disasters like credit default swaps, collateralized debt obligations, and “negatively amortizing” mortgages whose principal grows instead of shrinking.

In spite of the public’s mistrust, entrepreneurs and academics are plunging ahead. They’re working on ideas they hope will help the consumer borrow more safely and build wealth more reliably. Some are ambitious, like reducing homeowners’ exposure to declines in local housing prices. Others are fanciful, like an electronically rigged wallet that becomes harder to open when your bank account is low, an idea from the Massachusetts Institute of Technology.

The big problem: It’s hard to tell the beneficial ideas from the ones that are self-serving or dangerous. Many top economists, including former Federal Reserve Chairman Alan Greenspan, once lauded subprime mortgages as a fantastic innovation. With this fresh in mind, there’s a risk that government will overreact and suppress good ideas along with bad ones.

Read the full article here

So Much for High Frequency Trading

It was only a matter of time. Via The Big Picture:

The Securities and Exchange Commission has proposed halting high frequency and flash trading.

In response, Nasdaq (and others) are now prohibiting flash orders. Supposedly, the NYSE is also considering banning the practice.

This was a given. The real question that remains unanswered and demands a thorough investigation is this: WHAT EXCHANGE OFFICIALS APPROVED THIS? WHO BELIEVED THAT ALLOWING FAVORED FIRMS TO FRONT RUN OTHER INVESTORS WAS OK?

Quite bluntly, the clueless dolts who allowed this to occur need to be publicly excoriated, fired from their job as exchange officials, and driven out of town on a rail. Oh, and, all the gains from this organized theft should be clawed back from all the front-running firms that stole this money — THAT’S RIGHT, ITS THEFT — one quarter cent at a time. Put the recovered ill-gotten gains into the SIPIC fund that compensates investors who have been defrauded by their stock brokers.

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Bloomberg: Flash Trade Halt Backed for Nasdaq, Bats as SEC Vote

Nation Currently Experiencing Both Inflation AND Deflation

Here are some words of insight from Jeffrey Saut, who writes the Investment Strategy letter for Raymond James Financial:

In last week’s letter we suggested that the nation currently is experiencing both inflation AND deflation. Consider this, it appears that the country’s top quintile of wage-earners (the folks with the most assets) are experiencing deflation as their house prices have collapsed, their 401(k)s are substantially below where they were in October 2007, their bonuses have been “whacked,” and the list goes on. Meanwhile, the lower income households are experiencing inflation with their healthcare costs rising, food prices escalating, insurance premiums climbing, etc. In such an environment it is logical that Treasury Bonds would rally in the short-run. Longer term, however, we continue think inflation will win out over deflation, which is why we agree 30-year Treasury Bonds are a “bad bet.”

On the dollar, after being bearish from 4Q01 until 4Q07, we turned neutral to moderately bullish on the “buck” in November 2007. At first that “call” was wrong, then it was right, yet all said the Dollar Index is no lower, or higher, now than it was in November 2007. Hereto, over the longer term we think the greenback is likely headed lower. But as the economy recovers, so too should the dollar. Accordingly, in the short term, we remain neutral to slightly positive on the U.S. dollar.

Speaking to the stock market, we have, and continue, to argue that at the March 2009 “lows” stocks were three to four standard deviations below “norms;” and that all we have done is rally back to normalized valuations. Given the severity of the 17-month decline (October 2007 to March 2009), there is no reason why the equity markets can’t rally to one, or two, standard deviations above “norms.” Moreover, stocks don’t necessarily need outsized economic growth to rally. All they need is growth. As our friends at the consummate GaveKal organization, whose service we highly recommend, note:

“The reality is that equity markets do not need high growth to thrive – they just need some growth. In fact, one could argue that a low-growth environment is preferable to one of stellar growth, since low growth is often accompanied by low interest rates and plentiful liquidity. Today, this is the environment which we will likely face for years to come. The latest Beige Book does a good job of summing up this story: the quarterly Fed survey reported that wage and price pressures were non-existent, that retail spending is lackluster in most areas, and that manufacturing activity has moderately improved. This will likely be the story for the foreseeable future. Consumers and banks will remain cautious, but interest rates will stay low, allowing for a gradual recovery in output. This is an ideal environment for corporate profit growth and also helps to explain why equities keep creeping higher.”

And, last week stocks continued to “creep higher” with all of the indices we follow trading higher for the holiday-shortened week. That action left most of those indices at new rally reaction “highs,” putting even more pressure on underinvested money managers. A case in point was an article from a few weeks ago whereby a money manager disclosed that he still has 80% of his $850 million under management in cash. I read the article with both amazement and amusement. Amazement because I was surprised that any portfolio manager would admit he had that huge of a hoard of cash after more than a 50% rally from the March lows. Amusement because he probably allowed himself to be quoted believing that the September 1st Dow Downer, of 185 points, was the beginning of the long anticipated correction.

Mr. Saut’s recommendation:

Our answer to this dilemma, in the current environment, is to scale “buy” into large-cap, dividend-paying, stocks. Manifestly, stock returns are a function of corporate earnings, the price-to-earnings ratio investors are willing to pay for said earnings, and the dividends they receive over time from those stock investments. That’s all you really need to know about the stock market! To reiterate, “If, however, you don’t embrace our near-term caution, we suggest doing what the underinvested money managers are being forced to do – buy lower volatility stocks with dividends.

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