An urgent secret business relationship with a transfer of funds of great magnitude

Dear American:

I need to ask you to support an urgent secret business relationship with a transfer of funds of great magnitude.
I am Ministry of the Treasury of the Republic of America. My country has had crisis that has caused the need for large transfer of funds of 800 billion dollars US. If you would assist me in this transfer, it would be most profitable to you.

I am working with Mr. Phil Gram, lobbyist for UBS, who will be my replacement as Ministry of the Treasury in January. As a Senator, you may know him as the leader of the American banking deregulation movement in the 1990s. This transactin is 100% safe.

This is a matter of great urgency. We need a blank check. We need the funds as quickly as possible. We cannot directly transfer these funds in the names of our close friends because we are constantly under surveillance. My family lawyer advised me that I should look for a reliable and trustworthy person who will act as a next of kin so the funds can be transferred.

Please reply with all of your bank account, IRA and college fund account numbers and those of your children and grandchildren to wallstreetbailout@treasury.gov so that we may transfer your commission for this transaction. After I receive that information, I will respond with detailed information about safeguards that will be used to protect the funds.

Yours Faithfully Minister of Treasury Paulson

(Lifted from: http://www.theseminal.com/2008/09/23/awaiting-your-correspondance-important-business-matter/)

Why Paulson is Wrong

Luigi Zingales of Chicago GSB has written a brilliant article on why the 'Paulson Doctrine' of dealing with the current crisis is a sure fire failure. Here are the reasons in brief:

• Liquidity is not the problem, its just a symptom
• The assets are illiquid because the market is not sure of their correct value. What makes Paulson think his men/women are more accomplished at valuing them than the hot shot Wall Street Bankers?
• Private profits and socialized losses will only put this crisis in abeyance till an even bigger one strikes
• Debt holders of private corporations are accountable as much for the risks they took looking for enhanced yields

The entire article is available in pdf here, or you can read it below:

By:
Luigi Zingales
Robert C. McCormack Professor of Entrepreneurship and Finance
University of Chicago - GSB

When a profitable company is hit by a very large liability, as was the case in 1985 when Texaco lost a $12 billion court case against Pennzoil, the solution is not to have the government buy its assets at inflated prices: the solution is Chapter 11. In Chapter 11, companies with a solid underlying business generally swap debt for equity: the old equity holders are wiped out and the old debt claims are transformed into equity claims in the new entity which continues operating with a new capital structure. Alternatively, the debtholders can agree to cut down the face value of debt, in exchange for some warrants. Even before Chapter 11, these procedures were the solutions adopted to deal with the large railroad bankruptcies at the turn of the twentieth century. So why is this wellestablished approach not used to solve the financial sectors current problems?

The obvious answer is that we do not have time; Chapter 11 procedures are generally long and complex, and the crisis has reached a point where time is of the essence. If left to the negotiations of the parties involved this process will take months and we do not have this luxury. However, we are in extraordinary times and the government has taken and is prepared to take unprecedented measures. As if rescuing AIG and prohibiting all short-selling of financial stocks was not enough, now Treasury Secretary Paulson proposes a sort of Resolution Trust Corporation (RTC) that will buy out (with taxpayers’ money) the distressed assets of the financial sector. But, at what price?

If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay. Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price? The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses. Remember that in the Savings and Loan crisis, the government had to bail out those institutions because the deposits were federally insured. But in this case the government does not have do bail out the debtholders of Bear Sterns, AIG, or any of the other financial institutions that will benefit from the Paulson RTC.

Since we do not have time for a Chapter 11 and we do not want to bail out all the creditors, the lesser evil is to do what judges do in contentious and overextended bankruptcy processes: to cram down a restructuring plan on creditors, where part of the debt is forgiven in exchange for some equity or some warrants. And there is a precedent for such a bold move. During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision. My colleague and current Fed Governor Randall Koszner studied this episode and showed that not only stock prices, but bond prices as well, soared after the Supreme Court upheld the decision. How is that possible? As corporate finance experts have been saying for the last thirty years, there are real costs from having too much debt and too little equity in the capital structure, and a reduction in the face value of debt can benefit not only the equityholders, but also the debtholders.

If debt forgiveness benefits both equity and debtholders, why do debtholders not voluntarily agree to it? First of all, there is a coordination problem. Even if each individual debtholder benefits from a reduction in the face value of debt, she will benefit even more if everybody else cuts the face value of their debt and she does not. Hence, everybody waits for the other to move first, creating obvious delay. Secondly, from a debtholder point of view, a government bail-out is better. Thus, any talk of a government bail-out reduces the debtholders’ incentives to act, making the government bail-out more necessary.

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain. Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.

The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.

Drawbacks of a connected world

Its usually believed that the more connected a system is, the stabler it is. Studies of network complexity suggest that the stability of a network of connected nodes usually falls when interconnections begin and then it increases.

However, there is also a theory that more connected systems are stabler than sparsely connected ones only with regard to regular shocks. They are however much more prone to complete and utter failure in case of extraordinary shocks (aka Black Swans, courtesy NN Taleb).

Therefore, one might infer that the increasingly globalized world is bringing lower volatilities in most aspects of our lives (however, this can also be debated ad inf.) but is in the process exposing ourselves to a very high degree of uncertainty in case of extreme events.

If you've been following the recent news, you might've seen that the stock of United Airlines was battered 76% intraday based on a news article suggesting bankruptcy filing by the company. The news dated Sep. 7, 2008 was from Florida Sun-Sentinel and later on carried by Bloomberg. There was however one small problem, and it was that the news article was some 6 years old!

Once it came on Bloomberg, and before anyone could figure this out, the stock was hammered down. With all the programmed trading these days, sell orders cascade onto more shorting of the stock leading to a downward spiral of death. The management was really hard pressed understanding what the **** hit them and trying to let the investors know the truth. Given the general swiftness of bankruptcies in America lately, no one wanted to be on the boat till the crack in the hull was confirmed.

Now, the best part is how did this happen? Google's beta product Google News is taking some flak for this. They've come out with their version here. They sort of want us to know that it is not their fault alone. They say that the news bot picked up a new link on the newspaper's website which had somehow appeared in the most read articles list and associated the only date available on the page (which was Sep 7, 2008) with the news. Then, a reporter from the Income Securities Advisors Inc. who wanted to do a quick report on bankruptcies did a google news search for "bankruptcies 2008". This unfortunately lead to the UA news article and was published as an advisory report from the firm. Things went berserk after this report was carried by bloomberg on their trading terminals worldwide. Connected world! It took half a day for matters to cool down. UA stock regained most of what it had lost during the day.

Google and Bloomberg have since then taken down the story. Read it here and here

One mistake by a completely unrelated bot lead to the decimation of the stock. Its not that some trading system failed and caused this. The point is that the error happened in a completely unrelated corner of the world.

"That's how much confidence people have in our system, when you can take the stock of a major corporation to zero in about 10 minutes," said Thomas Buffenbarger, president of the International Association of Machinists and Aerospace Workers, which represents mechanics and other employees at U.S. airlines.

Would you invest in a hedge fund which returned 41% annualized over a decade?

It may seem naive to question the capability of a hedge fund manager who has a record of returning close to 50% annually over a decade. You might be labeled a moron if you were to question his investment skills. Below is an insightful article written by James Hamilton in 2005. It talks about the research of MIT Professor Andrew Lo (published in Financial Analysts Journal in 2001) who established a fictional hedge fund called Capital Decimation Partners (CDP!) whose only strategy was to sell put options in the great bull run of S&P 500 during 1992-99. The fund returned an astounding 41% annualized with positive returns in every single year.

Read on ...

Hedge fund risk

Psst-- want to earn a 41% annual return over a decade? Then read on.

Originally, "hedge fund" was used to describe a fund that simultaneously buys and sells related securities, constructing a portfolio with desired risk-return characteristics or profiting from subtle differences in returns. Today, the term may refer more broadly to any unregulated private investment pool that adopts unconventional or aggressive investment strategies such as short selling, leveraged positions, program trading, swaps, arbitrage, and derivatives trading.

The Big Picture calls attention to this story from this weekend's New York Times:

Mr. Simons, who got into the hedge fund business after abandoning a stellar career in mathematics, has a track record that is jaw-dropping.... from 1990 to 2004, Renaissance's primary hedge fund, called Medallion, has delivered annualized returns of 33.21 percent. (The Standard & Poor's 500-stock index has returned, on average, 10.98 percent during those same years.)

I do not know anything about the investment strategy of Renaissance or Medallion. But let me tell you about one fund I do know about called CDP, which was described by MIT Professor Andrew Lo in an article published in Financial Analysts Journal in 2001.

1992-1999 was a good time to be in stocks-- a strategy of buying and holding the S&P 500 would have earned you a 16% annual return, with $100 million invested in 1992 growing to $367 million by 1999. As nice as this was, it pales in comparison to CDP's strategy, which would have turned $100 million into $2.7 billion, a 41% annual compounded return, with a positive return in every single year.

Want to learn more? CDP stands for "Capital Decimation Partners", a hypothetical fund created by Professor Lo in order to illustrate the potential difficulty in evaluating a fund's risk if all you had to go on was a decade of stellar returns. The strategy whereby CDP would have amassed a hypothetical fortune was amazingly simple-- it simply sold put options on the S&P 500 stock index (SPX).

Buying put options is a way that an investor can buy insurance against the possibility of a big loss. For example, the S&P 500 index is currently valued around 1250. You can buy an option (the 1150 March 2006 put) that will pay you $100 for every point that the S&P is below 1150 on a specified date in March. Such an insurance policy would today cost you about $750. If you've bought enough puts to balance the equity you have invested long, you have nothing to fear if the market goes below 1150, because every dollar you lose on your main holdings you can gain back from your put option.

But what about the person who sold you that put? They have now assumed all of your downside risk. Lo's Capital Decimation Partners would use its capital to meet the margin requirements (which guarantee to the exchange that CDP could in fact make the payments to the buyer of the put), and roll over the proceeds to make even bigger bets. Essentially it was thus using leverage to turn the relatively small proceeds from selling these puts into a huge return on the capital invested.

Of course, if you play that game long enough, eventually the market will make a big enough move against you that your capital used to meet margin requirements gets completely wiped out, giving you a long-run guaranteed return on your investment of -100%. But over the 1992-99 period, Lo's hypothetical fund dodged that bullet and ended up turning in a whopping performance.

Lo gives a variety of other examples of funds that could go for a long period with very high returns and yet entail enormous risks. They all have this feature of pursuing investments that have a high probability of a modest return and a very small probability of a huge loss. By leveraging such investments, one can achieve a very impressive record as long as that low probability disastrous event does not occur. It is certainly possible that some strategies along these lines would, unlike Capital Decimation Partners, earn a higher return than the market on average if you stuck with them forever. However, you should view that higher return as coming at the expense of much higher risk.

My discussion of Lo's hypothetical hedge fund should not be construed as a specific critique of any currently operating actual hedge fund. But suppose that all you know about a fund is that it has earned exceptional returns every year for the last decade, and you don't have access to information about the specific trading or asset holding strategy that netted those returns. Is it a good investment for your money? My advice would be no.

Adult Entertainment benefits from stimulus cheques

What would you stimulate if your government sends you a stimulus cheque?

 

The economic stimulus cheque is a nifty way to put some petty cash back in the hands of people for them to spend it around and in the process stimulate the economy.

 

However, it appears that many Americans took stimulus rather too literally and went about stimulating whatever was easiest for them to do so.

 

There's some solid 'research' by AIMR Co (the Adult Internet Market Research Company … 'Adult Entertainment' is really a BIG business.) which suggests that right during the time the stimulus cheques were being sent to the American people, many 'Adult Entertainment' sites witnessed an abnormal growth of 20 to 30 percent in their paid memberships.

 

Don't giggle … there are some very strong economic reasons for this. If you don't believe me, look at what Dr. Marc Faber (he's a renowned investment guru) has to say on the stimulus cheques:

 

"The federal government is sending each of us a $600 rebate. If we spend that money at Wal-Mart, the money goes to China. If we spend it on gasoline it goes to the Arabs. If we buy a computer it will go to India. If we purchase fruit and vegetables it will go to Mexico, Honduras and Guatemala. If we purchase a good car it will go to Germany. If we purchase useless crap it will go to Taiwan and none of it will help the American economy. The only way to keep that money here at home is to spend it on prostitutes and beer, since these are the only products still produced in the US. I've been doing my part."

 

So, when the American economy is already being screwed, it's best to do it yourself.

 

I hope they will be able to screw themselves out of this mess.

Top down approach of controlling volatility in financial markets

Where else could you have seen this other than China? It seems that the Chinese government is reluctant to let the volatility in financial markets affect the Olympics in any way. That is why the Chinese market regulator has issued a not-so-open warning to financial analysts in China to avoid making any public statements which would increase the volatility of the markets. Which in essence means that analysts can't give a sell (or is it underweight :-) recommendation and they will have to agree with the government that everything is fine in Chinese equities.

Its good to be an analyst when you have been told the results before your analysis. You save a lot of efforts this way :)

The FT story on this is available here

How do you predict the stock market?

I recently had a discussion with a colleague regarding best predictors of the stock markets. Having followed this subject both academically and as an intellectual pursuit, it is very interesting to note how the human mind is conditioned to create relationships using short term data where none exists. Detailed beautifully in "Fooled by Randomness" by Nassim Taleb, there exists a multitude of such phony correlations. "A mathematician plays the stock market" also has similar stuff.

 

Taleb mentions in his book an example of this. According to the research of Cal Tech professor David Leinweber, the "single best predictor of the S&P 500's performance" over the period 1983 – 1993 that he found was … hold your breath … butter production in Bangladesh. The lagged correlation is almost unity, which means that a y% rise/fall in butter prices in any year is followed by exactly a 2y% rise/fall in S&P 500 in the subsequent year.

 

So, if you tracked butter production in Bangladesh during that time, you could have made a killing on the stock markets and everyone would've taken you to be a genius.

 

Tough luck you didn't know this before hand.

 

That's the problem with back testing. It's what they say, "hindsight is always 20-20".