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Archive for January, 2009

Of course I’m referring to John Paulson (since Hank no longer matters), the guy who turned $500 million into $3.5 billion in a single year (2007) by shorting sub-prime mortgage backed securities through buying credit default swaps.

The New York Times received a copy of his year end letter, which gives his guidance for 2009…the NYT website won’t allow me to embed the letter, so here’s the link if you’re curious.

Since the report is 28 pages long, here’s some abridged analysis via Paul Kedrosky:

Looking forward to 2009, Paulson remains highly bearish. Here is his general strategy, he says, for the first half:

  • Slight short exposure to equity markets
  • Remain short financials
  • Focus on long distressed opportunity
    • Mortgages
    • Bankrupt debt
    • Distressed
    • Capital restructurings
  • Focus on strategic merger deals
  • Maintain short focus on financials, with the belief that we only perhaps half-way thru

To remain short financials, he must believe on some level that a nationalization is in the cards to wipe out the equity of troubled banks. That’s not to say that nationalization is the only shoe left to drop, since rising unemployment is likely to go hand in hand with continued mortgage defaults, along with the potential for more trouble in commercial real-estate.

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GE’s Inevitable Downgrade

From Bloomberg:

General Electric Co.’s and General Electric Capital Corp.’s Aaa ratings may be downgraded by Moody’s Investors Service. The ratings agency revealed its plans in a statement today.

It’s about time…One would think that the next step is a dividend cut, since they’re already having trouble justifying a $1.24 per share payout when their earning $1.32 (cash outflows almost equal their current inflows – and GE doesn’t give guidance anymore, so we can’t necessarily assume their earnings will get better). GE’s AAA credit rating has historically allowed them to finance their operations at a much cheaper rate than other blue-chip mainstays, such as IBM, which Moody’s has deemed an “A1”. To add some color to how this affects the cost of their debt, we can look at the coupons on GE and IBM bonds:

ibm-vs-ge1

These aren’t perfect substitutes, but it’s clear that GE can issue debt at a cheaper rate than IBM. What’s interesting when comparing these 2 bonds is that IBM trades at a premium, while GE’s AAA rating appears to have a reverse effect on their demand for bonds (they’re actually trading at a discount to IBM despite the better credit rating); As an investor, do we really need to compromise the better return from IBM’s bonds for the small level of added security on GE’s? Clearly not – they’ve both been around forever.

(Here’s a table which displays/translates the ratings hierarchy).

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Back To The Drawing Board…

geithner1

Timothy Geithner, our new Treasury Secretary, is starting off his tenure with a routine we’ve seen before:

Via Bloomberg:

Geithner also said, in written responses to questions from Senate Finance Committee members, that there are “no current plans” to request more financial-bailout funds. He played down any need to nationalize U.S. banks, without specifically ruling out the option.

We’ve seen what can happen when public officials come out and deceive the public; Hank Paulson & Co. (deliberately or not) downplayed the severity of our credit crisis and maintained that our trouble was sheltered in the realm of Subprime-Mortgages…regardless of whether people believed him (many did not), the important thing is that once his thesis was broken, we embarked into an age of volatility and bank runs (Lehman Brothers and Bear Stearns specifically, although not in the traditional sense). The markets realized his oppinions weren’t accurate, which tarnished Paulson’s authority and limited his credibility going forward.

Many people choose to study history so we don’t repeat mistakes of the past; in this context, the mistake is decieving the public. Thankfully Barack Obama abides by this philosophy (as evidenced by his inauguration speech) since he hasn’t come in with an attitude that he needs to be America’s cheerleader (much like Erin Callan did for Lehman Brothers).

Hopefully Tim Geithner has the sense not to go down the same slippery path like so many before him, or we could be in for a long ride.

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From the Financial Times:

ft-japan-comparison1

The point of the FT article was to describe how it is extremely difficult for the private sector to deleverage, or reduce debt levels, during periods of falling prices…As the charts show, the US is witnessing debt balloon to levels not seen since the 1950’s (as a percentage of GDP), while asset prices have fallen precipitously.

As the author describes;

It has long been argued that the US could not suffer like Japan. This is wrong. It is true the US has three advantages over Japan: the destruction of wealth in the collapse of the Japanese bubble was three times gross domestic product, while US losses will surely be far smaller; US non-financial companies do not appear grossly overindebted; and, despite efforts by opponents of marking assets to market, recognition of losses has come far sooner.

Basically, our situation is more similar to that of Japan circa 1990-2005 than we had anticipated – not to mention some  economic characteristics which are considerably less desirable (a global recession, leaving little room for other countries to pick up the slack in our budget/trading deficit by buying our debt and consuming our exports).

Surprisingly, part of the reason the author included all of this background was to advocate for a bigger stimulus package, not to be depressing.

Unfortunately, there is no discernible solution to the problems brought up in this article, other than the old “we’ll have to tough this one out” analysis:

The bigger point, however, is not that the package needs to be larger, although it does. It is that escaping from huge and prolonged deficits will be very hard. As long as the private sector seeks to reduce its debt and the current account is in structural deficit, the US must run big fiscal deficits if it is to sustain full employment.

There will be a Part II to this author’s column in next week’s FT, if at all interested.

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Despite the flood of cash from the government, Banks are still hoarding cash…What could explain this phenomenon?

From BusinessWeek:

They (Banks Chiefs) argue that the government funds are designed to shore up capital and support lending, but that they have no obligation to make new loans. “It’s not a one-to-one relationship,” says BofA CEO Kenneth D. Lewis. “We don’t write $15 billion in loans because we got $15 billion from the government.”

So there’s a disagreement on what the TARP money should be used for…But some may ask why banks won’t make new loans? The answer, as always, is dependent on money:

Right now there’s little financial incentive to make fresh loans. In the current unease, new corporate loans are immediately marked down to between 60¢ and 80¢ on the dollar, forcing banks to take a hit on the debt. It’s more lucrative, then, for them to buy old loans that are discounted already.

Just when you think all of the side effects of repealing Glass-Steagall were out of the system. Now banks won’t even make new loans; since there are so many discounted securitized mortgages on the market, they’re using the TARP money to buy outstanding mortgages…

Since the TARP was so Ad hoc by nature,  The government didn’t  force them to do otherwise, so you can’t blame banks for cutting the best deals.

The most important point regards their capital requirements:

Under federal rules, banks are required to maintain a certain level of capital based on their assets. When they incur losses, they either have to raise more capital or sell assets to keep those ratios in check.

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Design Changes

I got tired of the old blog template for a couple of reasons, but mainly because:

  1. There was very little you could do with it beyond writing posts, where this template allows me to embed things within my main pages…
  2. I liked the color scheme, but  lately I found that it was hurting my eyes.

I think this one is a lot cleaner, but I need to replace the picture I had before (since I cannot seem to replicate the green on this site, I may just collage a bunch of pictures/events from the past year…still in the process of figuring this out though).

The current picture is just like my old one, and is only temporary.

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“Dating back to work on the random walk hypothesis by French economist Louis Bachelier (1870-1946), the efficient market hypothesis asserts that stock market prices are the best available estimates of the real value of shares since the market has taken account of all available information on an individual stock.”

Economy Professor

Now from New York Times Magazine, which had an interesting 10 page spread about Risk valuation last Saturday:

VaR is often measured daily and rarely extends beyond a few weeks, and because it is a very short-term measure, it assumes that tomorrow will be more or less like today. Even what’s called “historical VaR” — a variation of standard VaR that measures potential portfolio risk a year or two out, only uses the previous few years as its benchmark. As the risk consultant Marc Groz puts it, “The years 2005-2006,” which were the culmination of the housing bubble, “aren’t a very good universe for predicting what happened in 2007-2008.”

How are these two phenomena related? The risk models our world of finance has been relying upon for several years are grounded in the Efficient Market Hypothesis; VaR models – or models which price risk – would not function without the corollary of the underlying asset being priced properly. We took comfort in this convenient theory, that everything is priced appropriately, all the time.

The counter to this argument is not another theory, but a series of real life outliers. If markets are efficient, How does George Soros continually compound his fortune by trading according to his boom/bust empiricism (like shorting the British Pound)? Warren Buffet also acknowledges fault with this theory: “I would be a bum on the street with a tin cup if the markets were always efficient.”

Every theory has shortcomings, and the admitted shortcoming of the Efficient Market Hypothesis is one of “black swans”, or in economic terms, exogenous shocks. These are events which cannot be predicted, ones which are often described as lying outside a 99% confidence interval, and ones which continually disprove the efficiency of market pricing – especially during times of panic.

The second glaring shortcoming is one which lies about the applications of the EMH, or one of our perception. One assumption of the hypothesis, like an assumption in micro-economic theory, is that the participants are completely rational (much like human calculators). This assumption has proven to hold under times of tranquility – like the times LTCM succeeded in making money – but during times of deception and opacity, many of us are hopelessly irrational.

To quote Michael Lewis’s most recent book, Panic!, on the pricing of Bear Stearns:

“If the market got the value of Bear Stearns so wrong, how can it possibly believe it knows even the approximate value of any Wall Street firm?” (P. 342)

The pillar of the EMH that comes tumbling down in times like today is “known information”…On the surface, who is to say that Bear’s balance sheet was all that bad? I’d like to believe we could extrapolate everything from the footnotes (never mind having everyone read them), but the population of people who called for the failure of Bear Stearns in 2006 lie far outside the depths of the “normal distribution.” Furthermore, here’s a real life example: how could the Nasdaq be accurately priced at 1,400 in 1997; at 5,000 in 2000; and back at 1,400 in 2002?

All of this is to argue that the notion of efficient markets, which we have taken shelter in for much of our modern financial history, stands paralyzed in times of uncertainty; this would provide insight into why panic ensues at the very signal that we are “in the dark” concerning anything (this could also be a reflection of our poor sentiment; the constant belief that we will be disappointed by Wall Street is becoming a part of our psychology). This would also provide an explanation for our dependence on models as a “crutch”, to grant us what has turned out to be a false sense of security by quantifying risk with numerical values.

The fallout of the sub-prime mortgage crisis has uncovered many of the issues with deriving models after this hypothesis – the only problem is, we haven’t come up with anything better. VaR were used heavily in the late 1990’s by none other than LTCM, but as the NYT article points out:

Firms viewed it as a human failure rather than a failure of risk modeling. The collapse only amplified the feeling on Wall Street that firms needed to be able to understand their risks for the entire firm. Only VaR could do that. (Page 7)

We then reverted back to their use.

I will end with a phrase which has time and again been a sure way to see oneself proven wrong – Maybe this time it’s different.

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