There is an interesting article in Barron's this week regarding catastrophe bonds. Basically, catastrophe bonds are similar to normal bonds in that you invest a principal in return for periodic coupons. Once the bond matures, you receive your principal back - hopefully. The hopefully part is where these bonds are slightly different. Yes, with all bonds you have the risk of losing your principal, but for cat bonds it is less about credit risk, and more, obviously, about catastrophic risk. In most cases this is a binary proposition. If there is no event, you get all your money back. If there is an event, you do not get anything back. In return you get a nice coupon to compensate for the risk you are taking. After Hurricane Katrina, one cat bond tranche was offered by Swiss Re with an annual coupon of near 40%. In fact, cat bonds have returned over 33% from 2005 to this May, ahead of the 19.1% offered by the Lehman High Yield Corporate Bond Index over the same time frame. A additional benefit of cat bonds, beyond the high yields, is that their returns are often uncorrelated with the returns of other equity or fixed income investments, providing another vehicle for diversification.

Cat bonds were designed as a way for insurance companies to remain solvent if an event they insured does occurs. Insurance companies could simply buy reinsurance, passing the risk on to another insurance company, but there is the worry of too much correlation to the event. As an alternative, they could sponsor a cat bond. In short, the company would create a special purpose entity (yes, I know what you are thinking) that would issue the cat bonds with the help of an investment bank. Investors would then buy the bonds and receive a coupon with a defined spread over Libor. This spread can be as little as 0.5% to 20% or more depending on the event and the likelihood of its occurrence. Recent catastrophic events also have an impact on defining the spread. You can get a little more background on cat bonds here and here.

Since cat bonds often involve the creation of a special purpose vehicle, some investors are a little worried that some reinsurance companies are moving beyond their specialties. They are also concerned that by moving the risk off balance sheet, companies are preventing investors and the market from knowing the real exposure each company is taking. Cat bonds do allow reinsurance companies to survive and be less exposed if a major event does occur. Therefore, companies are less exposed by taking out insurance themselves, but off-balance sheet items are more difficult to value and risks are less transparent. The effects on market participants, such as Munich Re, Swiss Re, Liberty Mutual, Allianz, and Hannover Re, among others, is difficult to tell. On the other hand, the benefits to the investment banks underwriting the bonds, such as Barclays Capital, Deutsche Bank, Lehman Brothers, Goldman Sachs, and Swiss Re Capital Markets, among others, is a little easier to see and quantify, along with the potential returns for institutional investors, who at this point are the only ones currently receiving cat bond distributions.

As mentioned in the Barron's article, to date only one cat bond has been triggered, implying a low probability of catastrophic events occurring, or at least the ones that are being underwritten. Then again, the last two years have seen a lower level of terrorist events and major hurricanes. In fact, the last two hurricane seasons, which have been forecast to be strong, have fortunately been milder than expected. This year is once again forecast to have an active hurricane season. Hopefully the forecast will be wrong again, and cat bond investors will get a return of principal, and the people on the coasts and around the globe will be spared from another major event.

I wrote in a recent post how Barclays was getting into the physical trading of crude oil. Now IndexUniverse.com is reporting that Barclays is launching a new iPath Exchange Traded Note (ETN) targeting carbon emissions - the iPath Global Carbon ETN (ticker GRN). As cap-and-trade becomes more prevalent, it is expected that ETN funds tracking carbon emissions will become more popular. Some estimates have the global carbon market being worth more than $50 billion a year. Talk about making money out of thin air.

For the uninitiated, Investopedia (here and here) and Wikipedia give an overview of ETNs. In short, ETNs were first introduced by Barclays in mid-2006 and represents a type of senior, unsecured, unsubordinated debt security that is similar to other forms of debt (since it has a maturity date), but is different in that ETN returns are based on the performance of some other primitive (be it a stock, index, carbon emissions, or anything else). Unlike normal bonds, no periodic coupon payment are made, and your principal is not protected. On the other hand, they can be traded on exchanges and shorted, similar to ETFs. Since they are like bonds, the value of the ETN is affected by the credit rating of the issuer, and is therefore impacted by credit rating changes. This may explain why more ETNs have not been issued in the current environment.

Why use them instead of ETFs? There are a number of advantages (see Wikipedia for an overview), but basically they offer flexibility and tax advantages (see iPath for additional overview of ETN characteristics). Since there is no interest payments and dividend distributions, neither incurs a tax. Capital gains also only occur when the investor buys or sells the ETN - not when gains and losses are taken by the fund, as with a mutual fund, or when securities must be sold due to composition changes in an index, as with ETFs. ETNs are essentially treated as a prepaid contact (like a forward contract), allowing the difference between the sale and purchase to be treated as a capital gain, deferring the tax payment. ETNs also have no tracking error, unlike ETFs which have to buy the underlying assets or futures, thereby producing an inevitable, albeit usually small, tracking error. ETNs do not hold the underlying asset, but simply promise the match the index. This is another area where credit risk potential creeps-in. In a sense, you are trading tracking error risk for credit risk. ETNs also offer the flexibility to gain exposure in areas that are difficult for ETFs to replicate (such as carbon emissions), and allow for the deployment of strategies, such as momentum investing.

Of course, not everything is rosy (see the April USA Today article). In addition to credit risk issues, ETNs also have the disadvantage of being illiquid at times, although as they become more popular, it is hoped that this will be less of a problem for individual investors. Redemption issues do exist for institutional investors. There is also a worry that current tax benefits will be removed/modified by the IRS, which is still considering tax treatment of ETNs (see update) and likes to say "show me the money." There is the potential that the IRS will tax profits as interest, and not capital gains (which long-term are currently only 15%). Single currency ETNs have already been ruled on, and are now being taxed at ordinary income tax rates. Finally, as with all products that offer a specific investment strategy, there are risks with each strategy. Yet, for ETNs this gets magnified since there are now more options available, and as a result, more potential risks for those choosing strategies without understanding the goals, risks, and fit to their current investment portfolio. After all, not everyone wants to worry about whether sub-prime credit problems are going to affect their carbon missions ETN investment, or whether crude oil being in contango is good for their commodity spread ETN.

Note: When researching about ETNs to see if there was any new information to include for this post, I did run across the following on the Investopedia site: "While the benefit of active management is arguable, there is no disputing the value that financial engineering has brought to the financial markets since deregulation took hold in the early 1970s. Financial engineering has made our markets more liquid and more efficient. The advent of ETN is no different. However, as with any new product, there are unanswered questions." Given all the negative connotation around the term financial engineering, this is refreshing. Then again, this article may not have been updated for a while. Nonetheless, every now and then you have to take what you can get.

The Financial Times is reporting that Barclays Capital is planning to enter the shipping business. The bank is attempting to increase its commodities exposure by hiring ships on long-term charter to move oil, gasoline, and diesel. As opposed to gaining exposure by taking derivative positions, Barclays hopes to cash in on the prices involved in hiring ships, which have been up more than 50% in the last six months. The move also allows them to support their new venture into the physical trading of oil. Physical trading allows for a more predictable price since you are not at the mercy of the spot market prices.

Of interest is how moving the physical commodity adds a new level of risk to banks hiring a fleet of ships on a long-term basis - the risk of an oil spill. For this reason, some companies go slowly with physical trading, transporting what are called "non-persistent" oils, such as gasoline, which dissipate in the water quickly. Given all the credit problems that banks are already dealing with, it is hard to image any would want to even consider adding additional exposure in this way. In fact, even though such a move is not unprecedented for banks, this may tell us more about the weakened ability of banks to generate revenues using traditional means, such as investment banking and making loans. It also makes you wonder whether the shipping industry has reached a short-term top, and whether some commodities themselves may be nearing a peak. Maybe speculation is beginning to reach a little too far.

The WSJ is reporting that Hong Kong is planning a new exchange that will trade fuel oil contracts. The new exchange, to be called the Hong Kong Mercantile Exchange - HKMEx, is expected to open as early as Q1 of 2009 and will sell U.S. dollar denominated contracts for delivery of fuel oil to China. If successful, China is expected to expand into other commodities it uses, such as soybeans and iron ore. All this is in an attempt to turn Hong Kong into an Asia-Pacific financial hub. China has tried similar exchanges unsuccessfully in the past, but conditions have changed. More money and capital is now flowing into the east, in particular investment in energy, metals, and soft commodities. The exchange will also give U.S. traders another outlet for both in- and after-market hours trading. Given all the consolidation that is occurring in the industry, it will be interesting to see if the HKMEx can maintain the necessary volumes to stay afloat, and if successful, whether or not it will eventually become an acquirer, the one being acquired, or stay independent. But then again, lets not get ahead of ourselves.

Reuters is reporting that Microsoft and Yahoo! are talking again. Apparently sources from each company have confirmed the talks. The report also mentions that: "The information we have is thin, but what one source is saying [is] that Microsoft is talking a price lower than the $33 they were offering when the talks disintegrated in May." Maybe the thought of going below $20 a share, which seems to be a real possibility given the recent price action of their stock, not to mention the current market environment, has Yahoo! reconsidering their agreement with Google. Of course, Yahoo! does have an escape clause - but that would require them to merge with someone. If it is Microsoft, escape is free. If not, it will cost another company $250 million more to acquire Yahoo!, paid directly to Google. Maybe "Microhoo" is not dead yet. The incentives are certainly there. I imagine Carl Icahn is also actively banging the drum behind the scenes, still hoping to bring home a return for all his billionaire friends that lined up behind him, at least those that have not already added to the recent selling pressure.

Update: CNBC is reporting that there are no new talks. Of interest is that the initial version of the Reuters article mentioned "unidentified sources," or something similar, but after reports were not confirmed by CNBC, they print that the source was the TechCrunch blog. Interesting. The TechCrunch blog also responds: "What we’ve heard is that the two sides are in current discussions over a complete buyout, not necessarily that there’s a deal in place or even that Microsoft has made any kind of firm offer. Another source at Microsoft reiterates to us that they’re a buyer at the right price, but isn’t saying what that price is."

Dark pools of liquidity are back in the news again. See a previous WSJ article, along with two recent posts (here and here) for more background. As reported in a recent Financial Times article, the stock exchanges themselves may now be willing to throw in the towel, and begin looking for ways to work with the dark pools. The reason is obvious. Dark pools currently represent about 12% of all U.S. stock trading, and the exchanges are looking for ways to get this volume back. There is also the implicit admission that dark pools are not a passing fad, given that many of the exchanges are also developing their own dark pool trading environments. In addition to the threat of individual dark pools, of which there are now approximately 40 such pools, the exchanges are also worried that some or all of the individual dark pools currently in existence will get together and form their own exchange. Nothing focuses the business mind like the potential of a new, stronger competitor.

As I have written before, it does not surprise me that such pool of liquidity are developing as more hedge funds (which are also growing in numbers) look for greater trade protection. No one wants to have others front-run you while you are entering or exiting a large position. On the other hand, it is still amazing to me that more traders, investors, regulators, and members of Congress are not more concerned about such pools, or discussing what impact they may be having on price discovery. Not that I welcome such intervention by Congress, but I suspect that after the housing mess, credit concerns, and the reason for high crude oil prices (i.e., speculators) are off Washington's hearing list, dark pools may begin to see a little more light. How this story ends - unfortunately - is probably not that difficult to predict.

As reported in a Bloomberg article, wheat output in Australia is expected to be 19.5 million metric tons for this year's harvest, compared to an original forecast of 23.7 million metric tons. Dry conditions, including the driest May on record, are being given as the reason for cuts in the estimates. Australia is the third largest exporter of wheat. Many farmers converted acreage to wheat as the price increased over the last year (before correcting). Wheat futures were up slightly in morning trading.

Rio Tinto has completed successful negotiations with Baosteel to hike iron ore prices. Baosteel represents Chinese steel mills. The price increases averaged 85% and were argued in part due to increased freight premiums that are necessary to reflect rising transportation costs driven by higher oil prices. China imported 383 million tons of iron ore in 2007, up 17.4 percent from 2006. Analysts are looking for another 1.5 years or so of additional price increases. A CNBC International video discusses the recent price hikes and their effects on the industry. Given that iron ore is cheaper to ship from Australia as compared to Brazil (from Vale), and market prices are continuing to rise, Baosteel really had no other choice.

Given increased transportation costs, it is unclear exactly how much this price increase may add value to Rio Tinto, although a Agence France-Presse article states, "The deal was "very significant" as iron ore is one of the three main drivers of Rio Tinto's earnings, along with copper and aluminum, a Rio Tinto spokesman said." Nonetheless, even if the deal did not directly affect the bottom line, it should at least give Rio some leverage against BHP Billiton's takeover attempt of the company and may force them to up their offer. Rio is a bigger producer of iron ore than BHP, and the recent negotiations illustrate Rio's ability to drive the market price of iron ore. As of now, companies set the price of iron ore in individual negotiations, although the exchanges are looking at offering iron ore contracts in an over the counter (OTC) swaps market, or even a futures market. BHP has already expressed interest in such markets given that it will allow them more ability to take advantage of higher spot prices on a daily basis, without needing to lock into long-term contracts, or renegotiate as prices move significantly.

While individual investors cannot yet invest directly in iron ore futures, they can purchase a few companies that mine and sell iron ore, such as Rio Tinto (RTP), BHP Billiton (BHP), and Vale (RIO), and can also invest in those companies that are demanding the iron ore - the steel makers, such as POSCO (PKX), ArcelorMittal (MT), U.S. Steel (X), and Nucor (NUE). While there is still concern of a global slowdown, demand for steel and the materials that are used for its production, as least in China, are still strong.

As reported at the WSJ and elsewhere, Saudi Arabia promised at this weekend's oil summit to increase production slightly by 200,000 barrels a day for the rest of the year, if needed. The announcement was expected. On a more long-term basis, Saudi Arabia has also promised to increase its overall output capability to as high as 15 million barrels a day by 2018. The Saudi's currently have an overall capacity 11.4 million barrels a day. This is just a long-term promise, and not a fix for current supply-demand issues, but does indicate that the Saudi's may have spare capacity. Recently, some have worried that the Saudi's were not raising production simply because they could not do so. The recent promises indicates they can, but of course, this extra supply may be difficult to pump and may only be economical at current high prices. The extra oil pumped will no doubt also be made up largely of heavier crude, and not the light sweet crude the world is demanding. Experts also think the 15 million figure is high, and that the Saudi's would be able to reach 12 million barrels a day, at best. Given that crude oil prices were up in Monday morning trading, it is easy to suspect that the markets were also not impressed with news out of Jeddah.

Interestingly, by telling the world what it wanted to hear, the Saudi's may have also put themselves up for more criticism. Indicating that they could increase production sends the signal that they have been holding back, and that supply-demand issues are potentially at the heart of the problem, and not just speculators and the dollar as often stated by OPEC.

As for the near-term impact of the summit, and its associated promises, it looks as though it has not changed the outlook for many analysts. In the Bloomberg clip below, Victor Shum, from Purvin & Gertz, elaborates on supply and demand issues and predicts that demand destruction will increase as we move towards the end of the year. He is also expecting more price spikes in the next few months until falling back to an average value in the $120s as high prices finally cause more extensive reductions in demand.

Nice article at seekingalpha.com from Roger Nusbaum regarding whether or not it is time to buy financials. Roger says no, and makes the case why not. I agree. Wait for confirmation of a reversal, both technically and fundamentally. Of particular worry now are the regional banks, many which have some of the same issues as the bigger banks, and may be the next group to take a hit (and currently are for some). Many regionals are moving into municipal bonds (see post here). Hopefully, they will not fall into the same capitalization problems.