As reported at the Financial Times and the WSJ, discussions have progress to the point that larger banks and dealers should have a central clearing house for credit derivatives by later this fall. The market for credit derivatives is currently near $62 trillion in notional value after being less than $5 trillion as little as five years ago. The goal of the clearinghouse will be to reduce the systemic risk that results from inefficient trading and uncertain counterparty exposure, both of which have increased as the market expanded. Automated trade-matching and electronic processing in other OTC derivatives market was also discussed. Credit derivatives in particular have caused concern as their rapid grown has made it more difficult to both track and measure the exact level of exposure being taken.

Recent credit problems have highlighted the need to better understand counterparty exposure. A central clearing house for credit derivatives should help in this area given that the clearing house will take the risk of a market participant's failure. Any failure would then be absorbed by the clearing house members, reducing the need for the Federal Reserve or Treasury to get involved, and possibly preventing the type of failure that was experienced with Bear Stearns. Like other clearing houses, trades are also likely to be better scrutinized when made, such as making sure that margin requirements are enforced and trades are verified and recorded.

To date the levels of electronic derivative trading in the various markets has been mixed. Currently, about 90% of credit derivatives are traded electronically. The interest-rate derivatives market, which is larger and potentially more worrisome, has also increased electronic trading and now sits at about half of all trades. Equity derivatives trading is bringing up the rear with only about one quarter of all trades executed electronically. Depending on the success of the credit derivative clearing house, plans could be expanded to also include the equity and interest rate markets.

One current hitch for the credit derivative clearing house is the need to make sure that the entire CDS market is integrated and electronic. To facilitate the move, dealers have agreed to reduce the total value of outstanding CDS trades, and to help sort out corporate defaults by incorporating a cash settlement mechanism into CDS documentation. Of note is that the market in many cases would still be private, but more centralized.

Although the details of the clearing house are still being worked out, such as what exactly the dealers and exchanges will control, any move is certain to benefit the exchanges as they will now have a direct link to the lucrative CDS market, while the large investment banks that currently control the credit derivative market will need to start sharing some of the billions of dollars of revenue. For some banks, this line of revenue has been significant. Companies that my be positively impacted include the CME Group (CME) and NYSE Euronext (NYX). Investment banks that may be negatively impacted, at least with regard to losing some of their current credit derivative revenue stream, include Deutsche Bank (DB), Goldman Sachs (GS), and Morgan Stanley (MS).

In another interesting move, Bloomberg is reporting that the U.S. Agricultural Department will not allow farmers to withdraw from a land-conservation program without penalty next year. The move has the effect of further limiting the acreage available for planting corn at the exact time that corn prices have come off record highs, demand is strong, and flooding has caused crop losses. While a win for environmentalists, the move will reduce the additional acres that many were expecting to be available next year. Not surprisingly, corn prices rallied on the news. Recently, corn prices had sold off, causing the margins for ethanol production to become attractive again. The current margins, along with the news of less than expected acreage increases are sure to have a bullish effect on corn prices. While there is most likely more to the story (there usually is), the fact that you would mandate something and then reduce your ability to produce or develop the raw material seems wrong on so many levels. Of course, this says nothing of how such moves will also continue to keep food prices artificially high as corn continues to be converted to fuel. If history is any indication, there is no doubt that as corn prices rise and more traders move back into this market, speculators will be blamed for the high prices hitting consumers, launching yet another formal inquiry.

Why should institutional investors and hedge funds have all the fun in the current credit crisis? Now you too can join in. Societe Generale is offering a new product that provides exposure to the credit default swaps (CDS) of speculative-grade companies. The new product is linked to the number of defaults in the iTraxx five-year Crossover Index, which is comprised of 50 European companies which Moody’s has forecast to remain below long-term average and market implied default rates.

As reported in an article at Structured Products, the product is designed to give investors an IRR up to 14.25%, provided of course that none of companies in the index suffers a credit event during 5 years of the product’s life. Events include bankruptcy, default, or restructuring. The notes can be purchased at 54-55% of face value and are redeemed 100% at maturity. They are also designed such that when each constituent experiences a credit event, 2% is subtracted from the total portfolio value. Estimates are that even if 17 of the 50 companies in the portfolio experience a credit event, the IRR would still be around 5.2%, above the 5 year European Interbank Offered Rate. Sounds good, but just remember that when major events do occur, certain assets will start to become more correlated very quickly.

As reported in the Financial Times, Blue Coast, a unit of the German insurer Allianz, is now selling catastrophe bonds that break down losses from hurricanes by the county in a state, instead of at the state level itself. The $120 million issue is the first to bring the event down to the county level. Whether this will encourage local municipalities along with states themselves to cover their catastrophe risk is difficult to tell. It will no doubt certainly allow investors more transparency as to the exact risk they are taking, at least from a location perspective, and could facilitate pricing and valuation.

For those unfamiliar with catastrophe bonds, they 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. As with other bonds you have the risk of losing your principal, but for cat bonds it is less about credit risk, and more 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. 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. After Hurricane Katrina one cat bond tranche was offered by Swiss Re with an annual coupon of near 40%. An 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.

A little over a month ago I wrote a post discussing a Barron's article on the subject. At the time a reader who worked in the industry made some interesting comments, one of which discussed the recent growth of cat bonds. It was mention that over the last 10 - 15 years the market for cat bonds had went through some abrupt growth periods which typically followed weather events like Hurricanes Katrina and Andrew, and other events like 9/11, but then growth usually stagnated in between. What is interesting now is that the current growth is not really being triggered by recent events. What could be driving the growth? As it turns out, hedge funds are initiating funds that invest in cat bonds given their low beta risk, high yield, and attractive Sharpe Ratios. Since both supply and demand has been strong, even without events increasing, the cat bond yields have stayed attractive.

The worry is that higher yields will cause more hedge funds to enter this asset class without really understanding the nature of the risk, driving down yields and increasing exposure. Furthermore, unlike for bankruptcy, or even credit risk, investors will have a more difficult time evaluating something like a catastrophe which can be both severe and unexplainable. This usually leads to a post-event attempt to assign blame to others with no hand in the event. Investors who put their toe in the water during the year of the event could lose their entire principal before they ever earn the high yields. The fear is that when the event does happen, the product, and those that offer it, may end up being the scapegoat, thereby forcing the government (and John Q taxpayer) to cover the losses. Imagine. A scenario where investors buy something they don't fully understand, capture the benefits of attractive terms, but have the government and taxpayers cover the risk when things go bad. Never mind. That would never happen.

There is an interesting article at the International Herald Tribune about how forecasting on Wall Street is getting "too wild," and how forecasts are getting less accurate. Data from Thomson Reuters finds that analysts correctly predict earnings only a fifth of the time. Approximately two-thirds of quarterly earnings beating estimates, with the remaining estimates being too low. This is not surprising since many companies attempt to managing earnings by reducing expectations and then delivering better-than-expected results. This year, only about 10% of companies matched expectations. Again, probably a combination of poor forecasting and earnings management by companies.

As mentioned in the article, "Even the collective wisdom of the marketplace has been wrong time and again. The stock market, that weathervane for corporate profits and the economy, keeps swinging from fear to greed and back. A glance at the major stock indexes over the past year reveals a host of false bottoms and fools' rallies." In fact, just looking at a Citigroup (C), General Motors (GM), Ford (F), JPMorgan (JPM) and other similar companies gives a picture of stocks that are relatively flat over the last month or so, even though price action during this time has made some significant moves up and down.

Of interest is that just as the markets become almost too difficult to forecast, due to market conditions and headwinds that reduce clarity going forward and prevent past trends from being trusted, is the exact time investors are looking for guidance, hanging on every forecast - and, in some instances, trading on that guidance as well. The recent moves also have the feel of the late 1990s in which new yearly price forecasts were meet in a day to two as retail investors piled in and bid up prices in an attempt to board the train before it left the station. Things have not gotten that extreme yet in the opposite direction, and the circumstances are certainly different, but the faith and need for guidance from Wall Street, or anyone for that matter, is reaching interesting levels. Whether this signals a reversal, as it did in early 2000 (but in the opposite direction), is difficult to tell. Furthermore, even if it does, it may take a while to see the effects. After all, Greenspan gave his "irrational exuberance" speech in December 1996, over three years before the market finally corrected and came to its senses.

As reported at the Financial Times, unsolicited bids for companies are running at their highest level in nearly a decade as companies use built-up cash, and in some cases a weaker dollar to acquire other companies. Data from Dealogic shows that since the start of the year, unsolicited bids have accounted for 19% of global mergers and acquisitions. This is the highest this number has been since 1999. As mentioned by the co-head of global M&A at Deutsche Bank, “The lack of credible white knights and activist shareholders pushing for quick resolutions and financing available for strategics is also fueling the high number of unsolicited bids”. Of interest is that the success rate of hostile deals has also increased, with only 31% of such deal failing in 2008, compared to an average failure rate of 42% since 1997. Apparently, activist like Carl Icahn are having an impact, Microsoft-Yahoo notwithstanding. On the other hand, given issues in the credit market, it could be that current deals going forward are more likely to have financing already in place and only include stable companies, thereby making a successful deals more likely. This news certainly provides a little better risk-reward for those trading on M&A news.

As somewhat expected, it is being reported at Reuters, the WSJ, and elsewhere that the SEC is planning to extend the temporary curbs on short-selling set to expire Tuesday. Plans are also being made to extend the curbs to cover additional equities, beyond the original 19 financial stocks. New curb limits could now include insurance, housing, and additional financial stocks. The SEC is also apparently considering making the rules permanent, but that would require later finalization, not to mention changes in the way shares are borrowed in order to speed up and automate the process beyond making phone calls for authorization.

Some on Wall Street, including executives and hedge fund participants, are lobbying the SEC in an attempt to get them to reconsider. I would suspect that if the curbs were extended, increased to cover more stocks, or made permanent (which I would assume would include all stocks), then we may get another SEC induced rally that now obviously includes more than just the financial stocks. Or will we? Some, even in the hedge fund industry, have mentioned that it is still easy to borrow anything you want. Others say that while borrowing is still possible, the cost of borrowing has increased, and is having an impact. Due to their size or frequency of trading, the real impact may be on smaller firms and those using programmed trading.

Markets certainly get nervous when regulators start getting more involved, but on the surface this seems more like a way to enforce what should have been done in the first place. Of course, that does not mean it will not impact a market that is used to borrowing now and worrying about that messy back office stuff later, or that it will not negatively affect those that need to provide liquidity to the market (the SEC is already considering market maker exemptions). A more automated system for borrowing will also need to be implement if the rules are extended and expanded. The worst thing would be for the SEC to continue to micro-manage the current sectors in trouble. Where does this end, and is it really the sign of a healthy market, rally or not?

There is a article worth reading at the MarketSci Blog about how the VIX may not be as magical as some make it out to be. The blog post is responding to another on the subject written by Mark Hulbert, whose opinion I agree with on this subject. BTW, the article is also discussed at the Daily Options Report, and there is a good exchange of comments with Bill Luby at the VIX and More site (also worth the read, as usual). The article does a pretty good job illustrating how the VIX is like any other indicator - it is just another tool in the toolbox, albeit useful and better than some.

While the VIX is based on a somewhat complex algorithm of implied volatility, it is not a perfect model in the strict sense of the term for how it is being used in that it has not been fine tuned with the optimal parameters or the best inputs in order to measure something other than, as discussed by Hulbert, "... the volatility that options traders are expecting the stock market to experience over the subsequent 30 days." The fact that we use the market sentiment implications of the VIX for timing market turning points, or by assigning relatively arbitrary benchmarks (like the market will rally when the VIX is above 30), makes it no more or no less a better indicator in my opinion, or more importantly, a specific model for the purpose we are using it for. Assigning a heuristic is helpful in that it starts to get us interested, but it does not make it any more predictive.

Like many indicators, the VIX may be just another way to measure an oversold market. Helpful, yes, and something I look at, but it should not come as any surprise that it is not anymore accurate than 3/4th of the time, and even then, timing is not exact. In fact, if it was nearly 100% accurate, with good timing, then I would not be writing this article, and you would not be reading it. Instead, a few lucky traders who spotted it first would be sitting on a private island somewhere, while a second group sometime later would have made a some money and garnered some fame writing about its use (with some nice historical relationships provided as support). Meanwhile, the indicator's predictive ability would have probably self-destructed, causing the rest of us to end up disappointed as its widespread use has now caused the indicator to simply tell us what we already know ........ while nicely giving us approximately 3/4th direction accuracy with less than perfect market timing.

Again, please keep in mind that I am not saying the VIX is useless. I look at it everyday, and find that when it starts spiking I need to start paying attention a little more to what is occurring in the market. My issues are from two areas: 1.) assuming that once it reaches a benchmark (30 for most), something is going to happen soon; and 2.) from taking something that was not really designed for how it is being used (market timing), adding a heuristic or two, and then assuming it is a model to be trusted. Rightly so, none of the authors mentioned and linked to in the article states this, or puts absolute faith in heuristic turning points. Like them, I believe the VIX is a good tool in the toolbox, as long as your toolbox contains more than one hammer, and as long as you are convinced that not everything is a nail.

There is an interesting article over at the Economist regarding hedge fund returns. As pointed out in the article, hedge funds had a great first half of 2008 when compared to standard benchmark indexes, outperforming Wall Street by 12%. On the other hand, given that the market lost slightly more than this on average, you could also say that hedge funds did poorly during the first six months, producing what amounted to their worst return on record. So which is it? It really depends on your perspective. Interestingly, if your mutual fund beat the market by 12%, even in a losing year, you would probably feel pretty lucky. Yet with hedge funds we expect more. We want that 30% per year, regardless of the market. After all, that is why we pay the 2-20, in good times and bad. We want returns that are uncorrelated, regardless of the market return (yes, I know, it does not always make sense).

Also of interest in the article, and something talked about before, is the pruning of hedge funds, or at least a slowdown in the net growth of new funds. The trend of the bigger getting bigger is continuing. The question is whether this will be good in the long run. As more and more pension, retirement, and endowment funds invest in hedge funds, the tendency to invest in more "stable," i.e., larger hedge funds will increase. Not only will fund-of-funds increase as institutional clients enter the industry, but this trend will produce a combination of fees upon fees, along with large diversified portfolios producing more mediocre returns. After all, a nice $500 million hedge fund can focus investments in, say, small or mid-cap banks, looking for opportunity and then taking a large position compared to totals assets. This is more difficult for the larger funds, resulting in more diversification and mediocre returns. As funds start looking and performing like mutual funds with flexibility (shorting, leverage, etc.), justifying the 2-20 may become even harder for some funds.