With banks trading at historically cheap valuations, private equity firms are now looking not only for bargains in the sector, but also for ways to get around regulatory hurdles (see FT article). Currently, federal rules prevent investors from holding more than 24.9% of a bank if they own other companies. The reason for the rules were to keep larger companies and conglomerates from buying banks simply to fund their other businesses. This has been a sticking point in the past given that many private equity funds like to have the flexibility to take large, and at times controlling positions. Furthermore, anytime you own a bank there is also the possibility that regulators will come in and require additional risk capital to be set aside, further reducing investment returns.
However, funds are looking for ways around regulations, and indications are that some are succeeding as regulators are starting to show flexibility. Some funds are launching new funds with different names and no direct ties with the home fund, allowing the isolated fund or investors to take a controlling stake in the banks. Can anyone say SIV? Other companies have been able to take stakes that are slightly larger than the 14.9% benchmarks that in the past have usually resulted in regulatory disapproval. Both moves seem to go against safety and transparency, and indicate not only more flexibility with the regulators, but maybe also a little desperation as well. Given the decrease in SWFs for being the capital provider of last resort for U.S. companies (see previous post regarding decreased sovereign wealth funding), some regulators may be forced with a choice between less regulation and transparency, or flat-out insolvency. Sometimes you just need to look for more choices. This may be one of those times.
Deutsche Bank is now offering ETNs that tracks the Benjamin Graham Intelligent Value indexes (see IndexUniverse article). The indexes are based on the value-based investment philosophy of the well-known and revered economist and investor for which the ETNs are named. Three value-oriented funds are being offered, broken down into total market, large-cap, and small-cap segments as follows:
- Benjamin Graham Large Cap Value ELEMENTS (NYSEArca: BVL)
- Benjamin Graham Small Cap Value ELEMENTS (NYSEArca: BSC)
- Benjamin Graham Total Market Value ELEMENTS (NYSEArca: BVT)
The WSJ has a nice article summarizing the auction-rate security mess, along with a short primer on what auction rate securities are, as well as how they are bought and sold through auction. Definitely worth the read for those interested in what has recently become a larger Wall Street focus. Auction-rate securities are essentially a form of debt issued by municipalities, student-loan organizations, and others interested in borrowing for the long-term, but doing so at short-term interest rates. How is this achieved? By auction, of course. Every 7, 28, or 35 days, depending on the product, banks will hold auctions in what amounts to a resetting of the interest rates as the securities are passed on to the new security holders (or reset for existing holders that want to stay long).
As reported, UBS, Merrill Lynch, and Citigroup alone have committed to buying back more than $36 billion of the securities. The problem that each of these companies find themselves in, among others, is that at times the auction-rate securities may have been promoted as being similar to short-term CDs, but with higher returns. Unfortunately, as credit problems increased, the auction-rate security market also began to freeze up, making it difficult for these securities to be re-priced. Many investors were left with bank statements that simply listed a "null" placeholder where their security prices were once quoted, implying that liquidity was poor enough that a reliable price could not be provided. To complicate matters, apparently the liquidity issue has persisted for a while, even as more securities were being marketed and sold, causing many banks to prop-up the market by issuing their own bids. The WSJ reports that UBS alone may have submitted bids in just under 70% of its auctions between January 2006 to February 2008. Allegations against Merrill Lynch imply that they gave the false impression that demand was high, driven in part by dark pools of liquidity in the auction market (see previous posts here, here, here, and here on dark pools of liquidity).
As recourse, and a way for UBS to hopefully reduced the intensity of this recent black eye (how many eyes does UBS even have?), the company has agreed to buy back from investors nearly $19 billion of auction-rate securities, starting with individuals and charities this October, all the way to institutional clients in mid-2010. It is worth noting that while UBS plans to start buying back securities in October, the actual purchase could take longer. As reported in a Barron's article back in May, and discussed in a previous post, how much money investors get back from auction-rate securities depends on who originally issued the securities. The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will probably have to wait a little longer. If you or one of you investment funds purchased auction-rate securities sold by a CDO or student-loan trust, well, you may be waiting a while to get your money back, possibly many years.
The auction-rate security issues once again highlight the need for better due diligence and a better understanding of risk. As we often forget, higher reward is almost always accompanied by higher risk - I dare say 100% of the time, but someone will always find exceptions in an inefficient market. If you look for more return, you need to understand the risk. Auction-rate securities based on CDOs should have raised red flags for some. Deception is one thing, but offering a blind-eye is another. Furthermore, the way we talk about risk also probably needs to change. For instance, have you ever noticed that we seem to be having "100 year floods" every other year, or how the metaphorical "perfect storm", whether in finance, insurance, or other fields seems to occur with more regularity? Anecdotal? Sure. But eventually simply stating that the recent event was the prefect storm or a once-in-a-lifetime event will not cut it. There are only so many times that you can cry wolf before no one cares about the real danger lurking in the woods. Maybe auction-rate securities and their current issues provide another one of those warning calls we need to listen to, regardless of its eventual magnitude and implications in the current market.
Reuters reports that while the failure of Bear Stearns would have likely triggered a series of counterparty failures in the credit default swaps market had the Fed not come to the rescue, CDS securities have actually held up pretty well and remained relatively liquid even while other financial markets have had their challenges. To date, since the market for credit derivatives has come into being, there has not been a default from a major dealer or bank. Ironically, the Bear Stearns issues themselves may have helped bolster the CDS market since not only did the Fed prevent potential counterparty failures associated with Bear, but they also gave the impressions that other major derivative counterparties were too big to fail.
Other markets have not fared as well. Recent credit problems and housing related losses have reduced the flow of capital in the mortgage-backed security, CDO, auction-rate security, corporate bond, and preferred shares markets. On the other hand, liquidity in the CDS market, especially for 5-year duration securities, has been better than other markets, even though it too has experience less dealers, lower liquidity, and wider bid-ask spreads than normal. Yet, it is still functioning and allowing investors with illiquid corporate bond exposure to buy protection with credit derivatives.
Of interest for traders is that in some instances CDS securities have weakened ahead of stock prices, giving traders some clue as to what equities are a cause for concern. As an example, the CDS spreads for Bear Stearns widened by 10 times over two months last summer, significantly under-performing the stock and giving some insight into potential problems. Shortly near the end of the two month period, two Bear Stearns hedge funds collapsed from bad mortgage bets. The traders that were focused on credit risk hedged their exposure in the CDS market long before problems became evident to the equity market. Something worth noting as we hear of new activity in the credit derivative markets going forward.
Since 2007, sovereign wealth funds have spent almost $80 billion to buy stakes in U.S. companies, in particular banks that were desperately in need of a capital infusion. Now, the International Herald Tribune is reporting that the lender of last resort may be having second thoughts. Even though most SWF don't have to report mark-to-market losses in public, they still want to make a return, and some high profile investments, such as those in Merrill Lynch (MER), are not turning out as expected. Many SWF are now entering "south-south" trades, or in other words, simply investing in other emerging economies. While the moves are being made to not only look for higher return, south-south trades also prevent emerging economies (many of which got their start-up capital from the West) from simply recycling their funds back into these same economies. Oil-exporting countries for one are looking to hedge against oil price fluctuations by becoming underweight assets correlated with oil prices, i.e., just about everything U.S. based. If this trend persist, then many small, medium, and even large companies may start depending more on alternative forms of capital, such as the hedge fund lending discussed in a recent post.
Here is the link to an interview on CNBC between Maria Bartiromo and Freddie Mac Chairman and CEO Richard Syron. There has been a lot of talk in the blogosphere about whether the NY Times piece was a hit job or not. While the interview was not very convincing, the CEO did seem to initially focus on the company, and less on himself, until asked later in the interview about the allegations (part 2, not linked here).
The New York Times has an article today about how the CEO at Freddie Mac ignored the warnings signs of potential problems, in particular its financing of questionable loans that threatened its financial health. Not necessarily news, and you can decide who you want to believe, but it once again stresses the need for not only implementing a risk management system within companies, but actually listening to the recommendations offered by the chief risk officer. Insiders at Freddie Mac say that the CEO of Freddie Mac, Richard Syron, made things worse by repeatedly ignoring recommendations from the chief risk officer at Freddie, David Andrukonis, regarding poor underwriting standards that were becoming too weak and too risky.
Andrukonis is quoted as saying:
“The thinking was that if something really bad happened to the housing market, then the government would need Freddie and Fannie more than ever, and would have to rescue them. Everybody understood that at some level the company was putting taxpayers at risk.”Moral hazard at is best, or ugliest. Of course, this comment is not quite as telling as the one made by CEO Syron, who contends:
“If I had better foresight, maybe I could have improved things a little bit. But frankly, if I had perfect foresight, I would never have taken this job in the first place.”While none of us has 20-20 business vision, the need for better insight is exactly why companies need to utilize some type of risk management. Although not a perfect science (far from it), risk management can at least provide managers some of that needed foresight. While the future cannot be forecast at a level that makes it easier to sleep at night, risk management can at least provide scenario analysis supported with statistics and various risk measures, among other techniques, that will give managers some idea of where potential problems lie so that safeguards can be taken (such as increasing capital or laying off risk) and corrective action can be planned and anticipated.
It appears that Wall Street and Corporate America are getting the message as companies struggle to educate themselves on enterprise risk management, implement risk management systems, and hire employees with the proper risk management skills. Understanding credit risk, market risk, operational risk, Value-at-Risk, Basel II, RAROC, and GARCH volatility modeling are causing businesses to seek out universities and consultants as they rush to receive the needed education and training. Of course, like TQM in the 1980s and 1990s, it is up to businesses to actually practice what they preach, or at least practice what they put in place. Fortunately, for those interested in risk management, challenges and job security will be available as innovation and capital growth offer new problems for businesses. Hopefully, it will not take another Bear Stearns, Freddie, or Fannie in a few years to once again drive the point home.
Hedge funds have traditionally invested in banks, but now some funds are actually acting as the banks themselves. As discussed in a recent Business Week article, hedge funds are turning out to be a lender of last resort for some companies as the credit crisis unfolds. In particular, small businesses that are unable to secure loans, and simply do not have the cash resources to ride the credit storm out, are turning to hedge funds for the necessary capital to continue operations. According to the Commercial Finance Association, a trade organization of asset-based lenders, the demand for such funds is on the rise.
Why are hedge funds interested? The loan terms, of course. Unlike traditional loans which may be offered for 2-3% over prime, so called "asset-based loans" can carry double digit interest rates (as high as 14% with fees for one example provided), along with double digit early payment penalties. Should you be worried about the risk as a hedge fund investor? Possibility, but often the loans are only given out to the most credit-worthy companies with a good business plan, and often only after performing a level of due diligence that would make a venture capitalist proud (in fact, some actually do deals that include options or equity stakes). As the name implies, asset-based loans require some type of asset to back the loan, be it hard assets such as inventories, or accounts receivable. In fact, some hedge funds actually require documentation and/or send people to check out the assets for themselves. Imagine that! Maybe the banks should take note.
The New York Mercantile Exchange is planning to introduce a futures contract that is based on U.S. Midwest market prices for hot-rolled steel coil (see WSJ article). The steel contracts are expected to be offered later this year in the fourth quarter, and be settled against an index developed by CRU Indices Ltd. The futures contracts offer a new way to price steel, which is typically bought through direct negotiations. The move comes at an interesting time considering that many in Congress and elsewhere are blaming speculators in part for the recent moves in crude oil price. Some steel company executives have also resisted steel futures since they too feel that the new futures market will only benefit speculators. On the other hand, a futures market will allow for more consistent pricing and less dumping into competitive markets. The futures market may also keep companies from bidding against themselves, not to mention allow smaller companies without negotiating power to work on a more level playing field.
Of course, beyond helping to eliminate the dumping of steel, a futures market will open up the potential for companies to hedge their steel cost. Given the increased costs of the energy, coking coal, and other raw materials needed to produce steel, the ability the hedge steel cost could not come at a better time for the automobile makers, aerospace industry, and other large users of steel. Therefore, while a potentially good development for companies such General Motors (GM), Ford (F), and Boeing (BA), the move towards steel futures is probably less good news for larger steel makers, such as U.S. Steel (X), Arcelor Mittal (MT), and Nucor (NUE).
There is an interesting article in the WSJ regarding recessions and productivity numbers. As seen in the figure below, the last six recessions have occurred at a time when productivity numbers were decreasing (although the numbers were still positive for the last two recessions, and productivity was relatively strong during the most recent recession in 2001).
While productivity has averaged 0.8% over the last six recessions, it is currently growing at an annual average rate of 2.5%. This is important since high productivity numbers allow the Federal Reserve to keep interest rates lower than normal since higher prices are being matched with higher productivity, at least to some extent. As an example, if workers are making x% more of a product in the same amount of time, then wages can increase by the same x% and the per unit labor cost will stay the same. Simplistic, but you get the idea. Productivity gains were the key to the 1990s, and one of the reasons Alan Greenspan was often espousing the benefits of high productivity, providing yet another reason to keep interest rates low, sub-prime notwithstanding.
Of course, higher productivity can allow you to keep from hiring new workers, or even allow you to reduce headcount, since now you can do more with less. Furthermore, the current high productivity numbers may just be an artifact of the recent environment. Housing, which is a less productive industry, is currently being shifted out of while higher productivity industries, like those exporting, are increasing in emphasis. The weak dollar is also having an effect in amplifying the export-based productivity numbers. Given that the U.S. is trading overseas more now than in the past, the higher export productivity numbers make sense.
So, if productivity is not cooperating for those talking recession, what about other numbers in comparison to previous economic conditions, such as the stagflation days of the 1970s that many analysts are comparing the current conditions to? Given higher energy costs, producer price increases for finished goods are worse now than during the 1970s, causing lower consumer confidence and higher levels of consumer credit as a percentage of GDP. The savings rate is down, as it has been for a while, and the number of vacant homes is increasing.
Yet, all is not bad, or falling off a cliff. The ISM index is hovering about the benchmark contraction / expansion levels, and disposal income has still not collapsed, even with increasing job losses. Industrial production, while flat, is also not severely contracting. Furthermore, core CPI (without food and energy) is not excessive, nor is core PPI. The unemployment rate, while rising, is also not yet close to approaching high single and low double digit levels. High productivity is keeping unit labor cost down (as discussed before), and wages have stayed in check for corporations. After-tax corporate profits as a percentage of GDP are also still good, and long-term Treasury yields are not excessive in comparison to the stagflation years.
So in short, is the picture rosy? No. But are we heading for another decade of stagflation with sustained lower growth and high inflation? Right now the data does not point to this conclusion, regardless of the continued comparisons. Housing and crude oil still seem to be ruling the day, the fallout of which is affecting nearly everything in the economy. When the former finally turns around, and the later sells off with conviction, we may be able to finally get rid of both the "stag" and "flation".
It looks like a number of hedge fund who were doing well betting against the banks and betting with commodities are finally starting to get their comeuppance as the easy money shorting the banks is decreasing, and commodities have begun to correct, at least short-term over the last month. As a result, hedge funds as a whole are on pace to turn in their worst monthly performance since July 2002, down 2.8% for the month, based on data from the group Hedge Fund Research that looked at the returns from 60 hedge funds. Some managers are now down more than 20% for the year. When corrections occur on short notice, even for those funds that are actually hedged somewhat (not all hedge funds are), you simply don't have enough time to adjust delta, especially for the larger funds, resulting in stories like the recent one in the WSJ. As they say, live by the sword, die by the sword.
