Zero Beta

A Tale of Two Summers: A Look at Basis Risk in the Post-Katrina Reinsurance Market and the Current Capital Markets

Note: Please visit this link on my new domain http://zerobetablog.com for original post.  Please update your bookmarks.  I will continue to post copies here for the time being.

Today, the market did not primarily sell off because of Ben Bernanke or the Philadelphia Fed Survey. It sold off because Hurricane Subprime, the credit storm that began to form this summer was upgraded to Category 5 and its path zoomed in on Wall Street. From Bloomberg,

"Credit-default swaps tied to MBIA's bonds soared 10 percentage points to 26 percent upfront and 5 percent a year, according to CMA Datavision in New York. That means it would cost $2.6 million initially and $500,000 a year to protect $10 million in MBIA bonds from default for five years.

The price implies that traders are pricing in a 71 percent chance that MBIA will default in the next five years, according to a JPMorgan Chase & Co. valuation model...

...The contracts trade upfront when investors see a risk of imminent default. MBIA and Ambac are trading at levels reached by Countrywide Financial Corp., the mortgage lender besieged by speculation it would file for bankruptcy before agreeing last week to be bought by Bank of America Corp.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite."

Naked Capitalism in covering this story writes, "I'm not in that market, but I can't recall ever seeing  figure like that."

Fortunately, I have had the unique perspective of seeing something similar a couple years prior. In the beginning of 2006, I was working at a major reinsurance broker as an analyst in the Capital Markets group. In 2005, Hurricanes Rita and Katrina crippled the insurance markets - especially the market for wind in the Gulf. Many insurers and reinsurers, still recovering from Hurricane Ivan in 2004 as well as the losses from 9/11 found themselves with insufficient capital for the hurricane season of 2006, which was supposedly going to be even worse than 2005 (it turned out to be very very mild). In the Capital Markets Division we helped this companies securitize this insurance risk and place it with hedge funds and other private investors because of a lack of capacity (aka capital) in the traditional market. As you can imagine, the rates were very large. Most of these transactions were done through Catastrophe Bonds and Industry Loss Warranties (ILW's) structures.

(Re)Insurers of most lines of business - whether it be Catastrophe or Monoline, share a very common trait - they tend to write tons of business during soft markets (when prices are low because there hasn't been a loss in an industry in a while) and much less business in hard markets (when prices are high because losses are recent and usually large). This is due to the fact that the industry is very undercapitalized and periods of loss result in writedowns and limit the ability for a (re)insurer to maintain its credit rating due to a shrinking balance sheet. Does this sound somewhat familiar?

The Insurance Linked Securities market developed as a response to this phenomenon after Hurricane Andrew and grew even more over the past few years. Hedge Funds and other Investors who are not subject to capital requirements (at least externally) are able to create a collateralized form of reinsurance that eliminates virtually any type of counterparty risk.

During the aftermath of Katrina in 2005 and 2006, as many reinsurers were facing credit downgrades, there was a mad scramble for catastrophe insurance. Rates on line (Premium/Indemnity) were going for about 40% and Energy Companies and Insurers of Energy Assets in the Gulf faced an insurance market in the gulf that had basically seized up. Those seeking any other types of CAT coverage found themselves in similar situations. It even affected most other lines such as Casuality and Marine/Aviation as the industry itself was dealing with a lack of capital.

In this market, however, the main concern of the insurance industry at the time was not of wind or any other event. Instead, it was basis risk. In general, basis risk is the risk involved by using an imperfect hedge. Reinsurance is just a hedge, so every contract involves not just event risk, but basis risk. In a standard indemnity based insurance contract basis risk is the disconnect between payout on contract and ceding insurers losses. Since the ceding insurer has more information the the reinsurer, it introduces the concept of moral hazard risk. In addition to event risk, an indemnity reinsurance contract essence transfers moral hazard risk to the reinsurer and counterparty party to the insurer. The some of these two should equal the basis risk of the hedge. Parametric triggers involved with Cat Bonds and other ILS are objective and have no moral hazard risk have very little counterparty risk, but still have basis risk as an insurer can suffer losses, but a bond may not be triggered and vice versa. It is in essence a derivative based on the actual event risk and takes underwriting standards out of the deal altogether.

In 2005-2006, the market arrived to a point at which standard insurers no longer wanted to take on counterparty risk, and hedge funds would not assume any more basis risk. The result was a hard market affecting many lines of business and many insurers and companies they insure ended up self-insuring their own CAT risks. This turned out to be a winning strategy as no big hurricane occurred in 2006.

That situation, however was very simple compared to what we have today. In today's market we have monoline insurers and reinsurers, who like their counterparts years prior, wrote too much insurance at too low a price. The risk they insured was credit risk on corporate, municipal, and asset/mortgage backed securities. In recent years an retrocession market for credit has developed through the use of Credit Default Swaps and other credit derivatives. Hedge Funds and large Investment Banks are the biggest buyers and sellers in the $30 trillion CDS market and also large holders of the securities that the monoline insurers have insured - perversity at its finest. If the insurers lose their credit rating, those holding the securities will face a downgrade and decline in value. So let's follow the logic in the worst case (not necessarily least likely) scenario,

1. Bonds default on Hedge Fund or Investment Bank holding them.
2. Bond insurers downgrade causes holders of securities and other speculators to buy CDS to cede their risk.
3. Bond insurers default and go into bankruptcy
4. Hedge Funds and Investment Banks suffer losses on these securities (as well as others due to poor financial market conditions) and find their balance sheet reduced and credit rating on watch.
5. Derivative contracts decline due to the increase in counterparty risk throughout the market, causing further writedowns.
6. Massive Market Failure.

(Merrill Lynch started the party early today, when they wrote down all of their bond insurance with ACA a sum totaling $3 billion -  which marked that insurance to market at zero)

This explains the price action in the markets today. If you are a major holder of these securities, you may want to try to hedge your risk in the CDS market. If you wrote that contract, you may want to hedge your risk by possibly shorting the stock. Upfront payments are being required by those writing the CDS contracts because of the counterparty risk involved in the system. This is a very spooky situation that could result in a massive deflationary spiral.

In the market for CAT coverage in 2005-2006, the market dislocation would not have been solved if the companies were given tons of cash. Hedge funds had plenty of it and still would not write any more coverage at any market clearing prices. As mentioned previously this was due to the idea of basis risk.

If there was a Fed for Insurance Markets (although the current Fed still affects them now), who cut insurance rates and providing retrocession to the reinsurers who would then be able to reinsure someone who could insure and so on, it still would have been difficult to stimulate that market to create liquidity. If the Fed operated like it did in the banking system through open market operations, knocked down the target rate that reinsurers charge for reinsurance buy reinsurance select, less risky layers, the problem would not have been solved. The reinsurers would have no moral hazard since these layers are the ones they wouldn't reinsure anyways, and the Fed has no counterparty risk. Thus they indirectly would assume basis risk by paying to cede something they would not have otherwise ceded. Since the reinsurers could find no way to cede the risks they wished to at the rates they wanted to they would have little incentive to swap their counterparty risk, for moral hazard risk, unless prices were higher. Ceding insurers who don't realize that they even have moral hazard risk let alone quantify it, would choose to keep the risk on their books. Thus, the extra capacity would not matter, because there is insurance in the system that was not underwritten properly at the bottom and has been bundled and made its way to the top with little sources of retrocession. The problem was basis risk.

When markets are soft, all this cheap reinsurance allows the underlying assets to increase in value as the cost of carry becomes lower. In the bond markets we saw this as the CDS market caused corporate spreads to narrow like crazy. As the assets increase in price and interest rates stay low, the desire for asset protection becomes greater causing this crappy underwriting to float all the way to the bottom of the reinsurance ladder as ceding the risk becomes easier, eventually causing underwriters to operate at a loss for years without even knowing it. When an event finally occurs, a system exists where the senior debt holders (reinsurers) hold the most risk, and are unable to pay the insurers, who are unable to pay the insured, causing all the basis risk that was hidden for years in the form of moral hazard to rise to the surface causing losses for everyone involved.

Today, the moral hazard risk was introduced by the Fed slashing interest rates and banks used this to lend like crazy and transferred it to holders of CDO's and other securitized vehicles, with liquidity puts transferring the counterparty risk back to the banks. These were then insured by the monolines transferring the moral hazard risk to the insurers and counterparty risk to the holders of the bonds. All these entities tried to get rid of this moral hazard risk by entering into many different derivative contracts such as CDS's and swaps further complicating the issue. Now as the moral hazard risk is coming to light, the counterparty risk is starting to surface in different pockets. But all this was created by the Fed assuming the basis risk in trying to hedge against an economic downturn. It has assumed great counterparty risk through its repurchased of Treasuries, but the cash it has given has not helped as its actions have slashed the rate it is willing to take counterparty risk well below what a bank is willing to assume that risk, since they are less and less able to take moral hazard risk. This is evident in the amount upfront that is necessary to purchase a CDS on the monolines. The problem in this market shock much like the shock borne by Katrina is of basis risk. Although more complex, the reality of the situation is that there are way too many hedges in the system that are not accounted for properly, understating the basis risk. If the rate that they target is much less than the rate that the banks will do business, a lower rate will not solve anything, and may make this worse.

Hopefully, we will see this summer turn out like the summer of 2006, but I'm afraid that this risk, unlike weather risk is too correlated with other risks in the system and may magnify as this plays out and as interest rates go lower.

Some Comments/Update the Move to Wordpress

The new blog is up and running on my own server.  You can reach it at http://zerobetablog.com.  I apologize for any problems encountered during this process, but I wanted to make the switch away from Typepad for some time, and figured the longer I wait the harder it will be. 

Typepad allows you to map domains, however I want to be able to use Wordpress software.  Therefore I imported all my posts to the new blog and will still leave everything here intact for a while.  If anyone knows how to get this to redirect to a new domain please let me know, but from what I've heard 301 redirections are not possible w/ Typepad. 

Feedburner allows you to change sites and still keep the same feed.  Since I used Feedburner at Typepad I would think there should be no issues with Feed Readers.  If anyone has an issue please let me know I would appreciate it. 

I still need to do some housekeeping on the new blog, but it is functional and operational (at least so far as I can tell).

Please let me know if you have had or currently are having any issues with either site, its feeds, etc.

Please update your Bookmarks with the new address when you get a chance. 

Thanks for your readership and your patience during this process.

ZB

Survivorship Bias In Financial Media

Note: Please visit this link on my new domain http://zerobetablog.com.  Please update your bookmarks.  I will continue to post copies here for the time being.

In his book, A Random Walk Down Wall Street, Burton Malkiel illustrates the idea of survivorship bias among mutual fund managers by describing a popular investment newsletter scheme. It goes like this:

1. Start eight investment newsletters. In four of them, forecast that the stock market will rise. In four of them, forecast that the stock market will fall. At the end of a year of enthusiastic proclamations, four of the newsletters will prove to have picked wrong. Close them down.
2. Now four newsletters remain. In two of them, forecast that the stock market will rise. Maintain the opposite prediction in the other two. At the end of the year, close down the two that went wrong.
3. Now two newsletters remain. Apply the same policy, leaving one   newsletter alive at the end of three years.

If you put out such a letter, you would look like a genius to one out of eight newsletter subscribers and probably generate tons of demand for subscriptions. In reality, you just take advantage of the idea of survivorship bias. Fund Managers and Brokers have been accused to have benefit from such a phenomena for years as they can put out tons of funds or stock picks, allowing for luck simply to run its course, and failure to be pushed below the surface.

But what about the media? Financial media (especially financial bloggers) benefit greatly from this phenomenon. Whether they realize it or not, they are in a business that is not much than an investment newsletter. Let's use CNBC as an example. On Squawk Box in the morning, filling in the 80% of deadspace in between news, earnings data, and economic data releases, there is a handful of pundits giving their predictions on the market. Usually these are Analysts, Traders, Economists, and Fund Managers and the person watching the show daily for a 30 minute block will get many predictions thrown at them. CNBC usually then gives the opportunities for those pundits to come back, refer to their prior prediction, and make a new one. The pundits that are "in-vogue" are the ones that make a string of timely predictions and go out of favor when the market turns against them and another pundit replaces them. Many would argue that Jim Cramer is similar in that he gives many stock picks every day, however for all the criticism he receives he is one of the few who actually go over some of the bad picks - eliminating some of the survivorship bias.

Magazines and newspapers such as Barrons or Forbes are no different. They many different columnists that make many different picks, and usually follow up on the ones that were successful rather than the ones that went bad. They also sometimes review their picks, but rarely if they all went sour.

Bloggers (myself included) are even more interesting. Bloggers usually have an underlying theme to their form of media. While some just try to pick stocks, most have a commentary on the current landscape and provide their view on where the economy and markets are going - either explicitly or implicitly. They are much more like the writer of one newsletter among many. Unlike traditional media, their media can be searched for, and their predictions are also archived. They benefit, therefore, usually by writing about what WILL happen before it actually occurs as people begin to search for certain keywords and stories on topics as they are developing and the "in-vogue" bloggers are then quoted by many Aggregators, etc.

One example from my blog is my story on Money Market Funds from August, Money Market Madness. This post is my most viewed page and has generated more Google hits than the rest. It was written the day that this story hit and contained many predictions which were right on the money (widening spreads, next shoe to drop, etc.) and could make me look like a genius to someone who searched for it a month or two later (and it may have as my readers went up along with incoming links to that page). I don't mention this to toot my own horn (I did nail that one though), but to illustrate a point. That week I also wrote about a post about KKR that was also speculation and hasn't turned into anything as of yet (as far as I know). But if it had come true, and not the problems with Money Market Funds, it would have been searched for and linked to and referenced and I would look even better. Bloggers therefore benefit from the creator of ultimate survivorship bias in digital financial media - Google (and Social Bookmarking sites such as Digg, del.icio.us, Stumble). If a blogger writing about many different financial topics and stumble on a big one, their Google Page Rank increases, Technorati Authority skyrockets, people subscribe to their feed, submit them to social bookmarking sites, and as future posts on topics are written, they are the ones who "survive" as they are on the top of searches.

Financial Media, unlike the fraudulent investor newsletter author, does not benefit from survivorship bias by cutting their "predictions" in half, but increasing them as much as possible. Since their audience is by and large "fixed" the survivorship bias comes in to place on who is left reading them. This also explains why MSM Financial Media is more trend-oriented and bullish and the blogosphere more contrarian and bearish. Since entities such as CNBC and the WSJ have very few competitors and reader base that consumes their media in real time and pretty much only in real time, they have the incentive to trend follow and report on the current trend and its continuance. Nobody goes back and reads the last two months of Wall Street Journal columns or watches the last week of Squawk Box continuously, they read the current issue, and watch what is currently on. Since their archives usually don't "survive" they have the incentive to just live in the now and hug the trend - which is bullish 2 out of 3 years. Betting on reversal would lose them great credibility in the long run

A blogger on the other hand, has the disadvantage of having to rely on the MSM for the actual news. They are always behind the trend from the start. Also, they compete with many other bloggers as well as MSM for readers who want to know their opinion on this news. Since they rely on search traffic and have readers that usually read a string of posts or a certain category or tag of posts, they have the incentive to make predictions that are against the grain. People search when they are facing uncertainty about anything - whether it be the phone number of a restaurant, or the outlook on the economy. So when times are certain, and the MSM is selling certainty, it is much more beneficial to write about the unknown and sell uncertainty. On days when markets are unstable, I get many more hits than when they are stable. This is due to many words of instability that permeate my posts - such as "recession", "subprime", etc. Since bloggers benefit greatly from operating on long tail, and the long tail in finance are lower probability or unlikely events, they are more inclined to pursue this part of the financial distribution to gain share in the blogging popularity distribution.

Although media personalities and bloggers generate success on the way that they write or speak, much of their success depends on what they write about and what actually occurs. If they write or speak more and more on many topics that are contrarian in nature, they put themselves in the seat to be a survivor amongst the many who do not operate like this. No wonder financial blogging is so stressful.

The Millennials: 2008 Election's Nascar Dad?

If you haven't read the latest Business Week, Michelle Conlin wrote an excellent article on my generation - which they refer to as the "Millennials". Please check it out if you haven't already as it is worth the read.

On the Millenials growing political influence,

Across the political spectrum, they say, Millennials are mobilizing around the idea that the federal government's operating system is in dire need of a sweeping update. Iowa and New Hampshire proved that candidates ignore these voters at their peril. Youth turnout surged by 25 percentage points in the Granite State over 2004, according to the Student Public Interest Research Group, which is dedicated to getting young people to the polls.

On why they are becoming politically active,

At first, the Millennials were the Children of the Rising Dow. They grew up during the greatest period of wealth creation in modern history, but watched their elders consume resources and run up deficits as if the party would never end. Then came the dot-com crash, terrorism, war, climate change. Epic uncertainty informs their worldview. When asked to name the issues they care most deeply about, bread-and-butter concerns such as the economy, health care, and education routinely rank high. In an October Pew Research Center poll, 80% of voters aged 18 to 29 cited the economy as a "very important" concern, vs. 61% who felt the environment was a major issue—a telling finding given all the campus activism swirling around global warming these days.

Talk of recession, a weak dollar, and rising unemployment all animate Millennials' economic angst. But there's a lot more to it than that. Young people may not know that the inflation-adjusted earnings of new college grads have fallen 8.5% since 2000. But they can feel it in the deflated salaries and shriveled benefits they command, even in white-collar jobs. They don't need an economics degree to understand that the middle class is squeezed. This generation has grown up watching parents struggle to stretch a buck. They lived through the mass layoffs during the corporate scandals earlier this century.

A more apt name for people like her may be Generation Debt. No group has ever started life so deeply in the hole, due mainly to mounting college costs, dwindling financial aid, and credit-card debt. The average college student now graduates with $20,000 in loans....

On how they are getting it done,

Given all the pressures and economic gloom, you might wonder why today's twentysomethings don't despair and disengage. There's a simple answer: They weren't raised that way. Growing up in the era of cater-to-kids politics, the V-Chip, and helicopter parenting, they were the most coddled generation ever, infused with their elders' belief that they possessed unique abilities. They also have been the most marketed-to generation, giving rise to their BS-despising, post-ironic disdain for any political solution—or candidate—that doesn't seem straight up. Thus their attraction so far to candidates, like Obama, McCain, and Paul, who they believe are outsiders representing change.

As any chief marketing officer knows, this generation believes in "owning" its favorite brands. Its members carry the same ethos to their political activism. Bringing the music and media industries to their knees was also empowering—providing Gen Yers with the self-confidence for a third-way, post-partisan manner of doing things. It's striking that the largest group of 18- to 24-year-olds, some 40%, consider themselves independent, according to a recent survey conducted by Harvard University, with 35% identifying as Democrats and 25% as Republicans. Millennials, like many Americans, may have lost faith in the political Establishment, but they have utter faith in themselves and their wiki-inspired abilities to get things done.

Are the Millenials the new Soccer Mom or Nascar Dad? Maybe. Many people who argue against going for the youth vote say that for years it has continuously been a poor investment - as they have had poor voter turnout for years. However, I believe there is no difference between a 25 year old and 45 year old except for incentive.

In any democracy (especially the one we currently have), voters turn out based on the assumption that that there are enough other like-minded people who are going to punch the same ballot as them. While most voters have the incentive to vote, they only end up in the voting booth if they believe that there are others who share that incentive as well. This is nothing groundbreaking, and is why targeting (and sometimes artificially creating) certain groups is a major strategy for politicians. In turn, organized groups of every sort have had enormous political influence in the past. The recent apathy and low voter turnout as a whole has come from the fact that the majority of our population - lower to middle class white people - have had no real identity. This has a lot to do with the dissolution of many labor unions as this group of people is the biggest subset of a major group - labor. They have no major unifying social cause to get behind, as they are the majority are not largely repressed in that respect. Their main motivation is economic, and unions gave them assurance that their vote would be cast with many others.

Since labor has deorganized, politicians have been desperately trying to artificially group these people together to get their vote on election day. These groups are formed usually in a social or cultural context, but as a way of taking advantage of some sort of other deep-rooted economic desires. In the 1990's it was the suburban "Soccer Mom" an image that 50% of the people 35 to 55 could identify with and Democrats were very successful at mobilizing a group of people, women, who for the first time in history became independent economic entities and could be counted on to vote their wallet. In 2000 and 2004 her counterpart, the "Nascar Dad" came along. This group, largely made up of lower middle class males in the rural as well as suburban areas were somewhat alienated economically during the boom in the 1990's. In turn, the Republicans were successfully at creating and mobilizing this group based on social, cultural, and religious principles. In both cases, the groups had an enormous economic incentive to vote, but needed the reassurance that there are others like them out there to make their vote count.

For years, the youth vote has been largely absent due to the lack of incentives. There have been no major wars or drafts and the economy and job market has been thriving on the whole. Since they are young, they have very little at stake in the actual near term economy. To someone just out of school making $40,000 a year who doesn't have a family of their own, a tax cut equates to the difference of ordering shots of Jose Cuervo or Patron on Saturday nights out. To someone older, who has assets, a family, and life rests on the fact that the next four years they will earn at least as much as they did the past four years, the incentive is much higher.

For the first time in a while, however, the situation is different. Although there is no draft or talk of having one, we are currently at war in Iraq and talking about going to war in Iran. On top of that, my generation is the first generation to come out with such a high level of student loans - increasingly from private lenders (at near credit card interest rates). This is on top of the credit card debt they have amassed while at school. The charts I have included tell this story well.

This group of voters went to college during the last economic downturn 1999 - 2002. Many saw their college savings evaporate during the years that they needed it and had to pay the price that was already inflated due to the years of prosperity and growth. On top of that they have seen the real wages of student with a bachelor's degree decrease dramatically. Michael Mandel at Economics Unbound has looked at this phenomena in depth and have included this chart as well.

This would make sense since more people have been going to college, thus increasing the supply of labor and driving down costs. Outsourcing has been named as a culprit, however I contend that the jobs going to India were not jobs that went to college graduates - on the whole. To a student who has very little college debt, a soft job market, although a problem is not an enormous deal. They can get by bartending or taking an basic entry level job at less pay until they find the job they want. They are able to mess around for a few years and probably actually enjoy it more. For someone with tons of debt it becomes a noose. They are entering the beginning of their adult lives - when they "should" be planning for a family and saving for a house. Instead they are working just to get back in the positive. It has serious ramifcations in one's "pursuit of happiness" - the major reason every voter casts a vote on election day.

Most important, these Millenials are not poor and uneducated, but middle class (maybe too) educated and savvy . They are people, who grew up with relative prosperity are now facing economic hardship. It can be argued that economically, on the whole, they are less better off than their parents were at their age. I will argue this has not happened in the history of our country. During the Great Depression, our Grandparents were the closest, however, their parents were largely immigrants and came here because economic conditions in Europe were poor.

So, while many pundits will scoff at the youth vote this election, these Millennials could be the swing vote as many are largely independent. The combination of a growing incentive to vote, sense of entitlement, and ability to network online could make them a very powerful voting block. Could this election be the first shots fired in the great Demographic War of the 21st century? We will find out.

Switching To Wordpress

I am currently in the process of migrating this blog to a self hosted Wordpress domain http://zerobetablog.com.  I apologize for any problems.  Please let me know what you think.

Having an Edge in the Wall Street Casino: Some Thoughts on Compensation

Andrew Clavell at Financial Crookery posted a great piece collecting many bloggers thoughts (and adding his own) on Wall Street Compensation.  He focuses on the question of whether Wall Street is paid based on actual alpha or some perversion of beta that is sold as alpha.  He writes,

A significant reason why the brightest still clamour to sign up at these banks, and why investment bank traders desire to run hedge funds is precisely because their pay is a non-recourse strip of yearly call options on market beta and talent alpha. Come on, we all know this, surely. The unwritten rule is that this cliquet option can be abruptly terminated; then you are on your own.

While I think this is an excellent point, I think the factor behind compensation is simple in theory, but somewhat more complex to ponder.  I believe Wall Street is one enormous Las Vegas, full of casinos and gamblers who get paid based on how much they can put the odds in their favor.

In The Way of the Turtle by Curtis Faith, he writes about how he made more money than anyone else in his class, using the same capital, the same rules, and following the same ten commodities because of one reason, he had an edge.  His edge was his ability to follow the rules.  He goes on to encourage the reader to discover the edge he or she has and learn to profit from it - drawing on the fact that a casino doesn't care if some high roller takes it for $2 million in craps in three nights in a row because they know they have an edge in simple odds and that high roller's success is simply drawdown. 

To cite another, more obscure source, my high school history teacher told me once, "You have discovered early in life what most don't ever realize.  You don't have to give 100% to be successful, you just have to do 1% more than the majority of people."  It was a great complement and I took it to heart and believe it to be true.  Essentially, trading and compensation is a zero sum game, where the majority of people are average and if you can gain an edge over most people, and recognize that edge, you will win out over time, taking money from the mediocre.  Most people have some considerable edge in something, those who are (financially) successful recognize it and those who are not successful never realize it.

In our Wall Street Casino Model, it is important to first find out who is the house and who is the gambler.  The sell side, for the most part, is the House, the casino, and market participants, or the buy side, is the gambling public.  Historically, the sell side has had an enormous informational edge that has enabled them to take money from the buy side in general and make it the houses money. This led to another enormous edge - wealth itself.  It is no secret that its much easier to make money if you have money.  A casino with little capital could get bankrupted by a high roller going on a lucky streak, but one with plenty of capital will realize their edge.  Along with wealth usually comes another edge - access to a network of other wealthy people.  Investment Bankers and many brokers are compensated so highly because they realize that edge.  Some blue-blood from Connecticut who may be dumb as a brick and lazy could easily be the highest compensated investment banker because he knows many wealthy people who own companies, have capital, and would make great clients for an Investment Bank. 

Traders on the sell side have historically been compensated based on taking as little risk as possible in executing orders and distributing deals so that they profit from marketmaking, and manage the risks of the deals they have bought up.  It is part sales and part risk management - hence "Sales and Trading". They are compensated based on Beta of their respective area.  When Equity Bankers do well, Equity Traders do well, and so on.  In their casino, they are essentially the dealers (hence "broker-dealers") and responsible for running the table games for the buy side without allowing for anyone to break the house and eliminating their edge.   

The brokers have historically been the marketers for the casinos.  They are paid based on the amount of people they can get in to play, what types of gamblers they get in, and how they can sway them to one game over another.  They historically either people with a network of very wealthy people, and/or very persistent and savvy salespeople, who are able to convince a gambler with the odds stacked against them that they can win.  Their edge derives nothing outperformance of investments,  but underperformance may begin to erode away at their edge.

On the buy-side, money managers have been paid to try to gain an edge on the sell-side, as well as other managers.  They mostly play an enormous game of poker against other buy side managers. In poker, the house has no edge, but just takes a rake.  The investors in the fund pay managers because of the edge, or perceived edge the managers have - either their ability to outperform the individual investor or their ability to market themselves as better than the others.  Think of the situation like the World Series of Poker.  It is filled with a few different types of players.  There are those who qualified based on winning multiple online tournaments and are usually superior players.  There are those players who get bankrolled to play and get a share of the winnings and are also very good.  And, there are those who can afford the $25,000 fee themselves and try to beat the other two types of players.  The buy side is one big and ongoing poker match.  All these players have an edge over the average poker player, but when competing against each other, their respective edges worsen and it becomes much more random - hence a full time sports agent winning. The buy side is paid based on skill or perceived skill in gaining an edge over other buy siders.  In aggregate they have been historically overpaid - unless of course they get a collective edge over the house.

The advent of the internet and financial media as well as regulatory shifts has changed the landscape however, shifting the informational edge to the benefit of the buy-side.  In turn, the sell side as a whole is no longer paid for it.  You only have to look at sell-side research to see this.  They were paid based on their perceived informational edge and manipulated by the investment banking.  Once this edge is gone, they are not worth as much, since research is not really too exclusive.  This has caused a shift towards capital and advice.  Lending and financing has become a big business as has advising on deals, and or investments.  As the internet spawned tons of discount brokerages who have an edge over the wirehouse brokers because they don't have to really pay brokers to bring in clients, nor research arms and bankers, and had very low overhead.  They use the internet as the main marketing tool and provide cheaper, and arguably better, third party research.  This along with the rise of ETF's has also hurt mutual fund money managers on the buy-side.  Since investors are now privy to much more information, mutual fund managers no longer have the perceived edge of skill, scale, or access to information that they once did.  In turn they have suffered.  Those with actual skill have seen their compensation go down because they are in an industry saturated by people without skill - who are now being paid for something different.  They instead flocked to more boutique managment firms and/or hedge funds - leaving lower paid, less skilled employees at the major fund families. Also, Big Investment Banks, facing a smaller retail market, are less able to underwrite deals and unable to exercise any informational and capital edge they may have. 

This shift in informational advantage has caused the house to have a much smaller edge, where skilled gamblers can actually gain an edge over the house - like card counters in blackjack.  It has in turn,caused the house to change which games it offers, focusing more on its access to capital, than its research and execution - focusing on Investment Banking, Private Equity, and most importantly dedicating itself to those clients who will buy up its deals - hedge funds. It has also caused them to employ gamblers themselves to go play at other casinos and try to gain an edge over other gamblers through their expansion of internal hedge funds and prop desks.

Let's look how this new reality has affected various areas:

Brokerage

Retail brokerage is focused much more on the higher net worth individual as they are now Wealth Managers and Financial Advisors and are paid based on their advice on a fee basis rather than commission.  They are much more relationship driven rather than transaction driven.  This is a service that is more readily utilized by the wealthier investor.  This is why these days, retail brokers are getting paid less overall, but the big producers with all the relationships are paid very well because they have the clients the firm wants.  Those that invest in hedge funds and money managers who in turn buy up their deals. This is also why there is a mad grab for assets with banks paying 2x 12 month trailing gross (very big premium) just to come over. 

Investment Bankers

Investment Bankers are still paid well, but the business is different than it was before.  It has become much more focused on M&A and PE rather than IPO's, as well as debt over equity offerings.  They are  forced to sell more to other companies and the institutional clients than to their retail clients.  Hedge funds readily buy up deals most likely in exchange for influence with their research arm and information on upcoming deals.  It, in turn, has become more of a retail business where they have the incentive to just do as many deals as possible without regard to risk.  This has perpetuated an enormous premium for someone with a huge rolodex, which is the capital lifeblood of the business, as well for entry level overachievers who have an edge in the fact that they always do 110% and are willing to work 80 hours a week, to crank out the material the associates and partners need to win business.  They are the labor.  They get paid well for their edge, but are very easily replaceable - except for those with connections - they do however have an edge none the less, but on an hourly basis they are compensated not all that much more than someone who works two 40 hours/week middle office jobs for $40,000 a year.

Traders

Sell side traders are either paid based on the deal flow to the buy-side - mostly hedge funds.  Mortgage Traders, Fixed Income, and Structured Products guys have gotten paid the best because thats where the Investment Bank has made their money.  They are given an edge either for their sales prowess, or their ability to manage their risks.  They are able to follow the rules, take risk, and remain calm - not easy to do.  They have been paid relatively well as they are now responsible of maintaining or gaining any edge they have over the hedge funds, which are more successful gamblers than their mutual fund counterparts. Prop side traders are paid the most for this edge.

Hedge Funds

On the buy side, hedge funds are professional gamblers who always try to beat the house.  They benefit from a few edges.  They have the ability to go short and invest in markets that the rest of the gamblers can not.  In the enormous poker game, they have the ability to see the river and the rest of the market only the flop and the turn.  They also are out to outsmart the house, either by gaining an edge over traders or over bankers, but the most edge they have is over the public in the fact that their positions are not transparent.  They are basically playing a game of poker where they can see everyone else's cards, but on one can see theirs.  They are paid a great deal of money for this edge - hence why they are compensated so well.  They are also enormous sources of capital.  Whereas the mutual funds used to basically transfer money from the buy-side to the sell-side, buy simply buying what the sell side was selling (ie playing in the casino), they are becoming the casino in some cases.  They are basically doing the equivalent of setting up their own poker game, playing at the table with other people and still taking a rake.  This increasingly gives them an edge over the house, because they can be both at the same time.  This is why sell side banks have stepped into prop trading and investment banking - the only trouble is they have to report their earnings. They have many edges over the house and are paid considerably for these edges - although the entrance of many other funds has hurt their collective edge

On the whole, in the global casino, the odds have turned from the house to the gambler, enabling those who can actually gain an edge (achieve alpha) to get compensated very well, and those who can not to gravitate towards mediocrity.   I think the current problem with the financials and the exodus from the sell-side to the buy-side the past few years shows how this shift in "edge" has caused a change in compensation and migration of talent.  A money manager in a mutual fund that has lagged the S&P 500 in this day and age doesn't get paid based on his perceived ability to beat a benchmark, but the preference someone has over letting him go to the casino rather than going himself.  This has caused closet indexing as mutual funds becomes a business that is compensated on something different.  Those who have an actual edge in the casino have gone to the buy side instead.  These types of shifts have occurred throughout Wall Street.  Someone who complains that they are underpaid just doesn't understand what they are being paid for and what their role is in the casino.  In the Wall Street is not the smartest or the hardest working that gets paid the most, but the person who can turn the odds the most in his employers favor - whether employed by the house or a gambler. 

If Emerging Markets Stop Emerging

"The four most expensive words in the English language are, 'This time it's different.'"  
-- Sir John Templeton

It is earnings season once again and as the numbers come in I would expect that, whether good or bad, we should see the continuance of an ongoing theme as managers give their guidance.  This theme dates back a few years and will be the collective chant that will contain something like, "Due to our expansion into the emerging markets, we expect earnings growth of about X% over the next few years" (with X usually greater than 10).  This will be countered by pundits touting their picks as "diversified internationally in the emerging markets". With domestic growth slowing it is almost as if many US companies have been putting it all on black on the global economic roulette wheel, and when "black" is emerging markets - their is a decent chance most will be seeing red.   

Unless you've been living under a rock (hopefully not funded by a subprime mortgage) for the last few years, you have undoubtedly heard of the emerging markets.  As an asset class, they have annihilated any others - look at the periodic table of investment returns to see.  Most asset allocators have moved Emerging Markets from a speculative portion to a much larger percentage of most if not all clients allocations.  Over the past few years, funds have flowed into these markets like Lindsay Lohan to rehab - doubling in 2007 to $40 billion. 

Investors in US Equities over the past year or two have been promised similar returns by the companies whose stock they own, because these companies have expanded into th emerging markets.  This first began through the phenomena of outsourcing that has occurred over the past decade and has been a major investment in labor.  As companies began to reap the benefits of their labor (<---play on words), their bottom lines exploded and they found themselves with massive amounts of cash.  In 2005, as the Fed was raising rates, housing was beginning to wobble, and domestic growth prospects became dim, James McGregor's book, One Billion Customers came out (and many similar followed), and became the bible in how to invest that capital into the biggest emerging market - China.   Since then, every company and their mother is making capital (not just labor) investments in China and other emerging markets and are receiving a higher multiple and given rosier prospects for it.  Companies are now frantically fighting for market share in this new economic frontier and using the weak dollar as ammo for their war. 

The fundamental question that should be asked is not if China and other Emerging Markets have great economic prospects for the future (I contend they do).  Instead, one should ask, "Will investments in these countries be lucrative, if not profitable at all?"  In the 1990's, the hoopla created by the idea of Moore's Law created a mass rush for both individual and corporate investors in technology and technology companies.  The belief at the time was that this exponential growth in technology would change all the rules - and for some time it did.  But investors in the late 1990's and early 2000's found out that although it was true that technology changed everything (it sure did) many investments in technology and tech companies were not that profitable.  For further clarification ask Time Warner about a little company called AOL.  This was due to the fact that it is difficult for business to keep up with the rapid increases in technology.  Sure chip speed can double every 18 months, but ask the company who just bought tons of computers 12 months ago and now much buy more to compete how much they like that speed, or to the guy in 1998, who spent a month's pay on a top of the line PC twice in the span of three years so he could run the crappy Windows 98 instead of his current Windows 95 (Start Me Up, Indeed).  Progress, both technological and economic, does not necessarily turn into profits.  Especially in the manner that most people believe it will. 

Let's examine the phenomenon that we are dealing with today in China.  Chinese consumers have become relatively wealthy over the past few years due to the opening of their markets to the west and the subsequent investment in labor by many manufacturers.  This has in turn spurred many other businesses to develop and the dollars that US and European countries have paid in wages to be invested in stocks.  In turn, many Western investors, hungry for growth, have put their investment dollars to work in these stocks and the stocks have done well.  This has given China tons of capital to employ and created a consumer base with disposable income that needs to find a home.  In turn, US companies (especially large multinationals) have expanded into this market so that they can capture these dollars that are supposedly just itching to buy what they're selling  This supply of dollars (as well as Euros and Pounds and Yen) in China has been translated to a currency that so happens to peg against the dollar enabling this relationship to hold.  It has kept Chinese goods as well as labor competitive in dollar terms as an artificially stronger dollar is able to get more bang for the proverbial buck.  This is THE load bearing wall in the Great House of Chinese (and most emerging markets) Growth because as long as the West keeps supplying labor to China and then purchasing its goods, companies will be able to turn around and capture some of these dollars by doing business there.  If it were truly sustainable, they would be able to do what up until now has been economically impossible - maintain margins in an increasingly competitive environment devoid of macroeconomic consequence.  This is pretty much the definition of "the end of business cycles". 

For some light on how this will most likely turn out, I encourage you to read the 2003 study put out by the Dallas Fed (Yes boys and girls, the very same Fed who brought you such countless treasures as "A Yo Technology", "Flip this House" and "Foreclose this House", as well "Contained", "Have You Hugged Your ARM Today?",  and soon to be a timeless classic "The New Global Economy") called "New Economy Myths and Reality".  In this report, which is uber-applicable to our current state, they write,

Excitement over new technology’s potential for lowering expenses, boosting profits and expanding market share sometimes leads analysts and investors to believe the good times will never end. In the midst of the 1990s boom, well-known MIT macroeconomic theorist Rudi Dornbusch proclaimed, “This expansion will run forever; the U.S. economy will not see a recession for years to come."

What will be the wrecking ball to the aforementioned load bearing wall in China?  It can come from multiple places, but most likely a combination of a few.  I have listed some of them below:

1. The US Consumer Comes Under Pressure.  This will cause a decline in consumption and less Chinese goods to be bought, which are mostly Consumer Discretionary items such as toys, clothes, and electronics.  Less dollars flowing to Chinese manufacturers means less dollars floating around China.  Companies who are banking on those dollars as a market for their products or services are all fighting over a declining supply - not a "great" return on capital situation.
2. The Yuan Appreciates. While this will make US Goods more competitive in the short term, it will cause Chinese goods and labor to be more expensive to the very markets they operate in.  Since the Chinese Economy relies on this as a major boost to their GDP, eventually the consumer will slowdown.  Also, as profitable opportunities arise, even more competition will step in and what was a nice competitive landscape for many US Multinationals will see profits slowly being eroded through pricing pressures.  Although this is inherent to China, any currency instability or shift from the status quo of the past few years (weakening dollar, certain dollar pegs, Yen carry trade, etc) could cause problems for those who have invested in emerging markets.
3. The Emerging Market Stock Markets Crash.  As we have seen throughout history and most recently in the Tech Bubble as well as the Housing Bubble, rising asset prices creates a wealth effect where will spend more because they feel they have more.  If that wealth becomes threatened ,all bets are off.
4. Protectionism.  Washington is abuzz with a backlash against NAFTA and other free trade pacts.  As the 2008 election increasingly becomes more of a populist orgy - expect this to be a major item on the agenda of whoever enters the White House in '08.  This will be detrimental to everyone invested in emerging markets - whether in their 401k or as part of their business strategy.  Also, historically we have tried to exercise control over economies that may be competition to us by flooding their markets with our goods (see Japan, as well as the Marshall Plan for great examples).  China doesn't want to see this and may also take protectionist measures in order to prevent a deflationary spiral like others have seen. 
5. Oversaturation.  Economic history has shown, if there are margins to be had, companies will move in to try to grab market share.  This diminishes both economic and accounting profit.  Up until now, accounting profit has been maintained as economic profit has been going into the red. As competition increases both measures of profit will come increasingly under pressure. Economic profit includes positive and negative externalities.  Growing concern over global warming, rising commodity prices, and increasing geopolitical instability are some negative externalities caused by this phenomena which may soon start to eat away at accounting profit - as protectionism and political measures are taken.

Time will eventually tell whether Bill and Ted's voyage to the emerging markets will be an "Excellent Adventure" or a "Bogus Journey".  I'm sure when Emerging Stocks finally begin their descent, it will be a very hot topic for the pundits and bloggers.  However, I contend that the real issue, when that happens, will be what it will mean to all the capital on US companies balance sheets and earnings flowing into the income statement budgeted overseas to earn a outrageous return which now is in jeopardy and the valuations of many companies who are "not tied to the domestic economy and diversified abroad".  This is cash that could have been returned to shareholders in the form of a dividend, but has been invested in the emerging markets turning a company that should pay a 4% yield with low earnings growth and a low P/E into a no dividend growth stock.  There are many such companies and many investors own them and I believe the market is just beginning to wake up to this reality as Industrials have recently begun to flounder. 

Are these unlikely suspects the tech stocks this time around?  Only time will tell.

Disclosure: Long EEV and FXP.

ZB Strategy '08: Long Nouns, Short Adjectives

No, that is not a typo.  For 2008, one theme we believe will prevail that does not focus on any particular investment, but for an investment philosophy is "Long Nouns, Short Adjectives".  What does this mean?  The job of an adjective is to modify a noun.  More generally speaking, an adjective describes a noun and/or adds to the overall understanding of the noun.  In practice, adjectives add a layer of bullshit.  My 12th grade English teacher told me to strip my writing of adjectives to make it more clear and concise.  Adjectives add a "fluff" factor that the uneducated find appealing, but the educated find annoying and disconcerting.  To those who really care, abundant use of adjectives signal to a reader that the author is trying to cover up some sort of shortcoming. 

Applied to the investment world, this means to go short any fund, product, or stock that uses adjectives in its marketing strategy.  For example, you have funds that are named the "ABC Fund Family Premium Diversified Strategic Enhanced Dividend Fund" or the "Premier Global China Opportunity Fund", sell those funds and buy dividends and China.  Usually, these adjectives are used to make something that is more or less an index, or something that is a pile of toxic waste look more marketable - especially to the retail investor who must choose between an index and a flashy fund.   In a time when volatility is low and greed is high, the bullshit factor works as there is ample liquidity to go around.  When liquidity becomes scarce it becomes bullshit-averse.  In 2000 and 2001, you saw the bullshit that CEO's of tech companies be valued much less by the market than  it was years prior.  It is a historic cycle that bullshit is most expensive at the top and cheapest at the bottom, as public's tolerance for bullshit is greatest at the top and lowest at the bottom. 

For 2008, adjust your tolerance early, and go short adjectives and long nouns.  You've all added adjectives to your term paper to get it to the 10 page limit to "fool" your professor, so why let someone add them to your investment portfolio in order to "fool" you. 

More On Counterparty Risk

Michael Panzer of the book and blog, Financial Armageddon, was the first to touch upon this important risk in the system - two years ago.  He republished the article, that when read now seems genius in its scope and foresight.  To be honest it is quite spooky.  I urge you to check it out.  I have reposted some excerpts that play on some of the other themes I posted on recently.

Volatility, Negative Gamma, Insurance

Another other popular form of derivative is an option. Options are different from futures and forwards in that one party has a right, rather than a firm commitment, to initiate a transaction at some future date based on the established terms. Typically, the option is granted by the "writer," the one who is obligated if called upon, in exchange for a payment up front.

In a sense, these types of contracts resemble traditional insurance products. The writer of the option is like Allstate, Prudential, GEICO or any other company issuing a life or homeowner's policy, where the holder ends up receiving a predetermined amount if an event takes place (e.g., a fire ravages the property) in exchange for paying a premium or premiums beforehand.

Plus this might explain why volatility as an asset class is so popular right now.  In reinsurance, a major problem is that in a hard market there is no capacity, so a new asset class developed for capital markets - insurance linked securities.  Just as reinsurers who insured the property along the New Orleans gulf coast found out, fat tail losses need to be prepared for.   For the capital markets, volatility is the risk that needs to be insured.  Major banks need markets for this risk and more and more liquidity.  They are now looking for volatility "reinsurance"

Buybacks

Or maybe he believes market prices are headed higher, and wishes to have temporary control of the property with a relatively small outlay. In this way, options represent a form of leverage, similar in some respects to the margin on a futures contract, where the holder can potentially receive the upside benefit without having to pay the full cost up front

Isn't this the same thing.  Management "thinks" price going up, instead of investing in a dividend, buys back some stock and gets a few years worth of dividends discounted by the market up front - and a nice pay package.  Investors don't care because they can. 

Anyways, there's lots I would like to comment on but I am too tired and busy.  Go read that article!

Great Quote on Counterparty Risk

Via Calculated Risk,

“It’s a zero-sum game. If you put trades on that worked so well that you bankrupt your counterparty, you will not collect on those trades.”

-Jim Keegan, a senior vice president and portfolio manager at American Century Investments

I have a feeling counterparty risk is going to come up in conversation more and more lately as half a quadrillion dollars worth of derivatives that are all intertwined and interconnected gets marked to reality. It's one thing to take a loss on a hedge or trade when what you were betting on never happened.  It's absolutely horrifying for that to happen when they it actually does.  I believe this one event, just by occurring, will cause many people to "check" their counterparty either by unwinding their winning trades.  I think then we will see more than a handful of less than stellar counterparties scattering about - kinda like cockroaches when you turn the light on. 

Prada is Planning an IPO: Are they looking for someone to hold the bag?

It was announced today that Prada, the Italian Luxury goods maker is seeking to file an IPO.  Is this a sign of the end of easy credit and the materialistic "living beyond our means" post modern Gilded Age.

From the press release:

Luxury goods companies have seen a surge in their earnings multiples during the extended economic boom, with unprecedented demand for high-end, high-margin goods, but capital markets are trickier now that the credit crunch and falling house prices are beginning to dent consumer morale.

Still, fashion executives insist undinted demand from newly middle class shoppers in China, Russia and India will more than counter any sag in U.S or European sales.

   

    Well, if FASHION executives insist, then we don't have to worry.  They also insist that I would look best in tight leather pants and puffy shirts, so they must be very good at predicting the geopolitical and global economic ramifications of an unprecedented credit event.  Phewww. 

Anyways, I have been looking for symbolic "signs" that the tides are starting to shift.  One was during the middle of the summer, as the subprime crisis emerged, one of the most popular rap songs played at all the clubs was "The Way I Are" by Timbaland.  If you haven't heard it some lyrics are below:

I ain’t got no money
I ain’t got no car to take you on a date
I can’t even buy you flowers
But together we be the perfect soulmates
Talk to me girl

I ain't got no VISA
I ain’t got no Red American Express
We can’t go nowhere exotic
It don’t matter ‘cause I’m the one that loves you best
Talk to me girl

Oh, baby, it’s alright now, you ain’t gotta flaunt for me
If we go touch, you can still touch my love, it’s free
We can work without the perks just you and me
Thug it out til we get it right

For years during the "Bling-Bling" era, where rappers were talking about Prada, Fendi, Gucci, as well as fancy cars, and nice jewelery, and people were buying.  Now, it seems all of a sudden a song that is the complete antithesis of that came out and was popular by the same people.  Its interesting because people listen to music that makes them feel good usually.  When they have tons of credit and are able to "floss" they want to hear that stuff.  When they are broke, they want to hear, "it's alright now, you ain't gotta flaunt for me".  I think this is one of the more interesting manifestations of this whole things we have seen. 

Anyways, now that luxury goods makers seem to be falling out of favor with those who can not afford their goods, whats better than to buy a share of their stock for fraction of the price?  Luxury goods by definition can not sustain growth without massive inflation.  They will always price out of range from the majority of people so they remain "luxury" in nature.  They benefit enormously when inflation runs rampant since their demographic usually benefits and will pay more.

There are always those special IPO's in hindsight that market the end of one phase and the beginning of another.  One recent example would be Blackstone's IPO ushering in the credit crunch.  Could one of the biggest beneficiaries of a global liquidity boom going public, be the sign of a deflationary shift?  Maybe, but if it is, I wouldn't want to be the Prada bagholder.