Zero Beta

Deflation Alert: Code Red

From Bloomberg:

Centro Properties Group, an Australian owner of 700 U.S. shopping malls, said it may sell assets to pay debt in a bid to survive after losing 86 percent of its market value in two days. The stock surged.

The company is so far the worst casualty in Asia of the global credit squeeze, with A$4.1 billion wiped from its market value earlier this week. Scott took on debt to help fund $9 billion of U.S. acquisitions in the past two years, including New Plan Excel Realty Trust.

``Centro is comfortable about the ongoing viability of the business and would not allow its securities to trade if this were not the case,'' the Melbourne-based company said in a statement today. Chief Executive Officer Andrew Scott must refinance A$3.9 billion ($3.4 billion) of debt for Centro and the listed trust it manages by Feb. 15.

``Until they start selling some of their assets, I couldn't know what's going to happen,'' said Michael Birch, who helps manage the equivalent of $140 million at Wallace Funds Management in Sydney. ``Companies paying more and more to refinance debt, that's the contagion.''

      

What is that you say?

Fire-sale of assets to pay debt? 

86 percent market value gone in two days?

A$4.1 billion gone? 

Debt more expensive?

Contagion?

Michael Birch?

Ok, no Michael Birch.  The article goes on:

``The real query is the transparency of the asset base is quite difficult for analysts to get a handle on at the moment,'' said Michael McCormick, who helps manage about $170 million at Leyland Private Asset Management in Sydney. ``The trouble is they have basically flagged that they are in some trouble and that is obviously going to have an effect on the asset prices they can get.''           

Ouch!  In case you don't speak Denial, I have listed some translations:

"Transparency" = discount to inflated value

"real query" = watching his share in the company take a 87% haircut in 2 days

"quite difficult for Analysts to get a handle on at the moment = Fuck!

"they are in trouble" = they are absolutely screwed

"an effect on the asset prices they can get" = asset prices are deflationary

Expect to see a lot of this going forward.  I think its especially interesting since it owns 700 US shopping malls - illustrating two  deflationary phenomena consumer spending slowdown and real estate collapse. 

A Few More Comments on Buyback

Today, David Merkel on the Aleph Blog, responded to the slew of stock buyback-related posts.  David is always very observant and warned about the shortcomings on buybacks in years past .  He wrote a great post taking the other side of the trade, and although I disagree with some of his arguments, we all need to see both sides of the trade as I sometimes become parochial in my views.  After this I will give buybacks a breather for now - I swear

First, he put together a great comprehensive list of the problems with buybacks that I thought I would reprint below:

Prior to the market hitting a spate of turbulence, for the last four years, I had rarely heard anyone say something bad about a buyback or a special dividend.  At that time, I tried to point out (at RealMoney) that buybacks are not costless:

• They reduce financial flexibility.
• They lower credit ratings and can raise overall financing costs, if overdone.
• They can become a crutch for weak management teams that aren’t active enough in looking for organic growth opportunities.
• They often don’t get completed, leading to some disappointment later, after the initial hurrah.
• They can be a clandestine way of compensating employees, because they hide the dilution that occurs from shares received through incentive payments.  In a sense, shares are shifted from shareholders to management.  Buffett has the right idea here: pay cash bonuses off of exceeding earnings targets.  Nothing motivates like cash, there is no dilution, and managers don’t get compensated/punished for expansion/contraction in the P/E multiple.
• A higher regular dividend could be more effective in some cases
• Finally, does management want to make a statement that they don’t see any good incremental opportunities for their business on the horizon?  That’s what a large buyback implies.

He then goes on to what he sees are some positives:

Buybacks can instill capital discipline, as regular dividends do.  A good management team, when considering an acquisition, should at the same time run the same numbers on their own common stock, to see whether the acquisition is an effective way to deploy capital.

I disagree that buybacks instill capital discipline and do not know what their share price has to do with it.  In capital budgeting you want to invest in projects with positive NPV or the highest IRR.  You do this by discounted cash flows at the WACC.  This is where you look at your own numbers, but the key is their ability to gauge the cash flows it generates. If an acquisition has a NPV over time that is positive and they believe it is the right thing to do, then they should do it, or else pay it out as a dividend or keep it on the balance sheet for future opportunities.  Whether management is good or not, human nature is geared towards short term gains and the path of least resistance.  If an acquisition takes years for synergies to be realized, and they know they have a few years to get things done or they are out, they are biased towards the short run benefit.  They shouldn't even consider their share price in the decision.  If they don't want to take the risk, then they should pay out a special dividend and let the market decide whether or not it is a good investment.  I want to see management take risk with my capital or give it back to me to take risk with.

The best buybacks are valuation-sensitive.  The company has an estimate of its private market value, and the buyback only goes on while at or below that value.  When a cheaper opportunity shows up to acquire a block of business, or a new line of business, or a whole business, the buyback stops, and the acquisition is executed.

It is management's job to increase long term shareholder value, not take advantage of short term price disparity in the market for its shares.  This is the absolute worse reason for such a program - regardless of what the true value is.   Shareholders do not give management their money so that they can take advantage of an informational advantage to rip off their own investors.  A shareholder holds your stock through a few earnings periods, and you try to take it from him at 4% below what you believe it to be, instead of giving him a 4% dividend for waiting for that value and providing other investors the incentive to wait along with him for the stock to realize its actual value.  I sure hope they don't sell shares when the value of their company is much lower than the market would think.   Instead of buying the stock at all why don't I just give them $10, wait outside the annual shareholder meeting and bend over.   Investors don't need to be told the obvious, they believe your stock is cheap, or else they wouldn't be holding it. Reward those investors with the extra cash who are patient and commit their capital for years, not those who are looking for the door.

A management team of moderate quality should not keep a lot of excess capital around, because they might make a dumb move with it.  A high quality management team can run with more excess capital.  In one sense, moderate quality managements should shrink their businesses, while high quality managements should try to grow their businesses organically, and through small in-fill acquisitions that enable  them to access new countries, markets, products, and technologies cheaply, that they can then grow organically.

I agree completely about the management teams, but don't see why I should trust a moderate team with my claim to earnings.  After allocating the cash to projects that will generate more cash in the future, give me back the cash that you earned on my dollar, or keep it around if you think profitable opportunities will arise.  A good money manager finding himself with a ton of cash and no good opportunities will not just add to his existing positions - giving the reason that they haven't hit their target value yet, in doing so he is doing right by the client.  However, if he sat on cash and underperformed his benchmark for a while, there would be a good chance that his client would pull the cash out and invest it elsewhere if not sell out altogether.  This is why many managers like to keep cash low and stick to an index.  Isn't buying back your stock the same thing?  Buybacks closet indexes themselves to their last EPS point and enables management to make sure that their earnings growth does not drift much from what it "should" be in the short run, but not over time.  Just as it is in the financial and business interest of the money manager to hold very little cash, it is in the CEO's interest to buy back stock over dividends or cash - not in the interest of the client or shareholder. 

My major gripe with buybacks is they are not the most efficient use of capital, ever.  If a company deciding whether to retire $100 million worth of shares, issuing $100 million cash dividend, or sit on the balance sheet should be a decision based on the value to a long term shareholder.  If a company want to sit on the cash can earn some short term interest on that cash and it allows for it to be flexible during an opportunistic time, then so be it. If it wants to return value to a shareholder, then a special dividend ALWAYS unlocks shareholder value better than a buyback.  If shareholders believe in the company they will reinvest the dividend and add 80% of that capital back in and take advantage of the fact that the stock is undervalued.  If they don't they will sell, enabling shareholders to move in who APPRECIATE the fact that management actually returns value, not just paper gains.   

I would much rather have money now than money later, and must be paid a premium to take money later and deal with market and liquidity as well as reinvestment risk.  Buybacks cause long term investors to be subject to enormous earnings surprise risk, while dividends provide an income stream to promote a stable capital base. Since many argue that equity investors should be concerned with their claim to the future earnings of a company, a stock buyback rather than dividend distorts the view of such a claim and puts tons of faith in the fact that someday there will be someone else who is willing to buy that claim from someone who never got any claim whatsoever.  It puts downward long term pressure on the stock and rewards short versus long time horizons.  One bad earnings announcement could erode away years of built up dividend payments and reinvested returns, whereas if a company paid a decent dividend, the earnings surprises would be much less severe, as the stock would not appreciate so fast. 

The best trade in this market right now may be short buybacks long dividends. Or simply just selling stocks that have bought back shares and bought those who haven't.  A buyback in my opinion is economically the same thing as a dividend, except for the fact that the holder of the stock is taking on much more risk than if he were to get the cash over time.  With many of these companies operating at margins that are stagnant but at all time highs and ROE's that have suspiciously soared to all time highs, cashing out your dividends in a one time lump sum and reinvesting it in a company who may be the investment style de jour soon, sounds pretty good to me into while this major liquidity is still available.  Obviously this is not a blanked recommendation but an idea, and you should look at all holdings seperately.  This phenomena speaks less to the managers of the company than the people who own the stocks, if they are near sighted on the way in, they will be the same way on the way out.  That is the ONE thing about buybacks that actually is a good thing.  They allow you to unlock shareholder value and provide liquidity to those who chose to sell.  When earnings growth does slow and/or buybacks cease to be profitable, you don't want to be the on the other side of the liquidity eqution, trying to bust through the crowded exits, instead you could be the one right outside with arms wide open and a fistful of dollars (or euros).

Disclosure:  I own stocks who buyback shares.  We all do. 

Asset Allocation Using Volatility: Is Risk an Asset Class by Itself?

From the people who brought you Mortality and Longevity, comes an all new asset class, Volatility.  While it sounds like a fragrance commercial or movie trailer straight from nerd hell, Adam Warner writes that Goldman Sachs has announced that it will begin to include volatility as an asset class when making client asset allocation decisions.  While I may be tongue and cheek when writing about Goldman, and not agree with some of their decisions, they are really quite genius and most certainly have the balls it takes to run a Private Client group that is interested in providing their clients with something new.  Adam writes,  

After so much sturm und drang in the global markets in 2007, investors increasingly will view volatility as an asset that can be traded, just like stocks and bonds.

This view has long been touted by options pros, but now it's being bolstered by a Goldman Sachs research paper recently distributed to clients. In it, options strategists Maria Grant and Krag Gregory argue that stock volatility is an asset class, and that investors should commit money to it when they make asset-allocation decisions.

Volatility, in its most pure sense is the variability of asset returns.  It is used widely as measure of risk.  An index based on a volatility measure, the VIX is the most common tradeable representation of this risk.  It represents investors expectations of risk based on the S&P 500 stock index prices - and is commonly called the "fear gauge."  For more in depth analysis, visit Bill Luby's Vix and More blog for an orgy of great Vix-related material.  There are currently futures and options on the index and it is readily followed by most traders and even non-derivative folk.  The VIX derives its valued from the implied volatility of option prices.  This is gained by using the Black-Scholes Formula (or some similar option pricing model), inputting current option prices, interest rates, time to expiration, and stock price, and solving for the implied volatility.  Usually, but not always, the VIX is negatively correlated with stock prices.

When trading, volatility is something that should always be kept in mind and many believe position sizes should be reduced in volatile times and increased in times that are not as crazy.  People invest in volatility based products such as the VIX for various reasons.  Most do so to hedge their exposure to market volatility. For example, if you are a relative value hedge fund manager trying to capture some spread between two stocks by going long-short, and are using obscene leverage in order to do so, you may not want to expose yourself to the volatility of the overall market, since you are not making a directional bet between two companies and not the market as a whole.  Or, maybe you have a position that you do not wish to reduce, but not leave exposed to wild price movements that it may experience in a volatile market you foresee.  Buying some VIX futures helps you hedge this risk.

Some people, however, simply trade volatility by itself, buying and selling this measure of risk as they would a stock, option, or bond.  This is done through variance or volatility swaps.  My knowledge on this area is limited, so I will leave it at that and welcome any further comments. 

I am more interested in the idea of volatility as an asset class.  Traders should not be as concerned with the definition of an asset, since they usually are renting the security which they trading, and care little about its fundamental value just the cost of carry.  Investors should care more as they have a longer term time horizon and seek some sort of cash flows or appreciation to invest in an asset.  Assets, on the other hand, can be intangible such as knowledge, as we have seen on the balance sheets of many corporations.  They are also used in context with traits and characteristics - as in, "His negotiation skills are his greatest asset."  These assets can generate returns for those who hold it, and can be purchased by companies who wish to hire someone who has them.  I am very open to what and what isn't an asset, as long as it is able to be valued and people derive benefits from it. However, I just don't see volatility as an asset class (and would fit better as a hedge fund strategy under "Alternative Investments".  There are two main reasons why I believe this, they are its role in the process and its

1.  Volatility is a Asset Allocation consideration, not a choice.  Volatility measures price movement.  It measures not where a price is going, but the path it takes to get there.  The crazier the path, the more the investor should expect to make when he reaches his destination.  It is also a major determinant in allocating a portfolio.  Assets within a portfolio should be evaluated based on the amount of return one expects based on the amount of risk.  Both are measured somehow and evaluated.  Some ways to measure risk are historical and implied volatility and correlation with other asset classes.  Every investment is an indirect investment in volatility and to be long an asset you are long the volatility of the asset.  Since return is a payoff for risk, effectively hedging one's exposure to this risk should cost an amount comparable to the return - since the counterparty must be rewarded for taking on the identical risk.

2. The long run expected return on volatility should equal the risk free rate. 

Volatility is the result of an absence of liquidity for an asset at the given price.  The more liquidity that is available the more likely demand (and supply) to come after price movements, the less liquidity, the more chance for larger swings.  Since liquidity in general will never completely disappear or go to infinity, volatility will be what it is, noise around a trend. The best example of this is in the concept of gamma.  Gamma is the rate of change of delta - the change in option price that corresponds to a change in the stock price.  Someone who is short puts or calls is short volatility and has a position with negative gamma and susceptible to large price movements.  The chart below shows the relationship of gamma with volatility:

When volatility is low, gamma is relatively unstable, and time value is small for OTM options but increases dramatically as the stock moves more towards being ATM.  In general, the risk of being short volatility is the highest and volatility is cheap.  When volatility is high, the time value of calls are already bid up substantially, and large price movements won't really affect the value of the call option as much.  What this does is set up a trading range for volatility.  When volatility is low, it is best to be long volatility  at the money, but as volatility increases, the bell curve above above flattens to the high volatility curve and going short gamma becomes more attractive, as time value becomes too rich.

The volatility of volatility, therefore decreases as demand for the volatility increases and vice versa. Having volatility as an asset class, I believe, will cause a much flatter gamma curve, as it will create a demand for volatility once the market absorbs this excess liquidity and demand. Also those who are short gamma need to hedge their delta exposure along the way - adding liquidity to the investment that they wish to hedge , meaning it will serve as less of a hedge against the underlying volatility it was supposed to protect against, until the gamma and vega exposure you have is offset enough by the negative theta to leave you simply with the risk free rate.  If liquidity is dying out and trending up, so will short term interest rates.  Thus, allocating towards cash, is the pretty much the same thing and much a much safer way of reducing your exposure to volatility and volatility should be correlated with short term rate movements as it has been, shown by the chart below:

Now, I am not a derivatives expert by any means and this could be easily refuted and I welcome it because I really enjoy volatility and believe it is important.   However, I do believe this is just taking advantage of an opportunity to offer an interesting product to their clients and create liquidity for their internal funds or clients who mostly likely trade volatility very often and need an active market, and/or structured products.  Either way, I think its cool, and would be interested to see how it would be used and how it would perform.  I also think the idea of allocating away from greed to fear is just an interesting conversation to have with a client and actually good for their overall investment education - possibly making it worthwhile anyways.

    

Update - 12/18/2007 - 1:31 PM

Upon reading further, I see that the "volatility as an asset class" is to be short volatility.  This will create a position with negative gamma.  I thought it was more along the lines of a fund that traded volatility like a CTA trades commodities.  It doesn't change my viewpoint, however, since it creates a more liquid market for fear, thus minimizing the effect of a change in volatility.  If one insurer wrote insurance on houses in towns as hurricanes were hitting and made underwriting profits each time, more people would move in to do so.  If many people were already doing it, they then create a liquid market for something that is up to know an illiquid transaction.  It would follow that one insurer would most likely profit from high rates and ability to selectively underwrite risk due to fear and illiquidity.  Many insurers would create liquidity and slowly erode those profits until the liquidity of the market erased any underwriting profits and most likely exposed them all to the possibility of large losses.  Also, as hurricanes come down, people will be less fearful because they know there is liquidity in the insurance market, which gives them pricing power earlier in the event.  The market would be no different.  A more liquid market for fear at times great volatility, will cause subsequent times to be less volatile on average, as the market will begin to expect a bid to come in.   Instead it has the effect of adding to the fat tail exposure of those short volatility, and perverting their risk exposure.  This leaves out the effect of hedging your delta, which would stems from the fear that the volatility seller himself has, and incentive for the underlying to be less fearful. 

Overall a hedge reduces volatility and a hedge against volatility will reduce the volatility of volatility itself.  So being short volatility is to be long the volatility of volatility, and this could go one and on and on.  As more people go short volatility , they will pay too much for the hedge and earn a poor risk adjusted return.  So by adding liquidity to this as an asset class, you are doing nothing more but hedging yourself and as the asset class catches on in popularity and becomes more liquid, its returns become less attractive.  You should expect to earn something inline with the risk free rate over time and open yourself up to significant losses along the way.

Are Buybacks Ever Good for Investors?

Today, Mark Hulbert published an article in the The New York Times, titled "Are Buyback Stocks Still Good For Investors?".  Drawing off the fact that so far this year companies who have initiated buyback programs have underperformed the overall market, he investigates the historical outperformance of buyback programs and explores reasons for the recent outperformance.

Before even digging deeper, I contend that even if buybacks are truly better for shareholders over time, looking a little over a year of underperformance, after many years of outperformance, should not be a reason to conclude that they are no longer beneficial.  Companies that issue dividends have outperformed the market for many years, but the fact that they have not during some periods does not disprove that dividends are beneficial for investors - but rather that investors at some periods of times do not prefer dividend paying stocks to non-dividend paying stocks. 

Anyways, companies buyback stock for a variety of reasons, all of which will not be mentioned here.  One main reason is to prevent the dilution of shares due to employee stock options.  Another reason is simply a way to reward shareholders instead of issuing a dividend.  A company who has a lot of cash but no attractive capital budgeting opportunities, and does not want to issue a dividend (which is usually something that is set in stone) can choose to buy back stock to reward shareholders - reducing the float and increasing their earnings per share.  Lastly a company can initiate a buyback program to indicate or restore confidence in their stock, or to concentrate voting power when facing possible takeover.  Buying your own stock indicates a degree of value and optimism about future profitability.

Note, that in the last reason I mentioned "initiate" a buyback program.  Many companies do not have to buyback stock when they announce that they will.  The announcement to the market that they will usually is good for a short term bounce as the market anticipates the move.  In his article, Hulbert writes,

Previous research has found that managers under extreme pressure to bolster their company’s stock price often make aggressive use of discretionary accruals. Their behavior isn’t necessarily illegal. But their accounting legerdemain typically has the desired effect for only brief periods. In the long term, such companies’ stocks tend to lag those of businesses that don’t make heavy use of discretionary accruals.

The professors reasoned that managers under pressure to increase their company’s stock price are likely to use all the tools in their arsenal. So if they were willing to mislead investors by inaugurating a bogus buyback program, it is probable that they will have also used discretionary accruals aggressively. Professor Ikenberry said he and his fellow researchers had found that, at most, only a “small minority” of companies that announced buyback programs from 1980 to 2000 had also made heavy use of discretionary accruals.

Though this doesn’t prove that the bulk of buyback programs were created without an intent to mislead, Professor Ikenberry said it is reasonable to make that inference. He cited another finding of the study to support this view: the stocks of buyback companies tend to perform much better over the long term when they don’t use discretionary accruals aggressively.

This basically states that companies who have bought back stock have done well over time, but those with unscrupulous managers prone to accounting chicanery, have not.  This makes a statement more upon management than anything else.  Obviously we would never be able to see how the companies would have favored if they had not bought back shares, or they had issued a dividend instead.  Additionally, reinvesting money in an increasing asset compounds growth and should outperform a buy and hold strategy over time.  This is why the dividend reinvested return is much greater than the price return of market indexes over time.  This is the fundamental argument for investing in dividend-paying stocks in the first place.  The chart below shows that this principle.

For each reason mentioned above, in neither case is the action of a buyback more beneficial than issuing a dividend.  In the case of the stock options, a buyback indicates nothing about the financial outlook of the company.  It is choice between share dilution, which is bad for investors, and no share dilution, which is neutral.  Plus, the fact that dilutions are smoothed by buybacks negates the whole point of compensating executives with options.  They are supposed to be an incentive to unlock shareholder value.  If earnings are being diluted at a rate faster than management expects them to grow, then ladies and gentleman, we have a problem.  Being able take care of dilution via share buybacks is simply a waste of shareholder capital.  Instead of using capital on earnings growth, investing in profitable capital projects it is used to buy up shares of the old capital projects and essentially pay wages.  This cycle can feed on itself as any earnings growth is offset by massive share buybacks, causing what may be a mediocre management team look like stars.  Furthermore, if a CEO knows that any share dilution his options package causes will later be bought back to fix, has much less of an incentive than one who is not.  The benefit that this takes away from shareholders is mainly transparency. 

Another reason to buy back stock is that a company has generated too much cash and the most profitable place to invest the cash is in shares of its own company.  This is a sneaky way of just leveraging their current projects without actually adding it.  Since it reduces the amount of shares outstanding, no earnings growth will increase earnings per share automatically - essentially taking this quarter's earnings and rolling them over to next.  An earnings per share growth of $10 million will have a much larger "per share" increase since there are more shares at time t than there are at time t+1.  Likewise, if earnings fall, earnings will fall much quicker than expected, unless of course more shares are bought back.  The point of using financial leverage is to borrow money against one's balance sheet to finance an investment that can have a return that is greater than the debt to fund it.  Companies who issue buybacks in this manner use this to leverage the earnings from their current capital expenditures.  Instead of going to the debt markets, however they are borrowing from shareholders.  Although this is widespread it is done sometimes by technology companies who have tons of Goodwill on their balance sheet, against which they can not borrow, this is their only way of obtaining leverage.  The problem is, just like a firm that is highly leveraged and burning cash on interest expense, a company who is continually buying back to reap a payoff is taking away from investing in future projects.  The difference, being, that it looks good doing it, while a highly leveraged company looks terrible.  Once again, the problem is transparency. 

The argument you hear from many CEO's when announcing a buyback, "We see is no better investment than our own company" is complete bull and a enormous assault on shareholder's rights. Shareholders elect management to invest their claims to earnings in working capital in capital projects and that is where they invest in their own company.  If they can not find any more opportunities, then they should expect their money back through a dividend.  If they believe the company's prospects are bright they can choose to reinvest in shares of the company, if they do not they won't reinvest or will even sell their shares.  This is management's way of taking shareholder cash and not just telling them what to do with it, but actually doing it.  Shareholders are owners of that cash and management is the users of that cash.  If management themselves say they have no other use for that cash, then the cash should be returned to shareholders to decide.  Dividend reinvestment is actual share buyback, not to mention than cashing out this "expected stock price" at the capital gains rate. 

The fact that a company has nowhere else to invest its cash is the sign of a maturing company - one that  should pay a dividend if it has extra cash.  And, like it or not, our economy has many of them because it is a maturing economy.  By buying back shares, a maturing company is trying to fool shareholders and itself that it is still in the early stages of its growth cycle.  If it were a person it would be the forty year old woman at the bar with tons of makeup, a body way past its prime, and clothes made for a 20 year old - we have all seen her.  All buybacks do is take away a layer of transparency and add more unpredictability.  As the lady at the bar will eventually find out, you continue to add layers of makeup, and buy new clothes, but you can't fight age. 

The New Goldman Sachs Tradeable Mortality Index

On Friday, Goldman Sachs announced it was going to create the first tradeable index based on mortality risk.

From the press release:

The Goldman Sachs Group, Inc. today announced that it has       launched the first index that will allow market participants to measure,       manage, and trade exposure to longevity and mortality risks in a       standardized, transparent, and real-time manner.

Longevity and mortality are the risks that realized lifespan differs       from expected lifespan, creating an economic consequence, often a price       change in an asset or liability. Holders of mortality risk -- typically       institutions such as insurance carriers and reinsurers -- are       economically exposed to a decrease in lifespan, while holders of       longevity risks -- pension funds, annuity writers, the social security       trust fund or life settlement investors -- are exposed to an increase.

The index, called QxX, is supposedly the first of many to come.  I have included some additional information from its website below:

QxX is designed to allow market participants to measure, manage, and trade exposure to longevity and mortality risks in a standardized, transparent, and real-time manner

QxX.LS, the first in an expected series of indices, is a representative sample of the US senior insured population over the age of 65. The initial index references a pool of 46,290 de-identified lives

• Reference pool consists of a rules-based set of lives, medically underwritten by AVS Underwriting, LLC
• Published monthly, providing real-time mortality information
• Mortality tracked by independent, third-party agent, based on the Social Security Death Index
• Indices will roll on an annual basis, providing a continually updated reference pool, capturing market evolution and underwriting trends

Participants will be able to initiate swaps based on the index where they swap mortality risk.  The website explains:

QxX.LS index swaps are designed to allow market participants to hedge or gain exposure to longevity and mortality risks, providing reliable, real-time pricing information and execution

• “Fixed Receiver” sells mortality protection and is “long” mortality risk – receives a spread and makes mortality-contingent payments
• “Fixed Payer” buys mortality protection and is “short” mortality risk / exposed to longevity risk – pays a spread and receives contingent payments
• Spread to represent market-implied mortality of the reference pool
• Net cashflows exchanged, representing the difference between the spread and the realized mortality
• Swaps will trade with a defined term profile – swap maturities will be certain at the outset of each trade

Before I go into some thoughts on the index, let me explain my background in insurance linked securities.

A few years back I worked for a major reinsurance broker structuring capital market solutions for our reinsurance clients.  When I say capital markets solutions, I mean any type alternative risk transfer of insurance risk including Industry Loss Warranties, Catastrophe Bonds, and Weather Derivatives.  This market exists because there is a major problem with capacity for insurance risk (in some areas more than others).  Most insurers and reinsurers have far too little capital and credit ratings that are suspect at best.  After Hurricane Andrew, Katrina, and 9/11, insurance linked securities such as Cat Bonds started to pop up.  These enabled insurerers and reinsurers, as well as some non-insurance companies to securitize some sort of catastrophe risk that is on their balance sheet through a bond that pays the holder on the  occurence of some event - a hurricane in Florida with winds in excess of 100mph, an earthquake in California greater than 7.0, or some aggregate industry or indemnity based loss due to an event.  The holder of the bond (usually hedge funds) receives LIBOR plus a very juicy spread and the issuer receives a fully collateralized form of reinsurance, and don't have to worry about time to assess and collect claims.  Many very big hedge funds play in this market - one enormous one is Citadel.  Hedgies, such as Citadel, like the fact that is essentially a zero beta asset class - it has no correlation to the markets.  They can also accept the risk that a bond can be totally wiped out (though it has only happened once I believe and that was a crappy deal done the year before Katrina).  Some in the industry envision a future where there are tradeable insurance products and the retail investor could hold a say 10% position in insurance in his portfolio.  A few believe that area will eventually replace the traditional insurance market altogether. 

One reason I left the job was that I did not see it taking off at the reinsurance broker worked for, for one reason - we didn't take risk.  We would advise on deals, but couldn't underwrite and distribute, and in the world of Wall Street that means you get paid very little.   I also saw one big Wall Street name in the market on every deal, slowly cutting us out of fees for advising on relationships and business that we brought them.  This company was Goldman Sachs.  Goldman has slowly been inching into the insurance business for years.  They are now the lead underwriter on many Cat Bond deals and them and Swiss Re (which is also makes a market in this stuff) have become much bigger players than the Guy Carpenters of the world would have liked.  Reinsurance brokers are the insurance industry's version of investment bankers and it was only a matter of time, I thought, before Goldman became a reinsurance broker who offered their clients good advice but something much greater - the ability to underwrite and either hold or distribute the risk. 

First off, I believe this is an enormous move and one that WILL be looked back on some years from now.  At a time when the market for "market risk", or beta, is in chaos, they are going into a market that is completely uncorrelated.  Usually, when the markets are afraid of eating apples, because they may be poison, Wall Street decides to just sell less apples.  Goldman is looking to sell oranges, and it may turn out to be huge for them.   Plus there are a lot of other phenomena going on that could make this huge if it is just going into this and only this insurance market.

That aside, lets look at some thoughts, questions, and concerns I have:

• Basically, this index allows one party to bet that a cohort of 65 year olds dies early and the other party that it lives long. Life insurance companies don't like it when people die - it means they have to pay a benefit.  They would love to be able to hedge this risk efficiently.  The US government, which has to pay social security until a person dies, would love to be able to actively hedge the risk that they keep on keepin' on, and this would be a means to do it.  Pension plans too.  So essentially this market will be a trade between the government and pension plans and insurers and reinsurers - very interesting, potentially VERY lucrative, and very likely to raise eyebrows at some point in time.
• The life tables currently used, have a five year delay in the mortality data built in, this is due to the time it takes to gather, analyze, group, and publish the data.  Although insurance companies may gather and use their data the ones published by the CDC and the SSA contain the most widespread and public mortality data.  The real-time nature of such an index could have enormous changes on the index. 
• The fact that this is an index along with the need for liquidity for insurance risk immediately make be think that an ETF-based product somewhere down the line.
• THIS NEXT POINT IS VERY SIGNIFICANT.  Goldman is also very busy in the market for "life settlements".  This is where people can cash in their life insurance policy now and forfeit their right to a benefit later.  Another article elaborates:
  

  "The index also could help manage risk in a burgeoning business market that, in effect, makes hedges on death itself. The business is referred to as "life settlements."

  The way it works is a firm pays the holder of a life-insurance policy a lump sum for the policy now, takes over paying the premiums for as long as the insured person lives, then collects the benefits -- generally worth far more than the firm paid -- when the person dies. The firm keeps some of the policies in its own portfolio. It sells others to institutional investors.

  In April, Goldman Sachs, Credit Suisse Group and Bear Stearns Cos. helped form the Institutional Life Markets Association to lobby against efforts to restrict the business. If successful, Wall Street firms could buy policies directly and squeeze out the middlemen. This year, Cantor Fitzgerald LP set up an Internet-based exchange for those who want to sell or buy policy rights.

  Life settlements stir objections, and not only because they make some people squeamish. Some state regulators have called life-settlement terms unfavorable in some cases to policyholders. They have also charged that certain arrangements flout the spirit of laws designed to keep speculators from taking out policies on strangers."
  
  In a time when costs are soaring, lending is contracting, and assets are deflating, many ordinary Americans still own one big asset and don't know it - life insurance.  They see it as an expense, since many have to pay premiums and never get to experience the benefits.  Life insurance is also somewhat exempted from creditor claims due to bankruptcy.  Some see this being the way for the credit happy American to have one more dance or try to pay off loans if in credit trouble.  If this is the case, this will be a HUGE market as we all know.  If you thought subprime was shady - this takes the cake. 

• Who are these 46,290 people?  They could be potentially the most valuable senior citizens on this planet.  Isn't it somewhat disconcerting that so much money will change hands based on whether someone's Grandmother dies of cancer.  Even though I believe it to be unlikely and very difficult given the amount that would have to be done, who has the list with names of these people?  In the old model, the insurance company - the person with specific names - was interested in its client living, and the government just in a general cohort.  This flips it around.  46,000 people is not all that many and we have no idea the scale of how such a market will trade.  I'm not implying that someone is going to kill these people to make a buck, but they have never had the incentive to before. 
• The website mentions there will be many subindexes and I believe they will breakdown by at least sex and cause of death or health problem.  The cause of death is most interesting due to all the talk of Universal Health Care - and Goldman's proximity to Washington. 

This news was announced on a quiet Friday in December.   I suspect that Goldman's foray (amongst other firms I'm sure) into the insurance fields will be a popular discussion in the near future as it has political, financial, and moral strings ramifications at a very tumultuous time.

Is Private Equity Digging its Own Grave?

Yesterday Andrew Sorkin announced on DealBook that Blackstone raised $1.3 billion for a distressed debt fund. 

"The fund, Blackstone Credit Liquidity Partners, will look for investments in bank debt, publicly traded debt securities, bridge loans and structured financial products like collateralized debt obligations, or C.D.O.’s. The market for virtually all those products, especially those for C.D.O.’s, which are collections of mortgages, has dried up. Ratings agencies have downgraded scores of those assets, helping drive billions of dollars in write-downs by investment banks."

Essentially they are buying up the loans from the banks in need of liquidity, and invest in all the crap that either their industry created directly or crap that is falling in value indirectly because of the banks obligation and inability to off load their crap.  But you won't hear that form them:

“Our objective is to generate superior risk-adjusted returns from a combination of current income and capital appreciation,” Hamilton James, Blackstone’s president, said in a statement. “With Blackstone’s outstanding track-record in debt and distressed investing, we are confident that we can benefit our new fund’s investors by capitalizing on current conditions in the credit markets.”

Ethics aside, I have a feeling this one will come back to haunt them in one way or another.  If this debt is truly undervalued, then they are going to be seen with great contempt by profiting from a trade with a credit market that has seized up and experienced great losses in partly because of Blackstone's and other PE's LBO bubble.  For any ongoing future deals, they will most likely receive financing that is more expensive if at they receive the necessary financing at all and it will eat away at their margins. Also, on the other hand if it is still overvalued and it took a loss I would imagine Blackstone's image would be discredited to its own clients who may become uneasy with its equity positions, and it would have a hard time both raising and maintaining capital in the future.  It also would signal to the secondary market that their equity is overrated and hurt the previous deals it has done.

In this case however, I will give them the benefit of the doubt and assume they are in front of a great distressed debt opportunity.  Their best move, if they really believe the debt is undervalued would not to do anything.   Let the banks and the holders of the bridge loans make the gains or someone else provide the liquidity.  This will enable them restore credibility in the market and get a fair interest rate on debt for future deals - not just pivotal, but absolutely necessary for future success. I believe that by entering the market they are killing their future margins.  Their bread and butter is buying and selling equity and not trading distressed debt and their costs are essentially interest rate expense and liquidity risk on the other side of the trade.  Imagine if at some point during the tech bubble popping, all the investment banks bought back all the crappy tech stocks that were underwritten from investors after they had dropped 70% or 80% from offering price, and instead of going to zero as they did they rallied another 30% or so up.  Even if they rallied more than that, their profits of selling tech stocks are still long gone.  Those who bought them up sill lost a ton of money making the business in the future of issuing Tech IPO's or equity IPO's in general very dismal - which it has been anyways.  Screwing people once is bad enough for business, twice is terrible.  The best bet for them to make therefore is hopefully they didn't screw them at all. 

The Steroid Scandal and the Credit Crisis

While watching the Mitchell Report today on Bloomberg and seeing many baseball legends discredited forever while major market indices, in the early innings of a credit crunch, quietly rallied from lows after two of the wildest days in the history of markets, I couldn't help but smile at it all. 

The Steroid Scandal went relatively unnoticed in Major League Baseball for some years.  Steroids are taken in eight week on and eight week off cycles and take a few cycles to really kick become noticeable..  As players started to hit more home runs, and get a little bigger many people attributed it to their hard work at the gym.  Then other players started to talk and learned the real reason for success, it began to spread. Superstars who already had advantages now needed an edge, and took got it through steroids.  At first when records started being smashed and statistical averages that tracked the history of the game started to go up, the All Stars of the era, Barry Bonds, Sammy Sosa and Mark McGwire found themselves battling for home run dominance for a few years. Until Sammy Sosa, who came out of nowhere, went from Goliath to David in a few seasons, the idea of performance enhancing drugs went from being discussed in small circles to a major issue.  Then, Jose Canseco came public and started naming names and more skepticism started to form.  Great players who either didn't want to do them for an ethical reasons, pride, or for the eventual health risk they cause lost millions of dollars to those players who did.  This is when things started to unravel. Statistics began to fall, the legends of the last few years ,who were touted as better than anyone at the game of baseball fell from grace, testified before Congress, and today many more followed them in the downward spiral.  Most importantly, years of baseball statistics have been shown to be artificially inflated, lessons have been learned, and credibility has been lost. 

With both Bloomberg and CNBC broadcasting this, traders, bankers, and brokers around Wall Street watched - some reacting with disgust, others with happiness, and others with astonishment that more names weren't on the list. I watched with hope that at least a few people on the Street took some time to look in the mirror.  Isn't Wall Street less than a year into its own Steroid Scandal?  Isn't this performance enhancing credit that has been pumped into the system over the past few years the financial equivalent of steroids? 

Credit in its simplest isn't something that is bad, rather it is healthy for markets.  Companies leveraging their assets to take on risks and hopefully earn returns is essential to a healthy financial market. Leverage is by nature designed to enhance returns.  If I borrow $100 at 5% to invest $200 in a stock that earns me a 10% return I made $10 more than another guy who just used cash.  I also made a much more impressive return on my $100, and look like a more astute investor. Much like steroids, credit has the ability to make an investment or investor better than it really is and as long as you consistently earn returns it can mask many of the risks that exist.  It especially has the ability of making those with talent, assets, or both look like rock stars.

Although it is true that credit enables great returns to be had, along with them comes greater risk.  Just as steroids have enormous excess health risks that may go unnoticed at first but develop after more and more cycles, credit has long term excess financial risks that grows with more and more cycles.  Both are also susceptible to sudden large losses - with steroids its the risk of your dignity or worse your health or life, and with credit is is risk of sudden financial ruin - insolvency.  Just as reputation, legal, and health risks due to steroids can be postponed with the help of a lawyer or doctor, financial risks due to can be postponed with the access to more credit - in the form of refinancing, restructuring, Fed intervention, or taxpayer-funded bailouts.  While most people agree that this illusion of relative safety causes excessive use, with steroids they seem to generally accept the fact that this causes more inevitable damage down the line with steroids and abhor the use altogether, and with credit they accept the complete opposite.  The reason for this of course isn't that steroids are illegal and credit is not (although many of the recent forms of it should be), but that we all have used too much credit and do not want to face the truth that we must someday experience the risk. If were were all steroid-fueled MLB superstars we wouldn't have seen this report today What if you are a superstar in a credit-fueled global economy?

At this point in time, it is 2005 and we are all Jose Canseco.  We are acknowledging the fact that excess credit is in the system and inferring that it is a problem, but severely underplaying the risk in a sad act of denial. In his autobiography, where he first brought the issue to the forefront by name-dropping alleged steroids users, he plays down the risk of the drug:

"As a result, baseball and other sports will be more exciting and more entertaining. Human life will be improved, too. We will live longer and better. And maybe we'll love longer and better, too."

"If you start young enough, when you are in your twenties, thirties and forties, and use steroids properly, you can probably slow the aging process by fifteen or 20 years."

Does this not sound eerily familiar to "adjustable rate mortgages if used properly can be beneficial for those who wish to own homes."  Or, "people remaining in their homes benefits us all"?

Other interesting parallels that I found:

• Is the undetectable Human Growth Hormone (HGH) the same thing as a Structured Investment Vehicle (SIV).
• Will Goldman Sachs, Blackstone, many Hedge Fund Managers, and the asshole on your block with the Lamborghini be the Credit Crisis's equivalent of Barry Bonds, Mark McGwire, the 2000 Yankees, and Sammy Sosa?
• Isn't it fascinating that Wall Street was glued to the TV today during one of the most volatile markets in history to watch this report - which has no effect on the market whatsoever?
  
• Is the decline in baseball's popularity around the country during the last 10 years symbolic of the decline of the United State's popularity around the world for the past 5 years?
• It is argued that steroids set a bad example for the youth, and I would agree.  What example does excessive credit set for the youth?
• Isn't it interesting that one of the main things to happen to baseball during the Steroid Scandal was the emergence and gradual dominance of baseball players from Latin America and Asia?  Is the recent emerging markets dominance in the global economy the past few years?
• Isn't the S&P 500 just a statistic?  How inflated is it from the performance enhancing credit and will the market follow the trend that home runs has over the past few seasons?
• Will the chart of the major stock markets have an asterisk next to this time period it in the future?

Most importantly, for years steroids had the effect of making the rich richer and the poor poorer.  The superstars became unstoppable legends and grabbed a lion's share of the overall profits. To those with a certain level of talent, steroids were a great thing. On the other side the good players who didn't use them were punished and the average players took too much of the health risk and never were really rewarded because they did not have enough talent.  As the public began to turn the game off, baseball moved to other emerging markets and signed players to help expand its revenue base.  Players trying to work their way up in the minor leagues found the low probability of success to now be much lower. Likewise, excessive credit has been no different. It has caused inflation and those with the financial equivalent of talent - assets have been able to benefit tremendously.  Those who did not have many assets have faltered.  The successful have been praised as genius and the youth has idolized those who made money by no other reason than just having it, or being leveraged up to their eyeballs.  Additionally, Finance is as much "America's Pastime" as baseball, and it, like baseball, has been moving overseas to emerging markets as real economic growth domestically has faltered. 

A few years from now while watching a ball game will we be interrupted with another list - this time listing all those companies and investors who suddenly went bust due to a massive margin call named deflation? Although it would be ironic at the very least, I doubt it will ever happen because in our financial system, unlike in Major League Baseball, the biggest users are also the regulators.

Some thoughts on the Fed's two day bender (aka "Mr. Bernanke's Wild Ride"

The last few days will no doubt be included in the Fed's perverted little scrapbook and many investors as well as the wild roller coaster ride saw the market basically cover nearly as much ground as it has moved since the beginning of the year, but essentially remain unchanged.  As I watched the market bounce around like a maniac on a pogo stick, some thoughts and questions came to mind, that I figured I would share.

• Immediately, when today's Term Auction Facility was announced I thought, "Why wasn't this announced yesterday?"
• Extending the the puzzlement above, I wonder if anyone was privy to this information, allowing for a VERY profitable two days of trading - much more profitable than the futures/spot "reporting error" that occured back in February.
  
• Many people believe this was a response to the  market's reaction to the disappointing 25bp, but somehow I don't think Bernanke recieved a ton of angry phone calls from Wall Street, Hank, and Dubya, and said "Don't worry, I'll whip something up by tomorrow morning"
• Rather I think this was the equivalent of a fire extinguisher they developed, put behind glass with a sign saying, "In Case of Emergency, Print Money" and in this case they were forced to use it. 
• Didn't a Fed cronie hint that the Fed was toying with an idea of using an alternate method of providing liquidity to the markets and would discuss it at its December meeting? (Can't find any links to articles but feel free to share. 
• Is its action today just a way in which the Fed will try to make its 100bps of rate cuts a reality.  Since its old tricks have failed to be effective
• Does anyone find an issue with the fact that this process is completely opaque, subject to expansion, and could further add moral hazard to the system?
• Is this essentially telling companies such as Citi and Bear Stearns if you need money don't go to Abu Dhabi or China - "If you need money then you come to me!" and doesn't think create an image of Pauly from Goodfellas in your head.
• Does this have anything to do with the fact that the SIV bailout plan is falling apart?
• Does the collusion with other countries show just how weak the dollar is (along with our credibility).  We have moved from telling other nations "It's our currency but your problem" to "them now telling us, "There is a real problem with your currency. 
• Does this $40 billion injection enable Wall Street to pay year end bonuses, and is it really politically wise under these conditions to pay a bonus this year.
• Is this why they all downgraded each other today - so as not to be seen as benefiting from such greed?
• How odd was the Citi CEO press release two minutes before the Fed?
• Did the structure of this announcement allow dollar holders abroad to sell dollars into yesterday's rally, before today's announcement put the greenback back in its place?
• Who or what sold off furiously around 3 pm today, as the major indices dropped 50 bps in a few minutes?
• Is this Term Auction Facility the equivalent of issuing the major banks and brokers a Federal Reserve equivalent of the American Express Black Card?
• How many more bailouts can be rolled out before people really start to get pissed off and turn off "Dancing with Stars" to scrutinize all these undertakings?

Risk Perversion Revisited and the Idea of Inflation Risk Arbitrage

Today, while perusing a favorite site of mine, Minyanville, I came across a great op-ed piece that touches on an idea of risk perversion that I very very poorly examined a few months back (I just reread it and stared blankly at the screen).  A few months older and maybe wiser, this article helped me better drill down on the ideas in my head and I would like to comment on and add to his analysis. 

The op-ed piece is basically an assault on the recent government bailouts and moral hazard surrounding fiscal and monetary involvement in the markets.  He writes,

As a result of my values and life experiences, I chose conservative personal finances. Due to my preference for security and prudence, I forgo the opportunity for larger gains and windfalls in exchange for the lower risk and security. It used to be that I could live with this trade-off. However, the last decade (and last few years in particular) have made this choice increasingly difficult. Not only have risky investments been deliberately supported by government policy, but less risky paths have been infected by overspill from the risk-taking activities; worse yet, my very own government is treating me as a sucker. I mean openly, which is kind of new.

This gets at the heart of the idea of risk perversion - a phenomena where investors accept misunderstood view of risk which spreads throughout the market and through processes such as reflexivity becomes dogma.  A great example of this is "home prices always go up".  This slowly infiltrated the real estate market over the past few decades and caused many of would-be renters to leverage themselves beyond their means and rationality in order to invest in an asset that they thought was risk free.  In doing so, the massive shift of renters to buyers caused this assertion of risk to appear to be correct by many statistical measures over extended time periods - up until recently. 

Extending this to the Modern Portfolio Theory definition of risk budgeting between the risk-free and the the risky asset leads to more interesting conclusions.  The risk-free asset, usually defined by a Treasury Bill, is supposed to be, well free of investment risk.  Since fixed income investment risk is made up primarily of purchasing power (inflation) risk, default risk, interest rate risk, and liquidity risk.  Since T-Bills are highly liquid, usually held to maturity, and virtually default-free, this leaves us with only inflation risk.  Inflation risk is a very sneaky risk, because it is not usually evaluated post-facto.  Although CPI measures can be subtracted to get a real rate of return.  An investor who invests $950 and receives $1000 a year later usually doesn't factor in the fact that his $1000 can only now buy $980 worth of goods and services, mainly because  that is not what it is used for as the investment proceeds are reinvested and 2% inflation over one year is hardly noticeable.  Although this should be and usually is considered before such an investment is made, it is usually not evaluated directly afterwards.  It is usually years later, when inflation begins to compound that these effects are realized and evaluated.  Additionally, under a normal yield curve environment, inflation should gradually push yields up therefore compensating the investor for inflation as he/she reinvests.  Should inflation risk get out of control, risk-averse investors soon find themselves taking on no risk and taking a loss to do so - which is not a characteristics of a healthy economy and capital market.

The slutty stepdaughter of Modern Portfolio Theory is the Capital Asset Pricing Model (CAPM), which has been used and sometimes abused by almost everyone in Finance over the past quarter century.  When choosing to diversify between the risk-free and risky asset, this formula gives an expected rate of return for an individual investment:

Expected Rate of Return = Risk Free Rate + Beta*(Expected Market Return - Risk Free Rate)

E(r) = R(f) + B*[R(m) - R(f)]

Let's assume that this risky asset is the S&P 500 SPDR (SPY), with a Beta of 1 the equation quickly reduces to what we would expect.   

E(r) = R(m)

I mentioned earlier that under NORMAL conditions inflation risk on the risk-free-rate of return is not really evaluated, however a inverted yield curve and inflationary period where year over year inflation (as measured by CPI and PCE) has increased more than the risk free rate.  The chart using CPI shows this to be a very recent and rare phenomena - occurring post-bubble from 2002 to mid 2005

and using PCE as inflation benchmark....

Well what does this all mean?

First, the obvious observation is that for a substantial period of time, the real risk free rate of return was actually negative.  During this time period, the risky asset dramatically outperformed the risk-free asset as the market roared back from the post bubble collapse. This is important because a large pool of investors allocated to the risk-free asset experienced a relatively substantial negative real return over an extended time period.  Up until 2003, any time that this phenomena existed or got close to existing it was immediately corrected. As the always appropriate George Dub once said, "Fool me once shame on me.  Fool me twice shame on you." I add, "Fool me three times and I'm a fool."

Next we should look at how this all factors in to the CAPM model, substituting the risk free rate, with the factoring inflation into the expected market return and risk free rate

R(e) = R(f) - i+ B*[R(m) - i - R(f) + i] = R(f) - i + B*[R(m) - R(f)] = R(e) - i

Therefore as expected we can conclude that by adjusting the various input returns for inflation we get an expected return that is adjusted for inflation. 

So, then we can conclude based on CAPM, adding inflation into the calculation does not fundamentally change anything, however the fact that the risk free rate of return is negative will affect how one allocates between the two portfolios. 

A fundamental concept of CAPM is that an investor should be compensated based upon the time value of money and risk.  The time value of money is represented by the first half of the expression, R(f), whereas risk is represented by the second half, B*[R(m) - R(f)].  If the real risk free rate is negative, the investor is not compensated for the time value of money, but rather PENALIZED for it, since he is not taking any risk.  Therefore the rational investor will not allocate towards it unless of course he is being compensated even less for risk. 

Whereas the time value portion of the equation is very straightforward and can be almost perfectly analyzed ante-facto, the risk portion is very difficult to analyze before investing.  Forecasts must be made based for market return and assumptions for beta. 

If an investor assumes that at the very least, he will be compensated more for allocating towards the risky portfolio and should be compensated at least at level equal to inflation risk for investing in the risky portfolio, thus substituting inflation, i, for R(m), the the second half of the equation changes to

-B*(R(fr)), where R(fr) is the real risk free rate

Then the new equation can be constructed where

R(e) = R(fr) - B*R(fr)

In a situation where the real risk free rate is negative, the equation is always maximized when the investor allocates away from the risk-free portfolio.  Only when inflation expectations turn positive will an investor in this situation ever allocate different.

Another important feature of all of this is that if real risk free rates are negative both market risk as well as any types business or financial risks of the risky portfolio that are added to expected market returns above inflation are irrelevant.  In any case he will choose the risky portfolio, if he believes both the risk free rate will remain negative and that risky returns will at least equal inflation. 

Thus, the perversion of risk.  Facing a negative return on the risk free asset, the investor is FORCED to either take a loss or take risk - sometimes much more than he or she would like or will get paid for.  Although inflation risk is the same for both portfolios, it becomes much more "rational" to risk loss to make a gain then to accept loss with almost 100% certainty, thus inflation risk is proportionally much higher in the risk free portfolio than in the risky portfolio although it is the same in magnitude in both.  In its crudest form, this may be  the framework that has perpetuated much of the madness that many of us have griped about for a few years now.  The relative risk free asset has been the one that doesn't take your money but gives you a shot at making money by taking risk - if that does not make sense then you are not alone.

The fact that investors would only need inflation to pass through earnings is what created a risk free asset from a risky asset.  Although this has not happened throughout history, I hypothesize that a debt infused economic boom devoid of real wage growth and characterized by rampant consumption and the outsourcing of fixed labor costs would almost exclusively be inflationary and any earnings growth should be equal to inflation plus any operating gains or losses.  If the credit fueled demand caused the price of Good A to increase almost 10% in the store and globalization and other factors only caused costs to increase 2%, the company selling widgets should grow its earnings by about 8% - add financial leverage to the situation and these earnings increase even more - offsetting any input cost inflation.

Essentially, this phenomena spawned what appeared to be a very profitable trade for many who picked up  it.  Inflation risk was priced differently in two very liquid markets.  In the risk-free market taking on inflation risk generated a negative expected return, whereas in the risky market it generated an expected return that greater and presumably could be magnified proportional to market risk as well other underlying investment risk.  Therefore the "astute investor" - and I use that term loosely - thought that they were simultaneously buying and selling inflation risk and capturing the spread - let's call it inflation risk arbitrage.   Obviously this thought process wasn't so technical, but has simplified by many notable investors and journalists who recommend that equities are the only way or easiest way to keep up with inflation and nurtured by famous investors such as Joel Siegel, who claimed that over time stocks offer greater return for much less risk.  The fact that many years passed where "safe" investors started to realize that they were losing money helped perpetuate such a trade and change the entire market's outlook on risk. 

The reality of the situation is that the risk profiles have not changed.  Inflation masked business risk and financial risk for risky investments as the special, global, credit driven, [insert whatever you want here] inflationary environment enabled companies to increase profit margins enough that any volatility in earnings, sales, or poor capital investment, went relatively unnoticed - which feeds into the idea that liquidity and volatility are polar opposites.  As liquidity dried up, many investors in financial and consumer discretionary stocks were introduced to business and financial risk that they unknowingly or perhaps were "forced" to take on.  This wiped away a few years inflation gains in only a few months.  The fact that bailouts are now punishing those who did not realize this even complicates the situation further. 

The probability distribution that describes business risk has a much higher kurtosis than that which describes inflation risk (bigger more infrequent observations).  This enabled the risk it to lurk underneath unnoticed and unseen and create what seemed to be a risk free arbitrage. When receiving a fixed payment inflation risk is easily approached ante-facto and managed.  When expecting to sell sometime in the future at a higher price, inflation risk is more or less embraced and hoped for.  Investors who thought they were capturing some sort of spread (whether they outwardly realized it in such technical terms or not) hoped to end up on the bright side of an inflation trade.  It wasn't until they got burned that they found out what they were really capturing was extra risk premium that was defined by infrequent and large (or severe) observations.  This trade was able to carry on for quite some time as many conservative investors after one or two years of investing in T-Bills, woke up to the fact that they were losing money and prices going up everywhere. 

To finish up touching upon the op-ed piece, the moral hazard of all these bailouts is not only that it encourages wild risks to be taken, but also does not allow for the pain and reflection that is associated with a loss and for the real reasons for that loss to be explored.  Loose monetary and fiscal policy and too much credit in the system enabled a dangerous situation where risk-averse investors lost money to take no extra risk rather than lend money to earn a return.  Poor oversight and suspect conflicts of interest enabled this to spiral into many years of perceived risk perversion and a damaged market psyche.

The ABX Indices and the Banks/Brokers

All over the blogosphere, the ABX indices have been making there way around again.  The first time I saw them posted was on The Big Picture in July.  More recently, Calculated Risk has done a great job on covering the fall from "grace".  These have acted as a very good and very profitable leading indicator on the stock market so far, as big downturns have usually taken a few days to infiltrate the S&P's. 

Today, while checking on my favorite market tells, the banks and the brokers, I found myself looking at a chart of the perennial subprime punching bag, Countrywide Financial, not to be confused with Country Time Lemonade (although CFC is quickly approaching the price of a nice 16oz bottle of that stuff).  Like my boy Pythagoras a few years back, I immediately uttered, "Eureka".  This chart looked familiar.  I had just seen it a night before, when browsing the ABX indexes.  In fact, the chart of CFC looked eerily identical to that of the BBB rated ABX index - the most subprime of them all (if that is at all possible).  Enough talk, look below,

and....

Please note that this chart looks almost the same as the A-rated vintage from this year. 

Ok, I will be the first one to be skeptical.  That being said, I decided to look at a bank who came out with earnings this week and has been said by some to be Countrywide Deuce - WaMu.  Chart looks much like the 06 vintage.  See below,

Ok, we all know they own subprime assets.  But what about the bigger banks and brokers?  They supposedly own better rated garbage.  Let's look at someone who reported (aka sh*t the bed)  today, Wachovia.

This chart is a little better looking than the previous two and covers a different time horizon (only because the ABX index that it mirrors has the same time horizon).  So, let's find out what they own.  Below is a AA-rated series from this year.

Ah, yes, this looks familiar.  Note from April to present, the A rated 06 vintage also seems to tell the Wackyovy-a quite well.

Last up to bat, the broker who "bet against subprime", Goldman "Look at our Enormous" Sachs.  Below is a chart of their stock performance since April. 

And, the AAA-rated vintage from 2006. 

Bet against it?  Probably more like - had the nicest garbage on the block, and took it out to the curb a little earlier than most. 

Now, this could all be data-mining, but most big banks and brokers can be matched up to these or other indexes just as cleanly.  Although the constituents of each index are spread around the big banks according to credit rating, the deviations may be simply be who was able to either underwrite better, hide better, or trade better. 

I am from the camp who believes that the banks are pretty much screwed.  With the savings rate as low as it is, and a good amount of the actual cash in the banks in direct deposits which get spent over the course of two weeks just to be replaced again, these banks are primarily sitting on loans as assets - some loans worse than others.  This may be why they are trading like the asset backed indexes they helped build.  They may not be much more than that.