Wednesday, February 25, 2009

Oh Sh*t...Even Index Arb Isn't Safe

When it rains, it pours so it is said. And indeed it does according to Kaminsky's 2004 paper on the relationship(s) between capital flows, macro policies and the business cycle. It also duly applied in 2002 when dozens of double-digit billion corporations 'fessed up to various forms of malfeasance from diddling and manufacturing bogus research, looting the kitty by backdating options, re-striking awards at lows and so forth, to the outright fraud on a scale that would have made te likes of Alan Bond and Juergen Schneider blush.

And while the scale of AIG (it WAS a fraud!!), Madoff, and more recently Stanford Fincl might have sent even adventursome investors running for the safety of the Index Arbitrage bunkers, today, we are told by Reuters that even Index Arbitrage offers offers no comfort, with the arrest of Walsh & Greenwood for nothing less than getting caught with their snouts in their clients cookie jar, much like Pooh Bear's head was stuck in the honey pot.

The pair are accused of nothing less than "appropriating" client funds for personal use. More than 80% of assets it is believed. Undoubtedly, few will have heard of WG Trading, but like Madoff they've been around for decades, had a fine reputation believed to be running a respectable Index Arb shop. It seems however, they were buying racehorses, paying alimony, funding the remodeling at Le Cirque, buying big digs in fashionable neighborhoods, hot wheels, and everything else a Would-be Wall Street Entrepreneurial Titan should be seen to be spending it on. We know not if either had a Net-Jets fractional, or a lease on a jet-powered titanium tube with wings of their own.

Now, like Madoff, there perhaps should have been some red flags and by way of disclosure, I have no inside information or special knowledge of WG. But it is common knowledge that no one has made money out of index arb in the USA since the 1980s. Certainly not enough - after management fees to fund a Larchmont-lockjaw lifestyle of thoroughbreds, polo, and rare Aston-Martins. Index arb was a means of getting cheap stock loan inventory, having inventory (before the downtick rule) to sell long when it was in spirit, a short-sale, and having a position to to use at expiration to manipulate prices for associated option trades as necessary. It has been, in short, a dealer business since anyone who was not doing all three (like most of the broker-dealers in might now be termed "The Glory Years") wouldn't get a proverbial word in edgewise since those that had the natural axe would inevitably be better offered on the way in, and better bid on the way out. And like Madoff, when the tide went out, it became impossible to answer the questions regarding the ability to competitively fund positions as a non-bank, non-deposit-taking, non-prime-brokering institution in an era of balance-sheet reduction. Or perhaps they just burned the balance of their clients money, quite literally, on hay.

And so due-diligence just got a whole lot harder - both for investors and managers. Now, Mr Hedge Fund Manager, Mr Investor (or Mr Kroll on his behalf) will be poking around in YOUR rubbish bins. Like the French Fisc, they will be evaluating your lifestyle and working backwards to see whether or not YOUR income is commensurate with your returns. NOW, Mr Investor will want to see the audited accounts of not just the Fund, but the investment Management company. And there will be no excuse (except the embarrassment of riches) to deny such access. Mr Investor will want to know - in fact will need to know - about messy divorces and spiteful wives from hell. Yes, life in the future will be whole lot different after this one...

What Price For Market Liquidity?!?!?

What is the price for equity market liquidity in size? Anyone who has any doubts about what the precise number should or might beat present need only look at Phil Falcone's (Harbinger) sale of it's Fortescue (hey John H, read this!) stake to China's Hunan & Valin Iron & Steel group at 20% BELOW the so-called market, according to a Bloomberg news report.. And Fortescue is reasonably liquid, but apparently not liquid enough.

When I see such a tangible tell-tale of market-structure reality (typically the result of filings), I think of several topics that the thoughtful practitioners should ruminate upon:

(1) What is the meaning of this for the accrual and payment of performance fees upon "Last Market-to-Market" valuations? Seems Mr Falcone pocketed 20% of all the market impact on the way up.

(2) What does this say about the true value of certain activists true portfolio liquidation value, particularly those like Warren Lichtenstein's Steel Partners Japan Fund where the positions are equally large if not larger, but the turnover but a fraction of that in something like FMG.

(3) Audits should almost certainly carry serious caveat warnings about liquidity-adjusted valuations. I've raised this with senior audit partners at financial practices before and they've looked at me like I was the Devil incarnate. Yet their opinions are qualified regarding hundreds of minute details, yet it disregards perhaps the most important: mark-to-market is fallacy where positions are large and liquidity constrained.

(4) IF disposing of a 10% position requires a 20% discount, then imagine the intentional market-impact one can generate on the way in (both on long and short positions) which again is the cornerstone of incentive fees, and should highlight for allocators and investors the large potential for abuse, and near-certainty that before this is over, ALL peformance fees will be paid on a new industry standard of some kind of rolling three or five year window.

(5) Systemically, this is instructive on the essential need to avoid liquidation. Not avoid longer-term deleveraging, but wholesale point-in-time Mellon-like liquidation. Imagine for a moment that "failing banks" (currently insolvent, or near-insolvent) are liquidated, and the extreme market impacts of their sales upon asset prices will of course force others into insolvency merely exacerbating the situation. Th LTCM managed unwind is a reasonable model here. Warehouse the risk, unwind it orderly in due time. For forcing systemic liquidation does not equate to market efficiency. Price discovery in illiquid markets is likely to result in overshoot, and exacerbate systemic difficulties. This doesn't mean that said asset prices warehoused are over, or undervalued, but that selling position to make position is merely systemically sub-optimal with real negative cascade impacts upon employment and output.

Saturday, February 21, 2009

Frankly Mr Shankly...

How did I miss this?!!? It was outside my realm of consciousness...until Thursday. But it's fabulous - both musically and lyrically, and it's been ricocheting non-stop off what few neurons I've left since Thursday eve. I know the song is quite to parochial to Morrissey, but I can't help feel there is a some greater macro relevance within. Perhaps it is the derisory view of dishonesty. Perhaps it's the Faustian bargain. Perhaps it's the suspicion that our Mr Shanklies are writing piss-poor poetry too. Perhaps it's the scathing coda...

Tuesday, February 17, 2009

An Excellent Read...

Silence due to travel, family business and obligations, all have taken precedence. Lots to say, just no time to say it, as the ratio of drafts to posts continues to increase uncomfortably.

Yet, amidst the decided market gloom, extreme pessimism of real economy data points, to the ultra-tail of pessimism (note: don't read this if you can't handle it), former bank analyst, John Hempton has prepared a fine and measured multi-dimensional analysis of systemic solvency in Bank Solvency and The Geithner Plan that is a must-read. It is not that it is optimistic. It isn't. But in comparison to tin-foil hat brigade's offerings, it is a welcome bit of sobriety. I am not alone in thinking this, as Dr James Hamilton at Econobrowser used Mr Hempton's post as a basis to Meditate on The Prospects for the US Banking System. It is, in any event, a welcome change from contemplations of a return to a neolithic existence, a Mad-Max or Blade-runner-esque future imminently awaiting us. So enjoy, and if you;ve comments, do please post them directly to the original post at Bronte Capita, or the link at Econobrowser where they'll be in better company and receive due review. In the meantime, I'll return to my Campari & Soda and the arcane study of French Property Law.

Monday, February 09, 2009

Pundit Rage

There is always a bull market somewhere so goes the old saw. Despite the sorry state of markets far and wide, and even sorrier state of the real economy that is lagging the former, a week of traveling, planes, trains, and hotels with attendant over-indulgence in popular newspapers, television and radio has revealed the latest rip-roaring and snorting bull-market: simple-minded interviewers wheeling out pedestrian interviewees from any remotely-related tangential financial discipline - most with paltry knowledge and understanding of the current economic crisis, economic history, and financial markets but all who are recriminating, pontificating, moralizing, wagging fingers, o denying and defending in a blind-leading-the-blind retributional media-equivalent of road-rage. If ever there were a moment to turn off the sound on the stupid-box, change the radio station to the local university's 24-hour indie music station, use the newsprint (FT excepted) for kindling or bog-roll (a Daily Mail recession-fighting tip?!?), limit one's consumption to the coterie of fine balanced and thoughtful blogs, or just read a book, preferably one written more than a hundred years ago, now is precisely the moment to do so. And like most bull-markets, this one too will eventually fall-in on itself out of internal fatigue, or perhaps more, optimistically through a mass-epiphany by their consumers that such simplified uninformed demagogic treatment is one of the reasons why we are here in the first place.

(inset pinched from an old Big Picture borrowing of the original screen shot)

Thursday, February 05, 2009

"Camille's Reclining" Declining

Contrary to momentum investor hopes, buying high, or recent highs, can be perilous to your financial well-being for a very very long time, in nominal terms but more acutely in real and relative terms. Such an emblematic example was reported in Bloomberg yesterday:
Feb. 4 (Bloomberg) -- A Claude Monet painting of his wife Camille reclining in a flower-strewn meadow sold tonight at Christie’s International in London for 11.2 million pounds ($16.2 million) with fees.

It was bought by a Paris-based representative of Christie’s, taking instructions over the telephone.

The 2-foot 8-inch wide canvas, dating from 1876, had been estimated by the auction house to fetch 15 million pounds, making it the most valuable estimated work offered in London’s February series of Impressionist and modern art sales. Its final price was less than a bronze version of Degas’s best-known “Little Dancer” sculpture that sold yesterday at Sotheby’s for 13.3 million pounds.

The Monet’s price history reflects historical demand from art collectors. It had last appeared on the auction market in November 1999 at Sotheby’s New York, where it sold for $15.4 million.

In June 1988, at the height of the last art market boom, the painting sold for 14.3 million pounds with fees at Sotheby’s in London.
Twenty years, and nominally one hasn't made a penny!! And the real-term returns would undoubtedly be more negative than -50%, an astronomical difference between even something pedestrian like T-bills. Of course one presumably has had the privilege of Camille Monet's two-dimensional company for the duration which may be some consolation to those prefering Monet to say, Leroy Neimann. Van Gogh's "Dr Gachet" (see post) hardly fared better only coming back into the money 18 years after Daishowa's Saito rang the bell, and then only briefly, for today, Ken Griffin is no longer "bid", and impressionists, while still eye-wateringly expensive for mere mortals, are clearly no longer be the store of value in real terms previously believed.

So yes, price matters. Homes bought in hot markets this decade, tech stocks, EM bonds and stocks bought mid-decade, US Bonds and perhaps Gold bought now, are also reasonable candidates to suffer Dr Gachet's curse.

Monday, February 02, 2009

Simon Cowell is a D*ck

Simon Cowell is a d*ck. I don't think there is a more pleasant or articulate word to describe him, without referring to or repeating this base American expression. Maybe I haven't expended enough energy upon the task. Maybe Joyce, had he been alive, also would have arrived at the same place in the dictionary. Gore Vidal might do better, but it is his job, and he's paid for such eloquence.

That said, I actually like Simon Cowell. I admire his perception of, and focus upon, the clear and present reality of his "contest". He refreshingly cuts to the metaphorical chase. He is cringe-ingly honest. Cruel, yes indeed, but honest. And rarely wrong in his area of expertise, though needless to say I would hesitate to consult him on issues relating to good-banks and bad-banks, or the relative virtues of The Taylor Rule. Daresay I am no expert on things Idol (or X-Factor for those on the receiving end of Jim Rogers latest abuse). But, I will admit (somewhat ashamedly), that I have paused during occasional channel surfing sojourns, and watched his spectacle with a rubbernecker's combination of morbid fascination, bewilderment and bemusement.

While I suspect there is something unsavourily dishonest about the antics of some of the contestants who willingly submit themselves to the inevitable ridicule and abuse, beyond the strange desire for a few moments of celebrity, there appears to be (if my bullshit detectors are in order) a far greater number of contestants who are genuinely confused, surprised, not to mention seemingly devastated by the reception they receive from those on the far side of the judge's table. These people genuinely seem NOT to understand that their perception of reality (often longly and dearly held) is, and has been, continents apart from, not just the cruel, critical, honest eyes of the panel, but of - and I hesitate before invoking the phrase - the world of objective reality. Perhaps as a result of overly-sympathetic and/or sensitive friends and family, an overly-supportive "everyone's a winner" culture, or their own denial, they are, in a single word, clueless.

And as I am watch yet another now-teary-eyed hopeful [if not rightfully then accurately] crucified by Mr Cowell, I cannot help myself from making the comparison to American's similar bewilderment over the causes of the current crisis, and economic state which they collectively find themselves. They too, don't have clue and quite genuinely seem not to understand what has happened, what they did wrong, what got them here, or there, as if the words "reflection" or "introspection" were entirely foreign from the English language on these shores of the Atlantic. This reveals itself in the pronouncements from lawmakers, interviews with ordinary people, selective lynchings by the media without the wholesale indictment of the hand that feeds them.

Yet sober-minded people DO exist in America. It was thirty years ago that Jimmy Carter donned a cardigan and spoke of malaise, it's causes, and proposed solutions, (thrift, parsimony, hard-work, sustainability, quality vs. quantity, replacing the emptiness of consumption with more spiritual things, faith, morality, optimism). Little of said redemption recipe was heeded despite the inherent correctness of his advice. And for twenty-five subsequent years to the present, rather than seeing the wisdom in his words, America as seen them as sanctimonious choosing instead the absurdity of renting the public interest for parochial gain, worse-than-neglectful energy policy, managed healthcare, unrelenting geographic sprawl, the dismissal of pricing negative externalities, rights without responsibilities, self-regulation, ballooning expansion of credit without any reasonable tether to sustainability, billions in bonuses coincidental to negative-billions at the bottom of the income statement, sub-prime lending, LBOs, SIVs, ZIRP, internet bubbles, housing bubbles, commodity bubbles, government bond bubbles, persistent half-trillion-a-year current account deficits, lending to a borrower to withdraw equity leaving a wafer-thin margin upon an illiquid depreciating asset that recently doubled or tripled, the packaging of non-recourse under- or un-secured loans-to-already-indebted people without a Plan-B and calling them 'AAA', leaving the lights on everywhere when no one is around, electing a President (twice!) whose unashamed objective was to terrorize the Public Interest, or building low quality 2x4 wooden homes in hurricane alley on a floodplain is almost beyond comprehension. And undoubtedly one could add their own litany of petty tyrants that offend any semblance of prudential decency or common-sense. And while this is going on, lawmakers and The People occupied themselves with steroid use in professional sports, how to insure prophylactics and birth-control pills receive second billing to abstinence, the un-sanctity of gay marriage, 10 things not to do with a cigar, amongst others trivial pursuits.

But now, America has finished performing. Now, Simon Cowell-The-market has harshly declared judgment. It isn't kind. It isn't nice. It stings and hurts. But it is truthful and honest and correct. Yet it remains almost unfathomable that they still cannot see its own culpability, despite it cutting wide and deep into each and every crevice of the Polity - in media, in government, in individuals, in academia. There's anger. There's disbelief. Dreams have been shattered. The tears are coming. But please, don't beg. Don't cry. Stoically face up to it. Affirm culpability. Introspect. Deal with reality. And most importantly, learn from your mistakes...