Tuesday, August 31, 2010

Another One Bites The Dust

Things formerly with integrity now seemingly compromised...

Professional Cricket
Professional Cycling
High-Frequency Trading
Professional Baseball
Professional Tennis
Municipal Bond Underwriting
The Catholic Church 
US Congress
UK Parliament
Analyst Research
Credit Ratings
Newtonian Physics
The Stock Market
The Food Pyramid
Incentive Stock Options
Reinsurance Brokerage 
Lou Dobbs
The Mortgage-Backed Securities Market
Hedge Funds
Social Security
Government Balance Sheets

Errr ummm Professional Wrestling is starting to look good by comparison - at least it makes no pretensions to be anything other than it is.

Saturday, August 28, 2010

Pop-Quiz: Terms of Trade

Terminology is important but often abused. Some employ it to obfuscate the truth. Others to legitimize something that oughtn't be. I doubt this Pop Quiz will ever be given to MBA students but I reckon it's worthy of a go....

Instructions: Choose the Word, Phrase or Answer that best describes its preceding passage:

1. It's nearing the end of the fiscal quarter. The CFO is concerned that leverage ratios are too high. You've located  some friendly (reasonably-rated) counterparties who've more cash than investment opportunities and who are happy to take the other side of temporary financing trades that will reduce ratios to levels that won;t offend analysts, provided you guarantee the counterparty they will make their spread and not lose money.  This is termed: 

(a) Balance Sheet Reporting Optimization
(b) Window-dressing 
(c) Lipstick on a Pig
(d) Repo 105 (tnx WT!)
(f)  Rather Illegal
(g) Bigger (unearned) Bonuses All-Around (Again)
(h) All the above

2. You are the senior manager of an Equity Trading desk at a large Investment Banking  firm. Amongst your activities, you act as agency broker for customer flow, employing some algorithms that fill customer agency orders at the prevailing best bid or best offer. In addition, your high-frequency trading desk, using it's co-located servers, market-maker status and memberships on multiple-venues and dark-pools, has tools that allow your desk (with a very high-degree of certitude) to execute inside  the spread. Many of your customers give you discretion (assuming execution risk) yet, you always fill customer orders at the prevailing best-bid or offer - always keeping the spread achieved on internalization of orders for The House . This is termed:

(a) Advanced Customer Facilitation Algorithms
(b) A conflict of interest
(c) Great business  (if you can get it)!!
(d) Stealing and Questionably ethical 
(e) The funder of your coveted house in the Hamptons
(f)  Within the letter of the law but not the spirit
(g) All of the Above

3. You started an FX bucket shop that offers an electronic trading platform and extremely high leverage to retail clients. The platform gives the impression you are executing their trades in a a large central and open marketplace.  You use all manner of advertising to entice the punters in.  Initially, of course, you did execute their trades in the marketplace in order to hedge your risk, but you found that the life expectancy of the average small-time retail FX punter to be measured not far beyond nano-seconds, and that they are, en masse, usually wrong.  As a result, you've stopped "hedging" and now more or less take the other side of all their risk, despite little regulation, oversight or capital adequacy. This situation is termed:

(a) Optimal Use of Scarce Risk-Capital Resources
(b) Dead clever
(c) The logical thing to do
(d) "a Bonnie Situation" (*)
(e) Less than ethical
(f) An accident waiting to happen
(g) disingenuous for not adequately disclosing the credit risk of acting as principal
(h) Eponymously...The Sting  
(i) All the above

(*="Bonnie Situation" as seen in Pulp Fiction)

4.  For your investment bank employer, you structured a fantastic deal (meaning your bank made lots of money when it was inked!). While the initiator of the deal was its impetus, you easily found counterparties for the other side of the deal requiring only a smidgeon of truth-stretching, the normal amount of obfuscation and truth-dodging, in addition to the requisite amount of white-lying necessary to get it done. Sadly the deal went raaather pear-shaped for The Bank, the Buyers, The American People, and indeed you - everyone except the initiator (who subsequently became a folk hero, not to mention richer than Croessus).  From your view, it's best termed:

(a) Sacre Bleu!!
(b) An Ethical Wake-up Call 
(c) An erreur of judgement (in use of e-mail and bravado)
(d) A montagne out of a molehill
(e) Being Hung-Out To Dry
(f)  Being The Scapegoat
(g) Poor Disclosure in not Insuring all representations are embedded in the fine print of the fine print of the Prospectus

5. Your company has a quality problem. As a result of - quite literally - the company's good luck, you will make TOO much money this year, and though questionable, you decide that you want to defer a portion of it over the next several years, since you know The Street has an inexplicable preference for "growth and stability" to "feast and famine", irrespective if both leave you in the same financial place. Just as fortunately, as it would happen, one of the richest men in the world can help you do this (for a price, of course) as he is as sweet, as anyone there is, with words as they relate to the letter of the law (not to mention The regulators and Politicians) . This is best termed:

(a) Temporal Income Statement Classification Optimization
(b) Do As I Say, Not As I Do
(c) Conservative Earnings Management
(d) A Public Relations Disaster
(e) Business as Usual
(f)  Criminal Fraud
(g) Finite Reinsurance
(h) All of the Above

6. You lucked-out and that little software widget you wrote has turned into a multi-billion-dollar company.  Your 25% stake in what is ostensibly a wildly-overvalued company is priced by the market at over US$ 300 million - most of which you'd like to "bank" (though, being a skeptic, not literally). One catch: the shares would immediately tank if you sold, so you arrange long-term structured collars, that you can borrow against and which lock-in your sales price within a price corridor. Fortunately you don't have to file anything with the SEC until the derivatives are exercised - likely years into the future. This is termed:

(a) An executive hedging transaction assisting portfolio diversification
(b) A de-facto forward sale
(c) Bona-fide smoke and mirrors sale
(d) A sham trade
(e) One that looks like a sale, smells like a sale, but ABRA-CADABRA!...It isn't!
(f) A regulatory free lunch

7. The private investment management company you founded has done well for investors and ostensibly yourself, and has grown into an international multi-billion dollar business. Clannishly secretive by nature, trying hard to avoid the spotlight , you wish to protect your profile by preventing any public dissemination or discussion of your investment performance by investigating and prosecuting someone responsible for alledged indiscrete violations to so-called privacy entitlements despite the huge number of external investors - many of whom have their own transparency and disclosure necessities. This is termed: 

(a) Enforcing Contractual Rights to Keep Private Information Private
(b) Being a First-Class Bully
(c) Hilarious
(d) Ludicrous 
(e) Pedantic
(f)  Hilarous, ludicrous, and pedantic.
(g) Oh, and Pointless - since any Competitor with the faintest urge to know can easily find out if they want

8. As a lawyer for a major Government regulatory organisation, you investigated and filed charges against a major Investment Bank for market abuse and trading transgressions in which they were, as the saying goes, caught "red-handed". Yet you have negotiated a proposed settlement of the charges for a payment of a large (though not excessively painful) sum of money, but as is customary with such settlements, the accussed will  "neither admit nor deny guilt". This is termed:

(a) Realization of a Positive Expected Return From a Regulatory Gamble
(b) No-Fault Financial Regulation
(c) Spoils of Rent-Seeking
(d) A Travesty of Justice
(e) A Bloody-Good Deal (for them)
(f)  Not Biting the Hand...(That Will Feed You When You Leave the SEC)
(g) All of the above

9. You like Peter Lynch before you, are the manager a now-massive-sized public fund. While you are not bigger than the market, you are often the largest marginal player. You've cultivated a public persona and use your soapbox to influence investor opinion to help shift your positions in sizes that would otherwise be impossible to move without eating all of your incremental return, rather than for the sake of bona-fide improvement in public-policy . This is termed:

(a) Free Publicity & Excellent Public Relations
(b) Talking your book
(c) Do as I Do, Not as I Say
(d) Beware of pseudo-"acquaintances" bearing seeming gifts 
(e) Less-than-ethical
(f)  Caveat Emptor

10. You ran a Hedge Fund (or commercial bank, or investment bank) that racked-up good returns (for a while), and then imploded due to amongst other things: hubris, overconfidence, mis-calculation and mis-extrapolation of equity and credit availability, common credit exposures, stupid and illiquid investments, excessive leverage, and subsequent negative impacts due to the redemption and liquidation cycle . Since the implosion happened when you were at your peak asset base, one can honestly say that you lost more money than you ever made, even if in the unlikely case early investors got their original investments back. Nonethless, despite your investors getting hosed, and remaining side-pocketed, you banked  $100mm - FREE AND CLEAR!!.  This is termed:

Tuesday, August 17, 2010

Anchors Away

Long before the internet bubble, synthetic CDOs, asset-swapping convertibles and high-frequency front-running, the sexy strategy which added numerous zeros to many-a-skeptical portfolio manager's trust fund was the dull but reliable strategy of shorting IPOs. This used to rank near the top of tried and trusty ways to, in a rare pursuit, beat the house. After all, there never was any satisfactory justification for for the 2x to 4x-plus valuation leap between final VC financing rounds and the lipsticked-pig's tarted-up presentation to the public at-large as a listed entity. Of course, we realize, now, from indictments, accusations, kiss-and-tells, e-mail records seized by public prosecutors that even the nutty interlude was for the most part, not Salem-like, ergot-induced mass-delusion, but careful (and admittedly artful) manipulation and orchestration by the underwriting puppeteers - one which assured  (no pun intended)  that the ass of any shorts (besides the underwriter hisself and perhaps a few cronies), was blue, bluer and bluest. Masterful, yes, but not sufficiently discreet to pass my muster. And yes, some, with strong constitutions, deep pockets, low leverage, and locked-in investors, did manage a large when the lightwave phenomena was finally extinguished.

Japan, aside from a precious few small-float growth issues, has remained proverbial fertile ground for new-issue skeptics - right up to today. Take, for instance, the much trumpeted $11bn dollar demutualization listing of century-old Dai-Ichi Life in April of this year. One would be forgiven for confusing chart (above left) with a ship's anchor, so relentlessly has it plummeted. I am certain you can imagine other metaphors (a skydiver, a sugar-cube sinking in a cup of mint-tea, or a twirly-whirly-gig falling from an oak tree). Nonetheless, despite the number of like-behaving IPOs, they (whoever "they" may be, though "they" is likely the people of Japan via their pension fund managers) have, over the years, kept coming back for more. Perhaps the repeated humiliation is as pleasant as playing a familiar video game, or cycling the same course. Unlike other pursuits, familiarity apparently doesn't breed contempt, and so Dai-Ichi was miraculously able to flog a reasonable slug of stock at YEN 170,000, sure in their knowledge of the ire and contempt investors might soon hold them.

So, here we now sit in mid-August - deep in summer lethargy, which is perhaps an apt time to ponder whether or not"they" have been punished enough. Perhaps those who took a flyer on it, have now all flown. And just as the moon has its reliable phases, perhaps the shorts too must soon cover. For those opportunistic folk didn't fund their trust funds holding out for the Rapture...

Thursday, August 12, 2010

Hello Myrna Loy

Nineteen hundred and thirty-five was by most accounts another in a succession of crappy years. The dustbowl on the American plains, enactment of the Nuremberg Laws, a devastating Hurricane that slammed into Florida killing many hundreds though this paled to the devastation of Yangtze Floods that wiped out several hundred-thousands. This year also witnessed Italy's invasion of Ethiopia, as well as Japan's of Manchuria, presaging the horrors to come. Despite these ominous telltales, the march of progress saw rapid advances in many fields though particularly aviation, Jesse Owens setting a dramatic new long-jump record while the young Donald Bradman racked up a double-century in just 191 minutes somewhere in Queensland. More to the poiint of this post, nineteen thirty-five was also the year that the seductive Myrna Loy and handsome Spencer Tracy starred in the thriller "Whipsawed". I bring this to your attention not least since it was (by the NY Times account) a reasonably entertaining film worthy of a diversion on a rainy Sunday morning, but because like the film's eponymous title, Whipsaw has been eclipsed in the last decade by the success of the tribe of trend followers, and the ear-boxing and deprecation of the counter-trend trader.

Such style success has historically been, if not cyclical, then irregular at best. Older practitioners know this, and the more honest do not shy away from it in their marketing pitches, though many have admittedly watered-down its purity in recent years with diversified programmes and time-frames ostensibly to smooth returns for more risk-averse investors. In its purer form, the fat years have indeed been fat but historically fewer and farther between, whereas the lean years, though more numerous as they have been have (at least for the more disciplined) been negative, though of decidedly smaller magnitudes than the positive. The honest argument (stylistically) remains that such modestly positive aggregate returns with admittedly high variability and prolonged periods of drought have high utility due to their unusual lack of traditional asset class correlations during times of stress. Fair enough. And while intellectually I must admit that I remain snobbish about such a seemingly mindless pursuit, I do accept the premise of the arguments and their agnostic point of departure with regards to the underlying and believe there is a role for such in portfolios. A victory perhaps for function over form.

That said, I believe one can state that during the last decade, price trends across markets and asset classes have been reasonably attractive to this pursuit stylistically - perhaps more attractive than historically one might surmise or forecast it ought to have been. Now, of course, each epoch is different. This epoch may indeed be driven by forces that cause prices to maintain long extended trends that bear no relation to the apparent mean-reversion (stylistically-speaking) of the past. This is an argument one might make with fortitude, given the macro state of the world. But, then again, perhaps not. Perhaps not because perhaps stylistically too many moths may have been attracted to the stylistic flame. Perhaps because the volatility of volatility might have increased and (Hello Myrna) the return of episodic whipsaws might be both more numerous and of heretofore not seen magnitudes that, in a word, bugger existing model parameters, and perhaps more importantly to those who've over-specified, bugger the adaptations to emergent regimes.

It might be foolish to forecast with certitude such a future. Nonetheless, I suspect there is a sea-change about, a sea-change worthy of contemplation in the same thought as Myrna and Spencer. There can be no table-pounding in this regard, for it is not proverbial low-hanging fruit. But for the introspective (and Andy Grove paranoid) it is always worth looking around to see who is playing, how they are playing, and in what relative size they are playing. The now-hackneyed "Risk-on, Risk-Off" paradigm being exemplary. For when too many pursue the same, using similar methods, returns inevitably drop, while unexpected shit happens. So look around, observe, and ruminate upon the old saw..."too clever by half".

Monday, August 09, 2010

What Goes Up Might Come Down - Less 20% or So....

Having periodically spit venom at some notorious Japanese activists for pursuing business models that (at least in this observer's opinion) were rather obviously on a collision course to enrich themselves to a far greater extent than their less-fortunate investors, I was pleased to see the recent working paper released last quarter by Hamao, Kutsuna and Matsos entitled "Activist Investing in Japan: The First Ten Years".

The abstract echoing some of my sentiments, and noteworthy of attention for allocators reads:
This paper provides a comprehensive look at the first decade of foreign investor activism in Japan, the second largest stock market in the world with many underperforming and cash-rich firms. Barriers to shareholder activism have historically been high but we document an unprecedented wave of block acquisitions by hedge fund and other investors with a total of 916 stakes reported in the period between 1998 and 2009. There is, on average, a modest positive stock price reaction to the announcement of activist investments, particularly for events involving hostile funds. The long-run returns on activism are low overall, but positive for events involving hostile funds. We find that while activists have forced target firm managers to increase their payouts compared to peer firms, there is no evidence of major operational improvements or restructuring. Finally, after 2006 there was a widespread adoption of "poison pills" by firms, particularly those targeted by activists, and a subsequent drop in investor activism. Our paper illustrates the limits to shareholder activism in a country where the takeover market is thin and cannot be used by the activist investor as an exit strategy.

My vilification has NOT been of the seeming opportunity, nor of the potential benefits to shareholders (and society) of energizing possibly moribund managements, but rather the Activists apparently cynical disregard of their own shareholders by using the weight of new money (or available leverage) to goose prices of existing positions well-beyond the levels of a reasonable exit to either a trade-buyer or private equity buyer, or even levels that make sense for management to buyback shares, presumably for the sole purpose of parochial gain - notably around incentive-fee crystallization dates. In other words: the racket of unsuccessful pursuit. While the authors do not address my specific pet-peeve, their aggregate data do suggest pedestrian returns indicative of (at least in part) the omnipresent agent-principal conflicts of the investment manager, who by all account have not made out poorly despite the rather modest aggregates.

Errrrr...ummm....Did I hear someone say "Multi-Year Clawback Clauses"??!?

Monday, August 02, 2010

Wily Wyly's

I used to smile sophmorically at the sight of a Dentist named Dr Fang, or a Plastic Surgery clinic named Dr Tuck, just as I have long-chuckled at the sight of the The Wyly Brothers moniker in print. Monday morning quarterbacking is always easy, but I can tell you that there was always something fishy about the way their stocks traded (both Sterling Software and Sterling Commerce) - and now, of course, we know why. Wealthy self-made Texans (however grey their machinations), it seems, are inherently disdainful of regulation and authority, and a sucker for low-hanging fruit irrespective of prevailing law. But rather than being "men" about it (so to speak), and simply taking their  operation private at an early stage, or checking out and becoming a citizen of Belize (like Tory Chair Michael Ashcroft or paper-cup scion Kenneth Dart) or creating their own island state with its own zero-tax and regulatory regime (like the Berkley Brothers),  the Wyly's chose to speaketh in forked tongues, milking the system for its benefits, while systematically gaming it in reasonably cynical fashion. Even sadder, they authored a now-dubious book about their formula success - one which undoubtedly excluded a few ignoble "trucs de chef". The Wyly's, it would seem, expected nothing more than proverbially "having their cake whilst eating it too" versus paying more than their share of tax, forgoing illegal trading gains, or limiting their presence in their beloved fire-ant state to 180 days per calendar year. 

There are lessons for the contrarian here, and ammunition for those trying to explain the price momentum phenomena: The Wyly brothers were not alone. I do not mean "alone" in the sense of being in the company of Mr Waksal or Mrs Stewart. Rather, I mean that their entourage, like the Remoras (or sucker fish) feeding upon their hosts errr umm crumbs,  was omnipresent in riding the coat-tails of each abuse of material non-public information.  Indeed, the daisy-chain is unlikely to have stopped there. Humans DO learn quickly where the fish are hiding, and all manner of observant executing trader, back-office clerk, and/or personal assistant,  will surely have suspected  the cause and effect of winning trades. Beyond that, information is power, and is often used to curry favor for those looking to reward or impress.  In short, it is a picture-postcard of inside information seepage and dissemination which is that bane of the options market-maker(s) (like Timber Hill and Susquehanna) who are routinely skewered by such realities.  Today, add to this the front-running cunning of the lurking high-freq cherry-pickers, and information is amplified quickly and rapidly, perhaps to the point of forcing would-be bidders' hands earlier than desired.  Of course bogus rumours are subject to the same amplification lessening the pain for the dedicated, bona-fide jobbers, and hopefully (for them) they are far more numerous - sufficient to overcome the Wyly fat tail.  Needless to say, the government should share some of the spoils with the bona-fide market-makers whose asses were made blue.  For it is they from whom the money was stolen. I can see the ambulance-chasers chining up as I press "Post"....