Monthly Archives: August 2007

Creating Alpha – On The Short Side

For some reason the market doesn’t seem to want to admit that the housing market is on a continually downward trajectory and this will continue to impact the broader economy.

I guess it is hard to admit that things got way out of hand and now the economy and those benefiting from the ride will have to suffer a bit.

So on a day when the Dow was down over 275 pts, it seems appropriate to reflect on individuals who have been proactive about finding investment opportunities – on the short side – ahead of and during the current unwinding.

I stumbled upon an interview with Mark Cuban where he discussed a number of topics, including how “the internet is dead”.

But what jumped out at me was the criticism surrounding described as:

A site Cuban “launched [in July 2006] with veteran business journalist Christopher Carey, with the stated goal of uncovering waste, fraud, and abuse in publicly traded companies”

Apparently the goal of the company is to uncover publicly traded companies who have misled or otherwise defrauded shareholders, while Cuban and others short these stocks in the mean time.

Some other heavy hitters in the finance industry were recently called out on and accused of hiring a “hit man” to investigate improprieties in a stock that they were shorting: Hedge Fund Hit Man Hired by Cohen, Loeb, Sender, Says Insurer

Both Cuban and these hedge fund investors have been accused of proactively seeking to profit from uncovering wrong doing – a type of event-driven arbitrage, where the investor in these cases create the event.

It is unclear exactly what the facts are surrounding these situations; however, even assuming the accusations are true (for what its worth I am skeptical of the Bloomberg piece in particular) the question remains:

Is proactive investigation of impropriety a bad thing?

It seems to me that having highly intelligent and sophisticated investigators out there searching for companies who have been guilty of fraud or otherwise manipulating their financial statements to the detriment of their shareholders is a good thing. Not only are potential perpetrators caught and exposed, but just as CEO’s are inventivized to be more honest through the deterrent example of Skilling, so too potential manipulators might think twice next time after seeing these other companies caught in their lies.

And if on a day like today, when the market gets hammered, these guys are strategically positioned because of this hard work – more power too them. That, in my mind, is really alpha.

What "Efficient" Markets

Yesterday afternoon I experienced the irrationality of the markets first hand both as an onlooker and an emotional participant.

As most of you have probably seen, Bank of America injected $2b of capital into Countrywide, ending a week of speculation about a possible takeover of the company only a week following Countrywide’s tapping of its $12b credit facility as rumors swarmed that it was going under.

As the headline hit my blackberry via Pownce – Bank of America Invests $2 Billion In Countrywide – I initially panicked. Although I have almost completely closed my short position in CFC I still had a bit of exposure, and more than the pittance of capital at risk, I was worried that I had been wrong: for me a shot to the ego can be more painful more than a shot to the pocket book and it is even worse when they correlate.

After digesting that reaction and seeing that the stock was up over 20% in after hours trading, I decided to delve in a little further.

As it turns out, BofA basically bought a junky piece of preferred equity with a conversion price at a significant discount to the after-hours trading price of $26/share at $18/share. The math isn’t complicated, and as this article explains, the deal was smart for BofA as, they were able to mark-to-market a huge gain and also make a strategic expansion while a major player has their backs to the wall:

Countrywide Gives Bank of America $447 Million Gain

Even with this headline on Bloomberg screens across Wall Street, Countrywide’s stock opened up the day up almost 10% (down from its peak of an almost 20% increase overnight)…

But by the end of the day, the luster had worn off and CFC ended flat with the previous day’s close.

Even this result seems somewhat irrational mathematically, as the company just gave away 20% of its equity value for a discount to the current stock price – but perhaps different return requirements or something could begin to explain some divergence in the two securities.

In any event, the reactions – both my initial gulp and the market’s initial pop – were driven by emotion, rather than reason. And even now the volatility surrounding it makes reluctant to go near this situation…

So the next time someone tells you that markets are “efficient” invite them to play poker and feel confident that at least for that day, you won’t have to worry about that saying about the sucker at the table being you…

Finally The Fed Admits: Contained = Contagion

On Friday, the Fed finally did an about face and openly admitted what the entire world had already figured and priced into the global securities markets by suggesting that the “subprime” crisis was not simply relegated to one basket of securities, but rather – it is part of a larger problem growing out of the aggressive lending policies surrounding the boom in the real estate markets over the last half-decade.

As investors scramble to assess just how far this contagion will “spread”, typically-savvy fixed-income brainiacs are dumping securities across the board and driving up prices (and down yields) on the only surely safe thing left in the market – US T-Bills: Tough love on Wall Street
As lenders hunt for bad loans, Pimco founder and Fortune columnist Bill Gross says the Street is learning hard lessons about disclosure.

Putting The Pieces Together

This report does an excellent job walking through the economic indicators that show that the housing market has been both the weight driving the pendulum of the markets up and now down again over the last few years.

Anyone with 20 minutes on their hands who wants some insight into where we are and where we might be headed should give this a read:

Midsummer Meltdown Prospects for the Stock and Housing Markets

“This paper examines the factors that have led to the recent instability in financial markets, specifically the housing bubble and the recent run-up in stock prices. Prices in both the housing market and the stock market are often moved by psychological factors that have little to do with fundamentals.

The paper notes that the economists and analysts who give advice to the public and policymakers are often caught up in the psychology of financial bubbles along with everyone else. “

Revisiting The Indicators

It has been awhile since I posted the beautiful (read: scary) charts of the ABX indices that were the start of all of this trouble:

ABX Indices by Markit

These reflect the reality that has been driving the crisis in the credit markets.

This article does a great job walking through a summary of what has been going on in the underlying real estate mortgage markets. It is a great refresher or intro for anyone:

In a Credit Crisis, Large Mortgages Grow Costly
“When an investment banker set out to buy a $1.5 million home on Long Island last month, his mortgage broker quoted an interest rate of 8 percent. Three days later, when the buyer said he would take the loan, the mortgage banker had bad news: the new rate was 13 percent.”

I also discovered these CDX indices for the first time tonight. They show how the woes that started with mortgages have now spread literally across the spectrum of the credit markets (and the equity markets of late):

CDX Indices by Markit

Notice this Emerging Markets chart in particular:

The cost of protecting emerging market debt has almost doubled in the last week or two…one can only speculate about what is driving this particular factor, but I would imagine the “flight to quality” and “unwinding” of positions is to blame.

And the Asian markets continued their tumble overnight. Stay tuned.

What Tomorrow Brings

The weather analogies continue as the first storm to hit land dissipated much like the huge drop in the market mid-day today.

Now another storm, this time a hurricane, looms on the horizon, and I can’t help but press the weather metaphor to the breaking point.

Just as forecasters struggled with fear anticipating the worst hurricane season in history only to see the second consecutive weak season to date, so too doomsdayers (myself included) anticipated a major correction heading into late 2006 and 2007 only to see the Dow hit a record high mid-summer…

Now as the markets seem to be showing sure signs of the crisis we have feared, a hurricane is finally brewing in the tropics – both bring threats of disaster, but hope remains.

Predicting which way it will turn is hard, and as it turns out, apparently even Einstein can be mistaken…as the speed of light may not always predictable according to German Scientists who recently stated: ‘We have broken speed of light’

Good luck over the next few weeks…let’s hope the storm stalls over cool waters.

Like Rain in Texas

Irony can be ironic: the same day that the first tropical storm of the season made landfall in Texas, the markets have been pouring down on investors across the board.

One of the greatest challenges when trying to understand the financial markets is recognizing that the “price” or “value” of a security is driven by what people are willing to pay for it above all else. This value is driven by 2 primary factors: 1) how the company/asset underlying the security has performed in the past and 2) what investors expect out of the asset/company in the future.

Although the first factor can sometimes be complicated and hard to pin down, it is the second factor that drives price appreciation and today, depreciation.

As the uncertainty of the implications of our over-indulgence in the credit markets looms overhead, investors around the globe are increasing the discount rate of their future expectations – which by definition reduces valuations.

The VIX continues to spike and speculation is running rampant that the Fed is talking out of both sides of its mouth…all of this is like a deluge on the expected values of securities across almost every market.

Predicting the future is hard…especially when it comes to weather and people.

Sobriety Can Be Hard

I just returned from a trip to Cabo San Lucas, and I have to say after not a drop – the City looks different when not seen through tequila-laden eyes…

And so do the rating agencies when seen through the reality of the underlying credit rather than the “mark-to-model” numbers that seemed all-so-convincing as recently as May. It turns out that the “ratings” given to the senior tranches of certain CDO securities were more of a mirage than a reality, as the underlying mortgage credit has continued to weaken across the country.

Moody’s, S&P Lose Credibility on CDOs They Rated

The last few days have continued the downward spiral that started with these CDO’s early in the summer and now is spreading to global equities, as the reality of a deepening world-wide credit crunch is becoming more clear. As I feared in my post last Monday the rebound before the Fed did not move apparently was nothing more than a brief pause on a continuing downward trend.

One of the most surprising data points that continues to be discussed surrounds the massive negative moves in so-called “quant-based” hedge funds over the last couple of weeks.

Goldman, who’s funds have perhaps been the most visible of the sufferers, with clear eyes and looking into the midst of the storm, agreed to re-up its commitment to the strategies by committing “$2 billion of its own money” and into one of its losing funds according to Bloomberg:

Goldman Fund Cuts Fees to Woo Investors After Loss

The fact that Goldman is being joined by Perry, Greenberg, and Broad – some of the savviest investors of our time – suggests that perhaps there is opportunity to be had in keeping a level and clear mind in the midst of the recent volatility.

I continue to remain cautious and selective – but I also continue to dive in where clear opportunities present themselves…like enjoying a mexican sunset with open eyes.

The Limits of Expectations

When I first read this doomsday article yesterday, I thought the guy was frankly a bit extreme to say the least:

MBS Monetization and US Dollar

It wasn’t only that the graphics atop the page made me hesitate, but I thought that the idea underlying his argument – that “Fannie Mae will eventually become a funnel for monetization, after functioning as a centralized efficient clearing house…” was far fetched, especially when Bush yesterday kept a lid on Fannie and Freddie Mac’s capacity.

However, overnight the Fed made such a doomsday picture for the dollar more believable, as it made the writer of this complimentary article eat his words:
Fed Joins Banks Adding Cash to Stem Credit Collapse and Fed Adds $35 Bln in Funds, Most Since September 2001

Some of the figures tossed around in these articles make me begin to wonder whether such an extreme scenario is not that far fetched – particularly when I read that the intent is to provide “reserves to “facilitate the orderly functioning” of markets”…in other words to provide an artificial buffer to inaccurate underwriting.

I personally think that the system will not spiral out of control for a number of reasons, maybe the most important of which is that we don’t want it to – in other words, investor psychology and American optimism should provide a “floor” of some kind.

However, the second consecutive brutal day in the market highlights that things are not looking pretty right now.

And those who have made heretofore money hand over fist using predictable trends are continuing to struggle as the underlying credit continues to unwind: Market Turmoil Is `Perfect Storm’ for Quant Funds

As the article states and I mentioned yesterday, today is a different day: ““Previously uncorrelated factors have recently been falling with the same pace, leaving investors with very few places to hide.”

Correlation, Causation, and Change

Reality reared its ugly head overnight last night as the Europeans realized that they have some trouble on their hands in the form of U.S. denominated mortgage backed securities.

The equity markets took a pummelling as the beneficiaries of global liquidity (i.e. broker-dealers) faced tougher prospects for an easy out: U.S. Stocks Tumble on Credit Concerns; Banks, Brokers Retreat

Interestingly, at the same time that more bad news emerges around CDO’s and other asset-backed pools of securities, many quantitative hedge funds are apparently taking large hits as their statistical models face a changing marketplace: Highbridge, Goldman `Quant’ Hedge Funds Lose Money

To me this is unsurprising and driven by the same trend causing the implosion in the CDO markets. Most of these “quantitative” hedge funds are driven by modeling techniques that utilize a high degree of statistical analysis. Statistics is great for telling a story about what has happened and also powerful for picking up potentially unnoticed correlations (and therefore – in theory – causation). However, this power is harnessed and utilized in the context of looking at historical data.

The challenge facing the credit markets and statisticians generally is that things seem to have changed. For whatever reason (I have speculated about many possible theories below), the underlying credit dynamics of the housing market and the surrounding financing markets have had a dramatic impact on the mispricing of risk generally, and now reality is coming home to roost. It is not surprising that as these underlying changes play out, models based on data collected in a different historical context sometimes fail.

Maybe part of the reason why these models don’t work as planned is because the system is built on the backs of sometimes not entirely rational creatures – american homeowners.

This article offers an interesting take on why home owners are lured into loans they may not be able to afford: The Psychology of Subprime Mortgages

As the author states: “I think a big part of the reason sub-prime loans remain so seductive, even when the financial terms are so atrocious, is that they take advantage of a dangerous flaw built into our brain. This flaw is rooted in our emotional brain, which tends to overvalue immediate gains (like a new house) at the expense of future costs (high interest rates). Our feelings are thrilled by the prospect of a new home, but can’t really grapple with the long-term fiscal consequences of the decision. Our impulsivity encounters little resistance, and so we sign on the bottom line. We want the house. We’ll figure out how to pay for it later.”

Such a statement sure sounds like it makes sense and is predictable to a human being like you or me. But unfortunately, statistics speaks a different language than common sense…and as it turns out that linguistic gap may have dramatic consequences.