The great untangling: Credit Derivatives

Some of the criticism heaped on credit-default swaps is misguided. The market needs sorting out nonetheless.

THEY are, says a former securities regulator, a “Ponzi scheme” that no self-respecting firm should touch. Eric Dinallo, the insurance superintendent of New York state, calls them a “catastrophic enabler” of the dark forces that have swept through financial markets. Alan Greenspan, who used to be a cheerleader, has disowned them in “shocked disbelief”. They have even been ridiculed on “Saturday Night Live”, an American television show.

Until last year credit-default swaps (CDSs) were hailed as a wonder of modern finance. These derivatives allow sellers to take on new credit exposure and buyers to insure against companies or governments failing to honour their debts. The notional value of outstanding CDSs exploded from almost nil a decade ago to $62 trillion at the end of 2007—though it slipped to $55 trillion in the first half of this year and has since continued to fall. Traded privately, or “over the counter”, by banks, they seemed to prove that large, newfangled markets could function perfectly well with minimal regulation.

That view now looks quaint. Since September a wave of large defaults and near-misses, involving tottering banks, brokers, insurers and America’s giant mortgage agencies, Fannie Mae and Freddie Mac, has sent the CDS market reeling. Concern that CDSs are partly to blame for wild swings in financial shares has frayed nerves further.

The failure in mid-September of Lehman Brothers showed that the main systemic risk posed by CDSs came not from widespread losses on underlying debts but from the demise of a big dealer. The aftershock spread well beyond derivatives. Almost as traumatic was the rescue of American International Group (AIG), a huge insurer that had sold credit protection on some $440 billion of elaborate structures packed with mortgages and corporate debt, known as collateralised-debt obligations (CDOs). Had AIG been allowed to go bust, the swaps market might well have unravelled. Similar fears had led to the forced sale of Bear Stearns in March.

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The Crisis & What to Do About It by George Soros

The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact—that the defect was inherent in the system —contradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting. The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it. To understand what has happened, and what should be done to avoid such a catastrophic crisis in the future, will require a new way of thinking about how markets work.

Consider how the crisis has unfolded over the past eighteen months. The proximate cause is to be found in the housing bubble or more exactly in the excesses of the subprime mortgage market. The longer a double-digit rise in house prices lasted, the more lax the lending practices became. In the end, people could borrow 100 percent of inflated house prices with no money down. Insiders referred to subprime loans as ninja loans—no income, no job, no questions asked.

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The Demand Side by P.S.Mueller

The incredible shrinking funds- from The Economist

It wasn’t supposed to be like this. After all, most hedge funds pride themselves on providing clients with positive “absolute returns”—ie, on turning a profit whatever the financial weather. Until now that promise had been largely met. In 1998, the year that Long-Term Capital Management (LTCM), a giant hedge fund, collapsed, the industry still managed a small positive return. During the previous big financial bust of 2001 and 2002, when American shares fell by over one-third, the average hedge fund was roughly flat.

This time, however, it really is different. Bans on short-selling have made many strategies unworkable. Poor management by hedge funds may be partly to blame: the industry has more than its fair share of illiquid assets that have been hammered during the crisis. But it also appears that forced sales of assets by hedge funds have driven prices lower, in turn hurting performance—a typical case of contagion. The 30 core American equity holdings of the biggest hedge funds, tracked by analysts at Merrill Lynch, have underperformed the stockmarket since the end of August.

What is the cause of the fire sales that seem to be at the root of the industry’s problems? The obvious answer is a withdrawal of credit, which has in turn forced hedge funds to offload assets. Sceptics have long argued that for all the skill they claim to possess, hedge funds just use cheap money to amplify mediocre returns. By this account they are simply another part of a vast, debt-dependent ecosystem that is now being starved of oxygen. Yet the role leverage has played in bringing the industry to its knees is subtler than this. And there is another prime suspect for hedge funds’ suffering: their own clients.

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Anatomy of a bottom: Psychological characteristics of capitulation are largely absent

ANNANDALE, Va. (MarketWatch) -- Panic is not the same as capitulation.

That in a nutshell captures much of the confusion over what happened in the stock market earlier this month.

Without a doubt there was panic. The Dow Jones Industrial Average dropped more than 25% in less than a month.

But capitulation is something different, as I have learned in recent weeks as I have read more and more about the subject.

Capitulation has a number of distinguishing psychological characteristics, such as investor disgust and exhaustion. Having been burned by the market for so long, investors capitulate by resolving never, ever, to trust the market again.

In the wake of capitulation, therefore, interest in the market declines. Apathy rules. To be sure, this definition cannot be mechanically measured. It is hard to pinpoint when investors become maximally dejected and apathetic. But my hunch is that we have yet to experience capitulation.

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The Difference is, American Banks Allowed to Fail

LONDON (MarketWatch) -- Who says the regulatory arbitrage game isn't alive and well?

On the surface, the American and British programs on bank capitalization look pretty similar, but key differences are apparent.

In both cases, governments are issuing preferred stock. Sure, the terms are different -- taking on the Brit preferred incurs a steep 12%-a-year payout; Uncle Sam wants 5% a year, unless the holding is still on the books after five years.

In both the U.S. and the U.K., banks will face limitations on paying dividends -- American institutions won't be able to increase them; U.K. ones can't have them at all -- and both have executive pay guidelines.

But the real difference is to who it applies. In the U.K., the basic system was, get your capital up to certain thresholds privately -- or take the government money, and strings, to get there. HSBC Holdings (HBC 74.34, +0.09, +0.1%) and Barclays PLC (BCS 17.60, +1.85, +11.8%) were able to go down the private route, while Royal Bank of Scotland (RBS 1.20, -0.73, -37.8%) and Lloyds TSB (LYG 10.75, -1.42, -11.7%) were not. A quick check of the stock price shows the difference between taking private or public cash.

The U.S. one, by contrast, is voluntary. Other than the "big nine" that got roped into taking the cash, there seems to be a strong incentive for all but the most troubled lender to take a pass.

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The Housing Bubble by P.S.Mueller

Best Market Reentry Indicator: Reduced Counterparty Risk

Suppose you are watching US equity markets. You could be thinking of bailing out. You might be someone who has been in cash, but you do not want to miss the "bottom." Whatever your position, you seek some magic indicator.

We have already provided the basics that should help readers make this decision. Here is some extra color, but still not the full picture. We are sorry. It has been a busy time.

Meanwhile, here is some help.

The Key Question

The key question is the freeze-up in credit markets. If ordinary businesses cannot get loans, holiday retail and auto is affected. If the commercial paper market dries up, ordinary commerce cannot take place.

This is not a matter for political posturing or personal opinions. Many people who have never run a business or a bank seem to have a strong opinion on how much leverage, how much liquidity, and what duration is "correct." We think that anyone offering such an opinion should show some expertise and/or a successful business model to prove it.

Meanwhile, it is pretty obvious what the market wants:

• Participants want to know that there is no counter-party risk, something that we highlighted for you last week.
• People will not lend without knowing they will get paid back. It freezes commercial paper. It escalates LIBOR, and it causes a spike in CDS swaps.

So that is the problem, the most important problem, and possibly the only significant problem. If it is not solved, the economy may get much worse. If it is, we may escape with a milder recession.

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Bargain Buys for Patient Investors-Barron's

The credit crisis has shifted emphasis back to the importance of a strong balance sheet, something many investors willfully forgot about during the bull market through 2007. Those same investors, who once urged CEOs to take on debt to buy back stock, are now focused on upcoming debt maturities and refinancing fears. With the markets taking a bruising and most major stocks now valued at less than 10 times estimated 2008 earnings, this could be a historical opportunity to buy stocks at bargain-basement prices and wait for a recovery. Barron's Andrew Bary highlights twenty-five cash-rich companies that patient investors can pick up on sale.

Exxon Mobil (XOM) leads the cash race with $30B, Corporate America's largest cash hoard. At $62, it trades at just seven times projected 2008 earnings market value. The firm may shift some of its cash from a stock buyback program to an acquisition, as some independent energy firms face debt refinancing troubles.

Smaller companies may have less cash on hand in real terms, but their holdings make up a greater percentage of their market values. IAC/InterActiveCorp (IACI) and KBR (KBR), for example, both have cash holdings that account for over half their market values.

Once criticized as overly conservative for holding too much cash, several tech leaders are now seeing those cash holdings pay off. Apple (AAPL) and Dell (DELL) have cash equal to over 25% of their market values. Motorola (MOT) and Electronic Arts (ERTS) have cash positions worth 30% of their market values. Yahoo (YHOO) has around $2/share in cash and another $3/share in investments.

Microsoft (MSFT) has a strong balance sheet with $23B in cash and another $6B of equity investments. It also has a monopoly software business and a P/E of just over 10, the lowest in its history. Microsoft may miss its FY 2009 earnings target, but trading at $21.50, one could argue that a miss is already reflected in the stock price.

Industrial stocks have been hurt lately as investors worry about domestic recession and a drop in global demand, leading to P/E ratios at their lowest levels in years. Caterpillar (CAT) trades at just seven times 2008 estimated earnings, United Technologies (UTX) trades at less than ten times earnings, and Deere (DE) at eight times earnings. Citigroup analyst David Raso set a price target of $65 for Deere (currently at $38) and $72 for Caterpillar (currently at $43).

Jim Paulsen, of Wells Capital Management, succinctly said "assets are being given away." He added, "they may not do well in the next several months, but looking ahead two or three years, investors may see some of the best opportunities of their lives."

• The rest of the list: L, NTE, TEX, PCAR, INTC, EBAY, NVDA, BRCM, NOVL, RNWK, CMI, HON, ITW

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Things are looking up

Collateral Damage- Hedge Funds: An Industry Struggles

HEDGE funds are supposed to hedge. This year, they haven’t. The fund-weighted composite index compiled by Hedge Fund Research, a firm that tracks the industry, fell by 4.7% in September, the second-worst month on record. Since the start of the year it has lost 9.4%. The industry’s promises of “absolute returns” for investors now ring rather hollow.

To be fair to them, hedge funds have not been allowed to hedge. The restrictions on short-selling (betting on falling prices) imposed by regulators round the globe have played havoc with managers’ strategies in recent weeks.

Take the worst-performing strategy, convertible arbitrage, which lost the average fund 12% in the month. Convertible bonds are fixed-income securities that can be exchanged for shares in the issuing company. Historically, these bonds have been underpriced, because too low a value has been placed on the right to convert them to equity. So arbitrage managers have tended to buy the bonds and sell short the shares. Thanks to the Securities and Exchange Commission’s ban on the shorting of more than 900 stocks from September 19th to October 8th, that strategy no longer worked. And since the managers could not short the shares, they had to sell the bonds. As a result, the bonds’ prices plunged.

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Blocked Pipes- When banks find it hard to borrow, so do the rest of us

ANY good tradesman will tell you the importance of the bits of a house that you cannot see. Never mind the new kitchen: what about the rafters, the wiring and the pipes? So it is with financial markets. The stockmarkets are the most visible: as they soar or swoon, the headline-writers get to work. The money markets, however, are the plumbing of the system. Normally, they function efficiently and unseen, allowing investment institutions, companies and banks to lend and borrow trillions of dollars for up to a year at a time. They are only noticed when they go wrong. And, like plumbing, when they do get blocked, they make an almighty stink.

At the moment, these markets are well and truly bunged up. In the words of Michael Hartnett, a strategist at Merrill Lynch, “the global interbank market is effectively closed.” The equivalent of a run on banks has been taking place, without the queues of depositors seen outside Northern Rock, a British mortgage bank, last year. This stealthy run has been led by institutional investors and by banks themselves.

Many banks have had to be rescued by rivals or the state. This week the Irish government felt compelled to guarantee the deposits and some other liabilities of the country’s six largest banks. Surviving banks have become ultra-cautious—“just taking things one day at a time,” says Matt King, a strategist at Citigroup.

The effect has been most dramatic in the overnight rate for borrowing dollars. Bank borrowing costs reached 6.88% on September 30th, more than three times the level of official American rates, while some were willing to pay a remarkable 11% to borrow dollars from the European Central Bank (ECB). Banks have become so risk-averse that they deposited a record €44 billion ($62 billion) with the ECB on September 30th even though they could have earned more than two extra percentage points by lending to other banks. It was the last day of the quarter and, for balance-sheet reasons, banks were particularly keen to have cash on hand. (Overnight rates fell back on October 1st, but one-month rates rose further, indicating that the crisis had not eased.)

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