Sunday, April 3, 2011

SEC investigating structured products: Déjà Vu all over again?

Never let it be said that the denizens at the Securities and Exchange Commission are a stodgy, humorless bunch. A recent WSJ article,Complex bond faces regulators Scrutiny , almost got me. I am not sure if they meant to have an early jump on April Fools, or if some fat fingers at the WSJ was involved.  In any event, well played Schapiro!

The Complex bonds being scrutinized, also known as “reverse convertible notes” falls under the broad investment category of structured products or in the old school vernacular Derivatives, the eleven letter four letter word.

According to the complaint, apparently the bad boys of Wall Street:
“failed to disclose the risks and fees to the investors before they bought the notes.” and possibly failed to disclose “potential conflicts of interests, such as selling a note linked to the stock of a company it is advising.”

Not only have we been down this path before, but with a few well placed directorships, maybe an IPO allocation or two, whatever the legislation and if indeed there is one, it will be tepid and ineffective. I have many reasons for my opinion but I will give three. One is history, two is legislating for greed, stupidity and downright laziness is nigh on impossible and the third I will give you at the end.

So, a brief history lesson: In the early to mid 90s, the SEC, CFTC and the Senate Banking committee “investigated” similar structured investments, after many well-known firms announced multi-million losses resulting from derivative transactions in which, they claimed, they were misled. The most infamous of these were Gibson Greetings, Procter & Gamble, and Orange County.

There followed a plethora of law suits, most of which were settled out of court. Any of this sound familiar?

One such settlement involved Bankers Trust, a big player in the derivatives market at the time.  BT was found to have been less than forthright in its dealing with clients, fined $10 million by the CFTC and the SEC, and entered a written agreement - naughty boy smack on wrist without admitting guilt -  with the Federal Reserve Bank of New York.

Under this “agreement”, Bankers Trust was directed to make sure that its customers know about every wart, wrinkle, and whisker of their leveraged derivatives. Most significantly, Bankers is required to provide "transparency" about prices. If a client, for example, has entered into a highly leveraged contract, it is entitled to know on a daily basis what the contract's value is.

Moreover, in 1995 to pre-empt further regulatory initiatives on derivatives, the Derivatives Policy Group comprising senior officials from six of the United States' largest broker-dealers (Goldman Sachs, Merrill Lynch, CS First Boston, Salomon Brothers, Morgan Stanley and Lehman Brothers) released a code of conduct, Framework for Voluntary Oversight with the subheading the OTC Derivatives activities of Securities firm affiliates to promote confidence and stability in financial markets.

Inasmuch as there has been some chicanery in the marketing of structured products, I firmly believe investors should start sharing some of the blame.  For some obscure reason while the general public may have outgrown Santa Claus and the Tooth Fairy, much of the investing public still firmly believe in the Investing Genie - He of the above average return with below average risk .

Back in January I posted light hearted pokes at structured products. I detailed a JPMorgan offering on Bank of America and a Morgan Stanley Offering on Bank America. I found the disclosures to be quite adequate for those with a basic grasp of english comprehension and math skills.

In spite of one such offering disclosing that :
“We may engage in business with or involving Bank of America Corporation WITHOUT regard to your interests”. and   “Hedging and trading activity by our subsidiaries could potentially adversely affect the value of the securities”.

over $100 million notional of these investments were sold.  At $1000 per unit, 10,000 of this things were greedily snapped up.

As with anything that requires a modicum of intelligence and a smattering of getting one’s hand dirty or brain into gear, left in the hands of the lazy, incompetent and yes the downright stupid - it WILL lead to tears.  At some point in time investors must be held accountable for their actions and indeed inactions. My erstwhile blog mate the_analyst has advocated a revolutionary notion on many an occasion. One with which I whole-heartedly agree with.

License investors! Put the Series 7 to good use, have the general public take and pass it with annual re-certifications.

I leave you with my third reason why I think this investigation will come to naught:

1. At the January 1995 Senate Bank Committee hearing on derivatives regulation,  Fed Chairman Alan Greenspan said unequivocally that the Bankers Trust agreement should not be construed as setting general guidelines for the industry.

2. The person in charge of the CFTC in the 90s during the first structured product investigations was none other than Mary Schapiro, the SEC's current chairperson.

Happy Trading!

Sunday, February 20, 2011

The Art of War, or:How China plans to dominate the world economy

(This note was originally posted on Jan 31, 2011 @ StoneStreetaAdvisors)

“If you lay siege to a town, you will exhaust your strength and resources. Therefore, feed off your enemies and forage for their resources.”
~ Sun Tzu

With a war chest of $2.85 trillion, and a renewed swagger it was only a matter of time before China flexed its economic might by diving back into investing in western banks.  After ill-fated multi-billion dollar investments in Blackstone Group LP, Morgan Stanley and Barclays PLC, last week a Chinese bank agreed to buy a stake in the US arm of Bank of East Asia.

Industrial and Commercial Bank of China (I.C.B.C.), the largest of China’s “big 4” state owned commercial banks agreed to pay $140 million for an 80% stake in the United States subsidiary of the Bank of East Asia, which is based in Hong Kong and has 13 branches in New York and California. The rationale was:
“Chinese banks are aggressively seeking to expand overseas, hoping that they can support Chinese companies abroad instead of losing them to American and European financial companies.”
This was I.C.B.C.’s second investment in North America, after buying a 70% stake in the Canadian operations of the Bank of East Asia Last year. It’s most notable investment however, is the 20% stake in Standard Bank South Africa that provides it with access to mining, energy and other resource firms in Africa.
According to a recent PwC analysis: "China's appetite for overseas assets is insatiable, with natural resources remaining a key industry target, as the country aims to secure the resources it needs to fuel its engine of economic growth," Mr Brown said.  As predicted by PwC earlier in the year, apart from continued strong interest in natural resources, there has been an increasing number of acquisitions of high technology companies, as Chinese buyers look to bring know-how back to China to foster a developing economy.  There is also strong interest in machinery and equipment manufacturers, and the automotive sector.”
Nothing new there you might say, except with the Yuan appreciation, the stumbling Euro and the continued Dollar malaise, it seems outbound Chinese M&A is about to explode, after rising by more than 30% in 2010.
Two recent developments also give impetus for reassessment on how to play China:
  • Chinese financial institutions are pushing into Europe, opening bank branches(I.C.B.C is opening branches in Paris, Brussels, Amsterdam, Milan and Madrid this month), scouting for deal opportunities and even attending German banking classes(China Development Bank is one of four finalists bidding for a large stake in troubled German bank WestLB AG).
With the continent's banks in shambles and no viable alternatives, China’s quest to be the global powerhouse could very well be accomplished before it’s begun.
  • China Opens a Door on Currency Swaps, China will allow some banks to trade currency swaps for corporate clients starting March 1, extending the use of the financial derivative beyond the interbank market—a move that facilitates corporate foreign hedging as Chinese trade continues to expand and cross-border investments accelerate.
Letting corporate clients enter into currency swaps could also pave the way for China to allow foreign companies to issue Yuan-denominated bonds in China, traders said.  Could this be the precursor to letting the Yuan float (somewhat) against the Dollar?
I would keep an eye on $CNY, $CYB, $FXI, and $CHIX.
Could all these moves be the set pieces for the next phase of world war III mentioned by georgetownjack?
I know what I think!.
I will leave you with one final quote:
All warfare is based on deception. Thus:
When able, manifest inability.
When active, manifest inactivity.
When near, manifest far.
When he seeks advantage, lure him.
When he is in chaos, take him.
When he is substantial, prepare against him.
When he is strong, avoid him.
When he is wrathful, harass him.
Attack when he is unprepared.
Emerge where he does not expect it.
~ Sun Tzu

Tuesday, February 8, 2011

A Response to Arbitrage Pricing Theory - MBA Mondays with Darwin

Initially,  I meant this response as a comment to a recent blog post, Arbitrage Pricing Theory - MBA Mondays with Darwin, however as I began to write, it has taken on a life of it’s own.

I commend Darwin in his endeavor to educate the general public, however to quote Darwin himself from a previous post :

“Not only do I disagree with his opinion, but I’m concerned that his advice is actually dangerous and gullible readers will lose money as a result.”

I realize that merger or risk arbitrage is presently alluring due to the raft of deals! coming to the fore.  In Risk Arbitrage back on?, I gave the reasons why many arbitrageurs are gearing up for what could be a banner year. I would caution, however that the subject is somewhat daunting, the scope of which cannot be covered in a single blog post.

That being said, I believe a little more color would dissuade any notion that putting on a risk arb trade is as easy and profitable as Darwin suggests. Hopefully I will enable readers to have a better understanding of the process of trading a merger deal .  Risk arb hedge funds have done rather poorly for the past few years, due to amongst other things the length of time a deal takes to go through which really screws with your return.

Merger Arbitrage - Whilst I agree with the basic outline of Darwin's merger arb paragraph, I think he is doing his readers a disservice by the rather simplistic overview of Risk Arbitrage given.  The announcement of a merger deal is merely the first scene of the first act of a production that could give Wagner’s Ring Cycle a run for it’s money.

Due to the scope of the subject matter, I will merely address the points Darwin has raised. He mentions that the price never reaches the theoretical price of the offer, this is technically not true as sometimes the price exceeds the offer price. Depending on whether the acquirer is paying a large enough premium, or if the offer undervalues the target, the target stock price will react accordingly.

Perhaps there is an alternative bidder as in the deal cited - AVIS(CAR) /Dollar Thrifty(DTG).  Initially the deal was between Hertz(HTZ) and Dollar Thrifty(DTG), The terms consisted of an exchange ratio of 0.6366 HTZ + $25.92/share in cash, and a $6.88/share special cash dividend to be paid by DTG immediately prior to the transaction's closing.

But the biggest reason the prices do not converge is it is not a “done deal”. There are many hoops to jump through beyond the initial announcement.  Typical timing for a non hostile, non regulated deal is 90-120 days.  That gives it enough time to clear the HSR antitrust act hurdle, and get SEC, DOJ , FTC and respective shareholders approvals.  Should it be in a regulated industry such as utilities, as in the recent Duke/Progress merger, timing increases to 1 year on average, to clear the additional regulatory bodies.

Now we get to the sexy, exciting, risky part of risk arb. The calculations have to work for you to even consider the trade.  How is the offer structured? all cash? cash and stock? In the deal cited, AVIS(CAR) initially offered $39.25 cash and 0.6543 CAR for every DTG in July 2010. That spread blew up(DTG stock price traded at a premium to the offering price) as the market thought the offer was not reflecting the inherent value of DTG.

Lets take Darwin’s hypothetical:

"So, let’s say you went out and bought shares on Monday and within a month, the FTC ruled that the deal could go through.  That would be a gain of ~$3 per share (6%) in a month, which is well over 70% annualized."

AVIS(CAR) upped the offer to $45.79 cash and the same ratio 0.6543 in September 2010, for a theoretical offer price tonight of $53.24 vs  RTG ask price of $49.9 for a $1.69 spread or a spread premium of 3.27%.  To get the spread you have to lock it in  - so for every 1 DTG you buy , you have to sell .6543 CAR.

As a retail investor you would get shitty borrow rates - if your broker can get the borrow that is - right there your 3.27% return is more like 2%. The retail investor can bump returns up with leverage(like hedge funds) - which you also have to pay for - so that cuts further into your return. Depending on the broker, there will be a short interest credit(interest on the short sale of CAR - but again as a retail customer, its bupkiss)...

As an alternative to buying the target and shorting the acquirer,  you can utilize a buy-write(selling calls against a long stock position) or put purchase strategy to alter the risk reward profile.  In this example, Buy 100 DTG and sell a DTG Call or Buy 100 DTG, sell 65 CAR and buy 1 DTG put.  A word of caution, the put purchase strategy would cut sharply into your return, but your risk would be greatly reduced also.

I will end here as I guess 80% of you are no longer interested. For those of you that are interested, shoot me an email. I  would agree with Darwin that the deal is looking dicey but only in terms of what the eventual company would look like.  I think there will likely have to be some divestitures which might play havoc with the accretive numbers Avis is pumping out..

To wit, I am all for education, however there is no short cut or easy way. There are no cliff notes either. The work and risk involved should be made crystal clear, it is NOT easy.  Look at the mutual funds that thought they could replicate a risk arbitrage strategy. It is by no means impossible, but it takes a lot more work than the normal investor is willing to put in.

Happy Trading!

Saturday, February 5, 2011

T2 Partners’s Mea Culpa: A Study in Behavioral Finance.

T2 Partners eagerly anticipated investor letter(H/T is finally here and what a doozy it is.

Why was it eagerly anticipated? Well in early December T2 managing Partner Whitney Tilson publicly disclosed his short trade analysis on Netflix ($NFLX).

Whether that analysis was posted as a genuine critique of the stock or as an attempt to pressure the price, no one can know for sure, but there are many arguments for and against such a post.  In any case I commend him not only for putting his analysis up for scrutiny, but also for acknowledging in his most recent January investor letter that he was wrong, albeit belatedly and significantly lighter in the wallet.

From the January T2 Investor letter:
"Over time we've been quite successful shorting fads, frauds, promotions, declining businesses, and bad balance sheets. Where we have had much less success, however, especially in recent months, is shorting good businesses that are growing rapidly, even when their valuations appear extreme. Such open-ended situations, regardless of valuation, are very dangerous, so going forward we will avoid them entirely unless we have a high degree of conviction about a specific, near-term catalyst."

My first reaction was, hang on a minute, If in the future you are only going to go short based on a high degree of conviction, what was your conviction for shorting in the past? Granted, in an earlier post I suggest that success is never guaranteed, no matter your educational pedigree or tenure in the business, but a necessity in trading and investing is confidence and a high conviction in your analytical conclusions. The question is, when and how to reevaluate that conviction?

My second reaction was, judging from his original argument regarding NETFLIX ($NFLX) it seems the reason Mr. Tilson held onto the stock as long as he did, and even added to the position was due to a high degree of conviction in his analysis that $NFLX was overvalued.

Over at The Big Picture, Barry covered his 8 Basic rules for shorting stocks, and I would like to posit that a 9th rule to consider is the psychology involved in holding a short position. T2’s $NFLX saga is a worthy candidate for such a behavioral finance case study.

Behavioral finance is the study of the influence of psychology on the actions of financial practitioners and the subsequent effects those actions have on markets. Behavioral finance is interesting because it goes some way to explain the inefficiency that exists in the market, by way of human irrationality. Bye, Bye Efficient Market Hypothesis!

The basics of behavioral finance are that humans are prone to cognitive biases that cause us to throw rational, linear thought to the wind. The T2 $NFLX trade, exhibited evidence of many of these cognitive biases, in fact Mr. Tilson even brought up the very notion of being biased.

The emotional side can be even more difficult. Numerous studies of investor behavior (the field is called behavioral finance) show that once an investor has a position in a stock, there are tremendous biases to seek confirming information, ignore disconfirming information, and not admit a mistake. We don't claim to be immune from these emotions, but we've studied them extensively and do our best to block them out.

The  cognitive biases that stand out to me were overconfidence and confirmation bias - particularly underemphasizing the impact of growth(international and domestic), failure to account for sentiment surrounding the stock and overemphasizing the impact of increased content costs - and escalation bias, whereby  T2 continued to invest in $NFLX even tough it was a losing trade, perhaps to the detriment of a winning trade.

First, we think it's healthy to disclose and fully analyze our mistakes (although in this case we are not yet conceding that we've made a mistake in our analysis, but we obviously made a mistake in terms of timing our entry into the position).

This is after admitting in the very first sentence that :
We've lost a lot of money betting against Netflix (NFLX), which is currently our largest bearish bet, in the form of both a short and put position.

This is a clear indication that having knowledge or information does not always lead to taking action.

We are all guilty of these and more biases in our investing/trading lives, and it is particularly helpful for the beginning trader, finance professional, or retail do-it-yourselfer to see that even one as storied as Mr. Tilson is not immune.

Happy Trading

Tuesday, January 25, 2011

Exploiting Economic Illiteracy

“I think it’s important for people to understand the ideas of scarcity and decision making in every day life so that they won’t be ripped off by politicians”,

“Politicians exploit economic illiteracy”

- Dr. Walter Williams.

Those were the comments that resonated with me in the recent WSJ Op-Ed,The State against Blacks; Then I got to thinking, yah, not only politicians pal!

In the article, Dr Williams, a George Mason Economics Professor, discusses how the welfare state has done more harm to African-Americans than slavery did. And that “black people cannot make great progress until  they understand the economic system, until they know something about economics”

Not to take away from Dr. Williams’ message, but I believe his statement holds true for more than just the African-American population.  I believe its imperative for investors - of all stripes - to have a basic knowledge of economics. With the cacophony of noise emanating from Wall Street and politicians pushing their agendas, many investors are tearing down the rapids sans a guide and indeed some without a paddle.

A proper understanding of the true state of the global economy is vital for investors to avoid investment land mines.

Yesterday, Mark Cuban (who incidentally made his fortune in the stock market; during the Tech bubble nonetheless), blogged in Wall Street’s new lie to Main Street - Asset Allocation:

Today, your investment advisors want you invest in things you have absolutely no fricking clue about and have pretty much absolutely no fricking ability to learn about”.

Although I agree with one half of his proclamation, I do not agree with the other. With this one sentence, I believe he highlighted one of many myths and misconceptions under which current investors toil, that 
you can’t possibly, under any circumstances possibly learn this stuff!
Nothing ensures the longevity of myths and misconceptions like a modicum of half-truth.

The misconception that economics and finance is indecipherable, is one that is perpetuated admittedly, by many in finance for selfish reasons.  While the profession may not be seen as academically rigorous as the legal or medical, it does take hard work and study to gain insight. And even then, success is not guaranteed.  

Investing is NOT a real science like physics although, the reams of academic papers with unintellligible equations, talk of Chaos Theory, Brownian Motion and Levy Flight would probably convince you otherwise.  Although many professional investors have used these theories successfully, it didn’t happen overnight and it did require some serious study and application of brain usage on their part.

Too many investors want a magic elixir that guarantees outrageous profit with no risk, either to their pocket or their brain cells. Should you invest in a 1 year 8.10% Callable Yield Note linked to the performance of the Ishares MSCI Brazil Index Fund and SPDR S&P Metals and Mining ETF? Well for starters, it would help if you knew where Brazil was. Then maybe what’s in the index and the ETF before thinking about the possible 8.1% yield.

While, I agree there is a lot of scuttlebutt floating about, as highlighted in my post, ETF Mania or: A Study in Herd Behavior, I think everyone should be investing at their comfort and education level. In The stock market is for suckers, MIT professor Andrew Lo proposes to: “license retail investors to educate and protect them”.

I’ll leave you with two quotes i keep very much in the front of my mind:

There is nothing more frightening than active ignorance.-- Goethe

There are two ways to be fooled: One is to believe what isn't so; the other is to refuse to believe what is so. --Soren Kierkegaard

Happy Trading

Thursday, January 20, 2011

Merger Arbitrage Candidates: Interesting Reads

Following up on Risk Arbitrage Back On?, today Morningstar (MORN) and its unit Footnoted published their respective 2011 M&A outlooks, along with a list of top takeover candidates:
CHICAGO, Jan. 20, 2011 /PRNewswire/ -- Morningstar, Inc. (Nasdaq: MORN), a leading provider of independent investment research, today published its Merger & Acquisition Outlook for 2011, a comprehensive research report that outlines merger and acquisition trends by sector, identifies the 100 most likely takeover candidates across Morningstar's equity coverage universe, highlights the likely acquirers, and examines the implications of merger and acquisition activity for bondholders.
"While global merger and acquisition activity has been on the decline over the last few years, we observed the inklings of a revival in 2010 and expect both the number and size of deals to substantially increase in 2011," said RJ Hottovy, director of equity research for consumer stocks and editor of the report. "We expect some of the key M&A themes to include interest in emerging markets, companies that have mastered a unique niche in their respective industries, and the ability to generate free cash flow."  

Interesting reads:

Morning Star M&A Report


ETF Mania, or: A Study of Herd Behavior

Nestled on page B11, in this weekend’s Wall Street Journal was an article, “Social” Funds Embrace Emerging Markets.

One of the fads that’s irked me for some time is Socially Responsible Investing.  
Surely, that must go against the whole capitalist ethos, no?
What does Socially Responsible Investing even mean? And I don’t mean the wikipedia definition. I mean,  you’ve got 30 secs to explain it to me........... go!

Uh huh, thats what I figured. Sounds good though, right? All you need is a prospectus plastered with an image of giggling children frollicking in a field of daisies, under a sun filled sky et voila.
This whole ETF and theme-based fund frenzy is really getting out of control.

This one fund in particular, the MMA Praxis International Fund(MPIAX), aims for 20% Emerging Markets exposure, screening for companies that produce alcohol, tobacco and weapons. Therefore, mining and sweatshops that employ cheap efficient labor have a free pass.

Talk about coming to the party late and with nary so much as a cheap bottle of plonk. While procrastinating over how the write researching this post, along comes the WSJ with Here Comes The Dumb Money (hat tip stonestreetadvisors). Gee, I wish i’d thunk o’ that title.  

Because over the last year, the MSCI Emerging Markets Index has risen over 35%:

And since 2008 over 142% - Not to also mention that HUMONGOUS Volume spike during Sept of last year:

And inflows for the week ending Jan 14th 2011 show that the leading Emerging Markets ETF, Vanguard’s Emerging Markets ETF (VWO) was once again among the ETFs with the highest inflows ($840mn).  Admittedly, the iShares MSCI Emerging Markets Index (EEM) was among the ETFs with the highest outflows (-$1.1bn).   

However, I believe the outflows from EEM has more to do with cost of VWO (ubercheap), and EEM lagging the MSCI Emerging Markets Index. Perhaps, lately a third reason - How EEM is structured.

VWO uses a replication strategy (it seeks to own as many of the underlying stocks in the index as possible),  holding as many as 800 stocks. EEM on the other hand uses a sampling strategy designed to deliver the index’s returns without owning all the securities in it and “optimizes” - a not-so-clever euphemism for backing the truck up on derivatives.  

Understanding ETF methodologies is an important criteria that is often overlooked by both professional and retail investors.  Of the roughly 1200+( numbers change frequently with additions and closures) ETF and ETNs that can be traded, maybe 75 are truly understood and should be traded.   
The rest are an exercise in futility, pandering to the masses desire for an investing elixir.
This is all part of the greater trend of investors missing out on a rally, and getting into the latest fad/innovation to jump start gains. Ordinarily, you would chuckle at the "dumb money", but plenty "smart" money gets in on the act too. 
You’ll know we hit bottom when there is an art mutual fund/ETF or worse an ETF that allows investors to Put Money on Lawsuits to Get Payouts.  Look carefully before you leap. 
Happy Trading