And The Winner Is...The Bond Market!

If only one thing comes out of all of this market turmoil, it should be the universal acceptance that the bond market is the primary financial market in the world. Stocks go up and down, commodities sometimes have their day, but when the bond market doesn't function properly, the whole world is affected. This isn't surprising to those of us that have toiled away in relative obscurity for years, but now everyone is forced to take notice. This should be of special importance to those that try to impose equity market-like solutions on to a vastly different bond market. That's it, nothing profound, nothing earthshattering in today's post as it is March 31st, always a strange day in the markets as it is quarter end and Japanese financial year end.

PS: To all of you working on the Presidential campaigns that have been reading this blog and incorporating some of its musings into candidate's speeches, I'd like to say that I am available for the Treasury Secretary's position regardless of who wins.

The Value of Information and Advice

It is always quite amazing that every time the markets go through one of these periods of upheavals, investors learn little from them. People seem very content to go ratcheting from bubble to bubble, blithely unaware of the consequences. As information becomes more accessible, transaction costs decline, and an investor's ability execute trades becomes easier, this problem has become worse.





What prompted me to blog about this today was an article in the Personal Journal section of the WSJ. It referred to a product being referred to a reverse convertibles. As with most items in the investment world, I've seen the term reverse convertibles applied to other, not so similar, products. In this instance, they are referring to a bond sold primarily to individual investors that provides an above market coupon payment. The issuer is usually a bank, investment bank, or a special purpose vehicle (not like the ones that have gotten banks and others into trouble), the maturity is generally, but not always, a year or less, and the bond's return is tied to the performance of a single stock. Basically, if the stock stays above a "barrier" level set at the time of the pricing of the reverse convertible (usually some percentage, say 20%, below the current stock price), you receive the coupon promised plus the initial investment at maturity. If the stock breaks the barrier price, then you would receive the coupon promised and the number of shares in the stock that the initial investment represented (hence the term convertible), regardless of where the stock is priced at the time of maturity of the bond. I have attached the table (above) from the WSJ for more clarity.



The point is not to denigrate reverse convertibles but to make a point about investment information and advice. This product can be appropriate for some and not others. Labeling it as a "CD alternative", as one firm in the article did on the basis of both of them being an interest bearing instrument, is disingenuous at best, but it highlights the kind of advice unsuspecting investors may receive. A simple rule of thumb is that if the person trying to get you to invest in something can't explain it to your satisfaction, like Nancy Reagan, just say no. It still may be an appropriate investment, but find someone who knows your circumstances, your goals, your risk tolerance AND can explain it. Ultimately, you are in charge of your own finances. Even if you turn control over to someone else and they don't serve your best interests, the buck stops with you.

However, what if the information, explanations, and advise sound plausible? Don't be afraid to get a second opinion on your investments and investment strategy. I don't mean just searching the Internet for validation or further description. As mentioned in the first paragraph, technology and the Internet have opened up a vast array of options to the investor, but just having information doesn't mean it is understood or should be acted upon. I'm sure I could find information online how to perform bypass surgery, but it doesn't mean I should do it or could it myself. This, of course, is an extreme example, but history is littered with the stories of people that turned over tremendous sums of money to people the barely know to invest in things they don't understand. If you were going to have surgery, unless it is an emergency, you would most likely get a second opinion. Feel free to to that with your money. This will most likely cost something, even if it is just you time, but it is well worth it.

PS: I know the old adage, "You get what you pay for." On that basis, coupled with what I wrote above, why should anyone listen to me? I'm not charging for this information, so how good is it? Here is my response: I'm not providing specific information (buy x, sell y), I'm not selling a service (yet), and I'm not even making any ad revenue (my astute readers don't click on the ads). The point of this is to shed light on an opaque area of the investment world to most people, the fixed income market. In 20+ years of being involved, I saw many people placed in investments that probably weren't appropriate, given the circumstances of the individual. Wall Street generally ignores the individual fixed income investor. With all of the turmoil surrounding fixed income markets today and all of the bad/mis-/inappropriate information out there, especially on TV, I try to explain market happenings and put them in perspective for readers. However, like any advice, you can do what you want with it.

Forward

The markets, with a lot of help from an under appreciated and imaginative Fed, are finally starting to plow through the serious issues that have faced it over the past almost one year now. This can be seen tangibly in narrower spreads, greater clarity over sticking points out there, and earnings that are starting to trickle in. With respect to earnings, of course they are lower. However, it isn't all dire. The traditional profit makers over the past few years are gone (for now), but there are other items taking its place. Foreign operations (LEH reported that 62% of its revenue came from outside the US), private client divisions, and trading have all held up well. Somewhat lost in all the hysteria recently is that with all volatility out there, this has been one of the greatest trading environments in years, particularly in equities and equity derivatives. I deliberately left commodities off that list; it really doesn't take any trading acumen to make money in bubble markets. I'm sure many pilers on got crushed this week when the bottom dropped out of commodities as speculators took off or were forced out.

This post, however, is about what happens next. As what is now known as the "Great Unwind" continues, more hedge funds will go under. Without changes in regulations with respect to hedge funds, new ones will spring up in the ruins of the old. For the short term, all hedge funds will actually have to earn their substantial fees as the easy, follow someone else's strategy returns are gone.

Speaking of regulation, the current regulation system in the US needs to be overhauled, and perhaps scrapped, in favor of one that is more a reflection of today's market. Most US regulations date back to the Thirties. When Glass-Steagall was repealed, the '33, '34, and probably the '40 Act should have been adjusted or replaced to reflect the changed role of banks and investment banks. The tinkering of those laws over the years, including Sarbanes-Oxley, haven't helped in the long run, and in some way exascerbated the situation. A pretty clear link can be established between Sarbox and the rise of all of the offshore, off balance sheet vehicles that are at the crux of the current problem, in addition to the other Sarbox issue around corporate executives understating all forward looking statements for fear of being thrown in jail. It would be nice that while the government is focused on the current market problem, that they take some bold initiatives that give us some common sense, rules-based regulation that actually works. (wishful thinking). How about one regulator, one that is not the Fed, to deal with all securities market issues?

The final note here goes to Bear Stearns investors and employees. There is no other outcome where you end up in a better situation. The Fed took its action to stem a potential financial panic caused by a lack of confidence in Bear Stearns. There would be no lending facility otherwise, there would be no engineered JPM buyout of Bear Stearns. Bankruptcy would have meant locked doors, no jobs and significant dislocation. Go blame company management for allowing the firm to get into that predicament in the first place. Your anger is misguided and misplaced.

Liquidity Always Equals Solvency

So, the Bear Stearns name passes into history, joining the likes of Drexel Burnham Lambert and EF Hutton, two firms that passed out of existence in similar stressed circumstances. It can't be said often enough that in the financial world, without liquidity, without entities willing to lend you money, you are out of buisness. This is a de facto bankruptcy; the $2/share offer by JPM is a placeholder, a way for JPM to get control of this company without a long and drawn out Chapter XI proceeding, something the market doesn't need right now. This price is very much like the price ING paid for Barings in 1999 (1 pound), although Barings swift end came about as a result of fraud (BSC looks to be a case of poor management/risk management).

Here's my take on the going forward. With respect ot the Fed, this Fed has done more than any other Fed in the 95 years of its existence. They have been creative, active, and will to do what is necessary to try to help. The naysayers and critics should get a grip (you know who you are). The people out there that were clamoring and ranting for faster Fed Funds rate cuts, do you really think it would have made a difference? The best case scenario there would have been to postpone for a little while the inevitable that has occurred. Funds are 225 bps lower than seven months ago (and maybe as much as 325 bp tomorrow) and there hasn't been much help. The problem was never the cost of capital, but rather the amount of leverage employed and the transparency related to that borrowing. If there is a criticism of the Fed, it was they left rates too low too long, which allowed for the housing market and lending market to get way ahead of itself and that they didn't raise the flag early enough in either market (not that anyone would have listened).

With respect to govenrnment regulation, the repeal of Glass-Steagal a few years ago allowed banks to operate like investment banks. This pushed investment bank to operate more like hedge fund, levering up to the hilt. This has come home to roost. Going forward, the has to be more transparency and better capital regulation, which will require new legislation.

With respect to the markets going forward, Bear Stearns was clearly (all along) the weakest player in all this. They had the most exposure to the weakest part of the market and employed the greatest amount of leverage in that area. Bankruptcy is part of the capitalist system, and if there was more confidence in the economy and markets right now, that is where BSC would be. There may be more consolidation moves out there, and that would be good as it places stronger players in the market.

As a final note, the big winner here is Jaime Dimon. Forced out of Wall Street almost ten years ago, he has returned to become the savior of the day and now the go-to-guy for the Fed. Well done!

People In Glass Houses...

I don't usually make a foray into politics here, but today I will make an exception. What was Eliot Spitzer thinking? I think I know what he was thinking, but, come on. Here's a guy that made his whole life on being holier than thou gets mixed up with prostitution, and money laundering to boot. I think Ken Langone, major Spitzer target over the years and probably the only one that didn't back down in the face of his prosecutorial harassment, said it best when he said something to the effect that he hoped that Spitzer's hell would be a little hotter than everyone else. He has to go, he should do it voluntarily and do it now. This morning, the comparison was made on TV to Bill Clinton lying under oath. While the general public (not me) was under the opinion that lying under oath on matters not of national security was acceptable, I would generally agree with the panel that what Spitzer did was worse. With Bill Clinton, his supporters (again, not me) accepted or at least tolerated the idea that he was morally challenged from day one and were willing to operate on that basis. Spitzer, on the other hand, made his mark going after corruption and ethics violations, and made a lot of enemies in the process (In an ironic twist, it was a top-down degradation of standards in the Nineties that gave rise to a crusading Eliot Spitzer.). Spitzer, by always operating from the moral high ground, had and has to be cleaner than everyone else out there.

Eliot Spitzer's actions over this decade forced a lot of change on Wall Street. It cost a lot of business in the United States, as operations were shifted offshore to less restrictive environments. As mentioned before, he made a lot of enemies. Still, many of the changes have now become accepted practice. There is no going back. Part of the market mess today can be traced back to the movement offshore of a lot of this business. The lack of rules and transparency have been a major contributor to the uncertainty in the markets, particularly fixed income. There should be some effort, now while this is fresh in everyone's mind, to standardize the rules of the game globally.

Eliot Spitzer will always be remembered for the actions of the past few days. His methods of achieving results were at times zealous and, at other times, harassing. In some cases, he went too far. However, he did shed light on Wall Street procedures that needed to be illuminated. It is too bad that he couldn't maintain those high standards in his personal life.

The "D" Word

The "D" word, in case you aren't aware, is deleveraging. It is a fancy buzzword for something that has been discussed here many times, risk reduction. The risk in this case is borrowed money. Entities borrowed a lot in the market run up to "leverage" their equity, hence the term deleveraging as those loans are being called out, paid off, or otherwise being removed from the market. The sad part about this (from my standpoint) is that over the past few years, there were a few of us out there that saw what was happening to the market, particularly in cash bonds, couldn't do much about for a variety of reasons, got frustrated with the situation, and left the active participation of the market.

There have been many vocal critics of the Fed over the past eight months (you know who they are), saying they haven't done enough and/or were too late to respond. In retrospect, they were too late, by about three years. If, in the waning years of the Greenspan Fed/early days of the Bernanke Fed, the Fed had taken some action to stop the "leveraging" from ramping up so rapidly in the first place, maybe the current mess could have been avoided. However, I can just imagine what the criticism of such action would have been, ranging from "you are hobbling business", to "you are killing economic growth", to finally " you are accelerating the decline of New York as the financial capital of the world" (A note of this criticism: For all of you out there that are big proponents of principle-based regulations, as is the norm in London, over rules-based regulation, as exists in the US, most of these opaque CDO and the like entities set up to issue these difficult to value securities, were set up and issued offshore, outside everyone's purview in the US).

The LTCM crisis in 1998 is an excellent example of rapid deleveraging. At the time, the market seized up as no one could figure out, or was willing to tell, what their exposure to LTCM was. The Fed stepped in, got all of the relevant people involved, and set up a facility to oversee the orderly liquidation of the fund. While it would have been thought, certainly by me, the LTCM's method were discredited after their debacle, in fact, their methods were duplicated and replicated by everyone and everybody over the past decade. The LTCM "crisis" was a drop in the bucket compared to today's problems (This should also shut up the Fed naysayers who simultaneously hold up the Greenspan Fed's action in that situation as why Bernanke isn't up to snuff. As I said , today is much worse.).

Art Cashin this morning called what is happening now potentially a death spiral for the markets. He is correct. The more this uncertainty goes on with respect to asset holdings and valuation, the less likely anyone is going to lend to anybody for any reason. The deleveraging going on now is necessary and healthy, but it needs to be done in a systematic way so that the baby isn't thrown out with the bathwater. We've seen the spillover into markets where there really shouldn't be any meaningful spillover. Full and complete disclosure of holdings is needed now. The Fed's action today to increase the TAF helps, but they need to open it to all financial institutions, not just banks, so the banks just don't sit on the money to improve their own positions. We're rapidly approaching a situation where the only way out is to establish a RTC-like facility for crappy assets in order to establish a clearing price for them. Using that type of facility, those that have cash will do quite well cherry picking good assets. Current participants will not do well in that scenario, which is why they need to (again) come clean.

The Headless Chickens Rule the Roost

Commodity prices have had a speculative bid for years now helping prop up their prices, especially oil. In the last few months, that bid has ramped up to ridiculous (yes, that is the appropriate word) levels. As mentioned in a previous post, is there any real world justification for the price of wheat to be four times higher than last year or for silver to be three times higher? The middle class of emerging markets, the alleged driver of the current price moves, couldn't possibly be demanding that much of everything simultaneously to cause this kind of move. It isn't often that you get to see a bubble form, so take advantage of the opportunity. Money looking for a home these days (take a look at the money flooding into money markets recently and you can see that there is plenty of liquidity, read the Fed has done its job, floating around. However investors are shying away from risk, hence the buyer's strike in non-commodity markets.) is being attracted to the only way is up market, commodities. The "big" money is playing the futures and the "small" money is playing the futures and ETFs (as a side note, if I had recommended making an ETF that used a single bond, say the 10yr Treasury as its backing, I would have been vilified in the press and brought up on charges by the SEC for ripping off the small investor. In the commodity world , it is OK.). Hedge funds especially love this because of the 100 to 1 leverage (or gearing, for my British friends) available in futures. To quote a popular radio ad, it is the biggest no-brainer on Earth, particularly when you figure the market only moves in one direction.

Here's the problem. The players in the commodity futures market has changed recently, but the structure of the market has not. Originally, these markets were set up by producers and users of the commodities as hedging vehicles. While that still occurs, the vast majority of action happens due to speculative moves by the various participants. Considering how little real money must be put up, there is a strong parallel today between commodity futures and gambling. At first, it is somewhat surprising that this market situation, as a problem, isn't being talked about in more detail. However, here a parallel can be drawn to my own area of expertise, the fixed income markets. In the media, both fixed income and commodities are treated as some sort unfathomable black hole. Right now, the media loves to talk about commodities because it gives them a positive market amidst all the negatives. Their experts they bring on validate their points all work for commodity trading houses (or trade themselves) and talk up the market. This is what Bill Gross has been doing for years. I don't blame any of them for anything because there are no rules or guidelines in place preventing them from doing so, like the ones that came into being in the equity market after the last stock market bubble.

Before any real damage is done to the economy, the government (you won't often hear me say this) needs to step in to reduce the speculative bid to a reasonable level. While I'm all for people being allowed to throw their money away on stupid investments, there is real risk to the worldwide economy. I would suggest that the CFTC step in and do whatever is necessary to increase margin requirements for speculators (it can do what it wants with hedgers). The futures market was supposed to provide price discovery for cash market participants, as well as providing a hedging vehicle. That isn't happening anymore; the futures just drag the cash higher, regardless of supply and demand. In a perverse way, market forces are being co-opted by the speculation crowd. Investors are piling in to relatively small commodity markets, pushing them ever higher and therefore creating more equity for those in first. Because of the extreme leverage, it behooves the market players to get more and more investors at ever higher prices. I have yet to hear anyone say that these are the correct prices for any commodity currently, only making vague statements in reference to the abovementioned EM middle class. I wouldn't want to liken the commodity markets to a Ponzi scheme, but this and every other bubble in the history of mankind have had similar characteristics.