Sunday, July 29, 2012

How the Financial Markets Enable the EU Sovereign Debt Crisis

Imagine Barack Obama or Mitt Romney saying, "If re-elected/elected President, I'm going to do everything I can to restore prosperity and full employment, and, believe me, it will be enough." The stock market's reaction would be neutral to negative, and a lot of people, perhaps most, would laugh and suggest the candidate try out as a joke writer for the Tonight Show.

Last week, the head of the European Central Bank, Mario Draghi, vowed to do everything he could to prevent the collapse of the Euro zone and added that "it will be enough." He offered no details on what he had in mind. The stock market rallied and Euro zone interest rates dipped. The next day, the leaders of Germany and France, Angela Merkel and Francois Hollande, rose from the chorus and shouted "Amen" (while also skimping on details). The stock market rose again, with the Dow Jones Industrial Average closing over 13,000, a threshold it hadn't crossed since May. In the last two trading days of the past week, the Dow rose almost 400 points (or 3.15%)--all because a few EU leaders swore on a stack of sovereign bonds that, by golly, they were going to something or other really good.

This follows a pattern that has persisted throughout the EU sovereign debt crisis. Storm clouds gather, interest rates rise, and stocks fall. European leaders, alarmed by the market action, issue rosy press releases, promising rose gardens while avoiding any detailed explanation of how salvation will be attained. Stocks rise while interest rates fall. Everyone is happy.

But, then, reality inserts itself. The baseline problem with the EU debt crisis is that the sovereign liabilities in questions are simply too great for the debtor nations to repay. The question is where the losses will fall--on creditors, citizens of debtor nations, taxpayers of wealthy EU nations, issuers of credit default swaps or other interested parties? The intractable tussling over this essential and, for some, existential, question forces examination of ugly details revealing that there are no easy answers. Bottom line: someone needs to give up a shipload of real wealth to pay off the debts. There are no volunteers. Stocks again fall and interest rates again rise.

But the EU's leadership has learned that the financial markets respond to talk therapy, and talk is cheap. If they talk interest rates down, even if only temporarily, they can stall on making the hard choices needed for true resolution. Politicians have never met a hard choice they wanted to make. So they yak their way to a brief respite, and fiddle until the markets waver again. Meanwhile, overall debt levels among EU nations keep rising while Europe slides into recession. There's something wrong with this picture. But, as long as the financial markets display an appetite for b.s., the EU's leaders will keep serving it up.

Saturday, July 21, 2012

Hedge Fund Money Managers

In Hedge Fund Market Wizards, author Jack D. Schwager explores the trading styles and techniques of 15 current or former hedge fund money managers. The book, provided without charge to this writer by publisher John Wiley & Sons, Inc., presents interviews with each trader featured, along with commentary by the author. The traders, whom the author believes to be highly successful compared to their peers, include some who are well-known in the financial community and others who are not. The interviewees are variously active in one or more of the major financial markets, including stocks, bonds, commodities, and derivatives. Some trade hundreds of times a day, holding positions for as a little as a few moments, while others are value investors, seeking in some cases to outsmart their peers by outlasting them.

The featured traders were asked to explain the keys to their success. Each has a different story. Some got their start as elementary school age kids. Others drifted into trading. Some manage billions of dollars of investor funds. Others deliberately limit themselves to tens of millions. Their ranks include academics, attorneys, accountants and college dropouts. While their paths to success varied greatly, all were persistent, patient, open-minded and willing to learn from mistakes, and loss averse. The last trait may be the one that the ordinary investors have the hardest time emulating. Each trader featured in the book has stringent ways of limiting losses, and learned to pull the plug on losers quickly, even if doing so meant admitting error and taking a few hits to one's ego. Most, perhaps counterintuitively, weren't terribly greedy. They would start taking profits without trying to score the maximum gain possible. Making some gains, and then looking for another good opportunity, is generally preferred over squeezing the last penny of profit from any given position (with its concomitant risk of overplaying one's hand).

Some of the traders employ rigorously defined parameters. Others apparently rely mostly on their intuition. But they weren't all numbers crunchers and screen watchers. One, perhaps not illegally, got some nonpublic information about a public company from a U.S. government agency. Another (mentioned but not interviewed), hoping to profit from the impending collapse of the real estate market in 2007-08, may have convinced an investment bank to create a derivatives based investment relating to real estate assets the trader suggested, believing those assets to be weak and to provide a good shorting opportunity.

Who would benefit from reading this book? Other traders, for one, just to get an idea of what their peers are thinking. Much of the material in the interviews is already well-known to money management professionals, but the ways that successful traders mix and match the kaleidoscopic inflow of information and ideas into the financial markets can be insightful. Of course, one cannot expect that the interviewees revealed everything they know and do. No good trader would do that. Not if he wanted to keep making money in the markets.

Potential hedge fund investors--in other words, accredited investors--would find the book helpful in revealing the enormous variety of money management styles and techniques. As author Jack Schwager emphasizes, you can't rely on past performance as a certain indicator of future performance. You have to look at investment approaches and risk management, and find a manager with whom you are comfortable.

Ordinary investors might find the book insightful, not because they could use most of the trading techniques discussed. Hedge fund managers do a lot of stuff that you shouldn't try at home. But reading the book can help crystallize an individual's thinking about his or her personal investment approach. As Mr. Schwager highlights, it's important to invest in ways that you find comfortable, to learn from your mistakes, to adjust to changes in the markets, to limit losses, and to find out how you personally can be successful.

The book presumes a considerable degree of financial literacy on the part of the readers. The author is an experienced money manager and tosses around many terms and concepts familiar to the cognoscenti that aren't defined in the book. Have a good Web browser handy if you don't know the lingo of the financial markets. In addition, very little math is presented in the book. But mathematical concepts underlie the financial markets. If you don't have a facility for arithmetic and a basic understanding of statistical analysis, you won't follow the discussion much of the time. Beginning investors should start their reading elsewhere.

One limitation of the book is that it casts little light on high speed computerized trading, which comprises the majority of today's stock trading volume. The impact of algorithmic trading by the millisecond, particularly on the perhaps decreasing number of live humans active in the markets, is a crucial question and problem as we look toward the future. Answers are difficult to discern, but badly needed. Humans can't possibly keep up with machines that trade faster than the blink of an eye, especially when the algorithms deployed are dynamic (i.e., they can change on the run). If Mr. Schwager can coax some high speed traders into talking for his next book, he might well do investors and the financial markets a considerable service.

Sunday, July 15, 2012

LIBOR: Good Enough For Government

The Libor price fixing scandal keeps growing. Following Barclay's payment of $450 million in a settlement with regulators, word now comes of a U.S. Department of Justice criminal investigation into the morass. Indictments may come soon. Private civil lawsuits galore have been filed. The potential liabilities of the banks caught up in the scandal could run tens of billions, and maybe hundreds of billions if the price fixing is shown to have taken place over a sufficiently long period of time. If the latter were proven to be the case, many of the world's major banks would possibly be insolvent. Which would mean that the world's financial system could be at risk of collapse. Taxpayers on both sides of the Atlantic should brace themselves for yet another bailout of the major banks.

A crucial reason for the enormous potential liabilities is derivatives. (Yes, derivatives have done us in again.) The big banks that participated in setting Libor were often major dealers in the derivatives markets, and many of their products were based on Libor. That meant that they were exposed whether Libor was rising or falling. If they manipulated Libor up, one set of customers and/or counterparties would be injured (and therefore have a right to sue). If they manipulated Libor down, another set of customers and/or counterparties would be injured (and therefore have a right to sue). Since the price fixing could violate U.S. antitrust laws, the defendant banks may face liabilities for the treble damages permitted under the antitrust laws. Trebling the effect of the bad behavior could mean big, big money.

Vast legions of lawyers are now licking their chops at the prospect of suing or defending big banks with respect to the Libor mess. Their retirement accounts will reap rich harvests. Many will finance their childrens' higher educations with the fruits of their Libor engagements. And the modestly paid attorneys working on the government side of the cases can burnish their resumes with high profile cases.

If we want to reduce the likelihood of such windfalls for the legal profession--and, incidentally, enhance the integrity of the financial markets--we must find a better way to determine Libor. The British Bankers Association, a private organization that doesn't appear to be subject to direct government oversight, currently presides over the process of determining Libor. It's done a lousy job. Time to do a Trump and relieve BBA of this responsibility.

What's the best candidate for the job? The U.S. government. Not exactly the most obvious choice, but better than the alternatives. The private sector methodology for determining Libor was too easily infected with agendas and ulterior motives driven by the profit imperative. Government statisticians don't face such pressures. Admittedly, government statistics aren't perfect. But their methodologies are publicly known. We can praise or criticize those methodologies, and work to improve them. But we don't have to worry about price fixing.

One U.S. government statistic, the Consumer Price Index, plays a role in the economy comparable to Libor. Social Security benefits are adjusted when the CPI increases. Many public compensation schemes and private contracts adjust pay and/or benefits when the CPI increases. While numerous economists, statisticians, pundits, bloggers and other riff raff decry this or that about the CPI, no one has said it's secretly rigged. The Bureau of Labor Statistics is trusted to calculate and announce CPI figures.

Perhaps a group in the U.S. Commerce Department could be given the responsibility for determining Libor. (We should disregard America's special relationship with Britain and exclude the Brits from Libor calculations; they had their chance and blew it, big time.) The Commerce Department does not regulate any banks, nor does it have responsibility for monetary policy, nor does it finance the operations of the U.S. government. It has no vested interests, and could credibly determine Libor (preferably using actual market transactions, rather than the opinions of banks of the interest rate at which they could fund themselves, which is the formulation of Libor that has proven to be so problematic).

Having the U.S. government determine Libor would accomplish two important things. First, it would enhance the integrity and credibility of the announced rate. Since public confidence is, ultimately, the only thing that really matters in the financial markets, integrity and credibility are worthwhile. Second, a government determined rate wouldn't give rise to private liabilities the way that Libor has with each manipulated tick up and each manipulated tick down. The massive potential liabilities that major banks face, and the possible collapse of the financial system they could produce, would simply not arise. The cost of a handful of government statisticians putting out Libor might run a few million a year. The cost to taxpayers of bailing out the dodos at the big banks who have screwed up yet again could run billions and billions more and then billions more. At the risk of voicing a political heresy, there are some jobs government does better than the alternatives, and calculating Libor is one of them.

Thursday, July 12, 2012

Stocks Are Not Cheap

Forget what the bulls have to say. The Federal Reserve Bank of New York just released a study showing that over 50% of the increase in the S&P 500 since 1994 is due to Federal Reserve actions. Without central bank intervention, the market as measured by the S&P 500 would be around 600 instead of today's close at 1334.76. In other words, based on economic fundamentals, stocks are overpriced by more than 100%. That's a sell if there ever was one. It looks like all the retail investors who are abandoning the market aren't so dumb after all.

One may quibble with the Fed's methodology. Its staff looked at market activity in the 24 hours before the Fed announced Open Market Committee decisions, totaled and netted the market movements, and came up with the more than 50% figure. It's certainly possible that some portion of the market movements in the 24 hours before announcements of Open Market Committee decisions could be attributed to other causes. In fact, it would be surprising if the only discernible reason for these movements over an 18-year time span was anticipation of the Fed. But even if only 25% of the S&P's rise since 1994 is due to the Fed, stocks still remain seriously overpriced. They're a buy only if you have faith in the efficacy of central banks. And history does not vindicate such confidence.

Of course, the Fed isn't recommending that investors sell. It's certainly not about to undo all the accommodation and easing it's instituted over the past 18 years, not for quite a while. So the central bank put for stocks will remain in place for now. But ultimately, the government, including the almighty Fed, cannot prescribe stock prices (even though it's acting like it desperately wants to). If you choose to invest in stocks, expect volatility (especially if things in Europe continue their slide into the septic system) and a long wait before any big payoff arrives.

Friday, July 6, 2012

Target2: The EU's Little Surprise

Well, it seems that if the financially weaker members of the Euro zone were to go belly up, their Target2 liabilities alone might be enough to soak up the entire EU bailout bazooka. Isn't that something?

What are Target2 liabilities, you ask? The Euro zone operates a settlement and clearance system called Target2. Settlement and clearance systems have existed for centuries, serving to provide centralized places where checks and other funds transfers between banks can be netted out and paid. For example, most major European banks have claims on each other for payment of checks, wire transfers and numerous other types of funds transfers. These transactions can be done directly with each bank (highly inefficient), or presented to a centralized clearinghouse, which adds up all claims of and on each bank, nets them, and asks the bank at the end of each business day to make a single payment to (or receive a single payment from) the clearinghouse. The Federal Reserve System operates a humungous settlement and clearance system for American and foreign banks dealing in dollar denominated transactions. Without settlement and clearance systems, modern finance couldn't exist.

The prototypical settlement and clearance system doesn't extend overnight credit. Its job is to make sure there are no unpaid liabilities on the part of member banks and expects each member to completely pay all its obligations at the end of the business day.

But the EU's Target2 system evidently is different. It seems to have a little spigot for overnight credit. And, indeed a fount for some EU member nations. Greece reportedly has a 100 billion EU indebtedness at Target2 (see The total unpaid Target2 liabilities of Greece, Spain, Italy and other troubled Euro zone member nations could be in the range of 700 billion plus Euros, equal to or greater than the 700 billion Euro bailout bazooka. And we haven't counted the formal sovereign debt of these nations, which totals in the trillions of Euros. Target2 requires collateral for intraday credit. But its collateral requirements, if any, for overnight credit are unclear. There may be none.

This is a funny way to run a settlement and clearance operation, with credit available on a continuing, overnight basis. It contravenes the basic purpose of settlement and clearance, which is to balance the books. By allowing member nations to participate on an unbalanced basis, Target2 seems to have bought itself a mission creep problem that it can't solve without blowing up the European Monetary Union. After all, how does Target2 collect from Greece or another nation with an unpaid overnight balance? If it boots that nation out of Target2, it effectively boots that nation out of the Euro zone. That, in turn, precipitates all the dire consequences that Europe's leaders profess to want to avoid.

If a Euro zone member nation--let's randomly pick Greece--is unable or refuses to pay its Target2 liabilities, the losses evidently would be allocated among the central banks in the Euro zone. Most likely, the central banks of the larger nations like Germany and France would bear more liability than, say, Finland's central bank. Hence, the incentive for the EU powerhouses to keep trying to muddle through the crisis even though Greece is trying mightily not to repay its debts and Germany is striving mightily not to pay Greece's debts, either.

How Target2 became a secret sugar daddy for the spendthrift Euro zone members remains unclear. Whatever the explanation, the sudden surfacing of these liabilities only darkens the clouds gathering over the European financial world. Target2 evidently has been quietly carrying these liabilities without forcing repayment. That doesn't promote confidence in its financial solidity. Wary member banks might be inclined to take defensive measures, and those, if extreme enough, could resemble a credit crunch. We just had a credit crunch in 2008 and it made for a lousy party. There's no easy way to reduce these Target2 liabilities since the debtor nations ain't got the moola to pay down the outstanding overnight balances. Which means they'll be barking up any nearby tree for yet another bailout.

But the EU's bailout bazooka appears overwhelmed once Target2 is added into the mix of indebtedness it's supposed to cover. High ranking EU officials will surely issue a comforting sounding press release or two to paper over the Target2 problem. But talk therapy, a favorite EU maneuver, hasn't done squat to resolve the crisis and it won't help much here, either.