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Some of you might recall the commercial where a little boy shows up at his parents’ bedroom door. The mom asks, “what’s wrong, did you have a nightmare?”, and the boy responds by saying “No, I’m concerned about this family’s financial future”, and he rattles off a variety of issues facing all of us: retirement plan predictability; supplemental health insurance; estate planning; and car insurance. Finally, the father responds, “Buddy, we’re with AIG!”, and the boy says ‘Oh, don’t get up, I’ll tuck myself in.’ (Watch Video)
Well, that poor little boy IS having nightmares and the term “We’re with AIG!” took on a whole new meaning this week. The market value of one of the world’s largest companies plummeted this week as AIG sought to raise capital to post additional collateral on their outstanding obligations.
AIG is one of the largest insurers for the obligations of other companies. The instruments are called Credit Default Swaps and many investors, including hedge funds, buy these CDS’s as insurance against a company defaulting on any of their debt. With the housing and credit crisis causing many firms to collapse or otherwise default on their payments, AIG has been on the hook as the insurer, causing both S&P and Moody’s to downgrade AIG.
Once a company is downgraded, many of the creditors can ask the company to post additional collateral and in the case of AIG, that additional collateral was initially estimated to be $15 billion or higher. With a lower credit rating and a stock price approaching zero, AIG has been left with very few options to raise the needed capital. That is why the FED, the Governor of NY, and several others were scrambling to figure out how to resolve the issue. Meanwhile, the share price for AIG continues to spiral downward. Without a resolution, AIG will be forced to file for bankruptcy and the potential of a systemic shock across the globe would be imminent.
The fear arises from the fact that AIG equity and debt is very widely held by institutions all over the world. It has operations in over 130 countries and if these securities are deemed worthless, there is the possibility of more writedowns, additional downgrades, and mounting liquidity issues.
So in order to reduce the probability of a global meltdown and asset writedowns for many of the money market mutual funds that hold AIG debt, the verdict is that AIG will receive an $85 billion loan from you, me, and every other person that pays taxes, and the US government will own 79.9% of AIG. The result is an extension of a wedding between two mortgage giants, consummated earlier this month, and includes a diversified insurance company to boot (kind of like a mother-in-law that you weren’t counting on!) A much more exotic combination, for sure! Can you say ménage ‘a trios?
Don’t get up, I’ll tuck myself in!!
Tuesday, September 16, 2008
Wednesday, September 3, 2008
The Economy Still Coughing
The beige book released by the FED today showed signs of weakening across all US regions. The lone bright spot in the economy, exports, may even begin to slow down as foreign demand slows further. There were a few data points that gave the markets optimism, but the bad news was far more dominating.
Tuesday, September 2, 2008
Rollercoaster
When the markets opened today, all the indexes shot through the roof and it looked like it was going to be a positive day. With oil down 5% on the day after Gustav slowed down, it looked like a typical reaction by the equities. But at the end of the day, the Dow, S&P, and Nasdaq all ended in negative territory, while oil prices remained at 5-month lows. Huh?
Monday, September 1, 2008
What is a Hedge Fund?
Hedge funds and mutual funds have many similarities. A mutual fund is a pool of assets made up of investments from many different individuals and institutions. They invest in mutual funds because mutual funds provide diversification and there is a person or team of people that manage the investments of that mutual fund, usually under an investment mandate explicitly stated in the fund’s prospectus. (So what are the differences?)
A hedge fund is very similar in that it is a pool of assets from many individuals or institutions. In the case of hedge funds, however, they are limited in the number of investors they can have and the types of investors they can accept. The number of investors depends on whether the fund is a 3c1 (100) or 3c7 fund. For the most part, only accredited investors can invest in hedge funds. An accredited investor is one that has $1 million in investable assets and has made over $200,000 a year in two of the preceding three years. If a couple is being considered together, the requirement increases to $300K.
Both hedge funds and mutual funds can invest in the same securities. At least in most cases. The difference is that hedge funds can enter into combinations of investments not available to mutual funds and they can also apply leverage to their portfolios. There are probably as many unique hedge fund investment strategies as there are hedge funds so for simplification we try to categorize the different strategies to make comparisons. The process is similar to grouping large cap managers with large cap managers, or growth managers with growth managers.
Some of the hedge fund strategies include: long/short, convertible arbitrage, merger arbitrage, relative value arbitrage, global macro, commodity trading advisor, fixed income arbitrage, and several others. There are a handful of hedge fund indices that have their own set of indices and similar but distinct categories. For the time being, I’ll describe a very simple long/short strategy.
When a mutual fund manager thinks a stock will appreciate from $50 to $100, they will buy the stock. A hedge fund will do the same. However, if a mutual fund manager thinks a stock’s price will go from $100 to $50, there is nothing they can do. A hedge fund however, can borrow the stock from someone else, sell it in the market for $100, and hope they can buy it back in the future for $50. If they are right and the stock drops to $50, they can buy it in the market and return the borrowed stock plus interest. The net result to the hedge fund manager is a profit of $50 minus interest to borrow the share. This is called short-selling, and long/short hedge funds enter into a diversified set of transactions on both stocks expected to appreciate (long) and stocks expected to depreciate (short).
We should also consider that many hedge funds are managed by some of the most talented fund managers. Lured by the thought of 2% management fee and 20% incentive fees, many good managers may leave the larger mutual fund firms or brokerage houses to start their own hedge fund. There is a drawback, however, which is that the 2/20 fees also attract poor managers and now that there are close to 10,000 funds, by some estimates, it gets harder to uncover good managers.
Within a portfolio, hedge funds can provide good diversification and either enhance returns or reduce volatility. There are hedge funds that are designed to generate very high returns, sometimes reaching 30% or more. These hedge funds carry with them a great deal of risk, however. It’s the only way to generate such high returns and although risky, can enhance returns to a well diversified portfolio. There are other hedge funds that use very conservative strategies that can be used as substitutes to fixed income, particularly now that interest rates are so low. These funds provide stability to a well diversified portfolio and uncorrelated returns to both stock and bond markets.
Don’t believe all the hype that hedge funds are bad. The only ones that make the news are those that blow up. We never hear about the ones who quietly generate 12% per year with low volatility. That would be too boring for CNBC to cover. That’s OK, we’ll cover them here!!
A hedge fund is very similar in that it is a pool of assets from many individuals or institutions. In the case of hedge funds, however, they are limited in the number of investors they can have and the types of investors they can accept. The number of investors depends on whether the fund is a 3c1 (100) or 3c7 fund. For the most part, only accredited investors can invest in hedge funds. An accredited investor is one that has $1 million in investable assets and has made over $200,000 a year in two of the preceding three years. If a couple is being considered together, the requirement increases to $300K.
Both hedge funds and mutual funds can invest in the same securities. At least in most cases. The difference is that hedge funds can enter into combinations of investments not available to mutual funds and they can also apply leverage to their portfolios. There are probably as many unique hedge fund investment strategies as there are hedge funds so for simplification we try to categorize the different strategies to make comparisons. The process is similar to grouping large cap managers with large cap managers, or growth managers with growth managers.
Some of the hedge fund strategies include: long/short, convertible arbitrage, merger arbitrage, relative value arbitrage, global macro, commodity trading advisor, fixed income arbitrage, and several others. There are a handful of hedge fund indices that have their own set of indices and similar but distinct categories. For the time being, I’ll describe a very simple long/short strategy.
When a mutual fund manager thinks a stock will appreciate from $50 to $100, they will buy the stock. A hedge fund will do the same. However, if a mutual fund manager thinks a stock’s price will go from $100 to $50, there is nothing they can do. A hedge fund however, can borrow the stock from someone else, sell it in the market for $100, and hope they can buy it back in the future for $50. If they are right and the stock drops to $50, they can buy it in the market and return the borrowed stock plus interest. The net result to the hedge fund manager is a profit of $50 minus interest to borrow the share. This is called short-selling, and long/short hedge funds enter into a diversified set of transactions on both stocks expected to appreciate (long) and stocks expected to depreciate (short).
We should also consider that many hedge funds are managed by some of the most talented fund managers. Lured by the thought of 2% management fee and 20% incentive fees, many good managers may leave the larger mutual fund firms or brokerage houses to start their own hedge fund. There is a drawback, however, which is that the 2/20 fees also attract poor managers and now that there are close to 10,000 funds, by some estimates, it gets harder to uncover good managers.
Within a portfolio, hedge funds can provide good diversification and either enhance returns or reduce volatility. There are hedge funds that are designed to generate very high returns, sometimes reaching 30% or more. These hedge funds carry with them a great deal of risk, however. It’s the only way to generate such high returns and although risky, can enhance returns to a well diversified portfolio. There are other hedge funds that use very conservative strategies that can be used as substitutes to fixed income, particularly now that interest rates are so low. These funds provide stability to a well diversified portfolio and uncorrelated returns to both stock and bond markets.
Don’t believe all the hype that hedge funds are bad. The only ones that make the news are those that blow up. We never hear about the ones who quietly generate 12% per year with low volatility. That would be too boring for CNBC to cover. That’s OK, we’ll cover them here!!
The Consumer Grows Weary
The economy seems to be struggling along and you wonder if it might not be better for the thing to finally collapse than to torture us through this never-ending drip drip drip of stagnation. Economic data continues to have huge impacts on the movements of markets but for every ounce of good news, there is an equal if not greater amount of bad news.
Gross Domestic Product was revised upward to 3.3% from an expected 2.9%. Taken alone, that is not a bad level of growth for our economy. However, dissecting the parts reveals that the majority of that growth was driven by the growth in exports due to the weaker dollar, and the contraction in imports due to slower US demand for foreign goods. The overall impact of the export/import affect is estimated to be 3.1%. For those of you who don’t remember, GDP is made up of government spending, consumer spending, business investment, and exports minus imports. If the exports minus imports portion was 3.1%, the remaining drivers contributed a measly 0.2%. That is why it feels like we are in a recession even though the GDP numbers are coming in strong.
Consumer spending, which had been kept afloat by the federal stimulus package during the second quarter, seems to finally be weakening amidst higher unemployment and higher prices. In July, personal income declined by 0.7% from the prior month and consumption measured in real terms (accounting for inflation) fell by 0.4%. It looks like the consumer is starting to reach for the white towel. There is some hope however, in that consumer confidence had increased from prior month levels, but the index is still at recessionary levels and much of the improvement in confidence came from lower prices at the pump.
Even though the weak dollar should continue to benefit US exporters, the slowing growth in foreign markets will serve as a counterforce and should mute the affect of currency advantages. The real question looking forward to the rest of 2008 and into 2009 is how well the manufacturing sector holds up and how the consumer will react. The manufacturing sector has held up well as revealed by an unexpected rise in durable goods orders. Month over month, durable goods increased by 1.3% but a closer look shows that when adjusted for inflation, the increase was only 0.3%.
As for the consumer, the tax rebate impact is now gone and estimates are that only 30% of the rebates were spent. The rest of the money was used to either pay down debt or is being saved for a rainy day. With so many hurricanes swirling around, this may not be such a bad idea.
We should expect slower growth in Q3 and Q4 as issues continue to be shaken out and those less affected wait and see. There was a time not long ago when economists were insistent about the world economies ‘decoupling’ from the US. Either they were completely wrong or it just happens to be a coincidence that the world is now starting to slow considerably.
Gross Domestic Product was revised upward to 3.3% from an expected 2.9%. Taken alone, that is not a bad level of growth for our economy. However, dissecting the parts reveals that the majority of that growth was driven by the growth in exports due to the weaker dollar, and the contraction in imports due to slower US demand for foreign goods. The overall impact of the export/import affect is estimated to be 3.1%. For those of you who don’t remember, GDP is made up of government spending, consumer spending, business investment, and exports minus imports. If the exports minus imports portion was 3.1%, the remaining drivers contributed a measly 0.2%. That is why it feels like we are in a recession even though the GDP numbers are coming in strong.
Consumer spending, which had been kept afloat by the federal stimulus package during the second quarter, seems to finally be weakening amidst higher unemployment and higher prices. In July, personal income declined by 0.7% from the prior month and consumption measured in real terms (accounting for inflation) fell by 0.4%. It looks like the consumer is starting to reach for the white towel. There is some hope however, in that consumer confidence had increased from prior month levels, but the index is still at recessionary levels and much of the improvement in confidence came from lower prices at the pump.
Even though the weak dollar should continue to benefit US exporters, the slowing growth in foreign markets will serve as a counterforce and should mute the affect of currency advantages. The real question looking forward to the rest of 2008 and into 2009 is how well the manufacturing sector holds up and how the consumer will react. The manufacturing sector has held up well as revealed by an unexpected rise in durable goods orders. Month over month, durable goods increased by 1.3% but a closer look shows that when adjusted for inflation, the increase was only 0.3%.
As for the consumer, the tax rebate impact is now gone and estimates are that only 30% of the rebates were spent. The rest of the money was used to either pay down debt or is being saved for a rainy day. With so many hurricanes swirling around, this may not be such a bad idea.
We should expect slower growth in Q3 and Q4 as issues continue to be shaken out and those less affected wait and see. There was a time not long ago when economists were insistent about the world economies ‘decoupling’ from the US. Either they were completely wrong or it just happens to be a coincidence that the world is now starting to slow considerably.
The Biggest Wedding of the Year?
The latest word is that perhaps the best way to solve the problems of two separate but similar entities is to have them joined. With Minister Paulson as the master of design, it’s quite possible that Freddie Mac and Fannie Mae will be united in what may be the biggest wedding of all time.
As foster mother, OFHEO failed to live up to her motherly obligations and now we have Freddie and Fannie running rampant and causing all types of havoc. With plans to have the ceremony at the White House, the reception on Capitol Hill, and the honeymoon at the Treasury, you would think the two crazy kids would have gotten hooked a long time ago. The Treasury, after all, does print the money you know! (See Below)
There has been talk about the possibility of merging Fannie Mae and Freddie Mac. How and when that would happen is still a mystery. But one thing is certain. The failure of one or both of these Government Sponsored Entities (GSE) would be disastrous. If one of these GSE’s fails, we could assume that the same forces will cause the other GSE to fail, in essence, making the mortgage market all but shut down in the near term.
Fannie Mae and Freddie Mac were established to make homes more affordable for lower and middle income Americans. They are both ‘sponsored’ by the US government but the implications of that have become dubious at best. Neither provides home loans, but each one stands ready to buy mortgages from banks in order to take them off the banks’s books and provide the bank with capital to make additional loans. In some cases, the GSE’s don’t buy the mortgages, but provide a guarantee in the event of default. They currently hold or guarantee roughly half of the $12 trillion market in mortgages making it clear that their failure would be much worse than the failure of Bear Stearns would have been.
For many years, critics of the two firms pointed to their sheer size and business practices and felt that they were both too big and unregulated. They were both extremely risky, some said. Their size didn’t happen by mistake, however. Over the years, both firms lobbied hard to pass legislation that allowed them to remain independent, grow rapidly, and remain unregulated. As the connection between the GSE’s, Wall street, mortgage bankers, real estate agents, and lawmakers became tighter, both Fannie and Freddie became profit drivers for the above-mentioned constituents, which made sure that the status quo held firm. Both firms had members of their board who were tied to political power-players and they hired well connected lobbyists to protect their interests. In the early 90’s the Office of Federal Housing Enterprise Oversight (OFHEO) was made regulator for both Fannie and Freddie, but we now know that OFHEO was a weak regulator.
So what went wrong? Since Fannie and Freddie owned or guaranteed roughly half of all outstanding mortgages, the subprime meltdown and subsequent effects has had a detrimental effect on the value of the assets they hold. As foreclosure rates rise, they are on the hook for those mortgages and the mortgages they hold, and which are now trading at much lower levels. It moves them closer to violating their minimum capital requirements and making them look insolvent. As a matter of fact, by general accounting standards, if their assets were marked-to-market (priced at what current buyers are willing to pay), some economists say they are already worthless!!
Since banks and other lenders rely on Fannie and Freddie to buy their mortgages in order to free up capital and make more mortgages, the elimination of either or both of the GSE’s will freeze up the housing market through ever tightening bank standards. Already, even the most qualified borrowers are facing less favorable loan terms.
Now, Treasury Secretary Hank Paulson is considering all possible options, along with Ben Bernanke and a few others. One possible scenario was a merger of the two to form one larger, more stable firm, but this would be highly unlikely. Besides the uncertainty of whether a merged firm will emerge stronger than the sum of it’s parts, it doesn’t address the risks inherent in the business model. Risks that are surfacing now: that perhaps these agencies got too big!
There is also the possibility of further regulation, in the form of higher capital requirements or limits to lending standards. For some, this would be a natural step since both Freddie and Fannie have always been free-wheeling children of the US Government. The least that the US government could do is give the agencies a curfew.
Finally, one or both agencies can be placed in a conservatorship. In this scenario, their shares would be worthless and you, me, and the rest of the taxpayers will pick up the tab. A conservatorship has quite a bit of flexibility to overhaul the agencies but cannot close them. What will come out of this will surely be some form of consolidation and distribution. Perhaps a smaller, combined entity can fulfill it’s purpose within a system that will eventually shift risk to the private sector. It would be a huge undertaking and could take a decade or longer to complete.
When it’s all said and done, we should end up with a structure that on the surface looks less risky. But rest assured that financial innovation will someday challenge the limits of even the most well thought out solution.
As foster mother, OFHEO failed to live up to her motherly obligations and now we have Freddie and Fannie running rampant and causing all types of havoc. With plans to have the ceremony at the White House, the reception on Capitol Hill, and the honeymoon at the Treasury, you would think the two crazy kids would have gotten hooked a long time ago. The Treasury, after all, does print the money you know! (See Below)
There has been talk about the possibility of merging Fannie Mae and Freddie Mac. How and when that would happen is still a mystery. But one thing is certain. The failure of one or both of these Government Sponsored Entities (GSE) would be disastrous. If one of these GSE’s fails, we could assume that the same forces will cause the other GSE to fail, in essence, making the mortgage market all but shut down in the near term.
Fannie Mae and Freddie Mac were established to make homes more affordable for lower and middle income Americans. They are both ‘sponsored’ by the US government but the implications of that have become dubious at best. Neither provides home loans, but each one stands ready to buy mortgages from banks in order to take them off the banks’s books and provide the bank with capital to make additional loans. In some cases, the GSE’s don’t buy the mortgages, but provide a guarantee in the event of default. They currently hold or guarantee roughly half of the $12 trillion market in mortgages making it clear that their failure would be much worse than the failure of Bear Stearns would have been.
For many years, critics of the two firms pointed to their sheer size and business practices and felt that they were both too big and unregulated. They were both extremely risky, some said. Their size didn’t happen by mistake, however. Over the years, both firms lobbied hard to pass legislation that allowed them to remain independent, grow rapidly, and remain unregulated. As the connection between the GSE’s, Wall street, mortgage bankers, real estate agents, and lawmakers became tighter, both Fannie and Freddie became profit drivers for the above-mentioned constituents, which made sure that the status quo held firm. Both firms had members of their board who were tied to political power-players and they hired well connected lobbyists to protect their interests. In the early 90’s the Office of Federal Housing Enterprise Oversight (OFHEO) was made regulator for both Fannie and Freddie, but we now know that OFHEO was a weak regulator.
So what went wrong? Since Fannie and Freddie owned or guaranteed roughly half of all outstanding mortgages, the subprime meltdown and subsequent effects has had a detrimental effect on the value of the assets they hold. As foreclosure rates rise, they are on the hook for those mortgages and the mortgages they hold, and which are now trading at much lower levels. It moves them closer to violating their minimum capital requirements and making them look insolvent. As a matter of fact, by general accounting standards, if their assets were marked-to-market (priced at what current buyers are willing to pay), some economists say they are already worthless!!
Since banks and other lenders rely on Fannie and Freddie to buy their mortgages in order to free up capital and make more mortgages, the elimination of either or both of the GSE’s will freeze up the housing market through ever tightening bank standards. Already, even the most qualified borrowers are facing less favorable loan terms.
Now, Treasury Secretary Hank Paulson is considering all possible options, along with Ben Bernanke and a few others. One possible scenario was a merger of the two to form one larger, more stable firm, but this would be highly unlikely. Besides the uncertainty of whether a merged firm will emerge stronger than the sum of it’s parts, it doesn’t address the risks inherent in the business model. Risks that are surfacing now: that perhaps these agencies got too big!
There is also the possibility of further regulation, in the form of higher capital requirements or limits to lending standards. For some, this would be a natural step since both Freddie and Fannie have always been free-wheeling children of the US Government. The least that the US government could do is give the agencies a curfew.
Finally, one or both agencies can be placed in a conservatorship. In this scenario, their shares would be worthless and you, me, and the rest of the taxpayers will pick up the tab. A conservatorship has quite a bit of flexibility to overhaul the agencies but cannot close them. What will come out of this will surely be some form of consolidation and distribution. Perhaps a smaller, combined entity can fulfill it’s purpose within a system that will eventually shift risk to the private sector. It would be a huge undertaking and could take a decade or longer to complete.
When it’s all said and done, we should end up with a structure that on the surface looks less risky. But rest assured that financial innovation will someday challenge the limits of even the most well thought out solution.
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