Saturday, June 30, 2007

No surprise

The bank problems described below will come as no surprise to readers of this blog.

Chinese banks in $2.4bn disaster
Jamil Anderlini, Beijing
June 30, 2007

CHINA'S state auditor yesterday named three large banks for "illegal or
irregular" behaviour involving more than $US2 billion, highlighting the
massive governance problems that exist in the country's financial system.

Bank of China, Bank of Communications and China Merchants Bank, all of which
are listed in both Hong Kong and Shanghai, were cited for making illegal and
irregular loans to the real estate sector and for problems in their
settlement operations.

But, according to the National Audit Office's annual report, the bulk of the
money was the result of outright fraud with $US1.34 billion stolen by
individual employees in 37 separate incidents.


The REcapitulator was asked by an acquantance the other day how the CDO market is effected by the MBS markets, and I found my response was far too complicated for a layman.  This deficiency cannot stand uncorrected, and thus I write today to simplify how these two derivatives interact.

An MBS, or mortguage-backed security, is a derivative that provides cash-flow rights from a group of mortgages to a buyer of the security.  
Lenders to homes like to securitize liabilities like mortguages because it frees
up capital for other purposes in addition to being a profitable business itself.

However, when the MBS is backed by "sub-prime" borrowers, it is difficult to find bidders for the securities (one of the reasons investors like MBS's is because they exhibit a property called negative convexity, and a post on this will be forthcoming).

I-banks cater to needs of disparate investors, some of whom like very safe investments, some willing to hold more risk, and some willing to hold a great deal of risk, of course hoping to reap a more handsome reward.

So I-banks divide the MBS securities into several different "levels" (spatially speaking, not geographically speaking) of risk and return.  The levels are typically described, proceeding from lowest risk level to highest risk level, as "Investment Grade", 
"Mezzanine", and "Equity".  These categories as also known as "tranches" and are now grown up to become "CDO"s, or Collaterlized Debt Obligations - securities that depend on the values of the MBS groups so divided.

And so we follow the money.  Cash flows from the mortguage payments now flow first to capitalize the safe, from a probablistic standpoint, investment grade bonds.  Any remaining cash flows go to the mezzanine level, and then any remaining cash flow finally makes its way to the (by now somewhat nervous) "Equity" level CDO holders.

When there are mortguage defaults and slowing cash flows, firms like Bear Stearns, which opened a coupld of hedge funds for the specific purpose of investing in the "Equity" level of CDOs, get in trouble very quickly.  Since the securities depend on the cash flows from the underlying mortguages, no money flowing to the Equity level means that these securities, which are not often traded, must be valued at far, far less than when the housing market was booming.

Friday, June 29, 2007

Inflation Expectations and the Fed

It is well-known among the finance community that Ben Shalom Bernanke believes inflation expectations is a more useful predictor of future inflation trends than current (that is, "current" in the sense that CPI figures is a compliation of data gathered in the past) inflation.

Mr. Bernanke has been very transparent about this.  So now the REcapitulator is wondering how our wonderful Fed, the most important central planning organization on the planet, is going to react to the inflation expectation figures complied by the University of Michigan:

Month                Inflation Expectation (one year ahead)
July                      3.4%
June                     3.5%
May                      3.3%
April                     3.3%
March                  3.0%

This will be an interesting test for close observers of the Fed to see how Mr. Bernanke deals this report, and compare it to previous central bankers who are now part-time consultants to very large bond funds.

Wednesday, June 27, 2007

Modus Ponens

Economic theory and economists tend to make arguments based on narrative causal connections based on some sort of "equilibrium" theory.  The REcapitulator thinks pundits like Jeremy Siegel are amusing when he opines that it is "more difficult to analyze" commodities than traditional asset classes like stocks and bonds.  If "more difficult to analyze" is a euphemism for "I don't have the proper tools to B.S. an answer", then I completely understand.

Modus Ponens (B follows A, A is present, therefore we have B) is a simple logical format, and, finding little fault with the basic logical structure of the argument, we instead find that Modus Ponens is misapplied to a system that is far too complex 
to simply collapse "N" (where "N" is a very large number) variables into "B follows A".

I am reminded of Ludwig Van Mises and his unending critique of this system of thought.  This quote sums it up nicely:

"there is no experience of future happenings…the experience to which the natural sciences owe all their success is the experience of the experiment in which individual elements of change can be observed in isolation. The facts amassed this way can be used for induction…No laboratory experiments can be performed with regard to human action. We are never in a position to observe the change in one element only, all other conditions of the event remaining unchanged”

The REcapitulator agrees.  Thinking participants alter the game, and 3rd order thinking ("What does he think I think he is thinking") is not observed amongst the natural sciences.

The Fed's Perspective

This excerpt from the FT, in light of my previous post on the Fed, is important:

By Krishna Guhain Washington

Federal Reserve officials are expected to discuss ways to redirect market
attention from current core inflation to its forecast of headline inflation at
this week's meeting of the rate-setting open market committee.

The meeting, the first since the sell-off in the bond market pushed up long-term
interest rates, will end with the Fed affirming its focus on inflation risk.

However, there could be extensive changes to the statement to reflect evolving
concerns on prices.

To date, the Fed has talked about the current level of core inflation, which
excludes food and energy prices, as "elevated" and emphasised the need to ensure
it comes down.

But with core inflation as measured by the personal consumption expenditure
deflator likely to edge below 2 per cent in May, Fed officials no longer agree
on whether it is elevated or not.

Tuesday, June 26, 2007

The Fed's view

It is axiomatic when analyzing the Federal Reserve's opinion of their management of short-term interest rates (the price of Federal Funds), one must attempt to determine which factors the Fed over or under weights in their view of the economy.  

To that extent, the REcapitulator submits these words from Mr. Bernanke in his Humphrey-Hawkings testimony from 2/14/07:

Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes. Such an outlook is reflected in the projections that the members of the Board of Governors and presidents of the Federal Reserve Banks made around the time of the FOMC meeting late last month. The central tendency of those forecasts--which are based on the information available at that time and on the assumption of appropriate monetary policy--is for real GDP to increase about 2-1/2 to 3 percent in 2007 and about 2-3/4 to 3 percent in 2008. The projection for GDP growth in 2007 is slightly lower than our projection last July. This difference partly reflects an expectation of somewhat greater weakness in residential construction during the first part of this year than we anticipated last summer. The civilian unemployment rate is expected to finish both 2007 and 2008 around 4-1/2 to 4-3/4 percent.

The risks to this outlook are significant. To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006.

Monday, June 25, 2007

Paper Dragon

Readers of this blog already know the REcapitulators opinion of China.  Now, the Bank of International Settlements weighs in with a good rendition of the "somewhat" obvious...

The Chinese economy seems to be demonstrating very similar,
disquieting symptoms," it said, citing ballooning credit, an asset
boom, and "massive investments" in heavy industry.

Some 40pc of China's state-owned enterprises are loss-making,
exposing the banking system to likely stress in a downturn.

It said China's growth was "unstable, unbalance, uncoordinated and

Still Communist.  Still Centrally Planned. Still harboring great masses of people that have no access.  Hayek's "The Fatal Conceit" contained all of the intellectual groundpinnings for the refuation of such a plan.

Now let's add massive corruption and near institutionalized cronyism, which appear to be invevitable evolutionary appendages to Communism, and you have the paper dragon of China.


The REcapitulator has reviewed many prospectuses in his day.  Most of the statistical studies included therein are utterly depressing.  

The most glaring problem is the sample period of returns.  Mutual funds, as a rule, cannot help but fit their returns to the time period that produced the greatest period of compounded returns...fancy that.

And do not get the REcapitulator started on "risk" parameters such as beta or the sharpe ratio, both of which fall prey to difficulties with autocorrelation.

Since "Beta" (again:  WHY do we insist on using Greek variables in Finance?) is a measure of the covariance between an asset and the "market" in terms of the variance of the "market", autocorrelation, or the tendency for time-series data to be MORE dependent on adjacent values than values from the past, rears its ugly head.

The REcapitulator has never seen good mutual fund reports that include all the correct statistical studies...but that would not be good for marketing, now would it???

Continued discussion with a Money Manager from St. Louis...

The latest rejoinder by yours truly, after my interlocutor presented some opinions from a demographic researcher (who came to the same conclusions as myself, albeit from different premises)

With regards to small/medium sized companies vs. large (index
components), the determining factor in my view is the pure yen/$
exchange (small and medium companies that sell to the JPN consumer vs.
the larger index components who are hedged to a certain extent by
revenue streams in multiple currencies. But your friend is
right...smaller countries are a purer play (with more concentrated
Delta risk on the Yen)

With regards to demographics in general, it is challenging to
extricate short-term causations (changes in immigration policy, etc.)
vs. long-term trends. Also, property rights and the rule of law serve
as the mechanism that unlocks favorable demographics. Luxembourg, for
example, has terrible demographics upon first glance...but it is the
"new" Switzerland (although not for long as the Swiss don't want to
ruin their franchise with ****'s oft-labelled "weaponization of the

Saturday, June 23, 2007

A query from a money manager in St. Louis...

leads me to a brief and rather non-analytical "hand-waiving" discussion of the Yen:

OK, lets talk Japan. (if you want my quick and dirty answers, go to
the "So, to SUM UP" section)

First off, I have reams of data as well as anecdotal evidence that
seems to support a general "Japanese Investors exhibit herd-like
behavior greater than most other developed countries".

Secondly, we have to delve into the "Boys from Todai" to understand
how the MOF thinks (and even more importantly, how they wantus to
think they are thinking). Soros has said many times that the MOF is
one of, if not THE most sophisticated participant in the market, they
don't get pushed around and have earned their "widowmaker" reputation.

Now, I met deputy minister Iwata (again, a guy from Tokyo University,
aka "Todai") and he claims the MOF follows a neoclassical inflationary
expectations model developed by Wiksell way back near the turn of the
century. Now, do they really believe in Wiksell's formulae? NO.

JPN, like every other macro scenario, is an exercise in timing and
cyclical response to economic stimuli. Deflation is still a problem
until domestic demand can be stimulated. Then the damn will finally
break (and your position is helped by declining US $ denominated
assets) and the rate of increase in the capital account (opposite side
of the current account, reflecting desire to net save US financial
assets) in Japan will decrease. The Yen goes up. Big.

However, since domestic demand has to be stimulated, the MOF will
intervene in the currency markets (as they have always done). This is
why me and my partner are long some JPN indexes, etc. Fiscal policy
is the lynchpin over there (as in ANY soft currency economy...and of
our friends, ###### is the one of the only ones to really
understand modern soft currency economics). And we watch fiscal
policy as a greater predictor of long-term price levels than the
short-term interest rates in distant JPY futures contracts.

SO, to SUM UP:

They will not raise interest rates soon. They are scared to death of
continued deflation. (and now there may be a good chance of deflation
here, which will not help them...but that opinion is not shared by
anyone at the moment)

The carry trade piper will most certainly be paid, and in a way that
will blow away risk parameters. NZ's economy is the size of Michigan.
What happens when the carry trade into NZ's $ unravels and those
players are forced to re-purchase Yen?

So, for the time being, I think your Yen play is a good one...but I
personally am much more comfortable with JPY assets that are more
derivatives of the general economy rather than the blatant
manipulative practices of the MOF.

Friday, June 22, 2007

Subprime woes continue to light the way...

...for acute observers trying to deconstruct how all this risk is financed.

It seems clear to the REcapitulator that foreign owned subsidiaries of US investment banks are financing massive risk-taking here in the States.  The current troubles with Bear illustrates this. Take a look at the relative repo rates of US/Euro area countries and you will see what I mean.

The VIX (which, for disclosure puposes, we have short interest in) and the implied vol. surface therein (although at the moment, the REcapitulator fails to remember all the consituent names in the VIX) is interesting.  I thought that July would be the capitulation with regards to bond yields and FED action.

Cantor is another interesting story.  The REcapitulator was unaware they traded exotic mortgages (they don't).  

And yet, they had to auction off some 350m of securities posted
by Bear, for pennies on the dollar.  How does one model that?

Thursday, June 21, 2007


Credit spreads have widened by 45 basis points since the beginning of this month on this index that tracks credit protection prices on 100 names.

The REcapitulator knows very little about the Byzantine and wild-west frontier of the credit markets (and he suspects that it is very much a rigged game), but what he does know is that when a movement like this occurs, re-hedging and re-collateralization is a very painful experience for weak hands.

Could it be possible that people actually are starting to think there may be some RISK in levering up low-yielding assets, buying higher yielding ones, and pocketing the spread?

Wednesday, June 20, 2007

Real Estate has just started...

...its descent.  The commerical RE indices have not budged very much, and the REcapitulator was speaking with a trader from a (very) large Hedge player here in Chicago yesterday...his thoughts were that this was one of the few low-risk shorts out there.  The wall of liquidity raises all ships.

But there are holes forming (and once again, the REcapitulator cannot take his own "no metaphors" medicine).  The Merill/Bear Stearns debacle continues to make the news, and traders are alight in rumours concerning some of the other large players selling inventory.  This story illustrates the difficulty of massive and extremely quick redemptions in the face of what amounts to term financing (or using the spread between two instruments as the primary financing vehicle).

July.  It may be earlier, but one would be foolish to short U.S. assets at the moment.

Monday, June 18, 2007

The Fed Model

The Recapitulator would like to take this opportunity to ask a simple little math problem:

What happens to a ratio when the denominator decreases
 and the numerator increases?

The P/E ratio (the inverse of its forward-earnings manifestation being the basis for comparison to the 10-year bond yield, which is also known as the "Fed Model"), which has never been a very good metric for valuation of companies in the REcapitulators opinion, owing to the usual retrospective/prospective predictive problems, has a special reverence for the public and sophisticated operators alike.

As for the Fed model, it has had a pretty good fun for predictive value.  The Recapitulator has long thought July expiry is a good month for short VIX puts (or hey, why not "Texas Hedge" and go long some calls or long some futures???) and he still thinks so.  As bond yields rise, forcing players to choose between similar yielding assets with vastly different risk profiles, and as the inverse of the forward earnings yield looks decidedly less rosy, we should see some excellent toing and froing next month.

Friday, June 15, 2007


Updates will be more frequent now as yours truly has time to clear some idea backlogs...and now the post:

With all this talk about weather (and 4^15 cicadas here in Chicago), I
can't stop thinking about scale. We all know the importance of time intervals and sample periods when looking at the markets, and it is somewhat unfortunate we lack millions of years of data to strengthen our inferences or provide additional hypothesis generation.

the financial markets rife with feedback mechanisms, both on granular (individual stocks) and global (indexes) scales.  Everything is connected and the thinking, human participants create another layer of complexity by adding 3rd (what do I think he thinks I am thinking??) order thinking into the mix.
Fortunately, the planet earth has a wonderful temperature regulation feedback system that serves to illuminate why global warming is a problem of scale – humans will have to actively engineer, on a massive scale (like blowing up the Rocky Mountains) carbon introduction into
the atmosphere in the future if we wish to live here.

The system can be characterized thusly: Plate tectonics produce carbon dioxide through volcanic emission, carbon dioxide warms the planet. Warming increasing weathering (surface water is a function of temperature, as temperature rises, water evaporates leading to clouds and subsequent erosion). Carbon dioxide then attaches chemically to silicate rocks experiencing weathering. This process removes the C02 from the atmosphere and cools the planet. Carbon Dioxide is introduced again by volcanic emission (and water is needed here as
well for subduction), and on and on.

This process that has kept the Planet at a relatively constant temperature (never below freezing and never above boiling) for around 4.5 Billion years. Planets need land, water, and plate tectonics to achieve this system that is very good for carrying life. An oceanic planet would not be a very nice place to live, and likely would not remain that way for long as the lack of temperature regulation would likely boil the planet. (in the spirit of good taste, I will withhold jokes regarding a certain movie starring Kevin Costner, as said movie has already experiences too much suffering)

This feedback loop is interesting to me because of its massive time scale. In the long run (geologic scale), we should be more worried about making more CO2. But on relatively short scales (hundreds of years), we may have a problem with increased temperatures due to our
own actions.

Looking at the markets, it is very clear what the "geologic" drift is, caused by an extremely complex feedback system of its own…but when you zoom in closer, it becomes apparent that too much on one side of the differential equation can kill 90% of "oxygen-dependent species".
Life does go on, but it takes a different scale of time for that to happen.