Hi,
A topic LINKS has seen in the press on and off in recent months has been the issue of whether Gold makes a good hedge against inflation. This issue clearly isn't the only one turning the grey matter of investors who have inflation issues.
Where are interest rates going? Can markets absorb the large supply and what will happen to inflation outright? Will governments use inflation to reduce the real impact of the huge wave of public expenditure of the last few months? At this stage it's unclear what will happen and it is this uncertainty that continues to drive markets.
It is unlikely that we will see inflation rear its head for some time while there is spare capacity in the global economy. However, those with a longer -term view or those looking at the tail risk should now be considering suitable hedges.
The obvious hedge for inflation is gold. Or is it? It's a position that has reached almost mythical status but supporting evidence is thin on the ground. In fact, the seminal work by Roy W. Jastram (1977) presented in "The Golden Constant" suggests something very different. He analyses the purchasing power of gold in England and the US from 1560 to 1976. The key conclusions are that:
- Gold is an ineffective hedge against inflation
- Gold appreciates in operational wealth in major deflations
- Gold is an ineffective hedge against yearly commodity price increases
- Gold maintains its purchasing power over long periods of time. This is not because gold eventually moves towards commodity prices but because commodity prices move towards gold.
The use of gold as an inflation hedge seems to have its roots in the collapse of the Bretton Woods agreement in 1971. Since gold was no longer regarded as money it would act like any other commodity. However, during Jastram's period of study gold flips between being "money" and a "commodity" on numerous occasions: it isn't this distinction that drives the relationship. Gold may not be money but it certainly acts like it. Gold is produced for accumulation, whereas all other commodities are produced for consumption.
The other reason for the strength of the hedgers' convictions is simply poor inductive reasoning. Because gold has preserved its value in periods of big upheaval does not mean that it is useful as a strategy against cyclical behaviour. It is a crisis hedge rather than an inflation hedge.
Those wishing to hedge inflation will need to be a little more creative, particularly given uncertainty over what will cause it and the point of its emergence. Something we will return to in a later blog.
Regards,
Dr Mark Tomsett
Sunday, June 28, 2009
Friday, June 12, 2009
Rolex quantitative strategies - beware of expensive imitations
Hi,
http://www.battleofthequants.com/agenda.html
I've just returned from the Battle of the Quants having survived a close scrape with a cyborg hedge fund investor sent from the future to melt the markets. Think Gordon Gekko crossed with the Terminator - not a pleasant experience. Now, in all seriousness, some of the claims from the quant strategists to be able to read the future didn't seem much more far fetched than my fictional market cyborg, yet they were adamant at the value they could guarantee to add.
Autoregressive models do have some merit, particularly some of the smarter times series analysis out there, but you're only ever as good as your data, and keeping these models current is tough in chaotic illiquid markets, especially when the markets have just gone through what a chaos mathematician would call a 'phase' change.
Despite this, I don't want to put investors off. If you do your homework and if your quant strategist is willing to pull the curtain back on their methodology, savvy investors will find some good returns in the quant strategy field. However, in this environment you must keep one eye on your exit. When quant strategies get too crowded, exiting with your returns intact can be a precarious business - the Goldman funds debacle of Aug 2007 is well documented and could easily happen again. Furthermore, whenever a strategy meets some degree of success, beware of what the biologists would call 'mimicry'.
For every sound quant strategy out there, you'll also find a manager or two with a poor idea yet the marketing machine to raise capital. This manager effectively gains an advantage by mimicking the successful credible quant players, despite having weak models and a poor idea. With 'black box' strategies still doing the rounds, and with complex lingo coming thick and fast in a world with cash rich investors chasing credible hedge fund managers, dud horses will inevitably be backed.
I can't stress enough for investors to ensure they have some explanation of the strategy employed, in what markets the manager believes it will work (there's no magic bullet for quant strategies, despite what the most bullish of quants may say), and, should returns prove negative, a rapid exit strategy.
You'd never buy a Rolex out of a suitcase on Times Sq, why do the same with your hedge fund investments?
Happy hunting,
Andy
http://www.battleofthequants.com/agenda.html
I've just returned from the Battle of the Quants having survived a close scrape with a cyborg hedge fund investor sent from the future to melt the markets. Think Gordon Gekko crossed with the Terminator - not a pleasant experience. Now, in all seriousness, some of the claims from the quant strategists to be able to read the future didn't seem much more far fetched than my fictional market cyborg, yet they were adamant at the value they could guarantee to add.
Autoregressive models do have some merit, particularly some of the smarter times series analysis out there, but you're only ever as good as your data, and keeping these models current is tough in chaotic illiquid markets, especially when the markets have just gone through what a chaos mathematician would call a 'phase' change.
Despite this, I don't want to put investors off. If you do your homework and if your quant strategist is willing to pull the curtain back on their methodology, savvy investors will find some good returns in the quant strategy field. However, in this environment you must keep one eye on your exit. When quant strategies get too crowded, exiting with your returns intact can be a precarious business - the Goldman funds debacle of Aug 2007 is well documented and could easily happen again. Furthermore, whenever a strategy meets some degree of success, beware of what the biologists would call 'mimicry'.
For every sound quant strategy out there, you'll also find a manager or two with a poor idea yet the marketing machine to raise capital. This manager effectively gains an advantage by mimicking the successful credible quant players, despite having weak models and a poor idea. With 'black box' strategies still doing the rounds, and with complex lingo coming thick and fast in a world with cash rich investors chasing credible hedge fund managers, dud horses will inevitably be backed.
I can't stress enough for investors to ensure they have some explanation of the strategy employed, in what markets the manager believes it will work (there's no magic bullet for quant strategies, despite what the most bullish of quants may say), and, should returns prove negative, a rapid exit strategy.
You'd never buy a Rolex out of a suitcase on Times Sq, why do the same with your hedge fund investments?
Happy hunting,
Andy
Wednesday, May 27, 2009
Business as usual.....
Hi,
Firstly, lots of people have commended us on the speed and pragmatism of our swine flu piece, see it below on this page if you haven't already.
Secondly, it has been a busy month for Links and one overwhelming sense I have seen this month is of 'business as usual' in the financial industry. Banks are starting to recruit in certain areas, hedge funds are raising money again, investors are starting to commit capital; the paralysis that had gripped many parts of the financial markets seems to have eased to the point that the machine as a whole is starting to function again.
I wouldn't say we are out of the woods yet as we remain particularly vulnerable to an unexpected downside event, and the economy and the financial industry as it recovers will look very different to the one that went into this crisis in 2007, however, people are now mentally gearing up for the future and are looking to take some risk.
One point I'd like to make is that there is still much needed flesh to add to the bones of the suggested reforms in the financial industry. It's possible that, as the economy recovers, politicians will lose the drive for change under the misapprehension that it will stifle the recovery. What economies need is genuine 'value add' in a whole range of business rather than an economy feeding off what was arguably a bubbling financial services industry. Failure to get the financial reforms right could see a repeat of the issues which have caused the current crisis from which we are only now escaping.
Happy hunting,
Andy
Firstly, lots of people have commended us on the speed and pragmatism of our swine flu piece, see it below on this page if you haven't already.
Secondly, it has been a busy month for Links and one overwhelming sense I have seen this month is of 'business as usual' in the financial industry. Banks are starting to recruit in certain areas, hedge funds are raising money again, investors are starting to commit capital; the paralysis that had gripped many parts of the financial markets seems to have eased to the point that the machine as a whole is starting to function again.
I wouldn't say we are out of the woods yet as we remain particularly vulnerable to an unexpected downside event, and the economy and the financial industry as it recovers will look very different to the one that went into this crisis in 2007, however, people are now mentally gearing up for the future and are looking to take some risk.
One point I'd like to make is that there is still much needed flesh to add to the bones of the suggested reforms in the financial industry. It's possible that, as the economy recovers, politicians will lose the drive for change under the misapprehension that it will stifle the recovery. What economies need is genuine 'value add' in a whole range of business rather than an economy feeding off what was arguably a bubbling financial services industry. Failure to get the financial reforms right could see a repeat of the issues which have caused the current crisis from which we are only now escaping.
Happy hunting,
Andy
Wednesday, April 29, 2009
Risk managing swine flu when you aren't a virologist.......
Hi,
Swine flu is the big topic of the day and I thought I'd post a few pointers for those of you who are scratching your heads wondering what on earth to do. The path of least resistance is just to watch and see how this plays out, and I'm sure that's what the majority of people are doing. Unless of course you managed to pile into the pharmaceutical shares at the start of the week to jump on that predictable capital inflow bandwagon.
It isn't clear yet how deadly this virus is but given it has probably been around for a couple of months already and hasn't yet registered its first death in Europe, leads me to instinctively say that it won't be any where near as virulent as some of the more theatric media reports are suggesting. The media makes money from getting your attention, what better way to get your attention than the possibility of death by pig inspired influenza. Deaths will certainly come from this virus, and no doubt flu deaths are likely to spike above normal (for the UK normal is roughly 10,000 per year, ish, but these deaths never receive any media attention and are an accepted fact of daily life), but how far above normal is not an easy question to answer.
With markets flat lining, current popular opinion is that the flu will be largely a damp squib, not meriting the attention it is currently getting. Could we be surprised on the downside? It isn't impossible but I don't think so. Media attention is way overplaying the risk and unnecessarily alarming the public.
A few facts to keep in mind when considering what to do:
Firstly, the Spanish flu pandemic of 1918 killed between 2 and 20% of all those infected, one of the symptoms being hemorrhaging from the ears and mouth. So far, the reports of the symptoms don't come anywhere close to those of the severity of the Spanish flu outbreak of 1918. Of course the virus could mutate into something more sinister but it certainly hasn't yet and there's no guarantee that it will. The first reason to be cheerful !
Secondly, the majority of those who died in 1918 did so of secondary bacterial infections brought on by the initial influenza outbreak. For those people living in countries with well funded health care systems, the majority of those bacterial infections are likely be avoided through antiviral drugs and antibiotics. The second reason to be cheerful. In 1918 all you had was the whiskey bottle and your own constitution.
Thirdly,with international travel over the last 20years through plane, train and automobile available to the masses on a scale never before seen in humanity's history, human beings are more interconnected than they have ever been before. As a result, flu viruses spread through society much more quickly than ever before. While this is a risk in the sense that, if a killer flu does come along, it will spread very quickly, it is also a defence; due to human interconnectivity we all get a whiff of every virulent flu strain every year and our immune systems are that much more efficient at fighting them off, even if they are a particularly nasty strain.
In summary, ignore the media hype. Flu is here to stay, occasionally flu deaths will spike but the threat of a flu pandemic is an unavoidable fact of human life and something we are better prepared for than ever before. I would suggest carrying on as normal, have bacon with your breakfast if that is your habit and, if you must, buy OTM equity puts in emerging market indices, especially if it looks like the virus has mutated into something more formidable. Look for reports from key medical agencies that list more severe symptoms to give you a head start on whether a malignant mutation has occurred or not.
Happy hunting,
Andy Shaw
Swine flu is the big topic of the day and I thought I'd post a few pointers for those of you who are scratching your heads wondering what on earth to do. The path of least resistance is just to watch and see how this plays out, and I'm sure that's what the majority of people are doing. Unless of course you managed to pile into the pharmaceutical shares at the start of the week to jump on that predictable capital inflow bandwagon.
It isn't clear yet how deadly this virus is but given it has probably been around for a couple of months already and hasn't yet registered its first death in Europe, leads me to instinctively say that it won't be any where near as virulent as some of the more theatric media reports are suggesting. The media makes money from getting your attention, what better way to get your attention than the possibility of death by pig inspired influenza. Deaths will certainly come from this virus, and no doubt flu deaths are likely to spike above normal (for the UK normal is roughly 10,000 per year, ish, but these deaths never receive any media attention and are an accepted fact of daily life), but how far above normal is not an easy question to answer.
With markets flat lining, current popular opinion is that the flu will be largely a damp squib, not meriting the attention it is currently getting. Could we be surprised on the downside? It isn't impossible but I don't think so. Media attention is way overplaying the risk and unnecessarily alarming the public.
A few facts to keep in mind when considering what to do:
Firstly, the Spanish flu pandemic of 1918 killed between 2 and 20% of all those infected, one of the symptoms being hemorrhaging from the ears and mouth. So far, the reports of the symptoms don't come anywhere close to those of the severity of the Spanish flu outbreak of 1918. Of course the virus could mutate into something more sinister but it certainly hasn't yet and there's no guarantee that it will. The first reason to be cheerful !
Secondly, the majority of those who died in 1918 did so of secondary bacterial infections brought on by the initial influenza outbreak. For those people living in countries with well funded health care systems, the majority of those bacterial infections are likely be avoided through antiviral drugs and antibiotics. The second reason to be cheerful. In 1918 all you had was the whiskey bottle and your own constitution.
Thirdly,with international travel over the last 20years through plane, train and automobile available to the masses on a scale never before seen in humanity's history, human beings are more interconnected than they have ever been before. As a result, flu viruses spread through society much more quickly than ever before. While this is a risk in the sense that, if a killer flu does come along, it will spread very quickly, it is also a defence; due to human interconnectivity we all get a whiff of every virulent flu strain every year and our immune systems are that much more efficient at fighting them off, even if they are a particularly nasty strain.
In summary, ignore the media hype. Flu is here to stay, occasionally flu deaths will spike but the threat of a flu pandemic is an unavoidable fact of human life and something we are better prepared for than ever before. I would suggest carrying on as normal, have bacon with your breakfast if that is your habit and, if you must, buy OTM equity puts in emerging market indices, especially if it looks like the virus has mutated into something more formidable. Look for reports from key medical agencies that list more severe symptoms to give you a head start on whether a malignant mutation has occurred or not.
Happy hunting,
Andy Shaw
Monday, April 20, 2009
Stress testing and VaR models - finding the wood from the trees
Hi,
http://www.ft.com/reports/risk-management-april2009
Business is hotting up for us and I wasn't going to post anything until next week but the risk management report in the FT and the recent fretting about the Wall St stress tests has left me with some opinions I thought you'd find interesting.
VaR models come in for much criticism in the FT report but the pundits who are commenting on this are missing some basic issues and are still unable to see the wood from the trees. I've mentioned a number of times in recent blogs about the importance of understanding your risk models and their weaknesses. VaR continues to come in for much flak, especially the monte-carlo based models, however, the answer here isn't to throw them out and start building again, it is to adapt your models to the new environment, and make them 'future market proof'.
The scope of how to do this is too large for these pages but I stress, building again from scratch isn't needed if you have operational capacity to produce monte-carlo based VaR numbers. If you understand your model, you can easily adapt it to give you a much better guide on potential losses in future market scenarios. Now isn't the time to invest large sums of money in the alleged latest way to model financial risk. Now is the time for sound 'what if' analysis from your risk management department coupled with a smart hedging strategy.
This leads me neatly in to the Wall St stress tests which is the mother of all 'what if' projects. These numbers will undoubtedly influence share prices, but I suspect they will merely confirm what the market has decided in the past year. I don't think there will be a huge divergence in perceived health beyond that which has been implied already in the last two years of share price moves.
Pre-crisis, stress testing had been too lax with risk managers not able to make the conceptual leap from nonvolatile markets into possible future volatile ones. This is a classic human context mistake. If you are in a benign environment, it is very difficult for you to make the jump into a potential crisis enironment and come up with scenarios based off what a major increase in volatility would look like. Now that volatility has come, I'm sure that some of the possible future scenarios being suggested are the other way - much too conservative and apocalyptic. Despite the fact you may solve the context problem, assessing worst case scenario loss in chaotic markets and coming up with anything like meaningful numbers is an impossible job to do accurately. Stress scenarios are typically driven by liquidity issues and forced unwinds of a defaulted firms positions than assets jumping to certain fundamental levels which banks were able to anticipate in their stress analysis.
As a result, financial firms need to subtly change how they use this information to help to protect themselves in a downturn. They should consider dampening losses through a clever hedging strategy as any possible scenario, however comprehensively thought out, is exactly that - only a possible scenario. Of course then the challenge becomes how much to spend on your hedging strategy and how to apply it. Well, good risk managers are going to more than earn their money in the coming years, and the best of them will be the ones who can get the most bang for their company's buck in terms of hedging their business strategy. If you can get this right, it will have the potential to catapult your company's brand beyond your competition when the next wave of volatility hits the market as you will sail through it as opposed to being sunk.
Happy hunting,
Andy Shaw
http://www.ft.com/reports/risk-management-april2009
Business is hotting up for us and I wasn't going to post anything until next week but the risk management report in the FT and the recent fretting about the Wall St stress tests has left me with some opinions I thought you'd find interesting.
VaR models come in for much criticism in the FT report but the pundits who are commenting on this are missing some basic issues and are still unable to see the wood from the trees. I've mentioned a number of times in recent blogs about the importance of understanding your risk models and their weaknesses. VaR continues to come in for much flak, especially the monte-carlo based models, however, the answer here isn't to throw them out and start building again, it is to adapt your models to the new environment, and make them 'future market proof'.
The scope of how to do this is too large for these pages but I stress, building again from scratch isn't needed if you have operational capacity to produce monte-carlo based VaR numbers. If you understand your model, you can easily adapt it to give you a much better guide on potential losses in future market scenarios. Now isn't the time to invest large sums of money in the alleged latest way to model financial risk. Now is the time for sound 'what if' analysis from your risk management department coupled with a smart hedging strategy.
This leads me neatly in to the Wall St stress tests which is the mother of all 'what if' projects. These numbers will undoubtedly influence share prices, but I suspect they will merely confirm what the market has decided in the past year. I don't think there will be a huge divergence in perceived health beyond that which has been implied already in the last two years of share price moves.
Pre-crisis, stress testing had been too lax with risk managers not able to make the conceptual leap from nonvolatile markets into possible future volatile ones. This is a classic human context mistake. If you are in a benign environment, it is very difficult for you to make the jump into a potential crisis enironment and come up with scenarios based off what a major increase in volatility would look like. Now that volatility has come, I'm sure that some of the possible future scenarios being suggested are the other way - much too conservative and apocalyptic. Despite the fact you may solve the context problem, assessing worst case scenario loss in chaotic markets and coming up with anything like meaningful numbers is an impossible job to do accurately. Stress scenarios are typically driven by liquidity issues and forced unwinds of a defaulted firms positions than assets jumping to certain fundamental levels which banks were able to anticipate in their stress analysis.
As a result, financial firms need to subtly change how they use this information to help to protect themselves in a downturn. They should consider dampening losses through a clever hedging strategy as any possible scenario, however comprehensively thought out, is exactly that - only a possible scenario. Of course then the challenge becomes how much to spend on your hedging strategy and how to apply it. Well, good risk managers are going to more than earn their money in the coming years, and the best of them will be the ones who can get the most bang for their company's buck in terms of hedging their business strategy. If you can get this right, it will have the potential to catapult your company's brand beyond your competition when the next wave of volatility hits the market as you will sail through it as opposed to being sunk.
Happy hunting,
Andy Shaw
Saturday, April 11, 2009
Hedge funds, private equity and a retiring politician's bete noire - short selling.
As the politicians pick up the task of repairing the worlds financial system, one opinion that hasn't seemed to have filtered through is the idea that hedge funds and private equity firms have an important role to play. I guess in the current environment, it simply isn't good politics to voice support for an industry incorrectly held to blame for many of the problems we have seen.
Let me fly in the face of popular opinion - hedge funds and private equity firms are crucial to the future of the finance system if we want an efficient fair system. And I think I speak for everyone when I say, not only do we want an efficient and fair finance system, we desperately need one. However, hedge funds do need appropriate control and regulation, which has been lacking in recent years. This is all the more surprising when you think that LTCM's blow up over 10years ago almost brought the financial system to its knees - you'd have thought we'd have learnt some lessons from that debacle, but clearly not.
Perhaps the LTCM disaster was actually the point at which Gordon Brown felt that 'boom and bust' had finally ended and hence he stuck with his light touch regulation despite the evidence suggesting this wasn't the best of strategies? However, that's a blog topic for another day. So why are hedge funds so crucial and how should hedge funds be regulated without stifling innovation and liquidity and chasing them into offshore havens?
Pools of private capital willing to take risks more conservative investors shy away from, or expose flaws in the financial system, or help deflate asset bubbles to fair levels, are crucial to creating efficient liquid markets. Markets typically are far from efficient. Efficient markets should trade at levels considered by the market to reflect fair value. To do this they need a variety of investors who analyse assets in different ways, who innovate new valuation tools, and who are able to gamble on stock prices either rising or falling. If you restrict short selling, or indeed ban it altogether, you limit the scope for investors to force assets back to their fair value if they start to 'bubble'. This isn't so bad for stocks, as hedge fund investors can short names by buying CDS protection, or buying equity puts, but it can cause problems in markets like housing for example.
The straw that broke the US housing markets back, and most importantly destroyed value in subprime CDO's was the introduction of the ABX CDS product. This product effectively brought the first efficient method of shorting subprime mortgage pools in large size. Up until then, the financial markets didn't have the ability to efficiently short the subprime market. As a result, with a market only populated with buyers combined with a hopeless misunderstanding of CDO technology, the US subprime market started to bubble with no wily old hedge funds to bring asset levels back down to more realistic levels.
And then along came the ABX CDS product and give or take six months or so, the rest is history - the US housing market, particularly in subprime areas, collapsed. Had the ABX CDS product been launched 10 years earlier, the US housing market bubble arguably would never have happened or at the least been much smaller.
Hedge funds are the investors who have their fingers on the pulse of new innovations in markets and it is these innovations which help bring effeciency and fair valuation to assets.
Furthermore, hedgefunds and private equity firms also bring liquidity to projects which otherwise wouldn't see the light of day. This is key to encouraging a dynamic thriving economy. People need to find the innovation frontier in the economy in order to drive the discovery of new products and new markets. The only way to do this is in taking risk through entrepreneurs. So not only are hedge funds key for ensuring assets trade at fair prices, but they also help the economy grow and reinvent itself.
Hedge funds, and investors in general, should be given the whole range of products to trade all kinds of risks. The issue then becomes, ensuring the size of these risks remains appropriate for what the risk is.
For hedge funds to access liquid markets, they must typically do this through an investment bank or prime broker. Hedge funds need to be forced into having a prime broker so regulators can come to one investment bank and survey a hedge fund's entire assets. If the hedge fund has assets at multiple brokers, the regulators can't do this so easily. From here, the regulators need to decide appropriate sizes for risks at any one hedge fund. This also isn't an easy thing to do, but your goal is to ensure a hedge fund can default and be liquidated into the market without melting it. Fortunately there are now many examples of a hedge fund being liquidated to help guide this solution.
If you get the regulation right, and you help set up a virtuous circle which encourages investors and encourages an efficient financial system, you'll also make great strides in reducing systemic risk in the economic system. As the financial systems approaches some level of improved or 'peak' efficiency, you'll find that hedge funds strategies will get more varied and more and more diverse - this is the sign of a healthy financial system.
If hedge funds are all betting in the same direction in a particular market, you can bet your last dollar that they have probably all spotted a major inefficiency and they're simply waiting for the levee walls to breach.
I know some of these hedge fund managers who court publicity can be somewhat unpalatable. And the flaunting of their money too can be unpalatable. However, the more efficient the system gets, the less these people will get paid. Surely that's reason enough for encouraging them? And as for the politicians who want to ban short selling. If you look at the key people behind the drive, they are mostly at the end of their careers and at retirement age. They perhaps think, incorrectly, that a quick ban on short selling will save their pensions. Well, they're 10 years too late for that. They are, to some degree, reaping what they have sown.
Happy hunting,
Andy Shaw
Let me fly in the face of popular opinion - hedge funds and private equity firms are crucial to the future of the finance system if we want an efficient fair system. And I think I speak for everyone when I say, not only do we want an efficient and fair finance system, we desperately need one. However, hedge funds do need appropriate control and regulation, which has been lacking in recent years. This is all the more surprising when you think that LTCM's blow up over 10years ago almost brought the financial system to its knees - you'd have thought we'd have learnt some lessons from that debacle, but clearly not.
Perhaps the LTCM disaster was actually the point at which Gordon Brown felt that 'boom and bust' had finally ended and hence he stuck with his light touch regulation despite the evidence suggesting this wasn't the best of strategies? However, that's a blog topic for another day. So why are hedge funds so crucial and how should hedge funds be regulated without stifling innovation and liquidity and chasing them into offshore havens?
Pools of private capital willing to take risks more conservative investors shy away from, or expose flaws in the financial system, or help deflate asset bubbles to fair levels, are crucial to creating efficient liquid markets. Markets typically are far from efficient. Efficient markets should trade at levels considered by the market to reflect fair value. To do this they need a variety of investors who analyse assets in different ways, who innovate new valuation tools, and who are able to gamble on stock prices either rising or falling. If you restrict short selling, or indeed ban it altogether, you limit the scope for investors to force assets back to their fair value if they start to 'bubble'. This isn't so bad for stocks, as hedge fund investors can short names by buying CDS protection, or buying equity puts, but it can cause problems in markets like housing for example.
The straw that broke the US housing markets back, and most importantly destroyed value in subprime CDO's was the introduction of the ABX CDS product. This product effectively brought the first efficient method of shorting subprime mortgage pools in large size. Up until then, the financial markets didn't have the ability to efficiently short the subprime market. As a result, with a market only populated with buyers combined with a hopeless misunderstanding of CDO technology, the US subprime market started to bubble with no wily old hedge funds to bring asset levels back down to more realistic levels.
And then along came the ABX CDS product and give or take six months or so, the rest is history - the US housing market, particularly in subprime areas, collapsed. Had the ABX CDS product been launched 10 years earlier, the US housing market bubble arguably would never have happened or at the least been much smaller.
Hedge funds are the investors who have their fingers on the pulse of new innovations in markets and it is these innovations which help bring effeciency and fair valuation to assets.
Furthermore, hedgefunds and private equity firms also bring liquidity to projects which otherwise wouldn't see the light of day. This is key to encouraging a dynamic thriving economy. People need to find the innovation frontier in the economy in order to drive the discovery of new products and new markets. The only way to do this is in taking risk through entrepreneurs. So not only are hedge funds key for ensuring assets trade at fair prices, but they also help the economy grow and reinvent itself.
Hedge funds, and investors in general, should be given the whole range of products to trade all kinds of risks. The issue then becomes, ensuring the size of these risks remains appropriate for what the risk is.
For hedge funds to access liquid markets, they must typically do this through an investment bank or prime broker. Hedge funds need to be forced into having a prime broker so regulators can come to one investment bank and survey a hedge fund's entire assets. If the hedge fund has assets at multiple brokers, the regulators can't do this so easily. From here, the regulators need to decide appropriate sizes for risks at any one hedge fund. This also isn't an easy thing to do, but your goal is to ensure a hedge fund can default and be liquidated into the market without melting it. Fortunately there are now many examples of a hedge fund being liquidated to help guide this solution.
If you get the regulation right, and you help set up a virtuous circle which encourages investors and encourages an efficient financial system, you'll also make great strides in reducing systemic risk in the economic system. As the financial systems approaches some level of improved or 'peak' efficiency, you'll find that hedge funds strategies will get more varied and more and more diverse - this is the sign of a healthy financial system.
If hedge funds are all betting in the same direction in a particular market, you can bet your last dollar that they have probably all spotted a major inefficiency and they're simply waiting for the levee walls to breach.
I know some of these hedge fund managers who court publicity can be somewhat unpalatable. And the flaunting of their money too can be unpalatable. However, the more efficient the system gets, the less these people will get paid. Surely that's reason enough for encouraging them? And as for the politicians who want to ban short selling. If you look at the key people behind the drive, they are mostly at the end of their careers and at retirement age. They perhaps think, incorrectly, that a quick ban on short selling will save their pensions. Well, they're 10 years too late for that. They are, to some degree, reaping what they have sown.
Happy hunting,
Andy Shaw
Sunday, March 29, 2009
Obama's toxic asset giveaway
The toxic assets that continue to occupy the balance sheets of most key US banks, and that as a result make these firms a no go area for many investors, are still central to the continuing problem in the US financial system. Solutions have been slow in coming as the crisis is now entering its third year.
The idea that Obama and Geithner are pushing, in essentially enticing investors to take on the risk from the banks, is hardly revolutionary policy. However, given how CDO technology works, now is the very first time it has been sensible to push this solution - any time prior to this and the volatility of many of these assets would have scared away anyone but the most foolhardy of investors. Not to mention the banks themselves were struggling with generating a meaningful valuation. However, it seems that Obama's timing, by accident or design, is possibly perfect. The opportunity in this 'toxic' asset giveaway is a fabulous one for an investor willing to do a little homework now that the first grass shoots of stability in the US housing market have appeared.
There are three key hazards to negotiate before this opportunity becomes a good one. And if you do this properly, the opportunity could be an excellent one:
1. Do your homework on the mortgage pool - some 'subprime' pools are more rotten than others. Finding a subprime mortgage pool with a fundamental supporting market and solid reasons for a stabilising of house prices is key. Some subprime areas, where all the neighbours were borrowing money they couldn't afford, could well become ghost towns. Prices in areas like this are trapped in a race to the bottom. For these pools, any signs of recovery are more a pause before the downward march is resumed rather than a turnaround. Other pools, where subprime mortgages have a fundamental floor on account of solid surrounding economic support, are the pools you need to identify. This requires local analysis. If you can't find a pool you like, stop right there.
2. Once you feel you have a good idea how your chosen mortgage pool is likely to behave, you need to value the CDO derivative correctly. Conventional valuation tools do not work for these securities in volatile markets. Indeed, many CDO tranches generate an effect which is the opposite of diversity - hence why they are so risky. You need to develop a more fundamental approach to valuing these assets and play through some different scenarios from now to asset maturity to frame the risk you are taking on. If you use quantitative techniques you don't fully understand, it is likely they will lead you up the garden path.
3. The Treasury is committed to extending a floor to your asset - it is likely they will value this floor very generously giving you an asymmetric pay off. Governments are not always known for their financial acumen and they also need to price this stuff to sell. The value in this floor is a function of you fully understanding the last two hazards.
If you understand your mortgage pool, how your CDO will behave for different forward scenarios, and then combine this knowledge with a generous Treasury floor, these assets will be a fabulous opportunity. However, get on the wrong side of one of these issues, and it could be very painful one.
And bid low ! Let your scenario analysis drive the size of what you will pay for the asset ensuring that if your price is filled that you make money even if we see further house price falls and rising default rates from today. This is as much a giveaway as an auction. No-one will be bidding aggressively.
Happy hunting,
Andy Shaw
The idea that Obama and Geithner are pushing, in essentially enticing investors to take on the risk from the banks, is hardly revolutionary policy. However, given how CDO technology works, now is the very first time it has been sensible to push this solution - any time prior to this and the volatility of many of these assets would have scared away anyone but the most foolhardy of investors. Not to mention the banks themselves were struggling with generating a meaningful valuation. However, it seems that Obama's timing, by accident or design, is possibly perfect. The opportunity in this 'toxic' asset giveaway is a fabulous one for an investor willing to do a little homework now that the first grass shoots of stability in the US housing market have appeared.
There are three key hazards to negotiate before this opportunity becomes a good one. And if you do this properly, the opportunity could be an excellent one:
1. Do your homework on the mortgage pool - some 'subprime' pools are more rotten than others. Finding a subprime mortgage pool with a fundamental supporting market and solid reasons for a stabilising of house prices is key. Some subprime areas, where all the neighbours were borrowing money they couldn't afford, could well become ghost towns. Prices in areas like this are trapped in a race to the bottom. For these pools, any signs of recovery are more a pause before the downward march is resumed rather than a turnaround. Other pools, where subprime mortgages have a fundamental floor on account of solid surrounding economic support, are the pools you need to identify. This requires local analysis. If you can't find a pool you like, stop right there.
2. Once you feel you have a good idea how your chosen mortgage pool is likely to behave, you need to value the CDO derivative correctly. Conventional valuation tools do not work for these securities in volatile markets. Indeed, many CDO tranches generate an effect which is the opposite of diversity - hence why they are so risky. You need to develop a more fundamental approach to valuing these assets and play through some different scenarios from now to asset maturity to frame the risk you are taking on. If you use quantitative techniques you don't fully understand, it is likely they will lead you up the garden path.
3. The Treasury is committed to extending a floor to your asset - it is likely they will value this floor very generously giving you an asymmetric pay off. Governments are not always known for their financial acumen and they also need to price this stuff to sell. The value in this floor is a function of you fully understanding the last two hazards.
If you understand your mortgage pool, how your CDO will behave for different forward scenarios, and then combine this knowledge with a generous Treasury floor, these assets will be a fabulous opportunity. However, get on the wrong side of one of these issues, and it could be very painful one.
And bid low ! Let your scenario analysis drive the size of what you will pay for the asset ensuring that if your price is filled that you make money even if we see further house price falls and rising default rates from today. This is as much a giveaway as an auction. No-one will be bidding aggressively.
Happy hunting,
Andy Shaw
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