The Answer to Bubblevision's Favourite Question

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Valuing Large Options in the Absence of Collateralisation

Update 16.15pm: BAH - edited plainly incorrect figures resulting from Moody's-like "model error". Incorrect figures left struck out so you can see how daft I was.

Seemingly everyone in (my) blogoshpere has some sort of view on these Berkshire put options so, feeling somewhat left out, here is my potshot.

What is the value of a very large put option, purchased on an equity index, where the owner of the put option does not benefit from collateralisation, that is, the owner is exposed to the credit risk of the option writer? As appears to be the case for Berkshire Hathaway's options sold to (or through) Goldman Sachs, there is a nasty correlation effect in play: as the put option develops more intrinsic value, whoever owns it is increasingly worried about getting paid and BRK's credit spread has blown out.

In his 2007 letter to shareholders, Warren Buffet wrote "the puts in these contracts are exercisable only at their maturity date" and "in all cases we hold the money, which means we have no counterparty risk". Neither of these statements makes it clear BRK has no collateralisation obligations. If Warren were forced to disclose that there are potential cash-calls, perhaps as as a result of credit rating triggers, mark to market losses or some other mechanism, all bets are off - they would be in horrible shape. What follows is based on the hypothesis that there are no such triggers.

Let us assume that BRK sold $40bn notional 20 year puts (over 4 indices) in 2006-2007 at an average equivalent S&P 500 level of 1400. At the prevailing swap rate and dividend yields, and implied volatility of around 24%, this would have realised premia of approximately $4.5bn, close enough to the premia actually received not to worry too much about the exact details of the transactions.

The undiscounted future value of this liability, ie the fair value expectation of payment in 2027, is presently around $33 $19bn. (At the money long dated volatility has expanded to 38%; this option now is well in the money and the skewed volatility for 1400 strike is more like 33%). The present value of this liability, before the impact of credit spreads, is around $19 $10bn using the current swap curve.

So far, so simple. But this valuation does not take account of the credit spread of the writer of the put. If you're not into the dirty technicalities, skip the next bit and move on to "in other words". Otherwise, wrap a wet towel round your head and stay with me.

From put-call parity, we have

P(rf) = C(rf) + X * Z(rf) - S

where Z is a zero coupon bond, S is the spot price, X is the strike and the subscript "rf" denotes an instrument in the absence of credit risk. Let us make a heroic assumption that the issuer is quite positively correlated with equity markets, so a call option written by it has the same value as a risk free call (ie it is highly unlikely that a rising market correlates with BRK going bust), so C(rf)= C(brk), where the subscript "brk" denotes an instrument in the presence of credit risk.

We then have:

P(rf) = C(brk) +X * Z(rf) - S, and using put call parity again, we can replace C(brk)

P(rf) = [P(brk) + S - X * Z(brk)] + X * Z(rf) - S

= P(brk) + X*(Z(rf)-Z(brk))


In other words (are you back?), a put written by BRK without collateralisation is worth less than a fully collateralised put by an amount equal to the notional of the put times the difference between a risk free zero and and a zero valued at BRKs credit spread. With a BRK credit spread of 50bps our credit-risked put is worth 9.1bn, but with current CDS levels of, say, 400bps the credit-risked put is valued considerably considerably less than $10 $5bn! (1)

It will be interesting therefore to see if BRK choose to mark the present value of the puts discounted at their own credit spread in much the same way as banks have realised mark to market gains on their fixed income liabilities as their credit spreads have blown out. (I doubt they will).

Whoever actually still owns these puts/BRK credit risk (GS is still my favourite) likely hedged some credit risk on BRK at inception. Not enough! As equity markets fell and implied volatilities have risen, their credit exposure to BRK has increased enormously. The put owner has been forced into purchasing a lot more credit cover in a nasty cross gamma effect. No wonder BRK's credit spreads have gone bananas; they will likely remain volatile as there is a short cross gamma hedger out there for the next 20 years.

Moreover, as a result of the credit hedger's scramble for CDS protection, his mark to market on the original option is potentially worth only half the value had he been fully collateralised. Time to boot this into the level 3 asset pool I suspect, even if most of the pricing inputs are observable in the interdealer market. Note however the converse is also true - if the market rallies and volatility subsides, the put owner will be long way too much CDS protection on BRK.

Meanwhile, Warren sits there like a contented actuary. He has the cash, he doesn't have to post collateral (we hope), he's comfortable that in 18 years the market will be 65% higher, and he claims he doesn't care about the mark to market risk. I'm not sure he thought it through completely though: even if he has no collateral issues, the action of the person covering themselves against his risk certainly does, and that person is screwing up Warren's ability to finance himself elsewhere.
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(1) This is quite an exaggeration of the haircut in reality - of course if BRK went bust with nil recovery today the put would have zero value and this simplistic model would give it a negative value which is of course impossible. If you wanted to develop this idea further, and I guarantee you the capital structure arbitrage mob do, you would be considerably more rigorous regarding correlations between the credit and equity risk instruments here, but simplicity will suffice for this post.


See more Financial Crookery posts here

Mrs Watanabe Strikes Again: USD Swaps Trade Through Long Bond

Across the Curve, a must-subscribe daily update on bond market colour, keeps us informed here about the historic case of 30 year swaps trading 25-30 basis points through the long bond. Notable technical factors are at work, one significant such factor being reported as fixed income exotics desks having to rehedge positions on their books related to power reverse dual currency (PRDC) notes and swaps.

So why is this happening? PRDC products were sold by the yard to the pervasive Mrs Watanabe lapping them up in a quest for yield enhancement on Yen deposits. They typically look like callable thirty year yen bonds whose annual coupon resembles a call on dollar/yen, but are sold as "5% a year until you get your dough back". If the dollar appreciates vs den, a higher coupon is paid until the appreciation is such that the note is called (and, presumably, Mrs Watanabe is stuffed with another one).

Fine when the yen was the carry trade currency du jour. Now it isn't, in some style, the impact on the PRDC product is twofold: coupons are vapourising and they ain't going to be called. The duration of these notes is lengthening dramatically, to the point where they look like 30 year yen zeros to Mrs W. That's a nasty long term position for an attempt to pick up a few percent of yield over a year or two. No doubt the secondary market bids are, to coin a phrase, "not good".

From the perspective of the hedging bank, they sold a strip/cliquet of annual dollar call options, which strip was itself terminable. With the diminishing likelihood of the structure being terminated, the longer dated dollar call options become considerably more important in the valuation and risk profile of the overall structure. Hedging banks thus have an increasing need to adjust their long dated USD/JPY forward hedge which requires them to lock in long dated US rates/receive fixed in 30 year swaps.

By all accounts, this is a technical supply and demand issue - there is not much natural two-way business in 30 year swaps. I admit I am surprised that PRDCs are mooted as the major factor in the negative swap spread, but I don't have a meaningful handle on the aggregate PRDC market size. Still, surely it is time for the largest and best capitalised corporates which still have access to capital markets to extend their debt maturity profile at these fine swap levels. If USD snaps back against JPY the 30 year swap spread will blow out in a heartbeat. Maybe its one for Warren Buffet to set up. He's got an eye for an apparent mispriced long dated trade - though his own CDS levels probably mean he has other things on his plate at present.

See more Financial Crookery posts here

Conversations From the Shop Floor

A recent conversation overheard on an investment bank's equity trading floor between Paolo the Manager and Didier the Head Trader

Paolo: "So, Didi, its been a good year for you. You are a valuable member of my team and your performance this year, even if the firm is not doing so...."

Didier: "Get on with it - what's my number?"

Paolo: "OK Didier, for 2008 your total compensation will be one point eight and so your bonus is one point five."

Didier: "What! That's ridiculous. How can I be down 60% when my pnl is up 35%"

Paolo: "You know the answer to that. The firm's performance is poor, the fixed income and credit guys have killed us and there is overwhelming external scrutiny of bonus pools being paid out by all the investment banks."

Didier: "So what. I made the money"

Paolo: "Or so you think. Listen Didi, the world has changed. 20% of your bonus is in cash, 30% in restricted options and 50% in restricted stock...."

Didier (interrupting): "You're giving me three hundred cash? That's like one twenty sterling after tax. Its a fucking rounding error. Fuck you."

Paolo: ...."and the restricted program has a few changes this year."

Didier: "Uh huh - the so called malus lunacy I have been hearing about?"

Paolo: "Well, we're calling it the Long Term Corporate Responsibility Alignment Program. It can be withheld if your trading books don't realise in the long term the value in the positions you have booked this year."

Didier: "Long Term CRAP? Plus options over this company's piece of shit stock? I'm already down five bars on the last 5 years of options and restricted stock."

Paolo: "Well, we are all affected, I can promise you that. Luckily I have been paid a lot more than you in the last decade so I don't care. What I suggest is you go and sleep on it and tomorrow you will accept the inevitability of it all. It is out of my hands, executive management hands and even those of the board."

Didier: "Like I'm a government employee or something"

Paolo: "Yes. But still earning twenty times what they do."


Two weeks later, and the paltry sum of one twenty sterling is safely in Didier's bank account.


Didier: "I'm quitting, and so, I think, are 5 other exotics traders"

Paolo: "where?"

Didier: "Don't be stupid, there are no damn jobs. We're just quitting. Out of the game. Might start a hedge fund, might start teaching, might be a taxi driver. Who knows."

Paolo: "You'll never raise enough assets to start a hedge fund. You really should stay here and run the books to collect your Long Term Crap."

Didier: "er, by the way, you might find a few surprises in there"

Paolo: "Such as?"

Didier: "Oh, you'll find them, trust me. Or they will find you. You'll probably want to hire someone to get you through them. Good luck with that."
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Three months later on the newswires:

London, Feb 19 2009 (Reuters): Embattled investment bank EuroBank announced losses of $1.2 billion on equity and multi asset derivatives trades as global markets continued their rout. The loss, equal to almost twice the revenue from equity sales and trading in the last quarter of 2008, spelt the end of Paolo Motelli's career at Eurobank where he was formerly Global Head of Globalness.

"They were hit from all sides with the trades they had written" said Arma Gessin, analyst at boutique firm Brunette & Co. "We knew they were selling billions of dollars of puts on hedge funds to fund of fund marketers so they could in turn sell protected hedge funds to retail investors. What we didn't know was that a moderate monthly fall in those hedge funds would blow them up completely. They couldn't hedge, as the hedge funds all stopped redemptions."

Eurobank's derivatives losses also mounted due to dislocations in correlation between currency and equity index movements and the two week shutdown in global equity markets agreed by the G20 in the emergency summit in January.

Eurobank officials were unavailable for comment althouh the executive board was reported to be bemused by the nature of the risks on their books. Shares fell 7% on the news to a new low of 4 Euros. The shares have fallen 91% in the last 12 months. Calls to Mr Motelli's mobile were unanswered.

Listing Credit Default Options

A Credit Default Swap is not economically identical to a put option on a bond. The CDS only triggers payment on actual default. A bond put option is more valuable as it may have a payoff even if the issuer has not defaulted (curve steepening &/or spread widening, for example).

This should not stop a listed market for CDSs developing, but let's stop calling them "swaps" first. This anachronism is a result of the product emanating in credit land which plainly likes everything to be quoted in terms of spreads. When an issuer gets into difficulties, CDSs rapidly morph into being quoted with an up front premium - Morgan Stanley suffered this ignominy - and this is the way an exchange traded product must surely be constructed. Here's a possible (rather simplified) specification for a listed Default Option:

• Reference Bond: $[ ] par amount of XYZ 8% of 2020
• Cost: $[ ]% of par
  
• Strike Price: [100]% of par
• Expiry: 5 years
• Settlement: Physical or Cash on Event of Default
  
• Physical Settlement: Delivery of Reference Bond for Par
  
• Cash Settlement: Max(0, Strike Price - Default Settlement Price)
  
• Default Settlement Price: Auction to occur [ ] days after Default Date
  
• Settlement Trigger: Event of Default must have occurred as determined by [ ]

How hard is it for that to be exchange listed and traded? The up front premium is of course none other than the present value of all the (current) CDS payments, less an adjustment reflecting the fact that CDS swap payments cease on default in the current model. It is easy to conceive tweaks which would modify Default Options for fixed recovery rates and other innovations presently in the CDS market.

Come to think of it, how hard it is for many benchmark bonds to be exchange traded as a result of staggering technological advances of the last 20 years? Stock exchanges presently list bespoke equity derivative products at the drop of a hat with very little fuss. Opacity equals profitability for the sell side, I suppose; it has always puzzled me why the bond market, many multiples the size of the equity market, has transparency a fraction of that of the equity market. ICAP & Garban IDBs might just get a little bored were this to come to pass.

An Ugly Marriage of Convenience

"We went down to the courthouse

and the judge put it all to rest
No wedding day smiles, no walk down the aisle
No flowers, no wedding dress"

The shotgun marriage of Merrill Lynch to Bank of America inches warily towards consummation (merger arb presently 16% & 5 year bond spread differential c.130bps). To date Ken Lewis has tossed a few gobbets towards performing brokers in Merrill's retail channel and assured jobs for some senior executives. For the investment banking franchise however, radio silence so far.

Compensation expenses accrued at Merrill were $11.2 billion for the first nine months of 2008, down 3 percent from the comparable 2007 period. Although this sounds promising for those clinging on to their jobs, in conversation last week one Merrill MD found it inconceivable that BoA will let this cash out the door. Judging by his sense of resignation, if there ever was a year where managing expectations is a piece of cake, this should be it.

Ken Lewis declared he had had as much fun as he could stand in investment banking in October 2007. He only agreed to buy Merrill, warts and all, because he wants the 15,000+ brokers. He is desperate to sell fee laden, poor performing investment products to price insensitive retail customers through an army of salesmen masquerading as advisers. Good business that, always has been: three cheers for the wealthy financially illiterate. But investment bankers? Not so much.

Maybe there will be a trade sale of the banking franchise. One would be forgiven for thinking there still might be a bid given Barclays/Nomura hoovering up the Lehman carcass. Yet a month is plainly a long time in these markets. What part of a traditional full service investment bank looks likely to be usefully profitable in 2009/2010? M & A? Cash Equities? Equity/Debt Capital Markets? Credit derivatives? Commodities? Prime Brokerage? Many of these businesses must feel like desolate wastelands, so who's the buyer?

BoA's future investment banking business will likely stumble on, wounded, and shedding staff for years. Boutiques and remaining hedge funds will benefit, but they will have the luxury of being particularly selective.

So what's a foot soldier to do? If you've made enough money in preceding years, either by exercising your traders option or even by being useful, what do you care? You knew it was a regulator-approved shell game, so you played along. Time to get out and enjoy the rest of your life. In coming years the ranks of many different trades will be swelled by hordes of exiting drones. The stock of teachers, for example, may be genuinely advanced by an influx of ex-bankers who aren't doing it for the money, but because they have rediscovered what it means to care about something else.

For the bewildered but bright-eyed hopefuls who entered the industry in the last 2-3 years, that now looks a howler of a career choice. If your personal balance sheet is as stretched as that of your alma mater, the news is grim. If you live by the sword, you die by the sword, and it will be the death of a thousand cuts.

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Disclosure: Long MER options from old employment. Yeah, those old 78s.

Bubblevision Comes Clean

Another slew of talking heads on Bubblevision blathering on about (i) whether now was the right time to get your foot bitten off by dipping a toe in the market and (ii) what governments should do to stem the crisis, when out of the blue, a lone voice of sanity, Rick Santelli:

"this healing process is going to go on and on until it's done and there isn't a force on the planet that can stop it"

He could not have framed it better, and nor can I.

Why Gordon Brown Demurs over Deposit Guarantees

The man on the Clapham omnibus may be wondering why Gordon Brown doesn't do for UK savers and wholesale lenders what the Irish did for funders of their leading banks this week.

Ireland
GDP: EUR 180bn
Debt: EUR 40bn (22% GDP)
Financial sector liabilities guaranteed: EUR400bn (2.2x GDP, 10x Debt)

UK
GDP: £1420bn
Debt: £614bn (43% GDP)
Financial sector liabilities (p T70 of first document): £6,000bn (4.2x GDP, 10x Debt)

The six trillion pound put? It's hard to see it. Of course, the bus-traveller is already heading down to his local Irish bank satellite branch, hard earned savings in hand (lest we forget, savings globally are always "hard earned"). That should start to reduce UK bank sector liabilities, we just have to find a way of liquidating assets to pay him. EuroTARP anyone?

They said there were other ways to short stocks....

Plenty of debate on the Wilmott forums as to whether the ability to short delta is a necessary precursor for risk neutral arbitrage, or whether the models stand up on their own. Indeed, in an earlier post I challenged some of the loopy valuations of Buffet's GS (and now GE) warrants floating about in blogs and mainstream media.

We can agree that we have been in a higher volatility world for the last few weeks. Good for convertible arb hedge funds, surely? Their business model is usually long the converts and hedge with short delta, listed options and CDS instruments.

Apparently not. Inability to short seems to have taken its toll and traditional pricing models have broken down as far as I can see. The chart attached is the HFRX convertible arbitrage index (courtesy Mahalanobis). I'm open to other suggetions as to what's going on here.




I'm not a Talebian anti Black-Scholes mood, I just accept it is limited in practice to when certain pre-conditions exist. It is a special case model, works in many situations, yet sometimes it doesn't. Knowing this is useful, just like knowing that Newton's laws are pretty useful when driving a car, but at relativistic speeds the old chap looks pretty stupid.

Ireland is a Hedge Fund (or Noddy Does Sovereign Economics)

I'm pretty comfortable looking at the balance sheet of most forms of enterprises, assessing risk profiles of contingent liabilities and so on. But I haven't had to start doing this in the context of a whole country until the Irish government's recent staggering decision to guarantee all the senior creditors of its banking system.

I suspect I would have been better prepared for this sort of analysis if I had paid more attention to Economics 101. While a whole country's revenue account is a simple enough concept (Taxes in, then public expenditure, infrastructure capex and debt service out), what does the balance sheet look like? In particular, how do you put values on the assets to determine if the country is solvent or not in the conventional sense? I suppose it looks a bit like this:

Assets
Land (& natural resources therein)
Labour's inclination to show up in the office/factory/hospital/school every day
Infrastructure Capital (housing, buildings and machinery etc)
Goodwill, IP, or "Entrepreneurial Capacity"

Liabilities
National Debt
Capitalised future social security obligations
Other liabilities (like guarantees)
"Stockholders' equity"

Where Stockholders are citizens and their "equity" is some capitalised measure of the quality of life or GDP/head. If this horrible simplification offends any economists, know that I am just pouring it out of the top of my head to allow some focus on the impact of the guarantee, and for that I apologise.

Some figures:

As at December 2006, the last date for which I could get hold of the Irish complete financial accounts, the National Debt was EUR38bn. Contingent liabilities, or guarantees of state sponsored vehicles' debt, stood at EUR3.3bn. On the revenue account side, tax and other income was EUR46bn roughly matching public and capex spending of EUR46bn. GDP was around EUR180bn at purchasing power parity, though who knows how you capitalise this for balance sheet value.

Broadly then, the Irish action adds a EUR400bn contingent liability (being the deposit and wholesale funding base of the banks it has guaranteed) to a EUR38bn national debt of a country with a EUR180bn GDP. However you cut it, those are scary figures; this is like a hedge fund embarking on a lemon strategy and rolling the dice.

By implementing the guarantee for two years, Ireland has effectively written a put option on the value of its banking sector's assets to the holders of the liabilities. (Long time readers must have known this was coming). The assets stand at some EUR460bn, so the put option is 13% out of the money. If the banking sector's revenue account is flat over the next two years (ie the forward on the assets is flat), then a crude estimate of the value of the put option at 20% volatility is around EUR24bn which should appear as a contingent liability on the balance sheet above if mark to market rules applied. Crudely therefore, this is the sort of state acquisition of banking sector equity which we should expect to see if the Irish citizenry are to be appropriately compensated for their assumption of private sector risk. No surprise then that the Finance Bill notes that

"The (finance) Minister may subscribe for, take an allotment of or purchase shares and any other securities in a credit institution or subsidiary to which financial support is provided under this section on such terms as the Minister sees fit."

Expect a crude, unreasonable transfer of value from present shareholders to debtholders, which will be an affront to the whole concept of "equity" for the political expedient of restoring confidence. Failing institutions should be allowed either fail or survive, we need to take our lumps, bear the consequences and move on.

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Edit: if this looks scary I strongly recommend you do NOT try and do a similar back of the envelope analysis for Iceland.

Light at End of Tunnel is Hedge Fund Redemption Train

Policy makers may well be surprised at the sanguine market response to a few House Representatives getting the hump about signing a resignation letter voting for the bailout bill. This light at the end of the tunnel may morph into an oncoming freight train headlight if the quarter end brings significant hedge fund redemptions. The HF community appear to be sitting on a lot of cash in anticipation of this event, but I doubt anyone knows if it is enough. A few thoughts on impact:

(1) If a run on hedge funds occurs, it will be accelerated by the deleveraging of vast amounts of protected Hedge Fund products. These products, (cutting through the generous expense structure - 1% protection fee top of 1+10 at FoF level on top of 2+20 at underlying fund level), essentially employ a geared portfolio insurance strategy to deliver returns linked to the underlying managers. MAN Group, for example, are enormous issuers of this sort of product, much of it marketed on the back of their black box quant fund AHL. Hopefully the words "portfolio insurance" will trigger fond recollections here.

(2) Hedge Fund of Funds will add to the mess; their redemption terms are often more generous than those of their underlying portfolio investments. As and when this deleveraging starts to occur, we should expect to see more announcements such as that released by the Millennium Wave HFoF this afternoon.

The Directors of the Company wish to announce the temporary suspension of redemption of shares in the Company. Accordingly, the redemption of shares in the Company will be suspended with immediate effect and all reasonable steps will be taken to bring such suspension of redemptions to an end as soon as possible and will be subject to regular reviews by the Directors.

The Directors believe that, given the extreme market conditions currently prevailing, the Company cannot currently dispose of its investments without seriously prejudicing the interests of shareholders in the Company.

I don't mean to pick on this fund in particular; it is not particularly large. It will however be reasonably well known as it is promoted and sub advised by John Mauldin. (The chap writes a well known retail investment letter with an email distribution list purportedly running to over 1 million subscribers. The email list seems to be used as a Glenross style lead generator for subscriptions into the HFoF.)

The fund "is a fund of hedge funds that invests in non-directional, niche strategies where barriers to entry tend to be high. The portfolio aims to achieve low correlations among the underlying funds and to traditional asset classes. It targets returns of 12-18% pa". Unsurprisingly, it failed to achieved its target, but it hasn't blown up either, having returned around 1-2% pa since launch. Of course the suspension event disclosed above simply looks like a "get out at all costs as soon as possible" message to all the investors who hadn't actually tendered a redemption notice; who wants to be the last guy invested?

Anecdotal stuff to be sure, but if a diversified HFoF in no apparent distress can't get its investors out of the door, the portents for big liquidations are not good. In particular, where redemption notice timeframes on HFoFs are shorter than those for their underlying investments, the scramble will be particularly acute.

(3) Lemon strategies will get shown up very quickly indeed. Shall we put forward RAB Capital as the business school textbook example of choice, if indeed business schools are educating wannabe bankers at all in the future.

Church in finance guru shocker

Could this be the most ill conceived intervention in recent history? No, not the bloody bailout plan, the preposterous statements of John Sentamu, archbishop of York, echoed by the archbishop of Canterbury:

"To a bystander like me, those who made £190million deliberately underselling the shares of HBOS, in spite of its very strong capital base, and drove it into the bosom of Lloyds TSB Bank, are clearly bank robbers and asset strippers.

We find ourselves in a market system which seems to have taken its rules of trade from Alice in Wonderland, where the share value of a bank is no longer dependent on the strength of its performance but rather on the willingness of the Government to bail it out, or rather on whether the Government has announced its intentions so to do."

Bank robbers? With masks and crowbars and getaway drivers? Strewth, they will be poking holes in evolutionary biology next. To suggest short sellers are to blame is misguided, and on a biblical scale too. Banning short selling is like telling someone with flu to stop coughing: it may seem quieter but it doesn't stop pressure building up inside.

In reality these two pillars of the establishment have been duped by the non-financial media, regulators and government ministers into believing this guff(1). Anyone spot the irony? Dissemination of fear based memes as a survival mechanism has kept the Church in business for a couple of millennia. At least the FT has got to work on the Church's rank hypocrisy with its own investments.


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(1) Including Gordon Brown's unusual claim that naked short selling involves patiently borrowing shares from a willing lender

When a warrant is not a warrant

Many commentators appraised the Berkshire-Goldman deal using black scholes for the warrants, then stood up, cheered and applauded Buffet's outstanding eye for a deal. Bubblevision anchors practically slavered with admiration.

Black scholes valuation assumes arbitrage. Goldman Sachs cannot be shorted so no one can extract realised volatility gains from the position. Look at the recent destruction in convertible arbitrage hedge funds. That Berkshire had no intention of realising volatility in this way is moot. A massive haircut is required on whatever volatility assumptions were used to come up with the warrant valuation. In fact, intrinsic may be the most appropriate measure of value. It may well still be a good deal given the advertising content embedded in Berkshire's endorsement of Goldman, but let's rein in the obsequience. Who does it benefit the most?

Market votes on UK dividend cuts

Liquidity in listed options for UK banks has returned to something like normal following last week's events. Here's the expectation for the change in next year's final dividends backed out of the June 09 contracts (call-put).

• LLOY: -13%
• BARC: -29%
• HBOS: -42%
• RBS: -55%

Government, regulators, depositors and creditors might question why dividends should be paid at all while capital positions are so poor. Fear over shareholders' reactions in the event of a suspension will likely ensure these dividends continue to be paid. Who's in charge?

Regulators Save the World (delay the inevitable edition)

Widescale borrowing of money by unsophisticated investors to buy assets, cheered on by politicians and regulators, got us into an unusual bubble from 2003-2007.

Borrowing of assets by sophisticated investors to buy money is not now, apparently, going to help us find how we get out.

FSA bans short selling


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Disclosure: not short anything. Nor going to be it would seem

Paulson's Perks

(someone please mash this up better than I could)

Warren Buffett's Vega Games

Between 2005 and 1Q 2008 Berkshire Hathaway sold index put options totaling approximately $40bn notional amount, receiving almost $5bn in premium. These at-the-money options were written over the S&P500 and three international indices (most likely the FTSE100, EuroStoxx50 and Japan's Nikkei or Topix - these are the most liquid indices for long dated options). The initial term of the options was either 15 or 20 years.

Before taking the other side of these trades, the investment bank counterparty would have formed a view on the following risks:

(1) What is the right price for long dated index volatility? Very long dated options have significant vega (sensitivity to implied volatility). One volatility point changes the model value of a 20 year S&P500 put by approximately 0.75% of the notional amount. By contrast, a 1% move in the index changes the model value by only 0.09% (9% delta).

There are takers for the other side of this volatility risk. Well, maybe not for 20 year duration, but at least out to 10 years or so. Constant buyers of long dated vega are retail investors, usually purchasing structured protected products - the simplest protected product is a zero coupon bond plus a long dated call option.

(2) Where is the 20 year forward for the S&P500? Buying puts from Buffet means the bank is short the S&P500 forward. Unfortunately, selling calls to retail investors also leaves them short the forward. The market's demand for long dated forwards has always been so one-way that these forwards tend to trade rather high. Put another way, long dated options typically imply very low estimates of cash dividend growth. Presently, the 15 year S&P500 cash dividend growth implied from forward prices is negative 3%pa. Do we really think $30 of S&P500 dividends today (2.15% yield) will have dwindled to $16 in 2028? It's the same for international indices too.

Berkshire and Buffet think completely differently to an investment bank in relation to these risks. Roughly summarised, their thought process is "markets ain't gonna be down in 20 years, we could use the premium income wisely, we never have to post collateral so let's just hit vega bids when they look attractive." Note the market call here is perfectly in sync with Berkshire's view that long term returns on equity markets will be in the mid single digit range. Selling puts for premium in the absence of collateral covenants is a useful source of risk-adjusted long term funds.

But it is the forward quirk which leads me to question Berkshire's strategy. No, I don't agree with Mish Shedlock that "anyone short S&P puts is asking to have their heads handed to them on a platter." Berkshire's approach is simply not the same as a "hidden" put selling strategy embedded in a so called lemon hedge fund.

No, the flaw in Berkshire's put selling strategy is that it locks in negative dividend growth rates: they get less money for their puts than they deserve. If Berkshire do stand behind their long run market call, they ought to believe that cash dividends will grow, on average, over the same timeframe. Sure, financial stocks may cut dividends in the short run, but it seems inconceivable that the market grows 5%pa over 20 years and cash dividends fall 3%pa - the index dividend yield in 2028 would be less than 0.5%!

Berkshire could be paid up front for opposing this paradox. So, Warren (I know you're an avid reader), I would have overlaid a fixed for floating dividend swap to reverse your forward position. 1 year cash dividends on the S&P are around 2.15%, or say $1bn on $46bn notional. The "fixed" leg paid by Berkshire would be an annual payment of $1bn increased by a fixed 3%pa for 20 years. The floating leg received by Berkshire would be the actual dividends paid on a notional portfolio of $46bn invested in the S&P500.

This dividend swap should generate an up-front payment to Berkshire of some 13% of the notional amount, or $6bn. This is the same order of premium that Berkshire received for selling the puts in the first place. Two premia for the price of one view! Provided cash dividends grow by 3% or more on average, there is also the promise of further payments to come. If Berkshire like their put selling strategy, this one's the proverbial no-brainer.

Black Swans, Black Scholes and Black Holes

As coined by Taleb, a Black Swan is shorthand for an a priori unpredictable event which carries a large impact on occurrence, and following which we seek explanations to make it seem predictable. Taleb has his share of detractors - as onetime hedge fund manager Eric Falkenstein commented in a particularly acid dismissal of Taleb's career: "the bumper sticker "shit happens" is kind of funny, kind of true, but hardly profound." Yet the runaway success of the phrase is a Black Swan in iteslf. There has been a huge recent increase in the adoption of the term, though many advocates miss a key point: a fulfilled doomsday prophecy cannot itself be a Black Swan (since it was prophesised).

Nowhere more so than in the field of physics. The Large Hadron Collider (think London's Circle Line underground tunnel with some chilly magnets) at Cern, Switzerland will be operational later this year. The plan is to accelerate subatomic particles to near light speed and bounce them off each other in a search for, among other things, the Higgs particle and Hawking radiation. The Higgs particle is the physicist's missing link - it would explain mass, startlingly - and confirmation of Hawking radiation would mean a pretty quick trip to Stockholm courtesy of the Nobel Institute for the wheelchair bound thinker.

Of course a Black Swan event as a result of this experiment might be, shall we say, troubling. But most of the potential catastrophe scenarios have been hammered out already. In particular scientists have examined the possibilities of localised black holes, magnetic monopoles and/or the creation of as yet unseen particles called strangelets. The physicists are convinced of the absence of risk, and I certainly don't doubt them. Nonetheless it is entertaining to listen to the prognostications of the doomsday advocates.

The risk of the creation of a mini black hole somehow expanding to consume the lot of us is standard science fiction fare, and I can't get too excited either about a magnet with North only. A strangelet is a more peculiar beast altogether. Certain physicists kooks postulate that if one of these dark matter particles is created by a near relativistic collision of other nuclear particles, it will infect anything it contacts and convert it too into strangelets. The ensuing chain reaction turns our planet to strange custard in short order. Not good, by all accounts. To think I was worried about putting the recycling out for collection.

Given this possibility has been predicted, even by kooks, technically it wouldn't count as a Black Swan even if we were around to debate the point. But I am a man of caution, and were the LHC physicists to be wrong, I have been developing a solution. Place you right hand in the air as if swearing in at a presidential inauguration. Do the same with your left hand. Start waving your arms around shouting "we're all going to die" repeatedly. That should sort things out, but be quick about it.

Presented without Comment

(click to enlarge)

Poor Academics Grouse at Wealthy Hedge Fund Managers (again)

Hedge Fund managers are greedy robbers who don't deliver? Surprised? That's what these people think: only two weeks after Martin Wolf gives a big thumbs-up to the Wharton "hedge funds are lemons" paper published by Dean Foster and Peyton Young, the same paper and the Wharton puff piece summarising it get another airing courtesy of the Journal's DealBook blog.

Spare yourself the agony of reading the paper. Yet another hashed out explanation of the age old "trader's option" with some sparkly mathematics thrown in for academic credit. The trader's option is the incentive to take extended, but largely unintelligent, short gamma and/or leveraged beta bets with other people's money in the knowledge that success will be rewarded handsomely and subsequent failure will not result in clawback.

Wharton finds the potential for this skulduggery a startling revelation. The paper goes on to describe the hedge fund world as a "lemon" market, akin somewhat to the used car market: you have no idea if you purchased a bad one until it is apparent you purchased a bad one, and by then, well, tough.

Why is this newsworthy? Yves Smith picked this up a while ago, and poses one for Martin Wolf:

First, [Wolf] seems shocked, shocked that investment managers can make a lot of dough while delivering mediocre returns. Where has he been? It's almost a truism that active managers don't earn their fees; numerous analyses have found that ones that outperform don't sustain it over time. It's just that hedge funds have elevated the fee extraction to unimagined levels.

Indeed so. In reality of course there are both lemon managers as well as competent managers. I don't begrudge the General Partners of either type their loot one iota. What the academics fail to understand (choose to ignore?) is that for lemon strategies the General Partners' business model is "to raise money at 2+20", not "to deliver alpha". Theirs is a sales job at which they have been particularly proficient. Congratulate them for it, at the expense of investors gullible enough not to carry out appropriate due diligence before investing. Whether alpha accrues is of secondary importance, whatever is claimed. If, in applying their business model, General Partners have earned super normal returns, this speaks more to the limited negotiating capability of hedge fund investors generally. Herein lies the rub. The academics (and Martin Wolf of course) want to gnash teeth at those who made easy money with lemon strategies, not question the motivations of the chumps who funded them based on a powerpoint presentation and confident smile.

Indeed, the Wharton paper makes a number of suggestions to redress this balance: (a) assess payments based on final returns after an extended period, (b) require General Partners to invest alongside or (c) assess penalties for underperformance. Astute readers will recognise this as exactly the same old mulch trotted out in response to egregious investment banking pay. Come on now, if you're the type of entity or person who invests in investment banks or hedge funds, don't be moaning that you weren't aware of the nature of the game.

**EDIT 8 Apr** For the avoidance of doubt, this post is an attack on those who cheaply malign hedge funds, not an attack on hedge funds. I'm agnostic as to the prevalence of sustainable alpha, but I do believe the adaptive markets hypothesis is the right framework to explain why temporary alpha is widely available.

Bullet Dodging, Bank of England Style

Today's middle market press headlines:

• Hunt begins for £100m rogue trader behind fake bank collapse rumour (Mail)
• Hunt for rogue trader after attack on HBOS (Telegraph)
• Malicious traders attempt to topple major bank (Times)

The theory being that, after shorting HBOS shares, one or more Doctor Evils spread rumours that the company was facing funding difficulties. All manner of denials by the company, the Bank of England and the FSA failed to prevent a fast run on the equity. Faced with potential headlines such as "Is Halifax the next Northern Rock?" and an inevitable (perfectly rational) run on deposits, I suspect the authorities engaged in serious arm twisting of media proprietors/editors resulting in the calming headlines above. It's always better for the country to be on the hunt for the city bad guy than standing in line for its money back from the Halifax. Let's face it, Halifax has a relationship with 40% of UK households so it could be a long line.

OK, well, here's a slew of nasty rumours about HBOS:

• 59% (£164bn) of their £278bn wholesale funding matures in less than 1 year
• The retail deposit base is just £215bn, in context
• Their recent Tier 1 debt issue paid a spread of 512 basis points over gilts
• The share price has fallen 60% from its highs
  

Oh, what - these are not rumours? Sorry I meant facts taken from published accounts and elsewhere. There was no assertion of insolvency yesterday (nor was there for Northern Rock), just the constant background hum of investors wondering if HBOS will survive the year from a liquidity perspective. So some people talked about it to others in the city? Big deal. Perversely, yesterdays market action makes survival more likely, but future earnings less so. The tri-partite mandarins had another wake up call and HBOS can expect a vast liquidity line from the Bank of England whenever it needs it.

And as for the Doctor Evil witch hunt, Alphaville got there before me.

Why Retail Structured Products Depend on Iceland's Economy

Q. When are bonds issued by stricken Icelandic banks valued virtually the same as identical instruments issued by Royal Bank of Scotland?

A. When they are valued for the purposes of comforting retail and private client stockbroker investors in structured products, of course.

Derivative based retail structured products (you know the type, give me 100 and I will give you 100 +/- "some market performance" in 5 years) have been with us for well over a decade. Until now, all of them have done exactly what they said on the tin. But as well as the payoff profile, investors now have to ponder a different issue: regardless of the product's entitlement under the terms, will the issuer be solvent when this entitlement comes due? Is appropriate credit risk priced into these instruments?

My example du jour is a Close Asset Management product: Japanese Accelerated Return Fund II (JAC.L). Beneath this exhilarating name hides a payoff profile which is essentially a 180 pence maximum less a 5x geared put spread on the Nikkei expiring in 2012. All well and good; the Nikkei's performance since launch may be poor, but at least investors know how the linkage works.

Where it gets interesting is that the 180 pence maximum is secured on a pool of bonds. Two of these bonds, or 33% of the gross assets of the investment, are issued by the Icelandic banks Glitnir and Kaupthing (who? who indeed). Yet the formal valuations of the bonds at 31 Dec 2007 implied these Icelandic behemoths have virtually the same credit risk as, for example, Royal Bank of Scotland. Amazingly there was also no mention of the continuing deterioration in the credit quality of these issuers in the results announcement of 29 Feb, surely the perfect opportunity to alert investors in the trust.

No doubt the manager got a friendly mark from their dealer to back up the valuations; they are not that stupid. But it is another thing entirely to recommend that the directors of the fund sign off that the accounts give a true and fair valuation of the assets. The secondary market price is also not yet close to reflecting the credit risk. Investors may be indifferent to the risk, but perhaps that's because the manager's NAVs are accepted in good faith.

The UK has had its fair share of retail financial disasters - split capital trusts, precipice bonds, endowment policies - you name it. By and large, they are a function of the structure of financial advice provision in the country, but that's another post topic. If one of these banks fail, Close will be hoping to avoid being added to that list courtesy of the Icelandic government pulling a Northern Rock stunt out of the hat.


**EDIT 20 Mar** With Glitnir going on S & P negative watch for a downgrade from A-minus today, and the CDSs jumping to over 850 bps in sympathy, we may get to find out sooner rather than later.

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Disclosure: No position

Bear Stearns Shareholders: Turkeys Voting for Christmas?

If you are Joe Lewis, surely you would want bankruptcy, and the optionality that thereby remains in your stock position in Bear Stearns (BSC) rather than giving up at $2...who cares about the $2?

If you own CDS protection, might you want bankruptcy, and a payout on your default swap on BSC? Does paying > $2 to vote against it help?

If you are a (typical) Bear employee, do you really think that merging with JPM is the best chance of preserving your job, while giving up the optionality on your stock for $2? You're gone buddy, either way. No reason to vote for the deal, just like Joe Lewis.

Without the deal, of course, BSC is looking into a dark hole from which it might not return. Yet the entire financial system would have been looking into a darker and deeper one in the event of BSC's bankruptcy. Whither this negotiating power available to BSC over the weekend?

Somehow it seems that BSCs management have underplayed this last Ace. The deal works for everyone except those who get to vote on it. Is it too late for shareholders to remind us?

When Convertibles Don't Convert

Merrill Lynch today announced it was exiting the subprime mortgage origination market. Probably good news, right? At the same time it announced a modification of the terms of one of its existing convertibles. No discussion, no reason, just a modification. Probably bad news, but not for convertible holders.

The bad news is winning. The stock is down some 6%, plumbing new lows. Here's my attempt at why, for those with the stomach for dull technicalities.

The convertible securities are LYONs - "Liquid Yield Option Notes". A fancy name for an variable rate accreting nominal, puttable, callable zero coupon convertible bond. OK it's a fancy instrument too. In this case, the accretion rate is 3m LIBOR-2% and the conversion ratio is 14.0915 shares per bond.

What really counts, though, is that one of the put dates falls next Thursday, March 13, and Merrill don't want to run any risk of shelling out the $2.2bn redemption price. This is not "plan A" - these convertible bonds were supposed to turn into balance sheet equity at some point.

Today's sweetening amendments (i) increase the conversion ratio by 17% and (ii) add a couple of put dates in 2010 and 2014 (the maturity date is 2032). Merrill get nothing in return for these new features, they are unilaterally value-enhancing for the bonds. The bonds' fair value is now presumably sufficiently above next week's put strike that bondholders will not exercise. Cash call avoided, at least for now.

The increase in conversion ratio increases the delta of the bond, or its sensitivity to the stock price. The required additional delta hedging by convert arb funds, plus the inconvenient reminder that Merrill's balance sheet is stretched, is plenty enough to prompt the share price falls seen today.

John Thain may well have commented that "we will not have to go back to the market to raise capital". Unilaterally changing the terms of convertible bonds to avoid a redemption serves the same purpose.

Bad Guys Before Congress: Round One

A right old who's-who of finance bad guys is shortly scheduled to face the indomitable wrath of the US House Oversight Committee. In the red corner, Angelo Mozillo, E Stanley O'Neal and Chuck Prince stand ready to defend their pay. In the blue corner, the same elected representatives who recently grilled Rocket Roger on alleged steroid use in baseball get to show us their grasp of high finance.

The hearing has been delayed at least twice and may be again, which would be a shame. One can only guess at the scheduling difficulties the witnesses face in their recently unencumbered professional lives. Still, with some luck we will get to see the action on March 7.

Letters sent to these witnesses included the threatening paragraph:

"According to press reports, you collected tens of millions of dollars in payments and other compensation upon your departure from [Merrill Lynch]. I request that you be prepared to provide your perspective on this reported pay package. You should plan to address how it aligns with the interests of [Merrill Lynch] shareholders and whether this level of compensation is justified in light of your company's recent performance and its role in the national mortgage crisis."

The witnesses responses to questions along these lines should be pretty straightforward. One suggestion might be:

"Chairman Waxman and Members of the Committee:

Thank you for inviting me to be here today. I appreciate the opportunity to tell this Committee and the public — under oath — that my retirement severance pay is a matter between me, the compensation committee, and shareholders of my former employer. Now is this going to take much longer as I have a tee-time back at Bethpage and the chopper is waiting?"

which, admittedly, might come over a little contumelious (go on, look it up, I had to). That said, there's not much to lose in getting things over with quickly; I doubt any of the 3 have much by way of reputation to salvage.

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**EDIT Mar 7** (to remove an unusually rebarbative final paragraph). Separately, these hearings have indeed been held today. Witnesses did not have a particularly rough ride, all things considered, and this is no bad thing. Companies making poor business decisions, whether on executive compensation or on business strategy, are hardly a subject for Congress, though the scapegoat search will no doubt continue.

The American Civil War

The American householder is at war with the financial services industry. At stake, around two trillion dollars. At least, this is the inevitable conclusion if one accepts at face value Nouriel Roubini's recent testimony to Congress. This testimony rehearses the Professor's well publicised conviction in a doomsday scenario and concludes with dire forecasts:

"So let us consider the implications for the household sector of price declines of the order of 20 to 30%. The math is simple as I will flesh out in this note: 10 to 15 million households will end up in negative equity territory and will be likely to default on their homes and walk away from them. Then, the losses for the financial system from these massive defaults will be of the order of $1 trillion to $2 trillion"

Uh huh. 15 million households. Let's see - there are some 116m households in the US population of 303m. So sometime soon, Roubini expects 13% of them will be in the market for a U-Haul truck, cardboard boxes and a decent brazier against which to warm their hands under the arches. Steady on, chap. This isn't Darfur we are talking about. I'll keep it simple - where will these people go? Hmm, hang on, I just noticed something: 15m households on the street, and 15m empty homes. Now let me think about that for a minute.

We are only just commencing an enormous path-dependent value transfer process. The end point, whenever it comes, is when these 15m households are back in (or never leave) the same homes with the ability to pay their way, renting or mortgaged, against a new price base. In the meantime, if you believe Roubini, there is the matter of up to $2 trillion of capital losses to be apportioned. Who is going to eat these losses? Either the financial services sector, ultimately funded by its investors, or the state, ultimately funded by tax increases on those 100m householders who have not gamed the system. That's just a question of whether the solvent rich or solvent rest pay.

Those who prefer chicken to egg blame the financial system for this debacle, deeming these speculators innocent victims of the credit bubble. Yet if Roubini is correct, who is having the last laugh here? None other than the 13% of underwater, insolvent, speculative households presently dialling 1-800-GO-U-HAUL. They have nothing more to lose; they cannot be compelled to pay without the means to pay. They have even managed, somehow, to destigmatise the concept of reneging on a mortgage. I don't doubt that there are presently some terrible hardship stories out there, but ultimately the cavalry will come. They will have their aspirational homes in the end - they just won't have had to work for them and pay for them.

Equity/Credit Decoupling? Not So Fast

There is plenty of debate about the apparent decoupling of equity and credit markets. A cursory look at iTraxx credit spreads(1), and most equity markets' apparent indifference to their recent moves moves provides ample evidence.

Is the equity market in denial? I don't think so. I have a pet macro-explanation for why current market moves are not as inconsistent as they seem. Growing uncertainty about economic growth means that expectations of volatility of corporate cashflow/EBITDA is on the rise. Credit instruments (corporate bonds) are essentially risk free bonds with embedded short put options on this pretax corporate cashflow. Equities are call options on after tax corporate cashflow, struck at the present value of the credit instruments.

So in this increasingly volatile environment, is it any surprise that short-vol instruments decline sooner and more negatively than long-vol instruments in the first instance, before confirmation of negative movements in corporate cashflow? Credit markets always seem to move first in these sorts of times. Of course I don't want to imply that equities should go up, just that declines should be damped by the nature of their claim on corporate cashflow.

As a corollary, if we actually move into recession, corporate cashflows will start to fall. As expectations of the corporate cashflow "forward" move down equities have a much greater sensitivity: they actually have greater recession delta. Put simply, credit markets anticipate, and equity markets confirm, recessions.

And if this all looks like just another ludicrous attempt by Financial Crookery to shoehorn everything into an options framework, you would be right. We try to stick to our knitting. And that's the last time we will use the Royal "we" too.

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(1) It looks as if an unwinding effect is going on in the protection indices too at present - CPDOs, for example, don't actually need to hit the 10% breakup level to trigger index swap unwinds; no doubt many of these are being sold back to the dealers on the way down and the rehedging of these positions by the dealers itself is doing a lot of damage. Its not my market though, so I'd look to Alea for real insight

Robert Redford: Derivative Salesman?

I was pointed by Naked Shorts to a dispiriting Bloomberg article about iffy derivative sales ("schools flunk finance"). It's a long piece; my handy summary goes as follows (to strains of the Entertainer in the background):

I. The Setup: A Pennsylvania school board is badly short of cash, its buildings are crumbling and it cannot afford new textbooks.

II. The Hook: An investment bank salesman (the "Mastermind") introduces a school board representative (the "Mark") to an independent derivatives advisory firm (the "Patsy").

III. The Tale: Together, the Mastermind and the Patsy blind the Mark with a dazzling presentation on the merit of selling swaptions for premium. Conveniently, the premium plugs the hole in current year education budget. The Patsy assures the Mark of his independence and technical competence, persuades the school board to execute a transaction with the Mastermind and provides a fairness opinion.

IV. The Sting: The Mark executes a transaction with the Mastermind, inevitably at the wrong price. The Mastermind pays the Patsy a fee out of his spoils (huh? Yup). Subsequently the transaction turns sour and the Mark loses a lot of money. The Patsy is subsequently investigated by the FBI on municipal antitrust matters, while the Mastermind has vanished to close in on the next mark.

OK so I stretched the analogy a bit. But there are a slew of issues here:

(a) the acceptability of the school board assuming a particular financial market risk (in this case, the writing of a swaption). I won't comment except to note we only hear about the trades that go wrong. The article would be less compelling if the school board had pocketed the swaption premium and the option had expired worthless.

(b) the price paid/received for the assumption of the chosen risk. Quoting Bloomberg:

"School districts don't know whether they're getting fair market values with swaps because the contracts are private; they don't know how to compare their deals with those done by other districts."

Erm, how about three quotes from different dealers on the trade date, rather than a single quote supported by a fairness opinion from a chop-shop in the pocket of the investment bank trying to close the deal? I suppose school board districts can't pay superintendents much so is it any surprise they exhibit investment grade naïveté in these sort of dealings.

(c) the gullibility of the "independent derivatives adviser". It must be exhilarating for them to be joint pitching with real investment bankers. They become playas in the big leagues! You can imagine the beer and backslapping after the deal is done, after the banker strolls off with a huge profit and coughs a paltry $60k to the Patsy. And then the angry resentment when the independent adviser's activities, not those of the bank, become the subject of regulatory scrutiny when the deal implodes.

Yes, derivatives salesmen are experts at getting deals done, any way, any how, and with an army of in-house counsel to make sure their trail is wiped clean. The traders behind them know how to extract every last cent of profitability or fees from their transactions. (OK the traders all lost money on mortgage products, but that was a warehousing decision and is a separate issue).

So let's assume you work at a Pennsylvania school board, or a Swiss private bank, an Australian life insurance company, a German corporate treasury, a UK Pension administrator or any one of thousands of other buyside entities, supposedly with sufficient expertise that an investment bank can classify you as a non-retail customer.

The more complex the structured product, the more opportunity for agents to extract fees at your expense. Do you have a handle on the investment cost and risk profile of everything you own? An interest rate swaption is a pretty vanilla instrument; could you describe all the ways banks squeeze money from, for example, a CPDO? I found eight without much thought, only half of which are explicit in transaction documentation. (For a primer on CPDOs, not particularly complex in reality, there is only one place to go.)

Admitting you don't know is pure alpha; you will not claim to have any edge and this may put you off involvement in the product. If you claim you do know where the fees are, banks want you as a customer. You don't know. Really, you don't. Hang on, I hear you shouting that you're actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don't. Know.

Still, the risk/reward profile of a particular structure might actually be useful to you, provided you are rewarded appropriately for the risk. Again, let's use a CPDO as an example. There are always more efficient ways of assuming a similar risk profile than entering into a nicely packaged transaction - simply buying a solid vanilla floater and selling enough iTraxx/CDX OTC protection for your target yield enhancement would get you close enough not to worry much. iTraxx/CDX_IG default swaps are quoted on pretty thin bid-offer spreads so you're not ceding much value. (If you got really twitchy and closed it all out when your mark-to-market was down 90%, it would would be an even closer a representation of a CPDO).

If this alternative is unavailable to you, for example, because your trustee documentation forbids trading derivatives, why on earth should it be OK for you to access those derivatives just becuse they were wrapped up in a funded structure with a pretty rating?

The derivative salesman will do anything to get the deal done. If that means spending countless evenings schmoozing you in restaurants and, ahem, afterwards, it will be done with faux camaraderie. So remember this: as you dab your sweaty upper lip while the dancer gyrates round your paunch, your investment banking "friend" is eyeing you with equal measures of contempt and avarice. As WOPR, the computer in the film War Games, eventually concluded, "the only way to win is not to play". The banking salesman exists because you exist.

Bill Gross to Ambac: "Please Die Quickly"

On January 30 Pershing Square released an open-source spreadsheet containing information on CDO guarantees written by MBIA and Ambac. Naturally I wanted to take a look and I apologise for the lateness of this post. The delay was unavoidable - Pershing operate "twin Intel 3.16GHz Quad Core Xeon X5460’s (a total of eight cores sharing 2 x 6Mb of L2 Cache on a 1333MHz front-side bus) with 4Gb of 800MHz DDR2 ECC SDRAM." Sadly, once my Sinclair ZX81 had run for 89.236 hours to recalculate their spreadheet, its 16k RAM pack was hotter than molten plutonium and begged off any further recalcs for the weekend.

My first thought on examining the 120MB spreadsheet was pity for the poor analysts (Goldman or Pershing) who compiled the data. It is a root canal drilling exercise second to none. Bill Ackman has some seriously dedicated minions and I doubt they are paid by the hour.

The 700 tabs of gut-wrenchingly dull data funnel up to an estimation of CDO losses for Ambac and MBIA. Oddly enough, these aggregate losses seem unexceptional, particularly since they are expected to be incurred over the remaining life of the guarantees. But my walkaway feeling about the whole "open source" exercise is that it is a smokescreen: Pershing need some kind of capitulation event to close their shorts efficiently. Their nervousness may be justified as foolish talk about a monoline rescue continues to swirl. Pershing's argument is not whether the monolines are AAA or AA-, but whether they are solvent or broke.

This appears a different issue to what is vexing the rest of the market. For a typical corporate, a one or two notch credit rating downgrade is not a catastrophic event, but for the monolines it is the end of the world - it kills their new business opportunities stone dead and puts them in runoff. But the wailing and gnashing of teeth over Ambac or MBIA simply suffering a downgrade from AAA reflects far greater fear than one might expect over this eventuality - there is a huge impact for the broader credit market.

Firstly, investment banks would take further write downs on CDO assets guaranteed by the monolines. Yawn. There is a more sinister risk though: it is not just the bond insurance business model which is broken, the whole fiduciary structure of asset ownership is inappropriate. The root of the problem lies in dusty trust deeds which both prescribe and proscribe eligible investments for countless numbers of investment entities: "Got AAA? You're A-OK". With the arrival of the monolines, promoting a standalone single-A or AA rated muni bond to AAA status with an illusory guarantee was just too damn easy a way to arbitrage these investment restrictions.

An Ambac/MBIA downgrade might trigger a tsunami of forced liquidation for all kinds of assets (including staid municipal bonds), even if this changes the creditworthiness of their issuers not one iota. Possibly today's market prices for these securities are already pregnant with the risk of such a liquidation event, maybe they are not, and the market does not like this uncertainty. Banks like JP Morgan appear ready to take it in their stride while a panel of European banks think it such a serious issue they have considered their own bailout.

In any event, it makes a lot of sense to start viewing one's investment world as if Ambac and MBIA didn't exist. We are due a cathartic clearance from this episode, and we are going to get it sooner or later. As Bill Gross notes in today's FT:

"How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world’s sixth-largest economy? How could an investor in California’s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation’s largest state with its obvious ongoing taxing authority?"

Now that is wide-eyed clarification. Forget about the bond insurers and put them into runoff. Bond investors can get about their business of honest examination of underlying credit and security risk. And while they are at it, learn to do without the comfort blankets known as Moody's and Standard and Poors. The market assesses volatile equity risk every day without anybody officially "rating" stocks.

If the trustees or their managers are unable to carry out proper credit risk assessment, they should offload mandates to those who can. Large investment managers with the capability to assess credit risks in the absence of rating agengies will prosper. Pimco must be rubbing their hands with glee.

Earth to Borrower: Jingle Away...

I wrote about optionality in housing markets last year (here and here), and this subject deserves revisiting. Tanta at Calculated Risk recently went on the technical offensive, explaining the role of prepayment optionality in mortgage bonds. There are two types of optionality at work: (i) modellable prepayment optionality within the mortgage asset structures and (ii) the behavioural optionality on housing assets created by the loose availability of mortgage products per se. It is the latter of these which is most relevant to the present housing situation.

For a traditional owner-occupier, the purchase of a house simply hedges their future need for housing shelter. At the time of the purchase, the occupier is "flat shelter". Obviously this situation is different for buy-to-let investors, second homeowners or for flippers, but this is a minor part of the market.

By "flat shelter" I mean the purchaser has perfectly hedged their future requirement for housing shelter at the level, or utility, provided by the asset purchased. A four child family living in a 3 bedroom condominium remains "short" the real estate market - the utility provided by this asset is insufficient for its shelter needs. A four child family purchasing a 5 bedroom home in an area which it deems socially acceptable is flat shelter. Renting may also hedge a short shelter position, but it is hedging long term liabilities with short term assets. Occasionally, this may make sense - for instance, when the cost of the long term hedge is out of line with the short term hedge. This is where we are today.

What we witnessed in the recent 3-5 years was a dramatic increase in the cost of the shelter hedge. Most people say "house prices rose a lot" - but it's the same thing.

At the same time, the cost of options to acquire shelter hedges declined dramatically. Which was the chicken and which the egg? 100% LTV availability, teaser rate finance, and a highly accommodating finance distribution channel provided those who wanted to increase the utility of their shelter with a strong incentive so to do. Make no mistake - these were options, they were cheap and they had contingent pay structures too.

In the past, to walk away from an upside down or negative equity mortgage ("ruthless" borrowers, in industry jargon, thanks Tanta) might have been considered socially unacceptable . These attitudes are changing. The youwalkaway.com website has received acres of blog coverage; mainstream media will surely follow. I suspect it will be hard to find much coverage which views potential use of the service as financial leprosy. The increasing social acceptability of jingle mail further enhances the value of the call options originally sold by desperate lenders to homeowners. Once through the denial and anger stages of a doomed housing purchase it is easy to see how the erstwhile borrower might take sadistic pleasure in slamming his lender into ownership after a 10 month free ride in the property.

So lenders sold the calls cheaply. Application of put-call parity (and recognising that the collateral for the mortgages were the houses themselves) instructs us that this was no different to lenders being short puts on housing collateral. Where was their upside? Collecting option premium in the form of mortgage payments after the expiration of teaser rates - doomed not to occur once the market turned. And so some investors lost a lot of money on assets into which these short puts were embedded. Until the market rids itself of inappropriately priced optionality, normality cannot be restored to housing.

Old news, admittedly. Yet it is instructive to continue to examine house prices in the context of utility and behavioural optionality. As far as I can see (and in fairness I haven't looked hard), the short term shelter hedge did not seem to perform similarly to the long term hedge in the last 3-5 years. Rents where I live are the same as or lower than rents five years ago.

Housing can only find a bottom when the marginal new jingle mailer finds that continuing to pay their mortgage is cheaper than renting from a new landlord. Everyone needs to hedge their housing shelter position somehow. New landlords ought to demand a return on capital in sufficiently excess of risk free rates to compensate for the liquidity risk, credit risk and management costs of owning the asset. This premium does not yet seem available - it will materialise due to prices falling further or rents rising. Until the latter is more likely than the former it is perfectly rational for stuck owners to keep jingling.

Astonishing Soc Gen Transcripts Emerge.....*

Saturday morning. A particularly nice apartment in an upmarket residential district of Paris. Monsieur Bouton is shaving in front of the mirror. A lady lounges on the plush bed. The telephone rings.

Bouton: " 'allo?"

Voice: "bonjour, Danny, eet iz Christophe 'eere"

Bouton: "Christophe?"

Voice: "yes, Christophe Mianne....your 'ed of capital markets and derivatives...ze one who got you Equity Derivatives 'Ouse of ze Year"

Bouton: "yes, what do you want. I am busy eere. And call me sir" (he winks at the lady)

Mianne: " 'ow you like ze markets at the moment sir? Ze equities I mean?"

Bouton: " zat is your job to tell me. I pay you 5 million euros last year for zis game. I don't like your question"

Mianne: "OK OK OK. I sink we 'av accident. I 'av unexpected exposure."

Bouton: "How unexpected?"

Mianne: "about 70 billion euros unexpected. All long"

Bouton: "70 million? And you are bothering me about zis on le weekend?"

Mianne: "Sir, you mis'eard me. I said billion. Seventy sousand million euros of long exposure"

Bouton: "Is zis bad?"

Mianne: "une catastrophe, sir. I sink you 'av to come into ze office today"


Monsieur Bouton ends the telephone call. He apologises to the lady, dresses and summons his chauffeur from his slumber in a not so nice apartment in a not so nice residential district of Paris. We move to Saturday lunchtime. An equally plush boardroom in la Defence, Paris. Many, many assorted senior faces present.

Bouton: "What is 'appening?"

Head of Risk: "Sir, we 'av discovered some unausorised positions in ze equity derivatives delta one desk. Because of zis we have beaucoup de long exposure. We 'av lost about 1 billion Euros so far. I recommed zat we quickly close zis position and...."

Bouton: "...who ze fuck are you?"

Head of Risk: "I am ze 'ed of risk sir. We 'ave a junior guy who 'id some trades. It eez a large position which we found by accident. It eez not my fault."

Bouton: "Shut up. I am announcing our results in 4 days and I do not want zis position."

Head of Risk: "Me too. I think zat we...."

Bouton: "Shut up.....merde.....Mianne, 'ow we get rid of zis position and 'ow much we lose?"

Mianne: "Sir, ze US she is closed Monday. Lazy Americaine. If we unload on Monday ze impact will be huge"

Bouton: "'Ow bout we call some banks and 'edge funds and place it?"

Mianne (with panic in the voice): "SIR, it is seventy billion euros! Zis is like a quarter of ze whole belgian market. Eef I even mention zis figure on a telefone ze other party will 'ang up and start shorting. We will be killed! We can tell no one, sir, no-one! We 'af to be fast"

Bouton: "'Ow much we lose if we sell?"

Mianne: "Eet doesn't matter. If people find out before we are finished eet's a bigger number"

Bouton: "I don't understand"

Mianne (patiently): "sir, zis figure is so impossibly 'uge zat we are dead if anyone know it."

Bouton: "Merde. OK sell. Zen we talk again OK"


Wednesday evening, Paris.

Mianne: "we 'ad some 'elp from ze Fed. Zey so dumb zey thought it was a recession. We only lost 4.9 billion euros. Zis is good, no?"

Bouton: "who was zis guy, ze tradeur who did zis?"

Mianne: "we lost him, sir. 'E 'as vanished"

Bouton: "tomorrow 'e is famous. Zey will find 'im, ze press. I am 'appier being me zan zis tradeur"



* with apologies to the cast, crew and writers of 'Allo 'Allo

Banking pay just won't go away.

I had wanted to move on from the weary subject of bankers' pay as there are many other interesting things to write about, but Martin Wolf's provocative FT article needs consideration. His argument summarises thus: (a) banks are disproportionately important to economies (b) they know it, so capitalise on it - "no industry has a comparable talent for privatising gains and socialising losses", (c) as a result banking employees are conflicted with the rest of the world so (d) please regulate their pay.

You cannot fabricate demand for any product. You can market it aggressively, charge too much, fail to provide good service, but if that product is not wanted, it will not sell. This applies to mortgages and other financial products (e.g, dotcom IPOs) as much as it applies to iPods. The availability itself of esoteric mortgages to borrowers, and of exotic mortgage-backed assets to investors, was not the most significant factor in the growth of the present cancer. Nor was the apparent connivance of some of those in the distribution chain.

No, individual mortgage borrowers demanded their chance to improve their social and financial standing with scant regard for the potential consequences of their actions. MBS Investors (read hedge funds, money market funds, pensions, mutual funds as well as banks) demanded 'attractive' yields for the perceived risk, and had incentive structures and abundant liquidity available to encourage risk taking.

Mortgage borrowers and mortgage-asset investors were both long housing assets, the former with a call option on the upside, the latter by shorting puts on the downside for yield premium. Investment banks, at whose doors Mr Wolf et al are laying the blame for the outcome of this misguided speculation, just saw an opportunity to intermediate this activity and did so successfully. It was their own badly conceived warehousing of some of the assets which is causing them so much mark to market pain at present, but that is not the issue.

Are we supposed to blame the bankers for being oil in the cogs in the capitalist engine? Are we suggesting that banks should have desisted as they knew a bubble was developing? Why are we ready to pronounce them the bad-guys again? Purely since their pay is the most public and the most despised by outsiders. So let's regulate it. Claw it back. Withhold it for 10 years.

Never mind that politicians and central bankers set the tone for investors (loosely, the American dream). They don't get paid much, so let's not blame them. Let's also not claw back their salaries or appropriate large fractions of their fees from lucrative speaking tours or book sales following their exit from public duty.

Never mind that the majority of ordinary people are illogically risk seeking in housing markets, or dot com shares. Ordinary people don't get paid like bankers, so let's not blame them. Let's not try to educate ourselves properly about finance before we wreak such destruction.

Never mind all that. Blame the intermediary who earned too much.

Some rays of light do emerge in the article though. The most interesting point in the article is as follows:

"An alternative suggestion is “narrow banking” combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public. The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess."

Not necessarily so. The narrow banking plus 'the rest' concept is worth greater consideration as it would make much clearer the distinction between risk and absence of risk. I would probably include regulated vanilla mortgages as assets in which the narrow system could invest. I also don't think Martin Wolf is advocating complete deregulation outside the narrow system - the 1933 and 1934 securities acts, and their foreign cousins would remain, as would the SEC, FSA and so on. In this structure, institutional failure would result not in 'socialised losses' but insolvency. Instead of regulating bankers' pay, show them some real downside, for this is what is missing from the present picture.

Edit: you have to read this. It is more eloquent than anything else I have read on this issue.

Sub-prime: Been There Done That. What's Next?

Observant visitors will notice a new look for the blog layout, courtesy of a crash course in XHTML. It's not perfect yet but at least I am on the way. In the meantime:

The scale of the latest credit write downs at a number of investment banks should shortly be public, as should the fruits of those banks' capital raising efforts. The Merrill and Citigroup results announcements will be the first under their respective new stewardship; it is reasonable to expect that their approach to write downs will be savage. Their predecessors were in duck and cover mode - no surprise with hindsight that the first slew of write downs last year didn't quite get us there.

Analysts will dissect the small print with particular focus on level 3 assets, those for which management has the most discretion in valuation. Their efforts are unlikely to particularly fruitful. The beauty of level 3 assets is that management can also be pretty opaque when discussing valuation methodologies.

But what we do know is that there has been little activity which demonstrates wholesale dumping of toxic housing assets at distressed prices, E*Trade apart. The marks are not being validated with observable two-way business. There may be no buyers anyway, but more likely the banks do not want to dispose of their mortgage inventory near current marks preferring to cover the mark-to-market losses with fresh capital.

This appears sensible. I suggested in November that the worst case scenario would be for a default due to liquidity rather than insolvency, requiring fire sales of sub-prime assets to a decidedly unwilling market. Then and now, I feel that mark-to-market losses on mortgage assets, however real today, will dissipate with time. The assets will earn their way out of trouble, not back to par (!), but certainly upwards from the current depressed marks. For the banks who have been at the confessional, they have bought the time to let this happen.

Market focus has turned to other potential risks anyway. Rising corporate default risk, credit default swap exposures, broader credit damage and the general health of the economy. With last year's experience under our belts, the "Black Swan Defence" will be available to no-one in 2008 if any of these turn ugly.


** EDIT ** Merrill reported 17 Jan. They have indeed not sold much of their toxic credit portfolio. However they do appear to have hedged a lot of it at present depressed levels by purchasing insurance. This action seemed designed so Thain could 'tell the market' that it has hedged its exposure. Indeed, inital media coveage of Thain's conference call performance was positive.

The stock price disagrees, down 10% on the day. No wonder. Thain has eliminated any possible upside from the current mark to market levels on its mortgage portfolio. Yet if the hedge is successful, he may not be able to collect; the insurer's ability to pay is strongly negatively correlated with its requirement to pay. This dim strategy looks to be a misguided response to the situation the Company faces, and is in sharp contrast to the polish shown in its announcement.

Banking Pay: Moan On, You Crazy Downers

The FT continues the investment banking pay debate (it's January: must grumble 'bout dem bankers), granting column space to professor Raghuram Rajan. The impeccable Yves Smith at Naked Capitalism runs the rule over the tone of this article - his her succinct summary of Rajan's point is as follows:

The big issue is that owners of capital (think shareholders investment bank stocks as well as investors in funds) should pay a premium for alpha, or manager skill, and not beta, or market returns. But a lot of people are paid for what Rajan calls "fake alpha," which is basically taking undue but hidden risk, or finding chumps (which can lead down the road to litigation, another hidden risk) rather than creating value for investors.

But what Rajan misses is that everyone in these firms is conspiring together to create the impression that they are all generating real, risk adjusted, excess return. Think I am making this up? I know plenty of people who complain bitterly that they are underpaid when they are making well over a million dollars a year. And none of them could go off and start a boutique business in the same field and generate the same level of income.

Can't dispute this last point. Yet most complainants are only unhappy on a relative basis, remaining secretly staggered with absolute levels of pay (though perhaps not this year in, shall we say, certain divisions). I would like to note in passing that "taking hidden risk or finding chumps" is an impressively precise description of how today's trading floors work either in banks or hedge funds. But one might as well howl at the moon as clamour for changes in compensation structures.

jck at aleablog sides with Rajan highlighting this comment in the original article:

All these strategies essentially earn the manager a premium in normal times for taking on beta risk that materialises only infrequently. These premiums are not alpha, since they are wiped out when the risk materialises.

Yup, agreed again. But so what? Its not like no-one knows this is going on, and has been for years. What's a poor investor to do? Rajan himself suggests this solution:

Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur. The managers who blew a big hole in Morgan Stanley’s balance sheet probably earned enormous bonuses in the past – Mr Mack certainly did. If Morgan Stanley managed its compensation correctly those bonuses should be clawed back and should be enough to pay those who did well this year without increasing the bonus pool

How clever. How noble! Er no. Preposterous, actually. When I finally clambered back into my chair I re-read it just to make sure he wasn't joking. A significant reason why the brightest still clamour to sign up at these banks, and why investment bank traders desire to run hedge funds is precisely because their pay is a non-recourse strip of yearly call options on market beta and talent alpha. Come on, we all know this, surely. The unwritten rule is that this cliquet option can be abruptly terminated; then you are on your own.

Not that this will seem either fair or reasonable to the common man - the absolute figures involved are extraordinary - but the structure exists because it works. Executive management pay is another issue, but to muck around with rank and file producer compensation schemes is suicide.

Management know this, even if they do fiddle around with the percentage of bonus paid in restricted stock from time to time. The industry is somewhat oligopolistic in this regard - if one firm broke ranks on compensation structures as Rajan suggests, its employees will vapourise, starting with the best, and the firm will be destroyed. And good luck recruiting at Harvard or INSEAD next year too. The real compensation lever available to management is headcount. Timing is difficult, as those who cut the deepest in 2001/2002 found out in the following years, but headcount management works.

Understandably, shareholders (or hedge fund investors) are unhappy when the hidden risks being taken with their capital don't pay off. But let's not fool ourselves that these investors thought they owned a utility. Some of the main reasons financial conglomerates exist are purportedly to smooth earnings volatility and to facilitate appropriate capital allocation. It's not working, plainly. Why not let the market do the job - perhaps what's really needed is separation of capital and identification of risks. Spin the conglomerates into separate companies: Trading, Corporate Advisory, Retail Advisory and Fund Management. The 1970s all over again.

We already know how to value the Blackrocks of the world, and firms that earn fees through the provision of advice. Investors in the Trading entities would demand more by way of competent risk management and disclosure - it;s already happening for hedge funds. These companies would then find their own valuations, in the prior knowledge that investors have already sold a strip of compensation calls to 'dem heinous traders.

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At Bonus time, No One Can Hear You Scream*

For many investment banks, January is the month when it happens. The phone rings, the foot soldier trots down to the honcho's office, and, with a poker face worthy of Phil Ivey, hears about a dozen words and nods non-committally. A simple ceremony at the culmination of a year's warfare.

The bonus process starts around October. No, strike that.....what am I thinking. Unofficially its more like July....er..no, make that April. Yup. If you start making some decent money in April then you would be a loon not to start managing upwards with indecent haste. Managing upwards is the time honoured practice of ensuring that credit for good stuff is attributed to you and nasty reversals are studiously buried elsewhere. Preferably under some stooge who doesn't know the game is being played, let alone how to play it.

The best paid employees are always professional upwards managers - employing subtlety and immaculate timing. They also avoid making "dead" PnL from mid-November, wisely deferring it to the next financial year as bonus allocations have already been finalised. True talent is a secondary consideration to playing the game well. True talent knows how to turn the screw when other producers are bid away to other houses, ideally in big "team moves". Nothing scares a decent line manager in a good year more than a big chunk of his earning capacity hoofing off to a bulge bracket wannabe firm.

Yet in good times, the line manager's job - let's say "Head of Derivatives Sales" for example - is a breeze. Say the right things to the mob underneath, hire aggressively, let the market do its thing and get on with your own upwards management.

Due to the apparent ease of this management game compared to the grisly business of finding actual customers and making them want to do profitable business with you, it is no wonder foot soldiers vie to join management ranks. Of course there are never enough proper management jobs, so important sounding but irrelevant roles are invented to accommodate the dissemblers in good years. Yet everyone knows who pulls the strings, who is the only person that counts: the guy in front of you in January.

As markets inevitably turn, the tidemarks of competence recede under the weight of over-zealous budgets and stalling profitability. Dead wood masquerading as pseudo-management gets to spend a month replanting gardens before taking equally posh sounding jobs in sleepy second tier banks. Dear reader, of course they were simply fired for being rubbish - but if you meet one of these types mumbling about "interesting opportunity" or "heightened responsibility" it is wise just to nod sagely.

A few years ago this was the story of the equity world. It's not hard to suggest that today's bulge-bracket fixed income trading floors are strewn with human wreckage which will be reincarnated as tomorrow's "Unicredito Global Head of Globalness" types.

I digress. Let's return to the day when foot soldiers are informed of their "number" - use of this abstract word apparently softens the vulgarity of the event - Bonus Day. Closure of the only feedback loop that counts in the dynamic instability system of an investment bank.

I've experienced extremes of emotion in these sitdowns, not, hopefully, that anyone could tell at the time. So if I may, a couple of observations if it's your turn this January: (1) if you are getting handily overpaid for averageness, it is wise to look as if you've just been slapped with a wet fish; and (2) the words "well done this year, keep it up" combined with a pony(**) bonus are as close as it gets to an actual slap with said fish. Your upwards management stunk - must do better.


* "At Bonus Time, No one Can Hear You Scream" is a great book by David Charters which should be in the same required reading category as Liar's Poker.

** pony: cockney rhyming slang. Or a misprint for puny if you prefer.

Merrill's Death Spiral Financing?

When cash strapped companies raise money by issuing securities where the number of shares issued increase as the the share price falls, the transaction is occasionally referred to as a "death spiral convertible".

Last week, no more than 23 days into John Thain's tenure, Merrill Lynch became the latest bank to arrange a capital infusion from a Sovereign Wealth Fund. Temasek of Singapore is purchasing $4.4bn of stock at $48/share with an option to purchase a further $600m of stock for up to 3 months from the date of the initial purchase. Davis Selected Advisors, a US money manager is chipping in with a $1.2bn stock purchase at $48.

At the September 2007 quarter end Merrill had 855.4m shares outstanding. Including 25m shares for the Davis investment and 91.7m shares for the initial Temasek investment results in 972.1m shares outstanding. The two initial sale transactions thus represent 12% (Temasek9.4%, Davis 2.6%) of the enlarged share capital issued at a 13% discount to the pre-deal price of around $55 . That in itself is decent dilution at considerable cost. But there are other peculiarities relating to the transaction:

1: Another fund raising is needed before Temasek can exercise its $600m option:

Unless there has been an increase in the number of shares outstanding since the September 28 period end of which this author is unaware (1), if Temasek exercise their option on 12.5m shares, they breach the 10% ownership limit forbidden under the terms of the deal. To receive the full Temasek capital infusion, Merrill must issue a further 57m shares or over 5% (for $2.5-3bn) to another party before March 28, 2008 . Either John Thain isn't done diluting existing shareholders, or Temasek's option to purchase a further $600m of stock is not all it seems. No wonder Goldman Sachs' analyst is able to forecast a kitchen-sinked quarter if there is another capital injection on the way.

2: Anti-dilution provisions look unfavourable for Merrill:

The term sheet also references a price "reset". The specific language is:

If Company sells or agrees to sell any common stock (or equity securities convertible into common stock) within one year of closing at a purchase, conversion or reference price per share less than $48, then the Company must make a payment to Purchaser to compensate Purchaser for the aggregate excess amount per share paid by Purchaser. At the Company’s option, the Company may issue additional shares of common stock in lieu of cash to Purchaser with a market value equal to such excess amount.

Translation: Temasek has a put option of sorts on its investment. If Merrill goes cap in hand for more capital later in 2008, it ain't going to be above $48. Temasek are immunised against this risk for 12 months. For example, if some unforeseen credit writedown in Q3 2008 casues Merrill to require another $8bn at a perfectly conceivable $30/share, Temasek will have to be repaid $1.875bn ($18 * 104.2m shares), or be issued a further 62.5m shares. Combine this with maintaining the 10% threshold and we are talking some serious potential dilution. Just when Merrill might need to raise capital more than ever, it will have to give it back to Temasek or dilute existing shareholders even further.

Is this a death spiral transaction then? Although the principle is similar, the answer is probably a qualified "no". Temasek are only entitled to their make-whole payment if Merrill go ahead and raise capital later in 2008. Surely a major reason these dangerous looking terms are embedded in the deal is that Merrill's management want to make a significant statement to the market that this will not be the case.

What Merrill are signalling, quite simply, is that they believe the worst is over. They must think that this transaction, plus the possibility of another $2-3bn infusion before March 2008, is enough to see off the rest of 2008 and beyond. Merrill shareholders, more than those of any other investment bank, need their management to be right with their call. If they are wrong, Merrill has compounded its downside with this transaction.

................
(1) Merrill had not responded to queries on the transaction (specifically, that the pre-transaction number of common shares outstanding was indeed 855.4m) at the time of posting.
................


Disclosure: Long MER options (from old employment)

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The Bond Insurance Barge Scam

ACA is downgraded to CCC. Negative watch for a pile of others. Good timely stuff from the rating agencies. Thanks chaps. CalculatedRisk quotes a portfolio manager at American Century Investments:

“It’s a zero-sum game. If you put trades on that worked so well that you bankrupt your counterparty, you will not collect on those trades.”

Succinct enough. The NY Times chips in with the story on the inevitable bailout by those owning the ACA insurance. Put another way, if I owe my lender $3,000, it's my problem. If I owe him $3,000,000,000 it's his problem.

Can anyone spot the difference in the following:

(A) In 1999 Enron effects a transaction through an SPV allowing it to get a [Nigerian power-generating barge] off its books allegedly in order to improve its reported numbers for the period. Later the trade has to unwind and the barge must be brought back on the books rendering Enron exposed to its real (somewhat less impressive) value all the time.

(B) In 1999-2007 investment banks effect transactions with SIVs allowing them to get a [lot of credit clag(1)] off the books allegedly in order to improve reported numbers for the period. In 2007 under adverse liquidity conditions [the SIVs with the worst liquidity constraints] fold and the credit clag must be brought back on the books rendering the banks exposed to its real value all the time.

(C) From 1999-2007 investment banks effect transactions with bond insurers allowing them to get a [lot of credit clag] off the books allegedly in order to improve reported numbers for the period. In 2007 under adverse market conditions the [insurer with the worst net exposures] goes bust, the insurance is worthless and the credit clag must be brought back on the books rendering the banks exposed to its real value all the time.


Plus ca change. Here's the one which hasn't happened yet:

(D) From about 2000-2008 many investment banks purchase credit default protection from each other allowing them to get [a lot of credit clag] off the books allegedly in order to improve reported numbers for the period. In 2008 under adverse default conditions the [bank with the worst net exposures] goes bust, its sold protection is worthless and....well, just make up your own forecast of how this pans out. It can't be pretty.

No new news here, I suppose. Yet there's no amount of ISDAs, Credit Support Annexes, netting arrangements or other protection which will help anyone if it occurs. For years the investment banks' internal credit and risk departments have been outwitted by smarter, better paid front office mobsters. These "business prevention officers/BPOs" may have wrested some control back in the last 6 months, but the credit default firework is primed and the fuse is burning faster than they can move. If we are lucky, the firework might not explode when the fuse reaches it, but that will be down only to chance.

(1) claggy ■ adj. Brit dialect tending to form sticky lumps. ORIGIN c16: perh of Scand. origin; cf Dan. klag 'sticky mud'

**************

Unrelated throwaway #1: if you're a capital strapped bank, would you rather sell influence in 5% and 10% lumps to the Middle East or to China? Or wouldn't you care....."just gimme the cash so I can save my job"

Unrelated throwaway #2: Gotta love hedging the rate risk on a subprime BBB short with a carry-matched subprime AAA long. I thought BPOs knew about short gamma so this couldn't happen. Shorting treasuries as the rate hedge would of course have made Morgan Stanley $2bn but sadly would have cost a few hundred basis points in carry while they were waiting. This used to be known as an "IBG/YBG trade".....if it works, bonus bonanza.....if it doesn't: "I'll be gone and you'll be gone". Presumably they're gone.

Mark to Citadel and go to hell?

Citadel recently purchased E*Trade's portfolio of mortgage assets at 27 cents on the dollar. Before we get to the details of the transaction itself, let's amuse ourselves with a few of last week's blog headlines:

Could Citadel's valuation of E*Trade's CDOs wipe out capital at three big banks? (blogging stocks)

The Citadel Discount: Armageddon Scenario For Three Banks (dealbreaker)

The mark to Citadel and go to hell meme is thus established, albeit weakly. Schadenfreude dribbles from the keyboards of these authors......"OK, 6 weeks ago we had never even heard of level 3 assets, but now we know that they all are way toxic. TOXIC I tell ya! You're all dooooomed!"

Why are they simply analysing the ABS part of the deal? E*Trade's SEC filing for the overall transaction with Citadel and its affiliate Wingate (go on, brave it out) notes the following components:

• a 1.7bn Springing Lien Note purchase in 2 parts
  
• 30.7m stock purchase
• the ABS portfolio purchase
• an Equities & Options Order Handling Agreement (Citadel gets some of E Trade's dealflow)
  

Analysing one part of the transaction in isolation is pointless. Yet commentators have seized upon the ABS purchase agreement like rabid rottweilers.

This agreement certainly states that Citadel paid $800m for around $3bn notional of ABS. Though out there in the fog, CalculatedRisk, the anonymous yet immaculate surveyor of all things housing, provides interested parties with some meat on the bones of the portfolio. This allows us to see how daft the 27% argument is: $1.3bn of the ABS notional is "AA or better prime residential first lien" product. The $800m purchase price implies that even if everything else is worth zero, these prime assets are worth just 62% of face value. Of course that is bunk; if a 70% original LTV mortgage being amply serviced by a wealthy professional is worth 62% of face, it implies that his home is worth less than half the purchase price. Grow up. Prime mortgage ABSs are not toxic CDOs. The so-called marks "validated" by this purchase are utterly spurious.

What is considerably more likely is that the $800m is just a balancing figure that Citadel paid for the ABS assets for agreeing to execute the larger E*Trade recapitalisation. It probably suits them to have the implied PnL on this ABS portfolio safe from the rest of the transaction. For all we know, the portfolio might be worth $2bn or more (somehow I doubt Ken Griffin will tell you). If this were the case, Citadel could lose $1bn on its direct E*Trade investment, but still be up overall.

Analysing the whole E*Trade transaction for value certainly falls into the category of "highly non-trivial", as my french derivative quant friends would say, but I have a hunch who had the upper hand in the negotiations. Do we think that prime housing collateral is suddenly worth less than 50% of its purchase price? Or do we really think that Citadel saw the most scared kitten in the basket, gave it a friendly smile then stomped on it with very large boots?

Finally, as to investment banks marking level 3 assets to 27 cents on the dollar? What those doomsday scenarios signify is that their proponents have voids where their brains should be, even if they have the ability to press buttons on a calculator.

Black Swans in Newcastle.

Northern Rock experienced unprecedented liquidity shortages during the credit crunch due to its business model and the structure of its liabilities. It was never apparently insolvent, but its solvency was threatened until the Bank of England provided a last resort lending facility and HM Treasury stepped in to guarantee retail and wholesale depositors.

Commentators have sought to apportion blame for the Northern Rock implosion as if what happened was somehow predictable or avoidable. Nassim Taleb's Black Swan concept addresses just this phenomenon. The three attributes of a Black Swan event are "(i) it is an outlier event, (ii) it carries extreme impact and (iii) in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable."

The evaporation of the global commercial paper markets and the peculiar reluctance of the world's largest banks to lend to each other were unforseeable consequences of the forseeable emergence of real defaults in US sub-prime mortgages. To blame management because Northern Rock's business model was particularly unsuited to this confluence of events is inappropriate. Secondly, the flaw in the tripartite regulatory regime (which led to the mishandling of the emergency funding and the run on Northern Rock) had neither been debated nor even acknowledged as late as mid-2007. To blame the FSA, Bank of England or politicians for their legally constrained responses is equally inappropriate. At least no one has tried to level blame at the queuing depositors; theirs was the most rational response of all.

NRK witnessed its own Black Swan event. It was unknowable, unpredictable, unpreventable, and baked into the system a long time ago. Anyone suggesting otherwise is simply playing Monday morning quarterback. How hard it is for humans to come to the conclusion that some things are nobody's fault. Can you imagine the market's reaction if in December 2006 management had come to the conclusion: "listen, chaps, this securitisation lark.....way risky from a liquidity perspective..that Johnny subprime in the US of A has got us by the short and curlies. We're out of here."

The law of unintended consequences

OK its time to square the circle on the ADIA/Citibank deal. I had intended a piece moaning about the quality of the headline reporting on the deal in the 24 hours or so since it was announced. I felt that mainstream commentators had failed to understand the deal structure, and given the general negative media bias towards the banking sector, slanted their reports accordingly. It was epitomised by the "Junk Citi" piece in the FT blog. I note now that Alphaville has corrected itself, and through their contacts were even able to get a convertible arb specialist to value it properly. Hopefully this leaves us all in no doubt that, from an economical/pricing perspective, the deal was not particularly burdensome for Citi, as much as any other capital ratio bolstering financing would have been. This clarification is a good thing.

I suggested how the media might have slanted their coverage if they were in the mood to be nice to Citi or unfavourable about ADIA's investment. I didn't want to opine on the prospects for Citi generally, positive or negative. Nor did I want to opine on whether the transaction was good or bad for ADIA, strategically. From the response to the post however it looked as if I had been interpreted as singing the praises of Citi. So I want to clarify things, but not as you might expect.

• Is the deal good for Citi? I simply don't know. If the current poor conditions in the credit markets subside, it will have been an equity capital raising they didn't need. If conditions worsen, the additional capital cushion might save them from having to liquidate assets at fire-sale prices, providing them some relative advantage over their competitors. Hence "smart business", if they are right. I don't know what will happen in the credit markets in the next week, let alone 12-24 months. I suppose like anyone else I could handicap what might happen, but I know for sure that my handicapping ability would be less adept than that of Citi or ADIA.
  
  
• Is the deal good for ADIA? Again, I just don't know. Current market conditions make now probably the only time that a Sovereign Wealth Fund could buy such a huge fraction of the US's largest bank without (i) much market impact or (ii) what appears much political fallout. They need to put huge amounts of petrodollars to work so I understand what they are doing from a strategic perspective. Again, if the credit crisis deepens, ADIA will surely look a bit premature. If it doesn't, their timing will look impeccable, especially if Citi's stock price recovers more than the first 17% on which ADIA will miss out. Selling puts then spending the premium on yield enhancement and out of the money calls is also "smart business" if your call is right.
  

Could the deal be good for both of them? You guessed it, I don't know. Moreover I don't want to make it my business to venture opinions on this sort of stuff. When someone sells equity (or structured equity) to another, you can look to see who "won" in your choice of timeframe. Nevertheless I suspect that the relevance of this bean counting exercise is swamped by the various strategic objectives each of the two parties think they are achieveing in executing the transaction.


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Citibank, ADIA and that pesky 11% interest rate

Its not always that both the venerable FT and the Wall Street Journal dive into a story and miss the point so absolutely that you have to question their sanity. The Alphaville chaps have summarised the two articles relating to the Citi financing deal with the AbuDhabi Investment authority under "Junk Citi" as the headline.

Selected quotes include:

"The securities will also pay a fixed coupon of 11 percent per year, payable quarterly. That may seem steep, but after accounting for the fact that 60 percent of that coupon is tax-deductible, the coupon rate is similar to the dividend rate on Citi’s shares, a person familiar with the matter said."

"Citi is paying a higher interest rate than companies that borrow on the high-yield, or junk-bond, market; currently they pay roughly 9% for straight bonds. Typically, convertible bonds pay lower interest rates than straight bonds, although a particular bond’s structure could affect the interest rate paid."

The Alphaville post ends up by noting:

"And why this highlighting of the fact that interest payments on the notes will be tax deductible (like most forms of debt)? And does 11 per cent represent a “slight premium” to a seven per cent yield on Citi stock? That’s actually a premium of 57 per cent. Even after the spurious tax argument, it is difficult to see how this funding can be costing much less than 9 per cent."

Oh dear. Oh dearie dearie me. Gentlemen, there was a clue in first quote. ....."although a particular bond's structure could affect the interest rate paid". You bet it can. Lets take a look at the key features of the deal termsheet.

• Size: $7.5bn
• Type: Mandatory convertible (DECS is the Citi brand for these ubiquitous instruments)
• Payment rate: 11%, quarterly
• Term: Approx 4 years
• Settlement amount: (a) 235m citi shares if stock below 31.83
  (b) 201.39m shares if stock above 37.24
  (c) straight line interpolation between these numbers.

The 235m shares @ 31.83 is, indeed, equivalent to a $7.5bn equity financing. But ADIA has effectively sold a call spread to Citi as well. It doesn't participate at all in the first 17% rise from the low strike to the high strike. Perhaps, just perhaps, the value of this call spread is equal to the 4 year additional yield premium on the DECS. Lets break down the deal into alternative components which have an identical cashflow profile (assuming pricing the day the deal was struck at 31.83):

• ADIA pays $7.5bn for 235m shares of citi stock at 31.83, at, say, 7% yield
• ADIA sells 235m calls on Citi stock strike 31.83 expiry 2010-11 (staged)
• ADIA receives 201m calls on Citi stock strike 37.24 expiry 2010-11 (staged)
• ADIA receives 4% pa dividend enhancement for 2.5-3.75 years (staged)

The dividend enhancement is probably worth 12% of the deal amount of $7.5bn. With sensible assumptions, the net value call spread is around 8% in Citi's favour, so the remaining cost to Citi is around 4% or about 1.5% pa over the weighted average life of the deal. Put another way, Citi has raised tax deductible, upper tier capital funds for 4 years at a cost equivalent to another financing source of Libor+150. Smart business. It may even be that Citi's stock has suffered since the deal was struck in part due to Citi itself hedging out its long callspread position.

The FT and the Wall Street Journal are guilty of sensationalist journalism and have totally missed the point in their quest to find the worst possible slant on any investment bank's activities. I suppose this is in vogue at the moment. Perhaps if they had wanted to batter ADIA instead of Citi, the headline might have been "Unsophisticated Arab financiers write massive put option on US investment bank".

Disclosure: No position in Citi

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It's a knockout....(option)

It's a Knockout (US: Almost Anything Goes) was a TV show popular in the 1970s. Basically, teams of willing idiots dressed in silly clothes to compete in ludicrous challenges, usually involving unstoppable downward slides on soapy tarpaulin mats. Commercial real estate (CRE) teams out there might think they have resurrected the game given the performance of their asset class recently.

The basic tenet of a CRE fund is bank debt providing geared exposure to large pools of tangible property. Covenants embedded in the bank debt give rise to a twist on my recent analysis of leveraged investment using basic building blocks of option theory (see recent posts here and here). Today's post examines another building block in the derivative world - barrier options.

Roger Ehrenberg recently posted about the short put nature of a typical hedge fund manager's business in contract to the long call nature of a fortune 500 CEO's daily life. "Nickels in front of bulldozers" vs "swinging for the bleachers" are well understood analogies. Knockout (or barrier) options are yet further instruments which can provide surprising insight into many real life situations.

I want to illustrate my point using a topical example. Invesco Property Income is a leveraged CRE fund listed in London. It was launched in 2004, plenty early enough to have capitalised on the boom in CRE assets. At latest results, the fund had gross assets of around £466m and borrowing of £298m for net assets of £168m, or 110 pence per share. Yet if you had bought one share for £1 in 2004 you would have received dividends of 28 pence (so far) and have a share which the market will today take off your hands for the princely sum of 40 pence. Somewhere along the line, this investment has not done exactly what it said on the tin.

So what's happened? We are not talking about a terrifically leveraged trust here. The board stated a target of borrowing only 55% of the gross value of the CRE in the fund. When new investment opportunities are identified, this borrowing target is temporarily relaxed to 65% to fund the purchase with the objective of "revaluing up" the capital asset as soon as possible, or raising a little more equity.

The fund's committed lending facility runs to 2014 and has a couple of innocent covenants: a loan to value ratio over 65% on a quarterly portfolio revaluation date, or a rental income to loan servicing ratio under 125% triggers the lender's right to demand immediate and full repayment.

Absent these trivial little covenant clauses, investors in the trust's equity own a 55-65% strike call on the capital value of the assets plus the "yield shift", as our CRE friends like to call their manifest carry trade. A standard options model might value the call at around £140-150m (95-100 pence per IPI share). This is a little lower than the "simple" NAV of £168m; a significant fraction of the yield shift is hoovered up by fees of the manager, its valuers and other advisers. The revenue account is almost flat - this trust is only able to pay its investors an "income" yield by a legal manoeuvre converting a quarter of its initial capital account to distributable revenue reserves.

Anyway these smoke and mirrors matter little. At latest results, the 61% loan to value leaves the fund manager reasonably close to a phone call from Mr Lender. The fund has announced plans to sell £100m of assets and deleverage somewhat. If they achieve full appraisal valuation on the sale (unlikely), this will leave them with £366m in assets and £198m in debt, a ratio of 54%. Phew. Nasty phone call averted.

But let us re-examine the CRE call option cognizant of the debt covenants. A 17% fall in assets will blow the covenant, presumably triggering a real fire sale and liquidation of the trust. Assume this fire sale knocks off another 10%. The fund is not akin to a simple call option if its 2014 maturity can suddenly be accelerated with a mild downdraft in capital values. The option has an embedded knock-out or barrier feature. It's a 7 year, 55% strike call with a down-and-out barrier at 83%. If the option knocks out, investors are rebated about 20% of today's gross capital value of the portfolio (ie the difference between the liquidated proceeds of the portolio less the repaid debt) and that's it, game over.

Even if commercial real estate valuations have not (yet) fallen much, fear over this possibility is palpable. Volatility is certainly on the rise. Increasing volatility is very bad news indeed for the owner of a down-and-out option. Earlier, I valued the simple unencumbered call option around £140-£150m. With the barrier present the option is worth some £50m, or 35% less per share! The debt covenant is spectacularly valuable to the bank as sentiment turns for the worse in commercial real estate: it virtually eliminates their potential for capital loss.

The recent price action in the stock certainly seems to imply that the market has woken up to the embedded knockout option. Since publication of the last results the stock has fallen from 110 pence to 40 pence. I am by no means suggesting it is cheap...part of the damage is certainly due to investor disbelief of the portfolio's current valuation, but that subject deserves another post entirely. The noise surrounding commercial real estate has woken investors to the potential impact of their embedded knockout option, even if actual capital values have not yet fallen. This is not a time for the faint hearted. And if you think Mr Lender is going to go easy on you, think again. He can't wait to get his money back right now.

Disclosure: no position in IPI, ever. But it might get too cheap.
Update disclosure (9 Dec)...it got cheaper. I am now long.
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New Star: more closed-end fund fun

New Star Asset Management isn't having the greatest time of it recently. Neither is the split capital industry. Yes the sector is off, assets are shrinking, and frankly, its going to get worse. So New Star's efforts preserve a distinctly whiffy split capital investment trust defy belief.

New Star Financials (NST) is a london listed investment trust with around £85m ($180m) of gross assets. It is geared by the employment of £41m of zero dividend preference shares whose maturity date is imminent. The trusts assets are a rag-tag bag of UK & European financial stocks which have performed spectacularly poorly of late.

When the zeros mature, there is no reason for the rest of the trust to exist. It is too small, it trades at a persistent discount and its expense ratio is ridiculously high. Investors looking for european financials exposure have a multitude of better alternatives. Yet the board, under the gentle persuasion of the manager, have recently announced plans for a reconstruction of the trust. This will involve:

• repayment of the zeros
• a tender offer for up to 50% of the ordinary shares of the trust at 3% discount to NAV
• re-gearing of the remaining assets using a prime broker liquidity facility
• modification of the investment mandate to allow short sales
• the introduction of an additional performance fee. What? you must be joking. Nope - true.
  

I understand that the manager expects around 65% of the current shares to be tendered, so these investors will be scaled back (and unhappy). The trust will then in essence be a £20m net assets long short hedge fund, geared as much as the prime broker will allow, with a third of its investors highly motivated to get out. You would have to be madder than a box of frogs to consider this a decent investment product.

Why not simply liquidate the trust? It has the wrong structure, an inappropriate mandate and only serves to maintain a fee stream to all those associated with it. Point your finger at the board, for not standing up to the investment manager in its desperate quest to retain a thin revenue stream. Perhaps maintaining their own directors' fees has lubricated their decision.

Disclosure: long a lot less NST than 6 months ago & tendering

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Crookery in Action #38776

Usually, crookery is pretty well hidden. Sometimes it screams out at you. This chart ought to be extremely well publicised in the mainstream media. It appeared first on All About Alpha but the grunt work was carried out here.




Not much explanation is needed. It is a chart of the distribution of monthly hedge fund returns. The two black bars are either side of the zero line. Hedgies seem to show a disproportionate number of "just above zero" monthly returns to "just below". Uh huh.


In essence, those bulldozer dodgers claiming to pick up nickels are probably only really finding pennies.

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Will John Thain Fool us with Randomness?

The dust has settled on John Thain's appointment as the first outsider to be given the reins at Merrill Lynch. Despite at furst blush the employment package looking generous, it should not go without noting that it looks a darn sight smaller than the loot his predecessor stuck in the swag bag as he passed out the door. That's not to say Thain comes cheap, but there are serious problems with boards continuing to acquiesce to compensation packages in the way they have for Thain.

Stripping out the slew of payments for loss of office at the NYSE, and ignoring the $750,000 annual salary + perks (who can live off that kind of pittance anyway?), we're left with half a million restricted shares, 1.8 million options striking around December 1, and some yet to be determined bonuses for 2007 and the rest of his term. The restricted shares and 600,000 options vest in 5 or 3 annual installments, respectively. The rest of the options vest in equal part when the stock price hits $20 and $40 above their strike.

Now I am all for incentivisation. But lets not delude ourselves that this is what the compensation package achieves. Thain has a number of decisions about Merrill's future strategy to consider, admittedly. Yet I simply can't see any of those decisions having the fraction of the effect on the stock price than the effect of the eventual resolution of the credit debacle over the next 18-24 months. If the crisis is weathered, MER will be up $20 and $40, even if Thain has sat in his office twiddling his thumbs (apparently he isn't a golfer). If things turn even uglier, so will MER. Anyone thinking that Thain's pending decisions will materially impact whatever transpires in "the great credit market resolution" should email me whatever they are smoking. The seeds have already been sown and the game will play out automatically, if you pardon the mixed metaphor. The paradox is that although no one knows how it will end, no one can really affect it, such is the size of the juggernaut.

Put another way, this kind of incentivisation is like knowingly paying a hedge fund manager 2 & 20 for rank beta. Many hedgies are earning 2 & 20 for masked beta, naturally, but it usually hides under some marketing guff about alpha. In the case of wall street executive compensation, they just write down the truth and send it to the SEC! CEOs are basically granted gargantuan call options on the future of the economy, largely unrelated to personal performance.

We should start by looking at the vesting schedules. As well as an absolute hurdle (ie stock must be up $40 to trigger vesting), why not haircut/boost the number of options vesting by 5% on any vesting date for each 1% the target stock price had under/over performed the average performance of a basket of peer companies. There's a hundred other ways you could cut it to satisfy both shareholder and CEO expectations. Imagine if all the wall street firms had similar absolute and relative provisions: in any year, someone would end up with next to nothing for bad underperformance. If the sector in aggregate performed badly, no one would be paid well. The price of bloodthirsty capitalism.

Finally, though, in whatever direction executive compensation moves, please let's make sure that more of the documents are put together by compensation & payroll officers as superbly named as Merrill's own Peter R Stingi. Peter, whenever I received one of your memos, its impact was usually blunted by a smirk at the signatory. Please accept my apologies.

Disclosure: long MER calls (old employment)

Here comes armageddon? A worst case scenario.

To follow up on my post regarding the potential fate for a large investment bank here is Nouriel Roubini's take on the impending recession and a worst case outcome for the banking sector. It certainly isn't pretty reading, but two paragraphs in particular stand out:

So at this point the debate is less and less on whether we are going to have a recession that looks inevitable; but it is rather moving towards a debate on how deep, protracted and severe such a recession will be. But the financial and real risks are much more severe than those of a mild recession.

I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets (think of LTCM to the power of three); a collapse of the ABCP market and a disorderly collapse of the SIVs and conduits; massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks (with the latter at even more severe risk as the recent effective bailout of the formers’ losses by theirs sponsoring banks is not available to those not being backed by banks); ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe known-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate and related CMBS; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed’s lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized.

Although I differ in my view of what, in 2015 say, the historians' calculations of the actual realised losses on housing, auto and other collateral were in 2006-2009, I am going to have to get a bigger tin hat today.

Subprime - a little perspective, please

It is time the market got a little perspective on the scale of the subprime mess. It is not difficult to form an estimate of the scale of the real losses which are going to be uncovered, though by no means am I saying it is easy to get the estimate right. Here's one simple analysis to get to a figure: $700bn of loans written, of which 30% go into default over their remaining lives. Losses on each loan = 50% of principal. Total realised losses $105bn. Add in some loss for Alt-A loans : $600bn x 10% default x 30% principal loss = $18bn. Add in some credit card writeoffs linked to the types of people defaulting on their loans. You get the picture. Figures for the aggregate losses I have seen range from $70bn to $300bn. My guess is that the beancounters in 2020 will determine that the actual loss had been in the $100 to $150bn range. But it is largely irrelevant. It is what it will be. **EDIT Mar 08** How stupid was I in Nov 2007? Hands up idiotic covers it. Still, the thrust of the rest of this post is on point.

Where a sense check is needed is that whatever the losses really are, this is all there will be. However many times the risk is sliced and diced in ABSs, CDOs, CDO squareds, CPDOs will not change the global picture. If the average loan in trouble had 5% equity from the borrower, the "market" in aggregate has written 95% strike puts on the realisable value of the underlying real estate (for what appears to be an unreasonably small premium by way of interest spread). As a typical ABS structured product is created, the the BB, BBB and A rated tranches effectively write a cascading series of put spreads, each further out of the money on the collateral, the value of the property securing the "raw product" mortgages. The supersenior AAA tranche has written naked puts at lower levels, which seemed to be well out of the money at the time, especially to the rating agencies. It's no different for the composition of a CDO, except the gearing is magnified impressivelyby the use of, for example, ABS BBB or A paper as the collateral for the structure. As convoluted as it sounds, a CDO super-senior or AAA trance is (at launch, anyway) simply a short an out of the money put position on a basket of nearer the money "secondary" short puts on subprime housing. You are short puts on short puts. Brutal. In theory, you were protected against some of the secondary puts blowing up. In practice, they all blew up simultaneously. CDO supersenior is now junk.

Nowhere in the picture does the slicing and dicing have any mechanism to increase the total losses. It just transfers the location of the losses. Yet what is unfolding is a biblical risk aversion to any structured product and to any institution warehousing any structured product. And don't the warehousers know it. Bids for product are non existent; yet were they to be available, the warehousers know full well that they are at the wrong price. The market may be sitting on what appears to be $300-500bn of unrealised mark to market losses for an actual loss which may only turn out to be $150bn.

The only thing which will stop this is time, and cool regulatory heads under pressure. Herein is the problem. The rest of the market's siren call for market based marks ("show us the real losses") will accelerate regulatory pressure. This will undoubtedly destroy some warehousing institutions because of the liquidity, covenant or solvency impact of the mark. The beneficiaries will be the vultures whose bid is hit on the door to oblivion by the forced sellers.

A simple analogy is the impact regulatory capital constraints had on the insurance + pensions sector in the 2001-2003 bear market. From running assets at 80% equity, as the market worsened regulatory capital obligations required accelerating selling activity in a short gamma spiral of sorts, all the way down to the start of the Iraq war. Of course the popular motto would have you "sell the politics, buy the guns". Guess what? They had no firepower left to buy the guns! In summary, a regulatory driven permanent loss of capital for the sector.

The guessing game is basically not "who owns the losses", but "who's going to be required to liquidate". The first losses to appear were, of course, for those who wrote the higher strike puts (remember a pair of Bear Stearns hedge funds, anyone?). Of course this money is gone, the assets are worthless so no bid is required. The housing market is down more than 5%. No liquidation really needed. But the big investment banks? Short yards and yards of much lower strike puts (ie up their gills in the AAA tranches either on or "off" balance sheet), hanging in there desperately maintaining liquidity so as not to have to liquidate these positions. One of them might not make it.

Disclosure: long MER calls from old employment.

Sub-prime: is anyone innocent?

Writing in the FT a while ago, correspondent Martin Wolf implied that the raw materials and tinder which started the credit fire, namely the sub prime borrowers themselves, were innocents. Specifically he writes:

"Those who borrowed the money to buy houses may, however, be deemed innocents. Whether this applies to people who exaggerated their earnings in applying for loans is an open question."

I can see where Mr Wolf is going with this argument, but I cannot accept the characterisation of the borrowers as innocent. They have knowingly taken part in what for them was one of the greatest freeroll tournaments of all time.

Hungry lenders, brokers, servicers, structurers and the rest of the fee driven system were falling over themselves to accommodate either outright speculation in real estate or inappropriate escalation of (or even initial mounting of) the housing ladder. After distribution of a few fees, the game involved the assumption of a long position in housing by both the lenders and speculators. Essentially, the "no-docs" borrowers and speculators owned a virtually free call option, and the lenders would be short a put option. Clearly the option prices were appealing and the supposed "innocents" were minded to move in gargantuan scale.

We now know the speculation has not been successful. The call option has expired worthless, but frankly, it didn't cost very much. The speculators have walked away from the trade with a small dent to pride and credit standing, and in a few cases a few percentage points of first loss equity. For those for whom this loss of equity is ruinous, blame is not to be spread aroud; a mirror should suffice. Yet the financial system remains collectively short a gargantuan in the money put option on the housing collateral.

This was smart business by the speculators, surely? These participants, whether they were off-plan gamblers in florida, wannabe homeowners in Ohio or second lien "keepy uppers" in California, have (occasionally unwittingly) indeed taken part in a freeroll tournament. Their cards were almost free, they lived the daily anticipation of winning the pot, until they were bust out from the tournament before the final table.

Those presently sat at the final table have found that not only did they initially fund the tournament, the pot has also been stolen while they were playing.