Classic Family Games Revisited

Trivial Pursuit:  Incomprehensibly stupid congressmen and media chase after Geithner and AIG.  No nasty  questions though.

Lego: BRICs run riot for a while then it all falls down.

Cluedo: Professor Bernanke in the helicopter with a sack of money. Not worth playing as everyone knows who did it. and its cousin..........:

No Cluedo: Participants appear on Bubblevision ostensibly to opine on financial issues while plugging a tawdry asset gathering outfit.  In the same genre as "Mad Money", a peculiar guessing game.

Monopoly: Players choose a bank and aim to collect as big a balance sheet as possible. All property must be mortgaged immediately, but there is no jail and you always collect $700,000 each time round. Good for kids as no one loses.

Bucking Bronco: Politicians surreptitiously must pile more and more debt onto the taxpayer's back until something gives.  Deluxe edition includes replica riot gear.

Risk: The rules went missing so no one understands this game anymore.

Dominoes: Players align a bunch of Southern European countries up alongside Ireland and the UK. Guest host George Soros will then start pushing.

Kerplunk: (can be played at the same time as Dominoes).  In a twist on this classic you are a hedge fund manager required to poke sticks into piigs until one bursts.  All players who avoid the ensuing vortex win.

Yahtzee: Not actually a game but the new name for the Renmimbi once floated.

Inspired by Bill Quango

What Does the UK Actually Do?

Greece is to Bear Stearns what Iceland is the to the subprime hedge funds which collapsed in 2007.  That is to say, Iceland failed (evidenced by its currency and banks), and sequentially Greece is teetering on the brink but looking increasingly likely to be rescued by a reluctant neighbour.

The rescue may come by EIB loan, outright purchases of (cynically: "investments in") Greek bonds by larger Eurozone members, or some other mechanism involving front loading of EU structural funds - all mechanisms postulated today by Reuters' Jan Strupczewski.

If Greece is saved, the other porcine overspenders will fall in the market's crosshairs, and of these only Ireland has started to take meaningful austerity measures.  However, in for one, in for all, will be the likely EU central response.  It is inconceivable that Greece would be saved and Ireland thrown to the wolves.

The next domino in the banking world was Lehman Brothers, six months after Bear Stearns. It was a proper failure, to put it mildly. If the above reasoning is correct, Lehman's sovereign mapping may be the UK rather than one of the PIIGS.  Who is coming tothe UK's rescue?  Pimco, Soros, Rogers and others are on record with colourful language about the UK gilt market though one must naturally dilute their rhetoric by their book positioning.

Apart from a now failed banking sector it does seem tough to establish what the UK actually does, makes, owns or controls that will provide the earnings to save it from a debt crisis.  It is not self-sufficient in food or energy, and although manufacturing accounts for 80+% of exports, it also accounts for just than 24% of output compared to 30% in Germany. The FTSE 100 index is littered with multinationals in the resources sector, but a shrinking fraction of the resource is territorial.

Simplistically, what does the UK actually do from the viewpoint of a foreign debt investor with an itchy sell finger?  Is it bereft of value or does British modesty cause it to hide its light under a bushel?

Not Every Counterparty is a Client (vying for the dullest post title ever)

Do investment banks routinely trade against clients? The always edgy ZeroHedge thinks they do and is outraged.  In a follow up to a Goldman "conflict of interest" letter recently obtained by Dealbook, EP/Marla at ZeroHedge(1) went on the offensive with a bizarrely detailed legal query to GS about its boilerplate disclosure.

Stirring stuff, if conspiracy is your thing.  In reality it is inconceivable that large capital markets firms knowingly act in a manner prejudicial to entities with which they transact business where they owe such entities a fiduciary duty of responsibility or care. Those who object fail to understand the difference between client and counterparty.  By way of example, here are some graded examples of interactions - judge for yourself:

1. IB's equity sales trader with a long standing relationship with a buyside trader from Fidelity takes an order to execute a large block of stock according to some parameters, after a meeting between the sellside analyst and a portfolio manager at Fidelity the day before.  A sales commission is earned on the transaction if it is completed.
   
   
2. A corporation performs an IPO of one of its subsidiaries working with IB's bankers to advise on the transaction, then executes the transaction with (selling the stock to) IB's equity capital markets dealer for onward sale to those institutions which circled indications of interest in the premarketing period.  The IB earns an underwriting fee on the sale.
   
   
3. IB's bond salesperson proposes an idea for a trade (the desk's axe) in a distressed credit to six bond fund portfolio managers with which he has a good relationship.  The trade is executed with a couple of them and the bank earns a margin built into the trade while at the same time flattening its books.
   
   
4. An insurance company, having sold to its retail customers a $100m variable annuity linked to the GSCI with a minimum return guarantee, sends a termsheet on which it would like to execute a derivative hedge for the guarantee to a handful of investment banks.  The IB's commodity trader is required to quote the business live at a fixed time later that day and the trade will be executed under a pre existing  ISDA OTC agreement between the two parties.  IB will earn a margin built into the price it quotes if the price is the most competitive.
   
   
5. A hedge fund portfolio manager calls the IB's dealing desk requiring a risk bid for $2m vega in 3 year Eurostoxx50 ATM straddles (a chunky transaction). The desk "quotes to lose" but gets hit immediately, somewhat drying up the traders mouth.

All in a normal day's work. Of course #1 and #2 impose fiduciary obligations on the IB, but for the remainder  the "client" is effectively a professional counterparty in an adversarial bargaining capacity. Many such counterparties are referred to as "clients" as the IB (usually) finds the transactions profitable, and therefore wishes to transact again in the future.  That's just business.


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(1) Who is surely too intelligent, erudite and eloquent to be posting at the populist ZH rather than back on her own blog

Iceland's Frosty Jingle Mail

An avuncular Icelandic president appeared live on British TV screens last night to explain why he was handing over the envelope and stamp, if not the keys, so the 320,000 strong public can engage in jingle mail.  It seems possible the doughty Icelanders will vote to repudiate direct, legally binding, sovereign obligations to Britain and the Netherlands foisted upon them by their uncontrollable banking sector.

In the US, low credit rating prospects with little ability to repay were offered virtually free money by fee grubbing securitisers.  With little credit rating to protect, jingle mail provided them a free put option on house prices.  When prices turned sour, they simply stopped paying the loans. Most now benefit from servicers' incompetence to extend their rent free dwelling as long as possible in advance of foreclosure.

That is rational strategic default as the consequences are low and the lender incompetent - the borrower simply returns to status quo ante.  In Iceland's case, the lenders are not. If the population mails in the keys, they can forget EU membership, IMF loans, and prepare for a decade of eating boiled fish (hot water and fish being the only two natural resources in the remote island).  Handing over the equivalent of $16,000 each to avoid this dietary choice may seem steep, but it is well worth considering.

Pesky 11% Investment in Citigroup Comes Home to Roost for Abu Dhabi

Oh this is priceless stuff.

Two years ago I wrote a blog post aimed mainly at mainstream financial media's inadequate understanding of  a structured finance transaction.  Citibank sold a reverse convertible bond plus call option package (under their brand name "DECS") to the Abu Dhabi Investment Authority (ADIA), and in compensation for the higher downside risk assumed by ADIA the annual payment on the transaction was 11%.

Financial media screamed that the huge coupon was indicative of the stress under which Citi found itself.  Citi may indeed have been under stress, but this was not reflected in the deal structure. My point was that the transaction economics were likely very good for Citi under the circumstances, and I included the following paragraph directed at mainstream media which caused quite a firestorm in my inbox:

Perhaps if [the FT and the WSJ] had wanted to batter ADIA instead of Citi, the headline might have been "Unsophisticated Arab financiers write massive put option on US investment bank".

And so to today.  Over the coming months ADIA will be requred to relinquish their original $7.5bn investment as consideration for 235m Citi shares at $31.83 per share, against a current market price of $3.56.  Hmm, that was indeed a massive put option.  They have filed an arbitration claim against Citibank citing "fraudulent misrepresentations".  Stock down, lost money, file suit. How boringly predictable.  Unsophisticated even.

I doubt there is any merit in the claim. Either ADIA will have to show that they were indeed unsophisticated - entertaining in itself - or that Citi were actually fully aware in December 2007 of the carnage that was to come in 2008/9.  Remember Chuck Prince was "still dancing" only a couple of months before the ADIA transaction.

Catching falling knives is simply a question of timing.  The Kuwait Investment Authority just about succeeded squeezing something out of a Citi transaction.  ADIAs timing on Barclays was also better, but they simply failed in the case of Citi. Take your lumps, people, and move on.

Darling's Bonus Tax Washout

Alastair Darling's banker bonus tax is a curiosity.  Given £6bn of bonuses originally expected to be paid to UK based bank employees, HM Treasury's anticipation of proceeds from the 50% levy of only £550m says a lot about what the government supposes the banks' reactions will be.

Certainly no one thinks it will mean that bonuses will be, heaven forbid, skipped for the year, in a show of thanks for authority's "world-saving" munificence.  The simplest explanation is probably the most plausible - banks will defer most of the payments to after the sunset date on the new legislation, April 5 2010.  This also happens to be the date after which the highest marginal tax rate moves from 40% to 50%.  10% additional tax on £6bn of bonuses is pretty close to the treasury's forecasts of additional tax.  Thus the bankers will get their bonuses as banking management fear their firms will implode if they don't.

For the bankers,  a 10% personal haircut is a rather acceptable result given the smouldering threats evident prior to yesterday's announcement.  For the government, a pathetic frightened attempt at punishment has been mangled into a small populist PR coup.

Happy days all round.

Overvalued and Underscrutinised: Lloyds CoCo Bonds

Lloyds Bank recently exchanged some £8.75 billion subordinated debt and preference shares for "Enhanced Capital Notes" in a spectacularly successful exchange offer.  The ECNs pay a coupon some 150-200 basis points higher than the exchanged notes to account for the fact that they will convert mandatorily into common equity upon a balance sheet deterioration trigger.  ECNs have been dubbed Co-Co bonds, for contingent conversion. There are other forms of Co-Co bonds out there but ECNs are unique in that conversion is both mandatory and dependent on a non-stock price trigger.  Confusion surrounds the securities: Are they really appropriate for debt portfolios, or are they equity-income portfolio products?  Bond index providers have flip-flopped as to their inclusion in the indices and no issuer has yet come to market to raise fresh capital with the structure.

By way of example, one of the largest series of Lloyds sub debt exchanged for ECNs is the 13% step-up perpetual capital securities, callable 2019 (XS0408620135).  Approximately £775m of these notes have been accepted for exchange to an ECN (XS0459089255) maturing Dec 2019 with a coupon of 15%. Mandatory conversion of the ECNs at a fixed price of 59.21 pence (1,689 shares for £1,000 nominal) is triggered if Lloyds' core tier 1 capital ratio sinks to 5%.  This is a decline of some 55% from Lloyds' expected post-rights issue tier 1 ratio of 10.8%, and would require a book loss of the order of £28 billion on risk weighted assets of some £480 billion.

Following exchange the 15% ECNs were indicated at 122/123 on minimal volumes, compared to 110/112 for the previous 13% series. Absent the EU-mandated 2 year coupon pass for the 13% security for "burden sharing", the 13% notes would have been trading around 132/133, so credit markets value the trigger risk at around 10 points higher than the additional 2% coupon.  Is this enough?  How should the ECNs be valued?

In exchange for protection from regulatory cashflow interference and the coupon hike, investors add a "wander to loss" risk to the pre-existing "jump to default" risk.  These two volatile processes are correlated, and can be modelled to value the ECN. It is essentially a 15% bond which knocks-out if either (i) Lloyd's book value falls around 45% during the 10 years, returning the value of the (correlated but more volatile) stock price at that time or (ii) Lloyds jumps to default in the normal credit way.

I am conscious of the jaundiced reader's likely view of model-based pricing. Nevertheless my own valuation of the ECN using this framework was in the 115-120 range(1).  The cost of the "wander to loss" risk is higher than credit markets are estimating.  The current ECN quote is not particularly cheap on this reckoning, particularly as the ECN would usually trade at some discount to theoretical value.  In short, I think the stampede to exchange may have been misguided.

Of course valuation in this case is particularly subjective, and the book value process is not hedgeable in any meaningful way.  There's no instrument which pays out when a company loses "half" its capital, in the way a CDS insures against outright bankruptcy(2).  I expect investment banks will be able to extract this exact instrument from a combination of the CoCo and the LLOY subordinated CDS and offer it to their hedge fund and other customers on a leveraged basis to eliminate their CoCo holding risk (innovation did not die just because CDOs blew up).

The only question remaining is why the market values the Co-Co's so generously.  The answer may be surprisingly straightforward: a hunger for yield, maintenance of current income and resolute belief in the sovereign put.  If Dubai's failue to stand behind Dubai World/Nakheel is the canary in the sovereign coalmine, the only Coco I want is powdered with milk.  Any other metaphors you need mixing, just let me know.



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(1) Not to bore you with details, but I used a simplified svj 2 factor monte carlo simulation, 30% (book) and 60% (stock) volatility, high book/stock correlation and jump to default intensity calibrated to the price of the original 13% note. It isn't particularly pretty but it did well enough for me not to charge into owning the instrument for a while.


(2) In the meantime as a proxy one has to figure out what event or sequence of events would cause a £25-30bn hole in Lloyds' book value.  Given the nature of its balance sheet, an out of the money put option on UK house prices might be the most useful hedging instrument!

Crookery in Action #67433: How Synthetic ETFs Rob Investors

Are synthetic ETFs better or worse than physical variants?  FT Alphaville is up today with a debate on the relative merits of the two centring on the Deutsche Bank product DB X-Trackers.  My short answer is: if all you care about is accurate index replication, you will get what you want.  But if you care about value for money and credit risk, synthetics are most definitely worse. 

Synthetic ETFs in Europe populate the UCITS III envelope with any old pile of "cheap to repo-in" equities, and total return swap the performance of that basket with the sponsoring bank for the return on the target index.  Take for example the MSCI Taiwan Index ETF run by DB X-trackers.  As at 31 December its annual report showed that the physical assets of the fund were as follows:

    Finnish Equities:         4.88%
    French Equities:         25.99%
    German Equities:       37.67%
    Italian Equities:          4.83%
    Japanese Equities:     26.7%
    Swiss Equities:         12.09%
    MTM of DB swap: (12.16%)  *this is the swap providing MSCI Taiwan risk
    TOTAL:                  100%

Not much by way of Taiwanese exposure, as we might have expected. Deutsche has just lobbed out its typical European/Japanese trading inventory into the UCITS vehicle, providing it (DB) with pleasing liquidity. A normal repo transaction on this pile of equities might price at Libor+50, but I have very little confidence that the UCITS fund is receiving this spread on this leg of the swap.  Frankly I was surprised it wasn't all Japanese equities, traditionally the hardest to fund in repo transactions, stuffed in there.  Put another way, the additional credit risk taken by the ETF due to the margined repo arrangement is not being rewarded.  Or put another way, even, the expense ratio (TER) of the fund (and so DBs profitability) is higher than the TER stated by the amount of the forgone repo spread.

Were I the regulator I would not abolish synthetic ETFs, but I would require eligible collateral to be constrained to AAA sovereign debt only.  Problem solved. In reality the the TERs would expand by the cost of providing this eligible collateral, but at least a closer like for like comparison with physical ETFs could be made.

** EDIT/Addition 13.55: One important point I omitted is that the main "failure" risk of a repo-collateralised synthetic ETF is emphatically not simply that of the swap counterparty (like DB) being unable to satisfy itsrepayment obligations. It is actually the risk that the value of the collateral beomes completely uncorrelated with the level of the target index at the time of failure of the swap counterparty.  The movement of this collateral could be beneficial or not compared to the movement of the index following failure of the swap counterparty, but in any event the UCITS ETF can liquidate relatively quickly and return cash to investors, even if the swap counterparty is finished with zero recovery.  In the case of the DB X trackers, 10% exposure is permitted to DB itself under the swap so this is the maximum theoretical credit loss from its failure.  As at 31 Dec 2008 above the fund had zero credit risk to DB - in fact the risk was the other way round!

A Constructive Proposal for Banking Compensation

I have yet to see a sensible mechanism put forward for how to reward bankers in the current environment. I don't mean a proposal for how large the bonuses should be, rather a structure which achieves some degree of insulation from moral hazard.

Most commentary I come across is populist diatribe claiming the sector is grossly overpaid,  and with public funds too, so requiring that bankers are paid next to nothing. "They wouldn't even be there if we hadn't bailed them out" is a fashionable argument.  Newsflash: That is not a solution, it is a quest for retribution against a single cog in a system which all stakeholders (employees, boards, shareholders, regulators, central bankers, tax collecting politicians etc) blithely allowed to develop over the last two decades

Let me assure you that average earnings at investment banks (and the capital markets operations of commercial banks) are going to remain high enough to keep you frustrated in perpetuity if you are presently at all angry about the issue. If you think otherwise, be prepared for eye bulging rage come the January round of announcements. I encourage you to let it go or find employment within the sector.......

With that caveat in mind, here's an attempt at a sensible remuneration system for a suitably chastened sector. (It's a version of a clawback system without many of the negative implications if you want to move on to the next item in your day).

As long as I can remember the total remuneration pool has been around 40-50% of top line firm revenues - let us call this the Compensation Fraction. The figure is a delicate balancing act between shareholders, management, employees and capital regulations and it should be left that way.

These revenues can be broadly summarised as the aggregate of (i) service revenues: items that you and I would obviously recognise as revenue such as sales commissions, fees for banking services like M & A or underwriting, asset management revenues and the like and (ii) proprietary earnings: return on capital deployed in the form of net interest margin and the change in the mark to market of proprietary positions over the course of the year.  Readers will no doubt be sufficiently familiar with discussions of level 1, 2 and 3 assets to know that it is the latter of these which is most subject to debate (or abuse/manipulation if that's your perspective on it). By way of example, I identify 31% of Goldman Sachs' recent 3Q earnings as service revenues: $10,922m out of $35,558m.  Goldman itself has identified its Compensation Fraction as 47% of those same revenues.

These sources of revenue can readily be measured separately but they cannot easily be delineated politically. The oft-cited example is that of the ability of an M & A banker to close a takeover and invoice a fee being conditional on the provision of debt finance to the acquiror, requiring a proprietary credit position on the trading books (at least for a period of time).  Internal arguments between Sales and Trading about ownership of relationships, revenues and the bonus pool have raged since time immemorial; this won't change, but it is irrelevant to an outsider - what is needed is a system which protects against negative externalities, not one which mollifies infighting.

Where the regulator should step in is to define how these very different revenue sources can be dispensed to employees once they have been determined and the Compensation Fraction agreed upon between the board, management and shareholders.  I propose the following:

The Compensation Fraction of service revenues can be paid in cash (to whomever the bank sees fit, not necessarily those who purportedly earned the commissions - remember, regulators, politicians and central bankers don't care about the infighting).

The Compensation Fraction of proprietary earnings should be remitted to an Employee Bonus Trust ("EBT"), which subscribes for annual series of preferred equity in the firm issued at par.  This preferred equity is redeemable in, say, 10 years, and pays a meaningful fixed dividend in any future year where a sensible profitability test is met by the bank.  For the purposes of dividends and redemptions, the EBT acts as a pass through trust.  Shares in the EBT ("EBT Shares") are distributed to whichever employees the bank sees fit each year, and they become transferrable on a 20% per annum vesting schedule in a similar fashion to many equity award schemes in use at present.  Once transferrable, the EBT Shares are tradeable freely on the open market.

Where proprietary earnings in future years are negative, no dividends would be paid on extant EBT owned preference shares and no proprietary revenues are disbursed to the EBT for that year - in fact the Compensation Fraction of the negative proprietary earnings is clawed back from the aggregate extant pool of preference shares (spread across all previous series).

Pretty simple really.  This achieves a number of goals (do you see how I like roman numeral lists?):

(i) For those firms where proprietary trading makes up a small or zero fraction of profitability, employees can be rewarded in cash as the firm presents little systemic risk.  Boutiqes will be able to attract smooth talking banker talent who don't drain capital into supersenior air pockets.

(ii) Firms highly dependent on proprietary trading remain incentivised to take risk through the cycle - a significant negative year will hurt the EBT but the impact on the firm's capital position will be ameliorated by the preference share clawback.  Commission earners in firms such as these know their fate is tied to those of the traders - sorry, but you chose to work in a bank which is in reality a hedge fund (but see (iii) below).

(iii) Any star prop trader or M&A rainmaker, in a bad year elsewhere for the firm's proprietary business, can still be compensated as the firm sees fit from either pool.  Again, regulators shouldn't care about absolute sizes of individual payments and how they are comprised.

(iv) If, in a poor year for proprietary revenues, management sought to make the Compensation Fraction  much lower than 40% to minimise the clawback hit to the EBT, this would apply to both the service revenues and the proprietary earnings.  For example, if revenues were net zero arising from $2bn of service revenues and a $2bn hit on the prop books, a Compensation Fraction would still be declared to allow some cash bonuses to be paid, but an equal amount of clawback would then be required from the EBT.

v) Employees are free to dispose of their EBT stock on vesting.  Nevertheless, the price at which they are able to cash out will depend on the market's perception of the value of these EBT Shares - they are freely tradeable and to the outside world the EBT is a pseudo closed end fund investng in fairly risky preference shares.  Would a market develop in these EBT Shares? Of course. There is a price for everything. Should the employee not like that price and choose to retain his EBT Shares they will be redeemed on a rolling program as and when the pref shares are redeemed.  Provided the firm remains solvent, retaining EBT Shares presents greater certainty of cashflow for the employee.

(vi) Requiring the EBT to invest in redeemable preference shares rather than ordinary equity allows the terms of the pref shares to be tailored to allow clawback.  Opponents might argue that ordinary equity provides better incentive alignment but a fixed upside (dividends) and unlimited downside is exactly the sort of deferred incentive a bank's most volatile businesses need to be encouraged not to engage in unwarranted gambling.

(vii) The longer maturity of the preference shares solves issues associated with temporary mismarking of level 3 asset pools.  The market price of the EBT shares will move to account for this perceived risk (I accept that there is the potential for some information asymmetry issues in the short term, but the signalling disclosures of knowledgeable insiders disposing of EBT equity should partially offset this), and 10 years is usually a long enough time for true value to emerge.

(viii) It does away with inappropriate employee option schemes.  Leave that to silicon valley & venture capitalists. Bankers don't really want options, and regulators don't want bankers to have to deal with the moral hazard implications of bankers with a pile of options

So there you go.  There are no doubt some problems with this proposal that I have not considered - it is a first cut - and I'd like to hear about them in the comments or elsewhere.  A proposal such as this might reshape the industry somewhat - polarising it into either investment banking boutiques or hedge fund trading outfits.  I think this is no bad thing.  In fact, the sooner the better so that we get to a point where we can easily disentangle a  third entity: the riskless narrow or utility bank contemplated by variants of a Glass Steagal for the 21st century which I advocated some time ago, but I will leave a discussion of what that bank should look like for another day.

The Triumph of Substance and Style

Concise, pointed writing is powerful. Whether the accurate - if plentiful - poisoned darts of a Richard Dawkins or the dispassionate clarity of the Economist, writing style counts even when the point you are making is patently valid.  I must try harder.  Felix pointed me to this article in the Economist:

AT THE heart of the current crisis is a fundamental confusion about the nature of wealth. Think about it from the perspective of a Martian. Were an extraterrestrial to be shown a room full of gold ingots, a stack of twenty-dollar bills or a row of numbers on a computer screen, he might be puzzled as to their function. Our reverence for these objects might seem as bizarre to him as the behaviour of the male bowerbird (which decorates its nest with shiny objects to attract a mate) seems to us.

Wealth consists of the goods and products we wish to consume or of things (factories, machinery, an educated workforce) that give us the ability to produce more such goods and services. Financial assets arise from the desire to postpone consumption so that money can be saved, either for precautionary reasons or to invest so that more goods and services can be consumed in the future.

Looked at in that way, financial assets are not “wealth” but a claim on real wealth. If those claims multiply or rise in price, that does not mean aggregate wealth has increased. If a pizza is cut into eight instead of four slices, there is no more food to eat. If everyone sitting at the table is given shares in the pizza and the share price rises from $1 to $2, the meal will still be no bigger.

Read the rest here.  I haven't agreed more with a line of reasoning in some time.  I hope I haven't overstepped their fair use policy too.

The Clean Green Steal, or Making Money the Easy Way.

How would you like to invest in a green technology company at a fraction of its traded market value? Boy have I got one for you. PSource Structured Debt (PSD.L) is your backdoor baby. The FT certainly buys it.  Their correspondent responsible for talking about, er, adventurous investments, buys it - loves it actually - oh yes, REALLY loves it.  You'll need to understand the company's genesis first.

(i) The US hedge fund Laurus Capital assembles a pile of private equity investments - PIPEs, death spiral convertibles etc - in cash strapped, low tangible asset, vapid companies.  Some are burst either by engineering technical default or by alternative means, rendering control of all the share capital up to Laurus.  This share capital is injected into listed shell companies.  (Nervous yet?)

(ii) The thin float of one or more of these companies - in this case, PetroAlgae (PALG.OB) is the darling - benefits from a rather impressive rise in value.  However this valuation uplift occurs, the fact that it occurs is is useful to Laurus for two reasons: (i) they are paid fees based on assets and (ii) it's opportune to offload the positions to related entities.

(iii)  PSD.L enters the fray.  It was created in 2007 and is an offshore vehicle with a bunch of Guernsey administrators as directors save for one individual affiliated with Laurus.  It raises around £50 million from unsophisticated UK private-client asset managers in 2008 in 3 placings led by a minor UK marketmaker grateful for placement fees.  It uses the proceeds to allow Laurus partially to offload the very same PIPE deals and pseudo-listed entities such as PetroAlgae and in the process unlock a nice gain "invest in a diversified portfolio of asset backed loans and debt made predominantly to, and equity warrants and similar instruments issued predominantly by, publicly traded small and micro-cap companies in the US and Canada ."

Laurus naturally disclaims its way out of the related party issues just in case.  A Forbes article on the transaction noted:

"Laurus admits in its financial statements that the transactions were among related parties and that the investment manager determined the fair value. If a third party had made the valuations, it acknowledged, the ultimate amount involved "could differ and might be materially higher or lower."

Hmm. Higher or lower.  Fair enough, could be either.

Today PSD sits at a discount of 40% to its reported NAV. Luvvly jubbly.  PetroAlgae, at the director's valuation of $6.81 per share, accounts for virtually half of the NAV.  Even more enticing is the fact that the 2% of PetroAlgae which is in the public float recently traded around $25.  So there you go - how much more of a discount do you need to load up on clean green?

So by now maybe you're ready to play?  I have a short checklist for you first, then be my guest:

1. Certain hedge funds' business models are not to manage money, seek alpha or any of that nonsense. They are to raise money at 2+20, then collect said 2+20 while looking for, erm, co-investors.  Be sure to confirm this isn't one of those cases.
   
   
2. Investors should familiarise themselves with the terms (a) pump and (b) dump.  Use your familarity with these terms to examine where between the two this investment might be located. Invest if this is to your satisfaction, but then again, if you're an asset manager making fees off other people's money what do you care?
   
   
3. Correspondents writing in the FT can be as intelligent or stupid as the next man, and in this case it's up to you to figure out which. I am not especially persuaded by recommendations from  wise monkeys, your experience may differ.
   
   
4. PetroAlgae is burning millions in cash, has $30-40m of stockholders deficit, and is being kept alive by drip feeding of cash from the Valens master fund (of course Valens is affiliated with Laurus, but I know you knew that). That said, OTC trades valued the company at virtually $4bn a couple of months ago and is on PSD's books at the discount price of $700m.  That's right, the intellectual property of a collection of ponds with CO2 chomping algae in them is worth hundreds of millions and maybe billions.  Right now. In fact, it's the "management of light exposure" to maximize chompiness which seems to be PetroAlgae's intellectually protectable edge, as there are other competitors with similar green ponds. Now it may be worth something, but those are lofty valuations indeed.
   
   
5. Ex PetroAlgae, PSD's NAV would be 55p instead of 105p.  Fortunately, it has a diversified range of other investments.  Convince yourself that it isn't a problem that they were all acquired from the same related entity, and you're now through the test.
   

What are you waiting for.  Fill yer boots.

Equity volatility - no material decline in last 6 months?

VIX observers would hardly concur with the title of this post, but the VIX is a notoriously short dated measure of volatility as an indicator of market risk. What about the term structure of implied volatility? The following chart shows this curve for at-the-money options on the S&P 500 index, both at the peak of the crisis and quite recently. Shorter dated vols have indeed sold off markedly but long dated options (10y+) have only seen a 2-3 point decline in implied volatility.

This is not the full story though. The index level is some 60% higher today, so this is not really an apples with apples comparison. The second chart highlights the implied volatility, for 12 month maturity options, for a range of fixed strikes as at the same two dates.


Hey - not much change at all. A 1,000 strike option is less than 2 vol points cheaper today than it was in March, and a 1,300 strike option was cheaper, in vol terms, in March! Equity derivatives traders refer to this phenomenon as the volatility surface being "sticky with strike".

Just a curious observation, or evidence that risk is still with us? These volatility levels are still a far cry from the sub 15% levels of index volatility prevailing in the mid 2007.