Tuesday, October 28, 2008

Looters after the Hurricane

I thought I was the first to use the term "Financial Terrorism" in the context of today's financial crisis, until I saw Jim Cramer on CNBC's Mad Money going crazy about it a few weeks ago. Seems like the idea that 9/11 type terrorists are going after our pocket books is gaining some ground on Wall Street. Although many banks feel like they've been victimized by motivational short-selling, I don't think we can call this one the result of "nefarious" international investors...yet.

The most popular purported "tool" of these economic pirates is called short-selling. Short-selling is the art of selling something you don't own. Until relatively recently, you could only be rewarded in the market if you correctly forecasted the company whose stock price would increase, but there wasn't a way you could benefit from your ablity to forecast a decrease in the stock price if you didn't own any shares.

Here's an example

XYZ stock price is currently $100/share - I think the stock price of XYZ will go down tomorrow - I don't own any shares of XYZ - I borrow 100 shares of XYZ from a bank for 24hrs and pay $5/share (total cost = $500) - Same day I sell my borrowed shares for $100/share (total proceeds = $10,000) - Next day stock price of XYZ falls to $85/share - I owe bank 100 shares - Purchase 100 shares for $85/share (total coast = $8,500) - I make $1,000 (10,000-500 cost of borrowing - $8,500) and 24 hrs earlier I didn't own any shares and only had a guess.

Short-selling is a popular practice of Hedge Funds. What's a Hedge Fund? The name is somewhat misleading and mostly historical. A Hedge Fund is nothing more than an investment vehicle open to a limited range of investors (either institutions or very wealthy individuals) and, because of the sophistication of their investors, is permitted to engage in a much wider range of investment strategies. It may be helpful for a moment to compare them to mutual funds. A mutual fund is nothing but a "shell", just like a Hedge fund. In other words, saying you own mutual funds doesn't tell us in any detail about your investment strategy. You can have mutual funds that invest in international stocks, in Tech stocks, in large or small companies, or in bonds. So we care more about whats IN the mutual funds. And they are heavily regulated and must stick to the disclosed strategy because they are open to the public. More bluntly, Mutual Funds serve the 80% of the population that make up 20% of the money. And because "Joe the Plumber" can own them, they must be simple (according to the SEC).

Conversely, Hedge Funds cater to the 20% of the population that control 80% of the global wealth. They escape regulations, in most jurisdictions, governing short-selling, the use of debt, and derivatives (options, etc.) contracts. To qualify for these exemptions, you must have fewer than 100 investors AND your investors must be "accredited," meaning an individual must have more than $5,000,000 in investable assets. ALSO, they do not have to disclose their activities to third parties. Approximately 75% of Hedge Funds are registered off-shore, usually in the Cayman Islands. Lastly, Hedge Funds control roughly $2.6 TRILLION dollars, and are attracting approximately $200 BILLION a quarter. Those are scary numbers. If you participate in a Hedge Fund, you are essentially giving your money to a manger with almost full discretion. For all of the reasons listed above, the government is taking a closer look at tighter control.

The SEC Hammer

Last month, the SEC banned short-selling of 799 financial institutions and issued this statement:

"We are concerned about the possible unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers, exacerbated by naked short selling. Our concerns, however, are no longer limited to just financial institutions."

Just before 9/11 several Hedge Funds, primarily using the Toronto and Frankfurt stock exchanges shorted the stocks of several airlines and financial companies housed in the Trade towers. Obviously, after the attack stock prices tumbled. Their profits were thought to be huge, and virtually untraceable. This time, the majority of short-selling is being done from London and Dubai. There are literally hundreds of Hedge Funds with murky ownership structures, investors, and strategies. If even a handful of them act in concert and begin active short-selling to "artificially" push the price down it would have a massive impact on the economy and they would be making millions of dollars. Where is that profit going? Who knows. But one thing I do know; because of all the words I've used in this post, I'm sure the CIA has at least read it.

Thursday, October 9, 2008

...And the Kitchen Sink. Part II

Why am I reminded of the movie "The Money Pit" as I watch our economy fall apart piece by piece? Probably because what looked good from the outside was really rotten to the core. It's clear now that what is moving the market is sheer contagion. The DOW is down around 20+% over the last month, with no signs of slowing down. The other day I was speaking with an older economist who felt the need to help me understand that I will never see this type of environment again in my lifetime. I wasn't sure what to make of that.

So I have just a few random thoughts to share, nothing too heavy.

1. I expect to turn out like my Grandpa. Those of us who had Grandparents that grew up in the depression are very familiar with the tireless rantings where our Grandpa/Grandma would espouse the virtues of savings accounts, CD's, no debt, and hiding money under the mattress. Now, I don't think that's such a bad way to go. Although, some savings accounts aren't even THAT safe these days. I truly believe this crisis will have a profound effect on the younger generation in respect to how they view long-term savings and their appetite for risk.

2. The most troubling statistic of the week. Earlier this week MSN reported that 1 in 6 Homeowners owe more than their house is worth. That's almost 20 million homes. If 25% walk away (likely to be much higher) then that means banks will own 5 million homes. That means more fire sales which will decrease the value of existing homes even further. And don't forget about the already existing inventory sitting on the market. Indeed, it is difficult to believe housing will recover anytime soon. Think at least five years out. My solution? Burn the home. This accomplishes two things. First, it decreases the supply of homes for sale, thus bringing the demand/supply curve into closer equilibrium. Second, it prevents a fire (no pun intended) sale from bringing down housing prices even further, preserving the current value for existing homeowners. Or you could donate it to Habitat for Humanity (I think they could use a solid pre-built home).

3. Regarding the recent rate cut by the Fed and European Central Banks. This was a fascinating development. On Monday the Fed decreased the federal funds rate another half-a-percent. At the same time, Central Banks in Europe also decreased their interbank lending rates. Why did they do it together? I think there are two reasons. First, I believe they want to demonstrate a very united front. European Banks started to slide and at least a dozen had to be bailed out. The message is SUPPOSED to be "Hey, we are serious about taking action and will do so on a global scale." However, I think it had the opposite effect. Most Americans, and, from the reaction of the market, most people worldwide, took the Central Bank's action as meaning "Yep, it's much worse than we thought and we don't know what else to do," which in turn served to confirm everyone's fears. Perhaps in this case, inaction is the best solution. But there is a more technical reason why the Central Banks cut rates in concert. They are worried about capital flight out of their countries. If interest rates in the U.S. drop, then, if I'm China, I pull my money out of the U.S. and invest it in another country that is paying higher interest. But if all major central banks cut rates together, and maintain the same relative relationship, then the economic incentive to pull your money is severely diminished.

4. The importance of Commercial Paper. The Fed also announced this week that they would begin to buy Commercial paper. Why is that significant? Commercial paper is short-term debt (usually with a maturity anywhere from 1 to 270 days) that a corporation will issue to fund operating cash flow. Think of it as a very short term loan. For example, if I'm Microsoft I issue commercial paper for $1 million dollars at 4% interest with a 30 day maturity. A money market fund will buy it from Microsoft because, after all, Microsoft is highly rated and the Money Market Fund can earn 4% interest over 30 days rather than 3% in the bank. At the same time, Microsoft can use the money to pay salaries or fund other assets. Now the problem is no one is buying this Commercial Paper from Microsoft because they don't trust them. Only highly rated companies are allowed to issue commercial paper. The fact that Money Market funds in particular don't trust them, even over a very short period of time, speaks volumes regarding the uncertainty in the market. The Fed stepped in because they recognize businesses depend on this financing to operate on a daily basis.

Hot Investment Tip of the Week. Residential homes in Houston, Texas. Some rather astute real estate investors have indicated that Houston has a bright future as a place to invest in a home. These professionals cite the low cost of living, and favorable population demographics based, in part, on the growth of the Energy sector which is getting ready to boom with the energy demands of the global middle class.

On the bright side, Alan Greenspan did say he thought the economy would turn around in the first quarter of next year. I think that sounds about right. I'm not sure though, I think I'll go ask my Grandpa.