Tag Archives: Banks

State Street’s Limited Duration Bond Fund: an ironic name for a cascade of poor judgments

February 9, 2010 By in Banks, Getting financial advice, hedge funds, Industry Analysis, Where are the customers' yachts? Tags: , , , , , , Leave a comment

The demise of hedge fund investment pools

I’ve been watching the demise of hedge funds over the past few years with what one might call a morbid mix of horror and fascination at the potent mix of marketing savvy, personal arrogance, snake oil and stunning technical incompetence the principals involved have displayed.

…and then there’s State Street

The case of State Street and its Limited Duration Bond Fund is an odd one.   The fund was sold as the equivalent of a money market fund, but ended up making speculative investments (which it misled investors about) using large amounts of leverage. It lost 80% of its value in the last twelve months it was in operation.

State Street recently settled SEC and State of Massachusetts charges by paying fines and reimbursing investors.

It’s rare in today’s world to see a large company, particularly one that projects an image of all-American values and stodgy reliability, to show itself to have no internal moral/ethical compass–nor, it would seem, either a compliance department or any deep knowledge of securities laws.  Also, no one seems to care.

The New York Times article

I first read about State Street’s settlement with the SEC and the state of Massachusetts in an article in the New York Times, titled “State Street Gave Some of Its Clients Better Data.” Huh?  Maybe its reporter/reader fatigue.  Maybe the blowup of a sub-prime mortgage investment pool isn’t news any more.  Maybe a disaster has to be big enough to bankrupt a company–which this wasn’t–to get any attention.

I find three things surprising:

–top management either had no clue about what was going on in the investment management business, or turned a blind eye;

–no one involved in the affair–no portfolio managers, compliance people, supervisors, marketers…stood up at any point and said “What we’re doing is wrong.” (you’ll see what I mean if you read the details below); and

–State Street got a slap on the wrist, and nothing more, from the regulators.

Here’s the story:

..or at least my summary version of it.  (You can get the full details from the State of Massachusetts consent order or the SEC “cease and desist” order.)

1. In 2002 State Street began offering the Limited Duration Bond Fund to institutional investors as an “enhanced cash fund.”  The marketing pitch was that it had all the safety of a money market fund, but with higher returns.  It could do this because it was investing in short-term asset-backed securities and some derivative instruments.  The fund might have some day-to-day volatility.  But it would remain widely diversified, more so than the typical money market fund, would restrict itself to high-quality credits and would use only “modest” leverage, if any, to achieve its goals.

(The idea of a “free lunch” is probably as old as investing itself.  People love it.  Invariably, I think, the investment strategy is based on a market anomaly that gradually disappears.  Then the concept blows up.)

As time passed, the fund increased its exposure to sub-prime mortgages, apparently figuring this was the only way it could generate yield. By the end of 2006, sub-prime had become the majority of the fund’s investments.

Shareholders, however, continued to be informed that the fund was widely diversified and involved only with high-quality credits.

(Where were the compliance people, the internal regulators who are supposed to make sure something like this can’t happen?  How could any responsible person sign the letters to shareholders?)

2. In 2005, State Street changed the way it disclosed portfolio contents to clients.  Previously it had shown the amount of leverage employed by having the portfolio contents add up to a number higher than 100%.  So if the portfolio was 115% invested, for example, that would mean that its market exposure was equal to 115% of the assets under management.  The extra 15% would be achieved through option-like derivatives.

From that point on, however, it showed the funds weightings only as a percent of the total market exposure, without reporting the amount of leverage in the fund.  All investors saw was market exposures adding to 100%.

According to the SEC, by 2007 the fund was no longer using “modest” leverage.  Routinely, 150%+ of assets were invested in sub-prime mortgages.  The new reporting format meant investors couldn’t see this change.

(Compliance?  Management?  who doesn’t see the red flag? could the change to less disclosure have merely been a coincidence?)

3. At some point, State Street decided to allow other internal finds to invest up to 25% of their assets in Limited Duration.  Through contact with the common trading room, membership on the firm’s investment committee and special detailed in-house reports not made available to outside clients, these internal customers learned the true situation with Limited Duration.  As a result, a number withdrew their funds during the summer of 2007.

State Street did not tell outsiders that insiders were selling.   Instead, it continued to assure them that nothing was wrong.  At no time, however, did it reveal the extent of the fund’s sub-prime holdings or its high leverage.  In fact, some external client contact agents told regulators that they were unaware there was any sub-prime exposure.

In one case where an external client withdrew money and then sued, State Street blamed the client for creating the losses by panicking out of the fund at the wrong time!

(Being a fiduciary means taking care of your client before you take care of yourself.  New concept for State Street.)

4. To add insult to injury, when State Street withdrew its internal money, Limited Duration portfolio managers used the most liquid securities to pay them–leaving the least liquid assets for the trusting outside customers.

(Maybe they had no choice, although the SEC says the investment committee discussed how to raise cash to meet anticipated redemptions.  Normally, a portfolio manager works first on selling the least attractive, less liquid assets.  This is partly because selling may take longer, but it’s mostly to avoid the outcome of being stuck with only unsaleable assets in the portfolio.)

An earnings release: organized crime in Italy

January 31, 2010 By in Banks, Industry Analysis, Investment firms Tags: , , , , Leave a comment

The Hands of Crime on Business

I read about this the other day in the Financial Times.  (You can see the original press release here.  The income statement, which, like me, you’ll be able to puzzle out with the help of an online dictionary, is especially interesting.)

The Mafia, consisting of five crime families, had a banner year in 2009 despite the financial crisis, according to the report–the twelfth annual– released last week by the Confesercenti, an association of Italian businessmen.

high revenues

Organized crime, which generated an estimated €135.22 billion in gross profits (7% of Italian GDP), has four main lines of business:

—illegal trafficking, mostly drugs, which accounts for half of gross

—“taxes” on usury and rackets, 18% of the total

—“commercial” operations, like gambling and forgery, which amount to 19%, and

—“ecoMafie,” which is things like trash hauling and makes up almost all the rest.

low expenses

Expenses are relatively low.

—money-laundering costs, at  €19.6 billion, are by far the largest outlays

—expense reimbursement, €6.5 billion, comes next

—bribes, at €2.75 billion,  are the third-largest expense, and

—salaries, €1.17 billion, are the final significant item listed in the report.

Profits before investments for the Mafia rose last year to €104 billion from €100 billion the year prior.  The gain comes mostly from increases on profits from usury, with smaller gains from drug trafficking.  Crime also kept a tight lid on expenses, with salaries falling by about a third and bribes paid by over a quarter.

looks a lot like banking

As I was reading about this, it crossed my mind that if we replaced “illegal trafficking” with “proprietary trading” and “bribery” with “lobbying” we might end up with a story about  the major financial institutions in the US and Europe.

two differences, though

Both have to do with compensation.

The Mafia has had the wit not to pay large bonuses to its executives.  Salaries of “capi” are flat, year on year.  Also, within overall compensation, pay for associates has fallen sharply, while compensation paid to “prisoners” and “fugitives” has risen markedly.  This is presumably the result of the Italian government’s efforts to crack down on organized crime.

For bankers, on the first count there’s probably nothing we can do.  On the second, we can only hope.

Japan today–the selfish generation

January 12, 2010 By in economics, Japanese development Tags: , , , , , Leave a comment

I’ve been watching the Japanese economy and stock market since the mid-Eighties.  (I’ve written my take on the post-WWII reindustrialization of Japan in an earlier post.)

I want to write about the recent switch in finance ministers by the recently elected Democratic Party and, in a wider sense, lessons for the US from the Japan of today.  As the first step in doing this, though, in this post I want to give a thumbnail sketch of how I think the Japan of today–which is just completing its second consecutive “Lost Decade”–came to be.

Recapping my earlier post

It seems to me that the first, and most essential, step in any successful economic leap forward by an emerging country is an implicit or explicit political pact:

–the current generation agrees to create a favorable environment for both technology transfer from abroad and the development of local industry–all with an eye toward building export-oriented manufacturing.  This means long working hours, low wages, deferring consumption and a loss of current national wealth through an undervalued currency.

People do this so their children and grandchildren will have a better life.  Post-WWII Japan is the standard example of the success of this strategy.  The sacrifice of workers of the Forties-Seventies has created the immense wealth of today’s Japan.

My view of the Japanese “bubble economy” (1986-1989)

During the “bubble economy” of the second half of the Eighties, Japan took two steps that proved to be horribly misguided:

1.  The banks raised tons of cash in the Tokyo stock market to satisfy international capital adequacy requirements.   But the banks were never designed to be anything more than conduits for national saving to support industrial conglomerates.  They ended up making highly speculative real estate and other loans, and basically lost all the money.

2.  Manufacturing companies, perhaps anticipating the aging of the workforce, made large capital investments in productivity-enhancing machinery.  Unfortunately, a lot of it was wasted.  It was not spent on genuinely new products or processes, but instead just increased the amount of Eighties-era equipment on hand, making the firms more vulnerable to competition from Korea, Taiwan and China–or to innovation from Silicon Valley or elsewhere.

Popping the bubble

In late 1989, Mr. Yashshi Mieno became governor the Bank of Japan.  He quickly raised interest rates in order to pop the speculative economic bubble.  This action stopped the speculative fever.  In short order, it also laid bare problems 1 and 2 for all to see.

Government reaction

What was the reaction of government and industry?–not to fix the problems but to cover them up!!

Banks were encouraged to continue to lend more money to prop up what became known as “zombie” companies, chronically loss-making and insolvent firms.  Legal and administrative roadblocks were thrown up to prevent competent outside managers from–domestic or foreign–from stepping in to take control of foundering enterprises and restructuring them.

This destructive behavior regarding the banks continued until Prime Minister Koizumi appointed Heizo Takenaka to address the problem in 2002.  Although limited change of control of industrial firms has been allowed from time to time, the government policy of denial of the problem continues to today.

Rather than deal with the causes of flagging economic performance, Japanese government policy under the Liberal Democratic Party (LDP) has consisted mostly in enacting successive debt-funded public works stimulus packages.  Much of the “stimulus” has been distributed along political lines rather than economic, however, resulting in lots of “bridges to nowhere” in the rural constituencies of powerful politicians–which are of little help in an increasingly urbanized Japanese society.  The net result of this policy has been a mammoth increase in Japan’s government debt.

Three tries to reject politics-as-usual

There have been three attempts by Japanese voters to remove the entrenched legislative apparatus from office.

The first, in the early Nineties, resulted in the Socialist Party taking power.  The Socialists managed to get election rules changed to limit the LDP’s ability to gerrymander election districts, but soon descended into partisan squabbling and were swept out of power.

The second was the election of LDP reformer Junichiro Koizumi in 2001.  Koizumi was able to fix the banking problem and start the process of removing the Japanese Postal System, long a source of pork-barrel finance, from the control of the legislature.  But the LDP resisted further reforms and Koizumi withdrew from office.

The third is ongoing, with the resounding defeat of the LDP in last year’s election its replacement in power by the Democratic Party (an offshoot of the old Socialists).

Why “selfish”?

Not only has the current generation in Japan enjoyed the economic prosperity created as a gift by the sacrifices of its parents, but it has financed its own consumption by running up a huge unpaid tab which it is leaving for its children to repay.  Japanese government debt, which was about 60% of GDP in 1990, has steadily risen to the point where it is now fast closing in on 200% of GDP.  If we ignore Zimbabwe, this number puts Japan in a league of its own in terms of debt.

Japanese government borrowing is almost totally funded by domestic buyers.   That’s bad if you’re a Japanese citizen being saddled with this obligation.  That’s “good” only in the sense that there would doubtless have been a financial crisis long ago if the country needed foreign buyers.


A 2010 equity portfolio: where the US market stands now

January 6, 2010 By in Shaping a portfolio for 2010, Strategy Tags: , , , , , , , , , Leave a comment

Facts and figures from the 2009 stock market

The S&P 500 ended 2009 at a level of 1115.  This represented a gain of 26.5% on a total return basis for the year.  Capital change made up 23.5% of that and dividend payments 3%.

The median stock was up 29% or so, meaning that smaller capitalization issues outperformed their larger brethren.

Recovery from the market lows of early March was even more dramatic, with the index up 67% since then.  The rise represents a reversal of about half the market losses since the highs of 2007.

S&P estimates earnings for 2010 on the 500 index at about $76, meaning the benchmark stands on a p/e ratio of 14.5x expected year-ahead results.  Value Line, which uses a very different methodology in estimating a market p/e, arrives at a roughly equivalent result–one suggesting also that smaller stocks are now trading on somewhat higher p/e ratings than large caps.

The prospective dividend yield on the market is 2%.

What they imply for 2010

Multiples are no longer at the give-it-away-for-free levels of March, but they’re not really expensive, either versus history or versus other asset classes.  At the moment, cash returns effectively nothing.  And the stock earnings yield (the upside-down p/e that academics prefer) of 6.9% compares favorably with the 10-year Treasury coupon of 3.9% and the 30-year of 4.7% (both of which will likely rise as the year progresses).

Over the past several months, S&P has steadily been revising the $76 figure upward.  If history is any guide, it will continue to do so.  Why is that?  Several reasons:

–the effect of operating leverage (the outsized effect on earnings of small changes in revenues) is notoriously difficult to forecast around turning points in the economy,

–analysts don’t want to look foolish by publishing numbers that turn out to be too high,

–institutional customers want conservative figures and probably won’t trust anything else,

–companies are doubtless exerting their usual pressure on analysts to conform to company “guidance” that leaves room for positive earnings surprises, and

–most earnings estimates originate in New York, the epicenter of the financial meltdown, where people are gloomier than elsewhere in the US (except possibly for the large bonus-collecting bankers who created the problems).

Editorializing aside, the first reason, operating leverage, is by far the most important factor.

If we figure that the actual eps number will end up being, say, $80, then the market is trading on under 14x earnings for 2010.

A 15% advance for the market this year?

I think it wouldn’t be at all unreasonable to think the S&P could rise by 10%-15% from here by yearend.  That would mean a rough target for the market of being at 1225-1275 in December.

How the bull market has played out so far

You can find what I’ve written about bull markets in my posts from the first half of last year.  In addition, I recently came across an excellent article on the subject written by Sam Stovall, the chief equity strategist for S&P.  It’s short and well worth reading.

On page 6 of the article, Mr. Stovall presents a chart in which he has compiled the performance by sector of the S&P 500 in the first year of recovery from every bear market (ten of them) since World War II.  He has also aggregated the results, so we can see what the average performance of sectors and the market has been.

Three points in particular stand out to me:

1. The rebound from the lows this time has been much faster than from prior bottoms.  Recovery from the second oil shock, up 52% in the first year, is the closest to the 2009 performance.  The average first-year bounceback was 33%.

2.  Sector returns are more widely dispersed in the current return than in earlier ones, especially for sectors that have underperformed to date.  For example, relative to the index return, defensive sectors have performed as follows:

——————–2009————-average bull market

Telecom                  -38%——————- -13%

Utilities                  -30%——————- -11%

Staples                   -24%——————– -4%

Healthcare                  -22%——————- flat.

Among the outperforming sectors, Materials is the only outlier.  This sector is up 19% more than the index vs. a typical performance of flat.  (I’ve excluded Financials from this list because of their most unusual performance during this cycle.)

Another sector I find interesting is IT, which is up a lot, but at the index +15 percentage points it is about in line with its recovery average of the index +16.

What does all this mean?

I think the numbers say that the lagging sectors are so far behind the index that at some point they are going to have to play catch up.   A trader would doubtless want to overweight the laggards in hopes that a rally will come soon.  My preference would be to keep these sectors at neutral weight and be prepared to underweight them if/when they show a period of relative outperformance.

I find the technology performance reassuring.  IT is a sector I like, but I’ve been bothered a bit by the fact that it is fast approaching 20% of the market, a relatively large size for any sector.

Growth vs. Value

In the first year of a typical upturn, value stocks outperform growth stocks.  The Stovall research shows this same pattern continuing during the current upturn.  In fact, 2009 shows the sharpest outperformance for value of any bull market listed.  This would seem to imply that the stock market is trumpeting the start of a vigorous economic rebound that will carry even the most commodity-like firm along with it.  I don’t think that’s correct.

The numbers for the bull market so far are certainly correct.  But if we take a slightly different time frame, we see a somewhat different picture.  Looking at full-year 2009, we see significant outperformance of growth over value.  Why the difference?

Bank stocks are classified as value stocks.  They’re the  sector that cratered in early 2009.  They rebounded by 135% through November, possibly creating the illusion of a value stock market when, ex banks, there hasn’t been one.

Of course, especially if you know that I’m a growth stock investor, you may be thinking (as I have been while writing this) that he doesn’t like what the data say so he’s manipulating the facts away.  A fair point.  It may be that the stock market is signaling a stronger upturn than the consensus expects and I’m just not hearing the message.

I’ll deal with this issue in my next post, on where I think we should be putting our equity money.  The short answer:  I’ll concede I have a point that may have questionable origins.  There’s no need for me to make this issue a keystone of my investment strategy, however.  Better to have a couple of good ideas to organize investments around and reject the rest than incorporate a dozen half-baked ones into a portfolio.

Nevertheless, I should also be on the lookout for signs that the recovery may be stronger than I, or the consensus, expect.

Participation

There’s still a lot of money on the sidelines, although it has begun to trickle back in small amounts into stocks over the past few months.  As I’ve mentioned in a previous post in this series, individual investors have been mostly absent so far from the stock market during the rebound.  They have, instead, been seeking the “safety” of bond funds, a decision that will probably cause a considerable degree of financial pain as/when the Fed begins to raise rates back to normal.

The current asset allocation is bullish for stocks, since at some point continuing reasonable equity performance will compel individuals to increase their equity exposure.

standard (i.e., exchange-traded) vs. OTC derivatives: what the issues are

December 16, 2009 By in OTC and exchange-traded derivatives, Vocabulary Tags: , , , Leave a comment

The financial crisis and OTC derivatives

During the financial crisis, the world found out that many of the “toxic assets” held by commercial and investment banks were OTC (over-the-counter) derivatives.  Worse than that, the holders were unable to say with any degree of certainty how much they potentially owed or to whom.  Even more distressing, the CEOs of the banks appeared to be unaware that they held these things or what the problems with them might be.  This came in spite of what was supposed to be a clean-up of derivative documentation forced by the Fed several years earlier.  As a result of this stunning negligence, during the crisis the authorities were working pretty much in the dark when they were trying to come to grips with the extent of the toxic derivative problem.

Congress is now in the process of crafting regulations about derivatives to try to prevent the country from getting into a similar mess in the future.  The simplest, and most extreme, proposal is to in effect ban OTC derivatives and force all derivative contracts to be standardized and all trading to take place on formal exchanges.  The idea is being opposed by bank lobbyists as well as by some corporate customers.  What are the issues?

What  OTC and exchange-traded derivatives are:

Exhcange-traded

The options market or any of the commodities exchanges are examples of how a standard or exchange-traded derivatives market works.  Central to its operation is a clearinghouse or exchange, which has three main functions.  It:

1. sets the characteristics of the instruments traded:  size of contract, settlement dates, manner of settlement and pricing.  No deviation from the rules specified by the exchange is allowed.

2. keeps track of all the contracts outstanding, so that it knows the daily details of who owes what to whom, and the world at large knows the aggregate information about each type of contract.

3.  sets and enforces margin requirements, to ensure that no parties default on their obligations.  This involves daily pricing of all contracts and settlement of any resulting requirements for additional margin.  Margin money consists of cash or liquid securities that can be sold, if need be, to cover losses on the derivative contracts held.

OTC

OTC derivatives, on the other hand, are private contracts between two parties, typically either between the proprietary trading desks of two banks or between a bank and one of its customers.  The attributes of an OTC derivative are:

—flexible structure as to the object being speculated in/hedged and the length of the contract.  In the equity arena, for example, it was very common at one time for foreigners to use OTC derivatives to circumvent local regulations that made it difficult for foreigners to buy stocks in India or Taiwan.

—no margin requirements.  The bank writing the OTC derivative might (or might not) require its counterparty to provide collateral to protect against default.  But a bank involved in an OTC transaction likely wouldn’t provide any itself.  Settlement would typically only occur at the end of the contract.

Why Congress wants standard derivatives

Transparency–the idea that regulators can know precisely at any time what the overall market position is, as well as what risk each individual participant in the market is taking–is the main reason.  Also, the existence of the exchange/clearinghouse as an independent third party to compel participants with losing positions to supply additional cash to their margin accounts is a significant protection against default.

Why the banks don’t

The OTC derivative business is very profitable under normal circumstances.  Customers may find it difficult to comparison-shop for complex products.  They may also fear that in doing so they will make their intentions widely known, drawing too much attention to a market inefficiency they hope to exploit.   Thus, they will tend to deal with only one or two banks and not worry that much about price.  Also, in really complex transactions, a non-expert customer may not be able to figure out very accurately how much of the price is cost and how much is profit.

Some customers may find the cash requirements of daily margin settlement too cumbersome.  Some may have contracts with clients that don’t allow them to borrow money.  This precludes setting up a margin account.   OTC derivatives are a way of getting around the restriction.  In these cases, you’d figure the bank charges a higher fee for providing a service the customer can’t get by other means.

Exchange-traded derivatives are less profitable because the contracts themselves are a commodity.  Also, gains would be split among the owners of the exchange, in proportion to their equity shares.  So there’s no possibility for firms with more skillful marketing to gain a higher market share.

Why non-financial companies don’t, either

Non-financials are contending they should be exempt from any requirement to use exchange-traded derivatives.  Their main argument is that, unlike the banks, they had no role in causing the financial crisis.  At present, they use OTC derivatives because their financial strength means counterparties don’t demand cash collateral.  Using exchange-traded derivatives, which would demand large amounts of cash margin, would be much more expensive.

What will likely happen?

I think Congress will order a massive move away from OTC derivatives to exchange-traded, in order to curb the activities of the banks’ proprietary trading desks.  Non-financial firms will likely be able to conduct business as they have done before.

If so, the result will be substantially lower profits for commercial and investment banks, but a more stable world.  Of course, the other major banking powers around the globe must enact similar legislation, or the high-risk, potentially toxic portion of the derivatives business will migrate offshore–just as it was drawn to the UK by relatively weak regulatory supervision this time around.