Financial Crookery

Crookery in Action #67433: How Synthetic ETFs Rob Investors

noreply@blogger.com (Andrew Clavell) — Mon, 02 Nov 2009 13:14:00 +0000

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

noreply@blogger.com (Andrew Clavell) — Thu, 29 Oct 2009 09:20:00 +0000

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

noreply@blogger.com (Andrew Clavell) — Fri, 09 Oct 2009 21:47:00 +0000

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.

noreply@blogger.com (Andrew Clavell) — Fri, 09 Oct 2009 12:26:00 +0000

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:

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.
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?
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.
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.
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?

noreply@blogger.com (Andrew Clavell) — Thu, 24 Sep 2009 10:28:00 +0000

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.

Socially Useless Customers

noreply@blogger.com (Andrew Clavell) — Thu, 24 Sep 2009 08:27:00 +0000

FSA Chairman Adair Turner's speech to the City on 22 September marked a new salvo in the regulator's efforts to eliminate risky trading activities: appealing to the banks' benevolent nature. Describing the problem:

"..the financial industry, more than any other sector of the economy, has an ability to generate unnecessary demand for its own services – that more trading and more financial innovation can under some circumstances create harmful volatility against which customers have to hedge, creating more demand for trading liquidity and innovative products; that parts of the financial services industry have a unique ability to attract to themselves unnecessarily high returns and create instability which harms the rest of society."

The key words are "generate unnecessary demand". Aka sell, beguile, hoodwink even. Does this really happen at investment banks? Most certainly. Is it restricted to complex derivatives? Certainly not. Yet this is what Turner and most others usually mean when they talk about socially useless activities. From the speech again:

"any banks which are involved both in complex trading activities and in retail banking activities...need to operate within limits. They need to be willing, like the regulator, to recognise that there are some profitable activities so unlikely to have a social benefit, direct or indirect, that they should voluntarily walk away from them"

Turner is further reported by Bloomberg to have said "Certain banks don’t lend to the arms trade, and there’s no reason why you can’t extend that concept to financial products. It would be for banks’ boards to determine what products are socially useful"

That would make for sprightly board meetings, and not just in respect of credit trading activities. Take M & A for example - the unashamed and entertaining pages of TED will regale you with stories of dissembling M & A bankers beguiling CEO's into ill-conceived transactions. Social utility? Well, fees for bankers mainly.

I doubt the FSA's attempt to foist this culling responsibility onto the banks themselves will succeed. It just won't happen unless forced via regulation. If banks can find customers for socially useless products, why are we not finding fault with the customers attracted by the shiny lights? Name and shame the blithering idiot who bought the triple-A rated CPDO at Libor+200 to see it blow up at 10 cents on the dollar 3 months later. The products exist because these ignorant berks with a series 7 licence exist. That too is a function of regulatory standards.

Barratt Rights Issue: RBS redux?

noreply@blogger.com (Andrew Clavell) — Wed, 23 Sep 2009 17:29:00 +0000

A steeply discounted rights issue for a UK company is typically pounced upon by financial media. The FT noted today in respect of Barratt Developments' placing and rights issue:

"The rights issue will see 1.3 new shares created at 100p a share for each share in issue, implying a 42 per cent discount to the theoretical ex-rights price – a measure that gives a sense of how cheaply the shares are being sold."

I suppose you can't knock a journo for a failing to comprehend a rights issue: headline figures of 40% discounts do indeed look drastic. But the conclusion is nonsense - there is no sense of selling shares "cheap". A rights issue is essentially a bonus issue of call warrants to existing shareholders together with the synthetic purchase of a put option from the underwriters. Short call+long put = short equity, i.e. the Company is guaranteed to sell the shares for the strike price.

(I say synthetic, as the put option is dressed up as the obligation of the syndicate of banks underwriting the issue to subscribe for rights shares if the prevailing share price falls below the exercise price)

One can get a handle on the value of this put option compared to the fee which banks are paid to underwrite the transaction. The rights period ends on November 3, and the strike price is a 42% discount to the theoretical ex-rights price.

Even assuming a charitably high volatility of 80% for the shares, this put option is worth around 0.25% of the theoretical ex-rights price. The discount is economically irrelevant for any particular rights issue, aesthetic considerations aside. The only economic issue is whether the price paid for the underwritten put option is fair and reasonable. Although the actual underwriting fee is buried in a non-public underwriting agreement, 1-2% would not seem unreasonable. The company is guaranteed to receive a known amount of cash, and the bankers get 75-175bps of value for arranging the deal and writing the put option. The delta on the put option is around 2% or around 11 million shares - not that difficult to get "on": 22m shares or 7% of the company were on loan via CREST as at 31 August.

Wary investors may however recall the disastrous RBS rights issue in April 2008. Although initially priced at a steep discount of 46%, the rights issue flopped as the share price blew right through the rights price, no doubt helped on its way by frantic shorting activity from the underwriting syndicate attempting to re-hedge their underwriting commitment.

So if Barratt's share price starts to motor south over the next month, however unlikely that may seem after today's reaction to the fundraising, expect the movement to be amplified if the syndicate re-hedges. Face it, only 12m ago the share price traded at half the current rights price. I doubt that Credit Suisse, UBS, Barclays, HSBC, Lloyds, RBS Hoare Govett want to own 56% of a flailing homebuilder in 2009.

The Answer to Bubblevision's Favourite Question

noreply@blogger.com (Andrew Clavell) — Wed, 25 Feb 2009 17:31:00 +0000

I'm not usually one for quicklinking, but there's a useful contribution here: isthisthebottom.com

** EDIT Sep 09** Well in retrospect, one might be forgiven for thinking that the appearance of websites such as the one I linked to was indeed akin to a big guy banging on a big bell to signify exactly the opposite answer the website provided.

Valuing Large Options in the Absence of Collateralisation

noreply@blogger.com (Andrew Clavell) — Tue, 25 Nov 2008 08:49:00 +0000

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.
_________________

(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

noreply@blogger.com (Andrew Clavell) — Wed, 19 Nov 2008 16:50:00 +0000

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

noreply@blogger.com (Andrew Clavell) — Wed, 19 Nov 2008 10:16:00 +0000

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."
........................................................

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

noreply@blogger.com (Andrew Clavell) — Mon, 27 Oct 2008 18:02:00 +0000

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

noreply@blogger.com (Andrew Clavell) — Mon, 27 Oct 2008 17:18:00 +0000

"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.

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

Bubblevision Comes Clean

noreply@blogger.com (Andrew Clavell) — Fri, 10 Oct 2008 12:46:00 +0000

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

noreply@blogger.com (Andrew Clavell) — Fri, 03 Oct 2008 09:26:00 +0000

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....

noreply@blogger.com (Andrew Clavell) — Thu, 02 Oct 2008 13:09:00 +0000

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)

noreply@blogger.com (Andrew Clavell) — Wed, 01 Oct 2008 12:39:00 +0000

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.

_____________
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

noreply@blogger.com (Andrew Clavell) — Tue, 30 Sep 2008 15:38:00 +0000

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

noreply@blogger.com (Andrew Clavell) — Fri, 26 Sep 2008 10:56:00 +0000

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.

_________________________
(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

noreply@blogger.com (Andrew Clavell) — Thu, 25 Sep 2008 09:46:00 +0000

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

noreply@blogger.com (Andrew Clavell) — Wed, 24 Sep 2008 11:32:00 +0000

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)

noreply@blogger.com (Andrew Clavell) — Thu, 18 Sep 2008 19:19:00 +0000

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

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

Paulson's Perks

noreply@blogger.com (Andrew Clavell) — Wed, 17 Sep 2008 21:25:00 +0000

(someone please mash this up better than I could)

Warren Buffett's Vega Games

noreply@blogger.com (Andrew Clavell) — Thu, 08 May 2008 12:57:00 +0000

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

noreply@blogger.com (Andrew Clavell) — Mon, 14 Apr 2008 15:09:00 +0000

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.