Category: investment vehicles

Everyone’s a contrarian

One of the arguments making the rounds these days for owning stocks is that bond fund inflows are swamping stock fund inflows. The bulls see this as a contrary indicator: If the little guy is binging on bonds, it must be time to buy those poor neglected equities. Unfortunately for the bulls, their analysis is completely bogus. Here are the year-to-date mutual fund inflows through Sep 30:

Stock funds: +$2.6 bil
Bond funds: +$268.2 bil

Pretty compelling, right?

First of all, 43.6% of all mutual fund assets are in stock funds vs. 19.2% in bond funds. (Now which asset class looks neglected?) That $268 bil inflow amounts to 2.5%, which I’ll grant you is impressive. However, money market funds lost about $400 bil over that time so this appears to be simply mattress money reaching for yield (not a good sign).

Let’s look at the figures since the March bottom, from April-September (6 months):

Stock funds: +$45.6 bil
Bond funds: +$214.6 bil

Not as impressive. Clearly, investors are plying the risk trade in both asset classes. Now let’s include ETFs which took in $65.3 bil over that time. Since the stock/bond ETF split is 86.2%/13.8%, let’s assume 15% of those inflows went to bond ETFs and the rest to stock ETFs. Here are the adjusted fund flows over the past 6 months:

Stock funds: +$101.1 bil
Bond funds: +$224.4 bil

Now keep in mind this money is largely coming out of old savings, not new, and it appears investors have climbed further out on the risk limb than most realize.

Further, that mystical pile of cash bulls maintain is waiting on the sidelines to buy stocks looks more like a mole hill. Money market fund assets as a percentage of total mutual fund assets were 31.6% as of September 30, down from 41.3% on March 31 and at their lowest level since August 31, 2008 when the S&P 500 stood at 1283 (currently 1110). Equity fund cash levels are even less impressive at just 3.8%, the lowest level since September 30, 2007 when the S&P 500 stood at 1527.

AIG: America’s Insolvent Guarantor

Since the Fall of 2008 the US government has committed over $11 trillion in new credit and or credit backstops to prevent the collapse of our modern day banking system. Closer examination of various TARP and other bailout recipients reveal the extraordinary demands of American International Group (AIG) which after Monday surpassed the $173 billion level. Hard to imagine when AIG had assured shareholders just one year ago that “excess capital was $14.5-19.5 billion”. At the same time we were commenting on how credit default swaps would follow sub prime lending as disaster du jour with AIG leading the charge. Of course as a taxpayer and reluctant current shareholder of AIG I have to ask how did we get here and how high does this bailout number get over the next several years?

If we rewind the tape back to the Summer of 2007 most market participants envied AIG, the world’s largest insurance company. How could you not after hearing statements like this from one of their top brass:

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

~ Joseph J. Cassano, a former A.I.G. executive, August 2007

Just 12 months later the shadow banking system was imploding and former Treasury secretary Hank Paulson called Goldman CEO Lloyd Blankfein and several other counterparties to discuss implications of AIG’s swap exposure. Unbeknown to many at the time was Goldman’s counterparty importance to AIG, specifically both credit default and interest rate swap exposure. Unfortunately 70% of the derivative market trades under-the-counter so specifics on CDS and interest rate swaps is difficult to decipher, until now. After reporting a quarterly loss of $61 billion last week, the largest quarterly loss in U.S. history, AIG’s largest shareholders demanded details on where the bailout money was dispersed. The list of culprits comes as no surprise.

Goldman Sachs Group Inc and a parade of European banks were the major beneficiaries of $93 billion in payments from AIG — more than half of the U.S. taxpayer money spent to rescue the massive insurer. Revelations that billions of U.S. taxpayer dollars were funneled through AIG to Goldman Sachs — one of Wall Street’s most politically connected firms — and to European banks including Deutsche Bank, France’s Societe Generale and the UK’s Barclays could stoke further outrage at the entire U.S. bank bailout.

It doesn’t to me seem fair that the American taxpayer has got to bear the 100 percent of the downside,” said Campbell Harvey, a finance professor at Duke University. “A hedge is not a hedge if you did not factor in the counterparty risk. And the U.S. taxpayer should not be obligated to make people whole for hedges that were not properly executed.”

My Comments: In a little over 12 months the largest insurer in the world has now become part of the zombie gang joining other former leveraged high fliers such as Citigroup, Fannie Mae and Freddie Mac. Latest disclosure documents from AIG put potential CDS exposure north of $500 billion. When adding interest rate swap exposure to the mix the total derivative book exceeded $1.5 trillion! Are derivatives becoming a problem now that the asset inflation game has come to a grinding halt? Citibank, Bank of America , HSBC Bank USA , Wells Fargo Bank and J.P. Morgan Chase reported that their “current” net loss risks from derivatives — insurance-like bets tied to a loan or other underlying asset — surged to $587 billion as of Dec. 31, 2008 . Buried in end-of-the-year regulatory reports that McClatchy has reviewed, the figures reflect a jump of 49 percent in just 90 days.

As the shell game continues we get closer to the real players in this collapsing fraud, primarily the insolvent TARP recipients who require yet another open ended capital conduit. Is it any surprise that the AIG bailout money flows through to politically connected zombies such as Goldman, Merrill (now Bank of America) and Deutsche Bank? Or that Bernanke makes a 60 Minutes infomercial Sunday night assuring the American people that money center banks will not fail based on his “new”reflation experiment?

Finally, we look at the Obama administration where Turbo Tax Timmy Geithner is assigned to the AIG bonus scandal hoping the distraction preoccupies most of main street. Unfortunately this too shall backfire since many of these potential bonus recipients know where all of the counterparty skeletons reside in this open ended bailout sham. Note to the administration: Be careful what you wish for.

End of bubble behavior

As the greatest bubble in history continues to unwind we now see the various fiduciaries turning on one another. Several weeks ago the monolines floated a trial balloon involving a split into two divisions, one municipal insurance and the other insuring defaults on structured finance. Today, the derivative plot thickens as hedge funds file lawsuits against Citigroup and Wachovia over credit default swap contracts.

In separate lawsuits filed in a New York federal court, a $58-million-asset hedge fund alleges that Citigroup and Wachovia Corp., respectively, improperly required the fund to pay out more money from insurance derivatives contracts known as “credit default swaps” amid a steep decline in the value of mortgage-backed bonds. The hedge-fund manager says he didn’t view the insurance-related trades as particularly risky and now says he feels “suckered.” Citigroup and Wachovia each say the fund’s claims are “without merit.”

Meantime, other financial players say they have been stiff-armed by trading partners when they’ve tried to cash out on profits from such insurance-related transactions. In one instance, a hedge-fund manager says he was blocked from selling out of a swap position, unless he made another credit-default swap (CDS) trade.

Of course the subject of counter party risk moves front and center while the results are somewhat discomforting.

The problem with banks and brokers buying credit protection from hedge funds is that you just don’t know when they are going to go dark, turn out the lights and say this is now the brokers’ problem,” says David Lippman, a managing director of Metropolitan West Asset Management, a bond manager in Los Angeles.

Unlike most other big players in the swaps market, hedge funds aren’t subject to heavy oversight by regulators or capital requirements. Financial firms usually guard against the risk of their hedge-fund trading partners being unable to pay by requiring they put up cash or collateral for their swap trades.

So are banks forcing hedge funds to over collateralize the CDS contracts?

One suit, filed Feb. 14, outlines a credit-default-swap agreement in which Ctigroup bought $10 million of protection against a security backed by subprime-mortgage assets from a small Florida hedge fund with just $58 million in capital. The security was a “collateralized debt obligation,” known as a CDO, or a thinly traded investment that packages pools of loans.

The fund — VCG Special Opportunities Master Fund Ltd., which is owned by an investment firm that also owns a Puerto Rican investment bank — alleges that Citigroup breached its contract after the bank demanded the fund post additional collateral. By this January, the hedge fund says, the collateral Citi sought from it nearly equaled the $10 million “notional,” or underlying, amount of the swap.

More importantly, is there really a secondary market for CDS? Some other hedge-fund managers say they’ve been bullied by securities firms when they’ve tried to cash out on profits from such positions. When one hedge-fund manager considered selling out of a credit-default swap — in which his fund bought protection on $10 million of bonds of Countrywide Financial Corp. — he says there was a condition attached by two securities firms. He says the firms — Bear Stearns Cos., which sold him the swap, and Morgan Stanley — told him they would cash him out of his profitable position, only if he would simultaneously enter into another swap-selling insurance protection on the bonds equal to his fund’s $3 million profit. Eventually, he says, his fund sold the position through Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc., allowing him to book the $3 million profit.

My comments: It appears the shadow banking system is dealing with the mother of all margin calls. One creating a viscous chain reaction whereby brokers, insurers and speculators are turning on one another in order to survive the perfect financial storm.

AIG becomes the other shoe

As we pointed out last Fall the credit crisis would eventually lead to the CDS reality TV show. Today, AIG reveals a small discrepancy in their “internal valuation models” regarding CDS:

AIG shares have dropped 11% today after the company said its credit derivatives portfolio lost $4.88 billion in market value in October and November — far greater than the company’s previous estimate of $1.15 billion in losses.

The company insures collateralized debt tied to subprime mortgages and other risky investments, but the positions they’ve taken in this market are hurting them now due to declines in valuation and other reasons.

“Although there is no immediate sign of defaults on these senior tranches, spreads are considerably wider and accounting for that means mark-to-market losses hit the balance sheet,” says Tim Backshall, chief credit derivatives strategist at Credit Derivatives Research in Walnut Creek, Calif.

My comments: This is the first of many “price discovery” stories unfolding on the derivative front. As I pointed out last year many of these auditing firms don’t want to be the next Arthur Anderson. Have we learned anything from the Enron era?

Florida halts withdrawals after bank run

Over the last several weeks more light has been shed on the State of Florida’s investment pool. Approximately three weeks ago some of the various school boards and smaller governments began questioning the composition of short-term instruments found in the Local Government Investment Fund. This coincided with SIV and other conduit headlines from Citibank leading to a multi billion dollar “bank run“.

Florida officials voted to suspend withdrawals from an investment fund for schools and local governments after redemptions sparked by downgrades of debt held in the portfolio reduced assets by 44 percent.

“If we don’t do something quickly, we’re not going to have an investment pool,” [Coleman] Stipanovich [executive director of the State Board of Administration which manages the fund] said at the meeting, held at the state capitol in Tallahassee. The fund was the largest of its kind, managing $27 billion before this month’s withdrawals.

Local authorities contemplate ways to stop the bleeding.

“We need to protect what is there in the interim,” said Governor Charlie Crist, a Republican and one of three trustees of the State Board of Administration along with Florida Chief Financial Officer Alex Sink and Attorney General Bill McCollum.

The fund has invested $2 billion in structured investment vehicles and other subprime-tainted debt, state records show. About 20 percent of the pool is in asset-backed commercial paper, Stipanovich said at the meeting today.

“There is no liquidity out there, there are no bids” for those securities, he said.

My comments:

  1. According to, “The pool was created in 1982 to provide higher short-term returns for local schools and governments than were available at banks.” Just another example that “more money is lost reaching for yield than at the point of a gun.”
  2. Liquidity breeds illiquidity.

GE bond fund breaks $1 NAV

Apparently Mr. Paulson’s subprime “containment” theory has been tarnished. Over the past few days numerous financial institutions, including GE , have announced impairments to either money market or short term bond funds.

A short-term bond fund run by General Electric Co.’s GE Asset Management returned money to investors at 96 cents on the dollar after losing about $200 million, mostly on mortgage-backed securities.
The GEAM Trust Enhanced Cash Trust, a short-term bond fund with about $5 billion in assets, told non-GE investors on Nov. 8 that they could withdraw their money before losses mounted. Enhanced cash funds usually offer higher yields than money- market funds by investing in riskier assets.

GE joins a growing list of other US asset managers warning of credit related hits. The $1.4 billion State Street Limited Duration Bond Fund, which lost more than a third of its value in the first three weeks of August, has recently been sued by Prudential and other institutional investors. On Monday, Bank of America announced over $3 billion in CDO write downs while adding $600 million to various money market funds in order to preserve the $1 NAV. Other asset managers announcing similar charges include Legg Mason, SEI Investments and Suntrust Bank.

My Comments: It seems every time a write down is announced from one of the large financial institutions we hear the spin “worst is behind us” or “charges were lower than expected”. At what point do investors scream uncle?

Lenders of last resort

Since the implosion of asset backed commercial paper market 11 weeks ago lenders have implemented contingency plans for future funding requirements. According to a recent Bloomberg article, the 12 regional Federal Home Loan Banks came to the rescue as other government sponsored agencies moved to the background.

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

Of course the funding was subsidized by the American taxpayer…

To meet the sudden demand, the institutions sold $143 billion of short-term debt in August and September, according to the FHLBs’ Office of Finance. The sales pushed outstanding debt up 21 percent to a record $1.15 trillion, an amount that may become a burden to U.S. taxpayers because almost half comes due before 2009.

The government is “taking a lot of risks through the Federal Home Loan Banks that are unnecessary,” according to Peter Wallison, a fellow at the American Enterprise Institute, a Washington-based organization that analyzes public policy, and general counsel at the Treasury Department from 1981 until 1985.

More moral hazard?

A loss of confidence in the companies could prompt investors to dump FHLB debt, potentially causing the collapse of one or more banks, according to Wallison and lawmakers including Representative Richard Baker of Louisiana. If others were unable to meet the liabilities, taxpayers would be on the hook, they said.

U.S. lawmakers need to ensure “the institutions don’t blow up in the taxpayer’s face,” Representative Christopher Shays of Connecticut, a Republican on the House Financial Services Committee that is responsible for oversight of the system, said in an interview.

My comments: Where will the marginal mortgage companies go for future funding since all government entities have hit a wall? Looks like Bernanke will be fielding lots of phone calls this holiday season.

Fed hot air fails to reflate structured finance balloon

Now that the dust has settled regarding the latest Fed rate cuts, most bond fund managers seem rather unenthused. According to PIMCO group:

“The reality is the fundamentals haven’t gotten any better, and, if anything, they’ve gotten worse,” said Mark Kiesel, an executive vice president at Newport Beach, California-based Pimco who oversees $85 billion in corporate bonds.

While concerns from many professional money managers involve credit disruptions.
About three-quarters of 30 fund managers who oversee $1.25 trillion expect a hedge fund or credit market blowup in the “near future,” according to a survey by Jersey City, New Jersey-based research firm Ried, Thunberg & Co. dated Oct. 1.

Is it fair to say a return to normal (pre Fed) market behavior is out of the question?

More than 65 percent of investors in mortgage-backed securities are struggling to find bids for their holdings, according to a survey of 251 institutions last month by Greenwich Associates, a Greenwich, Connecticut-based consulting firm. Among holders of CDOs, the figure is 80 percent.

The U.S. commercial paper market is shrinking. The amount of debt outstanding that matures in 270 days or less fell $13.6 billion the week ended Sept. 26 to a seasonally adjusted $1.86 trillion, according to the Fed. It’s down 17 percent in the past seven weeks.

My comments: There is maybe $6 trillion in mortgage-backed securities outstanding so 65% of that amount would be $4 trillion. In addition, there is approximately $2.5 trillion in CDOs outstanding so 80% of that amount would be $2 trillion. We are probably very close to reaching a situation where there would be NO BID on these securities. Can someone tell me how the world financial system could even function with NO BID on $6 trillion in securities stashed in financial institutions worldwide?

Barclays throws another lifeline

Barclay’s provided $1.5 billion to Golden Key, another highly geared commercial paper fund undergoing liquidity issues.

It is the third SIV-lite arranged by Barclays to announce a restructuring, following in the footsteps of vehicles managed by Britain’s Cairn Capital and Solent Capital Partners.

These structures use short-term funding to invest in portfolios of longer-term securities, mainly in the asset-backed bond market. They have suffered a double hit as investors have shunned their commercial paper, and the value of their investments have fallen sharply due to contagion from the U.S. subprime mortgage market to all forms of structured finance.

My comments: Over the next several days over $100 billion in commercial paper is scheduled to rollover. Bottlenecks should persist as brokers, hedge funds and investors refuse mark to market on the underlying CDOs. In November, FASB changes go into effect on many mark to model securities creating another headwind for the twilight zone economy.

From off balance sheet to on

Since the ABS commercial paper market locked up several weeks back the guilty have slowly disclosed some of their off balance sheet conduits. Today news from down under as the largest bank in the country, National Australia Bank, moved $4.9 billion of funding back on to their balance sheet.

“The banks are not totally immune and the credit shakeout is bound to have some effect on them,” said Hans Kunnen, who helps manage the equivalent of $117 billion at Colonial First State Global Asset Management in Sydney. “They have to take appropriate action when circumstances become extreme, but have big enough balances sheets to absorb most of the pain.”

My comments: Mr Kunnen makes the statement about large enough balance sheets but it appears the Reserve Bank of Australia has already hit the panic button. Both Australia and Europe have experienced uncontrollable spikes in overnight lending rates since the credit revulsion began. In fact, Libor surged today as apprehension among lending institutions becomes the norm. The confidence game is waning as most players have no idea what the real balance sheets entail.

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