A Frazzled Market

Posted on September 18, 2008 by Felix

I have no idea whether or not the government is going to set up the bailout fund to end all bailout funds — a new RTC which would essentially become one big "bad bank", precluding the need for entities like Morgan Stanley to set up their own.

What I do know is that all of the rumors and noise surrounding this story are going to keep a lot of reporters up very late tonight, despite the fact that most of them haven’t had a decent kip since Saturday. Here are the Facebook status updates for one reporter, starting Monday:

is apparently never going home. 9:23pm

will sleep when he’s dead. 1:12am

is pretty sure he’s getting home an hour early this morning. 12:13am

Combine overwork with the feverishness in the markets, and mistakes will happen, and financial stories will start to eat themselves:

As the fear that gripped markets after Lehman Brothers failed also enveloped the firm, John J. Mack, Morgan Stanley’s chief executive, spoke Tuesday evening with Citigroup’s chief executive, Vikram S. Pandit, about a possible combination, according to people briefed on the talks.

On Thursday, however, Morgan Stanley vigorously denied a report in The New York Times that Mr. Mack had said that Morgan needed to seek a merger in order to remain in business.

Mr. Mack was said to have made the comment in the conversation with Mr. Pandit. Citigroup, which had declined to comment on Wednesday night, also denied Thursday that such a comment had been made during the conversation.

Can we believe what we read? For instance, here’s Bloomberg on Barclays:

The London-based bank also is in talks to take over parts of Lehman’s equities business in Europe and may hire some of its employees in Asia, Barclays President Robert Diamond said today.

Did he really say that? When? To whom? I certainly don’t know, and the article isn’t clear on whether the reporter got the information first-hand, from Diamond himself, or second-hand, from someone Diamond spoke to, or third-hand, from someone purporting to have knowledge of what Diamond said.

(Incidentally, Diamond might be well advised to buy Lehman’s European business outright, rather than just cherry-pick the businesses he wants: that way he won’t end up facing a massive lawsuit from PwC, which is now running Lehman Europe, asking for $3 billion in cash which rightly belongs to Lehman Europe and not to Barclays.)

And if you think that financial reporters are frazzled right now, just imagine what it’s like for the people on the front lines. Stocks are going haywire, volatility’s soaring, counterparty risk is through the roof, regulators aren’t helping matters — and the upshot is shot nerves, hasty decision-making, and generalized chaos.

The same is true, of course, at Treasury, at the New York Fed, and at any other regulatory organization you can think of. And it’s a recipe for disaster. Just remember — if you can keep your head when all about you are losing theirs, it doesn’t matter, because they’re the people in charge.

This is why the speed at which things are falling apart is so worrying. Monster deals are being done and then forgotten about within hours: last night I was at a dinner party, talking about the crisis (natch) and listening to someone say "oh yes, AIG, I forgot about that one".

I don’t think anybody’s capable of holding in their head all the vital information needed to get a grip on things right now — not in the wake of Lehman and Merrill and AIG and the liquidity injection and the TED spread and Morgan Stanley and the money-market funds and counterparty risk in the CDS market and bans on short-selling and WaMu and negative nominal interest rates on T-bills and the oil price and the dollar and why on earth that German bank wired $300 million to a bankrupt bank and on and on and on and on. We’ve been overwhelmed by the complexity of the system, and nobody knows anything.

But hey, at least the stock market rose today.

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Hirst: Only the Russians Didn’t Get the Memo

Posted on September 18, 2008 by Felix

Liz Gunnison reports that 80% of the buyers at this week’s Hirst auction were Russian. If that’s true, then I’m more convinced than ever that the sale marks a top for the Hirst market.

Maybe the point of exhibiting selected pieces in Delhi and the Hamptons was just to make the Russians think there was a market for his work elsewhere.

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Volatility Datapoint of the Day

Posted on September 18, 2008 by Felix

statest.jpg

It doesn’t actually particularly matter which this stock this is. The point is that when the intraday range of stock values is larger than the difference between a stock’s 52-week low and its 52-week high, you know that trying to draw implications from stock prices is a fool’s game.

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When Regulators Panic

Posted on September 18, 2008 by Felix

The range of regulatory responses to the current chaos in financial markets is instructive. The SEC bans naked short selling, the Russians just close down their markets altogether before announcing plans to spend $20 billion on stocks, and the FSA, in the UK, has banned all shorting of financial stocks for at least 30 days.

Meanwhile, the broad US stock market — the closest thing we have to a gauge of overall market sentiment — is in the midst of yet another nasty lurch downards. The S&P 500 is now at a four-year low, and has lost more than a quarter of its value since May. Oh, and any institutional investors thinking maybe a money-market fund might be a good idea right now are going to want to choose someone other than Putnam, which is liquidating its $12.3 billion fund.

The regulatory responses aren’t going to be particularly effective: anybody who really wants to short financials will still be able to do so, by using options or ETFs or some other workaround. But maybe this is just the financial equivalent of x-raying shoes at the airport: it makes it look as though Something Is Being Done in the face of all the carnage. After all, regulators are just as adept at CYA moves as anybody else.

Update: This just in, from the WSJ: New York Attorney General Andrew Cuomo has started a "wide-ranging investigation into short selling in the financial market". Thanks, Andrew.

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Blogonomics: Blodget Poaches Carney

Posted on September 18, 2008 by Felix

This is not the best time to be looking for work — unless, it seems, you’re a financial blogger. Henry Blodget has just poached John Carney, Dealbreaker’s editor in chief, to run his financial blog, Clusterstock — although Carney says he might change the name. Here’s the IM conversation I just had with Carney:

John Carney:

So I’m leaving DealBreaker.

Tomorrow is my last day.

Felix Salmon:

definitely need some drinks tonight in that case! What’s the story?

John Carney:

Going to join Henry Blodget’s company. Will be running a site about Wall Street.

Felix Salmon:

Which one of Blodget’s companies? I can’t even keep up with the number of websites that guy has

John Carney:

Well, probably ClusterStock although I may change the name.

Same shop that does Silicon Alley Insider

Felix Salmon:

do you start there Monday?

John Carney: Tuesday

Felix Salmon:

Less juvenile than Dealbreaker, presumably

John Carney:

It will still have humor and gossip but, yes, it will be more mature.

Felix Salmon:

Will it look to compete with the Lex/Breakingviews/Heard on the Street crew?

like a free version of what they’re doing, but more timely, and concentrating just on financials?

John Carney:

We’ll concentrate on financials at first but might branch out over time

Felix Salmon:

And the reason for you jumping ship? More money? More responsibility? An overwhelming desire to work for someone who’s banned from working in the securities industry for life?

John Carney:

After two and a half years at DealBreaker, I felt like it was time for a change. I think they’ve got a great team in place to make it work. And, yes, the financial situation won’t be bad.

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Buffett’s Smart Buy

Posted on September 18, 2008 by Felix

Amidst the craziness in financial markets right now, there’s only one thing that’s certain: when it comes to valuations, nobody knows anything. Morgan Stanley can be cheap one day at $30 a share and then expensive the next day at $20: everything is incredibly fluid, and trying to make long-term investment decisions in the eye of a hurricane is a great way to lose a lot of money very fast.

For that reason, I admire Warren Buffett’s decision to sit this crisis out on the sidelines and not give in to the temptation to try to buy financial assets on the cheap. Yes, he’s a value investor — but values change over time, and Buffett likes the kind of assets where values rise slowly over the course of years, rather than falling precipitously over the course of minutes.

Which doesn’t mean Buffett isn’t buying. Quite the opposite: he just plunked down $4.7 billion, in cash, for Constellation Energy. Constellation has very strong real-world fundamentals:

Constellation Energy, a FORTUNE 125 company with 2007 revenues of $21 billion, is the nation’s largest competitive supplier of electricity to large commercial and industrial customers and the nation’s largest wholesale power seller. Constellation Energy also manages fuels and energy services on behalf of energy intensive industries and utilities. It owns a diversified fleet of 83 generating units located throughout the United States, totaling approximately 9,000 megawatts of generating capacity. The company delivers electricity and natural gas through the Baltimore Gas and Electric Company (BGE), its regulated utility in Central Maryland.

Constellation was being hurt hard by its energy-trading activities, which had enormous liquidity needs and were hurting the company’s credit rating. Now that Constellation has all the liquidity and ratings support it needs, it should be a nice little earner for Berkshire Hathaway.

Today’s Lesson from Warren, then, if you’re looking for such a thing, is that while chaos in the market can be a good buying opportunity, the best such opportunities are often going to arise at one remove from the market itself. Don’t buy AIG or Morgan Stanley: buy their counterparties, instead, on the cheap. Just look at where Buffett is buying, compared to how much Constellation would have cost him at any point in the past two years.

constellation.jpg

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Is Wachovia Too Small to Save Morgan Stanley?

Posted on September 18, 2008 by Felix

morganstanley.jpg

Did I say that today’s liquidity injection should at least get us through the weekend? Well, by "us", clearly I didn’t mean "Morgan Stanley". It’s not trading at zero yet, but it’s getting very close, and if the stock continues to fall at this rate MS will be trading at option value long before the markets close on Friday.

One thing worth remembering, though: we’ve now reached the point at which percentage moves in the MS stock price no longer mean anything. It’s trading at $15 a share? It could rise by 50% and still be distressed; it could fall by another 30% and still be in essentially exactly the same position it’s in right now.

I’m not sure I trust the CDS market to give me a reliable indication of what’s going on, either. All the new liquidity in the system has changed the baseline, and a lot of people are buying protection not because they think Morgan Stanley is going to default but just because it’s a necessary hedge right now.

I’m glad that Morgan Stanley is looking at a good bank/bad bank structure for any marriage with Wachovia, because if the two just enacted a plain-vanilla merger, the investment bank, with its trillion-dollar balance sheet, is entirely capable of taking the commercial bank down with it into bankruptcy. If things work well, the investment bank’s trading book and all its counterparty risk will stay in the good bank, while a large part of its assets, including anything remotely housing-related, will get put into the bad bank.

But the problem for John Mack is that it’s not obvious what the markets are ostensibly worried about. There’s no David Einhorn going on the television pointing at Morgan Stanley’s balance sheet and saying that this bit is toxic and that bit is probably OK. Instead, people are selling just because they have no idea what Morgan Stanley really owns and what those assets might be worth — which makes it that much harder to draw a good bank/bad bank line and decide which assets the stock market would be happy owning.

Reportedly Mack talked to Citigroup about a possible merger, but those talks went nowhere — that’s unfortunate, because Citi is actually big enough to be able to absorb Morgan Stanley without having to ring-fence potentially toxic assets.

Do you remember how the amount of capital that AIG needed grew from $40 billion to $70 billion to $100 billion over the course of about 24 hours? My feeling is that the size of partner that Morgan Stanley needs is growing in a similar manner. Yesterday, maybe Wachovia would have been big enough. Today, that’s not at all obvious any more.

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Breakingviews in the New York Times

Posted on September 18, 2008 by Felix

Everybody knows that newspapering is a business in desperate straits right now. So why is that financial opinion columns seem to be proliferating? Historically, there was just one, in the FT: Lex. As of next week, Lex alumni will be providing very similar content in both the Wall Street Journal, with its Heard on the Street page, and the New York Times, which is picking up Breakingviews.

Breakingviews can’t have its habitual Lex-like back-page presence in the NYT, because the NYT’s business section often doesn’t have a back page. (They’re consolidating sections with abandon these days.) So instead it will appear in the upper left hand corner of the second page of the Business Day section, every weekday.

That’s frankly the first thing which puzzles me: although the NYT has a seamless seven-day operation, the Breakingviews deal is only five days a week.

On the other hand, Breakingviews is becoming ever so slightly webbier with this deal. The NYT’s Dealbook blog will link to breakingviews.com, which in turn will see an uptick in the amount of analysis it publishes for free.

There’s nothing revolutionary here: Breakingviews is still being run very much on a subscription model — at an extremely high price which isn’t even disclosed on the website — and it makes very little money from its newspaper deals, which act more as free advertising for the rest of its content. As a result, Breakingviews is very reluctant — too reluctant, frankly — to give away too much of the shop. But it will have more free stuff on its website, which is good, and I’m told that it might even have the occasional external hyperlink, too!

From the perspective of Breakingviews, this deal is great: it gets into the most prestigious newspaper in America, as well as getting global distribution in the International Herald Tribune.

But what’s in it for the New York Times? Are they incapable of coming up with this kind of analysis themselves? In the press release announcing the deal, NYT business editor Larry Ingrassia said that the column "is a perfect complement to both our leading news coverage of finance and business and our roster of award-winning columnists". He’s right — the columns appear weekly, which makes it hard for the columnists to be particularly timely, and they tend to cover one subject in reported depth, which leaves a lot of other news uncovered from an opinionated-analysis perspective.

One of the reasons why I like the new-look Heard on the Street in the WSJ is that it takes this idea even further: while Lex and Breakingviews have pretty rigid guidelines about what and how they publish, with most articles coming in at around 350 words, Heard is happier to mix things up with much longer and much shorter pieces on a daily basis. If there’s lots of things going on, Heard can cover lots of things, while Lex and Breakingviews have to do more picking and choosing about which ones they’re going to concentrate on.

In any event, Breakingviews should help the NYT attract the kind of readers who don’t just want to know what’s going on but also what to make of it all, in relatively easy-to-digest bite-size chunks. The NYT’s Diane McNulty tells me that the nytimes.com website got a record 9 million visits on Tuesday, thanks to all the financial turmoil: clearly there’s huge amounts of appetite for finance-related content, especially when things are moving as fast as they are right now.

"Everyone’s going in the direction of high value added content," says Rob Cox of Breakingviews. "That’s opinion and analysis." Of course I’m liable to agree: as a financial blogger, that’s pretty much exactly what I do. But the fact is that this is still very much a newspaper deal first and foremost, with a bit of webbishness layered on top. The columns will appear daily, on a 24-hour news cycle, and once they appear they’ll just sit on the website without being updated as and when news breaks. Inevitably, they’ll often be overtaken by events.

And there are risks for the New York Times, too: people are going to consider this to be NYT content, and Breakingviews opinions are going to start appearing under the rubric "the New York Times says". Breakingviews as an organization tends to be significantly more market-friendly than the NYT, which means that with this deal, the NYT business section is tilting further towards the laissez-faire side of the spectrum.

There’s probably no harm in that, but maybe it helps explain why the Breakingviews column won’t appear on Sundays. With Gretchen Morgenson and Ben Stein holding down the fort in the biggest business section of the week, it will be hard to accuse the NYT of having too much in the way of free-market tendencies.

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A Lehman Story

Posted on September 18, 2008 by Felix

It’s clear now that the European and Asian operations of Lehman Brothers will be liquidated and not sold as a going concern. Barclays clearly doesn’t want them, and at this point they’re like bread or fish: getting staler and less appetizing by the hour.

Here’s the story I’m hearing: at the end of every trading day, the Asian and European operations would remit their (very large) cash float back to Lehman Brothers in New York. That makes sense: it helped to strengthen the New York trading operations during a time when the cash would otherwise be sitting unused. Then, come the weekend, they’d get their cash float back, and continue operations.

Except, last Sunday night, before he declared bankruptcy, Dick Fuld decided that Lehman’s Asian and European operations would not get their cash back. Instead, it stayed in the US — where it was bought as part of the Lehman US operations by Barclays.

Maybe all this was necessary, like some kind of medical emergency triage where only one of the triplets can be saved, and you have to put all of your resources into that one. But it’s still easy to see how the Lehman operations in Europe and Asia would be extremely unhappy about it. After all, they weren’t the ones who loaded up on dodgy residential and commercial real-estate assets — to the contrary, they were making lots of money, for themselves and for their parent.

But they’re now all unemployed, thanks to a bunch of fixed-income cowboys in New York who took on too much risk. It’s a very sad story. And if I were Dick Fuld, I’d be hesitant about showing my face in certain quarters of London any time soon.

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Picture of the Day

Posted on September 18, 2008 by Felix

erk.jpg

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Idiotic Idea of the Day, SEC Edition

Posted on September 18, 2008 by Felix

So far, America’s technocrats have held up reasonably well in the face of the hurricane-force winds buffetting the world’s financial system. You can (and many do) quibble with some of the decisions made by Ben Bernanke, Tim Geithner, and Hank Paulson, but ultimately they’ve all done more good than harm.

Christopher Cox, however, is a completely different kettle of fish. Here’s his bright idea from yesterday:

"In order to ensure that hidden manipulation, illegal naked short selling, or illegitimate trading tactics do not drive market behavior and undermine confidence, the SEC today took several actions to address short selling abuses," Chairman Cox continued. "In addition to these initiatives, which will take effect at 12:01 a.m. ET on Thursday, I am asking the Commission to consider on an emergency basis a new disclosure rule that will require hedge funds and other large investors to disclose their short positions. Prepared by the staffs of the Division of Investment Management and the Division of Corporation Finance, the new rule will be designed to ensure transparency in short selling. Managers with more than $100 million invested in securities would be required to promptly begin public reporting of their daily short positions. The managers currently report their long positions to the SEC."

Yes, you read that right: public reporting of their daily short positions. A more contraindicated and counterproductive policy it’s frankly hard to imagine. As Jonathan Weil says,

Cox might as well have told the world to short the United States of America, which actually has been a profitable trade recently.

It’s never easy making a lot of money shorting stocks, at least not over the long term. But there’s one strategy which always works: look for the people who are complaining in public about short-sellers, and short those stocks with glee and abandon.

Cox’s proposed rule would probably drive many hedge funds offshore. But before it did that, it would essentially place big red "short me" flags on any vulnerable leveraged stock. And he thinks that’s going to make things better? Someone get us a new SEC chairman, quick. This guy is not being helpful.

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Bank Megamerger of the Day

Posted on September 18, 2008 by Felix

While Wall Street has been utterly transformed by this financial crisis, US Main Street banking has not been. Yes, your local Fleet branch is now part of the same empire that owns Merrill Lynch, but it turned itself into a Bank of America some time ago, and nothing more is changing.

In the UK, however, we’re seeing the forced merger of two massive high-street giants, Lloyds TSB and HBOS. Both of them were pretty enormous to begin with, formed from mergers of their own: Lloyds Bank with the Trustee Savings Bank, and Halifax with the Bank of Scotland. They’re both so huge that in normal times this merger would face big anti-trust obstacles — but of course these are not normal times:

A deal generating such large market shares would normally contravene competition limits, but Mr Daniels said that consumers were well protected by UK regulations on market abuse.

In a statement, John Hutton, secretary of state for business and enterprise, said the public interest conditions normally applied only to media ownership and cases where national security was involved. He said that on the advice of the Treasury, the Bank of England and the Financial Services Authority, he would apply it in this case too.

The reason for the merger is cost savings and size: these are very mortgage-heavy institutions, in a country with a housing bubble which was bigger than the one in the US, and they face enormous potential losses. In such a situation, sheer enormity does help: just look at Citi or UBS, which are still very much going concerns despite losses much bigger than those at places like Lehman or Merrill.

Nothing like this is going to happen in the US. There are three US megabanks now — Citi, BofA, and JP Morgan Chase. It’s conceivable that one of them might end up merging with Wells Fargo, if the latter’s Californian mortgages end up exploding in its face; it’s not conceivable that any two of the three would ever be allowed to merge.

But it’s certainly a sign of how crazy these times are that the Lloyds-HBOS deal has gone through so easily.

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Getting Through the Weekend

Posted on September 18, 2008 by Felix

The latest move in the fiscal and monetary response to the global financial crisis has been to flood the world with money.

The Fed boosted its U.S. dollar swap line with foreign central banks by $180 billion….

The Fed also debuted new swap lines with the Bank of Japan for $60 billion, the Bank of England for $40 billion and the Bank of Canada for $10 billion. All the swap lines expire on January 30, 2009.

Well, they technically expire at the end of January. If the events of the past 14 months are any precedent, these swap lines will be around much longer than that.

The effect has been what was intended. $247 billion is a lot of money even by today’s standards, and overnight borrowing costs have fallen, stocks are up, and even Morgan Stanley is now in positive territory, after opening down a little.

The difference between this and previous central bank actions is that no one pretends or expects that it will have any big long-term effect. With any luck, however, it should at least get us through the weekend without panic setting in. Then, over the weekend, a few big things should be resolved:

  • The future of Morgan Stanley;
  • The future of Washington Mutual;
  • The future of Lehman Brothers’ European and Asian brokerage operations.

Without those big unknowns hanging over the market, there might be less nervousness. Or, of course, there might not.

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Wachovia Stanley? Really?

Posted on September 17, 2008 by Felix

Why on earth did John Mack put out a memo today blaming short-sellers for the decline in Morgan Stanley’s share price? It’s the corporate equivalent of pinning a "kick me" sign to your own back — and it looks like it might have helped drive him into the arms of Wachovia, of all possible merger partners.

Yes, Wachovia has a deposit base, but that’s a bit like your would-be spouse having a pulse: a necessary precondition, but hardly reason to get married. If these two do end up in a shotgun wedding, I predict divorce within a couple of years. On the other hand, when the alternative is summary execution at the hands of a brutal market, it’s amazing how attractive that altar in Charlotte can become.

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America’s Ad Hoc Fiscal and Monetary Policy

Posted on September 17, 2008 by Felix

What is this Supplementary Financing Program, under which Treasury is essentially lending money to the Fed? Does it mean that the Fed’s run out of money, as Paul Murphy would have it? Does it mean, pace Tyler Cowen, that central bank independence is gone and that American government has become dysfunctional? Alternatively, looking at things from Yves Smith’s point of view, has Ben Bernanke started up the printing press? Will the program mean a huge uptick in spending and therefore in the budget deficit, with potentially disastrous echoes of 1966? Or is it simply, in the words of the Treasury press release, no more than a "liquidity initiative" with essentially zero fiscal implications?

All answers gratefully accepted. Because I have no idea.

I certainly see no useful distinction to be made right now between Treasury and the Fed: just look at the AIG bailout, where the Fed is providing the line of credit, but Treasury gets the equity warrants. On the other hand, I think that’s a good thing. Central bank independence exists to prevent politicians from determining monetary policy — but when it comes to regulatory arm-twisting and game-changing bailouts, you want Treasury and the Fed to be on exactly the same page. Similarly, I see no way whatsoever in which hyper-politicized kibbitzing from the Federal legislature at the height of election season would be anything but noisy and unhelpful. Insofar as America’s Congressional representatives are letting the executive get on with things, good for them.

I suspect that when the dust has settled, we’ll have seen a lot of money being moved around in circles, but we won’t have seen a significant increase in actual government indebtedness. Contingent government indebtedness, yes: there’s now an implicit sovereign guarantee not only on Frannie but also on AIG. But the good thing about contingent indebtedness is that it doesn’t cost any money up front. And in the meantime, thanks to the FTQ trade, US borrowing costs have never been lower. Which is a good thing, fiscally speaking.

All the same, one does get the distinct impression that Paulson, Bernanke, Geithner & Co are making this up as they go along, and that they’re very much behind the curve. If the US government needs to borrow billions of dollars to make this crisis go away, it will: short-term necessity will override any concerns about long-term indebtedness. That’s the way it always is, in crises. And frankly I’m glad that at least the US government still has the ability to borrow essentially unlimited amounts of money to sort these things out. Because no one else can.

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Extra Credit, Wednesday Edition

Posted on September 17, 2008 by Felix

U.S. one month T-bill yield falls to 0.17 pct

The cost of protection on the Street

Moral Hazard for Corporations

The Economy in Two Minutes or Less: Obama trounces McCain in the battle of the TV ads.

Spot prices: Smart parking meters.

How Magazines Led Investors Toward Ruin: By recommending they buy the likes of AIG and Lehman.

What comes around goes around: The Germans help to bail out Lehman.

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Morgan Stanley in Distress

Posted on September 17, 2008 by Felix

The good thing about the fact that both Goldman Sachs and Morgan Stanley just released their quarterly earnings is that we have up-to-the-minute information on what (they say) their book value is. For Goldman it’s $99.30 per share; for Morgan Stanley it’s $31.25.

So as of right now, Goldman, down 23% on the day, is basically trading at book value; Morgan Stanley, down 31%, is trading on a much more distressed, and distressing, price-to-book ratio of about 0.63.

For comparison, Merrill Lynch’s price-to-book ratio, based on its second-quarter book value of $21.43 per share, is presently about 0.91. Of course, Merrill is a merger-arb play, not a value play. But clearly the market is saying that Morgan Stanley should find an acquirer fast. It’s directly across the street from Lehman Brothers: its executives are reminded every time they look out the window what the alternative is.

Oh, and one other thing: no, Goldman Sachs is not an acceptable acquirer for Morgan Stanley. It needs to be a big commercial bank with a solid deposit base. Um, any Canadians interested? The shortlist on this side of the border is looking decidedly, well, nonexistent, unless you include the US government as buyer of last resort.

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Beware ETNs

Posted on September 17, 2008 by Felix

The Chinese renminbi is one of the most stable currencies in the world. Its value against the dollar is severely constrained by the Chinese government, and it never moves very far in any given day. But, it’s hard for foreigners to invest in. So instead they tend to buy things like CNY, an exchange-traded note designed to mirror the performance of the renminbi.

But just look at how that’s been behaving today: certainly not like a stable currency. It opened at $36.49; less than two hours later it was down more than 24% at $29.37. Why? Just take one look at the fund’s home page:

Market Vectors Currency Exchange Traded Notes are senior, unsecured debt securities issued by Morgan Stanley that deliver exposure to the exchange rate of foreign currencies.

Oh. Right.

As my correspondent G P says,

Perhaps this might be a good time for a story to remind your readers about the difference between an ETN and ETF: an ETN is just a pre-paid forward contract, a form of debt security. There is no underlying basket of assets, unlike mutual funds or ETFs. Some CNY holders might imagine that they, in effect, hold cash in a renminbi-denominated bank account, which is not the case.

There’s risk in ETFs, too, actually. Many ETFs tracking indices or commodities do so by means of derivatives contracts rather than solely through owning the underlying asset. The ability to use derivatives in such a manner is far from assured; it’s surely harder today than it normally is. So remember, if you’re buying or selling ETFs right now, they might behave rather more wackily than usual.

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Morgan Stanley in the Crosshairs

Posted on September 17, 2008 by Felix

Why is the stock market down this morning? Haven’t we just averted catastrophe? Shouldn’t the fears — and shorts — of earlier this week be unwound?

Madlen Read of the AP reports:

Stocks skidded again Wednesday, with anxieties about the financial system still running high even after the government bailed out the insurer American International Group Inc.

The "even" is the giveaway that Madlen knows that this doesn’t make a lot of sense. When the US government bails out Wall Street, one expects Wall Street to rally in gratitude.

Part of what’s going on, I suspect, is that there’s very little trust in equities as a store of value any more — certainly not in leveraged companies, anyway. Shareholders have been systematically slaughtered of late, whether they held Fannie Mae or Freddie Mac or Merrill Lynch or Lehman Brothers or AIG or Washington Mutual or any number of other financial companies, including even relatively strong ones like Goldman Sachs (down another $11 today) and Morgan Stanley (down 17% despite stronger-than-expected earnings).

Meanwhile, bondholders in all of those companies bar Lehman have emerged unscathed so far, and are likely to remain unscathed for the foreseeable future (which, admittedly, isn’t very far). In any event, bank debt is cheap, and if you want to be long financials, it makes much more sense to make that bet by buying debt, which has a tendency to be bailed out, rather than equity, which has a tendency to be wiped out.

So what we could be seeing here is a rotation out of equities and into debt, since debt right now would seem to offer a far more attractive risk/reward profile.

On the other hand, there’s no indication at all that debt spreads are tightening. On the contrary, Morgan Stanley’s credit default swaps are now trading at 925 basis points, which is a very distressed level.

Does this mean that Morgan Stanley is now in the crosshairs? It would certainly appear so, yes. That alone could explain the stock-market drop: there was a brief rally yesterday afternoon on the AIG bailout, but Morgan Stanley’s balance sheet is just as big as AIG’s.

My feeling is that it’s high time Morgan Stanley found a buyer. Or things could get very ugly again very quickly.

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The $85 Billion Check

Posted on September 17, 2008 by Felix

Ottorock asks a question:

When a gov’t cuts an $85Bn cheque, where do the funds come from?

John Jansen hazards a guess at the answer:

If the Federal Reserve Bank of New York plans to write an $85 billion check to AIG , then Treasury market participants should duck for cover. They will likely raise the money by selling Treasury debt from the System Open Market Account. I have no idea how they would do that but it would be the largest such sale of securities since the dawn of human history.

The real answer, however, is that there won’t be any $85 billion check. AIG will draw down this liquidity facility only as and when it needs to, and indeed there’s a substantial chance that now the liquidity facility exists, it won’t get used at all.

At Libor + 850bp, the funds in the liquidity facility are very expensive, and AIG will tap them only as a last resort. What’s more, it’s now owned by the government, which means that it almost certainly won’t default. (The Germans call this Anstaltslast.) As a result, AIG can probably find cheaper private funding elsewhere.

In other words, the headline cost of this bailout is $85 billion. But the practical cost might well be zero — and the government’s getting 79.9% of the world’s largest insurer, to boot.

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Reforming the Patent System

Posted on September 17, 2008 by Felix

It’s easy to miss amid the chaos, but the WSJ has an important story this morning on Nathan Myhrvold and his company, Intellectual Ventures. It helps to counteract the fluffy excitement of Malcom Gladwell, back in May, which always seemed as though it missed the dark side of the company.

Myhrvold, it turns out, is essentially running a hedge fund specializing in intellectual property arbitrage. He even charges hedge-fund-like management fee of 2% of assets, plus an undisclosed "percentage of any gains".

Myhrvold is buying low and selling high: as Gladwell demonstrated, it’s really very cheap and easy for Intellectual Ventures to amass thousands of patents. And as the WSJ shows today, those patents are extremely valuable:

Verizon, for instance, disclosed in a July filing with the Securities and Exchange Commission that it plans to pay as much as $350 million for patent licenses and an equity stake in a patent-holding investment fund. The company operating that investment fund is Intellectual Ventures, according to a person familiar with the terms of the deal.

Intellectual Ventures and its ilk are arguably the single biggest risk to America’s continued leadership in technology and innovation. As dsquared elegantly put it in a comment here in May, the company might do a bit of R, but it doesn’t do any D. Instead, it acts as a brake on any company wanting to do substantive R&D of its own, since there’s a good chance Intellectual Ventures will have got there first, patented the idea, and then just decided to sit on it until somebody dares to violate it.

The long term repercussions of this will be a competitive advantage for companies based in places like China or Brazil which have much weaker intellectual property laws. It’s sad, because patents, as originally envisaged, can help to encourage innovation. Maybe, with the right litigation, we can return to those days:

The tech industry has sought to reform the patent system to make it harder for licensing firms like these to operate. Its preferred legislation stalled in Congress this year, but the effort still has momentum. Both Sens. John McCain and Barack Obama say they want to reform the patent system to reduce lawsuits, although neither side has any specific plans to deal with the so-called trolls.

It won’t be easy to get this legislation right, but it will be important.

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Extra Credit, Tuesday Edition

Posted on September 17, 2008 by Felix

The K-T Boundary: The best thing yet written on the future of investment banking. Read it.

Lehman v Argentina: It looks like Argentina has finally been overtaken as the Biggest Bond Default Ever.

Who Replaces AIG in the Dow? How about the Fed? Realistically, it has to be Google.

Competing Tax Plans: Two Perspectives

Merrill’s Thain, Aides May Get $200 Million for Year

Barclays – Lehman Deal Marks Bottom of Credit Crunch Panic: "Lehman shares soared 9.00% on the news to $0.2276 per share and the rising tide of confidence that the assets in the opaque portfolios of financial firms are more of a Polonium-210-slow-and-painful kind of toxicity instead of the quick-and-violent lethality of sodium cyanide rallied firms like Washington Mutual (WM) up a whopping 19.50% to $2.39, its highest point in the preceding 10 minutes. The news also boosted the second derivative of AIG’s stock price."

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Libor + 850bp

Posted on September 16, 2008 by Felix

It’s done. The US government is bailing out AIG to the tune of $85 billion. But boy is it an expensive loan:

Interest will accrue on the outstanding balance at the three-month London interbank offered rate plus 8.5 percentage points.

If everything goes according to plan, the outstanding balance will decline dramatically over the two-year life of the loan as AIG sells off assets. But to a first approximation, let’s just assume the $85 billion is repaid at maturity, and that 3-month libor stays at its current level of 2.81%. Then the interest rate on the loan will be 11.31%, and the total interest paid over two years will be over $19 billion. It’s kinda an open question here who’s bailing out whom.

To put that in perspective, total US corporate income taxes in fiscal 2006 totaled $380 billion — which means that the government’s interest payments from AIG will account for about 2.5% of all US corporate tax revenues over the next two years.

Assuming, of course, that AIG doesn’t default. But it won’t: it’s now owned by the US government, and entities owned by the US government don’t default.

This is basically the same thing as we saw with Fannie and Freddie: shareholders get diluted, bondholders get bailed out, systemic risk is averted. But with AIG, Treasury is making the company pay through the nose for the privilege of being bailed out. It didn’t need to do so: it could have just bought an 80% stake for a nominal sum, and made it clear that it guaranteed AIG’s debt. No big $85 billion headline figure, but the same practical result. The reason for the $85 billion loan is not that AIG needs the money — it doesn’t, now that it has an implicit government guarantee. Rather, it ensures that AIG ends up paying a lot of interest back to Treasury.

This is something which, frankly, only a lame-duck executive could pull off. It’s easy to foresee the screaming headlines tomorrow: the US government spending $85 billion, or $850 per American household, on bailing out Wall Street fat cats. No politician wants to see that. But Paulson isn’t a politician, and the president isn’t worrying about being re-elected. So they can do it. I don’t like it, necessarily, but at least we averted a counterparty-risk meltdown.

Update: Aha. It’s not actually a loan of $85 billion, it’s authorization "to lend up to $85 billion" — it’s a liquidity facility more than an actual loan. So total interest could be much, much lower than the numbers above, if AIG doesn’t find itself in need of the cash.

Posted in fiscal and monetary policy, insurance | Comments Off on Libor + 850bp

Why Bail Out AIG’s Bondholders?

Posted on September 16, 2008 by Felix

Much as the prospect of an AIG bankrupcy terrifies me, I’m not a fan of an $85 billion government bailout either. Bond investors have already taken enormous mark-to-market losses on their AIG paper; if they realized just a fraction of those losses, that would provide AIG with a huge proportion of its needed capital right there. Instead, it seems that they’re being bailed out.

AIG has about $190 billion in debt outstanding, which has a market value of about $65 billion. So conceptually it should be possible for someone to buy that debt for $100 billion, forgive the $75 billion of new capital that AIG needs, and still end up $15 billion ahead. AIG would be solvent again since its liabilities would have shrunk by $75 billion; its bond investors would make a mark-to-market profit of 50% on where their bonds are trading right now; and the white knight with the $100 billion would make a tidy profit to boot, so long as the remaining bonds were worth more than 87 cents on the dollar, which they would be.

Instead, the proposed bailout, far from reducing AIG’s liabilities, seems to comprise increasing them by another $85 billion. It also seems to leave all existing bondholders with a haircut of precisely zero — effectively trebling the value of their bonds overnight.

Why should holdco creditors get back 100 cents on the dollar after making such a dreadful investment? They shouldn’t. There’s a strong case for bailing out policyholders, or people who bought financial insurance (credit default swaps) from AIG. The case for bailing out those who lent to AIG directly, however, is much weaker.

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Damien Hirst: $200 Million Richer

Posted on September 16, 2008 by Felix

The final results are in: the Damien Hirst auction at Sotheby’s raised £111.5 million, which is thisclose to $200 million. (It would have been comfortably over the $200 million level at any point until the pound collapsed at the beginning of the month.)

The weak pound certainly helped, but mainly the art market seems to be incredibly good at ignoring the craziness on Wall Street. The Golden Calf sold for $18.7 million, while Shark II (er, sorry, The Kingdom) blew through its high estimate and ended up selling for only slightly less: $17.2 million. The third-highest price — $9.4 million — went for Fragments of Paradise, not an animal in formaldehyde but rather diamonds in a vitrine; it had been estimated at just £1 million to £1.5 million.

Richard Lacayo has the one-line summary:

Markets may plummet but butterflies just keep floating upward.

Still, I stand by my prediction: this is the highest that Hirst will ever float. He’s like Stephen Schwarzman: he managed to time his biggest sale for right at the top of the market. Good for him.

(And yes, I know that the $200 million includes the buyer’s premium which goes to Sotheby’s and not to Hirst. But at the same time it doesn’t include the five lots which weren’t sold during the auction but which were sold immediately afterwards. So let’s just call it $200 million and be done, eh?)

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