Forget $4 Gas – Can the US Handle $6 at the Pump?

The short answer is likely no, at least not at any time soon. That’s not to say, however, that middle east contagion fears are completely overblown.  The fact of the matter is that I believe that potential worst case scenarios are not as bad as many have come to believe long-term; but short-term, as we all know, anything is possible.

In the short run:

  • Muammar Gadhafi is a deranged lunatic, believed capable or anything from setting his nation’s oil reserves ablaze to genocide.
    • With sanctions having been imposed against Libya, their assets frozen, and the nation effectively divided in two, further escalation in violence may be imminent.
  • Saudi Arabia – given their enormous reserves, and that they have stepped up oil production to offset losses from Libya, concern of stability in Saudi escalates anytime the youth of the region so much as sneeze’s in its direction, it is understandable that the world’s eyes are focused turmoil in nearby Bahrain, Oman, and the country’s Shiite minority.
    • Bahrain and Oman will both be focal points in determining potential swings in crude, as worries of unrest spreading to Saudi grip the market
  • Algeria strikes many as a likely candidate for contagion due in large part to being situated in North Africa, near Egypt and Libya, considering it’s extremely high unemployment rate amongst the youth, and after having been run under a state of military emergency for 40 years – not to mention large oil reserves.
  • Though Egypt has been somewhat removed from our radar we must remember that they are essentially leaderless as a nation (with no president), and no elections scheduled until September of this year.
  • Iran. Appropriately one of only two ‘four-letter’ words on my list.  We know they’ve had issues, and we now know (courtesy of Rajat Gupta) that it’s easier to get information out of Goldman Sachs than it is from Iran.  Over the past two weeks rumors of Iranian warships entering the Suez tore through worldwide oil markets intra-day.  It is hard to assign credibility to any breaking news from Iran, and therefore I assign Iran as my ‘sleeper’ major headline-risk from the middle east (with Saudi being the 800 lb gorilla).

Of the above issues the most pressing is clearly that of Gadhafi in Libya, as history shows it’s difficult to assign probabilities to the potential actions of madmen – they’re literally capable of anything.  On the other hand, the President of Saudi Arabia was recently greeted with jubilation as he returned from medical treatment abroad, promptly instituting further benefits for the unemployed, and pledging to increase oil production to offset losses from other key mid-east nations.  Meanwhile, Algeria preempted many fears of further contagion by ending its 40-year old military sate of emergency – a state of control that Egypt had been under, until after their uprising.  This past week, further protests in both Tunisia and Egypt proved both successful and peaceful.

Though the future of the region as whole may be much brighter than many might believe, that doesn’t negate a few other pressing issues we’ll have to deal with.  With US forces having approached the shores of Tripoli amidst reports of Gadhafi  loyalists massing near rebel strongholds, and with substantial sums of Libyan assets having been frozen, full-scale escalation appears imminent if the US is unable to dangle their $30 Billion ‘carrot’ of seized assets and execute some sort of negotiated exile.  While any escalation would likely come in the form of a UN led security force (or at least for once a UN approved one), it will set an interesting precedent of supporting such uprising.

If Gadhafi has to go the hard way everything changes, and I mean everything.  If Gaddafi choses not to leave I believe that verifies that he is devoid of any logic or sound reason, and they since he doesn’t care about his money he therefore may no longer care about his oil reserves – if Gadhafi pulls a Saddam and starts lighting oil well on fire I don’t want to think about filling up my gas tank, let alone where crude might trade.  Longtime Gadhafi friend and Libyan ally, Hugo Chávez of Venezuela, has recently made news calling for negotiation with the Libyan madman, and has historically stood at his defense.  Rather then speculate further, suffice it to say that it is more than disconcerting having a Gadhafi supporting dictator with his own sizable oil reserves on this side of the planet.

Given the number of oil-producing nations currently, and potentially, experiencing upheaval it is not difficult to imagine crude surging to its previous highs; even if contagion does not spread further, if we were to get a meaningful and prolonged drop in production (or in the case of Egypt, transportation) of oil in most of or all of these nations, it would have a profound impact on oil prices in the short run – particularly in Brent crude, and with a disproportionate effect on the European economy as compared to the US.  Excess US supplies have been able to hold back WTI crude, and may very well continue to, but a prolonged shock could stifle recovery here as well.

Increased margin requirements at commodities exchanges (like CME) have curbed leverage that traders may use, and while in theory this should limit overall speculation, in practice, during times of heavy speculation, volatility may be heightened (particularly when requirements are altered during said speculative period) – so oil may not trade as high, but boy is it going to trade! The last time around when oil peaked we didn’t see gasoline prices above $4.00 f0r long, and that’s because oil prices didn’t stay that high for long (nor were they expected to, if you look at futures) – had oil prices even just hovered at $147  longer, gas would climbed further.

As a general rule always remember that for every $25/barrel of oil you can add $1.00 gallon at the pump.  Long story short, oil may or may not go higher than the famed $147  per barrel high in the next few months, but I can tell you that if prices stay at or near $150 per barrel for more than just a few months that we’ll see US gas at the pump surge to near $6.oo per gallon.

In the long-run:

This could be the best thing to happen to the middle east since air-conditioning.  The eventual outcome might be the best that Americans (though not necessary Dick Cheney) could have hoped for in the Middle East.  If we, as a nation, were actually trying to do anything more in Afghanistan and Iraq than playing “where’s the WMD?” then I think we waned Democracy to be contagious.  OK, yes to be fair let’s acknowledge that in a couple of instances here we have rebellions against US sponsored (or at least funded) dictators/monarchs (Egypt and Bahrain) – but if any President in US history was ever going to be able to look the Middle East in the eye and honestly say “that was then, this is now – we’re different” it’s probably the one named Barack Hussein Obama.

Oil production?

These people aren’t mad (again, with the exception of Gadhafi) – they don’t want to stop producing and selling their most valuable asset.  Understand that, if anything, you could argue that all of this turmoil is centered on dictators and monarchs who hoard, and do not distribute or utilize effectively, their vast oil wealth.  If anything I would believe that after a new government is installed, Libya will be capable of producing more oil with a competent government and improved infrastructure, for example.

The enemy of my enemy is my friend…

One thing worth noting in the negative column might be Gadhafi’s own comments this week that Osama bin Laden was to blame for the uprising in his country, and that Al Qaeda had drugged the youth of his country.  This gives me pause in the same way a parent might expect their child to spend time with the exact people they had told them not to associate with – to be spiteful.  I’d be at least mildly concerned that the youth of a country who hates their leader (Gadhafi) might be drawn to the person/group he seems to fear most, Al Qaeda. Whether or not they’re the ramblings of a lunatic, I pay some heed to the fact that someone with that much to worry about right now is having delusions about Bin Laden and his effect on the youth of Libya.

A crude reality

While I would characterize almost any continued spike in oil prices as just that, a spike, I am certain that the future of crude prices is elevated. Though we continue to improve fuel efficiency and are beginning to offer alternatives, it is not enough – and certainly not considering the forecast for increased global energy consumption. Without an energy policy the US is unlikely to make much headway and, even when we make the necessary switch to using more of our abundant natural gas resource, oil prices are likely to remain elevated.  Given global supply, geopolitical concerns, and that after shale is exploited most of our sources of crude will be more and more costly, I believe that in the next few years we may see oil below $100 per barrel for the last time in our lives.

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Internet Revolution Strikes, Again: Both in the Streets, and on “The Street”

Every analyst on the street already seems to be on the bandwagon, and every pundit on TV believes we should be scared by so many analysts being in agreement: tech stocks are cheap. Many of them have been cheap for a decade – and they were cheap for a reason.  The explosive growth of dot.com bubble wasn’t a total farce, much of that growth was simply robbed from the future – countless companies experienced a decade of growth in 18 months……and then the wheels came off.

Less than 4,000 days later……

The growth of the internet bubble was unprecedented; with companies’ valuations sorry virtually overnight, despite an internet still in its infancy and no profits at many companies.  Companies like Global Crossing and JDS Uniphase spent billions laying fiber optic cable and acquiring companies for growth.  The result: so much bandwidth, a glut, that it would take us a decade to work off the capacity.  And so, much like the very stocks that led the boom, both the internet and it’s companies had grown wildly faster than people’s ability to connect to internet, to do so with a high-speed connection, and be able to stream content.  Much like the prices of these very stocks, these companies had grown the internet (in terms of supply of bandwidth) much faster than the growth in demand for bandwidth.

And on the market side, perhaps more than ever, valuations finally caught up to stocks.  Then the seemingly infallible Alan Greenspan (after all of his talk of ‘Irrational Exuberance’) killed the ‘Golden Goose,’ raising interest rates perhaps one too many times….and Enron was exposed as a fraud (and with it Arthur Anderson), Investment Banking and Research were flipped on their head……September 11, 2001…..the Dennis Kozlowski episode at Tyco….and sprinkle in some Sarbanes Oxley – the golden age of stocks had ended.

Accordingly, nearly the entirety of tech-land has languished for the better part of a decade (not withstanding standouts like Apple): value (cheap) companies like IBM spent an entire decade getting cheaper, and cheaper – with its stock price never surpassing $135 (for 10 years) all the while steadily growing its earnings and revenue (much like Intel, though it is nowhere near its’ highs).  Recently, in fact, IBM was finally able to break-out above that very $135 level – technically, this amounts to a break-out from a 10-year consolidation.  No wonder that only days aver surpassing $135 , IBM was able to trade north of $160 (likely on its way to north of $200).

What happened?  Many things have happened….though there are a few key factors that demonstrate that this is the break-out tech investors have been awaiting since the dawn of the internet age.

A dearth of bandwidth meets soaring data demand……

Fast forward 10 years, 4 iPhones, not even Google nows how many Androids, 3 prominent social media sites (Friendster, MySpace, then Facebook), two incarnations of high-speed mobile networks (3G & 4G), and a President elected by the social-media age, and we find ourselves in a brave new world.We finally have the streaming content, mobile access, and are so socially connected that we, as a people, have completely overrun the entire internet infrastructure.  Just weeks ago the last IP address available was used.  In New York City, where I live, my iPhone has been reduced to a paperweight during times of high data-traffic.

Governments around the world are in a race to provide the vast majority of their populations access to high-speed digital internet, while mobile carriers struggle to upgrade their networks to meet demand.  Right in the middle of at least the second worst financial catastrophe in modern civilization, we are witnessing the equivalent of a ‘digital’ New Deal.  With the world on the verge of what could be considered a long-term structural unemployment problem we are witnessing  the mass reconstruction and build-out of the entire information super highway – and many of the broken companies of the past boom are back again to reap the rewards.

Make no mistake there are, and will be losers.  Some companies did not (or not yet) adapt to the changes of the second coming of the digital age (we’ve all seen Cisco’s last few quarters).  In other areas there has been a changing of the guard; Apple is one of the rare exceptions that never skipped a beat over ten long years, and Google appears to be he new Microsoft, but better – by being the leading software provider to the ‘new’ hardware (mobile devices), all the while using their search business to literally ‘print’ money.

The Revolution will not be televised……

From President Obama to the recent uprisings in Tunisia and Egypt, we have also seen the power and scope of the internet revolution we are in the midst of.  This social revolution has created a kind of momentum, social, political, and technological, that cannot be stopped and the will forever change the course of history.  Every day we are more and more connected, and those who are unable or unwilling to adapt will be left behind; people, companies, and countries alike.  This was perhaps no  more evident than when [former] President Mubarak of Egypt spoke the world this past Thursday; he adamantly implored his people, the youth of Egypt, not to listen what the people on TV were saying/telling them what to do.  In that moment it was so obvious. This movement that began with a Google executive’s post on Facebook, a movement against a President/Dictator that, despite weeks of protests, was completely oblivious to the root of the riots and, to what the world had become.

This is a lesson not just to other nations that might rise up in peaceful democratic protest, but to all of us.  It’s been called a ‘tipping point,’ or wildfire, even cancer, but, like or not, the digital proliferation of humanity can no longer be stopped.  Perhaps more now, than ever in history, the people of the world, the masses, have the loudest voice.

The bottom line, is exponential……

This translates to a world where the most valuable infrastructure is digital, the most important security is cyber, and the majority of the world’s capital flows through fiber optic cables and is then transmitted through the air – and the rate of the proliferation of any and all of these digital trends is more rapid than anything in human history.  Faster than anything the ‘old world’ could muster other than perhaps cancer.  This past year social networking/group-coupon company, Groupon, grew from literally $0 in value to a valuation of over $1.4 billion – in less than 8 months! The company’s value literally grew at the speed of ‘word of mouth.’

Whether it’s the growth of the conservative ‘Tea Party’ or the youth of Egypt throwing their own ‘Cairo tea-party,’ we can literally see the proliferation of the internet revolution on the street.  If we look at IT spending, or at productivity, or at the growth in profits and revenues at tech companies, we can literally see the proliferation of the internet revolution on The Street.  And this time, they’re growing at almost the same rate.

Why the street is wrong about what the iPhone means to Verizon

For months and months we have speculated (and been right) that the iPhone would inevitably come to Verizon and end AT&T’s reign of exclusivity with the popular consumer device – the time seems to finally be upon us.  Yet, all of the naysayers are now trying to convince us that the iPhone may be more trouble than it’s worth for Verizon; that subsidizing (the cost of being able to offer that sexy $200 price-point) the iPhone will crush Verizon’s margins; that bandwidth consumed by iPhone users might cripple Verizon’s network; that iPhone might cannibalize Verizon’s more profitable Android sales; and that somehow the moment we’ve been waiting for since the launch of the first iPhone might not be all it’s cracked up to be as a user experience, or as an investment.

Now let’s take a look at why none of he above will prove to be much, if any, headwind to the Verizon/iPhone experience:

The cost of subsidizing the iPhone will cripple Verizon’s margins.

Perhaps, and perhaps you’re mad.  Verizon is a $100 billion company, a significant portion of which is the landline/Fios business (Verizon [VZ] only owns 50% of Verizon wireless) if you’re worried about iPhone having an extreme negative impact on margins please bring it on, because iPhone sales would have to be extraordinary to affect margins much in the short run – and the long-run it should be a non-issue.  And like most carriers, Verizon limits the number of times per year you can upgrade phones and pay the discounted price (like the $200 iPhone) – so everyone who upgraded to Android or a Blackberry within the last 12 months will have to pay full-price or wait; therefore you can try to believe that iPhone will cannibalize Android or hurt margins, but not both – you are not allowed. Even if Verizon’s margins are hurt but the subsidy of new phone sales (with new contracts) all of those customers will extend (or sign) their contracts, and the rest will be defecting from other carriers – so if we see growing revenues with a hit to margins at Verizon, we’d probably see a hit in revenues at other carriers.

iPhone users will completely over-run and/or cripple Verizon’s great network.

Imagine the iPhone is LeBron James and that Verizon is the NBA.  Now realize that Verizon has known that “free-agency” was coming for several years and they have ramped their network accordingly – like NBA teams clearing salary cap space to compete for LeBron – they have capacity, 4G has come online, they have further investments to the network scheduled, and if they really need more bandwidth they can always buy Sprint or T-Mobile.  Again, if the network is crippled short-run (which is when I’d be worried, because they’re still improving their network) I’d have to chalk it up to a ‘good problem to have’ because it would indicate that not just usage, but also sales were fantastic – you’re no crippling that network overnight.

Cannibalizing Android sales…….money out of one pocket and into the other, and at lower margins.

As we discussed, I believe this issue is overdone.  Will it occur?  I’m sure it would have to at some level, but realize this: while Android has been growing market share, that growth has been accelerating.  Therefore a disproportionate amount of Android devices are likely to have been purchased more recently, and accordingly these users will not be eligible for an upgrade to buy a $200 iPhone – and several Androids are priced well below iPhone, meaning they are not in competition.  The dominant expectation continues to be that many iPhone users will defect from AT&T, hold-outs at Verizon will finally buy the phone they want, and others will move to Verizon that wouldn’t, for one reason or another, move to AT&T.

But, is that it?

This may be just the tip of the iceberg. Verizon seems to be the leader in 4G; so we should expect to see 4G versions of the iPad and iPhone in the not to distant future.  I also believe that Verizon’s network is good enough that continued success could prompt Apple to release other phones (an Apple phone not called iPhone?) – perhaps even one with a keypad. Analysts have said that the iPhone going to Verizon was priced-in the stock after is recent move, but that the market hadn’t discounted all of the above concerns .  The fact of the matter is that the market has already discounted the above, and Verizon will not likely fall into the category of “victim of its own success” – at least not any time soon.

Trading Notes: I’m not here to say if Vodaphone (the other 50% owner of Verizon wireless) is a better play than VZ – that’s up to you.  I do happen to believe Spring will be bought, or possibly merge.  And if you’re wondering what I think of AT&T – if my friend (and account manager) ever quits there I will run, not walk, to the nearest Verizon.

To be fair: I am at the time of writing, and/or manage accounts that are,  long Apple, Verizon, and Sprint. Members of family own Google.

The Day the Market Stands Still

Several years ago Warren Buffet proclaimed derivatives to be akin to ‘financial weapons of destruction’ – if only he knew the half of it. True that derivatives are opaque, illiquid, and often exotic.  Their very nature is both inherent to the way we do business and to the fear of how business is done today.  However, May 6th may point to a much more dire concern – how fragile is our market structure, really?

On the day of the Flash Crash one of my thoughts, on a day when most of us barely had time for a few, was that we had just seen a terrorist event.  Maybe it was (I’ve been told it wasn’t), maybe it wasn’t but, whether we like or not we were clearly exposed.   For the purposes of this discussion we will make an assumption; either May 6th was a planned mini-attack (let’s call it an incursion), or it wasn’t (a completely random perfect storm) – it cannot be both.  Either way one fact remains, certain vulnerabilities in the way business is done have been exposed.  Their have been advancements since the Flash Crash, particularly the single-stock circuit breaker that holds trading when an individual stock moves more than 10%  within 5 minutes.  Lack of uniformity was placed as the chief cause of the wild events that day, and ‘slowed’ trading on the NYSE was credited with lessening the damage. What has been exposed here is at the core of our financial system; our markets ability to operate and do so electronically, to provide liquidity regularly, are integral to our economy.  Detailed information of tick-by-tick information, not just of trades, but true market depth, called market-latency information is used, among other things, to decipher market activity and to improve quantitative models.  This information is available to anyone who can pay for it (namely hedge funds) and may most certainly be used to exploit the weaknesses of our system, but one integral ingredient is missing.

Why is that terrorists are often so difficult to overcome?  It is nearly impossible to defeat an adversary who is willing to take his/her own life; they are willing to inflict a kind of damage that no one who possesses the instinct of preservation can conquer – people willing to die to kill you are tough to beat; people with money to burn are similarly dangerous.  The markets would prove a devastating parallel to that conundrum.  Is an efficient market prepared for extremely large participants (by sheer size, or by derivative leverage) that do not care if they lose?  The market is supposed to be a zero-sum game, but I am reminded of a Keynes quote, “If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.” From ‘Long-Term Capital Management’ through AIG and Citigroup, that principal has been reinforced – be careful who owes you how much money.  What if someone deliberately created a LTCM, a ever-expanding web of leveraged bets upon leveraged bets, designed not to be bailed out (or to be bailed out, whichever you prefer)?  This is my point.

Now allow us to bifurcate.  We have two separate, yet not necessarily distinct issues; one is that, whether intentionally or not, our system has been tested and we can expect future tests, and two is that we don’t know how a market with a LTCM designed to disrupt the market would behave.  Either, in and of themselves, are completely terrifying.  What I suspect, however, is that the two need to be thought of as more intertwined, in the sense that derivatives are designed to be whatever they are designed to be – little else.  I am not saying that derivatives would be how a hypothetical financial cyber attack might be packaged.  What I am saying is that given the derivative exposure borne by the market today, that if and when such an attack were to occur it would be devastating.  An attack sever enough to close US markets for “an extended period” (as Doug Kass recently suggested) could bring renewed strain to global, and particularly US and European, markets still weak from recession.

In the absence of significant changes to market structure, and without addressing the portion of market activity comprised by automated trading, their remains reasonably high-risk in any short-run period due to market structure and possible liquidity crisis’.  With the leverage available on the futures and options offered on the myriad of financial products available today it becomes more than plausible that a, or a group of, participant(s), that may or may not care about preserving capital (they may be using capital as a weapon), could deliberately and effectively disrupt our entire market structure.  Moreover, if one combines the principles of what I’ve discussed with a breach in security, a cyber ‘hack’ if you will, they would likely discover an equally chilling prospect.

We’re All Naked, No One is at The Wheel, and How Much Was That Check Anyway?

Recently I encountered data showing the US derivatives holdings are at the greatest level in history (yes now, in Oct, 2010 – not in Oct, 2008).  Now Americans my ask “why,” they may ask say ” how could this happen, “why aren’t these things illegal?”  I’d wager that almost half of Congress might still think that, and that is the problem – they still don’t even understand what they just regulated! Many people still seem to think that the phrase ‘toxic derivatives’ somehow refers to something akin to a perishable good, perhaps some bad fish from the market.

The ideas I most often encounter, generally, fall into two categories:

  • They were perishable; at one point they were (the derivatives) edible, and later – not so much.
  • The banks were making crazy outlandish bets, and missed. (Close, but they didn’t know it)

These weren’t crazy bets (well, they were, but not in the sense you would think) in that there was no ‘swing for the fences mentality’ – they (most of them) were just looking for cash flow, not upside, and were oblivious to the risks (they confused minimal probability with minimal ramifications). It just so happens, in the latter part of the sub-prime bubble (say late ’06 – ’07), that these derivatives weren’t perishable – they weren’t meant to be consumed.  But, not for the reasons you might think.  You see, the houses that were sold during that time (for the most part) ought not have been sold.  You heard me.  People who weren’t qualified and didn’t know what they were spending, or at what terms, bought real-assets at prices that did not reflect their true value.  We’ll get in to more detail shortly but remember this key point: When a homeowner goes bankrupt the primary lessor (1st mortgage) will get the property and may fare well in foreclosure, the secondary lessor (2nd mortgage) – not so much.

For your derivatives, would you like ‘paper’ or ‘plastic?’

Derivatives are so named because, as an asset class, their prices are determined by the prices of another asset (derived from).  There are many derivatives in our lives; the jet fuel hedging of the airlines, a farmer selling his crop a few months before harvest (he’s really selling a contract to buy his crop at a later date), a ‘put’ option on a stock position, a CDS to hedge a bond position, and even your own insurance policy.  The notion that derivatives are, in and of themselves, some form of toxic, or treacherous, device is simply wrong.

All the types of derivatives that I have described (really all that exist, but let’s keep it simple) represent an obligation. They are a contract promising purchase or delivery of an asset, at (or up to) an agreed upon date, if certain conditions are met (time and price).   Now, understand that a ‘Credit Default Swap’ represents a contract insuring the value of a bond (perhaps mortgage-backed) and that the swap buyer will make regular premium payments to the seller of the insurance.  If the bond were to default the company who sold the insurance bares [theoretically] the risk of the entire value of the bond (say $1mm).  [If an insurance company insures your house they collect premium from you, and in exchange if something covered by your insurance destroys your home the insurance company owes you a new home (essentially) – the bear the risk of the entire value of your home]

A few things to understand:

  • CDS were usually created to insure entire bond offerings, often in denominations of $1 Billion
  • In 2005 the CDS market was in its’ infancy, and the public was convinced they could do know wrong in housing
  • As a consequence, there weren’t many buyers of CDS’s and prices were low (they thought risk was low)
  • Therefore, there were many willing sellers (like AIG)
    • Remember, the sellers get paid steady premiums (as if they owned a bond)
    • If the bond defaults – the CDS seller has essentially bought the farm
    • I have read quotes that in 2005 Bear Sterns was willing to insure $1Billion in Mortgage Backed Securities for $20Million/year (2%)
  • Even after people (AIG) got the drift, realizing that they were carrying much more risk than they thought ($200Million in premium income came with $10Billion in liabilities) – they did not unwind the trades
    • In the above example, even if AIG had never owned any MBS they would have $10Billion in exposure by selling the insurance.
  • Why would they sell the insurance?
    • They’re AIG, they sell insurance
    • They did not understand that entire mortgage bonds could become worthless – almost no one did

A few large buyers came into the market to buy CDS (like John Paulson), and they were not hedgers (no one was back then).  They wanted to capitalize on the impending catastrophe in real estate and they saw this cheap insurance not just as a tool to do it, but as evidence that the crisis was coming – the price of risk was very low.  In their effort to bet against the most toxic of mortgages, there simply not enough new horrible mortgages to bet against.  Enter financial innovation and exactly what Warren Buffet meant when he called derivatives “financial weapons of mass destruction” – The synthetic, sub-prime, mezzanine, negative amortizing, adjustable rate, stated income Collateralized Debt Obligation.

I’ll explain.  We know that a person who sells a CDS gets premium income, and we know that people who buy CDO’s (the bonds) earn income as well.  Now if there weren’t enough of these new bonds to go around, that means that there weren’t enough bonds for people who wanted to own them and for people who wanted to bet against them (at this point, every new issue was matched with buyers of the bond and the swaps – and then they sold the swap liability to AIG [as if AIG sold the swaps themselves]).  There was also another issue; AIG had been a big hole to shove CDS liabilities (all the risk) in to, now there was a need to find more people to take the other side of the CDS trades (sell the insurance).  Naturally, the banks kept some for themselves (as if they didn’t own enough of the bonds).  And then they did what was brilliant – they realized they could take CDS contracts (which pay a premium to the seller) and bundle them together into a kind of synthetic bond.  Every CDS calls for someone who will take the risk of the bond and for someone to sell that risk to them, just like a bond.  The great thing is they could pick any other bond to buy a CDS on, then they put the insurance contract into this ‘synthetic’ (it’s made of insurance contracts) bond, and those insured bonds could already have had insurance (CDS) sold against them.

What I am saying is that we’re now creating risk out of thin air – let’s see how:

  • Here we have a $1Billion mortgage-backed bond (XYZ) and there has been $1billion in CDS insurance sold against it (for $20Million/year)
  • There are no new bonds to insure.  I create a new bond called ABAC – ABAC has no mortgages in it to produce cash flow
  • I sell CDS insurance on XYZ to ABAC.
  • ABAC has now insured XYZ for $1Billion, in exchange for $20Million/year in income
  • ABAC (a bond) is sold to investors [desperate for yield, and knowing their bond is made synthetically], their bond yields them $20Million per year

Now let’s stress test our new model:

  • Home prices stop rising
  • Some adjustable rate mortgages reset, other homeowners are unable to refinance  as planned because their homes haven’t risen in price
  • Homeowners begin to default
  • The $1Billion of mortgages in the XYZ mortgage-backed bond default
  • ABAC and XYZ bond holders lose $2Billion – $1Billion in assets create $2Billion in losses
    • That’s a bubble

Why we haven’t really regulated derivatives?

The first notion I want to put forward is that of ‘arbitrage.’  Arbitrage is the practice of simultaneously buying and selling the same asset to capitalize on a difference in price.  We’ve already discussed that derivatives derive their price from the price [movement] of other assets.  Now, realize all derivatives and/or derivative exchanges are not treated equally under Fin-Reg.  This creates an opportunity for arbitrage – Regulatory Arbitrage.  In this practice let’s say that there is an exchange that is strictly ‘regulated’ for derivatives under Fin-Reg – then we could create a derivative that trades on an unregulated exchange, and whose price is derived from the price of an asset on the ‘regulated’ exchange.  We know have an asset (derivative) that is technically unregulated provides the full exposure of the ‘regulated’ exchange, just without any of those pesky rules.

We still can’t price these things?

To the true issue with this notion of ‘toxic assets,’ we can’t price them – more importantly, in the height of the prices it was difficult to price the bonds that the CDS’s insured; making it impossible to price the insurance.  Stock options are one of the most known types of derivatives, and they came into use in the 1970’s after the development of the Black-Scholes option pricing model.  Today you still see wild irregularities in the option prices of stocks that trade sporadically (like many of the bonds on which CDS are traded), and traders will tell you that option-pricing is an imperfect science – perhaps more an art than a science.  This is a problem when it comes to derivatives as a whole. Theoretically in stocks there can only be so many options contracts as there is stock to be delivered (I’ve seen rare exceptions in ETFs, this year UUP issued more shares following an extremely large call position being purchased), and that limits the potential losses to, says, the market cap of the stock.  In the example of synthetic CDS we learn that we can lose more money than there are assets, by orders of magnitude.  There is no specifically adopted ‘derivative pricing model,’ and if there were it certainly isn’t standardized (firms may not agree on what one asset [or liability] is worth).

Perhaps the greatest danger is that derivatives allow us to create more financial risk that what exists in the world – if there were only derivatives on ‘actual’ assets, bubbles would be infrequent, harder to inflate, and collapse more slowly.  Now imagine you made an investment, but you couldn’t track its price regularly, and you’re surprised to find that after many months you find one day that your investment is worth 30% less than what you thought it had been the day prior.  This was the issue with many of the illiquid bonds those infamous CDS contracts were based on; they traded infrequently, they were believed to be default-proof, almost no one knew what the bonds held, and therefore it was almost impossible to value the bond.  Remember we said that the people who sell the CDS insurance (AIG) look a whole like owners of the those bonds, and the people who bought the ‘synthetic’ bonds knew they were really selling insurance – but those guys thought they were selling blizzard insurance to people in Ecuador – and did so happily.

In Reality….

The fact of the matter is we (as human beings) ignore ‘unlikely’ events in our models, and then manage to be surprised when something “unexpected” happens that lies outside our model.  It’s how insurance companies work, for example; do you think insurance companies have enough capital to pay out all of their policies at any given moment should they all be called simultaneously?  Of course not.  Do you have enough money to pay all of your creditors should they call your ‘marker’ right now?  You don’t have to answer that, but you see my point – when the tide recedes you’ll see whose swimming naked.  The problem today is, almost everyone’s naked and even the people in the water don’t realize that everyone around them is naked too.


Measuring Risk, Weighing Unicorns, and Betting the Farm

Measuring risk is an oxymoron.  Unicorns are mythical creatures that do not [likely] exist, and hence can’t be weighed.  ‘Betting the farm’ is a metaphor for making an extremely large [if not excessive] bet; typically presumed to be risky.  The three notions meld together seamlessly; we can measure risk until we can’t, we can’t measure (weigh) what doesn’t exist [or we can’t find], and we like to make big bets.  But other than in very specific situations (e.g. you can count cards or are otherwise talented, or you got lucky) we’re not good at understanding risk or making good bets more than intermittently – and can’t identify situations when the ‘one time we were wrong’ could hurt worse than all of the times we were right (e.g. I win $1 ten bets in a row, and on my eleventh bet I lose $1000) combined.

But, how much would a Unicorn weigh?

Whether we’re talking sports betting, fantasy sports, stocks, bonds, new businesses, movie productions, or book sales, there is an inherent underestimation of the risks involved in such endeavors.  I’m told that Venture Capitalists, statistically, fare much better than their entrepreneur counterparts.  I am not surprised.  Roughly 90% of new businesses in the US fail (historically – now, who knows?) but, when they work, lookout!!! (See Google)

The point is, in investing in new companies for example, that we could over or under-estimate the risks involved.  Then we might be either unwilling to invest at all in fear of  ‘the odds’ or overly eager to invest because of how huge the ‘payoff’ might be.  Thankfully in the US we don’t have as many people in the ‘unwilling’ camp (historically) and, on the global scene, we’re viewed as the world’s risk takers – i.e. the innovators.  The problem?  As a people, we are not VC firms.  We do not spread a vast number of diversified, yet calculated, risky bets across a wide enough spectrum that we can achieve some margin of safety (and we don’t have the cash to play again to win it back).

How much for the farm?

Someone one once told be to “be wary of salesmen” and then I worked briefly with salesmen; be wary of salesmen.  It’s not because he’s trying to screw you ( he might be), it’s because there is a good chance he doesn’t know what he’s talking about, and there’s a better chance that his interests aren’t aligned with yours.  Equally, be wary of middlemen (the Madoff money-men) – they are salesmen too.  Suspect people who don’t invest their own money.  What does that even mean anyway?? It likely means that they only risk the money of others (risk nothing), and ‘eat’ no matter what.  You don’t necessarily have to be wary of the ‘free lunch,’ but of the person eating it – what did he/she do to deserve eating what you paid for, for free?.

Most CEO’s know next to nothing about the risks their companies face.  Coaches don’t know what their players are up to.  Markets, at any given moment, are inefficient.  That’s right, I said it.  Over time, or on average, markets are efficient [or close to it].  As Warren Buffet says, over the short-term the market is a ‘popularity contest.’  The world reacts, and mis-reacts, to information in knee-jerk fashion.   Point being – the world is not what it seems, mob mentality prevails, we are prone to fads and we usually over-react

We tend to define risk as something tangible that can be understood, categorized, and measured.  That may be kind of true, sometimes.  To me, risk has is what I might not be able to quantify (e.g. the likelihood that something that hasn’t happened [or is very rare] might happen).  Why do I speak of risk when questioning how much to pay for the farm?  Because if I don’t know the farm sits on a fault line I’m likely to overpay for it.  If I don’t know that the farm sits on oil reserves, I’m likely to sell it for less than I should have.  Missing a crack in the foundation is not likely to cost me near as much as either of the preceding two oversights.  The past decade has taught us that markets can stay inefficient for sustained periods of time (see real estate prices 2004-2007 in particular), and that longer the condition exists the greater the inevitable effects seem to be.  The point is that overlooking something that is entirely unlikely can, in our world, have exponentially greater ramifications that overlooking the more ‘obvious’ risk [the fault line vs. the foundation crack].

The lesson should be a different approach to ‘risk management’ [or bet selection], with a focus on determining the scenario that bares the greatest ramifications – regardless of its’ likelihood.  The lesson is not to avoid risk.  The lesson is to focus on what we don’t know, not what we know – it seems very seldom that people are surprised by the obvious risk, and more often that lives are affected by something that ‘could never have been expected.’