Thursday, April 30, 2009

Annihilate the Perverse Effect of CDS

A stable and sustainable economic and financial system should have few positive feedback loops, or as some call pro-cyclic factors. Unfortunately, finance by nature tends to be pro-cyclic, thus the saying about bankers lending out umbrella when it's not raining. So one must be especially watchful of positive feedback mechanism in finance.

One unintended consequence of CDS is exactly the disastrous positive feedback. Bond holders with CDS protection would rather push the company into bankruptcy, as demonstrated by Lehman and Chrysler.

The bankruptcy code, whether by conscious design or not, disincentivize stakeholders from forcing bankruptcy except as the last resort. It achieves this effect by prolonging the process of stakeholder recovery and increasing the cost. This encourages creditors and owners to try to work it out, even through Chapter 11. After all, even though bankruptcy is no moral evil, it's still better to avoid it.

However, CDS changed the game dynamics (to be exact, the change is a compound effect of bankruptcy code change of 2005, which is disastrous in retrospect, and CDS). If you own bond and buy corresponding amount of CDS with physical delivery, you'd want the company to go bankrupt as soon as it shows the first sign of trouble and the bond devalues. You get 100% back on CDS settlement. It's much sooner than the end of Chapter 11, and you get back not only much more than at the end of Chapter 11 but even much more than if you unload the bond right now.

Before you cry "head off CDS", however, please realize it's not necessary to dump the baby with the bath water. As I said many times here before, CDS is just a tool. If it's caused bad effects, blame the people who use the tool or how its use is regulated, not the tool itself.

Here's how to save the baby while dumping the bath water.

If a bond holder also owns CDS, then her economic interest in the debtor is reduced by the protected amount. In bankruptcy court, her say should be reduced accordingly. The hedged interest is transferred to the CDS seller, who could/should replace the hedged bond holder in bankruptcy court.

Simple as that. I'd also argue that a shareholder with option protection should be pro-rated in a similar fashion on shareholder meetings.

There're always complications. For example, a shareholder with CDS protection could be incentivized to drive down the company. Bankruptcy code reform alone will not be sufficient to cover all bases, nor should it be the only tool. But at least it's a good start.

Wednesday, April 29, 2009

USD Can and Will Drop

Recently there's been a wave of blogosphere opinion that USD is a win-win bet. It goes like this: if the world economy gets worse or stays in the dumps, then USD will remain strong, as demonstrated by its performance since Sept 08; if the world economy rebounds, then USD will of course be strong.

It is the "of course" part that I have a problem with. There're two scenarios under which USD will drop, and only one under which USD will remain strong in the intermediate term (a year or two). But even under the last scenario, USD is likely to drop in the longer term.

1. The world economy stabilizes. Make no mistake, we're not there yet. It won't happen until at least the clouds of CEE debt/currency crisis, US/European banking and credit crisis, housing price, unemployment, and consumer demand start to dissipate. But when that happens, the world will be shifting away from USD assets. Furthermore, it is very unlikely that the Fed has enough political will to siphon the massive amount of USD cash it will have printed off the system early enough and fast enough to pre-empt the surge of inflation once the economy stablizes and credit starts to flow again.

2. The world economy stays sickly for years. Under this scenario, the Fed would likely continue printing massive amount of moneyfor awhile. This would put other countries at a disadvantage since nobody else has this kind of monetary leverage. Therefore, they would be increasingly determined to seek alternative reserve currencies. True, right now there is no alternative. But I don't think it's wise to misunderestimate the world's determination and creativity when defending their own economic and strategic interests. When such alternatives emerge, a big part of the world would not feel sorry to abandon USD, a once safe asset abused and discredited by the Fed and US government.

3. As I mentioned above, there're still numerous cloud overhangs. We are quite likely yet to encounter a few more trigger events. Under this scenario, USD would strengthen. But there's a limit to how long the perception of USD being the safe harbor can last. If the crisis mode continues for another year or two, the world would increasingly re-examine the assumption and seek alternatives.

In particular, I find the assumption that China will remain contend sitting in the USD trap laughably arrogant, short-sighted, and lacking imagination. It may happen in the end. But don't take it for granted.It'd take a fundamental shift in US' China policy for China to stop trying getting out of the trap. So far they've talked about SDR, arranged a sleuth of bilateral currency swaps, and piled up on gold. None of the approaches is the end solution. But it'd be foolish not to take their effort seriously.

I've been long USD (against EUR and JPY), gold and TIPS since the beginning of the year. I remain comfortable with all three right now. I trade the intermediate time horizon, from weeks to months. But I'll be ready to flip USD in short order going forward. Against what I don't know yet. We'll find out. But with the wave of opinion of USD win-win bet, I suspect we'll find out soon.

Sunday, April 19, 2009

Random Musings from Dixie Country

It was shortly after midnight. I was sitting in a local 24-hr diner nearby my hotel, ordering my late-night breakfast. I was vacationing in Pigeon Forge, TN, just outside of Smoky Mountains. Dark and quiet outside, a few customers inside, local twang and country music lightly sprinkle the air. It felt like a scene from Sweet Dreams.

And the sausage gravy was awesome.

It brought back memories of my time in West Virginia and Michigan, the small-town USA. And I suddenly realized something odd: where is the recession?

I've been following the recession since before it blew up, circa 4/07. And there's no doubt in my mind that the current stock market rally is a sucker's rally, with a few more time-bombs and either a painfully slow recovery or a bubble/hyper-inflation ahead. But now, out of New York and away from blogosphere and numbers, life around me is as normal as it gets.

Pigeon Forge is a poorman's Disney. Lots of shows and amusement parks, some of which are not bad and many have distinct southern character. Kids love it, therefore I'm happy; besides, I actually enjoyed a few shows. Everywhere is crowded even though it's still far from peak season. Nothing fancy here, but it's solid, good stuff -- food, lodging, convenience, service, entertainment. Not to mention MUCH cleaner than New York city, which is a given everywhere except maybe Detroit. There'll be a car show Thursday. All hotels are sold out for Thursday night. Parkway (yup, just Parkway) is lined up with all kinds of old cars, quite a few American classics such as Camaro Z28 and Corvette Stingray.

I landed in this country in small-town USA. And this is where I first fell in love with this country. There's a charming, romantic deception to the honest, down-to-the-earth quality of small-town USA, I'm aware of it. But I can't help wondering which version of USA is more real, which is more of the root of livelihood and strength of this country.

New York sits on top of the food/value chain of the economy. It's the equities (or junk) tranche of a CDO called US economy. As such, it reaps huge returns in good times and suffers huge loss in bad. Everything about New York is exaggerated, amplified, blown out of proportion -- rich and poor, civility and barbarics, honesty and deception, geniuses and idiots, over-achievers and lazy bums, harmony and conflicts, awareness and apathy, inclusiveness and segregation.

But out here in small-town USA, even I feel safe and relaxed.

The South, however, shows the other schizophrenic nature of this country.

Dolly Parton flaunts patriotism (everywhere in Dollywood and her separate Dixie Stampede show) and internationalism (Festival of Nations) like her left and right tits. But my distinct take-away is that the former is the real theme while the latter is an overture, an effort at best. The deeply rooted contradiction between the two isms was not much of a problem during the good'ol days of American Empire. But as the world changes, the shallow, self-centered and arrogant nature of popular patriotism, or nationalism everywhere else as Americans call it, will become more and more apparent and difficult to reconcile.

Perhaps the most striking demonstration of this contradiction is Le Grand Cirque show in Dollywood. The only whites are girls walking the stage and one male performer; the rest are all Chinese (and although the white performer was nothing spectacular, he was given the center spot during curtsys nevertheless). Is this a symbol of what America has come to, I wondered, whites doing managing and marketing at the top of the value chain while foreigners (mostly Asians and Latinos) do the hard work? (This is not racial, Good Lord knows, but merely an observation of reality, albeit definitely incomplete and anecdotal. Come on, no observation on human society is ever 100% correct. I'm tired of putting up the standard disclaimer on statistics.) It's only a matter of time before others learn how to do management and marketing. Then what do we do? Should I teach my kids to do actual work damnit?

Speaking of Good Lord, the South feels no need for apology when flaunting religion, no more than Dolly flaunting her tits. During the Magic Beyond Belief show, which is very good, the magician spoke during recess, promising not to preach but went ahead and preached about God and all. The audience applauded and amened. One man stood up and walked out with his little girl in arms; I don't know for a fact whether it was a protest but the timing was certainly conspicuous. I didn't mind it. Besides, the show was actually good. But that was about as in-your-face as I could take it before getting annoyed. I suspect many of my Catholic, Jewish, and Muslim friends would feel the same, if not stronger.

So here it is, my first experience in Dixie Country. Very enjoyable, relaxed, romantic, and peaceful as long as I manage not to over-think and poke the hymen of my shallow being.

I'll be back.

As we walked out the magic show to the car, my 7-year-old declared thoughtfully, after a minute of silence: "Dad, I think I have my mind made up."

"About what?" I asked.

"I think we should make this our next vacation place."


The Legal Scam of FASB Statement 159

1. Set up Company, go IPO.

2. Sell $1B bond.

3. Spread rumor of Company's demise. Or better yet, actually run Company almost into ground. Quickly.

4. Buy Company's bond at $40 on $100 par.

5. Book $600M profit, and pocket the $600M extra cash from bond issuance.

6. Retire as a rich hero.

BTW, you don't even need to actually buy the bond in order to book the profit, thanks to the infinite wisdom of FASB (aka FASB Statement 159). Yes, the $600M profit will disappear into thin air by bond maturity, if Company survives, that is. But who cares about next quarter, not to mention 10 quarters later. In any case, the extra cash is real if you manage to drive Company almost into ground faster than spending the bond issuance proceeds.

And if you can recycle these paper as cash through the Fed, you don't even have to worry about financing. Spend the bond proceeds, buy back paper, give it to Fed as collateral for cash, buy back more paper. Zero cost, zero risk, much reward.

This applies to loans just as well, as long as it's securitized and traded on secondary market.

In reality, it takes good research to locate current bond holders and may take some persuasion to buy it from them. But if the gloom looks real enough and you're crafty enough (e.g., gradually over a period of time, through a third-party broker), it can be done without raising too much suspicion.

It gets better. Once you have bought back almost all of your bond, you can set up a phony market price whereever you want.

Companies have actually bought back their bonds on the secondary market. I'm not saying any of them did it intentionally, as outlined above. But this doesn't change the fact that such scams are legal and plausible.

Unless the bond is callable, the issuer should be forbidden to purchase it on the secondary market, be it at discount or premium, and such accounting games cannot be played.In terms of interest rate risk, buying one's own bond from the secondary market is equivalent to having an embedded call option, which otherwise would result in a higher coupon. In terms of credit risk, it is equivalent to selling one's own CDS or life insurance (not considering differences in financing), it doesn't make sense, nor should it be legal, except in the wonderland of modern financial accounting and regulation.

Wednesday, April 8, 2009

Too-Freemarket Has Become Anti-Free-Market

I mean, our financial industry has so overgrown that it has taken over iconic manufacturers such as GM, GE, and Boeing and become their main profit center for years, even decades. It has hired so many traders who don't even understand their own trades, risk managers who blindly throw VAR at everything like snakeoil (or Gaussian distribution, or mean reversion, or my personal favorite, 40% recovery assumption), executives who don't know or even care about what their companies have been doing, programmers who don't understand anything about programming beyond the syntax, and a vast army of middle-management whose only job it is to foward emails and track status. It has hijacked world governments and public policy to such an extend thatthe society has no choice but to bail it out, because it is too big to fail.

But here's the rub: we're making it even more too-big-to-fail.

There is no stronger an advocate of free market and presumed righteousness of market pricing than Wall Street. But when Wall Street's puppet government, across two supposedly ideological opposites no less, insists on using public money to create an artifical market, you know it has gone too far.It has gone straight around the circle of Yinyang and become its own moral enemy, its own Judas.

Free market has committed suicide.

But it gets worse. The Unholy Ghost of Anti-Freemarket is still walking the Earth, preaching the same words to the Great Unwashed Public, who nod and chant in unison: Yeah! Thou shalt not nationalize! Amen! WTF?!

No, that last part was me.

Free market is inherently unstable due to built-in positive feedback, which is in turn due to human greed and fear among other behavioral patterns. This is the source for fat tail or Black Swan. We may never be able to eliminate the instability short of killing free market altogether.But pretending we're still a Freemarket while using public money to create an artificial market is sheer lunacy.

I'm still against government regulation. And what we have now is regulation to the extreme. Instead, we should let banks fail as they may, re-enact Glass-Steagall, and let free market return to Wall Street in the form of private partnership investment banks.

Derivatives is not the problem. The problem is people playing derivatives with other people's money.

Bonus is not the problem. The problem is maturity mismatch between bonus and risk, or letting incompetent managers allocate bonus based not on merit but on personal politics.

Even bubble is not the problem. It's inevitable (instability, positive feedback). The problem is denying the possibility of bubble in the name of omnipotent Freemarket.

Kill Freemarket. Long live the free market.

Wednesday, April 1, 2009

China's Bilateral Currency Swaps: First Step

Before the proposal of replacing USD with IMF's SDR as the world reserve currency, made by Zhou Xiaochuan, China's central banker, China had already made a series of bilateral currency swaps with some neighboring countries, with maturities of up to three years. Now they're extending the arrangement to LatAm.

Here's the list (in Billion Yuan, recent CNYUSD exchange rate 6.835):

Hongkong: 200

South Korea: 180

Indonesia: 100

Malaysia: 80

Argentina: 70

Belarus: 20

According to a prominant economist in Beijing, these swaps serve dfferent purposes for each counter[arty country: for Hongkong, it's to prepare for the pending sale of Chinese T-bills there; for South Korea, it's for helping Korean companies raising capital in China; for Belarus, it's because Belarus wants to take CNY as their foreign reserve; for the rest, it's for settling bilateral trades (companies pay in the trading partner's local currency).

The implications are very intriguing:

1. The official line on the rationale behind these swaps is to reduce forex risk and trading cost. This is a valid point.

2. It offers support for currencies under downside risk. This applies to all except HKD.

3. It serves to diversify China's foreign reserve, albeit only a small percentage (5%) so far, away from USD and to align the composition better with trading partners.

4. Perhaps most importantly, the real meaning is that these are the first concrete step toward a post-USD world. The world trade cannot be based on bilateral currency swaps, to be sure. And CNY has a long way to go before it can become a world reserve currency. But as a transition, this certainly beats bartering, which has been remerging among countries and individuals.

Whether this will be brought up in the G20 summit remains an interesting question.