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HomeBasis Risks Will Lead to Future Financial Frauds
Posted by Larry Doyle on August 5th, 2009 8:24 AM |
How often have we heard from those involved in financial frauds that they never initially intended on perpetrating a fraud? Well then, what did they intend? Having personally witnessed more than a handful of ‘under the radar’ frauds in the form of intentional misrepresentations of investment values, the activity often centers on a financial term known as ‘basis risk.’ What is basis risk? Why do I think our current financial system has numerous financial frauds germinating?
Utilizing our friendly Investing primer (found in the right sidebar here at Sense on Cents), we learn that basis risk is defined as:
The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.
Or similarly,
Offsetting vehicles are generally similar in structure to the investments being hedged, but they are still different enough to cause concern. For example, in the attempt to hedge against a two-year bond with the purchase of Treasury bill futures, there is a risk that the Treasury bill and the bond will not fluctuate identically.
I have no doubt that a number of financial firms entered into hedging strategies over the last 9 months that present massive basis risk. While these financial firms own an array of individual investment positions (corporate, municipal, mortgage-backed, commercial mortgages, asset-backed, equities), the hedging vehicle utilized is often an index of some sort which is representative of an entire market segment or, in the case of a specific corporate entity, the CDS (credit derivative swap) for that company.
As financial firms move forward, they manage their investment positions and their hedges accordingly. Do not forget, however, that last Spring the FASB (Federal Accounting Standards Board) relaxed the mark-to-market accounting standard so banks could delineate between true credit impairments in their investments and liquidity risks.
While not every firm may have entered into hedging strategies, it is naive to think many did not given the perilous price action in the markets over the last 9 months. Fast forward to the current period and we see the SEC is seriously concerned with these issues, as well they should be. CFO Magazine reports, The SEC’s Most Wanted:
Last fall the Securities and Exchange Commission promised to scrutinize the regulatory filings of the largest financial institutions. So it’s little wonder that many of the recent comment letters sent by the SEC to corporations focused on the more controversial accounting issues that cropped up during the current financial crisis, including valuations of financial instruments and other-than-temporary impairments of securities.
The regulator has also niggled nonfinancial firms, by asking finance executives to better explain how they worked through goodwill impairment testing. Brad Davidson, a partner at accounting firm Crowe Horwath who recently compiled a list of frequent topics cited by SEC staffers in comment letters, says finance executives should keep the points raised by SEC staffers in mind as they put the finishing touches on their next round of financial reporting.
While firms may be able to disguise the hidden losses and embedded risks for a period of time (which can be extended, depending on the size and scope of the operation), basis risks have brought more so-called outstanding traders, portfolio managers, CIOs, and CFOs to their knees than they would ever care to admit.
Any readers who have direct or indirect experience with basis risks please share.
LD
‘Cash for Clunkers’ or ‘Ask Us No Questions, We’ll Tell You No Lies’
Posted by Larry Doyle on August 4th, 2009 3:31 PM |
Instinctively, I am very suspicious of how $1 billion was spent on the ‘Cash for Clunkers’ program within such a short time frame. As such, is it unreasonable to ask for an audit of this program prior to allocating more funds? Who is to say that some degree of misappropriation, if not outright fraud, has occurred?
Whose money is being allocated? Yours and mine. I want an accounting. Who is supposed to protect our interests? Our elected representatives. They must be held accountable.
Perhaps there has been no fraud or misappropriation in the allocation of these funds. Perhaps administratively this program is overmatched by demand. If so, those administering the funds should swallow their pride and say as much.
I find it totally unacceptable, though, that upon request those in Washington overseeing this program can not give a timely and accurate accounting. As the Associated Press reports, Obama Administration Withhold Data on Clunkers:
The Obama administration is refusing to quickly release government records on its “cash-for-clunkers” rebate program that would substantiate — or undercut — White House claims of the program’s success, even as the president presses the Senate for a quick vote for $2 billion to boost car sales.
The Transportation Department said it will provide the data as soon as possible but did not specify a time frame or promise release of the data before the Senate votes whether to spend $2 billion more on the program.
We deserve so much better!!
LD
Wall Street vs Main Street: The Great Divide Widens
Posted by Larry Doyle on August 4th, 2009 8:01 AM |
Please rank the following professions in terms of commanding respect:
1. used car salesmen
2. lawyers
3. Wall Street
4. dog catchers
5. burglars
6. politicians
Plenty could argue that dog catchers would command the most respect, with burglars a distant second. How so? At least you know exactly what their intentions are, admirable or not, and manage accordingly.
With all due respect to quality individuals in the other professions, those industries as a whole have always suffered from a very poor public perception.
Moving to the fully serious part of my writing this morning, I would venture to say that the chasm which has always existed between Wall Street and Main Street has never been wider and is widening by the day. How so?
I am being inundated regularly with comments and questions as to whether the market is truly representative of the fundamentals in the underlying economy. Others have asked me how an industry that is supposedly once again making sizable profits can shamelessly impose credit card rates of upwards of 30%!!
It is my sense that the American consumer and investor feels woefully neglected at this point in our country’s history. As such, I have little doubt that many people have exited the markets with the intention of NEVER returning.
I would not pretend that I can appreciate the level of anxiety and disgust of everybody in our country today, but I share your contempt for a crowd both in Washington and on Wall Street that has done little to nothing to protect your interests.
This contempt welled up this morning as I read The Wall Street Journal’s, Geithner Vents at Regulators as Overhaul Stumbles:
Treasury Secretary Timothy Geithner blasted top U.S. financial regulators in an expletive-laced critique last Friday as frustration grows over the Obama administration’s faltering plan to overhaul U.S. financial regulation, according to people familiar with the meeting.
The proposed regulatory revamp is one of President Barack Obama’s top domestic priorities. But since it was unveiled in June, the plan has been criticized by the financial-services industry, as well as by financial regulators wary of encroachment on their turf.
While I could wax poetic on the topic of regulatory reform, I will abbreviate my remarks with a very succinct and direct statement: “THESE PEOPLE DON’T GET IT!”
The fact remains, “Future Financial Regulation: Not a Question of Sufficiency, but of Transparency and Integrity.”
Does the American public understand how thay have been abused by both their political and banking representatives? I strongly believe they are gaining a greater awareness of this phenomena every day.
In coming full circle, my respect rankings from top to bottom would be:
1. dog catcher
2. burglars (at least you know their intentions)
3. used car salesmen
4. lawyers
tie for 6th between politicians and Wall Street
How about you? Please share your thoughts and rankings!!
LD
Navigating the Bond Market
Posted by Larry Doyle on August 3rd, 2009 12:16 PM |
Where should people invest these days?
Are we to believe the price action in the equity markets?
With short term rates on CDs and money market funds ridiculously low, where does one turn to make a safe investment with limited risk?
Prior to putting any money to work, always make sure you look at an investment in the context of an overall portfolio. Diversity and prudent risk management never go out of style and should be the cornerstones of any portfolio.
Sense on Cents recommends short to intermediate bond funds. I am concerned about longer maturity interest rates moving higher (in fact they have moved considerably higher this morning). As such, I would stay away from bond funds with longer maturities in the underlying investments.
What are some of the road signs investors should look for in navigating the bond market? The Wall Street Journal provides a very handy overview this morning, The New Bond Equation:
As the financial crisis heads into its third year, investors in bond funds are facing some difficult choices.
Investors usually turn to these funds for safety. But bond funds are facing a host of pressures that are driving down returns, raising long-term risk—and making it tougher to settle on the right investment strategy.
Let’s navigate!
1. Default Risk
Do not be presumptuous and think the portfolio manager is carefully managing individual exposures in a bond fund. Investors need to look into the actual portfolio of bonds and ask brokers or financial planners on questionable credits.
2. Interest Rate Risk
In the presence of a massive fiscal deficit and the likelihood that the deficit will grow, interest rates are likely to head higher. A rising rate environment means declining bond values, which is why I recommend short to intermediate maturity bonds which will be less impacted.
3. Passive Investing via Index Funds
Maximize diversity and minimize expenses.
4. What About the Perils of Inflation?
Gain some exposure to TIPS (Treasury Inflation Protected Securities) and commodity funds.
5. Should Investors Try to Time the Market?
Sense on Cents ALWAYS recommends a dollar cost averaging or value averaging approach, in which an investor puts in a set amount of money every month. NO investor or portfolio manager is so good as to pick the top or bottom in a market, despite what you may hear.
Discipline is critical every step of the way. Do your homework prior to investing. Make sure the execution at point of investment is handled properly. Monitor your investments as you move forward.
LD
New York Times ‘Kisses’ Raymond James on Auction-Rate Securities
Posted by Larry Doyle on August 2nd, 2009 3:34 PM |
My heartbeat accelerated this morning upon reviewing page 2 of The New York Times. As I perused the headlines of the lead articles, I saw Investors Without a Lifeline in the Sunday Business section. Could this be the article that would fully expose the fraud involved in the sales and marketing of Auction-Rate Securities? Would investors finally get some satisfaction in publicly exposing all those involved in Wall Street’s greatest fraud?
While I am heartened by any public attention regarding the ARS fiasco, this report by The New York Times falls woefully short. Let’s reveal color and analysis that The New York Times and every other credible business outlet should feel obligated to provide. In doing so, I can only hope that investors still holding ARS, whether sold by Raymond James or any other entity, can move one step closer to a return of their capital along with interest and penalties.
The New York Times hardly lands a blow on Raymond James in the ARS fiasco. In fact, I would define the reporting as the equivalent of a ‘kiss’ in what should be a brawl. The reporter, Gretchen Morgenson, does not even venture to ask who is supposed to protect investors before making an investment or a lifeline after the fact. The answer to those questions are the SEC and FINRA (Financial Industry Regulatory Authority).
While Raymond James has $800 million in ARS exposure, that figure only represents approximately .5% of the total outstanding exposure. Why does Ms. Morgenson focus strictly on Raymond James and not the entire industry? (more…)
Reminder: Sense on Cents Interviews Joe Saluzzi Regarding High Frequency Program Trading
Sunday Night at 8PM
Posted by Larry Doyle on August 1st, 2009 7:40 PM |
UPDATE: The show has concluded. Please utilize the following link for a full Review of Sense on Cents Interview with Joe Saluzzi on High Frequency Trading .
Or you can listen to a replay using the audio player below. We had some technical difficulties at the start of the show, so advance the audio player to the 8 minute, 57 second mark, at which point the show begins.
***********************
High frequency program trading is the single hottest topic on Wall Street today. No individual has generated greater focus on this topic than Joe Saluzzi of Themis Trading.
I look forward to interviewing Mr. Saluzzi this Sunday evening, August 2nd from 8-9pm on NoQuarter Radio’s Sense on Cents with Larry Doyle.
This show will comprehensively cover the gamut of issues and topics involved in this highly controversial trading activity. Does high frequency program trading engage in front-running? Are retail and institutional investors disadvantaged? Are the exchanges and regulators looking the other way? What were the developments in the marketplace which brought us to this point?
NQR’s Sense on Cents with Larry Doyle will address these questions and more with the man ‘in the arena’ and at the center of the debate, Joe Saluzzi.
The show is available as a podcast on iTunes, and also archived in an audio player right here at Sense on Cents so it should serve as a tremendous informational resource as we continue to navigate the economic landscape.
Please share with friends and colleagues.
LD
Related Sense on Cents Commentary:
“High Frequency Trading Debate: Mano a Mano” July 24
“Is Uncle Sam Manipulating the Equity Markets?” July 1
July 2009 Market Review
Posted by Larry Doyle on August 1st, 2009 12:20 PM |
In the process of reviewing price action across the entire spectrum of global equity, bond, and commodity markets, I am struck by one simple fact: virtually every market segment went up in value in July. That sort of price action in a challenged economy is uncommon, if not irrational.
Is this price action a sign of an incipient turn in the economy? Will we continue to rally? Are we going to have a V-shaped recovery? Come on back in, the water’s fine? What recession? Hardly.
I continually see the battle royale between the bulls and the bears in the markets. I truly believe we are entering into a new global economic norm and, as such, before we are able to thrive we need to survive. Thus, in my opinion, while others may consider themselves bulls or bears in terms of the markets and economy, I would classify myself as an animal which wants to aggressively survey the landscape, strengthen my reserve, increase my store of value (savings), and judiciously put some small stakes (investments) to work knowing that there remain real risks on the horizon. For lack of a better term, call me a friendly fox.
Without further delay, let’s assess the July 2009 Market Review:
I have added a few indices to take a more comprehensive view of the markets. These indices include: DJ-Global ex U.S., an emerging market index (MSCI), a commodity index, and a U.S. dollar index. I hope readers find these helpful.
Let’s grade my calls from last month, at which point I wrote: (more…)
IMF Sees U.S. Risks Tilted to the Downside
Posted by Larry Doyle on July 31st, 2009 11:38 AM |
The 2nd quarter GDP report this morning is surprisingly strong at a better than expected -1%. Are we supposed to disregard the significant downward revision (-5.5% to -6.4%) for 1st quarter GDP? Can we go somewhere to get an unbiased macro view of the U.S. economy?
It just so happens the International Monetary Fund released a review of our domestic economy this morning. This report, United States: 2009 Article IV Consultation, provides a rather sobering outlook as we continue navigating our economic landscape.
What do we learn?
>>financial strains are still elevated and the outlook remains for only a gradual recovery, with risks still tilted to the downside.
>>Policies under the Financial Stability Plan, notably the SCAP stress test, debt guarantees, and capital injections, have contributed to a significant improvement in financial conditions. However, risks persist, notably the risk that a prolonged recession could further erode capital. This situation warrants continued close monitoring and regular stress tests to evaluate vulnerabilities. The proposed reserve for stabilization funds should be retained, with the resolution framework for systemic nonbanks expeditiously implemented to improve the predictability and flexibility of crisis management. Balance-sheet cleaning remains a priority; the PPIP will provide a tool, although its usage may be limited. Recent steps to facilitate mortgage modifications are welcome, but more steps may be needed to encourage writedowns of underwater mortgages.
>>Monetary policy should remain highly accommodative until recovery is clearly underway. If downside risks materialize, additional credit easing and a strengthened commitment to maintaining a highly accommodative stance could be deployed. Additional fiscal stimulus could also be used, provided it were set within a credible medium-term fiscal framework.
>>For the Fed, a diverse set of tools will be needed to afford maximum flexibility in light of uncertainties about how market conditions will evolve and about the extent to which particular instruments can be used. In addition, Maiden Lane facilities should be transferred to the Treasury at an early stage, to reduce the Fed’s exposure to credit risk. On support to financial institutions, terms should be tightened on facilities that need to be extended, to avoid distortions, fiscal risks, and governance issues. Clear communication of the strategy would bolster market confidence, and international coordination will be warranted as well.
Recall that Maiden Lane was a facility used by the Fed to house Bear Stearns assets in the process of JP Morgan’s takeover of that firm. Sounds like the IMF has some concerns! (more…)
‘Cash for Clunkers’ Comments and Questions
Posted by Larry Doyle on July 31st, 2009 2:51 PM |
Uncle Sam just spent $1 billion via the “Cash for Clunkers” program over a 4 day time frame. Given the speed of that burn rate, The Wall Street Journal reports, House Votes to Extend ‘Clunkers’ Program.
A few questions and comments:
1. The National Highway Traffic Safety Administration is overseeing the disbursement of these funds. Think there may be a chance of some kickbacks or fraud going on here? Who is checking?
2. Assuming the average list price of the fuel efficient vehicles being sold is $20k, the subsidy of upwards of $4500 is approximately a 20% discount. Is this a true reflection of latent demand or partially a reflection of consumers responding to a gift?
3. What does this program do to the used car market? If I am in the market for a used car, my bid just went down at least 10% if not more.
4. How does this program affect the less fuel efficient car market? Does it strip demand away from that segment?
5. If there is such demand for the Cash for Clunkers program, should there be further restrictions on who may be able to benefit from this program going forward?
6. Given the speed with which the initial $1 billion was utilized, do you think there is a chance car dealers are working other deals with customers?
Not to be overly cynical, but as an industry car dealers do not exactly enjoy the best reputation. As such, while Congress can approve more funds, I would like to see a thorough audit of this program prior to the actual allocation of those funds.
Thoughts and comments welcome.
LD
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