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Basis 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.


Economy and Markets: Improving, Declining, or Adapting?

Posted by Larry Doyle on July 29th, 2009 3:35 PM |

While the dark economic storm clouds of 2008 may have passed, the economic outlook and landscape remain decidedly mixed as evidenced by the recently released Federal Reserve Beige Book. The key takeaways in this report include:

>> slower pace of overall economic decline

>> expectations of a moderate recovery in manufacturing in 6-12 months

>> extended soft labor market

>> sluggish retail sales

>> commercial real estate weakened in most regions

>> some pockets of strength in technology and health care

>> credit conditions remained extremely tight. Loan demand experienced a downturn, particularly from the household sector. Credit standards continue to tighten as delinquency rates are steady to higher.

>> a pickup in used car sales (don’t think this is a positive)

Bloomberg reports Fed Says Most Districts Report Slower Pace Decline:

The Beige Book provided few signs of outright growth. Retail demand was “sluggish” in most areas, with “mixed” auto sales. Non-financial services were “largely negative” with “a few bright spots,” and manufacturing was “subdued” yet “slightly more positive” than in the previous report, the Fed said.

Lending in most regions “was stable or weakened further” in most loan categories, and banks tightened credit standards in seven districts, the report said.

While most economists and market analysts are looking at statistics and data to determine whether the economy and consumers are improving or rolling over, my take is different. I view the economy and consumers as adapting to the new dynamic at work in our country. The color about consumers purchasing more used vehicles is a perfect case in point.

Automotive companies aren’t going to prosper with consumers purchasing more used vehicles, but consumers will continually look for means to save money and keep expenses down.

In regard to market news, this morning I addressed concerns in a post,  “What is China Saying? Sustainability and Indirect Bidding,” regarding the level of indirect bidders in our Treasury auctions. I wrote of yesterday’s 2 yr note:

While Chinese officials made these strong statements regarding our deficit, the U.S. Treasury auctioned $42 billion in 2 yr notes. How were these notes received? Not very well. In fact, the indirect bidders only purchased 33% versus close to 69% a month ago.

Today’s $39 billion 5 yr note was not well received, either. Indirect bidders purchased 37% versus 63% a month ago.

As we continue to navigate our economic landscape, I remain convinced that those who are able to most effectively adapt to the dynamic changes will be in the best position to thrive as we move forward.

What do I mean by adapting? Continue to work to keep expenses down, be judicious and disciplined in your investments, and be voracious in terms of absorbing data on the economy, markets, and companies.

It goes without saying a healthy dose of Sense on Cents as part of your daily diet is also strongly recommended!!


Obama and SEC Should Check FINRA’s Dirty Laundry

Posted by Larry Doyle on July 10th, 2009 4:50 PM |

Quiet, clean, effective organizations don’t need major advertising campaigns. Their professionalism and demeanor speak volumes.

Why does FINRA feel it needs to now advertise aggressively? As any individual knows, the best form of advertisement is word of mouth. If FINRA, and its parent organizations, had performed over the years, they would not now be in the position of having to spend a dime on advertisements.

Against that backdrop, President Obama is throwing around some heavy artillery on the financial regulatory front. I feel strongly that we do not merely need some new weapons, but much more so new generals and a new financial regulatory structure overall.

Bloomberg highlights, Obama Seeks Power for SEC to Prohibit Wall Street Pay Practices:

The Treasury Department today sent Congress legislation that would let the SEC ban “sales practices, conflicts of interest and compensation schemes” deemed harmful to investors. The measure authorizes the agency to remove individuals who violate rules from all aspects of the industry, rather than just a specific segment such as selling securities or managing money.

Who is charged with protecting investors? FINRA.  If FINRA had been performing, would new legislation even be necessary? No way. Rather than new legislation, how about we have a new regulatory body that is not funded by Wall Street firms. Dissolve FINRA and restructure it.

Bloomberg continues:

President Barack Obama’s SEC proposal is part of the overhaul of financial regulations in response to the worst economic crisis since the Great Depression. Lawmakers have vilified securities firms for selling investors unsuitable products and basing pay on how many transactions bankers execute without regard to whether deals succeed in the long term.

Unsuitable products? None more unsuitable and fraudulently distributed than our favorite, that being Auction-Rate Securities.  Last we checked there are still thousands of investors with approximately $165 BILLION ARS frozen.  Dissolve FINRA and restructure the regulatory oversight of Wall Street.  Expose all the firms involved in the ARS fraud, including FINRA itself!!

Bloomberg addresses another hot topic:

The plan targets mandatory arbitration agreements, granting the SEC power to prohibit them in contracts consumers sign with brokers, investment advisers and those who sell municipal bonds. Mandatory arbitration bars customers from suing financial professionals in court.

Who is charged with overseeing arbitration? You guessed it…FINRA. If  all these problems exist within the space FINRA is charged with overseeing, perhaps the problem is as much the overseer as those overseen. Sense on Cents feels strongly that without implementing a dramatic structural change of FINRA, we will largely run in place.

Bloomberg finishes by reporting:

The measure gives the SEC authority to reward whistle blowers who give the agency tips about those violating all securities laws. The SEC currently has power to pay individuals who provide the agency with tips on insider-trading violations.

Retroactively, the SEC should find some manner for rewarding Harry Markopolos for displaying the guts and integrity in pursuing the Madoff scam.

In regard to the ARS scam, perhaps the SEC could send a strong signal to ARS investors by compelling FINRA to release all the details on the sale of its $647 million ARS position in Spring 2007.  If the powers that be at the SEC are unaware of FINRA’s liquidation of ARS, just ask their boss Mary Schapiro, who came from FINRA.

For what it is worth, the SEC still has not responded to my communication with them addressing all these topics.

While Barack, Turbo-Tim, and team want to arm the SEC and in turn FINRA with new tools to cleanse the system, they may want to start by checking  the dirty laundry within FINRA itself.


Housing: Cheap and Getting Cheaper

Posted by Larry Doyle on May 26th, 2009 10:59 AM |

housing-market1The Case-Shiller Home Price Index was released this morning and disappointed with a worse than expected reading of -19% versus a year ago. Relative to the 4th quarter 2008, home prices nationwide are down 7.5%.

Are home prices continuing to decline despite the support of a variety of government programs or perhaps because of them? What do I mean? Any market – whether stocks, bonds, currencies, commodities, or housing – is constantly trying to assess both current and future demand and supply. Potential buyers or investors can most accurately assess the value of an asset when provided with full and accurate information.

In my opinion, our housing market is suffering from the unknown supply of homes – currently involved in a mortgage modification process – that will likely hit the market in the future due to foreclosure. The fact is that the ultimate default rate on many of the homes involved in a mortgage modification is extremely high. As the Wall Street Journal highlights this morning, Mortgage Modifying Fails to Halt Defaults:

A key finding from the Fitch report was that subprime, pooled loans that have been modified are souring at high rates despite a change in the loan terms. Fitch said a conservative projection was that between 65% and 75% of modified subprime loans will fall 60-days or more delinquent within 12 months of the loan change. That finding echoes prior U.S.-bank-regulatory agency reports of high redefault rates for modified loans.

The Fitch report said one reason for the high redefault rate was public pressure to modify loans even for borrowers who were likely to default whether the loan terms were changed or not. Fitch said another cause was falling home prices. Ultimately, these homeowners, deep underwater, walk away from the home, resulting in the redefault of a loan.

The simple fact is a significant percentage of the loans being modified NEVER should have been written in the first place. Modifying these loans merely forestalls the home from being foreclosed and sold. I do not believe government officials have real appreciation that this forestalled supply actually puts further pressure on housing overall. Why? The market is not being allowed to “clear,” a process in which an asset is moved from weaker hands to stronger hands. To wit, I believe we will continue to see ongoing declines in home values on a going forward basis.

A Look at Case-Shiller Numbers as provided by the WSJ:

“The tone of this report was clearly weak, and it comes at a time when markets were beginning to sense and price in (perhaps prematurely so) a stabilization in the U.S. housing market,” said Millan L. B. Mulraine of TD Securities. “Despite the encouraging signs that have been coming from the other housing market reports, we continue to highlight the risks that the correction in the U.S. housing market may continue for some time as the worsening labor market conditions and historically high inventory of unsold homes continue to off-set the favorable affordability conditions.”

That overhang of inventory will be perpetuated via the mortgage modification process. A full numerical chart highlighting the dynamics within respective metro regions is quite interesting. Not sure why Minneapolis is showing the greatest declines. Anybody who can provide color on the situation in MN, it would be deeply appreciated. Away from that, the other locales suffering the greatest declines continue to be in the obvious areas (Detroit, Las Vegas, Phoenix, Miami).  Charlotte, Dallas, and Denver are displaying signs of stability.

Please share insights on housing in your region!!


(About the numbers: The Case Shiller indices have a base value of 100 in January 2000. So a current index value of 150 translates to a 50% appreciation rate since January 2000 for a typical home located within the metro market.)

Home Prices, by Metro Area

Things You May Have Missed

Posted by Larry Doyle on April 7th, 2009 10:08 AM |

The stream of data and market moving news is non-stop. I found these items of interest and look to share them with you as I believe they provide interesting insights and perspectives from around the world. I beg your indulgence if some of these items are not news to you, but if they are I hope they help you “navigate the economic landscape.”

1. Australia’s central bank cut its overnight lending rate to 3%, the lowest level in 49 years. While that rate is one of the highest rates in the developed world, it was widely expected to be left unchanged.  Australia has had one of the strongest economies in the world. This cut is an indication the Australian central bank believes their economy is slipping into a recession.

2. Japan’s exports are reported to be down 40% versus a year ago. Additionally, Japan’s industrial production is reported to be down 30+% during the same time period. These economic figures are significantly weaker than most other developed economies. As a frame of reference, most other developed economies’ industrial production is down 10-15%. Clearly, Japan is so dependent on exports and it is now paying the price of not having more fully diversified its economic foundation.

3. Gold is now trading near $880/oz. A month ago this precious metal was trading slightly above $1000/oz. Why is gold down recently? Coming out of the G-20, there are expectations that the IMF may sell some gold reserves to raise funds for low-income countries. I commented the other day that gold is not perfectly correlated with inflation due to changing fundamentals and technical variables in the gold market. This development with the IMF is a perfect case in point of my assertion. (more…)

Economic/Market Highlights 11/5….Biggest Post Election Slump in History!!

Posted by Larry Doyle on November 6th, 2008 7:00 AM |

Today’s 5-6% market selloff is the biggest post-election slump in history. If you think the markets aren’t nervous enough already, the prospects of a Democratic Congress and White House added fuel to the fire.

I fully appreciate that the campaign and election captivated our hearts and minds and souls over the last days, weeks, and months. To that end I refrained recently from regular economic/market posts so as not to distract from the main focus. Against that backdrop, though, we all have bills to pay so back to work we go.

Our economy remains mired in a slump that I expect to only get worse over the next few quarters.

–Jamie Dimon, the CEO of JP Morgan cautioned employees in Hong Kong that he does not foresee an economic recovery until 2010. JPM is currently the strongest banking institution in our country and has business in virtually every sector of commercial and investment banking. Dimon is sending a message to not only employees but even moreso to shareholders as to what he expects. We should all heed what he says.

–Dallas Fed governor said that he does not expect to see a positive GDP report until 2010. (more…)

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