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Killing it like a hooker in Hong Kong

Singapore’s problems

Minister for Foreign Affairs George Yeo on the SPG culture

Minister for Foreign Affairs George Yeo’s Interview with Astro Awani Television on 4 February 2008

Q: Of course. So what are your comments then on generally people coming into Singapore? As you said it’s a city-state, you have got limited resources and then you are going to have this sporting event that will bring thousands and thousands and thousands of people. I mean it’s great for business but will Singapore be able to cope with it?

Minister: That’s a problem that we have got to solve. This is not a theme park, this is home for us. [] And Singaporeans sometimes get upset by this because prices go up or foreigners have habits which we are not familiar with, they make friends with our girls, I mean so there are all kinds of problems which we face because we are opening up even more than before. [] You open the windows, the flies come in, and of course you also get fresh air and the sunshine.

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April 3, 2008 Posted by | Singapore | , | 1 Comment

Misnomers: Hedge Fund and Private Equity

The terms hedge fund and private equity are probably the most mistakenly used in the finance vocabulary today. The industry has grown much faster than the public’s capacity to understand it, and not a day goes by without a newspaper columnist, layperson or well-meaning friend makes remarks that make me cringe at the generalizations made of an enormously complex industry.

Private Equity: Traditional private equity was precisely that, all it meant was investing in the shares of non-publicly traded companies. It relied on fundamental equity analysis to identify companies which were not large enough to be listed, but had great prospects. However, over time, a number of strategies began to emerge as the market outperformers during some cycles. These included

LBOs: Where a minimal amount of equity is used to take an inefficient public company private, using a large amount of debt. The idea is really that the public company has a baseline of cash flow even when it is inefficient, and this can support the debt. Any improvement in the company’s prospects is upside to the equity, the PE sponsor.

VC: Venture capital, another mangled term, means one of two things. The first, which is commonly associated with the VC term is really funding of early and middle stage technology companies. Exits are usually based on strategic sales or IPOs and these firms take on very little debt, as the tech companies usually do not have cash flows to support it. The lesser known use of VC, is really traditional seed funding of businesses, such starting up a hotel, a small manufacturing company, etc. But most people tend to ignore this aspect of VC, even though it is the far larger market for funding.

Hedge Funds: The traditional use of the hedge fund term would probably apply to strategies which have been around as long as a stock market existed. The initial, essential idea was that a money manager could short one security, while being long another, and this would help him make money regardless of where the market ended up going. In contrast a long only manager is a slave to the vagaries of the market. Even if you made a good bet, a market downturn would put you in the red. Over time of course, many strategies sprang up around this concept of long/short:

Risk Arbitrage: Legalized insider trading. Wait till a merger is announced. The price of the target moves close to offer price, the price of the buyer moves lower due to dilution concerns. The HF will start calling up his buddies in banking, accounting, law firms, brokerage desks to see whether the merger has a good chance of happening. After getting all the market rumors, from whether the shareholders of both firms are keen to whether the bankers are able to fund the deal, the HF decided whether or not the acquisition will go through. If so buy target, short buyer. If not, the converse.

Convertible Arbitrage: One of the most successful strategies, and has produced some of the big names of our times including Och-Ziff, Fortress and Citadel. A convertible is essentially a bond which can be converted to equity at a certain stock price. You’re protected on the down side by the bond like features, and get the equity upside if things go well. There are a number of mathematical trading strategies to realize profits over short periods of time due to the volatility of the stock. Plus margin leverage at up to 10:1 with some brokers.

Distressed Debt: Buy up the debt of a company in distress or unable to pay its loans. Pay40 cents on the dollar. Short the stock at the same time if you think company is heading into bankruptcy. Used the legalized insider trading and market rumor system to make short term profits over the bankruptcy process. Alternatively, propose a restructuring plan which rewards you with 80,90,100 cents on the dollar while the shareholders get wiped out. This strategy has been inconsistent over time. Similar to risk arbitrage. Just as you need a bull market for mergers to occur, you need a bear market for distressed.

Credit Trading:  Perhaps the most technical off all the HF strategies. It’s all about exploiting different values of fixed income instruments based on risk perceptions, maturity, spread, duration and currency. Complicated, and usually depends on leverage from prime brokers to amplify small price differences. Think Long Term Capital Management.

Quantitative Trading: Engineer builds computers. Puts in all the data in the world. Computer crunches historical numbers, tell Engineer what to buy and sell. Essentially  something like “Buy gold when Japan yen bonds yield x”. Requires liquid markets, lots of fast computerized trading. This strategy ran into trouble recently because all the Engineers read the same books and went to the same schools.

Commodity Trading: What started out as a system for mid western farmers to lock in profits by agreeing to sell their crop three months in advance is now a multi billion dollar HF industry. Guys trade options and forwards as well as physicals (I will ship 100m barrels of oil to you in Hamburg by next week). Names like Glencore, Ospraie, Olam, Philipps Brothers, Red Kite Metals

Welcome to a new world

And that’s just the beginning. What most laypeople fail to understand when they lump hedge funds together is the world of difference between what the various strategies do and who these people are.

An Australian Glencore trader who goes to a coal mine in Newcastle, buys 1m tonnes of coal, and then ships it to China where a power plant in Shenzhen would be forced to shutdown and create a blackout if it didn’t get coal on time.

is very different from

An equity long/short guy who sits at a Bloomberg terminal in a dingy building in Hong Kong, listening to endless company calls for these small mainland Chinese companies, buying stock in them while being short the market.

The skill sets, the risk-return, the value to society, the actual people, personalities, are all completely different.  The difficulties of the job, the people they communicate with, whether they build a business or just do some trades.

So hedge funds as a whole are never going to go away, and are never going to implode. Individual funds, certain strategies, at certain times, will perform badly. Like in any other industry, there will be some instances of fraud. But the only consistent thing about the industry is allowing a small number of people to play with large amounts of money and get paid like stars.

April 3, 2008 Posted by | Hedge Fund, Private Equity | , , , , , , , , , , , , | 1 Comment

George Soros: False ideology at the heart of the financial crisis

Great article from George Soros about the current state of affairs. Seems like he believes the 6% gain in my portfolio from mid March is a true dead cat bounce. I think another 6 months is going to bring us to the proper brink of the crisis. We’ll see.

The proposal from Hank Paulson, US Treasury secretary, for reorganising government regulation of financial institutions misses the point. We need new thinking, not a reshuffling of regulatory agencies. The Federal Reserve has long had authority to issue rules for the mortgage industry but failed to exercise it. For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief. The innovations remained unregulated because authorities believe markets are self-correcting.

Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system. When the subprime mortgage crisis erupted it revealed all the weak points. Authorities, caught unawares, responded to each new disruption only after it occurred. They lacked the ability to foresee them because they were in the thrall of the market fundamentalist fallacy. They need a new paradigm. Market participants cannot base their decisions on knowledge, or what economists call rational expectations. There is a two-way, reflexive interaction between the participants’ biased views and misconceptions and the real state of affairs. Instead of random deviations, reflexivity may give rise to initially self-reinforcing but eventually self-defeating boom-bust sequences or bubbles.

Instead of reshuffling regulatory agencies, the authorities ought to prepare for the next shoes to drop. I shall mention only two. There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed’s decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.

The other issue is rising foreclosures. About 40 per cent of the 6m subprime loans outstanding will default in the next two years. The defaults of option-adjustable-rate mortgages and other mortgages subject to rate reset will be of the same order of magnitude but occur over a longer period. With single family home sales running at an annual rate of 600,000, foreclosures will overwhelm the market and cause prices to overshoot on the downside. This will swell the number of homeowners with negative equity who may be tempted to turn in their keys. The fall in house prices will become practically bottomless until the government intervenes. Cutting foreclosures should be a priority but the measures so far are public relations exercises.

The Bush administration has resisted using taxpayers’ money because of its market fundamentalist ideology. Apart from a bipartisan fiscal stimulus, it has left the conduct of policy largely to the Fed. Yet taxpayers’ money will be needed to reduce foreclosures. Two proposals by Democrats in Congress strike a balance between the right to foreclosure and discouraging the exercise of that right. One would modify the bankruptcy laws allowing judges to modify the terms of mortgages on principal residences. Another would provide Federal Housing Administration guarantees that would enable mortgage holders to be paid off at 85 per cent of the current appraised value. These proposals will not solve the housing crisis, but go to the heart of the issue. They should be given serious consideration.

The writer’s book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, is released as an e-book by PublicAffairs on Thursday

Copyright The Financial Times Limited 2008

April 3, 2008 Posted by | Credit Crisis | , , , | Leave a comment