Eye on Re-Regulation: Where There's Smoke...

The Citi Never Sleeps*
But can trade and standards of living continue to increase indefinitely? Yes. That is the gift of competitive free markets and the irreversible accumulation of technology.
- Alan Greenspan, “The Age of Turbulence”


We nominate Bloomberg Inc for the Excellence in Journalistic Subtlety Award. The headline that popped up on the television screen on Sunday was “Citi Increases Government Stake with $25 Billion Swap.” Remembering that it is the equity holders that get wiped out first, we agree with the nuanced conclusion: Citi has increased its control over the Government, in return for which it was paid twenty-five large.

That headline was followed by an interview with Cal Ripken, including the inevitable questions about Alex Rodriguez. Meanwhile, it is now clear that our own MLB – Major League Bankers (“Merrill Lynch Blackguards”?) – have been on fiscal steroids for many seasons. Our question: should past years’ earnings numbers have an asterisk?

Ken Lewis showed up to more cameras than Bernie Madoff, and left his sit-down with Andrew Cuomo having proffered nothing more than Name, Rank and Serial Number. Meanwhile, well known banking sector analyst Richard Bove, interviewed on Bloomberg Radio on Sunday morning, pointed out that Bank of America currently holds one out of every nine deposit dollars in the US banking system. Who do you think blinks first? Our guess: not the one with the money.

The broader dialogue is sadly lacking the insightfulness of the anonymous Bloomberg headline writer: the bigger they are, the harder we fall. Treasury Secretary Paulson glommed $350 billion, cast hastily into his hands by a cowardly Congress, and handed it out with no strings attached. What recourse do we have now that only 5% of Paulson’s billions are accounted for? Should we have been worried that Paulson, without any vetting process, put one of his junior cronies in charge of the biggest corporate welfare fund in our history? And that this child was permitted (instructed?) to hand the money out without even obtaining an IOU?

Today we do not even have a list of who got what. Follow The Money meets Cover Your Tracks.

These institutions are not Too Big To Fail. They are too big to regulate.

Today’s quote, from Chairman Greenspan’s memoirs, reveals the profound disconnect underlying this insanity: for years our elected leaders, blinded by science, have abdicated responsibility to academic theory. President Bush was the butt of ridicule for making the statement: “I am the decider”, yet the test of leadership has little to do with being right, and everything to do with being decisive.

America’s Lost Decade lies not so much ahead of us, as behind, when all the world did obeisance to Chairman Greenspan. The fact that he could state openly – and with a grin – to Britain’s Central bankers, that European insurance companies had taken the losses on billions of dollars of failed swap instruments is the hubris of one who is either convinced that he is right, or that he is untouchable.

The Chairman’s theoretical statement of endless growth is perhaps true in the vacuum of theory, yet it disregards the way the world works. Incessant growth can occur, but under the constraints of human society it is localized, as someone pays the price. In the debacle of the ‘nineties, it was the European insurers. Before that it was Russia, Mexico, Brazil, etc. And at every turn, the average investor has taken a drubbing. Meanwhile the big market players have taken increasing fees on all manner of transactions.

We decry the political climate that progressively dismantled the regulatory system, but we recognize that market participants are so clever, so powerful, and so well advised by all manner of senior-regulators-become-lawyers, that they will always find the lucrative margin of the law and reap billions before the public – and the legislators – figure out what they are about. One creative market participant exploits a loophole. Once the majority of participants undertake the same activity, it is no longer a loophole but a sinkhole. Commerce and crime lie along a continuum and, while the question of critical mass is a matter for philosophers to debate, the nature of this phenomenon is well known to all who practice government and law, and studiously ignored in practice.

At this remove, and in light of the events that have unfolded since the Maestro shared his nasty little secret with England’s bankers, it is clear that Chairman Greenspan knowingly disregarded, or was reckless in not knowing, the fact that the investing public was suffering with every gyration in the markets.

The Dismal Science also knows the fundamental rule of What Goes Around, Comes Around. How did the Maestro think we were going to announce to the world’s bankers that we were stealing from them, and that it would not come back to affect us directly?

The inescapable conclusion is that we have been consistently lied to by those on whom we have relied most, and that there is no reason to believe the set of principles at work today are any different.

We would put our money in a mattress, if only we could find an honest mattress manufacturer.


The Gold-Bug
It may well be doubted whether human ingenuity can construct an enigma... which human ingenuity may not, by proper application, resolve.
- Edgar Allen Poe, “The Gold Bug”
It seems the dancing-madness does not need the tarantula’s bite to pass like cholera among the susceptible, but on all sides one sees the living descendants of William Legrand, all in search of fabled riches. Indeed, we wore out our fingers counting the number of times the word “gold” was mentioned in one week in the financial press.

The game is afoot. As witness the Wall Street Journal of February 23 (“Gold’s ‘Perfect Storm’ Rages On”). The headline reads: “Experts See A Rise To $2,000 As Investors Seek Safe Haven.” Like the famous Business Week cover story, “The Death of Equities”, this has the pungent reek of a turning point in the market.

The “Experts” who predict $2000 / oz. for the yellow metal are the managers of: the Global Resources Fund (PSFX: price on 29 February, 2008: 17.71. Price on 25 February 2009: 4.98); the Tocqueville Gold Fund (down 34.94% last year); and USAA Precious Metals & Minerals Fund (down 34.99% last year). The article does not mention the performance of the managers quoted – we had to look that up ourselves.

Which underscores the quote from Poe’s famous story: a little digging can yield a truly wondrous result. Poe’s tale was highly popular in its day, not just as a yarn of greed, but because it played on the popular fascination with ciphers and cryptography. Of finding something precious – in Poe’s case, the fabled treasure of Captain Kidd; in our case, transparency to understand who is trying to sell us what, and why they need us to buy it.

When oil was trading at above $140 a barrel, the media were alive with frenzied talk of $200 oil, $300 oil. The sky was the limit. Beneficiaries of the price frenzy included sellers of inflation hedges, alternate energy sources, and energy sector investment products.

Now that oil suffers shortness of breath every time it crosses forty dollars, how clever do those folk appear who loaded up on the energy exchange traded funds and notes (ETFs and ETNs) at the peak?

The question that went unasked was: whose narrative is this supporting, and why? As to the Experts quoted by the WSJ, they are in the business of investing other people’s money in gold. And, while these three funds have reasonable long-term track records, if you bought into them in 2008, hoping for a safe haven to balance your equities exposure, you suffered the double indignity of being very right – to take money out of your equities portfolio – and quite wrong, to believe these precious metal managers could provide any safety.

It is not clear to us why the article refers to these folks as the “Experts”, when they are getting smoked. We wonder why the Wall Street Journal has run a panic headline and backed it up by quoting money managers who have destroyed their portfolios in the last twelve months. It seems such blatantly irresponsible journalism that we wonder what’s in it for the Journal to be on the sell side of this story.

And just who is selling gold these days, anyway? And why are they getting written up all over Creation? Well, for one, the managers of the precious metals funds, who today look pathetic. Why should they suffer the indignity of massive withdrawals, just because they turned in a rotten year? And of course, the gold and silver ETFs.

By the way, we do not pretend to expertise in this market, but it is striking that the Tocqueville fund was down 34.94%, while the USAA Precious Metals fund lost 34.99%. Two independently managed funds, both suffering major double-digit declines, and their performance differs by only five basis points. Kind of makes us think there’s precious little independent thinking going on in precious metals these days. As one of our old neighborhood wags would say, “You notice you never see the two of those guys together at the same time. Coincidence? I think not!”

We believe we are witnessing a bubble in the ETF/ETN markets. We also suspect that the ETF and ETN market will soon face a double bombardment of regulatory action, and investor lawsuits.

Exchange Traded Funds purport to be a way for the average investor to trade like a professional by buying a single instrument that represents a basket of securities. ETFs originated as an institutional product. Where no pre-packaged exchange-sponsored index existed, basket traders would pay a trading desk to create a custom exchange-traded index security for them to arbitrage against.

The firms that were in the ETF creation business were servicing multi billion-dollar desks running high velocity trading algorithms where it was not uncommon for tens of thousands of trades to go off in a day versus a single ETF.

Having developed a new expertise, the major firms were eager to capitalize on it. In a textbook-perfect example of how institutional tools become retailed, the ETF was soon being flogged as a way for the average investor to trade like a pro. We believe the fall from favor will be equally paradigmatic – and is likely to happen with lightning speed.

Underlying the retail pitch to Trade Like A Pro is the acknowledgement that the individual investor does not understand instruments like index futures or options on the futures, and does not have access to the venues where they trade. Now, by buying one hundred shares of an ETF that tracks the index, you are trading Like A Big Boy.

The underlying fallacy is so blatant, it’s a wonder to us the regulators ever permitted these instruments to be marketed to the public. A retail customer is given access to an instrument that mirrors the behavior of a set of instruments to which the investor has no access, and which the investor does not understand. The instrument is then sold to the investor by a sales professional who is not qualified to understand or explain the investment, and who takes a commission on the trade.

This approach may have made some sense for ETFs that track a basket of equities by sector – energy or housing, for example – there is no logic to permit stockbrokers to market ETFs based on commodities or futures. The suitability requirements for a customer to participate in the futures and commodities markets are different from those that prevail in the equities market, and the licensing requirements for brokers are completely different. The Series 7 Exam, administered to Registered Representatives, enables them to sell securities investments and get paid commissions. Commodities and futures brokers are required to pass the Series 3 exam, which covers Futures Contracts and Options, Theory of the Futures markets, Hedging Theory and Strategies, Settlements, Margin Practices, and rules of the CFTC and NFA. None of which is addressed in the Series 7 exam.

In other words, the major brokerage firms have taken the much more complex product line of commodities and futures out of the hands of the professionals licensed to deal in them, and have placed them in the hands of individuals whose training does not even touch peripherally on the underlying instruments.

One reason the CFTC may want to stay far away from the mooted merger with the SEC is their reluctance to inherit the class action lawsuits waiting to explode when thousands of individual investors figure out they were sold investments that were not suitable for them, by people who were not licensed to understand them.

Here are the two most popular oil ETFs, for example: the DBO and the USO. Both of them trade on the NYSE, both are nondiversified oil portfolios that trade futures on West Texas Intermediate sweet light crude oil. Both ETFs are regulated like stocks, and sold to investors as though they were equities.

Here is what they say about themselves, as quoted from Yahoo! Finance.

DBO: Powershares DB Oil – “The investment seeks to track the price and yield performance, before fees and expenses, of the Deutsche Bank Liquid Commodity Index - Optimum Yield Oil Excess Return. The index is a rules-based index composed of futures contracts on Light Sweet Crude Oil (WTI) and is intended to reflect the performance of crude oil. The fund is nondiversified.”

USO: US Oil Fund – “The investment seeks to reflect the performance, less expenses, of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund will invest in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges. It may also invest in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC transactions that are based on the price of oil. The fund is nondiversified.”

These funds look very alike, if not fungible. True, one fund uses more diversified instruments, but the average investor nonetheless expects both funds to pretty much track the price of oil. In fact, these funds are managed differently and their performance diverges, both over time, and intraday, creating ongoing arbitrage possibilities. This is primarily because one fund trades near-month contracts, one trades year-to-year contracts, a fact not mentioned in their thumbnail portraits.

Just as an exercise, call your stockbroker – you know, one of those tens of thousands of guys who is getting 80% payouts to churn your account so that Bank of America can pay the legal bills to defend Ken Lewis for not answering Andrew Cuomo’s questions – and ask him which of these ETFs will better take advantage of backwardation in the oil market. Or does your broker think the trend is towards contango? We predict the answer will be: To be on the safe side, you should buy some of each.

On Friday, February 13th, Senator Carl Levin proposed to amend the Commodity Exchange Act “to prevent excessive price speculation with respect to energy and agricultural commodities.” Speculative position limits have been implemented from time to time in the commodities markets, and we believe the Levin bill could force a return to this type of regulation.

The fact is that purchasers or producers of the underlying asset are never the natural traders of the ETF. No physical market participant would use an equity look-alike with its constraints of size and composition, and its exposure to tracking error, to manage actual physical commodity price exposure. And it is that tracking error that makes ETFs a valuable tool for large institutional traders.

Tracking error creates the possibility of arbitraging the components against the basket. When exchanges create indexes, the arbitrageurs trade the components against the index, taking advantage of the inherent tracking error to scalp profits. When no index product exists, the arbitrageurs create their own tracking-error-producing index. Since index arbitrageurs structure the ETFs themselves, what odds would you give that the arbitrage program already knows where the tracking error is likely to arise? Does it make you feel better, knowing you just bought a synthetic instrument created to give an arbitrageur an all but guaranteed trading profit?

The CBOE will not comment publicly on their treatment of individual market participants, but they categorize ETF managers in general as speculators. Thus, commodity ETFs and ETNs are an obvious target of Senator Levin’s bill. The added benefit is “collateral regulation” as stockbrokers find their ability to pitch this product class to retail customers curtailed. There will be hue and cry from the banks who issue ETFs, but Congress will have to weigh this against the public rage and bad press once the plaintiffs’ bar figures out what the real story is on ETFs and ETNs.

Game on!


O Ye Of Little Faith!
Kool Aid, Kool Aid – Tastes Great!
Wish we had some. Can’t wait!

The headline reads “Merrill’s Losses Rise by $500 Million” (WSJ, 25 February, page C7). The story relates a half-billion dollar earnings miscalculation that has only now surfaced, forcing a surprised Bank of America to draw down another $20 billion in taxpayer money. Not to worry, assures B of A CEO Ken Lewis, on his way to stonewalling New York Attorney General Andrew Cuomo, B of A will do fine. (Remember that they are holding over 11% of the nation’s cash deposits.)

Right under that is a story announcing that veteran regulator Richard G. Ketchum has been selected to replace Mary Schapiro as CEO of FINRA which, together with the SEC, was responsible for oversight of Merrill’s internal controls.

The item quotes Mr. Ketchum as saying that FINRA is “an effective entity that doesn’t need to be fixed in any way.”

Words fail us.