Haziness and the Volcker Rule

The Volcker Rule is a bit hazy...

Over the past couple years there has been a lot of talk about the Volcker Rule. Basically this rule prohibits banks from taking safe assets and putting them up against liabilities as a result of proprietary trading. Essentially, the idea is that if you deposit money in the bank, you shouldn’t have to worry about the FDIC backing your deposits as a result of your bank engaging in trading that may tumble. The problem with this is defining what’s market making and what’s proprietary trading.

When it comes to equities, most equities at least, is that there is generally a good market for them. And for the ones that are illiquid, it doesn’t require much capital to hold to them. But with bonds and and other instruments, it requires a large amount of capital to hold on to these positions. By limiting the amount of money banks have to hold these positions, you will be holding back the amount of money they can spend on certain instruments, most notably municipal bonds and non-US sovereign bonds.

The latter is a significant problem because holding back on holding back certain instruments may upset some countries. How would large growing economies respond if the US started to suddenly sell their bonds? Given that it will actually increase their interest rates but decrease exchange rates. This helps because it makes their exports cheaper but also increases their borrowing costs. For smaller emerging economies, the effect on their interest rate will be less, essentially making it a good thing because they are more able to compete with the US while not raising their borrowing rates dramatically.

This isn’t calling the Volcker a complete disaster. There are solutions. Instead of making banks sell these positions, why not require them to hedge against them? Make them buy credit default swaps on some of the riskier debt. Now the problem with this being that to purchase credit default swaps, which is essentially a put option on interest rates, is that someone has to take the other side. Plenty of mutual funds now will also have a problem with the Volcker Rule. But they could also engage in the CDS market to take the other side of trades. Which saves AIG from drowning again.

Maybe it’s not a perfect solution, but it’s a start.

Links:
http://www.cfainstitute.org/newsletter/advocacy/volcker_rule.html
http://www.cfainstitute.org/Comment%20Letters/20120215.pdf

If you haven’t heard of BATS, you may be very well to question what it is. BATS has become the third largest exchange for equities in the United States, behind NASDAQ and the NYSE. While both of these exchanges as primary exchanges, BATS operates more of a back up exchange, as a place to provide additional liquidity.

In past years, a lot of these type of Electronic Communications Networks (ECNs) have been gobbled up by some the larger trading systems such as NYSE and NASDAQ. NYSE itself bought Archipelago Exchange in the mid 2000s. NASDAQ on the other hand purchased Brut and Instinet, two previous ECNs.

On Friday, there was a big fuss because BATS launched its own IPO primarily traded on its own proper exchange in order to try to bring itself business. This brought about a rare circumstance where a company’s IPO begins trading on its own exchange. Additionally, ECNs have come under criticism as a result of 2010 flash crash, which many people blame on Arca. But going back to last week, when BATS started trading, the company caused two big errors in trading.

First, Apple somehow got to be mispriced by $9.00 below its trading value. This caused a half across all exchanges in order to figure out what was going on with the stock. While this is a little crazy, it’s not uncommon for this to happen with some stocks. I have seen thinly traded stocks crash below the level of support for some exchange listed stocks to the point that it crashes below support (the price where anyone left is willing to buy the stock).

Second, BATS own stock got to be mispriced. This is a bigger deal, because there hadn’t been a stock listed primarily on the BATS exchange previously. I find this to be a problem because it questions the reputation of the BATS exchange, especially because they’re dealing with their own exchange. After the mishap, they elected to remove the IPO of BATS from the entire market, something that should have people concerned, at least in the short term.

While I think BATS will get their operations in order, it is going to serve as a black mark. Still, I don’t think that the sky is falling. As a society, a big part of our attention is going to be in finance and the continued advancement of technology in this sector. While this is a bad day for BATS, make no mistake, it shouldn’t hurt the company’s long term prospects. They’ve messed up and if history goes to show, people learn from their mistakes.

Building an order book in a stock that’s just opening is much different than doing it for stocks that have been trading already. First of all, people need to establish support and resistance (a large collection of offers [prices] where people are ready to sell stock). This is not easy because while analysts may have opinions on stocks, they have no precedent. Each one wants to see what the other will do first. One small mistake can send a stock tumbling down, and that’s what happened with BATS on Friday.

It’s my new favorite word in business. With the exception of ear-banging (Hint: Cue to recruiters at job fairs nodding sadly). And I just found out it has its own Wikipedia page.

Now, I’m not sure if you’ve heard but Yahoo is suing Facebook over patent infringement. Which is basically them saying “We came up with the idea of profiles, you just found a better way to use them so we’re suing you.” I don’t know how this happened. But they might as well sue Google for patent infringement also, right? Except they did. 

I don’t like lawyers much for the reasons I don’t like politicians (and I apologize to both set of friends who are involved in either). And we do need both, for one reason or another. But patent law is going insane if its allowing Yahoo to put patents on everything its ever tried and then going back and suing people.

Mark Cuban, whom I love to hate as a Heat fan, wants it to go through. Even though he thinks its insane. A good friend of mine described Yahoo as a fish flopping out of the water waiting to die. I can think of no better comparison.

But this is the world we live in. C’est la vie

In the prior week, banks fortunes have changed plenty. Consider Bank of America. A stock once considered to be cheap ran up to $10 and then back down as a result of the news resulting in their stress tests.

While I know plenty of people who liked B of A at lower prices, at 10 is when people start to get nervous. I’m certainly not going to say it’s overvalued at 10 but it’s not a place I’d like to know it. Not while there are plenty of other worthwhile banks out there. At 10 it’s trading half it’s book value, which might be a good thing to some. But considering it’s trading at ridiculous price earnings ratios and it has enough risky debt to question its balance sheet, you might think of other reasons why its valued as such.

On the contrary, look at Wells Fargo. A company that during the 2008 financial crisis definitely took its lumps. Afterwards it acquired Wachovia, a company with a good amount of bad debt in its books and in serious need of cash.

Wells on the other hand trades at about one and a half times its book value currently. Many people question the Wachovia purchase, but in reality, Wells didn’t have that many bad assets during the 2008 crisis. Instead, it was guilty of being in a bad neighborhood. While every bank was either selling (Bear, LEH R.I.P.), or tanking because of what it had on its books, Wells went down just for being a bank.

They saw an opportunity to buy Wachovia because they could and why not to expand operations? If anything, downturns in the economy shouldn’t make us feel like the sky is falling, it should make us look for opportunities, just like Bank of America did with its Merrill purchase, JP Morgan did with its Bear purchase, and Barclay’s did with its Lehman purchase.

While maybe I should like BAC a little bit more given that it looked for opportunities, that bank makes me nervous and I think its relying on its brand name. I definitely like Wells Fargo more because its a more true retail bank trying to expand, where as Bank of America was primarily a retail bank, expanded into something else, and is now paying for the consequences. You could argue that Wells may go the way of B of A, but I think it will manage its safe business with its more lucrative ventures in the future.

I remember watching plenty of soccer (football/futbol) matches. More specifically the 2009 Champions League Final between Barcelona and Manchester United. At the time, Manchester United was sponsored by AIG, which had received a $85 billion (which got up to $182 billion) credit facility from the US government. I just loved the irony that the American public was sponsoring a football club in the UK. Honestly, I laughed then and the joke still isn’t old. I honestly thought they should replace the AIG logo with a picture of Uncle Sam or the American flag.

This week, AIG announced they would be looking to raise $6 billion in order to help pay back the credit facility. In order to do this, they plan on selling AIA Group, an Asia based insurance holding company. While AIG certainly is in desperate need of some cash to pay back the US Treasury, I worry about the long term prospects of AIG.

As a result of taking the bullish side of the first credit default swaps, AIG really hurt itself as a firm*. In order to meet short term liquidity issues, it had to complicate its long term solvency. Meaning, it had to forego its long term credit for short term credit. Now, the bills are coming due and AIG has to trim the fat. The main issue I have with them selling off assets is that it will reduce the diversification of the firm.

Not only that, I believe that AIG’s sell of AIA is just the beginning. I’m pretty sure more will be coming. After this, AIG will have raised $6 billion of the money they need to pay back. Afterwards, they will owe about $42 billion back.

* Credit default swaps – A credit default swap is best thought of as insurance on a bond. You can buy a credit default swap on Greek debt. If Greek fails to live up to its debt obligations and defaults, you get paid. Think like a put option. You pay a premium for downside risk. You don’t have to own the underlying asset.

A lot of fuss came about when Google+ came to be over the summer. A lot of hype went into this platform, thinking it could rival Facebook. But right now, statistics show people are signing up but not using the service as much as intended. As as shown by this picture, it seems as though the only people using Google+ are Google employees.

Social Media Explained

The world of social media explained with donuts. Notice the last one.

In glancing at the above photo, you notice that there are different sort of “sectors” in social media. Facebook is a purely  social platform for people to connect with their friends. Foursquare, is one I really don’t understand to tell you the truth but it allows people to check in at places. Instagram and Pinterest are very similar in my opinion, with Instagram only serving on mobile devices and having filters to play with pictures. We all know YouTube by this point. LinkedIn is like a professional Facebook. Last FM is self-explanatory (though I would have put Spotify instead of that here).

After going through that, you may notice I skipped Twitter at the top. That’s because I worry about Google+ going the same way as their Buzz platform which was eerily similar to Twitter. In fact my first buzz posting which I put up without reading anything about it was that it looks a lot like twitter. To which I’m pretty sure I got a lot of people ripping on me for that. But the real reason I wrote that is because well, I had no clue what Buzz was supposed to be at that point.

I mention Buzz because it’s another venture that Google started and later shut down. While it wanted to be Twitter, it’s true mission was so that Google could get more information. And recently I read a WSJ article (The Mounting Minuses at Google+) that said that, “… the main financial goal of Google+ is to obtain personal data about users to better target ads to them across all of Google.”

That sounds a little scandalous, doesn’t it? Also in that article it shows a great picture that I will post here:

Average minutes per user on Social Networking sites for January (note: does not apply to mobile apps)

 Google+ even comes below Myspace in average minutes per visitor for the month of January. And everyone thought Myspace was dead! What’s more surprising is how Pinterest has grown, even more than Twitter and Linkedin. While not everyone may agree with Linkedin, it’s purpose is certainly different from Facebook. My dad and uncle would never consider joining Facebook (at least I think for my uncle), but they’re both on Linkedin as they both have professional post-graduate degree and operate in that sector.

Also, Twitter, Linkedin, Pinterest, and tumblr are able to connect directly with Facebook. These connections actually increase Facebook’s influence, even respective to their “competitors”. But Google+ is more of a direct competitor to Facebook.

Additionally (non Google employees), how many friends do you have on Facebook and how many connections do you have on Google+? I don’t want to disclose numbers but between Google+, Linkedin, Twitter, and Facebook, the lowest number of connections I have is on Google+. Twitter is hard to judge but on both Linkedin and Facebook, I know I can post and have almost 1000 people aware of my post.

This isn’t to say that Google+ is doomed. They just need a better strategy. As I stated before, Facebook can go down. And if they were, wouldn’t it be Google+ to take its place?

CAPM:

Ke = Rf + B x MRP
where:
Ke = Cost of equity
Rf = Risk-free rate (Basically, a treasury bond [long term])
B = Beta
MRP = Market Risk Premium

An except from Warren Buffet’s annual letter to shareholders:

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.

I’ve talked to a number of people about how stocks are priced and how they’re priced wrong according to the Capital Asset Pricing Model (CAPM). This is because CAPM assumes that stocks are perfectly priced which is based on the efficient market theory. A quick note on efficient market theory, it basically says that all equities are perfectly priced all the time. Meaning, a stock will be perfectly priced compared to everything in the market.

I feel like when you learn about pricing things in finance, that the efficient market theory is like a fairy tale. You want to believe all of that is true. In reality, it’s just used as a process used to make you feel warm and bubbly until you get hit with the harshness of reality. The reality is that markets will always be inefficient (at least in my opinion).

This is not to say markets become more efficient, if that makes any sense. As more and more people enter the market, instruments should be priced better. This is not to say that because the NYSE has the largest amount of volume that it is the most perfectly priced market. But ideally it should be. People’s sentiments go into pricing stocks. People are not always rational.

This brings us back to this concept of CAPM and beta. I read an article in the Financial Times also articulating the same point Mr. Buffet brought up in his annual letter to shareholders. What both are saying is that beta doesn’t accurately represent risk, it just represents how much a stock moves in according to a major market index. In the US, most people think of this as the S&P 500 index.

Therefore, in the US, let’s say there’s a stock ABC. If it’s beta is 1, that means when the S&P goes up one point, ABC will go up one point (on average). If it’s beta is 2, ABC goes up two points (again on average) when the S&P goes up one point. In the same scenario that the S&P goes up a point and ABC’s beta is -1 (which can happen but rare), ABC goes down one point (on average).

Now, let’s say a ticker, we’ll use BSC as an example, has a beta of .7. This doesn’t reflect the fact that they own a bunch of worthless bonds and that they are highly dependent on that portfolio for liquidity and/or solvency.

Most people will know that BSC was the symbol for the now defunct Bear Stearns. I really don’t know what their beta was in 2007 before it tanked. But I know it didn’t reflect the price of the stock properly. And that’s because most reports base their prices on CAPM.

(This may have a continuation)