Should we be scared in the aftermath of the New York bomb? What about the FOMC meeting on Tuesday and Wednesday? What if they were to decide to tighten?
Not really. On the first point, as one TV news interviewee pointed out, having lived through the 9/11 attacks 15 years ago last week, this is a minor disruption but not a life-changing experience. And for the second I add the same response, namely that having lived through the 1994 tightening cycle, 25bp would also be no more than a minor disruption but not a life-changing experience.
So what’s so scary? Markets had their 9/11 on September 15 2008 when Lehman Brothers, that great pirate ship, went up in a puff of smoke. At the heart of the global financial crisis was not only too much debt taken by and given to the wrong people but too many people trying to make too much money from it. I went into the crisis working in the structured credit group at Bank of America where I specialised in placing the first loss or equity pieces of cash-flow CLOs.
I am convinced to this day that there is nothing inherently wrong with CLOs (as opposed to synthetic CDOs which are far more likely to have toxicity built into their DNA) but there is one element which is rarely spoken about: the difficulty of end investors to really get their heads around the risks that are being taken on board in their name. Risks held several arms’ lengths away from the ultimate bearer of those risks is where the real danger was to be found.
Please bear with me.
Take as an example a principal protected fund of hedge funds. On first sight the end investor is in good shape. His capital is protected and the nature of a fund of hedge funds is to spread the risk of any one fund blowing up by mixing strategies. Turn it around and you have the hedge funds each taking “two and twenty” – that’s 2% management fee and 20% of the profit above a water mark, the fund of funds manager taking about the same and the principal protection overlay costing around 4% per annum. In other words, until the structure returned more than an underlying 10% return, the punter at the end of the line could at best hope to get his principal investment back in the future which is a pretty poor outcome for having made a load of people rich along the way.
The big secret of the success of many of the structured products – for the managers and structuring desks, of course – was that it was nigh-on impossible for an outsider to truly assess the risks embedded in the structure. We know how hard it is to really measure and get one’s head clearly around the risk on something as simple as a portfolio of prime residential mortgages but what chance on a dynamically managed portfolio of dynamically managed hedge funds?
And now I find the following in my weekend reading:
“JP Morgan’s newest exchange-traded fund is essentially a systematic hedge fund, but in an ETF wrapper and for half the cost. The JPM Diversified Alternatives ETF (JPHF) will use a multi-return factor model to pick securities and will invest using a broad range of strategies, such as equity long/short, event-driven, momentum and global macro. The ETF can also invest in currencies, bonds and derivatives. Only a few of the other 28 “liquid alt” ETFs in the market have attracted more than US$100 million in assets.
JP Morgan’s ETF may invest up to 15% of assets in a Cayman Islands subsidiary, a strategy often used by ETFs that hold futures contracts to avoid getting taxed as a commodities pool.”
Who is responsible for creating the myth that if something, anything, is wrapped in an ETF that it is less risky or more liquid than something which isn’t? Anyone who, like myself, spent the 80s and 90s ”painting pictures” – that is, making prices for everyone to see although not necessarily ones that could actually be traded at – on the Luxembourg exchange where many Eurobonds were listed in order to satisfy the German authorities will know that simply being exchange traded is no guarantee whatsoever of either liquidity or true and replicable pricing. To me the above just looks like another opportunity for a bunch of guys and gals on the structuring desk to get handsomely paid before Joe SixPack sees a cent… and we know where it all ended up last time…
That’s what scares me, not the Fed and not the lonely fanatic who makes bombs in his kitchen with ball bearings in a pressure cooker.
Meanwhile, the mighty of the residual 28 met in Bratislava, achieving nothing, agreeing on nothing and once again giving credence to my age-old observation that if there is a problem in the European edifice that can’t be easily resolved, the best they can do is to bury it under a pile of new initiatives. The currency doesn’t work? Asylum policy doesn’t work? The British have just voted to leave? Yippee, let’s behave as though all is well in the garden and move forward by creating a European army… As little as a single currency works without fiscal union, so a single army is worthless without a unified border force. Unites States of America – you can move a passport officer from New York to San Diego. United States of Europe – try to move Belgian customs officer to Piraeus. I rest my case.
While the great and the good were frolicking on a boat trip on the Danube, the electorate of Berlin was giving Mutti Merkel and her CDU another bloody nose by bashing them over the head with ballot slips bearing a cross in the Alternative fǘr Deutschland box. It’s not often nowadays that the SPD out-polls the CDU but Berlin had already sported the SPD as the largest party ahead of the CDU. What has changed is that the two, previously in a grand coalition, no longer command a joint majority. The former held 22% but the latter only 18% while the Left (Die Linke) came third with 16% and the AfD is projected to have garnered 14%.
There is no sense in moaning about the drift to the right and to xenophobia, such as does UN High Commissioner for Refugees Filippo Grandi, but to find out what has gone wrong and where the political and social leadership has lost touch with the man in the street. It’s not about leading from behind; it’s about leading the charge at a pace at which the foot soldiers can keep up.
I encountered in London on Saturday a demonstration in support of refugees. I cannot stand against this for both my parents arrived in this country as refugees shortly before the outbreak of World War II. Within a year, my dad was in a uniform and he spent the next six years fighting for king and country, the reward for which was citizenship and, upon demobilisation, two medals, a civilian suit, a rain coat and a pair of shoes.
So there we are; after a few days in the Doldrums, oil has picked up a tad today and risk asset prices are sure to follow suit. Banks have had a bit of a rebound of late but paper in Monte dei Paschi (or Monty de Parrot-Sketch as it has been termed by a very senior market figure who shall remain nameless) is looking – I can’t resist this one – like the proverbial Norwegian Blue as plans for a debt-swap hit the skids. Cross market risk will most probably trade in a highly correlated although undisciplined manner until after the FOMC.
Good luck for the new week.