Category Archives: Finance and Investments

Behavioral finance marches on

Quant. Shop Offers Heady Long/Short Hedge Fund

December 17, 2008 | Source: FINalternatives

Santa Monica, Calif-based MarketPsy has launched a quantitative hedge fund that incorporates psychology into its trading strategy. So far, the firm’s Long-Short Fund has outperformed its discretionary counterparts, returning 6.03% since inception in September.

MarketPsy’s fund, which focuses on U.S. mid- to large-cap names, profits from what it calls psychology-driven movements in equities prices.

“Our investment strategy is based on the fact that innate psychological biases distort investors’ perceptions of stock value,” said Richard Peterson, managing director. “We find misvalued stocks by examining investors’ and executives’ language in SEC filings, executive conference calls and stock message boards. We have performed extensive software development, trade back testing, and portfolio simulation. Our long-short strategy is based on our discoveries of the psychological factors that predict stock price movement.”

In September, Peterson said the fund’s performance lagged because investors were not emotionally overreacting to the crises surrounding Fannie Mae, Freddie Mac and AIG, the bankruptcy of Lehman Brothers, and the credit freeze. The fund lost 6.7% that month.

However, the firm says investors began to overreact to news reports and media the following month, resulting in a 9% gain. In November, the firm’s short positions in solar stocks performed well after the U.S. presidential election, consistent with the classic “buy on the rumor and sell on the news” price pattern, said Peterson.

“We also performed well in November due to strategic long positions in financial stocks during the bailout of Citigroup.”

The fund charges a 1% management fee and a 10% performance fee with a $100,000 minimum investment requirement. It has a one-year lockup period.

Do I really know something Steven Levitt doesn’t?

Steven Levitt writes:

Back in the old days, banks didn’t package and resell the mortgages they wrote. So when a homeowner got into trouble, they could go down and talk with the bank about working out some solution other than foreclosure. For instance, the bank could allow the borrower to pay back the loan over 30 years instead of 15 years, reducing the monthly payment.

Not really… Even in the old days (unless we’re talking really old days), the homeowner would not talk to the lender. Instead, they would talk to the servicer in charge of their loan (in the really old days, servicers were units of lender banks, but eventually, independent servicing companies sprang out all over the place). Here’s how Fannie Mae explains what servicers do and how they are compensated:

We do not perform the day-to-day servicing of the mortgage loans that are held in our mortgage portfolio or that back our Fannie Mae MBS… Typically, lenders who sell single-family mortgage loans to us initially service the mortgage loans they sell to us. There is an active market in which lenders sell servicing rights and obligations to other servicers.

Mortgage servicers typically collect and remit principal and interest payments, administer escrow accounts, monitor and report delinquencies, evaluate transfers of ownership interests, respond to requests for partial releases of security, and handle proceeds from casualty and condemnation losses. For problem loans, servicing includes negotiating workouts, engaging in loss mitigation and, if necessary, inspecting and preserving properties and processing foreclosures and bankruptcies. We have the right to remove servicing responsibilities from any servicer under criteria established in our contractual arrangements with servicers. We compensate servicers primarily by permitting them to retain a specified portion of each interest payment on a serviced mortgage loan, called a “servicing fee.” Servicers also generally retain prepayment premiums, assumption fees, late payment charges and other similar charges, to the extent they are collected from borrowers, as additional servicing compensation. We also compensate servicers for negotiating workouts on problem loans.

So from the borrower’s standpoint, not much has changed because of securitization; the borrower still deals mostly, of not exclusively, with the servicer.

I have four questions:

OK, let’s take them one at a time, keeping in mind that there are servicers…

1) With mortgage-backed securities, is it really the case that a given mortgage is stripped into multiple pieces held by different entities?

Not exactly. First, mortgages are assembled into a pool, which is structured as a separate legal entity with mortgages as its assets. Then, this pool can be stripped, with strips becoming the pool’s liabilities; the alternative is a simple pass-through structure. The company that puts the pool together (such as Fannie Mae) is the sole equity holder.

2) If mortgages really are stripped into pieces, how does foreclosure work? If many different firms hold a piece of the mortgage, who initiates foreclosure? Who pays the costs of foreclosure? It would seem to me that many of the same obstacles to working out a refinancing deal would be present for foreclosing as well.

Foreclosure works just as it used to before securitization. “Many firms holding pieces of the mortgage” are creditors and thus have no say in the foreclosure matters. The out-of-pocket costs of foreclosures are paid by the pool (meaning that in the end they accrue to the company that created the pool); the decision to initiate foreclosure is also made by the pool (meaning, essentially, by the company that has created the pool).

3) If mortgages are not stripped into pieces, are there firms out there trying to scoop up failing mortgages at rock-bottom prices and getting on the phone with the homeowners to try to negotiate deals to avoid foreclosure? If mortgages are not stripped into pieces, I don’t understand why it is so hard to value these mortgage-backed securities.

Where would those firms “trying to scoop up failing mortgages at rock-bottom prices” come from? By now, whoever wanted to invest in mortgages, already has more than they know what to do with; that’s why we have a credit crunch on hand… As to difficulties in valuation, they come not so much from stripping, but from uncertainties surrounding mortgages; the borrower can default (and the amount to be recovered from selling the foreclosed home is highly uncertain, as house prices change over time) or refinance. Neither of these eventualities is in control of the lender, so valuation ultimately depends on assumptions the lender makes about probabilities and timing of default and/or refinancing, as well as about the likely value of the home in the event of default.

4) If indeed mortgages are stripped into pieces, weren’t people worried about the complications that would result when these mortgages were divided into pieces?

Yes and no. Complications should be weighted against opportunities they afford. Mortgage securitization offered an easy and cost-effective way to invest in mortgages for mutual funds and insurance companies…

Meanwhile, in Mexico…

How Options Saved Mexico’s Budget
Nov-14-2008 | Source: Futures and Options Intelligence

The news that Mexico has locked in prices of at least $70 a barrel for 90% of next year’s oil exports has surprised many traders, and demonstrated the depth of the oil derivatives markets.

If reports are correct, Mexico has protected $37bn of revenue from oil sales, vital to its 2009 budget, at a cost of just $1.5bn. It is believed to have done so, far-sightedly, in late September and early October, while oil was falling from about $120 towards $90.

The government has already revised its budget, lowering its oil price target from $80 to $70.

With oil now dropping through $60, the country’s budget would have been devastated if it had not hedged so much of its production and if prices stay low. Oil revenues make up nearly 40% of public sector income.

By warding off this disaster, Mexico will likely have protected the public finances, its credit rating, its currency and its stockmarkets.

Moreover, Mexico used put options for the hedge, so that it will still be able to benefit if oil prices go high again, by choosing not to exercise its options.

News of the transaction appears to have broken in Reforma, a Mexican newspaper, on November 6.

The story was based on a footnote in the finance ministry’s quarterly report for the third quarter of 2008, saying that Ps15.5bn ($1.5bn) was spent from the country’s $10bn oil stabilisation fund on “financial investments, as part of the measures taken for risk management, and the payment of fees to the trustee and its auditors/advisors”.

It was then picked up by a team of UBS analysts in Mexico City, including strategist Tomás Lajous, who wrote a detailed and apparently well informed report on the deal the same day.

On November 11 the Financial Times reported the story, adding that Barclays Capital and Goldman Sachs had arranged the hedge.

Those banks have declined to comment, as has the Mexican Treasury. Deutsche Bank and Morgan Stanley are said to have participated in Mexico’s oil hedging programme in the past, but this could not be confirmed – nor is it clear why they were not involved this time.

Lajous believes the transaction was arranged privately in the over-the-counter market. The banks would then have hedged their own exposure in the open market.

Lajous estimates Mexico hedged about 90% of its annual production, expected to be 533m barrels, or 1.46m barrels per day (bpd).

He calculated the cost at $1.5bn, based on the Treasury report and the fact that in the past, Mexico has usually spent about $500m to hedge 20%-30% of its production.

That would mean the country bought put options for 480m barrels, which Lajous believes were at strike prices of $70-$100.

Based on options at $70 for a barrel of Mexican crude oil mix, equivalent to $82 for West Texas Intermediate, the hedge will be profitable for Mexico if WTI oil trades next year at any level below $80. In other words, the higher revenues Mexico obtains by selling through the options rather than in the open market will exceed the $1.5bn option cost.

Between $80 and $85 for WTI, the option cost will exceed any gain – above $85, the revenue from selling oil at higher prices again pays for the option cost and leaves a profit.

But this analysis clouds the real virtue of the hedge, which Lajous calculates is to lock in a maximum revenue shortfall, compared to budget, of $3bn, including the option cost, even if WTI oil falls to $40.

That cost is 7% of budgeted oil revenues. Without the hedge, at $40 a barrel for WTI, Mexico would lose 59% of its budgeted oil revenue.

Yet if oil goes back to $100 or $120, Mexico will still make $10bn-$20bn of extra revenue, and only give up $1.5bn of this.

The urgency of hedging is even more clear when one recognises that Mexico’s oil production – the sixth largest in the world – is falling steeply. In 2006 the country pumped 1.6m bpd. This dropped to 1.4m last year and is projected by some to fall to 0.9m in the coming years.

“A few years ago Mexico had more leverage to impact the market. But with demand rising and production on the low, after 2010 Mexico may no longer be an exporter of oil,” said Adam Sieminski, chief energy economist at Deutsche Bank. “It is no surprise that the Mexican government wants to see how much revenue it can get by selling oil, even just for forecasting purposes. It makes sense to do this.”

Food for thought

That Mexico was able to execute such a beneficial hedge on such a large scale may change the way other producers operate, and make market participants reconsider some of their assumptions.

If Goldman Sachs and Barclays Capital were indeed hedging their options during the last week of August and first half of September, that would coincide with a period of steeply falling oil prices.

Lajous analyses the six month out WTI future, which slid from about $118 to $91 in that time, before rebounding to nearly $110.

He argues this pattern of trading “supports the view that the hedge took place (and confirms oil market trading comments from the time, which suggested that a LatAm producer was involved in transactions that put pressure on the futures curve)”.

Raymond Carbone, president of Paramount Options in New York, told FOi: “There were clear signals that an oil producer was hedging over the summer. The December 2009 contract experienced a surge in volumes.”

Carbone believes Mexico’s hedging could have added some downward pressure to oil prices as the banks involved would have been pushed to sell the commodity in the derivatives markets to manage their risk.

But there is strong reason to believe that the mid-September bounce in the crude oil price was caused partly by US oil refiners being caught with an oil shortfall in the wake of Hurricanes Gustav and Ike (see the link below to Futures and Options Intelligence’s story on September 30).

And after the bounce, oil resumed its steady downward course until it sank below $70 in late October.

So there would seem to be little evidence that Mexico’s trading affected prices substantially.

The average daily trade in Nymex’s Light Sweet Crude Oil future was 504,000 contracts in August and 550,000 in September, representing about 500m barrels of oil a day for all delivery dates.

The corresponding option trades about one fifth as much: 111,000 in August and 146,000 in September, or roughly 100m barrels a day.

If the hedging was spread out over three weeks, it would therefore have constituted about 30% of daily trading in the WTI options markets, or 6% of the futures market – perhaps enough to move a placid market, but not one in which sentiment was being whipped by contrasting forces of economic gloom and hurricane damage.

However, stealth must have been an important part of the trade’s success. If the market had seen the two banks coming with $37bn of hedging to do for Mexico, it could not have got such good pricing.

“They have to be careful how they do this,” said Michael Wittner, global head of oil research at Société Générale. “They don’t want to sell too much or there will be too much downward pressure – they will end up shooting themselves in the foot.”

Mexico is said to be among the oil producing countries that is fairly transparent about its hedging strategy, while others are more secretive.

It will be a high priority for oil strategists to discover in the coming months how successful other nations and large oil companies have been at protecting themselves from what is already a savage fall in the oil price.

On real estate and interest rates

A question from Askville:

What’s the impact of the Fed’s $500B bailout on real estate and interest rate?

Will my mortgage interest rate drop dramatically in the next few months? (Planning to sell and trade up a bigger home for investment….)

Real estate prices, in spite of the recent drop, are still way out of line with both incomes and rents. As to mortgage interest rate, here’s a long-term picture for you to ponder (this is conventional mortgage rate as reported by Federal Reserve):

Mortgage Rates

As you can see, the current interest rates are still close to historic lows, so I wouldn’t expect a dramatic drop any time soon…

Hedge fund performance deteriorates

From Euromoney Online:

HFs Suffer Worst First Half Since ’90

Jul-14-2008

Hedge funds got off to their worst start in nearly two decades in 2008, the Independent reports. The exception was Man Group, the giant U.K. alternative asset manager, which posted solid results.

As the markets have weakened, hedge fund performance has suffered more than in the wake of the dot.com bust, as managers have had to write down billions or face closure. Peloton Partners, set up by Ron Beller and Geoff Grant, and Sailfish Capital have closed, while the private equity giant Carlyle ended its hedge fund business, and Citigroup in effect shut Old Lane, the manager it bought less than a year before.

Hedge Fund Research, a U.S. analysis group, said the industry index it compiles was the worst in the first six months of the year since it began tracking in 1990.

The group found that on average, hedge funds declined 0.75% this year, only the second time in 18 years the industry performance has fallen into negative territory. The first, in 2002, came in the fall out of the bursting of the technology bubble.

This compares with the first six months of 2007, when the industry advanced 7.45%. The highest recorded half year was in 1992, when global hedge funds were up 16.7%.

Hedge funds to consolidate?

Two articles from Euromoney Online:

* * * * *

Fewer, But Larger, U.S. HFs Up In 1H08

Jul-09-2008 (Source)

The number of hedge funds launched in the U.S. in the first half of the year may have dropped 50%, but the ones that are being created are amassing more money.

A survey by Absolute Return magazine showed that, while there were only 35 new launches in the Americas thus far in 2008, those funds took in $19.5 billion. In the first half of 2007, 72 funds were created and amassed $14 billion.

Five funds took in more than $1 billion so far this year, with Goldman Sachs Group Inc.’s (GS) GS Investment Partners, an equity long/short fund, taking in $ 8.1 billion. Goldman Sachs also received $1.1 billion from investors for its Mortgage Credit Opportunities fund. As such, the two funds took in 41% of investments in new Americas hedge funds.

The second-largest launch came from Conatus Capital Management, whose Conatus Capital Partners fund brought in $2.3 billion.

The hedge-fund industry is currently estimated at $2.65 trillion, with some 10,000 funds, but confidence is waning along with the economy, and some funds have faced difficulty recently. Investors are demanding ever-higher returns for the fees they pay to be in the funds, and as such new money flowing into hedge funds continues to decline.

Feeling the brunt of it are smaller hedge funds, including top performers. Only 1,152 new funds were launched globally in 2007, down almost 50% from a 2005 peak, according to Hedge Fund Research Inc. Because so many funds closed last year or merged into others, the business expanded by just 589 funds overall, the smallest increase in six years.

* * * * *

Bigger May Be Better As Minor HFs Quit

Jul-09-2008 (Source)

Bigger may be better for hedge funds at a time the $2 trillion (1 trillion pound) industry’s smaller players face tough choices of either merging or being forced out of business, reports Reuters.

In the first six months of 2008, more than a dozen smaller funds have already agreed to let larger players own a piece of them, and investors and managers expect that pace to quicken.

Man Group, the world’s largest publicly traded hedge fund group, has taken stakes in Ore Hill Capital and Nephila Capital, while Goldman Sachs’ Petershill unit has taken stakes in Capula Management, Claren Road Asset Management and Trafalgar Asset Managers.

“What we are finding is that managers of varying sizes are either merging with or selling a stake in their businesses to larger institutions,” said Ron Geffner, who works with hedge funds as a partner at law firm Sadis & Goldberg. “And in many cases the primary reason is to gain access to better infrastructure and distribution.”

While many hedge funds once operated with only a few people out of a basement or garage, bigger investors who have helped double the industry’s assets to $2 trillion in the last three years are demanding more for their money.

Risk management, legal departments and top-notch back office operations are must haves for big name investors like the Massachusetts state pension fund, trustees and fund officials said. That fund plans to put more money into hedge funds in the months ahead.

For smaller funds managing only a few million dollars these types of costs can put them out of business very quickly, several small fund managers said.

* * * * *

Hedge fund launches hit a low

HF Launches Hit Eight-Year Low

Jun-26-2008 | From Euromoney

The number of hedge funds launched in the first quarter was the lowest for a quarter since 2000, Financial Planning reports. This is chiefly because of volatile market conditions and the credit crisis. Fund liquidations increased from a year earlier.

There were 247 hedge fund launched in the first quarter, down from 251 a year earlier, according to Chicago’s Hedge Fund Research Inc. It said 170 hedge funds were liquidated in the three months, 23.2% more than in last year’s first quarter.

The attrition rate, defined as the percentage of funds liquidated, was 1.68, up “slightly” from a year earlier, the company said.

Single-manager hedge funds had the most liquidations, with 155 closed during the quarter. Of these, equity hedge strategies had the greatest turnover, accounting for over 50% of both launches and liquidations. Macro hedge funds, the top-performing strategy since the third quarter of last year, accounted for 20% of hedge fund launches in the first quarter.

Kenneth J. Heinz, the president of Hedge Fund Research, said hedge funds are generating “essentially flat” returns, generally because of difficult economic conditions.

Heinz said he would be surprised if returns remained flat for the rest of this year. The HFRI Fund Weighted Composite Index has returned 13.4% on an average basis annually over the past 18 years, he said.

“I expect to see greater capital flows into the industry, but I think we will see a lot of those flows moving into larger funds,” he said.