Inefficient Markets – Shorting, the VIX, and Unintended Consequences

October 5, 2008, Financial "Engineering" — @ 7:25 pm

I occasionally trade LEAPS and straddles. A couple weeks ago (Sep 22) I attempted to close out my last short position (a bear price spread on Goldman Sachs) after having a very heavy short bias in my option portfolio the past couple years. That is unfortunate because last week would have been a great time to have short positions. I’m still roughly 50% cash so I’m not broadly optimistic at the moment. However, there are some individual stocks trading at great valuations that I haven’t been able to ignore. Even if I started cherry picking them a little early.

A somewhat frustrating result of the no short rule is the unusually high bid/ask spread in the option market. I called my broker and asked why he wasn’t jumping between the bid/ask spread to fill my option order. Granted I could have done this manually by splitting my trade, but with the excessive volatility recently I preferred avoiding this. My broker said that due to the no shorting rule the market maker was not jumping between the spread to fill orders, but was instead just letting clients name the spreads. I said that explains why there appears to be no market maker, because basically there wasn’t one.

I’m sure governments around the world didn’t care about option bid/ask spreads when outlawing shorting, but it has an impact on the efficiency of markets. The no shorting rule will probably keep the VIX elevated for some time. The past month has seen the VIX spike straight up. One consequence of this is that this has been and will continue to be a great time to trade options.

I typically avoid writing about option strategies as there are many that know far more than me. However, I’ve been surprised that no one (that I’ve heard) seems to have connected the suspension in shorting hundreds of companies with the spike in the VIX. I could elaborate on how government interventions to increase market efficiency will have many unintended consequences that could actually increase volatility, but I’ll leave that to “the experts”. Alas testing is something that exists only in traditional engineering; not financial engineering…

CSH up 16% Yesterday on Higher Guidance

July 8, 2008, Financial "Engineering", Tech Investing — @ 12:36 am

Yesterday, Cash America (CSH), the leading pawn retailer and one of the leading cash advance merchants, dramatically raised its Q2 2008 guidance sending the stock up 16%.

Cash America “expects second quarter 2008 earnings per share to be between 51 cents and 54 cents. The Company’s updated expectation for the second quarter of 2008 is now between 62 cents and 64 cents per share, up over 44% from 43 cents per share earned in the second quarter of 2007. Cash America will release complete second quarter results on July 24, 2008 before the market opens.”

This is the second quarter in a row that during the quarter CSH has increased its guidance. On March 24, 2008 CSH raised its EPS guidance to $.80 - 82 from $.70 – 75 then exceeded that updated guidance on April 24 with actual EPS of $.86. Cash America’s business is really running on almost all cylinders.

“Revenue from pawn loans and increased gross profit dollars on the sale of merchandise exceeded expectations… [while the] online cash advance product offering experienced strong revenue growth and lower than expected loan losses.”

Regulatory Risk

The only cylinder potentially misfiring is due to regulation risks of its cash advance business. This caused the company to reduce full year 2008 EPS guidance by 15 cents and consider closing 139 stores. The regulatory risks warrant caution however several prominent 3rd parties, including the New York Fed and Yale, have released major studies demonstrating the positive effects of CSH’s type of short term lending.

Online Short-Term Financing Platform

Cash America has a strong, growing online cash advance platform. This platform offers short-term cash advances over the Internet to customers in 32 states and in the UK. The online platform, which was acquired in September 2006, has spent years getting various regulatory approvals and tweaking its proprietary lending models. Recently the president of the Internet Services division purchased 57,400 shares of CSH.

Crossover of Retail Customers

The current consumer lead recession has driven many sub-prime lenders from the market. This has caused many new marginal borrowers to seek financing from Cash America. In addition, many traditional retail customers are crossing over from traditional retail to pre-owned merchandise. Cash America offers a smooth transition for many customers with its strongly branded safe, clean stores easing the migration of new customers. The pre-owned merchandise offered by CSH allows consumers to stretch their limited dollars. For example, it is common for jewelry to be priced 35-40% below traditional retail outlets.

Solid Management & Growth

CSH’s seasoned management has a history of being conservative and open with shareholders. The company’s growth is high quality coming from its brick and mortar stores’ organic growth (not by opening new stores) and through the company’s online platform. Even after yesterday’s run-up Cash America has a P/E around 12 based on its current 2008 full year guidance which now appears extremely conservative. Below I’ve included a summary of Cash America’s Q1 2008 results to provide a better understanding of Cash America’s business and results.

Q1 2008 Results (April 24, 2008)

Revenue: $250.9M up 13%

  • Pawn segment: $170.3M up 14%
    • Includes finance and service charges on pawn loans and proceeds from sale of merchandise
  • Cash Advance segment: $79.6M up 10%

Net Income: $25.8M up 34%

EPS: $.86 up 37%

  • Driven by
    • Increased pawn loans
    • Increased cash advance fees, primarily through their online platform
    • Improvement in the credit quality of the cash advance loan portfolio, which is demonstrated in a decrease in the expense for loan losses

Highlights

  • Pawn loan balances outstanding finished Q1 up 11% well ahead of the pace at fiscal year end
  • An increase in the sale of merchandise generated an 18% increase in gross profit

 

Pawn Lending

Q1 2008

Q1 2007
Cash advances written at pawn locations     
Funded by CSH

$13,947

$15,486

Funded by 3rd party lenders

$37,996

$44,985

Total

$51,943

$60,471

Avg. pawn loan balance outstanding

$129,349

$118,242

Cash Advance Operations

Q1 2008

Q1 2007
Storefront - cash advances written     
Funded by CSH

$153,062

$157,756

Funded by 3rd party lenders

$25,564

$27,079

Total

$178,626

$184,835

Cash advance customer balances due

$43,295

$44,506

Internet Lending - cash advances written     
Funded by CSH

$159,921

$128,494

Funded by 3rd party lenders

$98,543

$70,024

Total

$258,464

$198,518

Cash advance customer balances due

$67,528

$56,802

Planning for a 2008 Recession

March 7, 2008, Financial "Engineering", Investing Assumptions — Tags: , , — @ 5:54 am

The media talks about individuals defaulting on subprime and Alt-A (e.g. liar loans) loans, but this is clearly a freezing of the overall credit market. There has not been a new CLO created since May of last year; almost a year ago. I don’t see how this lack of credit liquidity could not cause a recession as businesses and municipalities are unable to finance new projects.

Understanding that the credit market is a leading indicator of the stock market is the stock market priced for a recession? I don’t think so. In one of John Maldin’s recent letters the S&P 500 earnings are discussed. Let me summarize; all numbers are for one share of the S&P 500. In January 2007, S&P estimated that the earnings would be $89.10 (FP/E = 16) for 2007. They were actually $71.56, down 20% from the estimate at the beginning of the year and down 12% from the actual 2006 earnings. The 2008 estimate has gone from $92.30 (in March 2007) to $83.90 (in December 2007, a FP/E = 17.5) to a current estimate of $71.20 (FP/E = 19.2). The scary part of S&P’s estimates is that it expects earnings will grow 20% in both the Q3 and Q4 of 2008; very doubtful if we are in a recession.

The S&P is currently at 1,304.34 assuming earnings fall 20% from their highs which appears very reasonable from 2006’s historical peak in margins to a recession in 2008, then earnings will be roughly $65 in 2008. That would give the S&P 500 a price/earnings over 20. Expecting at least a bear market drop to a P/E below 15 seems reasonable. So, I don’t think the market has yet to price in a recession.

My approach to the current market is one third cash, one third stocks (mostly tech), and one third short derivatives (options and inverse ETFs) and gold. Since the fall last year gold has been my biggest position and has cushioned most of the drop in my stocks. If gold keeps going up at the rate it has lately you wonder if it moves into bubble territory.

I think as other central banks start cutting rates late in 2008 the old greenback will rally some. Honestly, I’d rather have less money in straight cash, but my 401K has horrible options…only one bond fund (Who designed that!?!) and I do not have the option to go self-directed, so I’m working with what I can in that account.

 

Note: The UltraShort Real Estate ProShares (Symbol SRS) was up almost 10% today so that was a nice gain. I’m still waiting to increase my stock holdings, but prices keep getting more appealing. F5 (FFIV) dropped below 20 today giving the company a valuation around ten times cash flow. Not sure how much cheaper I can expect F5 to get. Especially considering that their much panned acquisition of Acopia Networks might actually pay off.

Shorting Goldman

, Financial "Engineering" — @ 2:26 am

Last month I opened a short position in Goldman Sachs. I understand that they are best of breed and have a great franchise, but ultimately the majority of their profits come from trading. Here are a few reasons I think Goldman could have peaked

  • The fall in the Global Alpha fund during the market turmoil last year shows the weaknesses in using computer models to trade unusual markets
  • Goldman also has a huge portion of their portfolio in level 3 assets
  • Goldman may face significant counterparty risk from hedge funds, private equity, and financial guarantors
  • A highly leveraged firm in a market that is de-leveraging

 

“The derivatives business is like hell easy to enter and almost impossible to exit” – Warren Buffet

“Two parties to [a derivatives] contract might well use differing models allowing both to show substantial profits for many years” - Warren Buffet

 

Update April 2008

In early April I closed one of my two Goldman short positions. I had a put position that expired in January 2009 which I closed out at a small loss and I still have open a short straddle that expires in January 2010. I was disappointed to see the Fed provide financing to the investment banks without requiring any additional oversight or regulation.

The fact that our government is now directly financing an institution with 40 to 1 leverage is absurd. The Fed giving Goldman Sachs access to financing is like the government providing crack to a crack addict. With a Fed chairman and Treasury Secretary that are both Goldman alums you get a situation similar to Italy’s.

Calculating Risk…MBIA

March 6, 2008, Financial "Engineering" — Tags: , — @ 11:46 pm

My concern is that the current financial system is based on a pile of shit faith. The Fed is the church of the 21st century. That said, I’m in the market so I must still have some faith. I don’t expect a worldwide depression; just a recession. I do think financial engineering will have to be rethought. Consider that Basel II’s foundation is built on rating agency’s’ ratings and quantitative risk models. Checkout this or read my summary below of it of AAA rated bond insurance company MBIA.

1. Impact of losses measured on post-tax basis

  • Should be $5.13B (assuming a tax rate of 38%), not $3.18B

2. Covenant Violations and Loss of Access to Liquidity Facilities

  • Lose access to $500M

3. Loss Estimates Must Incorporate Reinsured Exposures

  • $42B ($21.5B is CDOs of ABS or CLO/CBOs) of reinsurance from Channel Re should be put back on the balance sheet
  • $11B from Ram Re
  • MBIA reinsures Ambac, and Ambac reinsures MBIA

4. Bond Insurers’ Investment Portfolios are Riskier Than They Appear

  • Portfolios include substantial amount of bonds guaranteed by bond insurer itself or other bond insurers

5. Commercial Mortgage Backed Securities (CMBS) Problems Ignored

  • MBIA insured $43B net par of CMBS securities (vast majority underwritten in 2006 & 2007)

6. Claims-Paying Resources Definition Overstates Capital Available to Pay Claims

  • Include present value of future premiums discounted at extremely low discount rates (~5%)
    • Ignore defaults or prepayments
    • Purchasers of secondary market guarantees likely to terminate periodic premium payments
    • No provision for overhead, remediation, legal, or other costs required to run the business

7. Holding Company Liquidity Risk

  • The holding company has $45B of derivative obligations (currency, interest-rate, + CDS)
  • Holding company legal expenses and litigation claims
  • Holding company downgrade scenarios

Historically, AAA corporate bonds have performed up to 80x worse (based on defaults) than A muni bonds. Care to guess how AAA CDO bonds performance compares? So ratings by themselves are often relatively worthless. Now if I was to guess what the quant risk models are based on….

Calculating Risk

March 5, 2008, Financial "Engineering", Investing Assumptions — Tags: , — @ 9:12 pm

I don’t accept the assumption that risk is well understood in financial markets. That the risks are just priced in.  I don’t think risk is nearly as mathematically quantifiable as the many financial engineers, hedge fund managers, and quant funds managers argue.  While I’ll admit I don’t understand much of the math behind the PhD’s risk management theorems I read enough econ white papers to have a vague enough idea to recognize many of the assumptions enabling this math.  Many of the assumptions are so large that it makes the whole mathematical exercise mute.

Calculating risk is still more art than science which is largely being proved out by the failure of Moody’s and banks to accurately gauge CDO and CLO risk. Moody’s and others just follow trend lines. As Egan Jones has asked, when have the major bond rating firms ever anticipated a market inflection point?  In addition, the lack of transparency exacerbates the problem.  On top of that I-bankers and analysts are paid annually so they are rewarded if years of investor’s profits are eventually destroyed through bankruptcy. 

Greenspan had one great call (understanding productivity was dramatically increasing) and one horrible call (exuberantly supporting OTC derivatives and dramatically increased leverage). The increased leverage was justified by the financial engineers’ fancy new models that were just assumed to work; but have now been refuted. So what has happened? The financial engineers just adjusted the models to the new trend lines.

Many financial parties break risk down to nearly a purely mathematical equation.

  • Quant funds (e.g. Goldman claiming two consecutive days of 10 standard deviation events)
  • Hedge funds (e.g. Citadel whose computers often account for more than 10% of daily U.S. listed equity options contract volume)
  • Ratings firms (e.g. Fitch’s models for MBS’s did not account for falling house prices…prices never decrease?)

These models never anticipated the apparent shock of the housing bubble. Even though the cover page of every magazine at Barnes and Noble exclaimed the current housing bubble, but the models did not see it. Risk will always be much more than a mathematical equation. We don’t need better math or better data; we need better analysts.

 

Shorting Financials (while waiting for tech to rebound)

, Financial "Engineering", Tech Investing — Tags: , , , , , — @ 3:00 pm

While I focus on technology investments, because ultimately that is what I know, all the money I’ve made the past year is on shorting financial companies and ETF’s like XHB or buying inverse ETFs like SRS, SKF, and TWM. I made some great calls shorting MBIA when it was trading in the fifties and shorting PMI when it was trading with a forty handle. Unfortunately, these gains have done nothing more than balance declines in other areas of my portfolio.

Considering my gains the past 9 – 12 months have come shorting financials (or being long gold) I’m pondering when to unwind these positions. Based on the write downs and continued freezing of the credit markets I don’t think financials have bottomed.

One metric I follow is the US banks non-borrowed reserves published by the fed, every two weeks, which are now negative and have been for three weeks.  I’m sure this played are part into why the fed lowered the fed funds rate an unprecedented 1.25% over 8 days. US banks non-borrowed reserves have fallen to a NEGATIVE $15 billion (last row on page 2, in the column nonborrowed).  I’m not implying the banking system is bankrupt; I’m implying several major banks are technically insolvent.  And yes, I realize that has happened before and many of the insolvent banks (including Citibank) recovered.

So far this year I’ve sold my puts on XHB, MBI, and PMI, but I think the financial sector will hit a new bottom. The bond market is usually a good leading indicator for the stock market and right now the pendulum in bond market has swung from greed to fear. I look forward to a bottoming in the financial market so the economy can get back to growing and I can get back to focusing on investing in the technology industry.