Posts filed under “Derivatives”
Here’s an issue I have been mulling over, without a satisfactory answer:
There have been many investment thesis (thesii?) over the past few years about the market which supported the bullish side of the ledger: Earnings were high, stocks were cheap, risk was moderate, the Fed model favored stocks over bonds.
Regardless of whether you found these arguments persuasive or not, global markets have gone higher. While the U.S. indices may have lagged the rest of the world’s bourses, they too, have powered higher.
Here’s the odd factor: It turns out that many of the arguments made in favor of U.S. domestic growth have been based on an assumption that turned out to be false. To wit: The Financials, the largest sector in the S&P500, had legitimate, sustainable, normalized risk-based earnings.
That basic premise turned out to be wrong.
Picture a race car driver, going way too fast in the first half of a track. He puts up record breaking lap times, only to crash and burn in the last turn. His driving coach would say his risk-adjusted speeds were irresponsible.
That’s how I perceive what has been going on with the Financial sector. It wasn’t Fraud, but rather a reckless disregard for Risk that led to outsized returns on many big cap stocks in the group.
Merrill Lynch (MER) just wrote down $8 billion dollars, erasing 5 years of profits. Citigroup (C) dinged $11 billion. Washington Mutual, (WAMU) Countrywide Financial (CFC), Bear Stearns, GMAC — there seems to be an ongoing parade of mea culpas that are erasing not just quarters of profits, but years of earnings. And there are likely to be many more of these, as tier 3 assets get priced appropriately. (UPDATE: Morgan Stanley (MS) now rumored to take a $3-6B writedown)
What’s truly astounding is that we may only be seeing the tip of the iceberg. Its possible that the big brokers and banks have $1 trillion in toxic debt on their books to be written down. That would equal decades — not years — of profits to be wiped out.
To paraphrase the WSJ, "the financial crisis is becoming Shakespearean comedy."
So here’s the odd question that I have been wrestling with: Given what we now know about how the true nature of the S&P500 earnings in this group, what did the past few years of data actually look like? Now that the big Banks have erased nearly all of their earnings of the past few years, what should that data have looked like from 2003-2007 with most of the Fins as a goose egg?
I would like to see historical data adjusted for the S&P500 for the Financial sector’s losses. Specifically, if we back out the earnings that turned out to be based on a reckless disregard for risk, what does the following data look like?
• What were year-over-year Earnings?
• How cheap were stocks really?
• What were the actual risk adjusted returns?
• Were stocks as undervalued as the Fed model suggested?
Consider our race car driver from before. If he fails to finish the lap, his time gets voided. Any Financial compan’s earnings are a function of measured risk versus potential reward. If earnings turn out to be based on far greater risk than assumed, and subsequent losses offset them — i.e., they are not sustainable — they too have been voided.
Question for our mathematics wizard readers: Can we figure out an easy way to take the historical data, and adjust these reckless risk-based earnings, now that they have been wiped out?
I don’t know the answer to these questions — but they certainly are food for thought . . .
Markets fear banks have $1 trillion in toxic debt
The Independent, 06 November 2007
Why Street Bankers Get Away With Repeating Old Mistakes
DENNIS K. BERMAN
WSJ, November 6, 2007; Page C1
Fears intensify for prolonged turmoil
November 5 2007 21:27 |
Yesterday, Traders embraced the release of the FOMC minutes. Indices were flat up until just before the 2:00pm release, and then took off, with the Dow gaining near 1%.
The thinking behind the Fed action was clearly revealed in that release. The emphasis was on the subsequent impact of credit on the entire system. The WSJ reported:
"Federal Reserve officials worried that credit-market
turmoil could reinforce slower growth at a time of "particularly high
uncertainty," leading to their half-point interest-rate cut last month,
minutes from the meeting show.
Without a cut, there was concern that "tightening
credit conditions and an intensifying housing correction would lead to
significant broader weakness in output and employment," the
rate-setting Federal Open Market Committee said. The minutes, released
yesterday, also showed members worried that market turmoil "might
persist for some time or possibly worsen."
They offered no clues about
the direction or timing of the Fed’s next move."
That last sentence is quite intriguing. Understanding whether or not a rate cut is forthcoming impacts yields, stocks prices, etc.
Given the significance of the Fed’s action, one would suppose that the markets which trade the Fed Futures would be, if not prescient, than at least telling about their future price action. One of the more fascinating aspects about this, however, has been the way the Fed Fund Futures have functioned over this time. They have been wildly wrong, forecasting an imminent rate cut since January 2006. I thought it might be instructive to look at why this maybe so, and what it might mean . . .