My wife and I took our little niece and nephew and family friends sailing over the weekend. What a blast! Aren't they the cutest little buttons you've ever seen? You just can't help but smile when you see their little faces! Don't you feel really good right now? Are you grinning from ear to ear? Hope so! Great!
Now Back to Cold, Harsh Reality.....
As you all know, it's been a volatile week for the markets. Shanghai (SSE) lost another 7.8% last week and Schenzhen (SZSE) was worse, dropping 9.2%, or 40.7% off it's June 15th high. China has been "limit down" on a more than occasional basis since. Of course, the talking heads have been disbursing the usual sage advice like "stay calm", "buy the dips", "you are in it for the long haul", "diversify", "You have to own stocks for the long run, this is just a blip on the radar", "China's markets have nothing to do with ours" ....and my favorite "The investors who sold at the bottom in 2009 missed all of the gains in the following years" (Note that they never mention how well the smart money did by getting out at the top in 2008 and buying everything back in 2010...obviously, these folks did even better than those poor buy-and-hold "calm" investors.)
A Very Abbreviated History......
Here's where we're at in China. In the last seven years the PBOC has created more new bank assets (loans) than currently exist in the entire US banking system. That's correct. China has issued US$ 15 Trillion in new bank credit, (More than all US Banks combined) since the 2008 financial crisis.
The PBOC has quadrupled M2 and somehow kept the Yuan/RMB trading in a pegged/constant range (See: "China's Dream.....Defying Financial Gravity" in this blog 4/12/15) All of this money had to go somewhere. For years, it was used to fund residential real estate projects and public improvements. When it became apparent that the economy couldn't absorb any more vacant residential units or ghost cities, more credit was issued to refinance these projects and additional funds found their way into Wealth Management Products (WMP's), Trusts, Money Market Instruments and unregulated shadow bank assets (loans). All of this liquidity continued to seek higher returns, moving from one bubble to the next until it eventually made it's way into the stock markets. As of June 2015, the Market Cap of Shanghai A-Shares, ChiNeXT and Shenzhen A-Shares had increased by more than US$ 10 Trillion. (150%) Again, for perspective, this increase is more than half the value of the entire NYSE... in only a year.
Along came July, a slowdown, a couple of economic bumps in the road and the realization by Chinese Investors that unlike the Ponzi-esque Wealth Management and Money Market Products, where interest payments can easily be made from new money/principal, stocks can actually decline in value rapidly. Moreover, after a few fits and starts it became apparent that the PBOC and the government either wasn't wholly motivated, or fully capable of propping up the values. After Herculean efforts like:
- Reducing Bank Reserve Requirements (2x)
- Making short selling illegal
- Requiring brokerages and SOE's to buy shares
- Enforcing a 10% daily limit
- Relaxing margin requirements and allowing roll-over margin loans
- Prohibiting certain large shareholders from selling shares at all
- Allowing Pension Funds to buy shares for the first time ever
- RMB devaluation
- Investigations of "malicious short selling"
- PR Campaigns extolling the virtue and patriotic duty to "buy and hold"
- A host of other stimulus
The markets continued to fall. As of this writing, the PBOC is apparently near throwing in the towel. They've run out of bullets, or at least they've chosen to save some ammunition. The week of August 24th proved to be a "limit down" week on increased volatility. Routinely, up to half the stocks on the exchanges would hit the 10% down limit and become "frozen" from time to time. Today, we've arrived at a place where China's stock markets aren't markets at all. To a great extent, like China's residential real estate markets, these bubble-ized assets have become a deep freeze for cash. Investor wealth has become hopelessly locked and destined to devalue over time as the asset values re-set. Like the Hotel California, you can check out any time you like, but you can never leave. The following data was provided to me by a good friend/investor in Beijing who, for obvious reasons would prefer to remain anonymous.
The above represents a snap-shot of what the Shanghai and Shenzhen markets looked like on July 9th 2015, shortly after the wheels began to wobble. Let's take a look at what these numbers really mean.
"Big Round Numbers"...
There were US$2.5 Trillion in "frozen" stocks on the two exchanges on July 9th. There is, of course, additional carnage on the ChiNext and NTB, or "New Third Board", with Hong Kong presumably soon to follow since many of the A-Shares are dual listings. A trader quipped "The NTB is great!....half the businesses listed don't actually exist....but there's real value in the other half!"
The P/E of the above "frozen" stocks is 200+/-. (200 years of current earnings (EPS) = Current Share Price). The valuation problem clearly resides in the "P" rather than the "E" (Note: based on my review of the larger ADR's the "E" might also be questionable). If these stocks were valued at a "normal" P/E of say...twenty (20), they'd have an asset value of 10% of their current value. In other words, 90% or about US$2.2 Trillion of "frozen" Market Cap will have to be written off. Moreover, the "unfrozen" market (US$3.2 Trillion) will also presumably take at least some type of haircut due to the inherent dearth of liquidity and current government imposed trading restrictions. Just as a rising tide lifts all boats, a receding tide puts them on the rocks. So now we've got roughly US$3 Trillion, give or take, in asset value gone from these two markets alone. And we're not done yet. Also, keep in mind that the debt used to finance these assets is still owed to someone and will also have to be eventually written down/off as well.
What's the problem? China's isolated...Right?
I'm hearing this often from the talking heads now. "We're not invested in China.... Americans don't own Chinese stocks.... It's illegal for non-Chinese investors to own A-Shares.... China has no impact on our business." etc. etc. etc.
Now let's go back to my posts on the ADR's and Dollar denominated bonds underwritten (and I use the term loosely) and sold by all of the US Investment Banks. There were roughly US$1.5 Trillion (Market Cap) in ADR equities trading on the NYSE and NASDAQ when I posted The China Syndrome on March 27th, 2015. US$ denominated bonds comprised an additional US$220 Billion. Over the last ten years, China's bond market has gone from virtually nonexistent to more than US$4.2 Trillion (US$57 Trillion in annual trading volume) at the time of the writing. An estimated 70% of trading volume is through commercial banks. Unfortunately, since trades are conducted through Registered Agents, it's impossible to tell exactly how much of this volume is owned by US Banks and Investors, but we can be sure the involvement is substantial. Add to that, the global nature of the S&P 500, that about half of its revenue is derived from overseas, it's tough for me to see how the media has come to the conclusion that these markets are isolated. On the contrary, I believe that these markets are more interdependent than ever....when a butterfly flaps it's wings....etc.
All of these ADR's and Bonds were brought to market by the usual suspects: Goldman Sachs, JP Morgan, Morgan Stanley, Citi, Credit Suisse, Deutsche Bank, HSBC, etc. etc. They all have the aforementioned logos stamped prominently on the offering materials. That said, It's no secret that these pillars of capitalism occasionally feel compelled to bend the rules a bit in pursuit of profit. Boys will be boys. (See: The London Whale, FOREX Rigging and the SEC Enforcement Actions, et. al.) The financial websites are continually littered with press releases announcing investigations, financial crimes, malfeasance, hefty fines and regulatory actions involving these folks. In deference to Mr. Blankfein, to me, this seems a bit removed from "Doing God's Work".
Enter the Hedge Funds.....
WARNING: The following content is laden with technical concepts and jargon. It may cause drowsiness. Do not drive or operate heavy machinery after reading it. If you don't want to deal with it, you might consider skipping down to the next section on Unknown-Unknowns if you trust my analysis.
Two seminal reports have been published in the last two months, the content of which will most likely become prophetic over the next year or so. The first report, Andrew Lo - July 2015 - Hedge Funds: A Dynamic Industry in Transition is a lengthy study of exactly how much we don't know about hedge funds (Andrew Lo - Systemic Risk), punctuated with snippets of what we actually do know. The second report is the June 2015 UK Financial Conduct Authority - Hedge Fund Survey. Feel free to click the links and read the reports if you have time.....I found them riveting. That said, since I know how busy my readers are busy, I thought I'd post some of my takeaways from the reports (with page references) to save you all some time.
- The Hedge Fund Industry has grown significantly. Assets under management in 1990 were US$39 Billion. Today they stand at about US$2.5 Trillion. (Lo - pg 1) As a point of reference LTCM, the culprit in the 1998 financial crisis had only $4.7 Billion in assets before its' demise.
- There are 3,359 Hedge Funds reporting data to Lipper-TASS as of January 1st, 2015, down from a high of 6,294 at the end of 2007 indicating a much higher concentration and greater NAV per fund. (Lo - pg 16)
- Little is known about the Hedge Fund Industry since no regulator requires any reporting. Their methods and holdings are considered trade secrets. They are capable of virtually any financial activity. Reporting is voluntary, generally to industry/trade publications, geared toward marketing and client procurement, which causes inherent bias. i.e.) only the successful funds report. The industry is, in all likelihood, much less profitable due to less successful funds ceasing to report. In the words of professor Lo, "Someone knows exactly what's going on, but he isn't talking".
- Leverage ratios vary substantially from fund to fund. Generally, the larger funds are more heavily leveraged. Estimated Financial (balance sheet) leverage is currently at 2.3x NAV for the average fund reporting. Synthetic (derivative) leverage is running at 27.9x NAV. (FCA - pg 19)
- About half (47%) of all hedge funds never reach their fifth anniversary. However, 40% of funds survive for 7 years or longer. (Lo - pg 1)
- A majority of funds allow for the re-hypothecation of collateral they post, as well as of the collateral they receive. However, the FCA survey indicated that 22% of the funds did not know how much of the collateral posted was actually re-hypothecated. Re-hypothecation occurs when banks or broker-dealers re-use the collateral posted by clients such as hedge funds to back the broker's own trades and borrowing. In the UK, there is no limit on the amount of a clients assets that can be rehypothecated, except if the client has negotiated an agreement with their broker that includes a limit or prohibition. In the US, re-hypothecation is capped at 140% of a client's debit balance. (FCA - pg 7 - I'll discuss this in greater detail shortly)
- The Counterparty Risk Management Policy Group II (CRMPG-II) (2005), a non-profit industry consortium concluded in 2005 that "the Policy Group shared a broad consensus that the already low statistical probabilities of the occurrence of truly systemic financial shocks had further declined over time." (Lo - pg 77) Oddly, this consensus was achieved just a few years prior to the biggest global financial meltdown in history.
- According to CRMPG II, the largest institutions had up to a one-year backlog on entering the terms of executed CDS contracts into their record-keeping and presumably, their risk-management systems. (Lo pg 77) Author's note: Are you kidding me?
- Lehman Brothers acted as one of the major prime brokers to the hedge-fund industry prior to its bankruptcy on September 15, 2008. (pg 69) Without specifically appointing blame, the report concluded a "high correlation" of the comparative illiquidity and unfavorable financial performance between Lehman and the hedge funds that used them as a prime broker. (Lo - pg 77)
- Gross Notional Value (GNV = Total value of all money/contracts to be delivered at some point in the future) of all Derivative Contracts was at US$630 Trillion as of 12/31/14. Interest Rate Contracts (Forwards/Swaps/Options) made up $505 Trillion (80%) of these contracts. (IBS - pg 15)
- The Gross Market Value (GMV = Maximum Possible Loss if all counterparties default) of outstanding derivatives contracts – that is, the cost of replacing all outstanding contracts at market prices prevailing on the reporting date – sharply increased in the second half of 2014. This contrasts with the downward trend of recent years. Market values stood at $21 Trillion at end-December 2014, their highest level since 2012 and up from $17 trillion at end-June, 2014. (24% increase) (IBS pg 1)
- The share of Interest Rate Contracts held by Other-Financial Institutions (eg. mutual funds, pension funds, hedge funds, currency funds, money market funds, etc) has increased from 50% to 83%. ($292 Trillion to $421 Trillion) from 2007 to 2014.
- Gross Market Value (GMV = Maxim Potential Loss) on these contracts has also increased from $2.4 Trillion (2007) in to more than $11 Trillion today. (pg 17 & Summary by Year)
Now, let's do a hypothetical, imaginary, could-never-happen, calculation to illustrate the impact of leverage at these levels. Let's say we have only two relatively small hedge funds, the Long Fund and the Short Fund. Each fund has one Billion dollars in investor capital. Both fund managers go "all in" on their strategy. After all, Hedge Fund managers are brilliant, clairvoyant and, according to them, they are never wrong. The Long Fund manager is absolutely sure oil prices will rise. The Short Fund manager is equally sure the price will fall. They enter into a derivative contract betting their entire capital balance and post the required collateral. Oil prices rise 5% the next day.
Here's what happens:
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The Long Fund has a one day gain of $3.2 Billion (320%). ($1 Billion x 2.3 Financial Leverage x 27.9 Synthetic Leverage x 5% = $3.2 Billion)
The Short Fund, of course, will incur the equivalent loss, receive the mother of all Margin Calls, most likely requiring the fund to post an additional $3.2 Billion in collateral and/or a consequent default.
Of course, if the price moves up 5% again the next day, the gain/loss is doubled.
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Based on the above we can do some top-side calculations. $2.5 Trillion in Hedge Fund Gross Asset Value leveraged at 2.3x yields a mean Net Asset Value (NAV = equity invested) of about $1 Trillion. We can calculate "Synthetic Leverage" (off balance sheet contractual/derivative leverage) at 27.9x NAV (excluding rehypothecation leverage). In big round numbers, that gives us a Hedge Fund Industry derivative exposure of $27.9 Trillion (GMV).
To put this in perspective, $27.9 Trillion is the approximate current Market Cap of the NYSE and NASDAQ exchanges combined. Coincidentally, it's also about the value of the entire US Residential housing stock. i.e.) if you took a bull-dozer to every house in America, $27 Trillion would be your approximate economic loss.
Rehypothecation...Infinite Leverage.
Now, lets add some rehypothecation leverage. (Allegedly what was at least partially responsible for the Lehman collapse) All/most of the collateral supporting these derivative contracts resides in escrow at prime brokers, which they are free to use as collateral for trading on their own account. (140% in the US and unlimited in most other countries). Of course, the list of prime brokers is remarkably similar to the list of "usual suspects" for the China/ADR/IPO's. (GS, JPM, MS, CS, HSBC, etc.) The prime brokers are free to rehypothecate, or use the collateral posted to enter into their own derivative contracts. In other words, the current $2.5 Trillion, unless limited by contract, could be used many times over to collateralize an infinite amount of synthetic risk. (Authors Note: if you or I used someone else's money to collateralize a loan without disclosing it, we would most likely end up in jail....not so with prime brokers.) So maybe today our $27 Trillion in Synthetic Leverage becomes $50 Trillion? $75 Trillion? through rehypothecation. The point is that since all of this leverage is off balance sheet and unregulated, it's impossible to tell until the music stops.
Before the Lehman collapse, the International Monetary Fund (IMF) calculated that US banks were receiving over $4 trillion worth of funding by rehypothecation. The possible role of rehypothecation in the financial crisis was largely overlooked by the mainstream financial press, until an August 2010 paper from Manmohan Singh and James Aitken of the International Monetary Fund examined the issue.
When Singh and Aitken added the U.S. banks data together with large
European banks with significant relations with the hedge fund industry, such as Deutsche Bank, UBS, Barclays, Royal Bank of Scotland and Credit Suisse , the total available pledged collateral was over $10 trillion at end-2007. All of that "free" collateral was reused to support derivative contracts traded on their own accounts. According to the IBS data, Derivative Contracts held by Financial Institutions (Prime Brokers) approached 25% of the GNV of outstanding contracts at the time. The conclusion was that the funds were generally rehypothecated at a rate of 4:1 yielding a probable derivative exposure of $40 Trillion (GNV) globally, with the banks/prime-brokers posting none of their own assets as collateral.
The Unknown-Unknown....
To paraphrase Don Rumsfeld, from one of my favorite interviews of all time, what I've described above is the "Known-Known". Today's post is, to me, a bit like playing the part of a financial detective. I'm trying to piece together evidence to solve the crime before it's actually been committed. Unfortunately, this role has become all too common in the daily grind of today's investor. As an investor, we are assigned the nearly impossible task of determining the potential delta of both Known-Unknowns and the Unknown-Unknowns.
So here are the Known-Knowns as described in this post and documented within this blog:
- Most of the Chinese ADR securities issued are either not economically viable or outright frauds.
- China's Stock Markets are crashing, temporarily supported only by PBOC and SOE intervention.
- Frozen A-Shares will have to be re-priced to about 10% of current value at some point.
- China is in the midst of a debt crisis. Defaults are rising rapidly.
- The RMB is depreciating quickly. 4% in the last month.
- We've had remarkable currency, commodity and interest rate moves over the last year. (Swiss Francs, Rubles, RMB, Oil, Gold, etc)
- Hedge Finds are larger and more heavily leveraged than ever before.
- The "usual suspects" are more exposed to these Hedge Funds than ever before.
- Derivative Contracts are increasingly held by Hedge Funds and Other Financial Institutions. (Specifically Interest Rate Forwards and Swaps) In other words, a greater proportion of outstanding derivative contracts are in the hands of the more heavily-leveraged players.
- Hair-Trigger Money (Warren Buffett term) has amplified volatility and volume. Money can move around the globe at push of a button.
- Liquidity events happen quickly, literally, overnight. (LTCM, BS, LEH, etc.) The "man behind the curtain" knows what's coming well before the naïve, chart-watching, money managers do. Retail Investors are used to years of riding the escalator up and have a difficult time understanding the rules of the game have changed. Many of them "remain calm" for far too long and ride the elevator shaft to the bottom, buying on the dips all the way down.
- Investment Bank Risk management systems and VAR calculations are not exactly real-time. (ibid - One year Backlog - CRMPG-II)
- There's a systemic incentive for the usual suspects (GS, MS, Citi, Credit Suisse, Deutsche Bank, JPM, HSBC) to continually reinterpret the rules in pursuit of profit.
- Central Banks around the globe have administered a "near-zero" interest rate policy since the financial crisis. In the event of a repeat liquidity event, Central Bankers would be limited in their ability to respond. Stimulus efforts would be generally relegated to open market operations and TARP-like asset purchases.
Here are the Known-Unknowns:
- Will the FED raise rates?
- Will PBOC efforts succeed?
- Will the E/U Greece plan work?
- Russia/Ukraine/Crimea?
- Iran/Syria/Israel?
- What are the real Hedge Fund holdings and Prime Broker Exposure?
- HFT/Computer-aided (ala Knight Capital) collapse
- Political Risk associated with a sovereign economic Collapse?
- Regime Change?
- Terrorist Event?
- War?
Here are the Unknown-Unknowns:
- By definition.....I have no idea.
The Canary in the Coal Mine....
This week we saw lots of canaries. They were dropping out of the sky and hitting us squarely between the eyes as we looked up to the talking heads for enlightenment.
Let's focus on one particular dead canary.
On Monday August 24th, The DJIA opened down a thousand points on "no news". AAPL dropped to $92.00 (a loss of 17%) on heavy volume. (160 million shares - 8 million + at the opening bell). Under normal circumstances this move is NOT possible. Of course, the stock recovered later in the day.
Here's what we know about this canary. AAPL is a staple holding of Hedge Funds, not necessarily because it a has great fundamentals (it does) but because it is the big dog of Market Caps, has huge daily volume, can universally be pledged as collateral, and allows for an immediate exit vehicle to raise cash if the Hedge Fund needs liquidity.
If we review the 6/30/15 13F's we see that just about every Hedge Fund owns AAPL (see the "What the smart Money thinks...." post for a list of Hedge Funds) Let's take a look at one fund in particular. For example, David Tepper's Appaloosa Fund Appaloosa - 6/30/15 - 13F owned 2,518,167 shares of AAPL at the time with a cost basis of $316 million ($125.00 per share). Hypothetically, let's say Tepper, or some other Hedge Fund, for whatever unrelated reason, had to raise cash on Monday from some other activity (margin call, derivative losses, collateral impairment, ect.) and had decided to unload the entire 2.5 million share block of AAPL, pushing the price down as expected. The HFT's and the other dumb-money computer models would be all over this anomaly, consequently "buying the dip", pushing prices back up, just exactly what happened later on in the day.
We're seeing these significant moves in nearly every market now, Oil, Commodities, Currencies, Stocks, Bonds, etc. There's volatility all over the globe. History has shown that periods of severe volatility always precede an asset value re-set. (Some of the largest gains in US Market History took place in the fall of 2008 and 1987) The mechanics are relatively simple. Hedge Fund (Investor) liquidity event (margin call), followed by an asset liquidation, followed by the computers and/or dumb money jumping in and buying the dips. For years we have been in a relatively predictable, steady-state where the smart money exits (voluntary or not) and the computer aided-mathematical-modeling-dumb money is jumping in on a daily basis. These models are designed to look for value in assets when compared to prior values/metrics. This mechanism is what's at least partially responsible for the daily high-beta volatility we're experiencing. Luckily, at least so far, there's always a "bigger fool" with a computer out there to prop up the values.
Unfortunately, when you combine this type of volatility with Hedge Fund leverage levels, at some point someone is going to be very wrong. We are in the midst of a high stakes zero-sum game. There are always (big) winners and losers. Lamentably, the canaries really start falling when the winners don't get paid. This cycle will continue until the dumb-money is all-in, the counterparties determine who's been swimming naked, the margin calls cease and asset values find their new equilibrium. Until then, volatility is here to stay. The canary is truly an endangered species.
Our stock markets will soon be worth much less than they are now. All the signs are there. Personally, I'm "risk-off" and sitting in cash (or hedged where necessary) until some of the Known-Unknowns and maybe even a few Unknown-Unknowns become Knowns. That's when I plan to buy everything back at a substantial discount