Deep Throat: October 2015

One of the joys I derive from this blog is the opportunity to think about, share and weave diverse ideas from seemingly unrelated sources into a flowing tapestry of financial prognostication. Thus, the following is one of the more complex, confusing and tedious topics I've attempted to tackle thus far. Given that preamble, I'd like to suggest the following materials you may want to become familiar with. This post will make a little more sense if you have a working knowledge of same. (URL's listed in the References at the end of this post) As always, if you'd like to skip the suggested reading and trust my analysis you are welcome to give it a shot. I'll try to summarize/simplify my work as much as possible.

Suggested Reading/Viewing

When Genius Failed - Roger Lowenstein - (any library or book store)
Flash Boys - Michael Lewis - (any library or book store)
The 6/30/15 10-Q's of JP Morgan, State Street, Blackrock, Goldman, Citi, Bank of America & Wells Fargo
The 12/31/10 10-K's of same.
SEC Report on Market Events - Flash Crash - 5/6/2010
CBS 60 Minutes - "Hands off the Wheel" the future of self driving cars.

Carl Icahn & Today's Thesis

A few weeks ago Carl put an entertaining little video clip on his website entitled "Danger Ahead". I didn't know what to make of it at first. There's some political rhetoric, philosophy and a dire warning. The cartoon of Janet Yellen and Larry Fink driving an "Interest Rate Party Bus" over a cliff as well as Carl's characterization of BlackRock as a "very dangerous company" caught my attention, if only because when billionaires make fun of other billionaires it makes for good theater. Carl is apparently really concerned about junk bonds, lack of liquidity and all of Larry's "Dangerous" ETF's. So here's my Question/Thesis.

Is Carl: A.) A disgruntled billionaire upset because he's not getting a big enough piece of the pie, airing his anger and frustration in public?, or: B.) Brilliant?

I've written about valuations, leverage and Hedge Funds in several prior posts (See: The Valuation Problem, Valuation - Additional Data, Don't Worry, be Happy) but I felt Carl was touching on something even deeper and more ominous in his video clip . So, let's start where we always start when we want to figure something out. The SEC filings of course!

The table below shows the Tier 1 Capital & Ratios, Equity, Bank Assets, Assets Under Management (AUM) and Off-Balance Sheet Assets (OBS) for "The Usual Suspects" as of 6/30/2015 vs. 12/31/2010. All of the businesses below are apparently speeding along merrily on Carl's "Interest Rate Party Bus".

The table above shows a couple of remarkable items for these businesses. First, all of the above, where applicable, meet the "Well Capitalized" Tier 1 Capital definition per the FDIC. Yet, from 2010 to 2015 Balance Sheet Equity has increased a mere $168 Billion while Total Assets (Bank Assets, AUM & OBS Assets) have increased roughly $20 Trillion. A table containing the related page references to the 10-Q's and 10-K's as well as the links to same are listed in the References Section below.

The bar chart to the left describes the enormous increase in Assets Under Management (AUM) of $3.8 Trillion and OBS-Assets (OBS) of $15.7 Trillion from 12/31/2010 to 6/30/2015. The Pie Chart below illustrates the percentage composition of the change in Asset Value. Note that the combined increase in Equity over the period, for this sampling of the largest financial institutions in the country, when compared to the change in asset value is what accountants might refer to as a "Rounding Error". Further note that there is no SEC requirement to describe the OBS increase. For example, State Street discloses the $28.6 Trillion of OBS Assets as a single line item on pg 4 of their 6/30/15 10-Q with a few details "by continent" and "by type" on pg. 12. That's it. You'd think $28. 6 Trillion might merit a bit more discussion. The "creation" of all of these assets wouldn't necessarily be disconcerting if the economy and earnings were booming, but unfortunately, they are not. Again, the relationship between this asset growth and the real economy is out of balance.

The Pie Chart below describes the Composition of this $20 Trillion increase, with Assets Under Management (AUM) and Off-Balance Sheet Assets (OBS) leading the charge. Keep in mind that this $20 Trillion increase ($98 Trillion Total Assets), is attributable to the nine(9) businesses listed above. According to the Investment Company Institute (ICI) there are nearly 17,000 Investment Companies operating in the US today. If I were to guess, I'd bet that the smaller businesses are doing their best to mimic the behavior of the big guys.

So let's think about the above in layman's terms. Financial Institution Assets are easy to understand. When you deposit cash with these institutions, that's their Asset with an offsetting Liability (i.e. they owe you the money). Assets Under Management (AUM) are a little trickier. These are generally Securities held in a fiduciary/management capacity subject to a change in value where the institution has a more limited liability to the owner of the Securities. In other words, they'll have to give the securities, or the equivalent value back at some point if requested. Value to be determined at along the way, therefore they are "on" the balance sheet. Off-Balance Sheet Assets (OBS) are even more difficult to visualize. Generally, OBS Assets, or "Assets in Custody" are derivatives, futures, options, or some sort of contract which the institution has no offsetting legal liability. For the purpose of this discussion let's just say that OBS Assets are simply contractual "Promises" to pay somebody something at some point in the future. The form is generally, "I'll Promise to pay you $1 Billion dollars worth (today's value) of Asset A in a year in exchange for your Promise to pay me $1 Billion worth (today's value) of asset B in a year. Since we are both fine upstanding citizens and have AAA credit, there's no problem if we accomplish this transaction with, as they say "no money down". The Promises are built on trust and faith in the counterparty's ability to deliver. Unfortunately, like the man who finds out that he's unknowingly married a retired escort, it's not unreasonable to expect at least some level of infidelity and a few broken Promises along the way.

These Promises are usually based on the value of some other security, property or index. OBS Assets are recorded in nominal form and are generally not described in financial statements. The thinking is: They don't have to be recorded as Assets and offsetting Liabilities since the institution has no legal obligation re: same. The institution is simply a repository, the same way that the contents of Safety Deposit Boxes are not assets of the institution or recorded on the Balance Sheet. Of course, like Safety Deposit Boxes, the institutions charge fees for their OBS custodial services. The concept of these Promises has been around for a long time, yet, in the history of finance we've never had more Promises on the books, or more retired escorts managing them. Now let's take a look at why all of these Promises have been created.

The Dawn of the ETF

ETF's have been around since the early 1990's with the launch of SPY,the "Big Dog" of ETF's which tracks the S&P 500 Index and currently has AUM of roughly $170 Billion.

US ETF assets have nearly quadrupled since 2008 from $531 Billion to More than $2 Trillion today according to the Investment Company Institute (ICI). These are relatively complex vehicles, although in Carl's words "nobody understands these things". They are marketed as mutual fund equivalents, intended to track stocks, bonds, indexes, etc., but let's take a look at some of the wording in a Prospectus. The language below happens to be from BlackRock's iShares S&P 500 (IVW) ETF (p S-2), but many/most of these funds have similar language.
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BlackRock's iShares S&P 500 (IVW) ETF (p S-2)

BFA uses a representative sampling indexing strategy to manage the Fund. “Representative sampling” is an indexing strategy that involves investing in a representative sample of securities that collectively has an investment profile similar to that of the Underlying Index. The securities selected are expected to have, in the aggregate, investment characteristics (based on factors such as market capitalization and industry weightings), fundamental characteristics (such as return variability and yield) and liquidity measures similar to those of the Underlying Index. The Fund may or may not hold all of the securities in the Underlying Index. The Fund generally invests at least 90% of its assets in securities of the Underlying Index and in depositary receipts representing securities of the Underlying Index. The Fund may invest the remainder of its assets in certain futures, options and swap contracts, cash and cash equivalents, including shares of money market funds advised by BFA or its affiliates, as well as in securities not included in the Underlying Index, but which BFA believes will help the Fund track the Underlying Index.

The Fund seeks to track the investment results of the Underlying Index before fees and expenses of the Fund. The Fund may lend securities representing up to one-third of the value of the Fund’s total assets (including the value of any collateral received).

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The remarkable thing about this structure is that these funds can use just about any financial instrument imaginable to achieve the intended results. They can also "loan" shares up to 1/3 of the portfolio. (Remember Re-Hypothecating & Infinite Leverage from my "Don't Worry, Be Happy" post?)

The SPY Prospectus, (which specifically prohibits the Fund from owning futures/derivative and Depositary Receipts) lists all of its equity holdings by share. Conversely, many ETF's don't provide a "balance sheet" actually describing the Fund's holdings. They produce a "fact sheet" or marketing materials describing the largest intended holdings. These "holdings" might be the actual stocks, they might be "loaned stocks" or they might be represented by Depositary Receipts or futures/derivatives. For example, in the IVW and funds with similar structure, due to "Representative Sampling", there may, in practice, be very few of the underlying S&P 500 Stocks actually held by the ETF. The structure of the fund not only allows this misdirection, but encourages the behavior on the part of the fund manager. Returns are magnified and cost of capital is reduced since the ETF has little/no requirement to deploy capital on underlying assets. They can rent Promises and the Prospectus gives them written permission to do it. The same, defined returns to ETF Unit/Shareholders, can be accomplished through derivatives or other means. Profits generated from the additional leverage can by siphoned off via fees and overhead since the fund is obligated to match the returns of the index. The end result is that Unit/Shareholders believe they own a piece of the S&P 500 when in reality, there might be very few "hard assets" in the ETF.

Feeding the Beast

If you've had a chance to read Flashboys and When Genius Failed you'll probably follow along pretty well with the concepts in this section. If you've not had a chance, I really think you'd enjoy these works if you're looking for a good weekend read. Flashboys is a wonderful, David v Goliath tale about a few young men who perceived a "wrong" and did everything they could do to figure out what the "wrong" really was, and their corresponding effort to correct it. The story pits these young men up against computer whizzes and the Titans of Wall Street, while describing, in layman's terms, the inner-workings (and shortfalls) of the technology and infrastructure of the financial markets of this country. When Genius Failed is an "ancient" work by Wall Street standards (2000) describing the rise and fall of John Merriweather's LTCM. It's a story of judgment, hubris and financial controls gone awry.

When we combine these two story lines we can see how nearly inconceivable levels of brilliance, ego, wealth, energy, initiative and technology could create the financial ecosystem we have today. Over the last decade we've developed a financial system which rewards the creators of financial instruments, traders who deploy cutting edge technology, disruptors who instantaneously arbitrage markets and institutions which collect significant risk free transaction fees.

Twenty years ago there were two primary Stock Exchanges (NYSE & NASDAQ) in this country. Floor traders wearing odd colored jackets used hand signals to buy or sell securities. They wrote down their deals on order pads and handed them to "keypunch girls" to get them into the "computer". Those days are long gone.  The trading floors are nearly vacant, a non-functional relic occasionally used by the media, I suppose, to convey some sort of nostalgic backdrop for interviews and photo-ops. Today, according to SEC filings, there are eighteen (18) separate National Stock Exchanges, six (6) futures exchanges, two (2) exempt exchanges and nine (9) recently approved applications for "new" exchanges.

As suggested above, we have tens of Trillions (perhaps hundreds of Trillions...no one knows for certain since most of it is OBS) of dollars in newly created notional value Promises relating to Stocks, Bonds, Mutual Funds, Trusts, Currencies, Commodities, ETF's, Swaps, Futures, Options, ADR's, Derivatives, etc. all designed to be traded at lightning speed an multiple platforms and Exchanges, potentially around the globe in the blink of an eye. The Industry has created dozens of order types (there used to be just "buy and "sell") specifically designed to provide HFT's the ability to glean information about the pulse of the market a few mili-seconds ahead of every other participant. Specifically, we've created innumerable points of price dislocation, countless securities and instruments which can be "dislocated" and an environment where automated front running has become legalized in the name of reducing the bid/ask spread. The guy in the plaid jacket driving the Cadillac used to siphon millions from the markets and he'd end up in jail. Now, the programmer from MIT siphons billions and he's on the cover of Forbes.

The opportunity to earn a fraction of a cent every millisecond via arbitrage and cross-exchange price variation abounds.  The opportunity to earn high-churn transaction fees is everywhere. The use of practically free money/leverage to multiply profits has never been more prevalent. The incentive for naïve investors to sink money into risk-on vehicles, due to the dearth of safe alternatives with an acceptable yield is accelerating.   The computing power deployed to exploit all of the above is in place and working overtime.   Finally, the lap dog SEC has abandoned its role as a regulator and become a de facto, rubber stamp operating division of US Investment banks. This has indeed, become a perfect storm.

More Wheezing Canaries......

The SEC Report on the Flash Crash of May 6th, 2010 was as much informative as it was a harbinger of things to come. As I've mentioned in previous posts, large market moves rarely have anything to do with a reaction to news or economic reports. A 1% drop in housing starts can't/won't cause a 500 point drop in the DJIA. Markets correct violently due to a lack of liquidity or default(s). That's why markets correct. Period.

To summarize the SEC Report, at 2:45 PM on May 6th, 2010 an order was put through for roughly $4.1 Billion of S&P futures contracts with a number of important parameters omitted from the order(s) instructions. The entire order was executed in 20 minutes rather than "over a period of days" as was expected. The trading systems of a number of HFT's and Institutions analyzed the activity and exited the market(s) abruptly, since the activity was beyond the scope of their circuit-breakers. In other words, they didn't know what was happening so they shut down. (Note, that a number of HFT's continued trading.) The spiral continued until it became apparent that the initial event was an aberration and the HFT's and Institutions returned to the market restoring liquidity. Several "Blue Chip" stocks dropped 40% and a number of "stub" orders were filled at a penny per share before the market recovered. The exchange voided a significant number of orders that were filled substantially outside a prescribed trading range under the "clearly erroneous" rule.

Since the Flash Crash we've had numerous "technical glitches" including:

The Facebook IPO debacle.
The August 2012 collapse of the HFT firm Knight Capital as a result of a "technology breakdown" causing losses of $440 million in one afternoon.
The NYSE "matching engine problem" in November of 2012.
The 2013 BATS computer error which caused trades to be processed illegally outside of NBBO since 2008.
The August 2015, 1,000 point drop in the DJIA and subsequent recovery later in the day.

As amazing as this technology is, we've learned repeatedly that due to the vastness and complexity of these systems, that things can and do go wrong. Related, and along the lines of incredible technology that has a few shortcomings, I really enjoyed the aforementioned CBS 60 Minutes piece on self-driving cars. The value that could be achieved in reduced accidents, traffic congestion, property damage, loss of life and injury; as well as increased productivity and fuel economy when this technology is perfected will be a game changer. However, today, the developers freely admit that they have some work to do. The systems don't yet do very well in snow, fog, rain or "certain situations". Occasionally, the driver-less car simply sounds an alarm and requests human assistance to bail it out of a situation it can't analyze. This is some of the most sophisticated software ever designed, by some of the most brilliant, creative people on the planet, yet, at least today, it can't account for every scenario.

As far as our financial system goes, we can expect more of these irritating glitches, resultant disruptions, volatility and occasional overnight business failures. Some computer whiz uploads the wrong code and an HFT, like Knight Capital, goes bust. etc. "Certain Situations" will come up and alarms will sound. In any case, the coal mine canaries will continue to chirp, choke and wheeze. All the while the Investment Bankers and the SEC will be proclaiming that "all is well".

So What's the "Trigger"?

As I've discussed throughout this blog for nearly a year, there's so much potential for dislocation in the system that any number of things could trigger a massive asset revaluation. Recently, Willem Buiter at Citi has become the third economist I'm aware of (after this blog and a friend of mine in Beijing who would prefer to remain anonymous for obvious reasons ) to make the "Chinese recession" call. In his forecast, Mr Buiter suggests that China is sliding inevitably into a recession, referring to the "Mendacious data" put forth by the NBS.

Any number of other events, less obvious than a global recession, could trigger a revaluation. It could be Carl's "High-Yield Bubble", "Accounting Games" or a "Dangerous Company". It could be an HFT or Hedge Fund gone berserk, a Knight Capital-like Computer glitch, or even the sudden realization that $2 Trillion of Chinese ADR's and dollar denominated bonds are worth much less than they are currently trading at, as discussed over the past year in this blog.

Conclusion:

Carl Icahn might very well be a disgruntled billionaire, but he's indeed brilliant. He sees what's happening and he is speaking up. I'm glad I took the time to put some numbers to it. I enjoyed the exercise. Now, the only thing we can hope for, is that we don't get any financial "snow, fog, rain or...certain situations".

Deep Throat

Wednesday, October 14, 2015

Why Genius is about to fail.....again.....