Amaranth update

Interesting. Things could have been worse.

Bloomberg.com: U.S.: "The New York Mercantile Exchange told Amaranth Advisors LLC that the hedge fund's natural gas bets were too big a month before the trades led to a $6 billion loss, said two people with knowledge of the meeting.

Amaranth unwound some of its natural gas positions after the warnings, according to the people, who asked not to be named because the communications were confidential."

Also from the same Bloomberg story:
First the predictable politcal intervention:

"Members of Congress .... want greater authority for the Commodity Futures Trading Commission to monitor energy trading, especially on the all-electronic Intercontinental Exchange Inc.

And then an update on Brian Hunter the Amaranth trader responsible fo "the biggest-ever hedge fund loss" ....is "no longer works at Amaranth, the Financial Times reported earlier today, citing unidentified people close to the matter.""

Time to throw a penalty flag

First, the good part: Tuesday Morning QB does a great job of laying out the issue and demonstating one problem with boards setting pay .

From last week's TMQ which appeared on ESPN.com: Page 2 : The five-month NFL forecast:

"Much news and sports commentary focuses on the ever-larger paychecks of professional athletes. But even Peyton Manning is a day laborer compared to the modern Fortune 500 CEO....Over his last five years at the helm, he got $162 million, even as Pfizer earnings faltered. Carol Hymowitz of the Wall Street Journal reported that the head of Pfizer's "compensation committee" defended McKinnell's windfall on grounds of market forces in executive pay -- which in this context appears to mean, "CEOs at other companies are picking shareholders' pockets, too."....McKinnell's pay for his tenure atop Pfizer equates to $130,000 per work day."

and slightly later:

"...consider that executive income usually is rubber-stamped by boards of directors whose members may be engaged in self-dealings with the firm, or who have a self-interest in rising CEO pay. As Julie Creswell noted in the New York Times, "Five of the six active Home Depot board members are current or former chief executives of public corporations … CEOs benefit from one another's pay increases, because compensation packages are often based on surveys detailing what their peers are making....The board members know the more they inflate CEO pay, the more they themselves will be able to pilfer from their own shareholders"

Ignoring the use of the word 'pilfer', this is a well-presented valid point. However, Easterbrook's next point deserves a yellow penalty flag and further review:

"Recently the Business Roundtable released a study purporting to show that CEO pay rose 9.6 percent annually from 1995-2005, while stockholder returns rose 9.9 percent in the same period. So things aren't so bad, eh? The Business Roundtable said the study 'sets the record straight.' The Business Roundtable is, by its own description, 'an association of chief executive officers of leading U.S. companies.' As Gretchen Morgenson, dean of Wall Street journalists, laid it out in the New York Times, the study systematically understated the income of CEOs... 'The study counts only the value of the options and restricted stock received by executives on the dates the awards were made.'"

Uh, wait, isn't that what we should be doing?

True, we should take into account the non normality of the stock distribution (induced both by rewriting underwater options and by the now famous back dating of options) which causes the Black-Scholes formula to understate the true value of the grant, BUT the value at grant is what we should consider. We can debate whether the Black-Scholes formula is correct or not, but theoretically the value at grant (again presuming a fair grant) is what matters.

Moreover, while it is true that the Business Roundtable is made up of CEOs, that should not be grounds for dismissal. The actual study does have several valid, and overlooked points. Notably that medians should be used, that the media "sometimes summarizes the pay practices for all CEOs from only the very largest companies", and the seemingly inarguable point that "pay statistics should be referenced accurately and applied responsibly".

Like other things, I will take the bad with the good. Overall
Tuesday Morning QB is still my favorite sports article. Its author is Gregg Easterbrook who is a former Buffalo School teacher and who wrote the Progress Paradox, does a great job weaving many topics together in a funny, witty manner. That said, I guess I can no longer count TMQ as "finance reading". LOL.

Continuing the inflation theme

Continuing the inflation theme:

While inflation can obviously lead to many problems, there is an important bias that must be considered (especially when you think of inflation measured by government statisticians.) As the NY Times so aptly points out, this problem can be illustrated with the humble snow-blower.

Life Is Better; It Isn't Better. Which Is It? - New York Times:

"...the benefits of the snow blower, namely more free time and less health risk, are largely missing from the government'’s attempts to determine Americans'’ economic well-being. The same goes for dozens of other inventions, be they air-conditioners, cellphones or medical devices...."

Why? In part because new inventions, or improvements of existing items, can take years to show up in official indicies.

Again from the NY Times:

"The cellphone and the air-conditioner also improved middle-class life, and also took years to get into the inflation numbers, by which point their prices had plummeted. Wal-Mart’s effect on prices is another blind spot in the index, which considers something sold at a discount to be lower quality (and, therefore, not truly a bargain) than something sold at full price...."

The result? Official inflation numbers are overstated. Not only does it enter our mental math on whether we are better off or not than past generations (we are contrary to what some will tell you), it has become a campaign issue, and can have major implications to cost of living adjustments (COLAs).

Best advice, realize CPI and other government inflation indicies overstate the actual inflation rate.

BTW be sure to look at the NY Times Graphic that shows how large of impact the inflation bias can have on "real" income.

And you think the Fed has it tough?

Post WW I Germany often is the example of hyperinflation used in Money and Banking texts, but for a more timely example you may want to consider Zimbabwe.

BBC NEWS | Business | Zimbabwe's inflation tops 1,200%:

"Zimbabwe's annual inflation rate continues its upward surge, reaching a record high of 1,204.6% in August, and adding greater strain to the economy."

Why is hyperinflation such a problem? Ignoring the impact it has on debt holders (they would get paid back with money that is next to worthless), try to imagine how inflation like that would affect your own behavior.

No longer would you hold any cash, you would want to spend any check immediately, you would want to be paid on a daily basis, etc. You forgo money and the economy falls back in to a barter system. All of this is inefficient and takes a toll on the economy.

More importantly, those who had saved money (especially in fixed income investments), will see their savings evaporate. This creates a sense of panic and increased risk premiums.

As people take their money out of banks, that source of capital disappears. This too hurts the economy and often leads to further government borrowing (which gives the central bank the incentive to monetize the debt).

Further, the sense of uncertainty and decline in value of the currency leads to hoarding of supplies (and accompanying shortages).

Which is a long winded way of saying that hyper-inflation is not merely "moving the decimal place" but that it does have serious economic repercussions.

The sleuth who exposed backdating scandal

I always like to see finance professors in the news!

Philadelphia Inquirer | 09/21/2006 | Sleuth who exposed backdating scandal:

A few "look-ins":

"From his second-floor office at Iowa's Tippie College of Business, [Erik] Lie spent months analyzing data to demonstrate how companies were illegally and retroactively timing, or backdating, stock option grants to fatten bonuses paid to top executives.

"He's uncovered a scandal that has just mushroomed," said Adam C. Pritchard, a former attorney at the Securities and Exchange Commission and now a law professor at the University of Michigan.

and later in the article:

"'The Enron stuff is very sexy, but that type of fraud was not pervasive,' said Andrew Metrick, a professor of finance and corporate governance at the Wharton School in Philadelphia. 'This is widespread, pervasive. I think when this is all said and done, the total amount of dollars that we'll find have been stolen from the corporate till is larger here than any other case we've seen.'"

Read the entire article here.

Basketball superstar meets superstar investor

I'd guess it was a pretty big tip for the waitress!

LeBron shoots the breeze with Letterman, Buffett - NBA - Yahoo! Sports:

"A few days earlier, James had lunch in Omaha, Neb., with billionaire Warren Buffett. ...James, who signed a three-year, $60 million contract extension with the Cavaliers in July, may have been seeking some off-the-court business advice from Buffett, the self-made billionaire investor.

Last year, in an interview with The Associated Press, James said one of his primary goals was to 'be the richest man in the world.' James, who will turn 22 in December, already has endorsement deals worth an estimated $150 million.

Buffett sported a full Cavaliers uniform, complete with a jersey bearing his name, during his lunch with James....James ordered a bacon cheeseburger, french fries and an Arnold Palmer, a drink concocted of lemonade and iced tea. Bubarek said he topped off his meal with an Oreo cookie milkshake delivered by a Buffett staffer."

HP Spy Scandal Hits New Weirdness Level: Financial News - Yahoo! Finance

This just keeps getting more bizzarre! Like I said two weeks ago, I want movie rights!

HP Spy Scandal Hits New Weirdness Level: Financial News - Yahoo! Finance:

"Not only did investigators impersonate board members, employees and journalists to obtain their phone records, but according to multiple reports, they also surveilled an HP director and a reporter for CNet Networks Inc....

They even snooped on the phone records of former CEO and Chairwoman Carly Fiorina....

And in a twist that might seem preposterous if it happened in a movie, The New York Times reported that HP consultants considered hiring spies to pose as clerical or custodial workers at CNet and The Wall Street Journal"

Breaking Down Silos at Yale

While curriculum discussions generally bore me, this one is the exception for the size of the changes and the potential ramifications. Yale's business school has done a major facelift to its offerings. Some look-ins thanks to Business Week:

Breaking Down Silos at Yale:

"...not just at Yale, but at any of the curricula that you would look at any of the major business schools, they were broken down by functional silos: a course in marketing, a course in accounting, a course in organizational behavior. But if you talk to any leader of a major corporation, they will tell you that the real value to be added is in working across those silos, and the disciplinary delivery got in the way of educating students in a way that could maximize their ability to add value to the organizations of which they are a part."

and also:

"We now offer a course on the customer rather than a course in marketing, a course on the investor rather than a course in finance. All of them are multidisciplinary in both their design and their delivery. And then we have a course called the integrated leadership perspective at the end which sort of brings together all the different perspectives."

While I am not taking any position on the new design, I will say that even in a traditional finance class it is important to understand the other functional areas. Indeed, every class I teach starts with that discussion AND it is yet another reason why no matter what your major is, there really are no "blow off" classes. You just never know when the material from a class is going to be valuable later in life.

Deja vu all over again? Hedge Fund Shifts to Salvage Mode - New York Times

As Yogi Berra would say "Deja vu all over again." Amaranth's troubles may be more serious than previously thought. Indeed, they have the potential of being the next Long Term Capital Management.

Hedge Fund Shifts to Salvage Mode - New York Times:

"Last night, as it had been since the weekend, Amaranth was locked in negotiations...in an effort to sell its energy portfolio to try to keep the fund company afloat.

At the same time, it was working with commodity exchange officials to reassign trades to try to minimize disruptions to the market.

The fund’s investors, locked into their holdings by Amaranth’s stringent liquidation terms, awaited further word on the status of the fund’s holdings, while regulators and traders watched for signs that the hedge fund’s losses might disrupt markets beyond those relating to energy"

Sound familiar? Hedge fund does well, then bets go bad, and suddenly the fund (and possibly market) is in trouble. Sure sounds like we've seen this one before.

Another similarity? Among the reported causes is the fact that it looks like El Nino is returning which keeps temperatures lower and hence leads to less demand. Once again, something that many people would have left out of their models.

FRB: Testimony, Braunstein--Non-traditional mortgage products--September 20, 2006

Sandra Braunstein is the Fed's Director of Consumer and Community Affairs. She spoke before a Senate Subcommittee today. The comments largely focued on the truth in lending law, but also discussed various "non traditional morgtage instruments and the Fed's efforts to assure that borrowers know what they are getting into.

FRB: Testimony, Braunstein--Non-traditional mortgage products--September 20, 2006:

"Nontraditional mortgage products have increased the range of financing options available to consumers and have grown in popularity over the past few years. With traditional thirty-year fixed-rate loans, consumers have equal monthly payments that are sufficient to cover the accrued interest and pay down the principal. In contrast, interest-only loans allow consumers to defer the payment of principal and make only interest payments for an initial period. Option-ARMs allow consumers to make 'minimum payments' of less than the accrued interest, which causes the loan balance to increase ('negative amortization').

Some consumers may benefit from these products and the more flexible payment options, for example, consumers with seasonal or irregular income. For consumers who expect their incomes to increase, the initially lower monthly payment with these loans may enable them to purchase homes that they otherwise might not be able to afford. But these loan products are not appropriate for everyone, depending on their individual circumstances. When monthly payments increase, sometimes substantially, consumers may face 'payment shock.' Thus, it is important for consumers to have the information necessary to understand the features and risks associated with these types of mortgages...."

Later:

"The Federal Reserve plays several roles and engages in various activities to ensure that consumers understand credit terms and the options available to them when they are shopping for mortgage credit."

She concludes:

"The Federal Reserve is actively engaged in efforts to ensure that consumers understand the terms and features of nontraditional mortgage products. Improving federally required disclosures under TILA is one aspect of this endeavor. We are also pursuing other opportunities, such as consumer education publications and interagency regulatory guidance that will include recommended best practices for depository institutions. We expect the Board will continue these efforts over time as mortgage products evolve in response to consumers' changing needs."

Teaching note: this would be a great fit for an institutions, money and banking, or commerical banking class. Or even a real estate class.

Hedge Funds Flirt With Heresy: Going Public - New York Times

Going public allows a firm access to more funding. However, this funding comes at the cost of required SEC filings aimed at reducing transparency and secrecy.

Hedge funds are famous for their desire for secrecy which makes the fact that Fortress Investment Group was considering an IPO al the more interesting. It must be that the desire to access capital trumps the desire for secrecy.

From the NY Times:

Hedge Funds Flirt With Heresy: Going Public - New York Times:

"Hedge funds...— are known for their secrecy....being private and secretive also enables them to develop investment strategies and manage their business, big fees included, without [outsiders]...criticizing their outsize pay. So it is not without some irony that a hedge fund named the Fortress Investment Group may be the first to tear down those walls of secrecy. Fortress is considering an initial public offering this fall in a deal that could value the company from $5 billion to $7 billion...."

An interesting research question that arises from this if in fact the IPO occurs is who will buy these shares. I would not be surprised if, like closed end funds, these are held largely by individuals. In fact, in this case likely owners would be small investors who are forbidden from investing in hedge funds themselves.

Ironically the news comes on the same day that the transparency issue was also in the news as volatile energy markets create huge losses at some hedge funds rasing the possibility of a fund going being unable to meet its obligations. From the BBC:

"Amaranth Advisors, said it was now "aggressively reducing" its exposure to natural gas to protect its investors...US natural gas prices, called futures, have slipped 40% since August. They had risen sharply after hurricanes disrupted supplies last year....Amaranth made around $1bn on the surging energy prices last year but lost more than $3bn in the recent downturn, the New York Times reported.

"Last week Amaranth multi-strategy funds experienced significant losses in their energy-related investments following a dramatic move in natural gas prices," the fund said in a letter to investors that has been seen by the Reuters news agency."

SSRN-102 Errors in Company Valuations (102 Errores en Valoraciones de Empresas) by Pablo Fernández

Want to practice your Spanish while studying Finance as well? This paper provides you the opportunity! It examines common mistakes that we tend to make in valuation.

I won't try to translate it for you (I actually suprised myself as I could read most of it!) but fortunately the abstract is in English.

SSRN-102 Errors in Company Valuations (102 Errores en Valoraciones de Empresas) by Pablo Fernández:

"This paper contains a collection and classification of 96 errors seen in company valuations performed by financial analysts, investment banks and financial consultants. The author had access to most of the valuations referred to in this paper in his capacity as a consultant in company acquisitions, sales, mergers, and arbitrage processes.

We classify the errors in six main categories: 1) Errors in the discount rate calculation and concerning the riskiness of the company; 2) Errors when calculating or forecasting the expected cash flows; 3) Errors in the calculation of the residual value; 4) Inconsistencies and conceptual errors; 5) Errors when interpreting the valuation; and 6) Organizational errors"

Guardian Unlimited Technology | Technology | Google to appeal, as court rules news site is illegal

Copyright protections are always a touchy topic. On one hand the creators of the information deserve to rewarded for their work. On the other hand, too strict of protections limits sharing and reduces the impact.

This is playing out with Google now.

Guardian Unlimited Technology | Technology | Google to appeal, as court rules news site is illegal:

"The case was brought by Copiepress, an organisation that manages copyright for the French and German-speaking Belgian press, including La Derniére Heure, La Libre Belgique and Le Soir.

In its judgment...the court said Google would be liable for a fine of €1m (£675,000) for every day it did not remove the offending content from the recently-launched Belgian site....

While many media groups have welcomed Google News as a means of boosting traffic, others believe they are benefiting the Google brand and boosting its user figures without any recompense.

Last year Agence France-Presse (AFP) sued Google in France over a similar dispute, claiming that it had removed photo credits and copyright notices. Google subsequently removed all of the agency's con"

While the potential damage is quite small now, currently the case is isolated to a few sources from Beligium, but could set a precident that would change the way articles, papers, and pictures are shared.

A look at the AMEX

The american Stock Exchange came up in class last week. Thus this article from Fortune, via NY Times is pretty relevant for my classes!

"...the Amex has shrunk to 427 domestic companies, 9 percent of all listed U.S. stocks. Its $565 billion in total market cap disappears in the shadows of the N.Y.S.E. ($22.6 trillion) and the Nasdaq ($3.8 trillion). An average day’s worth of trading on the Amex — 90 million shares — can be handled in half an hour at its bigger and more technically savvy rivals. It costs only $211,000 to buy a seat on the exchange, a 65 percent plunge since 2001.

Which is about what we saw last year when the finance club toured the AMEX.