How information gets into price

In most finance classes we talk about how information gets into the price of securities. Here is a great example. Apple (which SIMM owns) has traded down on rumors that Steve Jobs is sick.

Traders have been looking for information to prove or disprove these rumors. how far will they go? How about asking frozen yogurt clerks?

Steve Jobs In Great Health -- Frozen Yogurt Clerk (AAPL):

"Can't someone -- anyone -- verify that he's still walking around, doing his normal activities?

The answer: Yes, and he's fine, according to a frozen yogurt store clerk."

So suppose this clerk sees Jobs and then buys on this "news". It is by this trade that private information (Jobs had frozen yogurt) is incorporated into stock price.

Financial crisis of '08 among the worst ever

An interesting look at the current economic crisis from a historic perspective.

Financial crisis of '08 among the worst ever From SignonSan Diego:

"Scott Reynolds Nelson, a history professor at Virginia's College of William and Mary, suggests that 2008 may be much more like 1873 than 1929.

In 1873, the crisis started in Europe, where cheap mortgage terms spurred a residential real estate bubble. When the bubble popped, bankers in London tightened their credit terms, triggering a financial crisis in the United States, where banks already were overextended with speculative loans to railroads and railroad-related real estate.

“The echoes of the past in the current problems with residential mortgages trouble me,” Nelson wrote in the Chronicle of Higher Education. “As in 1873, a complex financial pyramid (in the past decade) rested on a pinhead. Banks are hoarding cash. Banks that hoard cash do not make short-term loans....”

The result in 1873 was an international depression that sparked double-digit unemployment rates, corporate bankruptcies and widespread labor unrest. The United States did not fully recover until the mid-1890s, by which time it endured another credit crisis, known as the Panic of 1893.

The response to the current crisis bears resemblance to past solutions."

Interesting. Here is Nelson's piece from the Chronicle. I won't go into all of it, but here is the conclusion:

"In the end, the Panic of 1873 demonstrated that the center of gravity for the world's credit had shifted west — from Central Europe toward the United States. The current panic suggests a further shift — from the United States to China and India. Beyond that I would not hazard a guess."

An Amazing Document On Madoff Said To Have Been Sent To SEC In 2005

What? There are enough sources on this one to report it. When I first saw it I assumed just an internet urban legend, but it seems legit enough (and yet still unbelievable as well) that I at least want to ention it so we can use it in class discussions. Wow!

An Amazing Document On Madoff Said To Have Been Sent To SEC In 2005 :: Business News :: Here Is The City News :: The Latest Business & Financial Markets News And Views:

"Here's a copy of a submission said to have been made in 2005 to US market regulator the Securities and Exchange Commission by money manager and investment investigator Harry Markopolos.

and later:

"As a result of this case, several careers on Wall Street and in Europe will be ruined. Therefore, I have not signed nor put my name on this report. I request that my name not be released to anyone other than the Branch Chief and Team Leader in the New York Region who are assigned to the case, without my express written permission. The fewer people who know who wrote this report the better. I am worried about the personal safety of myself and my family. Under no circumstances is this report or its contents to be shared with any other regulatory body without my express permission. This report has been written solely for the SEC's internal use.

As far as I know, none of the hedge fund, fund of funds (FOF's) mentioned in my report are engaged in a conspiracy to commit fraud. I believe they are naive men and women with a notable lack of derivatives expertise and possessing little or no quantitative finance ability.

There are 2 possible scenarios that involve fraud by Madoff Securities:

1. Scenario # 1 (Unlikely): I am submitting this case under Section 21A(e) of the 1934 Act in the event that the broker-dealer and ECN depicted is actually providing the stated returns to investors but is earning those returns by front-running customer order flow. Front-running qualifies as insider-trading since it relies upon material, non-public information that is acted upon for the benefit of one party to the detriment of another party....

2. Scenario # 2 (Highly likely) Madoff Securities is the world's largest Ponzi Scheme. In this case there is no SEC reward payment due the whistle-blower so basically I'm turning this case in because it's the right thing to do.""

It should be noted that even scenario #1 is illegal. Front running got many dealers in trouble over the years. It essentially is placing trades in advance of a large trade that you know is coming.

Lest we fall trap of going with a single made up story (hey it is the internet after-all), here are some more cites.

From Time.

"The WSJ describes them as "ranging from in-depth mathematical calculations that purported to show the Madoff investment strategy couldn't work, to little more than rumor or innuendo." That makes Markopolos sound like a little bit of a crank, but reading through his actual allegations doesn't leave that impression at all. Obviously hindsight plays a role here, but I can't imagine anyone reading them in 2005 and not concluding that there was something deeply suspect going on. Markopolos goes to great lengths to demonstrate that the investment returns claimed by Madoff were impossible to replicate by any known strategy. But to me that wasn't the biggest of his 29 red flags. The biggest red flag was Why on earth would a prominent brokerage firm chief run a giant, mostly secret money management business on the side and not charge any fees for his services if he wasn't up to something dodgy?"

From MSNBC:

"Markopolos waged a remarkable battle to uncover fraud at Madoff's operation, sounding the alarm back in 1999 and continuing with his warnings all through this decade. The government never acted, Madoff continued his ways, and people lost billions.

Markopolos reached his conclusion with the help of mathematicians like Dan diBartolomeo, whose analysis of the Madoff's methods in 1999 helped fuel Markopolos' suspicions.

"People should have seen the writing on the wall," diBartolomeo said.

Wow.

Traders Say Madoff's Strategy Was Unworkable - WSJ.com

Traders Say Madoff's Strategy Was Unworkable - WSJ.com:

"The other red flag easily available to investors was the shallow volume in the options Mr. Madoff claimed to use as a hedge.

About $3.25 billion of stock could have been protected by the total S&P 100 options outstanding at the end of November, according to the Chicago Board Options Exchange. Mr. Madoff was thought to have had as much as $50 billion under management.

A review of open interest in S&P 100 contracts showed that nobody owns more than 6,000 contracts at any single strike price, according to FactSet.

In a more liquid hedging market like that of S&P 500 options, there are often more than 100,000 contracts outstanding at a given strike price."

And the news gets worse

Now there appears to be a suicide tied to the Madoff case...

Bloomberg.com: Worldwide:

"Thierry Magon de La Villehuchet, who ran a fund that invested with Bernard Madoff, was found dead at his Madison Avenue office today, a New York City police officer at the scene said. The death appeared to be a suicide, he said."

Bernie Madoff: Ponzi For The Long Run

Clusterstock continues to do an amazingly good job at reporting on the Madoff ponzi scheme.

What is most puzzling is how one person could create and maintain such a intricate scheme. Just for instance, wouldn't the auditors (a small firm) have seen what was going on? How about those that invested with him?

Or even those people supposedly placing trades etc. It leads many to the conclusion that he either had help, or is a genius, or both.

So a few looks at Clusterstock's coverage

Bernie Madoff: Ponzi For The Long Run:

"Sixteen years ago the Securities and Exchange Commission cracked down on what was then one of largest ever sales of unregistered securities. Investors handed $440 million to two Florida accountants who promised unbelievable annual returns of 13.5% to 20%....How did the two investors deliver the promised returns? They had help from a powerful New York figure. You see, at the center of the scam was a mysterious money manager who authorities declined to name because they never charged him with wrong-doing....That man was Bernie Madoff.....accountants were represented by Ira Lee Sorkin. The same lawyer, a former prosecutor turned defense attorney, is now representing Madoff."

Clearly in any big blow up, some will be eating crow. In this case there are many, but possibly the largest portions may be saved for Fairfield Greenwich Group.

From Clusterstock: Fairfield Greenwich:We Anlyze Every Client Trade Every Day

"Opinions about how Fairfield Greenwich Group came to incinerate $7 billion of client cash at the hands of Bernie Madoff vary from "incompetent" to "criminally negligent" to "co-conspirators." Regardless of where the truth lies, one thing is certain: FGG was very proud of its due diligence and risk management processes....They will show that, day after day, the professionals at FGG were fooled by an amazingly intricate fraud in which Madoff figured out, retroactively, at the close of business each day, bogus trades that added up to the reported return and stayed within FGG's vaunted risk parameters--and then emailed this spreadsheet to FGG so they could feed it into their system."

Sure they did. But if you have doubts, you are not alone. A staggering 74% of investors agree. Again from Clusterstock:

"..a CNN/Opinion Research poll, 74% of those surveyed said they think Madoff's behavior is common among financial advisors and institutions."

Can that number possibly be right? Seventy four percent? And if so what does it say given Wisdom of Crowds etc. I would like to see that survey and a definition of "common".

This one will continue to play out.

Tale of the first $350 billion - Dec. 19, 2008

Have you wondered where the first $350 billion went? Here is how CNN reports it:

Tale of the first $350 billion - Dec. 19, 2008:

"

"

1. ..checks totaling $168 billion in varying amounts to 116 banks;
2. ...committed another $82 billion to capitalize more banks;
3. ... bought $40 billion in preferred shares of American International Group (AIG, Fortune 500) so the troubled insurer could pay off an earlier loan from the Federal Reserve;
4. ... committed $20 billion to back any losses that the Federal Reserve Bank of New York might incur in a new program to lend money to owners of securities backed by credit card debt, student loans, auto loans and small business loans;
5. ... committed to invest $20 billion in Citigroup on top of $25 billion the bank had already received;
6. ...committed $5 billion as a loan loss backstop to Citigroup;
7. ... agreed to loan $13.4 billion to GM and Chrysler to get them through the next few months."

Chinese Banks' Great Leap Backward - WSJ.com

In the department of what else can we worry about? The WSJ suggests that Chinese banks are being pressured to take some major chances.

Chinese Banks' Great Leap Backward - WSJ.com:

"...risk-prevention institutions built up over the past decade are now under enormous pressure to forgo prudence in the interest of maintaining economic growth. There have been two triggers for this. First, the global recession caused a plunge in demand for Chinese goods -- in November, Chinese exports fell for the first time in nearly a decade. At the same time, the property market continues to shrink in many major Chinese cities.

Anticipating a declining economy, in November the central government announced a four trillion yuan ($586 billion) stimulus package to be carried out in the next two years....

Banks are trapped in the middle, because they will finance much of the stimulus package. Of the four trillion yuan stimulus, only about a quarter will be financed by the government's central budget."

It would be make for a great discussion in a Money and Banking class.

My Favorite Christmas movie; yes with Finance content

Sure it is a great movie even without the finance content, but when you throw in some subprime lending, a liquidity crisis, a run on a bank, and even some regulatory issues, and you have both a great movie and a financial learning opportunity.

Yes, it is A Wonderful Life! Surprisingly, the whole thing is online.

History repeats itself

What a GREAT article. It is by Carole Loomis in Fortune, but comes to us via AllAboutAlpha.com

Featured Post Today's Post » Hedge fund industry enters time-warp in January 1970, pops out virtually unchanged in 2008:

A few look-ins:

"...the similarities between the hedge fund world of 1970 and that of 2008 and truly amazing - almost eerie in fact. Even the 39 year old Warren Buffett makes a cameo in this piece. As Motson pointed out to us, “…if you re-scale the numbers it could have been printed yesterday.”

and later:

"“…there is some disagreement these days as to the definition of a hedge fund…it would appear that they key feature of a hedge fund is neither the hedge nor the leverage, but instead the method by which the general partners are compensated.”

and still later:

"“Investing with the Stars”

Think Britney Spears and Sylvester Stallone were the first celebrities to invest in hedge funds? Think again. FORTUNE also reported that Jimmy Stewart, Rod Steiger, and Jack Palance were all co-investors in one California-based fund."

Great great piece. Very interesting and it reminds us the importance of history.

Is compensation to blame?

History will look for answers to what caused the problems, but somewhere in that mix, compensation has to be a part of the problem. From increasing an already risky environment, to rewarding lending to questionable borrowers, to creating incentives to increase information asymmetries, compensation practices have to be examined.

From the NY Times:
The Reckoning - On Wall Street, Bonuses, Not Profits, Were Real - Series - NYTimes.com:

"Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value.

Unlike the earnings, however, the bonuses have not been reversed.

and later:

"“Compensation was flawed top to bottom,” said Lucian A. Bebchuk, a professor at Harvard Law School.... “The whole organization was responding to distorted incentives.”Even Wall Streeters concede they were dazzled by the money. To earn bigger bonuses, many traders ignored or played down the risks they took until their bonuses were paid. Their bosses often turned a blind eye because it was in their interest as well."

In other words, when you pay a year at a time and payoffs are not for many years down the road, it seems to be a problem that is exasperated by, while simultaneously exasperating, information asymmetries. Then when you add to this mix the idea that the bonus (or stock option plans) increase in value with risk, you have a recipe that is conducive to excessive risk taking.

For those interested, this is similar in spirit to some of the ideas put forth in John and John's 1993 Journal of Finance article.

People (especially those who want a bonus) will no doubt continue to argue that compensation did not play a role, but I can not even come up with that argument.

'A university bailout? from WSJ.com

'Shovel-Ready' on Campus - WSJ.com:

"With the Big Three seeking a bailout from Washington,...executives of 36 public universities, state university systems and higher-education associations, urging Congress and President-elect Obama to rescue them.

Mr. Obama has already promised to expand federal subsidies to higher education by increasing Pell grants and making student-loan terms more permissive. The university chiefs seek an additional 'federal infusion of capital' -- as much as $45 billion -- to build new facilities, especially 'green' ones."

Dilbert on Finance-seriously.

The Motley Fool reports the following: 9 Things You Should Do Instead of Buying Stocks: "

Most know Scott Adams only as the creator of Dilbert. But ....Adams' passion for personal finance is matched only by his utter disdain for [individual] stocks. That's right, this keen observer of business and management trends believes that most people, himself included, cannot beat the market buying individual stocks -- especially when the companies behind those stocks are run by drunken chimpanzees.

Adams has nine steps that he says, when performed in order, can help you to generate -- and protect -- your wealth.....:

1. Make a will.
2. Pay off your credit cards.
3. Get term life insurance if you have a family to support.
4. Fund your 401(k) to the maximum.
5. Fund your IRA to the maximum.
6. Buy a house if you want to live in a house and can afford it.
7. Put six months' worth of expenses in a money market account.
8. Take whatever money is left over and invest 70% in a stock index fund and 30% in a bond fund through any discount broker, and never touch it until retirement.
9. If any of this confuses you, or if you have something special going on (retirement, college planning, tax issues), hire a fee-based financial planner."

Good advice.

In a full disclosure type of thing, Dilbert is often the last thing I read before falling to sleep or the first thing I wake up to in the morning, so I might be biased...lol...but come on Dilbert and finance has to be a hit!

Eliot Spitzer Lost Money With Madoff

Class jokes rarely are funny to those not in the class, but since some former students may still br reading the bog I will include the following from Clusterstock.

Eliot Spitzer Lost Money With Madoff:

"Add the name Eliot Spitzer to the list of prominent people allegedly ripped off by Wall Street trader Bernard L. Madoff. Yesterday at Slate's holiday party Spitzer, who is writing a column for the online publication, confirmed that his family's firm had investments with a Madoff subsidiary."

You see, the joke in one MBA class last spring was to try and tie everything to Eliot Spitzer. Sort of like 6 degrees of Kevin Bacon but all at least somewhat finance related.