Sunday, 30 January 2011

The Ratings Charade Continues: A CLO Investigation, Part I

The role of the ratings agencies in the financial crisis went largely unexamined by the powers that be. That's a crying shame. Because the game hasn't changed: Investment banks fork over big fees for ratings agencies to sign off on phony ratings for complicated products.

Today I'm going to prove it, step by step. I'm not going to show all my work (I don't want this expanding to the length of a Scribd academic paper), but I can separately (in the comments section or in a separate post) for anyone who's interested.

We start with one of Wall Street's darlings of complexity, called a collateralized loan obligation.

If you're going to hang with me here, you have to grasp the basics of how one works. It's like this: An investment bank bundles together say 30 leveraged loans (this is the risky debt that companies take on in leveraged buyouts). Now, recognizing that different investors have different risk appetites, the bank creates "tranches" of securities that receive payments in a "waterfall" structure, which is the complicated heart of the CLO.

Okay, that sounds confusing. But there's a simple way to look at it. Each of these 30 leveraged loans makes periodic payments (of interest, or interest and principal). Once you strap all the loans together, individually they still make the same payments on the same schedule. But how the money is distributed becomes a bit more complex.

That "pot of yield" generated by the 30 loans is divided as follows. The investors in the top, or safest tranche, get paid first. This tranche is generally ranked AAA. Investors in the next tranche down, which we'll say is AA rated, get paid after that. Then the A rated tranche holders receive their money, or "water." And so it goes, right down to the bottom layer of this structure, sometimes called equity (though it's not technically equity, for you finance nerds -- and there's often also something called an "overcollateralization" feature in a CLO, but we don't need to get into that here.)

When times are good, with all the leveraged loans paying on schedule, the waterfall is bountiful and everyone gets "wet" (i.e. paid). When some of the loans default, and the gushing waterfall of yield slows to something more akin to a trickle, there won't be enough money to go around. But you always start paying off investors at the top (AAA), then move down the structure. If the loans start to sour, the AAA guys are supposed to have an ample cushion before they feel any pain.

So, in a nutshell, an investment bank has taken 30 leveraged loans, tied to 30 companies that have 30 different stories, and roped them all together into a securitization that pours forth a stream of money that satisfies investors in the manner described above. If you're Standard & Poor's, it's a walk in the park to rate any one of those 30 loans compared with rating the slices of this Rube Goldberg-ian CLO. Which is probably why banks helpfully "suggest" the ratings to the ratings agencies and provide models to demonstrate their reasoning behind those "suggestions."

Now let's say you're Mr. Ratings Guy at Standard & Poors, in charge of signing off on CLO ratings. Your bull***t detector ought to be pinging pretty hard when something with these proposed ratings lands smack dab in the middle of your desk (I've condensed this from a Jan. 13 Bloomberg story):
Citigroup Inc. has revised the proposed interest rates on a collateralized loan obligation to be managed by WCAS Fraser Sullivan Investment Management LLC, according to people familiar with the terms.
A $15 million piece rated BBB by Standard & Poor's will pay lenders 400 basis points (note: there are 100 basis points in one percentage point) to 450 basis points more than the London interbank offered rate, while a $19 million slice, graded BB, will pay lenders 600 basis points more than the benchmark...
A $273 million piece rated AAA will pay lenders 160 basis points to 170 basis points more than Libor and a $13.5 million portion graded AA will pay lenders 250 basis points more than the benchmark, the people said. There is also a $31.1 million piece with an A rating and a $51.075 million slice of subordinated notes, the people said.
Why? Remember how our CLO was constructed: out of 30 leveraged loans. These loans pay a certain floating interest rate over Libor (the London interbank offered rate, or what banks charge when they lend to each other). And that's it. You can't wring out any more yield. So the size of our "waterfall" is constrained by what those underlying loans pay. Let's say it's 10% overall right now (not a bad assumption: a CCC and lower bond index right now is at 9.97%).

Now structuring isn't free. Citigroup isn't creating this CLO out of altruism. Here are some categories of CLO expenses: 1. The cost to structure the CLO and earn a profit. 2. The yearly costs to manage the CLO (for example, there's a reinvestment period, during which the manager must replace loans in the portfolio that pay down) 3. All other expenses, including paying the ratings agency.

Let's fill in some blanks. Let's say management fees average 51 basis points, or about half of 1% (source: 2009 report from PF2 Securities Evaluations). Let's say structuring fees run about 1.75 percent (this is according to a Bloomberg story). And, finally, let's say the life of the CLO will be six to eight years. Even though the management fee must be paid yearly, the structuring is a one-time expense, and can be averaged over the life of the securitization.

Do a little math and you get about 76 basis points as the yearly cost that has to be extracted from that 10% pot of yield you're getting every year. Now the size of that pot has been whittled down to 9.24% effectively.

So, as Mr. Ratings Guy at S&P, you should be getting a little suspicious at this point, even before you look at the proposed ratings: Citigroup claims to be able to strap these loans together and, through some bit of diversification/alchemy, just sort of poof! -- extract 76 basis points a year. If these loans, after being structured, were somehow "de-structured" but with all the fees still intact, you'd be left with the original 30 loans, but paying 76 basis points less apiece, which is a pretty significant gap in bond land.

That should make you go "hmmm." But once you look at the actual numbers for the proposed ratings, your reaction should be something like, "no way."

Just look at the generous yields on the tranches of the CLO! The AAA slice is 160 to 170 basis points over Libor. That's a super-juiced AAA yield. A AAA corporate bond -- once you make a few tweaks (for the fixed-to-floating swap rate, the difference in Libor vs. Treasury -- I won't show my work now but can later for anyone interested) has a comparable yield of about 54 basis points. How can this be, at a time when the credit markets are relatively calm, when even junk debt is selling like hotcakes? This isn't a period of high market stress and irrationality.

(Brief aside: Some readers may object: "Well, a AAA bond doesn't imply the same risk profile as a AAA slice from a securitization." If you think that, you may want to look at S&P's own writing on the issue from January 2010: "In developing our updated corporate CDO criteria (note: a CLO is a type of CDO), we collaborated with Standard & Poor's corporate and government ratings group to promote comparability of CDO ratings with ratings in corporate, municipal and sovereign, as well as other areas of structured finance. When we assign the same rating level to debt instruments in varying sectors, we are expressing the opinion that they have comparable credit risk.")

Back to our unfolding narrative! This is what Citigroup is essentially saying to you, Mr. Ratings Guy: "Hey, ya know, we just structured it and all, and found this great big pot of yield left over! Son of a bitch, funny huh? I mean, there was so much yield we shook out of this thing, thanks to our genius in structuring, that we could pay the structuring fees, pay the annual manager fees, pay all other fees, PLUS hand out extra yield like candy canes right up and down the waterfall structure!"

Because here's what you have: AAA is getting 111 basis points (1.11 percentage points) more than comparable corporate bonds. AA is raking in an extra 149.5 basis points, BBB an extra 229.5, BB an extra 218.5 ... (the spread for the A rated isn't given, but it's got to be consistent with the others because this grade lies between AA and BBB, so I extrapolated that one.)

That gives us another 116 basis points of yield a year, over the size of the entire CLO, that the structuring genies claim to have conjured from somewhere, for a total of 1.92%.

[Update: Reader “Anonymous” makes a good point below about the need to adjust the numbers to account for a call option premium. A fuller explanation of what that means appears at the end of this post. So the structuring genies are actually conjuring up closer to 152 to 180 basis points of yield out of thin air -- not 192 -- but that’s still a whole heck of a lot.)]

Think about that. These individual loans pay 10% overall. That was presumably their fair value. Somehow Citigroup is claiming, through the miracle of structuring, that it has been able to shave almost 2 percentage points -- one whole fifth -- of that risk away.

This structure makes no sense, right on the ground floor. You can't extract a bunch of fees, pay a bunch of rich yields, and have the math work out, considering there's finite money being paid out by the underlying loans. Structuring, in and of itself, can't produce such enormous savings. If it could, everything in the corporate debt universe would be immediately structured for huge and immediate gains.

Now, Mr. Ratings Guy, you should be saying, "Something smells really fishy here." And if you were thinking like this, you would reach an obvious conclusion:

These ratings have to be bull***t. The AAA tranche of this CLO, for example, deserves a grade closer to junk than to AAA.

Yet Mr. Ratings Guy still signs off on the ratings. Why? Hmmmm...

Stay tuned for Part II in which we answer: Why does Mr. Ratings Guy sign off on ratings he knows can't be correct and why does this farce exist at all? Is what's going on a benign "nobody gets hurt" kind of transgression? And who gets burned if these ratings blow up down the line?

Update: One objection that's been raised: S&P doesn't actually see the pricing when these ratings are proposed. It doesn't see that the AAA tranche, for example, would pay 160 basis points over Libor. Okay, that's somewhat exonerating for S&P, but it doesn't change the math. And what's more, Mr. Ratings Guy isn't that stupid. He can figure out what's going on.

He can easily find out what AAA rated debt pays for other asset classes. Even if he doesn't have the CLO pricing in front of him, he'll discover the same problem I outlined above. This structure supports a tremendous amount of what should be low-yield AAA, and even after you add in yields for the other stuff, there's an awful lot of leftover yield to go around (some of which is used to pay structuring and management fees). All of which leads back to the same questions: How does that act of structuring manage to create so much extra yield? How can these CLO ratings be accurate?

Update, Part II: I wanted to sneak in a second update for those readers who will say -- rightly -- wait a moment, don't loans amortize? So aren't you really receiving the interest rate on the loan plus a certain chunk of principal each year? That's typically correct, and I reference that up high in the post. But just to make clear: I am keeping this example simple with a focus on the interest rate portion only, because the yield is the sexy part. That's what you make over and above your initial investment -- the return of principal is just making you whole. If anyone has further questions/comments, put 'em below and I'll tackle them. The bottom line is the math doesn't really change.

Update, Part III: Explanation of the accounting for the call option: the equity investors (the ones who hold the junkiest tranche) have a call option on the CLO fund, which typically can be exercised after 3 to 5 years. The existence of that call option is undesirable for the other investors, so they’ll demand a premium to compensate for it. So in other words, if investors wanted to be paid 30 basis points above Treasuries for a AAA CLO tranche that can’t be redeemed early, once you add a call option, they’ll want even more.

How much more? That’s the key question. See more details in my reply in the comment section, but basically I give the example of a Wells Fargo note that’s effectively 6-year debt with a call option in two years, where the option appears to be worth 18.5 basis points. In a longer-dated note, the option is worth more: a Bank of America note that matures in 13 years has a call option that kicks in 3 years from now that’s worth 39.9 basis points.

Of course those examples aren’t CLO tranches. Still, for CLOs, the call seems even less valuable. Babson Capital Management looked at spreads for CLO bonds and found in the first quarter of 2007, they were 22 - 26 basis points for the triple A tranche. So even if you assume the investor is assigning negligible credit risk (say 10 basis points, which is paltry) to the asset itself, that leaves only 12 to 16 bps for the call option.

So, relating this to the example above, you can subtract somewhere from 12 to 40 basis points from the 192 estimate to account for the call option. Still, you get a good 152 to 180 bps of mis-rating -- which is quite a lot.

Friday, 28 January 2011

Insurance & We

The role of of insurance in our life is very important. It's very common that most of the people do insurance in their life because those people want to keep their life in happiness.
There are different kinds of insurance in the market for different purpose. In this article you can find out some basic idea about the insurance.
We can define insurance as a small amount of money deposited at a premium to protect against a big expense unpredictable ( claim of loss ). So, If we make insurance then we can protect our self against any major expense unpredictable.
The following are some example of different kinds of insurance like Life Insurance, Health Insurance, General Insurance and Travel Insurance etc.

Life Insurance is one of the good product in Insurance sector. Every people should do the life insurance because in this insurance you can cover those people who is dependent on you.
Life insurance is an insurance, where the dependent of policy holder receive a cash lump sum if he or she dies. You need to pay premium for life insurance as well but within this premium amount you can secure the life of that person who is dependent on you.

We know that health is wealth so if we believe this then we should do health insurance in our life. Health insurance provide financial protection in the time of sickness or injury. There may be some diseases which does not cover by health insurance in spite of this health insurance is very beneficial for people. Here is also you need to pay some premium but if you can cover yourself and your family members' health with some small amount then you should go ahead.

General insurance is a non-life insurance policies within this insurance you can cover the risk of automobiles and homeowner policies.
If you are a frequent traveler then you have a good insurance like travel insurance because travel insurance cover various aspects of loss before or during your vacation.

If you did not make any insurance then you should think about the insurance. Insurance can be the key of happiness in your life.

Tuesday, 25 January 2011

The Architect of the Middle East Peace Turns His Attention to Saving the U.S. Economy

Today, the Financial Times declared the Middle East peace dead. It said it in the heading of its editorial, which read: “Middle East peace hits a dead end”. The lead sentence said: “Any credibility the Middle East peace process retained has been dealt a crippling blow.”

One of the main “architects” of the peace process from the Israeli/U.S. side was a buffoon by the name of Richard Haas. If you google “richard haas + middle east peace”, you will get over 30,000 hits, which is a testimony to the extent of his involvement in the process. Either as a U.S. “official” or a think tank “intellectual”, he was involved in – nay, he planned – every wrong turn in the past 30 years that led to the current dead end. For his services he was made president of the U.S. Council on Foreign Relations.

Now, if after 30 years of constant planning, plotting, intellectualizing, scheming, conspiring, etc., you run the “Middle East peace” into a wall – and the U.S. credibility in the region into a gutter – what do you do next?

Why, you move into something about which, if that’s at all possible, you know even less.

So it was Richard Haas again, in yesterday’s Financial Times, who turned his attention from foreign to domestic affairs and offered economic and policy advice to the U.S. government. The commentary was jointly written with Roger Altman who has ambitions of his own (to replace Geithner). Naturally, it was about the urgency of cutting the social spending and what would happen if cuts did not materialize soon. Here is a gem from the piece:
The American economy is strengthening, and that will improve federal revenue. The annual deficit will narrow to 4-5 per cent of GDP – still very large – by mid-decade. But it will then widen again as the growing elderly population drives up medical costs. New tax cuts, along with the extension of old ones approved in the recent lame-duck congressional session, will only make matters worse.
The American economy is strengthening but then people will stop dying early and that, together with the tax cuts that we pushed for, will make matters worse so we have to cut social security NOW. Got it?

But sound reasoning is not the point of these pieces. A mercenary like Haas does not care about the principles of syllogism in the same way that a thug who pulls a knife does not care about the aesthetics of swordsmanship. The point is softening the populace for the upcoming assault through intimidation.

As for the “macro picture”, you can be sure that with Haas's involvement, a dead end is not too far off.

Sunday, 23 January 2011

Time Preference, Kim Kardashian, Quantitative Easing, Good Black Swan – 2 of 2

Since the beginning of this year, the Financial Times has been all over the case of oil. Its January 5 headline warned:

Oil price ‘enters danger zone’

‘Enters a danger zone’ was in quotes because it came from the chief economist of the “International Energy Agency” who told the FT that “the oil import bills are becoming a threat to the economic recovery.” FT took it from there and surmised that “the warning from the IEA will put pressure on Opec to increase its production.”

Then this past Wednesday, the paper “revealed” that Saudi Arabia had broken ranks with the Opec members and had “increased output quietly in a bid to avoid the impact of price spike”. The Opec secretary general called the rumors of tightness in the oil markets “incorrect”, but no matter. The editorial board of the FT has set its collective mind on doing something about the oil price. To that end, anything would do, whether diffusing disinformation or pumping out a two-man shop with a childishly grandiose name to issue warnings.

Whether the OPEC members will fall for these silly tricks remains to be seen. But the oil price is a serious subject in itself and regardless of who brings it up and under what conditions, it deserves serious consideration. Let us consider it then, starting with the reason for the price rise. Only a criminally insane doctor would prescribe a cure without having diagnosed the disease. We, too, must begin the cause, of which the price rise is a symptom.

Assume oil is $2 a barrel. Here is a picture of this value relation for those who learn visually:

The picture shows that one barrel of oil is worth $1 + $1 = $2.

The FT is saying and hoping that “the warning from the IEA will put pressure on Opec to increase its production.”

What would that achieve, this OPEC increasing its production?

Why, it is elementary. If more oil is produced, the same $2 would correspond to more oil, say, 4 barrels, as shown below.

That is the definition of cheaper oil: the same $2 buying more oil (4 barrels)than before (1 barrel). That is what the FT wants to see.

What happens if instead of more oil, more dollars were produced?

Then, the picture would look like this:

In this situation, confronting the same barrel of oil is more dollars than before. That is another way of saying that oil has become more expensive: more dollars are needed to buy the same barrel of oil.

That's the current situation. Oil supplies have remained constant for the past three years. The reason the oil price has gone up is the Fed's quantitative easing (QE) in the past year that has increased the supply of dollars.

QE is not the same as printing money. The latter increases the quantity of money as means of payment while the former increases it as the medium of exchange (to ease liquidity pressure). But that’s a distinction without a difference in terms of the final result, which is devaluation of the currency.

Because the US dollar is a reserve currency, its devaluation – lowering of its value – translates into an increase in the price of other currencies and commodities, including oil. Just replace the oil on the left side of the last picture with your choice of currency, commodity, mineral, metal, grain, what have you, and you will see this. They all become more “expensive”. Hence, for example, the sharp rise in food prices.

The high price of oil which is becoming a “threat to the economic recovery” of the oil importing countries is not the making of OPEC but the U.S. Federal Reserve.

Does Bernanke know that?

Yes, he does. The entire world, literally, is up in arms against his policy. From the New York Times of November 6, 2010:
The United States confronted growing restiveness with its economic policy on Saturday as leading Asian countries resisted its call to set limits on trade deficits and surpluses while also warning that the decision to pump more money into the American economy would have harmful global repercussions ... Countries like China, Brazil and Germany have warned that the unilateral move devalues an already-weak dollar, and could set off a destabilizing flow of funds into emerging economies that will inflate their own currencies and make their exports more expensive.

On Friday, the German finance minister assailed United States monetary policy as “clueless,” and China suggested that American officials explain their decision so as to calm international anxiety.

Even Japan has been complaining. “First and foremost, one of the biggest reasons for the yen’s rise is the dollar’s weakness, a reflection of American economic policy. We need for there to be a clear understanding of that background,” Prime Minister Kan told Wall Street Journal.

Yet, Bernanke remains resolute, pushing ahead with QE as if he had a vision.

What gives? How did a meek academic whom the Lehman bankruptcy knocked off balance morph into Mr. Resolve? A case of baptism by fire?

The answer is No; that would be an idle conjecture. What is more, the Fed can be very mindful of the “foreigners”. The statistics it released early last December showed that the foreign banking entities benefited as greatly from its various credit and liquidity “enhancement” programs as the U.S. banks and companies.

Wherein, then, lies the explanation?

The newspaper of record to the rescue. Under the heading “Sarkozy Brings Message on Dollar to U.S” it reported on January 11:

President Nicolas Sarkozy on Monday brought his campaign to lessen the dollar’s central role to the White House, where such talk has never found a warm hearing … Mr. Sarkozy has argued that the dollar’s role as the single global reserve currency does not reflect an increasingly multipolar world. Rising economies like China, India, Brazil and Russia are wielding increasing weight and, in China’s case, explicitly calling for a shift away from the dollar’s privileged status.

Mr. Obama did offer general words of support for Mr. Sarkozy’s efforts.

Can you imagine that? Can you imagine a foreign leader coming to the White House with plans for replacing the dollar as the reserve currency and receiving words of support from the U.S. president?

Can you imagine a foreign leader with plans for challenging the U.S. military supremacy being allowed into the White House, never mind receiving words of support from the president?

Yet, there was President Obama, offering support for reducing the role of dollar. That is the official U.S. policy then, with Bernanke aiding and abetting it.

On the face of it, the policy seems “unpatriotic”. Who would want to weaken the U.S. dollar? That is why Sarah Palin and the Tea Party types are against QE. That is also why the German finance minster called the policy “clueless”; he could not for the life of him understand why the U.S. government would undermine its currency.

But it is Herr Schäeuble and the Tea Party types who are clueless. They imagine that the U.S. policy makers would inject trillions of dollars into the international channels of circulation without having thought about the consequences or predicted the obvious immediate effects.

You see how quickly, logically and inevitably we get from finance to politics. They are one and the same subject.

A detailed discussion of QE must await Vol. 4. I merely note in anticipation that the status of the dollar as the reserve currency is a double-edged sword for the purpose of social engineering. In the same way that – and precisely because – it allows for the unchecked expansion of say, military expenditures, it stands in the way of – because it takes away the excuse for – deep budgetary cuts. That is why cuts to the social services in the U.S. have not been nearly as draconian as in Europe.

The dollar as a reserve currency, in other words, is an impediment to a fundamental social restructuring plan that involves replacing the government with private enterprise. So it must lose that status. That is the angle through which we must understand QE: as the bold move in the “Great Game” of finance and politics that is unfolding across the globe. The rest is secondary.

Thursday, 20 January 2011

Your First Step To Start Small Business

In this article you will get a basic idea that how to finance any small business. If you want to start a small business, then you should gather all the basic information about the business, which you want to start and run. It is very common that If you want to start a business, then it requires a large amount. There are many types of business you can start and run, but always you should keep in your mind that without money you can not start and run any business.

Capital is big factor to start or run any business so firstly you need to calculate that how much money, you need to start your business. If your requirement of capital is high then you can also share with someone.
You can find a business partner and you can share the financial burden with your partner to start your business, but make sure your business partner should be for long periods of time. There is also an another way to sort your capital problem i.e, business loan. You can approach for business loan. Just contact your local bank where you can get all the details about the business loan. If you have developed a history with the local bank then it will help you a lot for your business loan. In case of business loan you have to go through by some document process but if you can submit all the details regarding your loan then your loan will be sanction. But in case of business loan , Bank will not provide your all loan amount one at a time. 

If you are looking for more help to start your business then you can also contact Small Business Association. You can get the different types of idea about the loan.In this way you can get the basic idea that how to finance a small business. 

Internet is also a huge source about the information. So, you can take as much as information about the business loan and other way to finance your small business. 

Saturday, 15 January 2011

Happiness In Your Life With Insurance

Everyone in their life wants to happy and people do many things for their happiness. We know that a family is form with many relations like parents, spouse and siblings etc. Everyone thinks a lot about their family. We think of them, we care about them and tie a knot for good. This kind of love that happens in a family and always think about their safety, but one thing we must know that anything can happen at any time in our lives. Today, we see that there are many accidents happen in our environment. It is clear that we are aware of and conscious living as possible, instead of this we can make no assurance that we will be safe for all time.
If something bad happens to someone as an accident or illness and type of danger, then it becomes very unfortunate. At that point in time we have to take him or her in the hospital, etc depending on the situation. We don't know that how much money can be require on that point of time. If the casualty is big then may be your saving account is not enough to cover your situation. Those who are millionaires who have no problem to recover, but others who suddenly can not afford this amount and have to face significant problem.

Insurance is one of the best way for them who can not afford that much of the amount of a sudden because we know that we have a policy insurance life coverage, the policy of different types of accidents or Mediclaim by which we can claim our insurance. In insurance, we just have to give a premium base period determined by your insurance plan. Once you will make insurance then you can live your life without any tension as you know you have an insurance policy. If unfortunately something wrong happens to you in future then you can take the help from insurance to sort your money problem.

The main objective of this article is giving the information about the Insurance that how important for us ?. So, If you really want to happy in your life then today you should contact with the insurance agent. If you have made your insurance then you must be in happy mood.

Friday, 7 January 2011

Business Bank Loan

If you want to run any business then you need money. There are many types of business in the market and how much money is required for your business is dependent on the type of business which you want to run. So, if you don't have the money then you can not start your business. But the capital problem can sort out with the help of business bank loan.
As you know that if you want to run your business then you need a lot of things like office supplies, fax line, computer, phone systems, printer and so on. These are the basic equipment of your business without these you can not run your business as well as you will need some software for your business.

You need software for your business but the type of software depends on your business which you are going to run and the price of software is expensive. So, this is the list of things which you will require to run your business. But here is one more most important point need to discuss that is your office address. You have to require a place where you will run your business.

You can start settle your business in your home then you don't need to pay any money for the rent of office. But you business requirement is something where you have to select the option to take an office in rent then your capital will get increase. In this way your budget will get increase for your business. Bank provide all types of business loan but you need to fulfill all the criteria which are applicable for business loan. Its very common that the demand of business loan is very high as many people want to run business.

This is the reason that the demand of such type of loan is very high. You know that if you want to run a big business then you need big capital and bank is the only place from where you can get a huge amount of money in the form of business bank loan.

If you want to apply for business bank loan then you have to fulfill all the criteria for the business bank loan as well as if you have any preference of the person who have already involved in business bank loan then it would be good for you so contact those people who are associated with business bank loan. It will be good preference for you.

You can also get some basic information regarding the business bank loan from Internet as well. So take all the information from Internet about the business bank loan as much as you can. Once you will get your loan then you will start your business easily. Best of luck !

Sunday, 2 January 2011

High Frequency Trading and Flash Crash – 4: How the Pieces Fell Into Place

After Black Monday on October 87, there were loud and bitter complaints about the chaos which had prevailed throughout the day at the exchanges. The problems were especially glaring in Nasdaq, which mostly catered to retail investors. Many sell orders there were never acknowledged much less executed.

The chorus of drawn out criticism forced the SEC to act. Finding the path of the least resistance which also answered the greatest number of complaints, it compelled the Nasdaq market markers to create the Simple Order Execution System (SOES). The SOES was a computerized stock trading platform. Market makers had to display in it their best bid/asked prices for all the stocks in which they made market and honor those prices for at least 1000 shares.

As an example, Goldman Sachs displayed its prices for Microsoft as follows: MSFT 1000 24 1/4 x 24 5/8. This meant that Goldman was ready – and obligated – to buy 1000 shares of MSFT for $24 1/4 and sell the same number of shares at $24 5/8.

Since all market makers followed the same format – the main ones then, in addition to Goldman, were Lehman (LEH), Merrill Lynch (MER), Morgan Stanley (MSC) and Bear Stearns (BSC) – if one typed the stock symbol MSFT into the SOES, instead of a single price which was the stock’s last traded price (and the only price the investors were hitherto allowed to see), one saw the following:
  • MSFT 24 3/8 x 24 ¼
GSC 1000 24 1/4 x 24 5/2
LEH 1000 24 3/8 x 24 5/8
MER 2000 23 7/8 x 24 ½
MSC 1500 24 x 24 3/8
BSC 2000 23 7/8 x 24 1/4

Initially, market makers welcomed the system, reasoning that the “computerized” trading would boost the trading volume and thus, increase their profits. They were right about the volume. But the “thus” part, as in “thus increase profits”, did not follow in the expected manner.

Look at the price tableau above. As a market maker, BSC is obligated to sell 1000 shares of MSFT at $24 ¼. LEH is obligated to buy 1000 shares of the same stock for $24.375. One could buy $1000 shares of MSFT from BSC for $24 ¼ and sell it immediately to LEH at $24.375 for a riskless profit of $125.

Why would – how could – this relation exist? The answer is that, prior to the SOES, the market makers used the phone to take the pulse of the market and adjust their prices accordingly. If the prices changed rapidly, or if a market maker was distracted, he could fall behind in updating the prices. In the old clubby world of the market makers, where no outsiders were allowed, such complacency was harmless. LEH could still buy the stock for $24 3/8 because it sold it at $24 5/8.

Now, the SOES traders would bombard BSC and LEH with buy and sell orders – buying from the stock from one for $24 1/4 and selling it to the other at $24.375 – until either LEH lowered the bid or BSC raised the asked price.

That’s how day trading began

Economics and finance professors, too, welcomed the system. The SOES was the realization of their theories about the superiority of the “market based” solutions to all the problems. The SOES, as everyone could see, was bringing transparency and equilibrium to the markets. With a computer at each home and a day trader in each family, it was only a matter of time before stock prices could be said to be trading continuously; there would always be someone somewhere trading.

Such predictions and deductions seemed logical, in the way that a Norman Rockwell painting appears logical. In his paintings, there is never a violation of the principles of perspective and the subjects – humans, animals, things, nature –are depicted in a believable state.

The shortcoming of Rockwell paintings – and the standard theories of economics and finance – is their child-like, gullible simplicity that comes from the absence of experience. But adults “have been around”. Their “absence of experience” could only be due to an inability to comprehend the environment – the inability to see the surrounding social realities that are certain to get in the way of the happy picture.

Seth and Simon were two upper class friends. They finished boarding school and went to Harvard. After graduation, they decided to make a name for themselves by becoming independently rich. They would show their dads and moms their entrepreneurial skills.

One way of getting rich was scalping Indians. Indian scalps fetched $50 each. They decide to go West and scalp Indians.

They bought the most fashionable hunting clothes, the sharpest knives, the best ropes, the latest rifles and the fastest horses and headed West. There, they rode to the Indian Territory in search of Indians.

They looked high and they looked low but couldn’t find any Indians. After a while, they got tired and fell asleep.

Seth was the first to wake up. He looked and saw that they were surrounded by 50 Indians wielding axes. Behind them, in a bigger circle, there were 100 Indians with bows and arrows. Behind them, in a still larger circle, were 200 Indians with rifles. Seth was beyond himself. “Simon, Simon,” he shouted. “Wake up. We are rich.”

I have pointed out on many occasions that the subject of finance is not people. It is finance capital in circulation. Being a thing, finance capital cannot place trades, exploit opportunities or arbitrage “inefficiencies”. It does all that through humans who do its bidding. Likewise, in saying that speculative capital – the latest form of finance capital – is self destructive, I do not mean the speculative capital, as an abstract concept, somehow manages to commit suicide. The destruction, rather, is brought about by the actions of individuals who rationally strive to maximize their profit. That process – the individual profit maximization – is what destroys the conditions, the infrastructure and finally the very system which gave rise to speculative capital. From Vol. 1:
The manager of speculative capital must employ it in activities that are consistent with [its] attributes. True, the manager can decide the specific occasions of the capital’s employment, but that selection must be made from a menu of choices predefined by the attributes of speculative capital. He cannot commit the speculative capital to long-term mortgage lending. Thus, in the absence of any real option, the manager of speculative capital turns into its agent, someone who nominally “runs” the speculative capital but must in fact follow its “agenda.” Speculative capital becomes the grammatical subject of the sentence as if it were alive: speculative capital seeks arbitrage opportunities. Of course, it does so through its agent, the fund manager, but it is the speculative capital which determines the nature of its own employment and calls the strategic shots.
Implicit in the statement that speculative capital is self-destructive is the use of force, further connoting coercion and compulsion.

Look at the price tableau for MSFT. On top, the public quote for the stock is 24 3/8 x 24 ¼. These are the best bid and offered prices. As a customer, you could not sell MSFT higher than $24 3/8 or buy it lower than $24 1/4.

But these bid/asked prices do not come from the same market maker. Only LEH is bidding $24 3/8 for the stock. And only BSC is offering it for $24 1/4. Individually, the market makers have a much wider spread. If your broker had an “order flow” agreement with Merrill Lynch, for example – and everyone had an order flow agreement with a market maker – it would cost you $24.5 to buy one share of MSFT and you could only get $23.875 if you sold it. So MER made $375 in each 1000 shares of stock that it bought and sold.

That was true for all the market makers. Would they then allow a system which brought them tens of millions of dollars in profits each year be disturbed to their disadvantage?

The answer is that they would not – voluntarily. But then, on the other side was speculative capital.

In Vol. 1, I chronicled the open fight that broke out between the market makers and retail traders after the introduction of the SOES. I urge you to read that section as a case study of how events in real life take shape and unfold. Norman Rockwell sceneries they ain’t.

For example, whenever the market makers were caught as the subject of arbitrage, because they had failed to update the prices, they refused to honor the trade. This “backing away” from the trades went on for years without either the SEC or NASD taking actions to stop the illegal practice. A Wall Street Journal article from 1995 gives a glimpse of what was taking place. Note the paper’s framing of the story by use of terms such as “unsympathetic victims” and “SOES bandits”:
Major backing-away sanctions have been rare partly because so many of the backing-away complaints have come from … ’SOES bandits,’ whom dealers accuse of bombarding the market...with orders at dealers’ expense. The 12 backing-away incidents in the Morgan Stanley case all involved orders from SOES bandits, and the Lehman matter is understood to derive from bandits’ complaints, as well … yet despite unsympathetic victims, backing away from quotation is forbidden in the markets.
Put yourself now, if you will, in the position of speculative capital. Through the SOES, you finally have a venue to the world of market makers. You see that Lehman, for example, quotes MSFT at 24 3/8 x 24 5/8. That is a large spread. Why is there no mid price, say, $24.50?

The answer is that Lehman would not allow it. Market makers were happy with the way things were and would not allow a change. So their resistance had to be overcome – crushed, if need be. As always, the agents for the deed would be humans. From Vol. 1:
For years, the complaints of investors about the artificially high bid/asked spreads in Nasdaq stocks went unheeded. In 1994, the publication of a paper by two professors who claimed “collusion” among market makers finally drew the attention of the Justice Department which began an investigation. That forced the Securities and Exchange Commission (SEC) to act. In 1996, after two years of investigation, the Commission issued a scathing report about the conduct of Nasdaq market makers and demanded a series of changes to the system. One of the more significant of these changes was requiring market makers to post outside prices that improves the current best bid and asked.
Market makers fought back nail and tooth, through lobbyists, campaign contributions, placing stories in the press and even through legislation:
Three of the biggest Nasdaq Stock Market Dealers are mounting a behind-the-scenes campaign on Capitol Hill to block the Securities and Exchange Commission from imposing new rules on their market. [A lobbyist hired by some Nasdaq firms] has drafted a proposed amendment to a securities bill that … would obstruct the SEC’s plan to enact rules requiring more open display of prices on the Nasdaq over-the-counter market. The amendment would require the SEC to study, at great length, the rules’ effect on “the competitiveness and liquidity” of the market.
But the game was lost. Wall Street Journal, December 30, 1997:
A federal judge … granted preliminary approval to 30 securities firms’ $910 million settlement of a class-action suit alleging that the firms fixed prices in the past on Nasdaq Stock Market trades … The investors’ lawsuit alleged that more than three dozen Nasdaq dealers conspired to widen spreads on trades involving 1,659 stocks.
Speculative capital won the battle of the spreads. The bid/asked spreads which were kept artificially high at about .375 of a point, fell to 1/8 of a point or $.25. But who said that spreads must move in the increment of 1/8? Why not in mere pennies? That, too, came to pass. The New York Times, 1998:
After more than centuries of using a system descended from Spanish pieces of eight, American stock markets are now appear to be moving toward having stocks priced … in dollars and cents … If Wall Street does move, it is widely expected that it would lead to better … prices for investors. That gain would come at the expense of brokers, who have resisted the move in the past … A change in pricing could shrink their profit margins.
Against the will and interest of market makers, bid/asked spreads thus collapsed to what they currently are: a fraction of a penny for HFTers.

Speculative capital had one last vulnerability which its foes used to prevent it from dominating the daily stock trade. From Vol. 1:
To compensate for the shrinkage of profit margins, the size of the capital must constantly increase.
So if the size of speculative capital decreases -- or is forced to decrease -- it will lose its edge. That's where market makers made their counter move. Wall Street Journal, January 1997:
Nasdaq officials have asked the SEC to permanently lower the “minimum quote rule” to 100 for all Nasdaq stocks, saying it would help the market accommodate the SEC’s new sweeping order-handling rules.
The “minimum quote rule” above means exactly the opposite. It means lowering the “maximum” number of shares traders could buy and sell through the SOES. The SEC approved their proposal. A few months later, the same newspaper returned to the story:
[SOES] traders also hotly complain about Nasdaq’s 90-day test program that lets market makers trade only 100 shares of certain stocks at a time with SOES traders. The difference is vast; a quarter-point profit on 1,000 shares is $250; on 100 shares its only $25. And the pilot program includes the top-10 Nasdaq-traded stocks like Microsoft, Intel and Cisco Systems.
The Islamic legend has it that Azrael complained to God that it was unfair for him to be singled out as the cause of death on each and every occasion. God answered that he need not worry as there would always be a “cover story”: accident, disease, war, murder. Azrael’s name would never be mentioned!

Everything from the beginning of this post could be told as “human story”: Market makers vs. trades, regulators vs. market makers, or Nasdaq system vs. the NYSE system. But behind the stories is speculative capital whose inexorable logic, as the motivation of humans, drives the events.

Again, put yourself in the position of speculative capital. You have reduced the stock bid/asked spreads to under a penny, which means that the size of the trades have to be very large to be profitable or even make sense. But your size is reduced to a mere 100 shares. What would you do?

Why, you would do what every retailer knows: make up for lower spreads through the volume. That is high frequency trading. En ma fin, est mon commencement, you declare. The small time day trader is dead. Long live high frequency trader!