Thursday, March 26, 2009

Impact of Market Downturn on Hedgefund and Mutual Fund Industry

Both the industries have witnessed massive redemption. Their portfolios have shrunk due to the sudden fall in equities. Due to these, the overall portfolio sizes have shrunk. The industry will endure the following 5 changes.

1. Increase Fee Structure - Fees will rise to spread the cost to fewer investors.
2. Increased Consolidation - Industry will consolidate. Weak players will disappear. Weak Funds will disappear. strong funds and companies will strengthen.
3. Increase capital outflow and retail investment in stocks and bonds - With equities at decades low, retail investors are venturing into the stock and bond market in greater number.
4. Increased Regulation - Hedge fund industry has enjoyed relaxed regulation. That will be a luxury going forward. They will need to maintain higher capital to absorb risk. They will have to be more transparent with their methods. They will also be subject to more regulatory oversight.
5. Increased flight to ETF - ETFs are more tax efficient and regulated. Investors will fly to ETF to avoid the cost structure of mutual fund and hedge fund.

Fed Bond Buyback

Last week when Fed Chairman announced US treasury buyback, bond yield fell and soon after mortgage rates fell as well. Then, market digested the news. The next day the market sold off. When Secretary Geither announced the details of public-private approach to purchasing toxic assets, market reacted positively. Then, Treasury tried to buy bonds. It received lukewarm response. Then, it received massive response.

Overall, the investors are expressing confidence. Market seem to reinforce that. A week is too early to declare victory. But, given the rout in the stock market and the recent improvement, FED effects seem to be working in the right direction.

Tuesday, March 24, 2009

Call for new global reserve currency is premature

US Dollar is the currency in which many countries hold their foreign reserves. Due to the FED decision to purchase treasury bonds and due to recent the fiscal deficit, trading partners; especially, China is wary of US Treasury Bonds (also of US $).

Oil trades in US $. Exports trade in US $. US $ is free float. Ruble is volatile. Chinese Yuan is float within a narrow band. Many countries have tied their currencies to US $ due to its history and stability.

Current US fiscal deficit and rise/fall of US $ is a short-term phenomenon. US is blessed with the bounty of nature, innovation, free market and entrepreneurship to overcome the deficit and balance budget.

Let's analyze Euro. Euro has gained in strength since its inception (was equivalent to $0.84 and ended above $1.50 last year), has lost strength after the global economic crisis. UK has thus far remained outside of Euro. Euro is a global currency in a limited scale (within the Euro zone). Has this alleviated the problems of the member countries? No.

A new global currency is not something the world needs. World needs to rid itself of the toxic assets and get back to the path of growth. That is what is truly needed.

Removal of toxic assets from bank balance sheets

Treasury's model is public private model. This will help to establish a realistic market price for the illiquid assets. Fed is on the hook for 85% of investment while the private investor is on the hook for 15%. It is better than FED being on the hook for 100% of investment as in the case of the insurance giant.

Market has reacted to this positively. Several institutions have expressed interest in this.

By removing troubled assets from banks balance sheets, banks will start lending more freely.

This approach is promising. Off course, time will tell the outcome.

US purchasing Treasury bond

Purchasing treasury means FED is injecting money into the market. Here is the effect of FED decision:

1. More money in the market raises inflation.
2. More money flow into the market makes more US dollar available. The more US $ available, the less desirable dollar becomes. Hence, US $ weakens.
3. Since FED is buying, yield has fallen
4. Since bond yield has fallen, mortgage rates have fallen.

Net impact - Overall, the currency has weakened. Mortgage rates have fallen. Gold price has risen.

Benefits -

1. This is good for housing sector.
2. This is also good for global domestic comanies - this will thelp their earning.
3. But, will raise inflation. To contain inflation, FED would raise interest rate.

Wednesday, March 11, 2009

Redefining Mark-to-market

FASB 157 defined fair value and provides a framework for measuring fair value of assets. This was issued recently. Fair value is based on the market exchange. Under market failure, fair value is difficult to obtain and ascertain. Market failure has occurred for the mortgage based securitized toxic assets. Fair value does not apply to these toxic assets. Market has not experienced the 60%+ correction as it has over the past 18 months. Therefore, mark-to-market needs to be assessed and redefined. The redefinition will stop the demise of healthy banks and diversified financial.

Case for re-instatement of up-tick rule

Should up-tick rule get re-instated or should it not?

Dow has lost more than 60% from October 2007. Negative news keeps pouring day after day. This has given rise to irrational trading. Short sellers are feasting on long term investors. Big name stocks have turned to penny stocks.

Market needs to stabilize for consumers to regain confidence in the markets. For that to occur, up-tick rule is essential. To make matters worse, the ponzi schemes have eroded savings and confidence from investors. Up-tick rule was in place since great depression and was suspended at the peak of the last bull market. Confidence in market is critical for economy to recover.

Re-reinstatement of up-tick rule will be a great way to boost confidence.

Tuesday, March 3, 2009

Re-instate up-tick rule to instill confidence in capital markets

Derivatives play an important role in the capital markets. Selling securities short (sell what one does not posses) and cover when price drop to profit from a sell without pre arranged means to cover the shorts is naked shorting. During a time of heightened concern of the recession, maybe the impending depression, public sentiment is high to exit the capital market to save whatever of their investment is left. That negative sentiment is feeding on the naked short sellers. That activity is bringing equity prices well below the book value for reputed companies.

Naked shorting is illegal. To prevent speculative short selling, up-tick rule is designed. Under the up-tick rule, short selling can be done provided the security is sold above the current market price of the security. However, this rule has been suspended. This rule needs to be re-instated to instill confidence of public in the capital markets.

Monday, March 2, 2009

Where will the economy recover first?

Where did the down fall begin? Well, it started in the housing sector. Then, it spread to banking sector. Then, it spread to insurance sector. The order in which the downturn unraveled is as follows:

1. Housing
2. Banking
3. Insurance
4. Manufacturing
5. oil & Natural Gas
6. Retail
7. Tech

How will it recover?

The economy would recover as follows.

1. Banking - Unless banks are healthy, banks can not lend. Treasury is using all the tools available to strengthen the banking sector.

2. Housing - Once money starts flowing freely, mortgages will flow freely. This will aid housing sector.

3. Manufacturing - Manufacturing sector will benefit from the stimulus package.

4. Insurance - Stable banking, housing and manufacturing will bolster insurance sector.

5. Tech - Once businesses and individuals start spending, tech sector will tech off.

6. Retail - Once public has more money, it would spend. Retail will benefit from consumer spending.

7. Oil & Natural Gas - Once manufacturing sector improves, oil & natural gas sector should improve due to demand.


There are four proven methods of valuing companies: Discounted Cash Flow (DCF), Transaction Comparable, Trading Comparable and Leverage Buy-out (LBO).

Many raise the question whether these valuation methods hold true during recession.

The answer is still "yes". But, these are affected due to the market conditions in the following 3 ways.

1. Discounting rate for DCF is reduced due to risk free rate. Simultaneously, the Free Cash Flow (FCF) is reduced due to abysmal sales. The overall valuation is less than what it used to be in pre-recession days.

2. In case of Transaction and Trading comparable, the multiple has been lowered.

3. In case of LBO, high yield bond sell is difficult in this market. LBO deals have rarely taken place since last Fall. Essentially, LBO deals are out of favor now.

Strategic buyers are still making purchases at a time of low valuation to fill a gap in their product, service or geography. Financial buyers are waiting in the sidelines for the market to improve.