Monthly Archives: December 2010

The Thin Line Between Financial Markets and Gambling

A NYT article by Susanne Craig spots Cantor Fitzgerald, one of the lead brokers on Wall Street, expanding into the gaming industry. They have a subsidiary, Cantor Gaming, that runs the books for sports betting operations and other activities.

“Guys who trade Treasuries are doing it for basis points, and sports betting is not much different,” said Jeffrey B. Logsdon, an entertainment and gaming analyst for BMO Capital Markets. “Trading a million dollars in Treasuries is different than trading a billion. Sports betting is the same. You want the spread, volume and you see yourself as a match maker.”

The Strange Dynamics of Crises

Felix Salmon of Reuters has an interesting post yesterday on the possible dynamics leading to a default on municipal debt. He was riffing on comments made by the banking analyst Meredith Whitney on 60 Minutes. What was interesting to me is how well he captured the strange dynamics behind a possible scenario in which multiple municipalities default on their debt. Whitney is certain there will be many defaults, but Salmon quotes the arguments of others pushing back with all the reasons why the probability is small that any individual muni would choose default. But then Felix Salmon writes “The problem with this line of argument is that it ignores the way in which the correlations all go to 1 in a crisis.” He goes on to explain.

Rick Bookstaber, now of the SEC, provided a similar explication of the strange dynamics of market crises in a post on his blog back in June. In a crisis, all the dynamics suddenly change dramatically.

It’s Not Enough to Reward Performance

The most recent issue of the Quarterly Journal of Economics has an interesting article by Dean Foster and Peyton Young on the gaming of compensation schemes by portfolio managers. They demonstrate that any compensation scheme based exclusively on performance, without conditioning on any information about the actual underlying investment strategy, can be gamed. It’s not enough to reward performance alone. What’s necessary is transparency in managers’ positions and strategies. Then it’s possible to structure a viable compensation contract.

In an earlier post we emphasized that good governance of risk managers at non-financial companies requires making distinctions between types of strategies. The Foster/Young results, while developed for investment managers, have relevance for corporate risk managers, too. Only by scrutinizing risk managers’ positions and strategies can the company incentivize the right kind of hedging.

Using Cash to Repurchase Shares

Last week we highlighted a WSJ article on the growing cash balances at companies. We pointed out that in some cases the right thing for the company to do is return that cash to shareholders. The WSJ’s Real Time Economics blog reports today on Federal Reserve data showing increased share repurchases by companies.

Sadly, the blog worries that buying back shares “won’t lead to the kind of hiring the economy so desperately needs,” presumably because it means the companies are not investing in new capacity or other forms of expansion. But this confuses things. Just because a company is accumulating cash doesn’t mean it should be the one investing. A lot of good investments are to be made by new companies without cash, or by companies that suffered cash drains in the Great Recession. A signal element of a well functioning capital market is the ease with which cash is returned to shareholders to be reinvested where it is most needed.

Aggregate investment is still low right now, and the economy may be waiting a long time for sizable new hiring. But that is fundamentally driven by global economic forecasts. It won’t be helped by a mechanical focus on driving new investments specifically from the companies where the cash is piling up. That’s just a recipe for sclerosis. Given any forecast, we are liable to get greater new investments because cash is freely flowing back to investors where it can be channeled to the highest value new investments.

Catastrophe risks: the US National Flood Insurance Program

An interesting analysis of the US National Flood Insurance Program by Erwann Michel-Kerjan appeared in this Fall’s issue of the Journal of Economic Perspectives. One key issue in evaluating the program and its payouts versus premiums is assessing the probability of extreme events–always an issue in catastrophe insurance. Another key issue is incentives to game the program rules, something that also arises persistently in legislatively mandated insurance. In this case it is the use of outdated maps. And, the well known issue of reduced incentives to take actions to minimize the risk of loss. In the conclusion, the author points out that several other countries use private insurance markets for the same risks.

Blocking Competition in OTC Derivative Trading

The NYT ran a long piece by Louise Story describing how a few large banks operate to maintain their control of the OTC derivatives market against would-be competitors. It does a good job of giving the readers a feel for how difficult it can be to enter the market. But while one feels this, the story doesn’t explain the underlying forces that help maintain entrenched interests even when competitors could add value to potential customers. For that kind of analysis, one has to look elsewhere — for example, to this report from the NY Fed.

I have to say, I was also startled by the title of the story, which mentioned a “secretive banking elite.” Given the sad history of conspiracy theories associated with banking, and the antisemitism that often goes along with it, I would avoid using words like this. It’s always astonishing that these theories continue to live, but they do. Anyway, what the big banks are doing in this market is all being done out in the open, so I don’t see the secrecy.

Companies Cling to Cash

That’s the top headline in today’s WSJ, reporting on the continued growth in cash as a percentage of all corporate assets. The figure now stands at 7.4%.

One obvious reason that cash is increasing is that The Great Recession makes some investment projects look less profitable. But that begs two key questions.

First, the level of cash has been growing fairly consistently since the early 1980s, as the WSJ’s front page graph highlights. So while The Great Recession may be relevant to the recent spike, this spike appears to be just a swing along a longer term trend. There’s a nice paper in the Journal of Finance by Bates, Kahle and Stulz documenting the longer trend and identifying the causes. Their conclusion: company cash flows are riskier, and more of the businesses are R&D intensive with fewer assets in inventories and receivables, so that a company’s normal need to be cautious will lead it to hold a higher amount of cash.

Second, if a company is not going to invest the money, then shouldn’t it return it to shareholders? Perhaps not, if the company expects The Great Recession to be short-lived and investment opportunities to return.

Contagion in Natural Gas?

Wednesday’s FT has a story about the shuffling of US gas acreage among companies. Two things are happening simultaneously. First, the value of undeveloped shale properties has risen as the opportunities for profitable development become ever clearer. Second, while oil prices have climbed, natural gas prices have collapsed. Companies want to shift production to fields heavy in liquids and temporarily cut back production in fields filled with dry gas.

If companies already have acreage with liquids, great. Alternatively, if the company is cash rich, then it can afford to buy a new field with liquids. But companies with neither are under pressure to sell their dry gas acreage in order to fund acquisition of fields with liquids. Many companies are in this position, so plenty of properties are up for sale at the same time. Is that driving prices for dry gas acreage down even further than the fundamentals justify?

It would be a nice question to test empirically. There is plenty of academic literature about both fire sales and contagion. This could be another case study.

How much does the fire sale discount add to the value of companies with the liquidity to take advantage of it? How much does it subtract from the value of companies caught short of cash?

Sorting the Hedgers from the Speculators

Financial regulators are often in the position of attempting to proscribe or regulate certain types of trading activities. The Dodd-Frank financial reform legislation prohibits banks from proprietary trading. Futures regulators are often in the position of trying to distinguish hedging from speculating.

The task of sorting the different types of activities can be difficult. Cynics of all stripes exaggerate the impossibility of the task. Some belittle efforts to regulate by claiming that the different types of trading aren’t really different in any essential way, so that all regulations come down to arbitrary and ultimately counterproductive regulations. Others hype the ability of traders to evade any regulation by means of crafty relabeling, so that the regulation ultimately has no effect. These discussions are often poisoned from the start by the partisan nature of any debate about government regulation, so that it is impossible to get into a substantive discussion about real distinctions in different types of trading. But the need to make distinctions isn’t unique to the regulatory sphere. It is a general feature of good governance. Even corporate managers are tasked with defining the types of trading that the company’s own risk managers will be allowed to pursue on behalf of the shareholders.

Francesco Guerrera of the Financial Times called attention to a paper of William Silber’s in which he documents the distinctive footprint of proprietary trading. This is exactly the type of substantive discussion that is needed. Making the distinction is difficult, but that doesn’t make it impossible, and the distinction is critical.

Every non-financial corporation that seeks to hedge risks using derivatives needs to be able to make a similar distinction between hedging and speculation. It will want to prohibit its traders from conducting speculative trades. And all proprietary trading is speculation, so that’s a good place to start. The relevant footprint distinctions are going to be a little different from what Silber highlighted, since he was addressing financial institutions. But the idea will be the same.

How to Discount Public Pension Liabilities

Monday’s WSJ has a story about a move by the new House Republican leadership to put pressure on state and local public-employee pension authorities. Buried inside the political fights is an important valuation question: what is the right discount rate to use when valuing the liabilities of a public pension plan? The Government Accounting Standards Board has a project to review this issue.

Risk is a key element of many of the arguments. Proponents of the relatively high discount rates argue that (1) the right rate is determined by the return one can expect on the money invested to payoff the future liability, (2) a high rate of return can be reliably expected given a long time horizon, and (3) state and local governments have a long (endless?) life. Point #2 is a fallacy, but one that continues to have many adherents. This poor understanding of how risk compounds over time undermines many valuations. A number of articles by Paul Samuelson, Robert Merton or Zvi Bodie address this fallacy in various manifestations. A good one by Samuelson is here.

For another approach to critiquing the current practice, see the testimony of my colleague, John Minahan. Thanks also to John for suggesting this comprehensive introduction to the conflict between the historically received pension model and modern financial economics: a paper by Bader and Gold on “Reinventing Pension Actuarial Science.”


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