Play the Players

From the  BLOCK TRADERS’ ETF MONITOR, forbes.com  5/1/2010
By Peter F. Way, CFA

Last letter (4/19/10):  “The GS fraud case probably is not going to be a single-purpose or single-event action.  We may hear more from the Feds at Justice, and certainly from the “plaintiff’s bar,” now notified that suits against one of the “deepest pockets” imaginable will provide an ongoing legal fee lottery for some time to come.”

As predicted, the legal piranhas are swarming to the class-action attack.  Additionally, stories of criminal investigations circulate.  In recognition, GS stock has been reclassified by S&P to Sell.

There are clear indications that Goldman Sachs knew as much as a week earlier that the suit was coming.

This provides an opportunity to illustrate just how well a transparent risk-evaluating market (like listed stock options) functions.  The following picture is drawn from our related website, blockdesk.com, where we display how protection-derived price range forecasts for stocks evolve through time.

GS Daily Price Forecast History on April 30, 2010

In the week before announcement of the SEC’s initial fraud complaint against Goldman Sachs, the public market in GS stock stood in denial, with prices even rising a bit further. (They are partly obscured awkwardly, by the data table in the upper right corner of the picture.)

But the better-informed options market anticipated what was to come, adjusting its prices to forecast (in red) a drop to at least the $160 area from $180, and perhaps to as little as $140.

At the complaint, GS prices closed in the upper $150’s after seeing intraday lows there each day.  This Friday’s close took GS down to $145, with once-again lowered price projections.

Ironically, the GS options prices are dominated by the entire block trading and proprietary trading community, of which Goldman Sachs is the most influential member.  But it is a market driven by risk-neutral arbitrage, where no one party in the community can control outcomes, as this makes evident.

Live by the sword, die by the sword.

Goldman Sachs, although seriously wounded, will not perish.

The principal issue in the financial reforms discussion remains the enforced legal separation of trading roles between agents and principals.  Unless they are kept separate, conflicts of interest cannot be avoided.

This is what Glass-Steagall of yesteryear, and currently, “Volker rules” involve.  The legal structures of former securities brokerage firms, now federally-insured “banks,” throws additional political conflicts of too-big-to-fail and risk-taking-with-insured-public-deposits into the mix.  Common sense demands it all be unwound into separate firms that operate either as agents or principals, but not both.

The outcome ought to see a return to partnerships undertaking the proprietary trading role and the underwriting-dealer functions as principals, with corporations (possibly “banks” ?) acting as agents to facilitate trades.  But both functions are essential and must be provided.

The firms that need to be so dismembered are putting up a defense that such action would drive those markets offshore, to the detriment of US employment and economic recovery.  With so many countries abroad suffering from the world-wide market’s collapse, it is hard to conclude that there are many, if any, eager to be hosts for the possible future repeat of such atrocities.  This is a pure red-herring defense.

A multi-trillion-dollar market functioning from Guernsey or the Caymans is not credible.

The complete lack of any clearing and performance-guaranteeing entity in the mortgage securities market induced the immoral and unrestrained behavior leading to that market’s collapse.  Even Goldman Sachs admits that a clearing operation in mortgage-backed securities is essential, and offers its participation.

What is lacking further is a risk-insurance market that has standardization, transparency, and enforcement to provide liquidity in the MBS market.  Needed is the function that is so well performed in equity markets by the Options Clearing Corporation.

The risk-mitigating vehicles attempted were Credit Default Swaps (CDS), but rather than being related directly to the CDO securities, they were between institutions on a private-deal basis, with no standardization, transparency, or evidence of enforceability.

From someone with little knowledge of the bond markets for MBS, it seems like what needs to occur is the evolution of well-defined standards and genuine ratings for the CDOs (with some legal recourse to the raters), and an options-like market based upon CDO market evaluations.  Then this more specific put-your-money-where-your-concerns-are mechanism would act as the means of inducing liquidity into the market for MBS bonds, as well as ensuring ultimate responsibility of actions.

Copyright © 2010, Peter Way Associates.  All Rights Reserved

Recent News Market Forecasts, market-making, SEC

Finally some meaningful, active, operational discipline is returning to financial markets.  The SEC’s fraud charges against Goldman Sachs and related parties hopefully are the first sign of a realistic return of morality to a community desperately in need of public confidence.

Fifty-plus years ago at the beginning of our involvement with investment markets, the cop on the beat was the New York Stock Exchange.  They were the ones monitoring trading activity, setting the rules of engagement, and controlling access to the market that really counted.  If you wanted to be a part of the game, you had to play by the rules and behave.  Otherwise, you got thrown out, permanently.

That role continued up until the last few years, when it became undermined as major brokerage houses shed their partnership structures in favor of public-ownership corporation status.  Then when the exchange itself became a for-profit corporation with its own IPO, pretenses at discipline from that quarter disappeared.

During all this time the SEC was a paper pussy-cat, kept understaffed and emasculated politically, to the benefit of the investment community.  Only trivial matters of form, rather than substance, were dealt with.

Finally, when the Madoff affair appeared, publicly and politically obvious, postures at the SEC became intolerable.  Separately, the subsequent CDO/CDS whitewash and taxpayer-paid bailout of the perpetrators was the final straw.  Now national outrage is widespread, and we hear of tea-parties.

Nothing happens in the beltway until the involved bureaucrats are sure their backs are covered, regardless of which political party is nominally in power.  For the SEC to frontally challenge the king-pin of political influence from the investment community appears to mean that the oval office has been kept fully apprised and endorses the action.

That suggests major difficulties for congressional “financial reform” movements that simply tut-tut the status quo.  The GS fraud case probably is not going to be a single-purpose or single-event action.

There may be a parallel here to the recent 7.2 Richter earthquake in our neighborhood just south of the border.  In the following week there were over 2800 aftershocks agitating the immediate topology.  We may hear more from the Feds at Justice, and certainly from the “plaintiff’s bar” that have now been notified that suits against one of the “deepest pockets” imaginable will provide an ongoing legal fee lottery for some time to come.

While much will be made in the media of how terrible all this is, in fact the true nature of the events are beneficial in the longer term if the public can see that regulation of securities markets is being taken seriously.  Fair and honest markets are essential to the way society must operate in our style of democracy.

Because of the SEC charges of deception and fraudulent actions in the GS case, it is important that our subscribers know that all of our information comes from publicly available sources that are highly transparent and cannot be fudged.

The whole issue of derivative securities is poorly understood by the bulk of the public at large, including politicians, and unfortunately, even economists.

When there is a central clearing facility for all transactions in a given type of security, then for each trade a buyer can be matched up with a seller, and proper balances can be maintained to assure each one’s responsibility to act under the terms of the deal.  When those terms are standardized, as in listed stock options via the Options Clearing Corporation, the job gets much easier.  Major problems don’t happen.

That did not exist in the CDO/CDS world, and is becoming clearer in the SEC charges.  It is also explained somewhat in Michael Lewis’s book “The Big Short.”

To allow a return to a “dealer market” in these securities invites a repeat of the catastrophe already encountered.  When banks – either “investment” or “commercial” – are allowed to traffic as “dealers” without any disciplined track kept of who owes and who owns what, then pirates are again abroad on the mortgage seas and the buck will stop only at the least able buccaneer.

When the NYSE was in control, a broker that behaved like a “proprietary trading organization” was regarded as a “bucket shop” and was excluded from dealing with the investment public as a transaction agent.  Its role as a counter-party principal adversary was quite clear.  A return to that distinction is now badly needed.

Recent News market-making, SEC

We don’t pretend to know where the overall market is going, or why. But we do know what people who regularly enjoy $ million-plus annual take-home pay think is likely to happen in the next 3-6 months to many stocks, ETFs, and market indexes. They tell us, unintentionally, through their risk-aversion hedging actions.

What Can Be Learned From Past Forecasts

The bulk of capital committed to ETFs is in those that track major market indexes. An overall perspective of investor expectations may give clues to what will happen to the market indexes next.

To that end we aggregate the daily forecasts inferred from hedgers’ and market-makers’ self-protective actions as they deal with interests in, and concerns over, some 2,000+ stocks, ETFs, and indexes. The two pictures below draw on 11 million such forecasts collected live since the beginning of the year 2000.

Upside and downside expectations are pictured separately. In each, the broad vertical blue bars measure the proportion of all forecasts indicating potential percentage price changes on the scale at the bottom of the graph.

The colored lines running across the background of those blue bars are the same data as the tops of the blue bars. But instead of being a 10+ year average, they are proportional measures of one day’s set of forecasts. The green line was taken at the market’s most recent low, March 9, 2009, the red line at its high on October 9, 2007, and the yellow is of Monday, March 15, 2010.

Upside distribution through 15-Mar-10

Upside forecasts seem rather rational, relative to one another. While the historical average has a strong optimistic bias, at times of record highs that red distribution is more restrained. After markets have dropped and are about to recover, the green expectations are clearly more enthusiastic than average, yet realistic about the potential for advances.

Downside forecasts have a different character.

They do not span as great a divergence from zero as upside expectations, on average. Optimism again. But in good times they get a bit, well, more human. The prevailing attitude is “let the good times roll, this is the way it ought to be, enjoy it.”

Downside distribution through 15-Mar-10

In bad times, “Woe is me” green takes over from “What? Me worry?” red. The recognition of how bad it could hurt gets way beyond normal, with larger projected proportions of severe declines and smaller proportions of the normal, lesser declines.

The span of upside and downside estimates in good times contracts, and expands in bad times. This is what is seen in the CBOE Volatility index (VIX). Don’t get distracted here by those details.

What should be of current interest is whether the “now” yellow line looks more like the red or green lines, or is someplace nicely in between.

For the downside at this point there is no debate; yellow is congruent with “trouble” red. Upside forecasts could see a bit more shift of “now” toward the red “market top.” But there’s not much room for enthusiasm and normal larger expectations are already diminished, accentuating the usual center of gravity.

So, how will the present situation be resolved? It could go into another market drop – we’ve recently seen a -9% airpocket. The year-ago low is -45% below where we are now.

Or, more constructively (?), the world’s economic woes may respond to the combined balm of Madison Avenue and Wall Street, and US consumers, dumbed-down by the educational establishment, egged on by too-big-to-fail banks, will come again to believe they can spend money they haven’t earned, so market optimism will once more return. If it does, then a persistent upside yellow-line shift back to prior averages, or beyond, will save us all.

You may sense my bias, but many things are possible, and it is in the nature of stock markets to surprise.

Copyright © 2010, Peter Way Associates. All Rights Reserved

Recent News Market Forecasts