Junk Bonds Take a Dive

What would you do if you had around $800 million in cash and you wanted to buy some junk bonds…but you didn’t want anyone to know who you were or what you were doing…and you wanted to avoid fees? The answer: build up a position in a junk bond exchange traded fund by buying shares in increments, then redeem the shares all at once for the underlying bonds instead of cash.

And that’s exactly what one anonymous investor did. After establishing a position in the SPDR Barlcays Capital High Yield Bond Fund (JNK), the investor redeemed almost 20 million shares on May 10th…for just under $800 million in high-yield bonds (JNK is a ‘redeem in kind ETF’, meaning that investors have the option of choosing to redeem the bonds instead of cash).

You could say it was a smart trade. The investor remained anonymous, and kept costs down since buying all of the bonds on the secondary market would have resulted in pretty significant brokerage and transaction fees.

But the trade turned a lot of heads. It was the biggest redemption in the $12 billion fund’s history…and amounted to something like 6.5% of assets. The result was a huge outflow from the fund.

Before that, junk bonds were having a good year…with investors hunting for yield propping up the market. Investors poured $15 billion into junk bond funds in the first quarter, and $1.84 billion in the first week of May. But last week, investors pulled $3.05 billion out of junk bond funds globally (the biggest outflow since last August). In the US, investors pulled $1.97 billion.

It looks as if investors are doing a bit of an about-face on junk bonds – leaving as swiftly as they entered. And it could very well be that the outflow resulting from the JNK trade scared some retail investors away from high-yield debt, and what has happened over the past couple of weeks is a snowball effect.

Still, JNK has been thrown into a short-term downtrend (with net outflows of $452 million last week, and $871 million the week before). None the less, its long-term buy signal is still technically intact.

Jaime Dimon and the New York Fed: A Conflict of Interest?

In December 2010, MF Global sent a letter to regulators to say that they did not need tighter restrictions on how they handled client funds. In October 2011, just 10 months later, $1.6 billion was missing from MF Global client accounts and the firm was bankrupt.

Before disclosing a $2 billion (for now) trading loss, JPMorgan lobbied against financial industry regulations. CEO Jaime Dimon told shareholders that “we now have multiple regulatory agencies with overlapping rules and oversight responsibilities. We now have allowed regulation to become politicized, which we believe will likely lead to some bad outcomes”. The firm has 12 lobbyists, and spent $7.6 million on lobbying last year (according to the Center for Responsive Politics).

But that is to be expected. Industries lobby. Especially the financial industry. Last year, commercial banks employed 456 lobbyists, and spent a combined $61.8 million (the airline industry had 198 lobbyists, and the steel industry had 107).

Lobbying for the interests of your industry is one thing. Sitting on the board of the regulator that oversees your industry is quite another thing.

That’s exactly what Jaime Dimon is doing. On one hand, he heads a firm that just reported a $2 billion trading loss, and on the other hand, he serves on the Board of Directors for the Federal Reserve Bank of New York, which oversees banking activity. If that is not a blatant conflict of interest, it certainly smacks like one.

To be fair, Jaime Dimon didn’t appoint himself to the board. He was elected…by banks…to represent banks. Dimon is just filling the role, as it’s defined by the Fed:

“The Bank’s Board of Directors has nine members, all chosen from outside the Reserve Bank…directors are elected by the member commercial banks…directors are required to be representative of the member banks in the District and for the most part they have been officers or directors of member banks or their holding companies.”

And Dimon was quick to minimize his influence on the Fed, saying that it is “not like a board, it’s more like an advisory group”. But that’s not exactly how the Fed phrases it:

“The roles of Reserve Bank directors generally fall in three principal areas: overseeing the management of the Reserve Banks, participating in the formulation of national monetary and credit policies, and acting as a “link” between the government and the private sector.”

Even though Dimon is just doing his job, it certainly doesn’t sit well to have the ‘fox guarding (or advising) the hen house’ when the fox just lost $2 billion in a hedging strategy gone sour and the hen house has tax dollars.

And it clearly doesn’t sit well with Treasury Secretary Tim Geithner. When asked whether Dimon should resign from the Fed’s board, he stepped around it delicately and said “that’s a question he’ll have to make and the Fed will have to make”. He said that there is a “perception” problem. He didn’t say no. And in Treasury-speak that was a clear message to Dimon: it’s time to go.

Geithner just might have a good reason for calling on Dimon to leave. He was once the President of the New York Fed. He knows how things operate.

And Geithner is not the only one who would like to see Dimon go…he was only the most diplomatic in his language. Elizabeth Warren didn’t mince words when she said that “Dimon should resign from his post at the New York Fed to send a signal to the American people”. And MIT professor and former IMF economist Simon Johnson said that his involvement with the Fed is “no longer acceptable”.

But this sort of thing is nothing new. Last year, the Government Accountability Office found that 18 former and current members of the Fed’s board were affiliated with banks (or companies) that got emergency loans during the financial crisis.

At bare minimum, Dimon’s post on the board poses a ‘reputational risk’ to the New York Fed. And regardless of whether it is a real conflict of interest, or simply a ‘perceived one’, it muddies the Fed’s independence, and it stands to undermine its effectiveness. But don’t blame Dimon, or the Fed. Blame Congress.

Now, After the Hype

On May 18, 2011, LinkedIn went public, with an IPO value of $406 million. On November 3, 2011, Groupon’s IPO was valued at $805 million. On December 15, 2011, Zynga’s IPO was valued at $1 billion. On August 18, 2004, Google’s IPO value was $1.92 billion.

And then there was Facebook, which outdid them all.

The social network giant sold 421.2 million shares at a price of $38, and raised a record $16 billion on its public debut on Friday…making it the largest internet IPO ever, and the second largest IPO in US history (behind Visa’s $17.9 billion IPO in 2008).

Starting out, the IPO was nothing short of a frenzy. The investing community, and the media, created a lot…a whole lot….of hype around it. So much hype that retail investors took something like 20% of the IPO, a record for a new issue (typically retail investors access to an IPO is limited, and only available by making limit orders to stem volatility).

But while small investor demand was high, the ‘smart money’ was getting out…more than half of the 421.2 million shares in the offer came from insiders cashing out. Facebook executives and directors sold 189.4 million shares (after increasing the planned number by 62%). Goldman Sachs sold 28.7 million shares. Venture capital firm Accel offered 49 million.

For those insiders, it paid off. Facebook shares have been trading on the private market for over four years…one buyer grabbed shares in April 2008 for $3.50 (according to data released by CNBC). But now, it should raise at least a little caution when insiders are unloading their positions.

That’s not the only reason for caution. Much of the talk has, of course, focused on valuations, which are frothy…with the IPO price, the company is valued at 107 times earnings. But it’s the reality on the ground that’s a concern, too. The reality is that revenue growth is slowing: while revenue was up 88% in 2011…that didn’t match the 154% gain in 2010 (and growth slowed to 45% in the first quarter of this year). And the reality is that membership growth will slow…because it has no choice. Facebook currently has 901 million active monthly users (anyone who clicks on a “Like” button is a user – so it’s fair to say this number is exaggerated). Over the course of the past four years, “users” grew from 66 million to 800 million. If that pace continued over the next four years, Facebook would end up with 9.7 billion users. Considering that the entire human population is 7 billion, Facebook’s user base will inevitably slow.

Putting all of that aside, betting on Facebook is the same as betting on Mark Zuckerberg. Since he retained 57% of the voting power, he is in control. And he has already proven that he is willing to make decisions on his own accord (he went ahead with the acquisition of Instagram without consulting anyone…or possibly even overriding the board).

That said, the buzz around Facebook is understandable. In just eight years, it has evolved from a dorm room project to a company worth over $100 billion. But we need to remember that Facebook the company, and Facebook the stock, are not the same thing.

Facebook dove headfirst into the market. But after an inordinate amount of media attention, by the end of its first trading day, the stock failed to provide the first-day “pop” that investors were waiting for (the average first-day pop for a tech stock is 32%).

The excitement swirling around the IPO, or the relentless media coverage, or the historical relevance are not reasons to buy this stock. It’s important to remember that where there is upside potential, there is also downside risk. Unless investors have an iron stomach to cope with a lot of volatility, instead of buying into the enthusiasm, it would be better to allow the stock (or any IPO stock for that matter) to ‘season’ for a while before jumping in.

The Vultures Circle Greece…and Get Paid

Back in March, Greece made a deal to restructure its debt. The majority of Greek bondholders agreed to a write-down that amounted to a 75% haircut. They didn’t want to take the loss, but they basically had no choice. They were told if they tried to hold out and reject the deal, they probably would not get paid at all.

So imagine how much it must sting to watch the few holdouts get paid.

Last Tuesday, Greece made good on a €436 million debt payment to the few who refused the deal.

Greek officials claim that it was the timing of a lack of government that resulted in the payment (after an inconclusive election the week before, there is no new government in place).

But the real reason might be a fear of vultures swooping in for a lawsuit. Most of the payout went one place: Dart Management, an investment fund in the Cayman Islands (according to CNBC). Dart is a vulture fund; it buys the sovereign debt of distressed countries, and then sues the government if it doesn’t get paid.

What’s good for Dart is a slap in the face for everyone else. And it could end up coming back to bite Greece later. The next time the country goes to restructure its debt, its bondholders and creditors aren’t going to be so inclined to yield to pressure.

Going From Bad to Worse

The BP oil spill was a mess that spread faster than it could be cleaned. And after the spill there were questions about what risks were taken, and how the industry was regulated.

The JPMorgan trading loss has been referred to as “a BP spill in derivative form”. There was no loss of life, and no environmental pollutants, but questions about risk and regulation are surfacing.

It took just four days for JPMorgan’s trading loss to increase 50%…from $2 billion to $3 billion. If it is not an oil spill, it is a fast moving train running off track.

Regulators are opening investigations. The media is all over the story. But asking all the questions after the fact and getting tied up in the details puts a veil over part of the real problem. It’s not just a matter of what risks were taken…the problem is how the firm estimated those risks.

JPMorgan relied on a calculation called “value at risk”…CEO Jamie Dimon admits the math is “inadequate”. The point of value at risk is to measure the firm’s maximum probable loss. The problem is that the metric is flawed. The other part of the problem is that the CIO, the unit of JPMorgan that was conducting the trades the caused the loss, used a looser value-at-risk measure than the rest of the bank used…ironic, considering that the CIO was supposed to hedge against risk.

On April 13, the value-at-risk calculation suggested that the unit’s risk was $67 million. But when a stricter measure was used just a couple of weeks later, the risk rose to $129 million…double, but still nowhere near $2 billion. Value-at-risk is by no means a fail-safe metric.

But by the time the increased risk was calculated, the bank’s positions on the soured trades were so big there was no way to unwind them quickly…or painlessly.

And underestimating risk is not unique to JPMorgan. Long-Term Capital Management said that its value-at-risk was $45 million…before it lost $4.7 billion. And before its bankruptcy, Enron’s value-at-risk was $66 million…while it was losing eight times that amount in a day (according to The Financial Times).

There is a lesson to be taken from Wall Street’s miscalculations: there is no room for broad assumptions and underestimations in real risk management.

And all of this is a reminder that the financial sector has issues. The activity over the past couple of weeks has taken its toll: a proxy for the sector, Financial Select Sector SPDR ETF (XLF), signaled an intermediate sell.

JPMorgan’s ‘Mea Culpa’

To be fair, JPMorgan’s $2 billion loss isn’t as bad as it sounds at first…at least not to a bank with more than $2 trillion in assets (and the largest bank in the US). And it’s not that bad when losing $2 billion is offset by gains and really boils down to a loss of around $800 million for the quarter (as it’s estimated). And when that number is matched up against the fact that the bank made $5.4 billion in the first quarter of this year, the loss will not come anywhere close to sinking the bank.

But the dollar amount of the loss isn’t so much the issue. It’s the implications and it’s the message it sends.

Last week when the firm disclosed the trading loss, which stemmed from a failed hedging strategy, it was a stinging about face for the bank, and for CEO Jamie Dimon. In early April, Bloomberg and The Wall Street Journal reported on large, market-moving trades that were occurring at the banks’ Chief Investment Office (CIO). The CIO’s job is to manage risk for the bank….basically by acting kind of like insurance. The CIO makes sure that when the bank makes a big bet, the risk is hedged in the event the bet goes bad. Dimon was dismissive of the reports, calling them “a complete tempest in a teapot”. And he called the CIO the “sophisticated” guardian of the firm’s assets.

But that tempest in a teapot quickly turned into a windstorm. And now just a few weeks later, in the face of a glaring loss, Dimon was forced to acknowledge that the firm has ‘egg on its face’. He said of the loss: “there were many errors, sloppiness and bad judgment. These were egregious mistakes, and they were self-inflicted”. The presumably stellar guardian proved capable of a massive failure.

And don’t overlook the irony here: JPMorgan navigated through the fallout of 2008 without reporting a loss. It recently passed the Fed’s latest stress tests (leaving a hint of egg on the Fed’s face). The firm was considered to have solid risk management systems. That the institution considered among the ‘smartest’ on Wall Street could let this happen doesn’t speak well to the financial sector.

It’s no longer just a question of ‘too big to fail’. It’s also a question of too big to manage. And it’s not just that Dimon didn’t see it coming. It’s the fact that just a few years after the financial crisis, big risks are being taken again…and going terribly wrong, again. There should be a little more take away from the 2008 meltdown.

This is far from over. It could take the firm months to unwind the trades that caused all the trouble in the first place, and the losses could end up being greater. The loss, and the trades that caused it, have raised more than a few regulatory eyebrows. And, no doubt, regulators will be sharpening their pencils.

Prior to last week’s fallout, the bank’s stock was up 23% so far this year. And while the selloff was overdone, and the stock is being overpunished, I am not looking at this as an opportunity to buy.

Did Wall Street Arrogance Lead to the Fall of Lehman Brothers? Just Read the Emails

It’s no secret that Wall Street is a sketchy place. And that was made all the more obvious recently when the law firm Jenner & Block LLP decided to release a package of Lehman Brothers documents.

When Lehman Brothers collapsed in 2008, CEO Dick Fuld would have had the world believe that he and his fellow executives were unaware of the impending doom. But the newly released trove makes it clear that was not true. Not only were they aware of the danger the firm faced, but they were so blinded by their own conceit that they were just plain complicit.

At a board meeting in the fall of 2007, they were told that “the initial tremors were felt at the end of 2006, when the poor loan performance of sub-prime borrowers began to be a cause for concern…it became apparent that the performance problems in mortgage loans was not going to abate”. But the warning had no bearing. It was business as usual for Lehman. Instead of thinking about raising capital, executives were too busy convincing themselves that they everything under control: “During the last downturn (2001-2002), the firm outperformed its competitors”, according to management. And while other firms were trying to shore up capital, for Lehman, “aggressive capital raising is not necessary” because the firm was “strongly capitalized”.

Fuld did, however, acknowledge in an email that the firm could use a hand…but only with a good measure of machismo added, “I agree we need some help…but the Bros always wins!!”. Not exactly insightful.

And for his lack of foresight, Fuld was paid handsomely. In the years leading up the firm’s collapse (2000 to 2007), he was paid in the neighborhood of $500 million. And recently released documents from the firm’s bankruptcy reveal just how much other executives were paid; all told, the top 50 employees were paid $600 million the year before the firm collapsed:

Robert Millard, managing director in the global trading strategies group, was the highest paid, earning $51.34 million. He earned $44.5 million in 2006.

Marvin Schwartz, managing director in asset management, came in second, with a salary of $31.42 million. He was paid $27 million in 2006.

The lowest salary among the top 50 employees was $8.2 million. And only six of the top 50 employees saw their pay reduced in the year before the fall.

The Lehman documents are a reminder of what kind of damage a lack of leadership sprinkled with a little unbridled Wall Street hubris can do.

“Sell in May and Go Away?”

It’s May. Is that a good reason to sell out of the market? According to an old adage, yes. According to a timely strategy, maybe not.

And over the past two decades, May has become one of the better months. But the strategy still had some weight, because June, July, August and September have been the worst four months for the market.

But this year might be a little different…because of November. In election years, the age-old strategy seems to lose some of its currency. The market has shown a tendency to rally through the summer before an election.

So maybe this is not the year to “sell in May and go away”. The phrase is catchy. It rhymes. But a calendar and a rhyme is not an investment strategy in my opinion. And more to the point, the market is a buy, and trend indicators simply don’t support selling right now. And looking at a proxy for the equity market, S&P 500 SPDR (SPY), the fund signaled a long-term buy in January, and has held that signal. May is off to a rocky start (the fund is down -2.4%), but its long-term signal is still intact.

Will We Fall Off A ‘Fiscal Cliff’?

A cliff is a steep face of rock that overlooks something, like a canyon or a city. And putting a clever spin on the word, Federal Reserve Chairman Ben Bernanke is warning that we are skirting the edge of a “fiscal cliff” that has the potential to derail the economy.

The “fiscal cliff” is made up of a few things that will happen at the end of the year: the expiration of the Bush tax cuts and the payroll tax holiday, automatic spending cuts, and the end of extended unemployment benefits. The impending changes were triggered when the “super committee” failed to come up with a way to close the budget gap.

On the one hand, the super committee’s ‘failure’ was really a success in that it would force automatic cuts which would, in turn, reduce the deficit. But now that those changes are looming, the potential impact is coming into focus.

If Congress does nothing, the cliff will amount to hundreds of billions being pulled out of the economy… almost overnight. And it will shave easily 3.5% off of our economic growth. That would be enough to wipe out the recovery and push us into another recession.

And the Fed would be powerless to stop it. “If no action is taken by the fiscal authorities….there is absolutely no chance that the Federal Reserve would be able to have the ability whatsoever to offset that effect on the economy”, according to Bernanke. Or, in other words, ‘Congress, don’t mess this one up, because we can’t clean it up’.

While allowing tax cuts to expire and allowing spending cuts to go into effect would strangle the economy, doing the opposite (extending tax cuts and canceling spending cuts) would add something like $5 trillion to the country’s debt (based on the CBO’s alternative scenario).

But that’s not a very likely scenario. As it is, we will, inevitably, hit the debt ceiling later this year…again.

So will the economy fall off a cliff? Not likely. We will be pulled back from the precipice. That Congress would do nothing is a worst-case scenario that won’t happen. The reality is, of course, something will be done. Congress has proven to be very good at kicking problems further down the road when they need to.

The Book World vs. Amazon

When Amazon was founded in 1994, the book market was antiquated. But that was the nature of the business. Books take up a lot of space, and even the biggest brick and mortar stores can only hold so many titles. And stores typically relied on walk-in customers to move those titles.

So it was no mistake that Amazon targeted the book market. By cutting out the middle man (the distributer or retailer), Amazon connected readers with publishers. And because a book isn’t ordered until it’s actually purchased by the consumer, it doesn’t have the constraints of stocking physical supply, so it can ‘hold’ millions of titles.

And then in 2007 Amazon released the Kindle… and took a 90% stake in the eBook market. Amazon used its discounting power to dominate the market by dropping prices to $9.99 per book. Amazon was perfectly willing to forgo a profit to grab a bigger share of the market. And it was perfectly willing to use its market power to corner publishers into giving better terms. And it worked…not only does Amazon dominate eBooks, but a brick and mortar store selling printed books at $25 has a hard time standing up against it.

Novelist Richard Russo put it best: “When you sell books at a loss, by the millions, to corner the market, you’re not interested in competing…you’re interested in burying your competitors and then burying the shovel”.

Amazon had the eBook market in a stranglehold. So when Apple introduced the iPad in 2010, it came up with a new pricing model for selling books. The company made a deal with five publishers to sell books on the iBookstore through the “agency model”: publishers set the sale price ($12.99 and $14.99), and Apple would get a 30% cut. This differed from Amazon’s wholesale pricing model, where it bought books from publishers at a discount and then had full control over prices.

The Justice Department took notice. But rather than looking at the 800 pound gorilla in the book market, it took aim at Apple and the five publishers.

The Justice Department filed an antitrust suit accusing Apple and the five publishing houses of colluding to fix prices in an attempt to undermine Amazon. Three of the publishers, HarperCollins, Simon & Schuster and Hachette, settled immediately. Apple and the two remaining publishers are willing to fight it out in court.

According to Apple, “the launch of the iBookstore in 2010 fostered innovation and competition, breaking Amazon’s monopolistic grip on the publishing industry”. Apple’s iBookstore opened the door for more players, including some independent stores, to enter the eBook market. And since then, Amazon’s hold on the market has narrowed to 60%.

What the Justice Department has managed to do is give Amazon room to tighten its grip and regain power over the market. This couldn’t have worked out better for Amazon.

Granted, Apple’s ‘agency model’ deal drove the price of eBooks up, and with Amazon, readers paid a lower price. But that lower price has its own costs…there are potential consequences to giving Amazon too much control in dictating prices. It’s great if we can buy books at a low price…but pricing books too low makes it hard for publishers to meet their costs.

Regardless of the outcome of the suit, this is already a victory for Amazon and a loss for the publishing world. And the stakes are high. Ebook reading is growing… and 70% of eBook readers buy their books on Amazon (according to O’Reilly Media)… and those readers might stick with Amazon. Because most eBooks must be read on a proprietary device (Amazon books are read on a Kindle, and Barnes & Noble books are read on a Nook), the larger a consumer’s library, the less likely they are to switch to another retailer. And the more likely that the Justice Department just allowed Amazon to consolidate its monolithic grasp.

Amazon is a giant online retailer of everything. The company has better than 160 million active users and accounts for 20% of online sales in the US. Not bad. But I wrote a while back that Amazon needs to be careful about managing its image. I think that is still true. And I wrote that I wouldn’t buy Amazon. That is also still true.

Amazon may have found an unintentional ally in the Justice Department, but that doesn’t translate to a reason to buy. Shares may be up year-to-date, but they have held a long-term sell signal since last December.