Wall Street 3: Attack of the Machines

At 14:47:25 ET Thursday May 6th, the Dow Jones Industrial average dropped 998.5 points, or 9.19 percent to below 10,000 points for a few short, stressful moments as panicked gripped markets. The nightmare question of any investor- “Does someone know something I don’t?” – echoed through the minds of Wall Streets finest.

First reports sought to place the blame on the ‘fat finger’ fallacy, when a trader incorrectly places an order, causing market mayhem as the order is executed.

These fat fingers have created problems for banks in the past. In 2001, UBS mistakenly sold 610,000 shares of Japanese advertising giant Dentsu Inc at 16 yen per share, instead of selling 16 shares at 610,000 yen – causing severe volatility in the stock for hours, and causing a massive loss for UBS.

Amid all the conspiracies around the Wall Street fall, including alleged financial terrorism, a few days after “D-day”, the surfacing truth reveals that it was the machines….


Today's stock markets are overwhelmingly governed by mathematical algorithms programmed to jump in and out of the markets almost at the speed of light, in a frenzied search for trades that yield a quick profit. Much of the fall was caused by traders who had selling orders in the trading systems that were executed when the index fell a certain amount. Likewise, non-human controlled operations in which index futures were bought and sold when certain events occurred. Bottom line - the machines took over.

The machines were triggering sells orders and wrecking havoc on the market before human beings with qualitative senses could get a handle on what was happening. According to the Hindu (A public Indonesian Newspaper), only when traders began to manually respond to the sharp drop did the market seem to turn around, said the official, who spoke on the condition of anonymity because the investigation was not complete.

Today’s trading programs and systems, used by some of the most sophisticated institutions in the world is far removed from the primitive software that allows someone to enter a B instead of a M (billions instead of millions). "If you make a major mistake, you could destroy all your capital," said Lawrence Harris, a finance professor at USC Marshall School of Business. "The security of the firm depends on the fidelity of these systems,"

Jeremy Grant from the FT – “Algo-trading – changes speed of the game for Wall Street” – revealed his opinion on the dark side of this aspect of the financial world, outlinging that more than half the US equity markets involve the use of a form of algorithmic or high-frequency trading. Tomi Kilgore from the WSJ – “The Dark Side of Algorithims” – suggest computer based trading is the source for much of the volatility in financial markets, pushing passive investors, such as mums and dads, away from this asset class. These financially savvy bots may one day make even the most financially savvy humans irrelevant in the trading world.

Moreover, trading takes place not only on the main exchanges - the New York Stock Exchange and Nasdaq - but on a plethora of other platforms, including "dark pools", which a opaque platforms used by investment banks to execute block trades in seconds. Less than 35 per cent of trading in NYSE-listed shares actually takes place on the New York Stock Exchange these days.

Yohanes Obor from the Jakarta Globe criticised the use of computer trading and displayed an opinion seeking to keep it out of Indonesian equity markets, which remain relatively inefficient when compared to the equity markets of developed nations.
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The key question is should this systems be allowed in a market where mums and dads invest their retirement money? Is it fair for Mrs Jones to invest in Proctor & Gamble when computers designed by far more savvy and short-term focused traders, seek to make a quick buck?

The role of these systems in financial markets will not doubt come in question shortly following the key cause of the event. This issue will be watched even more closely by the ASX when Chi-X begins a rival exchange in Australia.

Introducing the Robin Hood Tax

Kevin Rudd, Wayne Swan and Julia Giddard

MORE than A$10bn of value has been wiped from the Australian share market since the government announced its intentions to impose a 40% tax rate on Australia’s key economic growth driver – the Resources Industry.

Widely known as the paramount reason the country finds itself in such remarkable shape following the GFC, the imposition of these reforms shows the remarkable audacity of Australia’s Labor government to attack the free market.

"It is highly regrettable that the Australian Government intends to single out one of the country's most important and competitive industries for punitive tax treatment, potentially damaging the entire nation's global competitiveness." - Xstrata chief executive Mick Davis.

The Australian mining industry accounts for ~50% of total goods and services exports and approximately AUD$80bn of the US$1.1bn economy. The imposition of the proposed tax of mining companies would make the Australian minerals sector the highest taxed in the world, eroding Australia's competitiveness, curtailing investment and limiting jobs growth.

Numerous criticisms have been voiced in opinion polls and blogs to those that are interested. With several pro-Labor views coming forward such as:

“The Labor government is merely trying to replenish the Budget deficit that was left by the Howard Era” Howards Problem Posted at 10:37 PM May 03, 2010 on Newsfeed.com.au

Any economically savvy Australian would realise this is not the case, and is actually Labor merely seeking new avenues for taxation to fund its reckless stimulus packages launched in the wake of the financial crisis. The losers are the equity investors of the resources industry, such as the Superannuation funds invested into the proud industry with family retirement funds.

"Stupid Dumb Labor, stuffs it up again, and the shares have now gone down as well. So everybody looses” No idea Labor Posted at 12:08 AM May 04, 2010 on SMH.com.au

But this point is even more misinformed, the winners here are the public and working class families, the unemployed and the immigrants who required Government aid to fund or help them enjoy more prosperous lives (which this writer does adamantly believe in).

However the underlying ‘Robin Hood’ principle, of stealing from the rich to give the poor, is not something that should be echoed in our government policies. Investors in the resources industry may withhold capital investment in the sectors if that cannot get adequate after tax returns, and furthermore delivers a hit to Australia’s free market policy that has invited capital investment for many decades.

Clive Palmer, soon to become Australia’s richest man had an interesting view that the policy was aimed at putting significantly more of profits being won from high commodity prices into the public coffers, was policy tried by “communists and socialists”.

Let’s hope a more rational government vetoes the 2010 elections before the ignorant Robin Hood Gang introduced the tax on the 1st July, 2010.

A vampire squid sucking the face of humanity

The article written by Matt Taibbi in 2009 for the Rolling Stone describing Goldman Sachs seems suitable following fraud allegations this week by the Securities Exchange Commission. The story has come at a perfect time for Finance industry critics, who are on their last legs trying to maintain interest in slandering the fat-cats of Wall-street.

The allegations claim that between January and April 2007 Goldman Sachs created an CDO investment vehicle called Abacus 2007-AC1. According to the marketing documents for Abacus, the mortgages included in the CDO were chosen by a company called ACA Management, which specialises in assessing mortgages for risk - and which was also the largest investor. But the SEC alleges that many of the specific mortgage securities in Abacus were actually chosen by hedge fund Paulson & Co, who at the time had taken a massive 'short position' against Abacus.

The Mail Online has covered the story in true from for its lower-middle class audience, giving them an individual scapegoat at which to direct anger – ‘Fabulous Fab’, also known as Fabrice Tourre. In a release by Sharon Churcher this week, titled “Revealed: British banker 'Fabulous Fab' - the high-flier at centre of huge Goldman ‘fraud’”, the use of words such as high-flier and huge commences the article in typical form. Discussed in the first few paragraphs is the individuals superior wealth and lavish part-boy lifestyle, in juxtaposition to investors that lost more than £645 million. Hidden at the end of the article are the non-loaded facts and the key elements of the SEC investigation.

The official stance by the SEC is currently a ‘complaint with further investigation’, with no concrete charges against the firm or individuals as yet, with the legal process likely to extend from months or years in the blurry area of conflicts of interest. This hate drumming to a financially less educated audience is evident both through Taibbi comments with the Rolling Stone and the Mails release. The FT journalists and headlines took a far more objective stance to the situation, dealing with facts for its economically oriented audience.

Two articles simply titled ‘Goldman Sachs’ and ‘SEC takes off the gloves on Goldman’ paint a far more respectable picture of the firm, one which outlines the grey area of investing banking conflict of interest management, and how important reputational capital is to these institutions. Making only brief members of the associated individuals and discussing the subject on a higher level than the left-winged Mail.

The ramifications of any official charges for the company would be severe, as no institution would want be a trading partner with an entity that has alternate investment motives other than your service. This was evident in the markets reaction to the announcement, with almost £8 million being wiped from the company’s market capitalization, loosely representing the loss of future business for the company.

But hate for this institutions and the individuals behind them is nothing new for the economically lower factions on society, who are still myriad in financial strife following the recover in asset prices (driving business for the aristocracy), but not unemployment (what the working-class care about).

This dichotomy has only fueled more unjustified rage against Investment Banks such as Goldman Sachs, with the key problem being a lack of understanding of what these firms actually do for society. Although Lloyd Blankfein’s views of “God’s work” may be overstated, these companies create a plethora of benefits for society – as a philanthropist, market-maker, capital raiser, and co-investor.

Illegal activity through mismanagement of conflicts of interests should rightfully be punished, both financially and through their reputational capital. However understanding of these institutions, before scrutinizing their actions, is an avenue that must be pursued by media journalists, and not defaming individuals to ill-informed audiences.

Sources:

http://www.dailymail.co.uk/news/article-1266831/Fabulous-Fab--high-flying-banker-centre-huge-Goldman-fraud.html#comments

http://www.ft.com/cms/s/0/4d8a3056-4981-11df-9060-00144feab49a.html

http://www.ft.com/cms/s/3/68108f96-498c-11df-9060-00144feab49a.html

Internet killed the Movie-Star

The 21st century will be characterised by the continued fragmentation of traditional media, as outlets for information and entertainment rapidly expand and decentralise the current TV hegemony. As these distribution channels grow and people become more comfortable with their use, the media often neglects a source of much of our entertainment, the film industry.

The decline of movie-appeal is only part of a much larger problem for the structurally declining industry. Consolidation to combat the excess capacity and reduce succession risk has already began in both the production and licensing film segments, with Walt Disney purchasing Marvel Entertainment (~US$4b), and the imminent sale of Metro-Goldwyn-Mayer Inc (MGM)for an expected ~US$1.5b.
Matthew Garrahan from The Times reported an interesting argument to light this week following Carl Icahn’s offer to increase his holding in Lions Gate to 30%, seeking to derail the management’s pursuit of the MGM film library, stating:

“I believe Library values are declining… Lions Gate already has a major investment in a library – its own”

This argument can be seen to present some truth, considering MGM was purchased by a Sony consortium for US$5b in 2005, as well as the lack of creditor belief in CEO Stephen Cooper’s continuing the business, being rejected by the creditors that now control the defunct business, instead pursuing a quick fire sale to recoup their investment.

Can it be true that these libraries of famous movies, which include the James Bond franchise, are declining in value? These massive archives of intellectual property that will continue to be viewed by audiences for generations? In this question opens up the plethora of thematic issues now driving the decline of the industry.

The growth of alternative entertainment, catering to a largely diverse and expanding population, have allowed former niche players to export their entertainment around the world at little cost. The most lucrative market is now Bollywood, where ticket sale numbers have dwarfed Hollywood receipts from as early as 2002, but now with rapidly expanding disposable incomes and population of India, the Bollywood industry is quickly catching up to Hollywood in film revenues.

Furthermore, the internet now exposes audiences to a variety of interests with a couple of clicks. Where as 15 years ago, Western audiences would have known little of the Manga revolution, these Japanese comics and cartoons now enjoy a rapidly expanding share of Western markets.

This increasing accessibility and ubiquity of the internet has likewise accelerated the decline of DVDs, as consumers can now download, whether legally or illegally, their entertainment. Likewise, with the expansion of Web 2.0, where users can actively participate and supply content, has enormously broadened the spectrum of entertainment offerings to users.

Finally, the recent credit crunch hasn’t don’t any favours for the industry, considering that ~90% of all films produced actually lose money, funding the production and distribution is highly risky, with financiers still licking their wounds from the 2008-2009 period. The economics of the industry rely on the ~10% of films that make stellar returns to keep the industry as a whole viable. Similarly, where problems occur in monetizing television, radio and newspaper news- these are all constant flows of operations, not the two year investment and one big splash we receive from the movies.

Although most of the media’s attention focuses on the decline of television and newspaper, the film industry is a quiet casualty. With convergence growing exponentially, it wont be surprising when soon there is no distinction between several mediums– a box in front of the couch that provides internet, television, blogs, shopping – the possibilities are limitless. Although we may hear about Rupert Murdoch and his struggle to monetize readership of online news, spare a thought for the movie-makers as they struggle to keep an audience.

Survival of the Fittest

Following Anton Valukus’ 2,200 page report on the demise of Lehman Brothers, the media has continued to dismiss the reputation of investment banks as nothing more than used-car sales men.

The now infamous ‘Repo 105’ transactions are now symbolic of the classed thievery that characterised investment banks preceding the global meltdown. But contrary to popular opinion, these opaque transactions and accounting methods were perfectly legal, being just another innovative adaption in order to promote a species continued success in the environment. As Charles Darwin wrote in 1859 in The Origin of Species, the process of natural selection is needed in order for continued evolution and growth of ecosystems.

Unfortunately for Lehman, which followed the fate of Bear Stearns in succumbing to the sub-prime meltdown, the adaption used was not enough to save it from being consumed by its environment. The bank collapsed in late 2008 with over US$613 billion in bank debt, and like the process outlined by Darwin, the characteristics of this bank were destroyed in natural selection.

Now in 2010, the investment banking world that remains is constituted of the surviving individuals that possessed some competitive advantage that ensured their survival, being able to transcend the meltdown and pass on its favourable characteristics.

Henry Sender for The Financial Times recently published an article outlining the use of Repo 105s, and how the now surviving banks were able to pre-assess Lehman’s position and reduce their exposure. It is said that Merrill Lynch, which continues to live under the shelter of Bank of America, warned regulators that Lehman was incorrectly calculating its liquidity position in 2008, with little action being taken by the so called Federal Regulating Agencies.

Likewise, it has recently come to public light that the monolithic HSBC was undertaking Project Milan, a codenamed project with the intention of disentangling itself from Lehman Brothers by avoiding margin and brokerage positions with the aggressive bank, as it too, saw the instability in the corporation’s structure.

This intellectual foresight has allowed these two banks, and many others, to survive the crisis, with now greater experience and understanding of the financial-dos and financial-don’ts of capital markets.

The world exists with a framework and rules for corporations to operate in, but without pushing the boundaries of financial innovation, and in-part breaking the rules, world markets would be a sluggish and un-innovative place. Although painful in the short-term, it is these continued adaptions to environments and pushing of the boundaries, whether successful or not, that stimulate growth and development.

What a boring world it would be without rule-breaking and controversy?

Long Live Credit Default swaps and Excessive Executive Remuneration

As George Papandreou this week called for the ban of naked Credit Default swaps, financially literate people will be rightly shaking their heads. Similar to the ignorant rhetoric that captured headlines a few months ago regarding executive remuneration – the current arguments re-iterate the fact that politicians have no place in financial markets.

Recently as the Greek sovereign debt crisis continues to unravel, numerous groups have pleaded for regulatory bodies to restrict or outright ban naked Credit Default Swaps. It has been argued by the Greek Prime Minister, that the use of these financial instruments have amplified the volatility currently characterising debt markets:

“We should not allow speculators to play around with the stability of the Eurozone”
(Sourced – H. Pulizzi from The Times, 11th March 2010)

To the non-financially educated, the three functional purposes for the existence of derivatives are:

1. Hedging is used to reduce or neutralise the exposure to the underlying asset or another risk.
2. Arbitraging discrepancies in pricing between markets or assets, thus keeping prices efficient.
3. Speculating on positions or views on the future of an instrument or market.

The United States' Affordable Housing Institute provides the defination of a CDS below.

(Sourced from AHI, Google images)

None of the above is more so important than speculating - naked positions – in adding liquidity to the market, being the foundation on which any effective financial market is built on. Investing in itself is a form of speculating, and without investment, capital markets would cease to function.

The involvement of speculators in any financial market significantly increases the financial depth and breadth for both buyers and sellers, allowing participants who need to hedge an exposure (hedgers) with significant more of a market to sell or buy to – therefore inducing further competition – and allowing these participants to attract better pricing. They are also paramount in the role of capital allocation, providing it for growth and withdrawing it from non-profitable avenues. As stated by Paul Murply from The Times: -“Speculators do God’s work”.

Contrary to the belief of the Greek Prime Minister, and numerous political groups, the CDS market, which constitutes only 2% of the outstanding Greek debt, does not have the power to push counties towards default. They are merely a tool for market participants to hedge or speculate. The Bond holders that invested ~€5 billion in the recent debt raising by the Greek Government, are far more educated the debt investing than to be concerned by the CDS market.

The fundamental issue is that ostracising the CDS market is a notion by political groups purely to impress or rally public support from the public. As Paul Murphy from the Financial Times outlined on the 14th of March, employees of the Greek government currently facing austerity measures, rightly would direct anger at any scapegoat seen to be associated with the pain.

The use of financial-buzz-words to stir-public anger and avert political scrutiny is no new concept, only weeks ago we observed the peak of the ignorance of political and media groups seeking to curb executive remuneration. These companies exist with the funding or their shareholders, not of the general public. If an individual believes that the executive remuneration in a company is excessive, he can simply cease to be a shareholder in that company. Albeit institutions that have received taxpayer funds to continue operations, should be governed by its shareholders – i.e. the taxpayer.

A derivative’s value, by definition, is an instrument whose value is based on another source. The CDS market is not the source of the problem facing the Greek economy. Greece is the source, struggling with serious concerns over its viability to refinance and tame the soaring budget deficit.

Politicians should focus on the source of problems, rather than seeking to divert the non-financially educated public’s scrutiny to financial derivatives.

Red Knights lead the charge to reclaim United

The key marketing ploy being used by the Red-Knight’s to rally support for an acquisition of the Manchester United Football club is a word splashed across newspaper headlines almost everyday in post-global financial crisis society. It is a word now used to evoke fear and disgust among non-financial savvy readers.



As the stigma of the financial crisis continues in developed governments and economies, debt is now a symbol of greed, recklessness and pain, fundamentally seen as the epitome of ‘those fat-cats that got us into this mess’. This continued miss-use and war-mongering of the word by economists and journalists has ingrained an unjustified fear.

Debt is structurally ingrained into our financial systems in the credit creation process, our consumers through credit cards and mortgages, and our businesses through providing greater equity returns from investment. Although its misuse in the American housing market triggered a credit crunch in 2007-2008, when used prudently debt supports economic growth and increases the standard of leaving of society.

The negative emotions now bound to the word have been used to rally support against the Glazer Family, owners of the 132 year-old Manchester Football club. The rebellion against the foreign American tyrants is being lead by the four Red Knights, playing on the nobility and courage of British Heritage. These individuals include Jim O’Neil, Keith Harris, Seymour Peirce and Paul Marshall – who themselves are members of the wealthy aristocracy, being prominent members in hedge funds and investment banks, but unlike the Glazers, they have been avid Manchester fans since childhood.

The Glazers purchased the company in 2005 through a £790 million leveraged-buy-out, a transaction structure that is ignorantly used to characterise the excessive greed of corporate America. An LBO is a acquisition structure where the assets of the acquired company are used as the collateral for acquiring the company with a significant portion of debt. The debt-servicing cost for Manchester United in the past five years is estimated to total ~£260 million. The corporation currently has £515m in debt, with a further £202 being held by The Glazers through their investment in the Club.

The Guardian’s coverage of the story on the 4th of March played perfectly on its largely working-class audience fears, portraying a fairytale in which fans rescue their team for the Glazers. The article quickly outlined that although the Glazers have publicly stated the Club is not for sale, the debt-heavy Americans would make a huge profit from a ~£1.4 billion sale (profit being another buzzword to stem dislike for the current owners).

It is in this capacity that the Red Knights seek to rally membership and fan support, to be seen as the crusading Knights to rescue Manchester United from its current debt binging tyrants. They have publicly scrutinised the club’s current financial structure, stating that money should be spent on investing in players, not in servicing debt.

The Financial Times coverage of the story, A contested goal on the 6th of March quoted “Debt has acted like a Leech on the Club. Sucking money out to feed The Glazers and their bankers”.

Animosity to the Glazers from the fans is nothing new to the club, with fans often wearing the clubs ancient green and gold to the club’s games, rather than the contemporary royal red. The largest Manchester Club on Facebook, with now just under 400,000 members, carries the symbol:


Support has been likewise seen in the official supporters trust of the club, The Manchester United Supporters Trust, has seen membership numbers rapidly double to over 100,000 since speculation of the bid surfaced last week. These trusts seek to influence the destiny of their clubs through democratic supporter ownership, ideally what the Red Knights seek to exploit, with the possibility of supporters potential funding up to 25% of the bid.

This idea of the noble Knights slaying the debt-beast is a fairytale most of the world would like to believe, and it has successfully drummed-up support to see ownership of the club return to ‘the fans’. However, corporate motivations have far more weight than social responsibility, and it is in the writers view that it wont be long before fans realise that the debt-beast may just be giving a collar, and in the interest of the equity providers, will continue to be part of the Club’s financial structure.