“A hedge is a hedge…until it isn’t!” TB
…back when TB was a teen there was a book titled “A House is not a Home,” written by a famous madam. He and his friends thought it was interesting…this book about something that was mysterious. Today, there is also something mysterious: hedges! So mysterious that those who are engaged in them do not know what they are or precisely how they work…or more accurately interact with the underlying security one is trying to hedge in the first place.
The reason for bringing up the brothel issue is that seemingly like, or correlated, things may be enough of the time that you believe they always will be, and as the above quote says…until they aren’t. They won’t be at the precise time one wants or needs them to be, so today we will study a few examples.
First, is housing. If you sell a house and buy another house, on the surface that sounds like you have not assumed more or less risk, but there are many variables to this. Suppose you had to move, or your job location moved so you decided to reduce your commute. Let’s say you moved from New York City to Cleveland. We all know that the Cleveland market has collapsed while NYC’s is strong (definitely on a relative basis although it too is showing signs of weakness now as are other areas where the supply of qualified buyers is dwindling), the same holds for microregions in most parts of the country.
But let’s say you own your home and sell a second home, carrying back the ‘paper’ on it. Most certainly you are not hedged because you might just get that other home back when you least want it but hopefully you got a sizable downpayment on it…unlikely these days, but hopefully. Worse yet, for the above commute reasons say you sold your home and bought a condo at the peak of the market. Most likely, while that appeared to be hedged, it wasn’t…especially if you paid up for that dream condo.
The point of these is that you did something to hopefully improve your lifestyle or financial situation and thus were hedged of sorts, but found out that instead of being better off, you were worse off…don’t forget all those fees and taxes you may have had to pay to accomplish this (financial models always ignore trivial things like this as non-meaningful as they clutter up the model, which is fine if you are an academician teaching a room of eager entrepreneurs who foolishly take what you teach them to heart.
Second, let’s assume you buy a Prius and sell a Suburban…looks like a good trade, but you paid $40,000 for the Suburban two years ago and took whatever you could get and bought the Toyota. You took an enormous hit on the Suburban and now are paying a premium for the Prius due to a lack of supply…but think of the gas money you are saving.
As good a car as the Prius is, it is rapidly becoming obsolete to the next wave of hybrid vehicles. Fine, you say, you will just keep it and save all that money on gas. But depending on your driving distance, that may not be as much as it sounds except over a long time period and you are now losing value on the Prius while the Suburban has probably bottomed out…especially IF gas prices suddenly decline again, not that they will but then at $16 a barrel in 2003 who would have thought…
There is also the issue of seemingly different priced assets moving differently…or as they say in bonds ’spread widening’. Condos are the last to appreciate and the first to decline in value in any cycle…of course subprime lending leveled the playing field in this selloff.
Third, is bonds…and this is where TB first learned about imperfect hedges. In the 1970’s, before financial futures, agencies like Fannie Mae, and Federal Home Loan Banks would issue large bond issues that dealers would ‘take down’ and hedge them by shorting a comparable treasury security. There was enough profit in the issues to overcome imperfections in the hedge…normally…but then when the economy began to weaken the spreads of agencies to treasury’s widened and the hedge failed to protect and in many instances traders lost money…they tried to overcome this by overhedging…buying more treasures than they needed for a 1:1 hedge…but then the spread narrowed and they lost again…at the same time adding volatility to the market. We still see this attempted in stocks today by selling stocks and buying treasury’s which sometimes works and sometimes doesn’t.
The advent of derivatives for financial instruments started in the late 1970’s with T-Bill futures and 30 yr bond futures, and later expanded to everything under the sun, so traders tended to become complacent until they discovered imperfect hedges. This is a result of basis risk where the contract doesn’t correlate to the underlying asset one is trying to hedge. The best example TB has ever seen is the current crisis. IF you were long the asset and short the derivative, such as a CMO or CLO, you lost your shirt, and points south, on the hedge as the contract did not decline as fast as the underlying asset (think homes and condo’s again). In today’s Heard on the Street, we see that as the market reemerges, the derivatives are outperforming the underlying securities. If you think about it, both of these make sense since the derivatives are leveraged, so if one wants to stick a toe back into the boiling water, that is the safest way to play it. Furthermore, as in the bond case above, a lot of people have overhedged due to the undeperformance of the hedge, so as the market comes back they are forced to lift the excess hedges. Ultimately…hopefully?…they will become correlated again.
The reason Goldman was able to emerge relatively unscathed is that being bearish on the market, they shorted the underlying subprime pools and hedged with the derivatives…if the market had continued to run, they would have been the goat…but on the upside they would still have lost far less as the two were correlated in that event.
A major problem in getting mortgages restructured is that nobody knows who owns the loans. To speed up loan processing a system called MERS was instituted allowing property to be registered in a nominee name…that is the only holder who has standing…yet they cannot be contacted since the holders are unknown. The bank that issued the mortgage is most likely still the servicer and is paid a fee for this, but the loans were sold to a dealer like Merrill, who packaged the loans into CLO’s and CDO’s and then sold them to investors. Months ago TB told how a friend, a lawyer in the Hampton’s, told him about MERS, and how she was getting several calls a day on mortgages in foreclosure, presumably by the holders but since they weren’t of record she could only refer them to the loan servicer…who in turn would have referred them to the dealer who packaged them…if one could even get an answer. The worst part of this is that now that the mortgages are securitized you have to get a majority of the holders to approve any restructuring. But with several tranches of these loans now worthless, those holders have no incentive in spending their time on a restructuring…or might use that as leverage to get something out of the deal. For instance, all those Aaa tranches that Merrill owns: it would clearly be in their interest to restructure so they can get some money back, but the holders of the tranches they sold might not even care if they were wiped out…once again a virtuous cycle has become a vicious circle…very vicious!
Similar to hedging and frequently seen in economic downturns is manufacturers selling their product to clients and carrying back the paper…presumably there is enough profit to offset typical losses. Watch closely for receivables changes along with sales, as that is a sign of trouble ahead. Levitz Furniture did that when they were a high flying stock in the ’70’s and it about ruined them…now think of all those electronics and furniture ads with no down and no payments until this year…and they are now offering those deals with no payments until 2009…so just because electronics sales remain strong…ask why! If you own the manufacturers, besides checking whether they were financing their sales, doesn’t this make the quality of their forecasts more suspect? It most certainly does! All is not as simple as it appears.
The economy is in a mess. You can believe the worst is over…TB believes it is going to be just one event after another until the excess of the past 25 years are sopped up.
Have a good day!
TB
Trader Bill thinks it is clear to anyone reading these missives that they are merely commentaries…as he sees it…and do not necessarily reflect the views of anyone other than his own. Information is gathered from sources he has found reliable, but no guarantees of accuracy are implied. These are merely observations of events in the marketplace offering in an attempt to offer a non-mainstream viewpoint. Hope you find it useful.
Copyright TBD Capital LLC May 21, 2008
