Is the market always right?

I've seen a lot of people struggle with fading the market recently. Fixed income markets have moved huge increments, pricing in everything from sub 1.75% fed funds to over 2.75% fed funds in the next six months. Many traders have been stopped out due to the move as they fade the market move in synch with their own view. Even economists have been forced into revising their views as most said a hike this year was impossible until after the market priced in 75bps of hike. Suddenly all economists were revising their forecasts to include at least one hike by the end of the year. I thought that was a sad showing. Economists, who are supposed to be more or less market independent, all revised their views to be more "in consensus" with the market. Fair enough if they think the market is always right, but then why do we need economists at all? Traders tended to fade the move until they got stopped out (everyone gets stopped out after 100bps of movement). So what gives?

Well, personally I think there's enough instability in the market that the Fed can't really hike this year. It would at most be one hike in December, but even that I believe is a longshot. But how is one supposed to express such a view in such volatile times? Every delta trader I know got stopped out of their position as they faded the move (actually one guy I know timed it right, but all the others were in too early). I think too many traders find themselves too focused on their particular market. Trading fixed income delta is great, but today's volatile markets are a difficult place to do so. Even if you "scale it right" you're likely to get stopped out.

Times like this are a great time to look for option based expressions. For example, fading the 75bps of hike by december via call spreads seemed to be an excellent expression as one can easily limit one's downside (premium) while having quite a good payout ratio. Other popular expressions were call flys (buy a low strike call, sell two of a medium strike calls and buy a high strike call) and 1 by 2s (buy one low and sell two high). Look for clever expressions of your view that limit your downside in markets as volatile as today's. It will prolong your life as a trader greatly as you won't be being stopped out (and perhaps "tapped on the shoulder") and you'll be finding risk-reward ratios that aim for that high payout at the end of the year.

You'll find that the market isn't always right. Emotions drive the market significantly, as do rumors and false information. Sometimes ancilliary effects (say. . .Europe) drive markets when they really should not. As a trader these represent great opportunities for those who can stomach the risk. Fading the market is extremely difficult--as they say "only monkeys pick bottoms." Finding the best expression of a view will payoff greatly when you identify times when the market is reacting incorrectly. They often say "timing is everything." I disagree. That's the old-school delta trader's view. Timing isn't everything. Getting the expression right allows you to do away with much of the timing issue.

Historic Times

Yesterday the front end of the libor curve moved 40+ basis points. The 2s-30s curve moved 38-40bps depending on who you ask. Since 1982 there have been 37 occaisions of the front of the curve moving 40+bps. 14 of those happened since 1990. The 2s-30s curve has never moved as much as it did yesterday, even when the treasury discontinued the long bond (the 2s-30s curve moved 30bps that day).

Last night Bernake gave a speech that was interpretted to be hawkish. We sold off an additional 20bps from that.

This morning (9am london time) the BBA came out with their anticipated tape bomb (and you thought I was joking when I posted that here: http://getonthedesk.blogspot.com/2008/05/bba.html) saying that they'll add new banks to the libor survey.

We are truly living in historic times. Perhaps the most volatile the markets have seen for two decades.

BBA

The BBA met on Friday to review how the different "ibor" rates are set. It went something like this:

"Well mates, what do we think?"
"I think it's too bloody late. Why did we have to meet at 5pm on a friday to discuss this piss."
"It's those American gits. They think they're the center of the world, so our BRITISH Banker's Association meeting has to meet when it's convenient for them--noon New York time."
"I thought it was supposed to be noon GMT, I was here five hours ago."
(laughter)
"Yea, it was noon Greenwich Mean Time, by which I mean Greenwich Connecticut."
(laughter)
"Alright boys, settle down. So what do we think. The world's making a big deal about LIBOR rates. Doesn't seem they care much about the other rates."
"So we agree that all the other rates will remain the same? All those in favor?"
"AYE!" (all in unison)
"Well, that's settled."
"On to LIBOR, then. There are several options on the table. 1) we claim to keep a close regulatory eye on the banks submitting rates, which will probably keep libor rates high and not change much. 2) we can add a few American banks to the mix, which will probably lower rates a little bit. 3) we can suggest a market based approach, like that used for Euribor. 4) we do nothing."
"Let the American gits suffer and leave it be."
"I say we don't change anything. It's worked this long, why should we change it now? The system is perfect, we just have to let it shake itself out."
"I say we put more pressure on the banks to submit true libor rates or we switch to a market based structure."
"What, are you limit short eurodollars in your PA or something?"
(laughter)
"uh. . . no. . . I'm not a market participant. . . that'd be. . .uh. . .unethical. . ."
"Why don't we just watch it longer? The panic over libor seems to be settling down. Maybe we can wait it out and not have to do anything?"
"Yea, if we have to change something, we can always tape-bomb them later."
(laughter)
"Preferably we can tape bomb them in the morning so the Americans have to get up in the middle of the night to figure it out. You can imagine Colin Corgan (head US swaps trader, GS) getting that call in the middle of the night and having to throw off some blonde hooker to get to a computer."
(more laughter)
"Settle down now."
"I say it's getting too late. We can let's leave this up to another day and head down to the pub."
"AYE!"
"Okay, okay. Are we all in favor of calling it a day and going down to the pub?"
(it was known to be a rhetorical question so they all file out.)
"Hey, who's going to do the press release?"
"Thanks for volunteering. We'll see you at the pub."

A Swapper's Paradigm

So a lot has changed since I last blogged. Most notably, the market has found two major deficiencies with the current conventions and ripped a hole straight through them. The first is the mortgage market and how the agencies work to keep order in the mortgage world. I'll write about that another time. The most fascinating change in my opinion (being a rates derivatives guy) is the changes that have happened in libor space.

Libor (the London Interbank Offer Rate), which I've touched on briefly in my Rates "Learn the Lingo" (http://getonthedesk.blogspot.com/2007/06/learn-lingo-rates.html), has seen some dramatic swings. Swap guys pay very close attention to libor because swap payments are set off of libor. While fixed payments are made at whatever rate was agreed upon, the float payments usually reset every three months according to whatever level the three month libor rate set that day.

Libor sets through something of a committee. Basically a bunch of member banks (16, I think) contribute rates at which they say they would offer to lend unsecured cash to other member banks. The top four and bottom four rates are discarded and the simple average is taken of the remaining eight. It is set sometime around 11:45 london time. Many tenors are published from overnight to one year. The most important are usually the overnight rate and the three month rate.

It's worth noting that the rates published by each bank are not necessarily the rates at which they actually lent money nor the rates at which they actually borrowed money (that seems kinda dumb to anyone? Yea, thought it might.). People had pointed out this deficiency before, but it never actually became an issue until recently. Swap and repo guys will know about turn of year funding issues, where year-end (literally dec 31st) and month end funding cost more because companies have to balance their accounting statements. Funding on those days are particularly expensive. The fed has had to flood the financial system with liquidity (read: give away money for free) on these days at times of crises to prevent companies from being unable to fund themselves (thus going bankrupt).

It turns out that this year a whole lot of these sorts of issues were happening and the liquidity of several companies were doubted. We've all heard of Bear Stearns and the "run on the bank" they had, making the older folks remenisce back to the Great Depression days when such runs on banks were common. Those involved also would have seen a similar process (and many rumors) take place with Lehman, although they turned out quite fine.

Libor starting setting higher and higher as banks started to hoard their cash. In fact, it got so bad that at one point the Fed having cut 100bps had completely priced out of the libor market. That is, libor was setting as high as it was when fed funds were 100bps higher. That was both ridiculous and showed how damaged the sytem was. Then the Fed came out with some of their cool toys, most notably the TAF and the dealer lending facility (the name of which evades me at the moment), to inject liquidity without lowering the funds rate. Down came libor again as panic averted and we came back into a "normal" market environment (or as normal as you can say 20bp moves every other day are).

At one point, the allegations came out about banks lying about where they were funding via the libor rates they contributed. Ironically, I think the most publicized version of this allegation came from a Citi analyst. Well, shortly thereafter libor rates started to skyrocket again as scrutiny around libor made member banks carefully set their libor closer to where they actually funded themselves (and citi's new libor rate was much, much higher).

At this point it might be worth noting that or "IBOR" rates aren't as retarded as LIBOR. Some of them, like Euribor, are set via a market rate or market average. That kind of makes sense, doesn't it? To be able to actually see where the rate should be via market transactions. Well, some people really started to notice this as their funding rates went through the roof and trounced their income margins.

Lately a movement has begun to move the derivatives market away from libor. The action itself makes sense, and a gradual transition of swaps and other derivatives away from libor would probably work. Specifically Goldman has suggested that OIS become the new benchmark rate.

What's OIS? OIS stands for Overnight Index Swap. No, that's not helpful. OIS is a swap that goes off of the fed funds effective rate (the rate at which banks lends excess balances to the Fed overnight--basically banks with more cash on hand than required can make a bit of excess interest rate by keeping it at the Fed). The fed funds effective rate is a transactional rate that anyone can observe (well, anyone involved in the markets, at least). The fed funds effective rate usually stays very close to the fed funds target rate, which is the rate the fed announces their policy cuts around at those FOMC meetings.

OIS swaps already trade a bit in the market, but libor swaps still dominate. OIS swaps make sense for people who are hedging, and the uncertanty around reset risk would go away for both dealers and counterparties. The overnight money markets are less active these days and there are usually very few longer dated transactions anyway (for example, why would a bank ever lend for 6months or a year at libor? It seems silly. The only rate really observable was the overnight rate for libor.). OIS, being tied to the specific set of fed funds effective rates, would make the value of interest rate derivatives much easier to predict.

It will be interesting to see if OIS ends up becoming the new libor over the next year or so. It seems the transition will be slow, and it will be a difficult transition to force. If all the dealers agree to trade OIS swaps instead of libor swaps, they'd still have to get customers to convert. For most institutions it probably makes sense to use OIS, especially those who are hedging rate risk for a balance sheet (specifically bank portfolios funding at the fed funds rate, which are a major player in swap space). For other institutions (i.e. industrial companies), it probably doesn't matter as long as they get some sort of interest rate exposure. Personally, I'd say never bet against those Goldman folks.

Credit Recession

It is said that a credit-driven recessions are the worst of the recessions. They happen extremely infrequently, but when they happen they tend to be far worse than the usual recessions. Recessions tend to happen every 3-5 years. Usually they last about a year and wipe out maybe 10-20% of equity gains (for lack of better yard-stick to measure the "severity" of a recession).

Credit recessions tend to impact the sytem much more heavily. They tend not only to give the equity markets a whallop, but they also leave lasting marks on the financial landscape. During a typical recession a few companies go out of business, usually those with operating cash-flow issues, and the rest move on the create record profits a few years later. Credit recessions are a different beast all together though. Major companies get wiped out, banks go under in droves, and the way in which credit is extended as well as managed changes. It is said that the California banking industry is still recovering from the last credit recession, which was probably 1990-1991. Too bad for them because a lot of signs are saying we're hitting another one.

So what's so bad about a credit recession? Unlike a normal recession, they are led by banks. When credit blows up, banks tighten up their purse-strings. That means banks stop lending as freely, and they do so by making their interest rates (credit spreads) prohibitively high. Then companies stop spending because they can't finance new investments with debt any more. The equity markets tighten up because earnings suck. Suddenly the economy stops cold. Companies go under in droves because they can't get adequate funding and aren't selling their goods/services as robustly, which further affects banks and makes them widen credit spreads even more. It's a pretty disasterous cycle. At the end of the day, usually a few dozen banks go under, sometimes insurers and other financials go with them.

It looks like this time around the subprime mortgage hit may have started an unfortunate chain reaction. Losing money on subprime has made banks wary of their balance sheet issues. If they lose money on the subprime mortgage stuff, then suddenly they have to defend the amount of balance sheet they are keeping. They do so by raising interest rates and not lending out as freely as they did before. Thus we start down the cycle that I described above.

We are already seeing the effects on our financial landscape. The behemoth Citigroup has all but died, their stock price back to levels seen in the last recession. They moved from #1 in market cap to #3 in the last year or so (they were passed by Bank of America somewhat before this credit blow-out and were passed by JP Morgan just a few days ago). It looks like SIVs (Structured Investment Vehicles--I'll do a Learn the Lingo on these at some point, I may have mentioned them in another Learn the Lingo post) may "go the way of the dinosaur" as they say. Banks will have to deal with those assets on their balance sheets instead of structuring them and spinning them into their own entities. Monoline insurers are looking pretty precarious right now as the first one (Ambac) just got downgraded from AAA. I'll also try to do a Learn the Lingo on monoline insurers, but the main issue is that they insure municipal bonds. They are absolutely useless if they don't have that AAA rating because why would you want anything other than a AAA rated company insuring a state/municipality? Ambac is the second biggest insurer, and people are already talking about the biggest insurer, MBIA, also being in trouble. Bad times.

So that's where we stand now. Credit recession or not, it looks like our financial landscape has changed once again. It'll be interesting to see what happens to CDOs, subprime mortgages and other financial instruments that were hit so hard this time around. Knowing Wall Street though, they'll always find a good way to get in trouble again. In fact, those same instruments may well find their place back in the markets in due time.

TAF? What?

The Fed introduced a new toy the night after last month's Fed meeting. The new toy has an acronym "TAF" as everything in finance has to have a stupid acronym. TAF stands for Term Auction Facility. In the scheme of things, it's the Fed's way of being able to mess with libor.
Up till now the Fed had three major tools: the discount rate, the fed funds rate (via open market operations) and the reserve ratio. See my post about the Fed (another "learn the lingo" posting) if you need details about these. Now the Fed has introduced a new tool that lets it have a more direct impact on libor.

But wait! Isn't the fed funds rate directly tied to libor? Well, sorta, not really. There's certainly a relationship, but generally libor trades at a spread over fed funds. That spread historically sticks to 1% or less. Right now it has blown way out, so the Fed needs something to deal with that spread issue. Enter the TAF.

Here's how it works. Memeber banks (note: member banks need to be commercial banks or savings and loan instutions--specifically, this EXCLUDES the investment banks) can borrow up to 10% of a $20Bn sum being auctioned off by the Fed. The auction works as a dutch auction so the money is lent out at whatever rate banks bid for the amounts they specify. The Fed announcement set two auction dates in December (already passed, clearly -- they were fairly successful and didn't show ridiculous demand for cash, which is good) and two dates for the roll in January. In fixed income a "roll" indicates when one needs to go from one security to another, in this case cash borrowed over one term to cash to be borrowed over another term.
By lending directly to banks via this auction, the Fed is creating cash on the balance sheets of banks. Then banks don't need to borrow as much in the libor markets so libor can set down. Brilliant. They're still flooding the cash markets via open market operations for year-end, but we should expect a lot of the cash-hoarding issues to be settled.

New Year

It's a new year. And what's that mean for Wall Street? Well, those who haven't reset their annual numbers in December now reset their numbers. Everyone's on a fresh slate. PnL, sales credits and deal closings are all zero or close to it. From today on, anything that happened last year for deals, trades, etc all are forgotten and you get a new chance to shine. Last year's rock-stars are no longer and need to prove themselves once again. Market liquidity comes back and bankers are back on the phones with new-found zest. There are few industries where each year brings a completely new set of risks and rewards. If you sucked last year, you could be the star player this year. If you were the star last year, you could blow up this year. It's a whole new game.

So what's this mean for you? It means you need to stop thinking about last year and start thinking about this year. Letting last year's victories and follies mess with your mind is the best way to screw up a new year. If you got on bad terms with someone, forget about it. If you screwed up a trade, don't think about it. If you lost a deal, it's history. There are new winners to be made.

What if you're still looking for that job? Well the new year brings opportunities for you too. Payouts happen between now and February, which just happens to be when people start moving around too. People quiting means openings in various positions. Firms have to hire to replace those who leave, and there will be a lot of people leaving their firms this year. February to April is the biggest hiring season for the Street. Look forward to it and pursue aggressively.

Good luck to all in the new year.

Turn of Year

A lot has been said about the turn of year premium this year. I'm probably writing this post a bit later than I should have. This would have been a more timely post a month ago or even three months ago. Alas.

First off, what is the turn of year premium? Well, in fixed-income-land, the turn of year premium represents the extra interest one charges to lend money over new year's eve. Generally this year-end rate is significantly higher, say 8% when libor is 5%. Sounds kinda silly right? It's just an artifact of financial regulations and having to shore up captial at the end of year when regulatory numbers are checked. A similar event happens at the end of every month.

Why is this important? It represents financial institutions willingness to lend to each other at the year/month end. This is a proxy for the financial institution's confidence in it's capital ratios. If a financial institution is under-capitalized it can mean all sorts of bad things for them from a regulatory perspective (not to mention a investor-base's perspective).

In the 1999-2000 turn of year, this overnight rate had been predicted to be ridiculously high. 3 month libor (the rate at which banks were willing to lend to each other for three months) starting in september started sky-rocketing due to the rate that would be charged for that one night. The overnight rate had spiked to over 200% annualized. Why? Y2K. People were afraid everything was going to fall apart when computers broke down due to the Y2K issue, so they were un-willing to lend over that evening (if everything falls apart, they may never get their money back). Well, the Fed made sure to flood the monetary system with loads of free cash and the turn of year disaster was averted (in fact the turn of year was quite cheap that year). The entry into the year 2000 passed with no disaster.

This year we had a similar spike in libor year-end rates. Not a computer bug that frightens the world this year though, something much scarier (at least from my perspective). Everyone's heard of the credit crunch occuring from sub-prime mortgages by now. Sub prime mortgage defaults and resets on stupid mortgages made for the past decade are catching up to banks and other lenders. Capital is at a premium because all the banks are having to write down so many of their assets (loans are assets to banks, if people are defaulting they're not worth as much). In fact banks are scared shitless that the sub-prime issue is going to spread to all credit products, and for good reason. As balance sheet capital becomes more dear to banks, our year end premium starts flying. Of course in the past couple weeks the Fed has pumped the economy full of cash again and it looks like we'll have another smooth transition into the new year.

These year end and month end spikes are a big deal in the fixed income world, especially in fixed income derivatives. The ramifications of interest rates ripple into all other markets though, as discount rates for futures (in equity, commodities, forex, etc) all depend on how the fixed income market is setting rates.

Big Losses and Big Excuses

I'm kinda annoyed by how many excuses are being made for these people heading up big firms. Particularly the CEOs of Merril and Citi have come under fire. People are asking if they were taking excessive risk in order to get short terms gains. Others are asking if the right risk management controls were in place. Others yet are wondering if they were trying to hard to catch up to Goldman. Fact is, the answer is NONE OF THE ABOVE.

The single reason these staggering losses are coming out is STUPIDITY. Anybody else wonder why Goldman was ranked 13th on CDO distribution? Anybody wonder why they didn't hold any? Same goes for Deutsche. Anyone wonder why they didn't hold any part of the CDOs they originated? The truth of the matter is these folks at Merril, UBS, Citi HAD NO IDEA what they were getting into. You can bet on the fact that Goldman had a conscious decision not to enter into that market aggressively because they decided the tail events were too painful, and we all know they are not a firm to avoid risk. Let's all quit making excuses for these companies and just realize that it was a LACK OF UNDERSTANDING and perhaps more specifically A LACK OF GOOD MODELING that fell them. I had done a little bit of work with CDOs, and it was annoying to see how so many firms were using the same mediocre model. You can be sure Deutsche and Goldman had some development time to create some specific models and then realized they didn't want to be a part of the imminent collapse.

That being said, you can be sure there are some opportunities out there. I'd be willing to bet that Goldman will start accumulating some of this subprime mortgage and CDO stuff. Just like when they collected CDO equity tranches in 2005 during the autos crisis, they'll swoop in to pick up a lot of this stuff cheap too. In fact, they may even buy a whole company to manage the specific operational issues with these products.

Learn the Lingo - SIV what?

Alright so the recent crisis is all about SIVs, ABCP and the like. Let's talk about this for a bit.

SIV - Structured Investment Vehicle. So most people don't really understand how these work (I didn't really know how they worked until I did some research a couple months ago when this fiasco started to come up). SIVs are similar to conduits or SPVs used for other structured products like MBS and CDOs. They are a legal entity that holds a bunch of securities. SIVs in particular are like mini-banks. They borrow short term and lend long term and make money off the spread--just like a bank. Usually SIVs stick to ABS and high grade bonds, mostly ABS.

ABS - Asset Backed Securities. These are securities created by pooling things like car loans, credit cards, student loans, airplane loans, etc. Generally they are tranched up to various credit ratings. Most of it is pretty high-grade since they are backed by an actual asset that could be sold off if necessary.

CP - Commercial Paper. Commercial paper refers to the world of super-short term borrowing.
Companies often issue commercial paper as a cheap way to borrow very short term. This financing is often used a bridge financing to keep their cash-flow timing balanced (say you receive money en-masse in the winter, but tend to have to borrow extra during the summer because your working cashflow isn't as good in teh summer).

ABCP - Asset Backed Commercial Paper. ABCP usually refers to the commercial paper issued by an SIV. They are considered asset backed because the SIV acts as a intermediary taking cashflows from the ABS and turning it into shorter term lending via the CP market. If anything should happen, the SIV could theoretically liquidate the ABS and pay off its debts.

Money Markets - The CP market is often considered the money market. You know those money market savings accounts at banks? Yea, they invest in CP. There are also treasury money market accounts which invest in treasury bills as opposed to CP. CP tends to yield more. Generally bills and CP are considered minimal risk, but as our current crisis shows CP is not risk free.

So hopefully this helps clear up why our financial world is in chaos. First off, if SIVs really started to go illiquid, billions of dollars of money market holders would feel the pain. That's consumers with money market accounts earning negative savings. That could be an issue. Next if the ABCP market dries up, so goes the ABS market as well. Since SIVs provide the liquidity needed in the market to pull these ABS off bank/dealer balance sheets and into the general public, this market drying up would stop ABS issuance to a large extent. That could be an issue to all sorts of consumers who need to take out credit in the form of car loans, student loans, credit cards, etc. Now you see why this SIV thing can have such an impact on our consumer.

Mix and Match

So rumors abound these days about various companies (e.g. Countrywide) nearing default. Suddenly it came to mind for me to use some of my past training as a credit quant. I'm sure you know by now, I trade primarily fixed income and currencies with some dabbling in commodities. Why am I looking at credit? Well, the credit problem is clearly driving all markets right now, but there's more to it than that. I was looking at specific credits (specifically an old model I once looked at on ABCP default rates). Stuff I can't trade at all.

So why spend time on this? Well, when it comes down to it more information helps everyone. As part of the team, if I can help anyone in the company, that's money in the bank (quite literally. . .unfortunately not money in my pocket though). Eventually I wouldn't be surprised to find myself trading a bit of credit as well. You can never foresee your career path, so there's no reason to limit your view at any time. If you're working in one area but you've found something interesting somewhere else, take some time to pursue it. Even if it's on your own time (as if often will be), that knowledge and that curiosity will serve you well in some role in the future. Who knows, it might even let you make a cross-division connection, which is how these large institutions justify their existence. People who can mix and match information and resources from across an organization are the ones who become leaders of organizations.

"Big picture, mate."

I, Quant

Goldman's Global Alpha fund reported it was down some 26% ytd today. Everyone's making a big deal these days that quant funds are losing lots of money in the current environment because of the inherent instability of the time (quants would say we are having a regime shift). I'm going to give you two competing takes on this chatter.

Some quants would say that this is an opportunity for these quant funds. They will trust their model and return ridiculous amounts when the world returns to normal--when the panic is over the quant funds will prevail. Models can't make money every single day, and there will be statistical anomaly days here and there. The strength of a quant model is that they can avoid the fear inherent in humans and trade into these days to come out victorious on the other end when efficient markets rule.

Others will say that every quant model must have a trader with good market sense there to override the model. When tumulus times like this come around, it is the prerogative of the trader to stop the model and trade the fundamentals. Quant models are meant for calm times to tick away the market discrepancies, but when thing are really moving is when the experienced trader prevails.

I was brought into this world as a quant. I tend to adhere to the "stick to the model" school of thought, but I tend to also make models that have resilience to market shifts like the one we are experiencing now (a couple of my models have been extremely profitable as of late and are covering the losses in some other models easily). I believe Goldman's fund will have a banner year next year or even come roaring back later this year. I do, however, also keep an account for pure macro-economic bets. That also has been very profitable lately. It's all a matter of scaling the right things at the right time. My main indicator in my trades is actually a model that tells me how to weight my risk between tactics.

The age-old adage goes: "Bulls get rich, bears get rich, pigs get slaughtered." Perhaps in this new world we can say "Quants get rich, fundamentalists get rich, pigs get slaughtered." Okay, so you don't get the animal theme, but you get the idea.

The Rumor Mill

Spreading of rumors on Wall Street is fast and furious. They appear in all sorts of shapes and sizes. Here are three from which you might learn.

1) A "bitch"-in party
A couple years ago some girl who was interning at a major i-bank decided to throw herself a party at a ritzy hotel. I don't know the girl, but I did see the invite for the party. This girl sent this party invite out to a set of friends (probably around 40). The invite included an assigned arrival time so as to stagger the arrivals of friends, suggested gift prices, dress code, and all sorts of other unnecessary details. It was quite amusing reading the obsessive nature of this girl and how obviously the party's details were going to fail (and be ridiculed). This invite note ended up being forwarded to everyone on the street (yes, EVERYONE). I don't know if too many people went, but it became quite a famous fiasco. It even got a mention in a newspaper (I believe the newspaper was in Hong Kong). So if you're throwing a party, try not to make the invite ridiculous. You could end up with street infamy.

2) Moving Markets
Just today a broker called me to tell me about a rumor going around about Goldman making an announcement after the close that they expect a negative Q3 earnings. Right around that time the bond market skyrocketed and the equity market tanked. One minute later Maria Bartiromo mentioned on CNBC that she heard from a trader that one of the big banks would be making an earnings comment after the close. Yet one minute after that she announces that Goldman is denying the rumor that they would make such a comment. Bond markets tank again and the equity markets fly back to their highs. It's amazing how a rumor like that moved markets so quickly in both directions.

3) Top Recruit
Some guy with a Russian sounding last name who went to Yale sent out the most ridiculous paper and video resume to the street. The resume circulated the entire street. He ended up on MSNBC and some newspapers due to the ridiculous nature of the claims. On the resume he had cited a non-profit that he supposedly founded and runs (no one could find it, although it did have a defunct website). He taught several celebrities tennis. He was some sort of hitman or something (don't remember the details on that one). He claimed more ridiculous stunts than any sane person would bother. In the end, everyone knew he was a fraud. In fact there were articles on msn.com, a couple newspapers and other semi-mainstream forms of media about him. I have a feeling this guy never got a job on the street (let me know if you know him and I'm wrong).

Fed Day

Big move post-Fed today. Market had priced in some Fed help, perhaps with a more neutral stance on monetary policy, but received full Fed hawkishness. Pretty quiet trading day going into the meeting, although the 7bp flatter curve was weird. Then the Fed hits, yield curve steepens 7bps, then goes right back to the flats.

One lesson the market will teach over and over again is that getting the forecast right does not necessarily mean you will be able to out-guess the market. After the initial Fed announcement, the fixed income market dropped, as did equities. Then the fixed income market flew up as equities continued to tank. Finally the fixed income drops like a rock while equities start flying up. Weird volatility. Certainly nothing I can explain.

A day as exciting as today, I was surprised how un-engaged a lot of the interns and new analyst/associates were. This is exactly the sort of day you can learn a ton about market dynamics and ask questions about why things are moving as they are. I'd be willing to guess that at least a couple of them didn't even know why today was such a big day. If you're new or interning, get engaged. Watch markets intraday every day. Get your mind into it and try to figure out WHY everything is happening (as opposed to staring at it mind-numbingly like your favorite sit-com).

"Engage, Maverick, engage!"

The Fed

Fed meeting this coming Tuesday. Looks to be a fairly important one. Let's talk a bit about what the Fed does and why they're so important to our economy.

The Fed is the United State's central bank. They control monetary policy, which is to say they try to control the money supply. There are three main ways in which they control monetary policy: The Fed Funds Rate, the Discount Rate, and reserve requirements.

The Fed Funds Rate is the interest rate banks charge each other for overnight loans. The market determines this rate, so the Fed can not use regulations to enforce this (well, maybe they could but that would screw with market dynamics). Instead of regulation the Fed conducts open market transactions to buy/sell treasuries from the open market to increase/decrease the amount of money available to the public. When there is less money circulating, the interest rate for borrowing it must increase. The Fed Funds Rate is what the market watches the most closely because it is the Fed's primary means of affecting the market.

The Discount Rate is the interest rate that the Fed charges for overnight loans. Most banks go to other banks to borrow at the Fed Funds Rate before going to the Fed for their loans. Clearly the Fed can choose its Discount Rate at will.

The reserve requirement refers to the amount of reserves banks have to keep as a percentage of their deposits. If banks have to keep more money in reserve (as opposed to lending it out or buying illiquid assets), then the demand for money is higher and interest rates go up. The Fed hasn't actually messed with the reserve requirement for along time, but if they did it'd be a really big deal. The reserve requirement is the Fed's sledgehammer when it comes to monetary policy.

Alright, so now we know what the Fed does. Now how does this effect the economy? Well all of the above change the supply and demand for money and thus interest rates. The Fed's mandate, however, involves inflation (go wikipedia inflation if you don't know what it is) and economic growth. This is slightly different from most central banks who are only mandated to control inflation. Too much money floating about invokes high inflation, which is disastrous on an economy (well, some theory says it doesn't matter, but in practice inflation has been the devil). So the Fed has to maintain a delicate balance between wanting to raise interest rates to control inflation and wanting to lower rates for growth. Most people think if the rates are high that's bad for the economy, if rates are low that helps stimulate the economy.

A "hawkish" Fed means they are primarily focused on the inflation rate (e.g. watching inflation like a hawk). A "dovish" Fed means they are kind on the economy and worry as much about economic growth as inflation. Most people agree that the primary target of the Fed should be inflation. A hawkish Fed tends to demand more respect and can more easily control inflation and the markets without having to mess with the interest rates.

When the Fed Funds Rate is high, banks have to fund at a somewhat higher interest rate, so they have to charge others a higher rate as well (for those of you familiar with LIBOR funding, LIBOR tends to trade at a spread to Fed Funds, we'll talk about this more later). When interest rates are high, however, companies can not borrow as much money, so domestic companies tend to suffer a bit and aren't able to invest in as many capital intensive projects. New bonds tend to come out at a higher interest rate. When interest rates are high foreigners are more likely to buy US dollar denominated assets, so the dollar would appreciate.

When the Fed Funds Rate is low, borrowing is cheap so liquidity is plentiful. Thus companies can invest a lot in projects with the thought that funding these projects is nice and cheap. Another way people talk about this is to say credit is plentiful, which seems to be a problem with the economy right now.

Alright, so now you know the basics of the Fed. Why does this seem like a timely post? Markets are really moving these days, and the markets just priced in a Fed "ease" (lowering of the interest rate) via the Eurodollar futures. Eurodollar futures basically point to LIBOR. Future LIBOR being lower basically means the Fed has cut rates. In fact a lot of what I saw on the ticker on Friday was a lot of banks buying Eurodollar future calls, which means people were buying protection against a Fed cut (if the fed cuts rates, then the eurodollars go up in value a lot and the calls are in the money). A lot of the hype is around the policy statement that the Fed gives after the FOMC meeting on Tuesday. As much as policy effects the markets, the statement tends to have just a large an effect because it points to future policy. A lot of the move in markets seems to be pricing in what the Fed will "say" about the state of the economy (and whether a cut will be necessary in the future.

A Messy Market

I'm sure many of you heard of the huge fall in the equity markets yesterday. A few might have even seen (or at least anticipated) the huge rally in fixed income yesterday. We see another 97th percentile event, and one of the days that makes or breaks many trading desks. Credit spreads are out, rates rallied, stocks tanked and foreign exchange markets whipsawed. As we navigated through the mess (quite profitably, in fact) something popped out at me in a much more vivid manner than usual.

A lot of people fall into one of two camps. Either they specialize so much that the only movement they see (or care about) is the movement int heir own market, or they see correlation in everything and mistake correlation for causation. In the first camp many people don't see the economy as a whole and often miss the macro opportunities. In the second camp large generalizations such as "oh, bond markets are up because equity markets are down" add to the confusion created by big market moves.

No matter what field you are in, you should not isolate yourself from your general marketplace. It always helps to have a macro view of the world and see the big picture. For example, bankers should keep an eye on the markets so that they know why their deals might be falling through. Retail people should keep track of consumer trends and competitors. I have to say, traders generally are pretty good at keeping a pulse on everything, which is an excellent characteristics. In all other fields, it is usually the people who understand the big picture who get promoted for the big jobs. In trading, people who don't keep a pulse on everything tend to get weeded out.

Confusing correlation and causality is extremely common. Just because two things happened to move together does not mean one caused the other. Most likely there is a third thing that caused both to happen. Just as importantly, seeing two things move together once or twice does not necessarily mean they are correlated (it's called a coincidence, for any who care). Looking at the big picture, it is often easy to see why two things that are "correlated" are actually just something caused by a third party. Even more interestingly, you might be able to predict the next effect this cause will have.

Come out of your holes people. There's nothing wrong with simply not knowing why things are happening, but don't settle for some mediocre reasoning from an easy to spot coincidence.

A Sad Moment

Sorry for the sparse postings last week. I took a bit of a vacation and couldn't peel myself away long enough to blog.

Anyway, it's worth your time to get an update of the news in the morning. This sort of thing used to be almost required of every intern and new associate out there. Nowadays, it seems, the ubiquity of easy media (i.e. the internet) seems to be making people lazy. The tone of the morning news sets the tone of the markets for the day. It's a good way to not only get the opinion of the masses, but every once in a while it keys you into something that you might have otherwise missed. You should find some way to get your news. RSS feeds, podcasts, newspapers, anything will do, but do be sure to get your morning dose of news. It really does help.

This morning I had a sad moment on my way to work. I listen to the WSJ and NYT podcasts on the way to work in the morning. I find it to be a great way to catch up with a lot of the news that I may miss during the day or overnight (I walk to work, so I can't really read the paper on the way in). The NYT Tech Talk podcast had a special on the iPhone. They claimed that the iPhone release was our generation's lunar landing. That somehow the ubiquity of the release paralleled the ubiquity of people watching the lunar landing. . . that's just sad. I disagree completely that those are even vaguely comparable. The lunar landing was a huge step in human discovery and exploration. The iPhone is a toy. It's like saying beanie babies were a huge turning point in American history. How depressing.

A bear of a Bear?

Figured I ought to write something about the Bear Stearns mess that just unfolded in the past week. I'm not sure whether I should be making my posts more timely as things are occurring or only after the fact. I had figured that I ought to write everything after the fact in order to avoid putting anything out there that might still be sensitive or incorrect information. Let me know if you have an opinion either way.

Well, it seems the players have made their entries and exits. A Bear Stearns' hedge fund backed largely by subprime mortgage backed securities got into some trouble last week and nearly faced liquidation. At one point people were talking about Merril the funds' assets to cover their margins. There was talk of help from Goldman, Bank of America, Credit Suisse, JP Morgan, etc. None of it came together. Then, finally, Bear decided to save its own hedge fund. That's cool. Then there was talk of Bear's other hedge fund and whether it would save that one too. They decided not to.

So what's it all mean? It had all sorts of implications on the credit/structured markets. ABX (the asset-backed securities index) was tanking from the subprime woes. A lot of that money went into treasuries, making a flight to quality type rally for a while in rates markets. Overall though, it didn't make that big a splash in the markets as far as I'm concerned. People are making a big deal out of something that really didn't change much.

There's talk now about whether Bear Stearns is in trouble too. Well, that's just bunk. Bear might show a PnL hit, but I doubt this would put them in jeopardy. Others talk about this making Bear Stearns prone to a buy-out / acquisition. I think that , while more likely than Bear Stearns going bust, is still crap.

Where I have heard the subprime mess and the Bear Stearns mess having effects is in origination. Apparently the appetite for these sorts of loans has significantly declined both on the originators side and on the buyers side. That means people are more stringent about their loan characteristics before they are willing to loan the money and buyers are less likely to buy the securitizations. Double whammy for the capital seekers there.

Holy Volatility Clustering!

So I'm sure some of you have read the comment about vol clustering by an astute reader of my kurtosis post. I figured I'd explain the idea of vol clustering a bit because, well, volatility continued just as the reader predicted.

Volatility clustering, just like it sounds, refers to the "clustering" of volatility. That is, large moves often come in packs. So when we saw our 2 standard deviation day, we expected more days with relatively large moves (and we continued to have 2 standard deviation intra-day moves every day since for four or five days now). Given volatility clustering, however, we would say that we have entered a new regime of higher vol, so these shifts aren't "that" big in stdev terms.

Volatility clustering is modeled by the ARCH and GARCH models. GARCH being the more advance and more used/known of the two. GARCH stands for generalized auto-regressive with conditional heteroskedasticity. A mouthful, eh? This is a type of time-series model. For those of you who would like to study time-series modeling/econometrics, the standard text is the Hamilton - "Time Series Analysis." Excellent book. You should have pretty strong math to go through it though.

Auto-regressive models are models that look back on previous periods' error terms (known as AR(n) models). The regression equation looks like [alright, I had to get rid of the equation b/c it was fucking up my formatting. E-mail me if you really want it, or look up an AR(2) model].

Heteroskedasticity is the state of having different volatility (standard deviation) describing the regression error. One of the primary assumptions of linear regression is homoskedasticity (the state of having constant standard deviation describing the regression error). Without homoskedasticity, linear regression is no longer efficient.

A regression is efficient if given any other estimate of the regression parameter, the efficient regression parameter converges to the real parameter faster. Actually, that's not really the definition, but it's close enough for those of you who don't know what it is. You should actually look up the proper definition, but it's a bit technical for me to write in a text blog (unless I post a LATEX document).

Anyway, now that we've defined the terms, what the hell does the GARCH model do? It allows us to say, "given that I just saw a shit-load of volatility, where do I expect my volatility to be going forward?" This is a rather helpful trait for modeling expected movements and even pricing options.

A lot of empirical papers have shown the existence of the volatility clustering phenomenon, and these last few days have also exhibited this behavior. It's interesting, to say the least. Might be worth someone's time to look at the effects of vol clustering and swaption implied vol. I've been meaning to because the swaption implied vol seems to be lagging the high vol effects. Then again, implied vol has historically been way to high in options pricing to begin with.

Kurtosis baby

Whoa baby, 2+ standard deviation move in the bond markets today! For those of you who are looking to get on the street but don't keep track of markets, you probably should start doing so. Big move, no good explanation, it seems? Rates market up 20bps today (10yr swap)! That's a huge move. S&P down some 1.75%. Prize to whoever can give me an explanation that I'll actually believe for the rates fallout today.

By the way, kurtosis is what statisticians call what market practitioners often call "fat tails." A lot of theory involves assuming that market returns are normally distributed (follow a normal distribution). In practice, we often see the distributions have a lot higher probability of a big move than a normal distribution would explain. Thus they say the distribution has "fat tails" or higher kurtosis compared to a normal distribution. Basically, days like today should not happen as frequently as they do if markets were normally distributed. But because of the high kurtosis, we actually expect days like today about three times a year.

For many of you, you will never view the markets like this. Most of the desks/traders today said "HUGE sell-off in rates markets." Only the quantitative types (only me, as far as I can tell) looked at it relative to the expected distribution. I'm a nerd, but I warn those less quantitative that we nerds are proliferating quite quickly on the street.

Ask for volatility and you shall receive. . .