How to funnel your hard earned money into our I-bank : the Goldman primer

Its fucking amazing.

Amidst the current economic mess, while jobs are being lost in millions, people are being forced to leave their homes left right and center, life savings, 401ks, retirement savings of the common man are being reduced to rubbles, I banks (read Goldman Sachs) continue to churn out amazing profits from what is now nothing but a naked form of state-subsidized (read Obama administration) profit generating racket for the remaining few I-banks (Goldman primarily after Merryl, Bear Sterns and Lehmann managed to go belly up with greed, as a sidenote the prestigious scumbag and asshole of the decade award goes to (Sloan) Harvard alum and ex Merryl CEO John Thain for managing to award himself and his fellow execs 100s of millions of $$ in performance bonus exactly 8 days before they had to go to the US government asking for a bailout).

Ok lets start:

The chief players: Goldman Sachs, SEC, White house
Cameos: Merryl, Bear Sterns, Lehmann
Comic relief: AIG
Act 1: The great depression of 09 aka how wall street managed to ass rape you

The story so far (quoted in green):

A former Goldman chief, Rubin, presses the Commodities Futures Trading Commission(CFTC, a federal government regulation and enforcing agency for the market) to deregulate a type of derivative contract whose chief benefit to an investment bank like Goldman is that it allows it to lend more — the CDS being most useful as a tool to move investment risk off a bank’s balance sheet. Then another Goldman chief, Paulson, pushes for further relaxation of lending limits. Then Goldman jumps head-first into the housing bubble, buying tens of billions in CDS protection to hedge their crazy investments. This massive explosion in lending by banks like Goldman, fueled in part by the use of derivatives like CDS and fueled still more by the 2004 change in rules, puts an enormous strain on the economy, leading to giant holes blown in its hull by the end of 2007 and on through 2008. It follows that when Goldman’s chief partners in those CDS deals, AIG, collapses as part of this wave of crashes, Paulson — now Treasury Secretary — rushes to the rescue, pumping billions in taxpayer money into AIG that is quickly funneled to Goldman. Then a Goldman alum is put in charge of AIG while another bunch of Goldman alums funnels still more bailout money to AIG, and yet another Goldman alum is put in charge of regulating the derivative market that is the focus of most of the bailout efforts.

In the midst of all of this, something amazing happens. Goldman Sachs, along with Bank of America, Morgan Stanley, and a host of other “troubled” banks, reports a profit for its first quarter in 2009! How and why that happened is another fascinating story, for another time. For now the only thing to remember is that all the same people who got us into this mess — Rubin, Summers, Goldman in general — are now being put in charge of the cleanup by a president who spent most of 18 months on the campaign trail pledging to end the influence of money in politics.

Add this together with the obscene giveaway that is the Toxic Asset program Geither has just devised (Goldman Sachs “expressed interest in participating in the plan as an investor,” according to the WSJ), and you have an amazing situation. Between the Bush and Obama administrations, you have a bailout program that has now figured three ways to funnel money to Goldman, Sachs: via AIG, via TARP, and now via this trillion-dollar “Public-Private Investment Program,” which basically lends huge amounts of money to investors and provides guarantees against heavy losses. It’s free money, state-subsidized profiteering at its most naked.

Hail Goldman, fucking assholes, all of you execs and b-school alums at Goldman should be lined up in a row and asked to eat shit burgers followed by a "thanks a lot, can I have one more and please can you piss on me while you are flipping those shit burgers".

In today's fun news: I played poker at the airport on saturday after my flight got delayed on a supremely dodgy Boingo connection, and managed to rip $8k off a huge donkish player in less than 2 hours.

EFF U WORLD: so says Citi and AIG and I-Banks

And the plot (conspiracy?) thickens. Those following the markets would know that there was a memo by Citi chief Vikram Pandit in early March, that got conveniently (?) leaked to the media and that shows that Citi was pretty profitable in the first quarter of 09, quoting Pandit:

"In fact, we are profitable through the first two months of 2009 and are having our best quarter-to-date performance since the third quarter of 2007. In January and February alone, our revenues excluding externally disclosed marks were $19 billion".

Of course soon thereafter other such news came gushing in from other I-banks (JPMorgan, BOFA, GS..etc etc) and all of them reported major profits in that time frame (first two months of 09). For the layman like me this was utterly puzzling, banks with garbage on their balance sheets suddenly should not, by any logical means, start raking in big profits in a market with ever widening spreads and a ultra tight credit market.

But spending a ton of time reading a ton of, usually useless information, does have its perks when I finally came up on these whistle-blowing bunch of writeups from Zerohedge, there is a followup post on Rortybomb as well.

Basically what Pandit and his clique at the I-banks are upto this time is the following, (I quote in green)

• AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam. (this happened in the jan-early march time frame of 09).
  

• What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were a) one-time in nature due to wholesale unwinds of AIG portfolios, b) entirely at the expense of AIG, and thus taxpayers, c) executed with Tim Geithner's (and thus the administration's) full knowledge and intent, d) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.

So essentially AIG is a clearing house, it funnels in tax-payer money in billions and serves it up on silver platters to I-banks with a ton of garbage derivatives on their balance sheets as profitable trade opportunities. The sad part is that the banks then come up with blatantly false follow-up statements, on the back of these criminally-shady deals, announcing "Hello world we are profitable invest in us".

One wonders how much low can this supposedly respectable executives at I-banks stoop to? As I have alluded several times in this blog "Ethics for MBA, often publicized with vigor by B-schools" is an eye-candy meant for mary poppins.

Also to those disgruntled soul(s) who have spammed my mail box/comment section (comment moderation is now on) on the previous post regarding false claims and charges of plagiarism, which I-bank do you work for?

Some Observations on Goldman Sachs from a finance applicant's perspective

My weekend reading yielded some interesting titbit pieces of info that could be of interest to mba applicants as well as mba students interested in finance. The titbits however are not encouraging if you are thinking of I-banks/Wall street careers.

Background: What I will talk about is the so called derivative space in I/commercial banking, a particular member of this derivative space : credit default swaps (CDS) is now being accused of being the villain that brought down the financial sector.

The CDS for the layman is essentially an insurance against something (usually company bonds/debt etc). An underwriter (AIG) like your local auto insurer charges the insuree a monthly payment (coupon) determined by the CDS rate and if something bad happens to the insuree's holdings the underwriter ponies up the insured money just like an auto insurer pays for your wrecked car in case of accidents. Of course when all these CDSes started defaulting simultaneously (primarily because they were junk grade to start with, for example a pizza delivery boy in orange county,CA ,offered a 350k house loan on zero down, underwritten by AIG, packaged as CDS instrument by Lehmann... u get the picture), the insurer (AIG) was called upon by a myriad of insurees for the lumpsump payments causing the meltdown.

Now the derivative space has some more members besides the CDS notably :

1. interest rate
2. foreign echange
3. equities
4. commodities
5. CDS
   

Brief history tutorial for the layman: During the boom period in Wall street (1998 to 2007) , leading to the meltdown, the entire derivative space ballooned from $33 trillion to about $200 trillion, while CDS grew from about $150 billion to $5 trillion.

However another silent player in this dreaded derivatives basket seems to have risen in a more alarming fashion. It is the interest rate (1, in the list above, specifically swaps but also futures and forwards) that has grown from $24.8 trillion to $164.4 trillion!

In simple terms an interest rate swap (IRS) are merely contracts exchanging a stream of interest payments for another party's stream of cash flows, the underlying interest rate is often the Fed rate. Now associated with the IRS and derivatives is something called Total Credit exposure (TCE) which is essentially a metric that measures a bank's risky credit/risk eposure. Higher the number worse the bank.

Now for the bad news:
The Office of the comptroller of currency released a chart last week for the top 5 banks and the percentage of their total credit in relation to the potential toxic risky credits/derivatives arising from interest rate swaps (item 1 in the derivative basket above).


Table reproduced for better visibility:
Total credit exposure to risk based capital (%)
JPmorgan: 400(Q4 03), 384 (Q4 08)
Bank of America: 178(Q03,08), 179 (Q4 08)
Citi 260: (Q3), 278(Q4)
Goldman: 4(Q3), 1056(Q4)
HSBC : 664 (Q3), 550(Q4)

And drum-rolls please we have a winner. IT IS OUR OLD I-BANK PAL GOLDMAN SACHS WITH A STAGGERING 1056% % ratio of their total credit in terms of interest rate swaps.

The ramifications of this I leave to the readers, but just for fun imagine GS defaulting on these, ah wouldnt that make the AIG collapse look like peanuts. For those getting ready to join Goldman Sachs be sure to ask your bosses about these charts, Id love to have an explanation for their immense love of interest rate swaps. Also those in the class rooms do me a favor ask your fin-profs about these numbers, either way I'd love to know whats going on with this epic GS and IRS love saga. And a true love saga always needs a tragic ending, right ;-)

Charts Source :
http://www.occ.treas.gov/ftp/release/2009-34a.pdf:zerohedge :Office of comptroller of currency's quarterly report for bank trading and derivative activies

I am back --- with a whimper

• 8-6 has got boring, although I am still in research, our whole group has had a recent focus/image makeover, making us almost completely service- rendering bitches for our clients (internal and external).
• I don't like the projects I am supposed to work in 09-10.
• With oil and the economy in free-fall our lofty bonuses (announced Dec08 for 09) are going to be severely trimmed.
• I am feeling immensely strait-jacketed in terms of my career road-map.

Sum total of this bullet-based rant: I WANT AN MBA, again.

So after being out of the game for just about a quarter, I am back, back to play my part in that indy-500 of rat races aka Mba-admissions (drummrolls please) and that too at an unprecedented time.

My mood is sour and am feeling especially bitchy, so lets continue on the path of dourness and take a sneak peek into the current economic scene from an mba aspirant's perspective:

1. Sales and Trading : S&T was the reason I started looking into mbas. I wanted to be in a hedge fund running money like theres no tomorrow. Sadly investment research reveal total AUM for hedge funds have fallen to $965 billion in Jan from just about $1.9 trillion in May 08, an astounding 50%+ drop in just about 3 quarters. In may of 08 there were about 10,000 operational hedge funds, today that number is less than 6000, steamrolling towards the 5k mark, of course as hedge funds go belly-up hiring freezes, newly hired traders go over to cnbc and some audition for stripper jobs. Since I am feeling especially pissy here is the story of a hedge fund manager netting 750k anually who now works as a pizza boy at $7.95/hr,but he does deliver your pizzas in his leased Merc, soon to be repoed though.
   
   Former Morgan-Stanley junior banker/trader now working as a full-time NYC stripper netting 100k+.
   
   
2. I-banking : Sell side finance to start with (sell side is for the dummies btw), where you are essentially a middleman (akin to a pimp, pimping for money in expensive $2200 black suits and gelled hair, instead of the bing and glean that your average pimp puts on) putting together exotic products for your clients and often mixing in super-toxic little understood instruments into those product pools. But hey you still make decent dough, well you used to, if I was graduating today from a B-school I wouldnt touch an I-bank with a barge pole.
   
   
3. REITS (Real estate): I said I wouldn't touch I-banks with a barge pole if was graduating today, in that case I need to make a will forbidding my offsprings to use the phrase REITs in any source or form ever. A few charts for the pain that has now been re-christened Real Estate investment:
   
   
   What the first chart basically shows is the massive debt maturities that most REITs are now facing through to 2011. The problem is that REITs need to get financing/refinancing or some structural revolving credit line with their existing as well as new creditors to deal with these. Now those into Real estate will know that earlier this month Simon property group, perhaps the biggest player in this space (also the one with the best credit ratings on moodys and S&P), announced it was raising $500 million in bonds to take care of its debt at an astounding 10.15%!!! Pain anyone.
   

Now that my finance options are out of the way and the post is lit up in red, I'll retreat into my corner and sulk some more.

edit: I finished some catch up reading on mba related stuff and realized that there seems to be a shift in career focus towards clean energy, biofuels and stuff like that at most major B-schools. That is pretty surprising primarily because if you are rejecting Wall street based on your risk-averseness, then moving towards clean energy is almost surely suicidal. It is a sector that survives solely on subsidies and realistically has little chance to be a major/significant player anytime soon. The name though sounds chic and cool "Clean tech".

Quantum of Solace

On Black Monday markets worldwide collapsed by 20%, today we are down just about 9%. Not everything is bad in today's world see !!

In this week's OMG news: I finally managed to ride my first stock to $0.00. I had aggressively bought Wachovia bank-WB when it was part of the financial rally early last month, managing to make a killing as it moved from the 9s (bought a big chunk at 10.x) to the 20s. Even booked a big chunk of those profit, but still held onto a fair number of shares. And today it is at $1.84. Life is good. Oh and yes the market is a bitch.

Cuurently: On life tilt. And contemplating moving my whole equity-portfolio to my poker accounts. To put it in perspective, ROI in poker 35% (essentially it means that on an average everytime I play an online poker game I make $45, extrapolate that to well over several thousand games), ROI in stock (YTD): -13.5%. Did I say life tilt??

United Sovereign Socialist States of America and $700 B

“Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency”

Yes this is one of the lines in the current 700 billion USD bailout-bill that the Treasury Sec of the United Sovereign Socialist States of America, formerly known as USA, Henry Paulson (formerly of Goldman Sachs) has sent to the Congress for immediate approval. Please re-read the sentence and try for a second to grasp its ramifications.

What this means is that once the bill is passed putting 700B of the taxpayer's money at super-risk,neither the secretary, nor the financials institutes who would be bailed out, are in anyway accountable to the people for either their past actions (no judicial hearings, no congressional hearings on their shady dealings) or for their future actions (meaning we will have no idea where/how/whether the 700 B will be used).

Now for those who are still unclear of what some of these so-called "shady" dealings that the big financial instituions have been practising for so long (out of pure greed) heres a primer (for all you mba applicants/students/alumni/b-school adcoms/faculty, remember while reading , that business ethics is something that the mba machinery has preached like for-ever, to me at this point it looks like eye candy at best, at the end of the day what matters to the mba machinery is $$$$ and nothing else):

• Sub-prime : This is something we all know, but the real problem arose when Lehman and its clique developed financial instruments via which they started trading these mortages as equities.
• Credit Swap: AIG owns a piece of a $500 million sub prime paper (packaged and sold by Lehman), but it aint sure whether the mortagee can pay him back. They go to a $100 million Hedge fund and ask him to cover/insure this mortgage they are holding. Now the insurer (the hedge fund here) has to provide some collateral, usually of the same value as the object being insured (500 mill). But the hedge funds get greedy, AIG hopes no one will notice, and a 100 mill hedge funds acts as an insurer for a 500 mill package. This is credit-swap. Currently the credit-swap market is worth 45.5 trillion dollars (twice the enitre worth of the whole US stock market).
  
• Leveraging : A typical Hedge fund takes 2% of Asset under management (AUM) as management fees and 20% of all profit as benefits packet. For a 100 mill break-even hedge fund that means that 2mill is what the fund-runners get. But hey, thats monopoly money on Wall street. Sheeeeshh. Hold on, suppose we leverage 10:1, so now instead of 100 mill AUM, our books will show we have 1000 mill AUM. What about our management fees, oh yea they went up 10 fold too. Lehman. Goldman, Merryl and the whole brotherhood was leveraged upto 30:1.
  
• Coming soon to a Wall street near you: ARMs (adjustable rate mortages), credit defaults, retail non-housing loan defaults etc etc.
  

But unfortuntaley the near Armageddon that these financial executives have brought in has not yet ended. With the govt sponsored free money (a mere 700 billion) that will soon be in Wall street heres how the bankers are reacting to it (via NYT)

• Wall Street is lining up at the trough for a piece of the action, lobbying to run some of the $700 billion fund — and take huge fees — for their own mess.
• And then there is the jockeying among the banks so they can sell their absolute worst stuff to the government — even loans that have nothing to do with mortgages — and change the rules in the process. The Financial Services Roundtable, which represents big financial services companies, wrote an e-mail message to members on Sunday suggesting, laughably, that “the government bid for the assets should not count as a mark-to-market value for accounting purposes.”

Next time some Bschool reps start preaching about their new course on the ethical business, be prepared for some chosen profanities coming your way. Oh and in the meantime, for those of you still writing your essays, please dont forget to leverage your lies 30:1 or more. I know I'll be doing it. After all its an excellent prep for the business world, especially the finances.

When pictures say a thousand words

For many of us wannabe MBAs, especially those interested in finance, the week of Sept 12-Sept 19th was a once-in-a-lifetime joy(?)ride. Call it a black swan, call it the beginning of the end for I-banks, call it a mere blip for the think-long-term advocates, call it whatever you want, but sure as hell this was one unforgettable week (actually this is turning out to be one unforgettable year !!).

If you fell asleep on the 12th. and are just waking up, heres a view of last week's mayhem (via tradermark):



Interestingly inspite of the absolute carnage in the market (driven almost in whole by the financial crisis), on Friday Sept 12th (week before the carnage) the S&P 500 closed at 1251.7 and on Friday Sept 19th it closed at 1251.3. So if you were truly asleep ala Rip-Van-Winkle, you would have woken up a week later, fired up google finance, and said to yourself "Blaaah, what a boring market, the indices havent moved an inch". Is anybody reminded of the Japanese markets of the mid 90s ?

As I get ready for my MBA apps, I wonder how this market will effect the ROI of a 150k+ MBA education. Will it be something like this for us fin wannabes:



In this week's OMG news: I won a seat via an online mega-satellite (1k buy-in) to the Europeon Poker Tour-London No-Limit-Holdem Championship event, starting October 5th at the Victoria Casino, London. By winning the satellite, I get my buy-in (10k pounds) for the tourney waived, free hotel, free food, free air-fare. I only need to get the visa and everything else is pretty much taken care of, EXCEPT of course freaking work. With a bunch of projects being worked on, my manager is going to flip out if I ask for vacation, lets see how things work out. If I cant make it to London, then I can probably keep the value of the seat I won.

Diamond and Kashyap from GSB on the current market

There is an interesting piece at the Freakonomics blog, where Doug Diamond and Anil Kashyap from the GSB give us a rundown on the current turmoil in the financial sector. They talk about why Lehman had to fail, Freddie and Fannie had to be rescued, AIG and the bleak scenario going forward for the fin service sectors.

A part of this post for the utter layman goes like this:

I do not work at Lehman or A.I.G. and do not own much stock; why should I care?

The concern for the man on Main Street is not the bankruptcy of Lehman, per se. Rather, it is the collective inability of major financial institutions to find funding.

As their own funding dries up, the remaining financial firms will be much more cautious in extending credit to normal firms and individuals. So even for people whose own circumstances have not much changed, the cost of the credit is going to rise. For an individual or business that falls behind on payments or needs an increase in short-term credit because of the slowing economy, credit will be much harder to obtain than in recent years.

Yesterday a friend of mine with a spotless credit record, super high credit score was denied a car lease, on the grounds that his credit history was not "sufficient for him to lease a second car when he already has one", his is a 150k income household.

Interesting times ahead.

Lehman Layman

The I-Bank behemoths have been crushed, the S&P has broken the 1175 mark (Bear-Sterns low of earlier this year), the Russian stock market has been halted, the retail investors have their hides nailed to the wall and on the back of these crushing news heres what the compensation/retirement/severence packages for the executives of these greedy, unregulated jackasses look like:

(1) The demi-god of I-banking Richard Fuld,CEO Lehman:
Awarded $71.9 million by his board for bringing down Lehman. Interestingly I learnt via Tradermark that in Lehman's board (supposedly in place to rein in rogue jackass CEOs like Fuld, who is best known for launching scathing public attacks on his executives in meetings) 9 are retirees, 4 are over 75, 1 is a navy admiral, 1 is a theatre producer, only 2 on the board ever had any direct contact with the finance industry. The board has a risk assessment commitee that has met atleast twice in both 06 and 07 (via SEC filings) and to them everything was fine.

(2) Merryl Lynch mariachies:

• Current CEO John Thain took up Merryl's reins in Dec 1 of 07, after being offered a 15 million USD signing bonus. Since Mr.Thain's first day in office Merryl's shares have fallen a mere 60% . If he decides to leave after the merger he is guaranteed another 11 million USD.
  
• Trading Chief at Merryl Thomas Montag who is at Merryl for less than 6 weeks (joined Aug 6th, 2008) is expecting 76 million USD in accelerated compensation of he decides to leave.
  
• Strategy head Peter Kraus who is at Merryl for less than a week now (yes you heard it right) will get 95 million USD for his hard work over the past week.

In the meantime 8%+ of my portfolio has been shaved off in the past 2 weeks. God bless Corporate America.

Hedge fund tracking

J over at Market Folly has started his hedge fund tracking series as hedge funds, with $100 million+ in AUM (asset under mgmt), start disclosing their holdings as of Jun 30th 08 to the SEC . And as always it is extremely interesting to see where and in what sectors the "big and smart money" is going in and out off.

Some of the hedge funds he will be tracking and reporting on are:

-Blue Ridge Capital (John Griffin)
- Lone Pine Capital (Steve Mandel)
- Maverick Capital (Lee Ainslie)
- Viking Global (Andreas Halvorsen)
- Tiger Global (Chase Coleman)
- Touradji Capital (Paul Touradji
- Tudor Investment Corp (Paul Tudor Jones)
- Moore Capital (Louis Bacon)
- Caxton Associates (Bruce Kovner)

"Straight up beastly funds" which you have to keep an eye on due to their awesome returns over the years:

- Atticus Capital (Timothy Barakett)
- Tremblant Capital (Bret Barakett)
- Clarium Capital (Peter Thiel)
- Pequot Capital Management (Art Samberg)
- Harbinger Capital (Philip Falcone)
- BP Capital (Boone Pickens)
- Greenlight Capital (David Einhorn)
- Paulson & Co (John Paulson)
- Jana Partners (Barry Rosenstein)

A few deep value & activist funds:

- Third Point (Daniel Loeb)
- Pershing Square (Bill Ackman)
- Okumus Capital (Ahmet Okumus)
- T2 Partners (Whitney Tilson)
- Tontine Partners (Jeffrey Gendell)

And, a few new funds on the scene:

- Conatus Capital (David Stemerman, ex-Lone Pine)
- Highliner Investment Group (Anand Parekh, ex-Citadel)

A massive shoutout to J for his huge effort in going through the 13Fs and coming up with his reports. Much appreciated.

Blaaaahh !!!

I had a horrible monkey tilt session in poker yesterday. On the weekdays, I usually play in the nights mainly on Full-Tilt , and yesterday I proceeded to drop ~5kish+ in less than 90 mins to an absolute donkey in Heads-up (one-on-one, for the poker uninitiated) cash at the $5/$10 No-Limit level.

Needless to say I am mega pissed. I am still up about 10kish for the month on the back of very little paying time, but the bottomline is I AM PISSED and ON SUPER MONKEY TILT.

Anyway, I'll be playing (well atleast planning to play) three live tourneys this week (live tourneys are by definition 1000-X-easier than online ones, as live players are god-awful horrid BAD, and have no idea of even the extreme basics of tournament poker strategy):
(1) Today: a rebuy tourney, rebuys are mega fun and complete donkfests.
(2) Saturday: $250 buy-in tourney, 1st place is about 4-5kish, I should win this if for once my AA>J8o
(3) Sunday: $100 buy-in tourney, 1st place is about 2-3kish, I have won this thing about 4-5 times this year and depending on my tilt-factor I should win this one too.

But for today its BLAAAAAAAAAAH.
F Poker. Bring on the MBA apps.

In other OMG TILT news: the bullshit rally in stocks continue, for the second week now. Stupid Wachovia Bank (WB) has rallied from a low of 8s to the 18 in less than a week (brace yourself for this) on the back of a mere "5 billion USD loss". The whole fucking nine-yards of those shitty banks and the fin sector (ETF XLF), with the help of those dastardly stupid Feds , have rallied upwards of 35% in one week (apart from GoldmanS which is dropping faster than a hedge fund on cocaine), while 5 of them who've reported earnings this Quarter have declared collective losses to the tune of "just 12 billion USD+". Not to mention even the stupid retailers are rallying.
It is official : Reason has no place in today's market anymore. I still like shorting here, even though we seem to be in a weird bull market anchored by bullshit sectors. I like SKF, FXP here.

Disclaimer: On life tilt, 30% cash position

A hedge fund in action

Hedge funds are usually passive position holders, meaning that even though they might have a pretty decent stake in a company, it will not usually use that stake to try and take over boards (unlike say the Jerry Yang/Yahoo board versus Carl Icahn ongoing saga), though it will of course keep a big bad eye on the operations of its bigger holdings. What this essentially means is that a hedge fund is a "passive investor" and not an "active" one. However, hedge funds, are trading entities and seldom will they let a good trading opportunity pass.

A recent development occurred in a commodity play in the US equity market this week that shows how hedge funds can suddenly turn active investors in search of a very profitable trade and thereby hurt the retail/individual investor heavily.

The background: Yesterday Cleveland Cliffs (CLF), USA's biggest iron-ore producer announced that it would acquire Alpha Natural Resources (ANR), USA's biggest coal exporter, for 8 billion USD+, the offering included a 35% premium on ANR's current share price.

Now those who follow the market will know that commodities are in a bull market and both these companies have been flying fast and high over the last 1 year. So obviously when these two top dogs decided to merge, shareholders expected a huge surge in the price pf both.

Hedge fund comes in: But curiously after a small rally, ANR's shares started to plunge in an alarming rate and as of today ended up trading lower that CLF's, completely confusing me and all other individual/retail investor, as this completely defies all logic. A company offered a premium over its current share price, cannot by any logic trade below that price.

Well on further digging we found that Harbinger Capital, an Irish based hedge fund, which owns 18%+ of Cleveland Cliffs - informed the co. they were going to be fighting it. That is they believed this deal to be against CLF's interest and suddenly turned an "active investor" from a "passive one", creating a huge short opportunity for the big money (hedge funds) causing the price to plunge.

The follow up play after Harbinger's decision for hedge funds would be --->Short ANR--> ANR plunges-->make profits on the drop in ANR due to this decision--> get out of the short position with a killing--->explains the complete weird stock price behavior of ANR

Hedge fund's fundamental trait: Remember, that unlike a value investor like Wbuffet, HFs have no interest in improving a company's operations and such things, they are in there to make profitable trades. And this sudden filing made for a perfect trade. Moreso if you understand that this deal would ,infact, have been a booming winner for CLF !!

Moral: Follow the big money, follow where HFs are going in and out of. But right now the HFs are really working in a weird and unpredictable manner, mainly because the downright wretched US market has completely spooked them and most of them are losing a LOT in this market, something which their investors are definitely not going to like. Remember HF investors are wealthy affluent folks (high net worth individuals) who put in obscene amounts into these HFs and therefore the HFs have to work under tremendous pressure to generate big returns for them or else have those funds pulled out , even in shabby bear markets like we have now. It is pretty funny to track these HF panic buys and sells in the current bear market. The trades are downright whacky !!

Now for the million $ Question:

OMG HowTF is this relevant to my MBA: For somebody interested in the buy side of finance, understanding of the market is almost a necessity. You cant just land up in B-school, and suddenly become a star trader overnight. Like any sport, learning trading and way trades are being done is a long drawn learning process with a fairly steep learning curve, not an overnight "stock -pitch" cram.

Disclosure: Long ANR in personal account

Mss.market and poker

I got into an interesting discussion last week as to whether the market is actually beatable by retail investors (or hedge funds and mutual funds for that matter) in the long term. The basic idea that my friend was trying to push through was that it is NOT BEATABLE. Majority of funds and even a bigger majority of the retail investors are either market trailing or will probably return at best the index's performance. He describes it as being a game of chance and those that are making money just happen to be on the positive side of variance.

In some ways I agree and disagree with him (more disagree ob). The market by nature and like poker is a game of incomplete information. Unlike, say chess, the information set needed in either poker or the stock market is not complete. Thus it is almost impossible to design a sophisticated algorithm running on a supercomputer with a teraflop performance that can play profitable poker, while Deep Blue and its cousin Blue Gene can always give Kasparov a run for his money.

I will try and highlight what I see as the biggest problems and of course potential remedies while trying to beat the market. I will talk primarily about hedge funds and retail investing, not about Mutual funds, as they have a bit of a disadvantage, being primarily LONG (but there are some top notch ones out there, Ken Heebner's CGM group of funds).

Now money is there to be made both in poker and the market. But key for both are the following:

(1) Bankroll management: This is absolutely critical. Bankroll management essentially refers to managing you roll/money/AUM. People get greedy and start placing bets way over their heads or way over their AUM limits via crazy leverages. The hedge funds that go down the drain and return 0$ to its investors for every $ invested are primarily guilty of this (and right now hedge funds are going down like pinballs) . It is hard to believe that funds supposedly run by such smart folks can make such horrible calls and place such atrocious bets. A recent case of a hedge fund's misfortune is this. The reason for the collpase of this family of hedge funds, Horizon funds, is the insanely crazy leveraged risks that the fund took. In some cases they were leveraged at 12:1 or more. While such huge leverage will print money in the first few years (Horizon returned 40% for the first 2-3 years) but it is a sure shot recipe of disaster (net assets turn to ZERO).

Another more bigger fall that highlights the poor bankroll management that hedge funds tend to practise is that of JWM Partners launched by Meriwether of Long Term Capital Management fame (i mean absolute infame). LTCM if people remember is that crazy hedge fund that was a yester-year bears sterns meaning that it was so big that it could not fail and had to be bailed out !! Details here. Now after the LTCM debacle Meriwether and his cronies having not learnt an iota of a lesson from thier past debacle, this time went about placing leveraged bets on mortage-related securities. And well once again they are close to being history, having pumped into the gutter more of investors' wealth (approx 1.4 billion). The story here.

(2) Atrocious bets: By definition a hedge fund is supposed to hedge risks, a market neutral hedge fund for example must always be that---> market neutral. But the reality is of course a bit more distant from that. Hedge funds are known to place some heavy and I mean really heavy bets on SINGLE POSITIONS, and in most cases via their star traders. So whatever the prospectus say, these HFs make some sorry ass bets that can turn against them faster than you can say bob's my uncle. Amaranth Advisors for example (I am choosing the famous/infamous ones here) had 50% of its portfolio (starting AUM of about 5-6 billion USD) bet on natural gas via their star commodity trader Brian Hunter. Such brash bets made huge returns in the first couple of years but then in one week of trading that 50% position dragged Amaranth's AUM down to 4.5 bill from 9 bill causing the fund to collapse.

I have heard and read that discpline is one of the first thing that a trader in a fund is instilled with --> Hedge your risks, dont fall in love with your positions, dont take leveraged risks, exit losing positions fast etc etc. But reality shows that discpline is something that the majority of the funds lack. Black Swans are supposedly once in a lifetime happening, but these days it happens once a few months !!! So for an outsider or an investor who sees these collapses, it is quite natural for him to turn extremely sceptic. But of course there are some good ones out there (though it is getting increasingly difficult to find the good ones) , SAC Capitals for example. But hedge funds can get bad to worse really fast when they forget the basic underlying principles of maintaining strict trading discipline and not making crazy bets (though it is very common, and driven almost exclusively by gut wrenching greed).

As for me Sales and Trading still remains a potential career option and poker continues to remain profitable. I am up over 20k YTD on the back of very very limited playing time. Touch wood.

Ooops this has turned into a huge post, part 2 later, part 2 will be for the retail investors..... one last parting word ---> there is nothing like self-learned knowledge, Wbuffet spends 99.9% of his time doing nothing but reading 10ks and 10Qs and prospectus.