Phases of fear and elation in the VIX

March 18, 2009

Here we show a nice relationship between the VIX and the SPX.  While this is a commonly referenced pairing, many still challenge the value of using the VIX as a market indicator.  There are numerous ways too use the VIX and almost everyone has their own tweaks.  This chart shows a very clear inverse relationship with several distinct “phases” discernible in the value of the VIX.  These “phases” correlate well with the action in the SPX.  We have labled these phases “euphoria”, “fear” and “panic”.  We also included the 400 day moving average (equivalent to the 80 week) which we discussed previously in The Significance of the 400 day (80 week) moving average.  This bull/bear market reference point matches up very well with the action in the VIX, as the VIX moves into the “fear phase” just as the 400 day is coming under assault, before eventually breaking.  A final test of the 400 day from below, which we highlighted in late April 2008, was accompanied by one last dip into the “euphoria” zone for the VIX.  That was the “last chance” to get out before the drop gathered steam as the SPX then dropped over 50% in less than 12 months.

We added the notes on Bear Stearns and Citigroup for a consensus of the “expert” opinion at the time.

vixspx031809


SEC gives banks more leeway on mark-to-market

October 1, 2008

Wed Oct 1, 2008 3:24am EDT
By John Poirier and Emily Chasan

WASHINGTON (Reuters) – U.S. securities regulators on Tuesday gave the financial industry a reprieve from marking hard-to-value assets down to fire sale prices, throwing a lifeline to an industry beset by strained credit markets and the latest round of bank failures.

The U.S. stock market added to gains on the news, in hopes that regulators’ new interpretation of fair value, or mark-to-market, accounting rules, will slow or reverse the heavy flow of mortgage-related losses on banks’ balance sheets.

In the new guidance, first reported by Reuters, the U.S. Securities and Exchange Commission reminded financial services firms that they don’t need to use fire sale prices when evaluating their hard to price assets.

“This is a significant first step and adds stability, confidence, and liquidity within the capital markets,” said Steve Bartlett, president and chief executive of The Financial Services Roundtable. “By clarifying how to treat assets in an uncertain market, the SEC is continuing to provide transparency to investors and helping institutions to provide credit in periods of market stress.”

U.S. accounting rule maker, the Financial Accounting Standards Board said on its Web site on Tuesday that it would change the agenda for its Wednesday meeting to focus on fair value accounting. The board is contemplating issuing additional guidance through a FASB staff position as soon as Wednesday, according to a person familiar with the matter.

MARK-TO-ESTIMATE

The SEC’s guidance on Tuesday, came on the last day of the third quarter for most U.S. companies, allowing them to incorporate the changes in their next round of financial statements.

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The perils of leverage

September 15, 2008

by Martin Hutchinson
September 15, 2008

The investment bank Lehman Brothers (LEH) spent last week teetering towards the sort of bankruptcy which like that of Bear Stearns (BSC), Fannie Mae (FNM) and Freddie Mac (FRE), may require a “bailout” by the long-suffering US taxpayer. All four of these institutions shared a common feature: they had far too much leverage, i.e. they had borrowed far too much money to be compatible with their modest capital bases. Excessive leverage is currently a characteristic of the US economy as a whole, and we are in the process of paying the price for it.

Investment banks traditionally had a leverage limit (total assets to shareholders’ equity) of about 20 to 1. That limit was fudged to a certain extent with subordinated debt, but fudging was limited by investors’ unwillingness to buy subordinated debt of such intrinsically unstable institutions. However, while investment bank assets traditionally consisted of commercial paper, bonds and shares that trade every day and can be valued properly, they have now come to include investment real estate, private equity stakes, hedge fund positions, credit default swaps and other derivatives positions that do not even appear on the balance sheet. Thus even 20 to 1 in modern market conditions is excessive. Adding in subordinated debt, and claiming that say Lehman has an “11% capital ratio” works fine in bull markets, but not when things get tough.

Scaling that 20 to 1 up to 30 to 1, as Lehman had at its November 2007 year-end, is asking for trouble. Even if the off-balance sheet credit default swaps and other derivatives don’t lead to problems, and there are no assets parked in “vehicles” that have to be suddenly taken back on balance sheet, an institution that is 30 to 1 levered needs to see a decline of only 3.3% in the value of its assets before its capital is wiped out. Such a decline can happen frighteningly quickly – it represents only a 10% decline in the value of a third of the assets.

Lehman’s leverage is not exceptional among Wall Street investment banks. At the last quarterly balance sheet date (May or June) while Lehman’s leverage had been brought down to 23.3 times through asset sales, Morgan Stanley’s (MS) was still 30.0 times, Goldman Sachs’s (GS) 24.3 times and Merrill Lynch’s (MER) an astounding 44.1 times (or to be fair, 31.5 times at its December 2007 year-end, before new losses appeared.)

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Govt, Wall Street races to try to save Lehman

September 13, 2008

Saturday September 13, 4:57 pm ET
By Jeannine Aversa, AP Economics Writer

As financial world frets, government and brokerage leaders try to hash out Lehman rescue

WASHINGTON (AP) — The financial world held its collective breath Saturday as the U.S. government scrambled to help devise a rescue for Lehman Brothers (LEH) and restore confidence in Wall Street and the American banking system.

Deliberations resumed Saturday as top officials and executives from government and Wall Street tried to find a buyer or financing for the nation’s No. 4 investment bank and to stop the crisis of confidence spreading to other U.S. banks, brokerages, insurance companies and thrifts.

Failure could prompt skittish investors to unload shares of financial companies, a contagion that might affect stock markets at home and abroad when they reopen Monday.

Options include selling Lehman outright or unloading it piecemeal. A sale could be helped along if major financial firms would join forces to inject new money into Lehman. Government officials are opposed to using any taxpayer money to help Lehman.

An official from the Federal Reserve Bank of New York said Saturday’s participants included Treasury Secretary Henry Paulson, Timothy Geithner, president of the Federal Reserve Bank of New York, and Securities and Exchange Commission Chairman Christopher Cox. The New York Fed official asked not to be named due to the sensitivity of the talks.

Citigroup Inc. (C)’s Vikram Pandit, JPMorgan Chase Co. (JPM)’s Jamie Dimon, Morgan Stanley (MS)’s John Mack, Goldman Sachs Group Inc.(GS)’s Lloyd Blankfein, and Merrill Lynch Co. (MER)’s John Thain were among the chief executives at the meeting.

Representatives for Lehman Brothers were not present during the discussions.

They gathered on the heels of an emergency session convened Friday night by Geithner — the Fed’s point person on financial crises.

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The degradation of accounting

April 14, 2008

April 14, 2008

Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005) — details can be found on the Web site http://www.greatconservatives.com

Fair value accounting, by which debt and equity securities on a company’s balance sheet are “marked to market” — written up or down to their market price — has been hyped by accountants and regulators as the epitome of modern financial reporting, enabling investors to gain a completely true picture of their investment’s financial position. Indeed, Gerald White of the Chartered Financial Analyst Institute, speaking at an American Enterprise Institute conference Tuesday, believes it should be applied to all items on the balance sheet, not just financial instruments. There is just one problem: in the turbulence of the last nine months it has completely failed to work, and has indeed shown itself to be pro-cyclical, encouraging economically foolish behavior in both up and down cycles.

As someone who only thinks about accounting once a decade or so, I wasn’t really aware that much had changed from my business school days in the early 1970s. At that time, the values of assets on the balance sheet didn’t move much. Everything the company owned was dumped on the balance sheet at cost price and stayed there for decades while the world turned. The only exception was when the company held bonds or shares that had declined catastrophically in value (the occasional wobble was ignored) in which case they were declared “impaired” and their value written down. The fun for analysts was in finding companies whose downtown real estate was still held on the books at its value of 1926, when it had been bought, since there just could be a little teensy-weensy asset profit that might be unlocked from the company if one could figure out how.

This attitude to values was maintained through the inflation-accounting period of the late 1970s and early 1980s. Assets were assumed to be held for the long term, so buildings were written up by the movement in the consumer price index between the asset’s purchase date and the balance sheet date. US and British accounts differed in their approach to inflation accounting, which may have been one reason why it was abandoned fairly quickly once inflation returned to single digits, but neither system attempted to “mark to market.”

The “mark to market” approach had been used since 1940 by US investment banks, holders of large numbers of tradable securities, who needed to convince their regulators that their capital was adequate. It was not however used by British merchant banks, equally holders of substantial amounts of tradable securities. Only a small portion of merchant bank assets was held in a “trading account.” The remainder was held on a “back book” investment account and valued at cost. In this way, merchant banks were able to manage earnings very effectively; generally they built up large “hidden reserves” in good years which were amortized into earnings in years of unexpected dearth, so that the overall picture was smoothened. The result was to increase the confidence of the market in each merchant bank; people assumed that 200-year-old institutions had accumulated enough “hidden reserves” and undervalued real estate to smooth out any problems that might arise.

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Level 3 Decimation?

October 29, 2007

Level 3 Decimation?

October 29, 2007

Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005) — details can be found on the Web site http://www.greatconservatives.com

There’s a mystery on Wall Street. Merrill Lynch last week wrote off $8.4 billion in its subprime mortgage business, a figure revised up from $4.9 billion, yet Goldman Sachs reported an excellent quarter and didn’t feel the need for any write-offs. The real secret of the difference is likely to be in the details of their accounting, and in particular in the murky world, shortly to be revealed, of their “Level 3” asset portfolios.

Both Merrill and Goldman have Harvard chairmen – Merrill’s Stan O’Neal from Harvard Business School and Goldman’s Lloyd Blankfein from Harvard College and Harvard Law School. Thus it’s pretty unlikely their approaches to business are significantly different – or is a Harvard MBA really worth minus $8.4 billion compared with a law degree? (The special case of George W. Bush may be disregarded in answering that question!)

We may be about to find out. From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks’ balance sheets. The new accounting rule SFAS157 requires banks to divide their tradable assets into three “levels” according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme Level 3 assets have only unobservable inputs to measure value and are thus valued by reference to the banks’ own models.

Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman’s capital of $36 billion. In an extreme situation therefore, Goldman’s entire existence rests on the value of its Level 3 assets.

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