Knight Pun Goes Here. “Dark Knight of the Soul”, For Instance.

August 3, 2012

 

This isn’t a stock photo. It really isn’t. We’ve run similar ones before. On any given day, you can find a trader assuming this position. (Assuming a position! Another double entendre! God, we’re clever)

Knight Capital is hanging by a thread this morning. A formerly robust business, and one of the biggest players on the New York Stock Exchange.

“A Wall Street firm got screwed? Good! Serves those greedy bastards right!”, capitalist oppression, the 1%, etc., etc.

Yeah, except it’s way more complicated than that, and besides, no poor people were hurt in the making of this fiasco. You want the real story, or do you want to sit there and pretend you know what’s going on?

Knight Capital is a market maker. That means if you’ve got a certain security to buy or sell, they’ll sell it to/buy it from you, instantly. Instead of waiting on the rest of the world so you can get the price you want, you can do business with Knight and get your stock or cash at the speed of light.

A market maker does this by keeping separate bid and ask prices. They’ll buy your Baltimore Opera Hat Company stock for, say, $10 a share. At that same moment, if there’s some other investor who wants a piece of Baltimore Opera Hat, he can buy it from a market maker for…$10.05 or so.

It shouldn’t matter to a market maker whether the stock is rising or falling. If Baltimore Opera Hat shoots up in value for some reason – a hostile takeover bid, LeBron James sporting one of the company’s hats ironically at a postgame press conference – a market maker adjusts its bid and ask prices correspondingly. The more powerful a market maker’s algorithms, and the more business it does, the smaller a spread it can offer between bid and ask prices. Taken to the extreme, a cosmically large market maker could buy a security at $10, sell it at $10.0000000000001, and make a profit by sheer volume. Thus market makers do serve a legitimate purpose, letting people trade all the faster. This is a good thing.

When you do business with a market maker, you’re paying for liquidity. Are you really that set on selling your stock at $10.50, knowing it might never get that high? A market maker might drive a hard bargain, but you get your money (or stock, depending on what side of the transaction you’re on) that much more quickly.

Market makers exist with the sanction of the exchange they do business on: Knight is officially designated as a market maker by the New York Stock Exchange. Also, a particular market maker only makes markets for particular securities. You can immediately buy or sell Garmin stock via a certain market maker, say, but not Walgreens stock.

Knight’s largest customers are retail brokerages, not individual investors like you. When you execute an order through your TD Ameritrade account, TD Ameritrade will sometimes (certainly not always) go through Knight.

There are hundreds of firms that operate as market makers, and Knight is one of the biggest, handling 15% of the NYSE’s volume. Was one of the biggest, until a couple of days ago.

Wednesday morning, Knight endured a computer glitch. A bug in the software. Knight started trading stocks at 10, 20 times their normal volume, leading to a concomitant and profound change in prices. Knight’s computers were executing trades that didn’t have a real buyer or seller on the other side. Which isn’t a big deal in and of itself; Knight wasn’t taking possession of people’s actual stock and/or money at false prices, and no individual investor got screwed.

But the trades still counted, and the prices were valid throughout the market. So other firms, ones with error-free information systems, saw the price changes and handled their own trades accordingly. Here, look at the chart and see if you can tell whether Knight was a market maker for Anheuser-Busch:

Knight was forced to trade out of its erroneous positions. It lost $440 million in one day.

 

no individual investor got screwed.

 

Wait, that’s not quite true. Knight itself is a publicly traded stock. That $440 million corresponded to a similar hit in Knight’s market capitalization. The company’s value shrank by 2/3 in one day. Here’s what happened to Knight stock overnight:

Understandably, Knight’s clients stopped doing business with it. They had no choice. These are big firms, too – Vanguard, Citigroup and other investment managers.

Just because Knight’s principals and employees wear tailored suits and wing-tips, that doesn’t mean they’re crooks. Far from it. Knight handled the 45-minute glitch the best way possible, immediately halting trades and disclosing everything to their customers, the market and the exchange.

The result is that Knight needs to borrow money, and fast. The company might go bankrupt. Investors hold $375 million in convertible notes issued by Knight, and could demand their money now, given how Knight’s business has changed so abruptly so quickly. (Knight’s biggest bondholders are the actual crooks at Goldman Sachs, but that’s a different lament.) The consensus opinion is that Knight should find a buyer before things get any worse. Yes, a company whose primary service was liquidity could go under for want of its own liquidity.

Speaking of a buyer, Knight’s stock is trading at barely twice earnings. If you’re interested, you probably won’t have to wait long to have your order executed. You might not even need a market maker.

This wasn’t a fault of regulation, or lack thereof. Putting an additional 100 SEC agents on the case wouldn’t have changed a thing. It was an error without malice or criminal intent. Now, go read the comment boards on Yahoo! Finance and see the easily confused blame Knight’s downfall on everything from Mitt Romney to the U.S. military to the Illuminati.

Filed Under: Capitalism, Finance, Investments Tagged With: , ,

LIBOR Scandal? Boy, That Sounds Like A Gripping Topic To Read About

July 20, 2012

 

Not again

 

This dwarfs by orders of magnitude any financial scam in the history of markets. 

-Andrew Lo, MIT professor, hedge-fund oracle, and a man who understands that an academic can make the Time 100 list only if he makes outspoken, authoritative pronouncements.

Alright, what the hell is he talking about?

It surfaced about a week ago, a scandal by which we all end up paying a few basis points extra on our mortgages.

LIBOR. The London Interbank Offered Rate, whose acronym incorporates a medial letter and thus avoids being an apt homonym for “liar.” It serves as a starting point for short-term interest rates, and it changes (rarely by more than a basis point) daily.

Every morning at 11:00, the LIBOR is released by the British Bankers’ Association. Which is a consortium – a trade association, if you will – of 199 banks. If your bank is one of the largest in the world, it’s probably on the list. Which is here.

There are actually multiple LIBORs: they’re measured for each of 10 currencies (pound sterling; euro, long may it wave; American, Australian, Canadian and New Zealand dollars; yen, Swiss franc, Danish krone, Swedish krona.)

Each of those is submitted for each of 15 borrowing periods (overnight, 1 week, 2 week, and every number of months from 1 to 12.) That gives us 150 rates, the most widely quoted one being the 3-month rate for the pound sterling.

This morning that rate sat at .79%, the lowest it’s been since last February. They post it on Twitter @BBALIBOR.

How is LIBOR different than the federal funds rate that Ben Bernanke decrees? First, LIBOR is announced daily as opposed to every few weeks. Second, the federal funds rate is more or less mandated artificially. LIBOR is established via the market and then reported, rather than the other (i.e. Soviet) way around.

It’s straightforward, or ought to be. Every morning the BBA (via its vendor, Thomson Reuters) begins with the 199 rates its members charge for overnight loans and lists them in numerical order. It discards the top 50 and the bottom 50, then averages the remaining 99.

With 199 components, how can the LIBOR be subject to skullduggery? One crooked bank, or even 50, can only do so much damage, right?

Here’s the problem. From BBALIBOR.com:

Every contributor bank is asked to base their BBALIBOR submissions on the following question:

“At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”

So take back what we said earlier. The rates aren’t generated via market transactions. They’re generated via whatever’s going through the head of the bank representative who’s tasked with answering the question.

It gets worse. One paragraph later:

BBALIBOR is not necessarily based on actual transactions

Up until a few years ago, college football named its champion by saying to a bunch of coaches and sportswriters, “Forget about determining a champion on the field. Who do you think the champion should be?” BBA is doing the same thing.

Wait, here’s the funniest excerpt of all:

Each morning between 1100 and 1110 a named individual responsible for cash management at each panel bank formulates their own rates for the day and inputs them into this application, which links directly to a rate setting team at Thomson Reuters.  A bank cannot see other contributor rates during the submission window – this is only possible after final publication of the BBA LIBOR data.

  1. (Boldface ours)
  2. HAHAHAHAHAHAHAHAHAHAHAHAHA

You know how you pay lower interest rates the better your credit is? And how all things being equal, you’d prefer to pay lower rates than higher ones, regardless of the strength of your credit? The same applies to big institutions, too. In 2008 Barclays – the 322-year-old British bank whose group chairman just happens to be the chairman emeritus of BBA – started submitting bogus low numbers for the daily calculation. Those numbers were still often as much as 60 basis points higher than the average from the other submitters. Barclays was admitting to being in bad shape, while being in even worse shape.

Then again, why shouldn’t Barclays have submitted fake numbers? There was no penalty for doing so, at least not in the short term, and at least not a huge one. Barclays benefitted by having people think it was rich and liquid. Lying about its numbers was the institutional equivalent of putting chrome rims on your Cadillac while living in the projects.

The then-chairman of the Federal Reserve Bank of New York knew that Barclays was being disingenuous. His emails with his counterpart at the Bank of England say as much. That regional Fed chairman chose to do nothing. A few months later, he became United States Secretary of the Treasury.

And we thought his predecessor was incompetent and crooked

If you have an adjustable-rate mortgage…first of all, why would you subject yourself to market whims like that? Especially when fixed rates are historically low? Oh, you couldn’t get a fixed-rate mortgage? Then maybe you shouldn’t be buying a house.

Or financing college. Student loans are often tied to LIBOR, too. You pay a going rate, plus whatever today’s LIBOR is. Plus a few basis points artificially tacked on by Barclays and its co-conspirators. Across the globe, that’s tens of billions of dollars extra.

But justice has prevailed. Barclays paid a $450 million fine. Or about 3 days’ worth of its revenue.

As with the provision of health care, the fewer intermediaries there are, the better. Some lenders set rates without respect to LIBOR. Those banks’ managers know enough about their own lending practices – what to charge, who’s going to default, how big their overhead is – to name their own prices without relying on an august body an ocean away. Do business with one of those lenders, and you’re exposing yourself to less risk. And saving money.

 

Filed Under: Capitalism, Education, Finance Tagged With: , , , , ,

The Streisand Effect, Revisited

July 13, 2012

Maybe she should invest in Revlon

 

To quote one of America’s dippiest celebrities on her investment strategy:

We go to Starbucks every day, so I bought Starbucks stock

Your humble blogger drives a Ford every day, and wouldn’t touch Ford stock with Ms. Streisand’s nose.

This is the stupidest way imaginable to invest. Equating the utility of a company’s products with the strength of the company’s finances is like saying “Brett Myers can throw a 91 mph fastball, therefore I bet he’d make a great husband.”

But back to the mentally deficient celebrity at hand. Ms. Streisand is more fortunate than you in that she can get rich (and did, and does) off active income. She’s one of those extremely rare people in that her talents alone made her a multimillionaire. She didn’t have to leverage her money and time, defer spending, and research investments in order to get rich. Her voice and acting chops did it for her. Furthermore, she can afford to lose millions in the stock market and not flinch. Depending on how big Ms. Streisand’s Starbucks position is, were the stock to tank, there’s a corresponding number of nights she can perform at the MGM Grand Garden Arena that will wipe the losses away.

 

Other companies we patronize daily include Nevada Energy (stock trading at close to a 52-week high) and Nestlé (makers of Friskies cat food, stock in a similar position to Nevada Energy.) Two companies, one a utility, one a multinational leviathan, both of which have something of a ceiling on their short-term growth. We need better reasons for investing in something.

Our investments include the following:

  • Netflix stock. Despite never being a member, and never wanting to. Your humble blogger hates both movies and subscriptions. But tens of millions of other people feel otherwise, and investing is more about considering what those other people are interested in, rather than what the investor is interested in.
  • Altria stock. It’s hard to imagine a stupider activity than smoking, but tell that to the billions of people around the world who see inhaling tobacco fumes as a perfectly normal thing to do. Hell, if it’s good enough for the President of the United States, why not?

If other people are going to behave irrationally (e.g. by smoking, or gambling, or drinking, or incurring credit card debt), and no one’s going to convince them not to, why not profit off them? It’s the responsible thing to do. Until mankind wakes up one morning and collectively decides, “You know something? Maybe actively introducing carcinogens into my respiratory system isn’t a bright idea. Time to stop now,” which it won’t, we’re going to continue to be indirectly responsible for selling them their poison.

  • Houses in lower-middle class areas. Because, as always, the price was right. Is right. “You make your money going in” is one of personal finance’s all-time great truisms. An inexpensive house that requires a minimum of upkeep (no lawn maintenance company to hire, no pool to clean) is easy to rent. The renters make the mortgage payments (and then some), leaving the landlord with a profit that requires just a little paperwork to maintain.

That’s exploitation of the poor.

Sure, if you say so.

Now that we’ve got the reactionary simpletons out of the room, let’s resume. Renting out comfortable shelter to people is the opposite of exploiting them. It’s providing for them – meeting the most basic of their requirements, no less. For a fair price, one made even more fair by the fact that these renters can’t afford to buy a house. We advocate home ownership on this site, multiple home ownership if you can do it, but not everyone’s in a position to buy. And we might as well make money off some of those otherwise disenfranchised people. Because someone is going to. So why not us?

It’s the same principle as that advocated by buying Altria stock. Say we were to wrap ourselves in righteous indignation and decide, “This is a travesty. Smoking kills 135,000 Americans every year – an entire Topeka or New Haven – and we won’t be a party to the wholesale genocide any longer.”

That position isn’t going to save a single life. And even if it did, why should we care? Altria customers gladly sign their own death warrants, in exchange for rich and mild satisfaction. On a far smaller and more benign scale, the same goes for Netflix customers. If they want to pay big markups for a service that we have no interest in, why should that be our concern? It might not be our business, but we’re making it our business. To the tune of increased returns (and in Altria’s case, years of ever-increasing dividends.)

Umbrage never made anybody rich. It’s a childish emotion…actually, that’s not fair. It’s an adult emotion. But it doesn’t matter. It’s an emotion. Any of which – anger, joy, trepidation – gets in the way of the subject at hand, which is earning enough money via our financial acumen that we can escape our unfulfilling jobs and subservience to The Man.

“Cold” is never intended as a compliment when attributed to a human, and “rational” isn’t regarded much better. But coldness and rationality are critical if you want to grow your money. If you’re going to get excited about a stock, do so because it’s grossly undervalued and no one else seems to notice. Not because its IPO is coming up and you think it’ll be fun to invest in it. Otherwise, have no emotions whatsoever.

Another company we have a big position in is Tesco, a name unfamiliar to most people on our continent. It’s the UK’s largest retailer, their answer to Walmart, with a smattering of stores around Asia and the rest of Europe. We’d say we’ve never patronized Tesco, only looked at the company’s financial statements, but it turns out that indeed we have given them our business.

Tesco also operates a few grocery stores under a different name in the United States: Fresh & Easy. If you’ve never been to one, and if you don’t live in the Southwest you probably haven’t, Fresh & Easy is one of the most self-righteous and condescending places we’ve ever patronized. When you shop there you make a statement, something along the lines of “Slap the word ‘organic’ on a package and I’ll nod my head in brainless approval. Plus I don’t have the budget for Whole Foods.” (If you’re wondering, the statement we made was “We’re stuck in Phoenix, we need milk, and this is the closest supermarket.”)

The parking spaces closest to the door are reserved for…well, here’s a picture:

 

 

(Aside: That’s not a handicap sign. It carries zero legal weight. Yes, we parked our 18 mpg SUV there and didn’t flinch. Besides, if management really cares about ecology, they’d let us park as close to the door as possible instead of forcing us to burn fossil fuels looking for a space somewhere else in the lot. A point we never got to share with the scrawny, disdainful man in the Nissan Leaf who gave us his approximation of a death stare when we disembarked and entered the store. A, You don’t know what’s under the hood, Slugger. B, No, we’re not going to pop it for you. Take it up with management. Guy looked at us as if we were ordering napalm strikes on the Amazon rainforest.)

The point is that this Tesco subsidiary is the kind of place we’d only spend money at under rare circumstances, and would rather make fun of. But the money rolls in, and as an investment, we love it. Tesco carries minimal debt, continues to build tons of market share, and has a history of dividends (even though its American operations are struggling – the company’s recently closed over a dozen stores.)

Smarmy environmentalism isn’t our thing, but again, this isn’t about us. It’s about the market. What other consumers want to buy. What producers, in this case Tesco management, want to offer. And that’s a far more sound investment strategy than “We visit ESPN.com every day, so we bought Walt Disney stock”, any day of the week.

Filed Under: Capitalism, Investments, Making Smart Choices Tagged With: , , , , , ,
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