Wow you don't say. Spreadbetting is not where I make my money. Ever heard of CFD's

Certainly have Bernard.

CFD's can be taxed either as capital gains or income - depending on factors such as other income and your relationship with you know who!

Not if you are expat

Sorry - talking about us mere mortals or should that be pats :-)

Wheres your mansion being built skinny.lol

Lego land!

lol

LLOY finally capitulating - down 9.1% as I type.

ow

it was interesting watching this one today - more of the same tomorrow i expect!!




one of many items doing the rounds citi + others... lol interesting day ahead - especially being friday............... more turmoil ahead.... coupled with opportunity to the savvy - gla





The Consequences of Austerity
Euro Break-Up The Consequences
Welcome to the Hotel California
The Slow March to Recession in the US
Preparing for a Credit Crisis
What Can You Do About the Weather?
Europe, Houston, New York, and South Africa

I am sure the Euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.

- Romano Prodi, EU Commission President, December 2001

Prodi and the other leaders who forged the euro knew what they were doing. They knew a crisis would develop, as Milton Friedman and many others had predicted. They accepted that as the price of European unity. But now the payment is coming due, and it is far larger than they probably thought.

This week we turn our eyes first to Europe and then the US, and ask about the possibility of a yet another credit crisis along the lines of late 2008. I then outline a few steps you might want to consider now rather than waiting until the middle of a crisis. It is possible we can avoid one but, as I admit, whether we do (and the extent of such a crisis) depends on the political leaders of the developed world (the US, Europe, and Japan) making the difficult choices and doing what is necessary. And in either case, there are some areas of investing you clearly want to avoid. Finally, I turn to that watering-hole favorite, the weather, and offer you a window into the coming seasons. Can we catch a break here? There is a lot to cover, so we will jump right in.
The Consequences of Austerity
The markets are pricing in an almost 100% certainty of a Greek default (OK, actually 91%), and the rumors in trading circles of a default this weekend by Greece are rampant. Bloomberg (and everyone else) reported that Germany is making contingency plans for the default. Of course, Greece has issued three denials today that I can count. I am reminded of that splendid quote from the British 80s sitcom,Yes, Prime Minister: Never believe anything until its been officially denied.

Germany is assuming a 50% loss for their banks and insurance companies. Sean Egan (head of very reliable bond-analyst firm Egan-Jones) thinks the ultimate haircut will be closer to 90%. And that is just for Greece. More on the contagion factor below.

The existence of a Plan B underscores German concerns that Greeces failure to stick to budget-cutting targets threatens European efforts to tame the debt crisis rattling the euro. German lawmakers stepped up their criticism of Greece this week, threatening to withhold aid unless it meets the terms of its austerity package, after an international mission to Athens suspended its report on the countrys progress.

Greece is on a knifes edge, German Finance Minister Wolfgang Schaeuble told lawmakers at a closed-door meeting in Berlin on Sept. 7, a report in parliaments bulletin showed yesterday. If the government cant meet the aid terms, its up to Greece to figure out how to get financing without the euro zones help, he later said in a speech to parliament.

Schaeuble travelled to a meeting of central bankers and finance ministers from the Group of Seven nations in Marseille, France, today as they face calls to boost growth amid increasing threats from Europes debt crisis and a slowing global recovery. (Bloomberg: see http://www.bloomberg.com/news/2011-09-09/germany-said-to-prepare-plan-to-aid-country-s-banks-should-greece-default.html)

(There is an over/under betting pool in Europe on whether Schaeuble remains as Finance Minister much longer after this weekends G-7 meeting, given his clear disagreement with Merkel. I think I take the under. Merkel is tough. Or maybe he decides to play nice. His press doesnt make him sound like that type, though. They are playing high-level hardball in Germany.)

Anyone reading my letter for the last three years cannot be surprised that Greece will default. It is elementary school arithmetic. The Greek debt-to-GDP is currently at 140%. It will be close to 180% by years end (assuming someone gives them the money). The deficit is north of 15%. They simply cannot afford to make the interest payments. True market (not Eurozone-subsidized) interest rates on Greek short-term debt are close to 100%, as I read the press. Their long-term debt simply cannot be refinanced without Eurozone bailouts.

Was anyone surprised that the Greeks announced a state fiscal deficit of 15.5 billion for the first six months of 2011, vs. 12.5 billion during the same period last year? What else would you expect from increased austerity? If you reduce GDP by as much as Greece attempted to do, OF COURSE you get less GDP and thus lower tax revenues. You cant do it at 5% a year, as I have pointed out time and time again. These are the consequences of allowing debt to get too high. It is the Endgame.

[Quick sidebar: If (when) the US goes into recession, have you thought about what the result will be? A recession of course means lower GDP, which will mean higher unemployment. That will increase costs due to increased unemployment and other government aid, and of course lower revenues as tax receipts (revenues) go down. Given the projections and path we are currently on, that means even higher deficits than we have now. If Obama has his plan enacted, and if we go into a recession, we will see record-level deficits. Certainly over $1.5 trillion, and depending on the level of the recession, we could scare $2 trillion. Think the Tea Party will like that? Governments have less control than they think over these things. Ask Greece or any other country in a debt crisis how well they predicted their budgets.]

The Greeks were off by over 25%. And they are being asked to further cut their deficit by 4% or so every year for the next 3-4 years. That guarantees a full-blown depression. And it also means lower revenues and higher deficits, even at the reduced budget levels, which means they get further away from their goal, no matter how fast they run. They are now in a debt death spiral. There is no way out, short of Europe simply bailing them out for nothing, which is not likely.

Europe is going to deal with this Greek crisis. The problem is that this is the beginning of a string of crises and not the end. They do not appear, at least in public, to want to deal with the systemic problem of too much debt in all the peripheral countries.

Without ECB support, the interest rates that Italy and Spain would be paying would not be sustainable. I can see a path for Italy (not a pretty one, but a path nonetheless) but Spain is more difficult, given the weakness of its banks and massive private debt. These are economies that matter.

How do they get out of this without a debt crisis on the scale of 2008? By coming to grips with the problem. Germany is apparently doing that this weekend, by preparing to use the money it was going to pour into Greece to shore up its own banks. That is a much better plan. But as a well-researched report (by Stephane Deo, Paul Donovan, and Larry Hathaway in the London office kudos, guys!) from UBS shows, solving the problem will be very costly. The next few paragraphs are from their introduction.
Euro Break-Up The Consequences
The Euro should not exist (like this)

Under the current structure and with the current membership, the Euro does not work. Either the current structure will have to change, or the current membership will have to change.

Fiscal confederation, not break-up

Our base case with an overwhelming probability is that the Euro moves slowly (and painfully) towards some kind of fiscal integration. The risk case, of break-up, is considerably more costly and close to zero probability. Countries cannot be expelled, but sovereign states could choose to secede. However, popular discussion of the break-up option considerably underestimates the consequences of such a move.

The economic cost (part 1)

The cost of a weak country leaving the Euro is significant. Consequences include sovereign default, corporate default, collapse of the banking system and collapse of international trade. There is little prospect of devaluation offering much assistance. We estimate that a weak Euro country leaving the Euro would incur a cost of around 9,500 to 11,500 per person in the exiting country during the first year. That cost would then probably amount to 3,000 to 4,000 per person per year over subsequent years. That equates to a range of 40% to 50% of GDP in the first year.

The economic cost (part 2)

Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalization of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around 6,000 to 8,000 for every German adult and child in the first year, and a range of 3,500 to 4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. In comparison, the cost of bailing out Greece, Ireland and Portugal entirely in the wake of the default of those countries would be a little over 1,000 per person, in a single hit.

The political cost

The economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the Euro would incur political costs. Europes soft power influence internationally would cease (as the concept of Europe as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.
Welcome to the Hotel California
Welcome to the Hotel California
Such a lovely place
Such a lovely face
They livin it up at the Hotel California
What a nice surprise, bring your alibis

Last thing I remember, I was running for the door
I had to find the passage back to the place I was before
Relax, said the night man, We are programmed to receive.
You can check out any time you like, but you can never leave!
- The Eagles, 1977

You can disagree with the UBS analysis in various particulars, but what it shows is that there is no free lunch. It is not a matter of pain or no pain, but of how much pain and how is it shared. And to make it more difficult, breaking up may cost more than to stay and suffer, for both weak and strong countries. There are no easy choices, no simple answers. Like the Hotel California, you can check in but you cant leave! There are simply no provisions for doing so, or even for expelling a member.

The costs of leaving for Greece would be horrendous. But then so are the costs of staying. Choose wisely. Quoting again from the UBS report:

the only way for a country to leave the EMU in a legal manner is to negotiate an amendment of the treaty that creates an opt-out clause. Having negotiated the right to exit, the Member State could then, and only then, exercise its newly granted right. While this superficially seems a viable exit process, there are in fact some major obstacles.

Negotiating an exit is likely to take an extended period of time. Bear in mind the exiting country is not negotiating with the Euro area, but with the entire European Union. All of the legislation and treaties governing the Euro are European Union treaties (and, indeed, form the constitution of the European Union). Several of the 27 countries that make up the European Union require referenda to be held on treaty changes, and several others may choose to hold a referendum. While enduring the protracted process of negotiation, which may be vetoed by any single government or electorate, the potential secessionist will experience most or all of the problems we highlight in the next section (bank runs, sovereign default, corporate default, and what may be euphemistically termed civil unrest).

Leaving abruptly would result in a lengthy bank holiday and massive lawsuits and require the willingness to simply thumb your nose in the face of any European court, as contracts of all sorts would have to be voided. The Greek government would have to conveniently pass a law that would require all Greek businesses to pay back euro contracts in the new drachma, giving cover to their businesses, who simply could not find the euros to repay. But then, what about business going forward?

Medical supplies? Food? the basics? You have to find hard currencies for what you dont produce in the country. Greece is not energy self-sufficient, importing more than 70% of its energy needs. They have a massive trade deficit, which would almost disappear, as who outside of Greece would want the new drachma? Banking? Parts for boats and business equipment? The list goes on and on. Commerce would slump dramatically, transportation would suffer, and unemployment would skyrocket.

If Germany were to leave, its export-driven economy would be hit very hard. It is likely that the new mark would appreciate in value, much like the Swiss Franc, making exports from Germany even more costly. Not to mention potential trade barriers and the serious (and probably lengthy) recession that many of their export and remaining Eurozone trade partners would be thrown into. And German banks, which have loaned money in euros, would have depreciating assets and would need massive government support. (Just as they do now!)

Can a crisis be avoided? Yes. But that does not mean there will be no pain. We can avoid a debt debacle in the US, but doing so will mean reducing debt every year for 5-6 years in the teeth of a slow-growth economy and high unemployment. It will require enormous political will and mean many people will be unemployed longer and companies will be lost.

Ray Dalio and his brilliant economics team at Bridgewater have done a series of reports on a plan for Europe. Basically, it involves deciding which institutions must be saved (and at what cost) and letting the rest simply go their own way. If they are bankrupt, then so be it. Use the capital of Europe to save the important institutions (not shareholders or bondholders). Will they do it? Maybe.

The extraordinarily insightful and brilliant John Hussman recently wrote on a similar theme. He is a must-read for me. Quoting:

The global economy is at a crossroad that demands a decision whom will our leaders defend? One choice is to defend bondholders existing owners of mismanaged banks, unserviceable peripheral European debt, and lenders who misallocated capital by reaching for yield and fees by making mortgage loans to anyone with a pulse. Defending bondholders will require forced austerity in government spending of already depressed economies, continued monetary distortions, and the use of public funds to recapitalize poor stewards of capital. It will do nothing for job creation, foreclosure reduction, or economic recovery.

The alternative is to defend the public by focusing on the reduction of unserviceable debt burdens by restructuring mortgages and peripheral sovereign debt, recognizing that most financial institutions have more than enough shareholder capital and debt to their own bondholders to absorb losses without hurting customers or counterparties but also recognizing that properly restructuring debt will wipe out many existing holders of mismanaged financials and will require a transfer of ownership and recapitalization by better stewards. That alternative also requires fiscal policy that couples the willingness to accept larger deficits in the near term with significant changes in the trajectory of long-term spending.

In game theory, there is a concept known as Nash equilibrium (following the work of John Nash). The key feature is that the strategy of each player is optimal, given the strategy chosen by the other players. For example, I drive on the right / you drive on the right is a Nash equilibrium, and so is I drive on the left / you drive on the left. Other choices are fatal.

Presently, the global economy is in a low-level Nash equilibrium where consumers are reluctant to spend because corporations are reluctant to hire; while corporations are reluctant to hire because consumers are reluctant to spend. Unfortunately, simply offering consumers some tax relief, or trying to create hiring incentives in a vacuum, will not change this equilibrium because it does not address the underlying problem. Consumers are reluctant to spend because they continue to be overburdened by debt, with a significant proportion of mortgages underwater, fiscal policy that leans toward austerity, and monetary policy that distorts financial markets in a way that encourages further misallocation of capital while at the same time starving savers of any interest earnings at all.

We cannot simply shift to a high-level equilibrium (consumers spend because employers hire, employers hire because consumers spend) until the balance sheet problem is addressed. This requires debt restructuring and mortgage restructuring. While there are certainly strategies (such as property appreciation rights) that can coordinate restructuring without public subsidies, large-scale restructuring will not be painless, and may result in market turbulence and self-serving cries from the financial sector about global financial meltdown. But keep in mind that the global equity markets can lose $4-8 trillionof market value during a normal bear market. To believe that bondholders simply cannot be allowed to sustain losses is an absurdity. Debt restructuring is the best remaining option to treat a spreading cancer. Other choices are fatal.

See (http://hussmanfunds.com/wmc/wmc110905.htm for the rest of the article.)

You think the worlds central banks and main institutions are not worried? They are pulling back from bank debt in Europe, as are US money-market funds. (Note: I would check and see what your money-market funds are holding how much European bank debt and to whom? While they are reportedly reducing their exposure, there is some $1.2 trillion still in euro-area institutions that have PIIGS exposure.)

Look at the following graph from the St. Louis Fed. It is the amount of deposits at the US Fed from foreign official and international accounts, at rates that are next to nothing. It is higher now than in 2008. What do they know that you dont?


The Slow March to Recession in the US
Until there is a real crisis in Europe, the US will continue on its path of slower growth. Economists who base their projections on past history will not see this coming. Analysts who base their earnings estimates on recent performance are going to miss it (again.) Note: analysts, as I have written numerous times in this letter, are so very, very bad as a group at predicting future earnings that I am amazed people pay attention to them; but they seemingly do. They consistently miss tops and bottoms. That is the one thing they are very good at.

John Hussman, in the same report, offers the chart below, which is a variant on themes I have highlighted in past issues, but with his own personal twist. It is a combination of four Fed indices and four ISM reports. And it has been reliable as a predictor of recessions one of which it strongly suggests we are either in or heading into.



And recent revisions to economic data suggest that companies are going to have even more trouble making those powerhouse earnings that are being estimated. As Albert Edwards of Societe Generale reports this week:

at the start of 2011, productivity trends took a remarkable turn for the worse especially compared to what was initially reported. An initial estimate that Q1 productivity grew by 1.8% was transformed to show a decline of 0.6%. A slight 0.7% rise in Q1 ULC (unit labor costs) was transformed to show a staggering surge of 4.8%! In addition to that 4.8% rise, ULC rose a further 2.2% in Q2. But the news gets even worse Last week the BLS revised the ULC rise in Q2 up from 2.2% to 3.3% QoQ. US non-farm business unit labor costs are now rising by 2% yoy. That is very bad news for profits. Bad news for equities. And because the pace of ULC is a key driver of inflation (upwards in this instance), it is bad news for an increasingly criticized and divided Fed.
Preparing for a Credit Crisis
There is so much that could push us into another 2008 Lehman-type credit crisis. As I say, it is not a given, but the possibility should be on your radar screen. Lehman may have been the straw that broke the camels back, but there were a lot of other problems. Prior to 2008, we had seen several large companies in the financial world simply disappear. REFCO comes to mind. Not a whimper in the markets. But Lehman was one of a dozen problems all over the world resulting from the larger subprime crisis. Howard Marks of Oaktree writes about simultaneous problems in the markets and what happens:

Markets usually do a pretty good job of coping with problems one at a time. When one arises, analysts analyze and investors reach conclusions and calmly adjust their portfolios. But when theres a confluence of negative events, the markets can become overwhelmed and lose their cool. Things that might be tolerable individually combine into an unfathomable mess whose extent and ramifications seem beyond analysis. Market crises are chaotic, not orderly, and the multiplicity and simultaneity of contributing causes play a big part in making them so.

I did an interview with good friends David Galland and Doug Casey of Casey Research yesterday. They are decidedly more bearish than I am, so wanted an optimist to sit on their panel. But they forced me to admit that some of my optimism depends on the probability of US political leaders doing the right thing. Depending on your opinion about that, you are more or less prone to think there is a crisis in our future. And while I like to think it is not me showing a home-town bias, I think Europe has worse problems and a tougher situation than the US. A crisis there is more likely, I think.

But whether you want to make it 50-50 to 70-30 or (pick a number), there is a reasonable prospect of another credit crisis. So what should you do?

First, think back to 2008. Were you liquid enough? Did you have enough cash? If not, then think about raising that cash now. When the crisis hits, you have to sell what you can for what you can get, not what you want for reasonable prices.

I am personally raising more cash in my business. I usually invest money as soon as I can. Now, I am still investing, and you too should still put money to work in places that you think have the potential to do well in a crisis. Go back and see what worked in 2008 and buy more of it! Long-only funds did not work. Those that were more nimble did.

In the next crisis, opportunities to buy assets on the cheap will grow, so having some cash will make it easier to buy things you want to own for the next 10-20 years, whether income-producing or just something you want for fun.

Think through your portfolio. In 2008 I watched investors liquidate solid funds, or sell off assets at fire-sale prices, because that was the only way they could raise cash, when that was the time to invest more, not redeem. Make sure you are the strong hand.

Understand, I am not saying sell your conviction stocks. I have some and am buying more. But no index funds, no long-only, unhedged funds. I make very specific choices when it comes to long-only investments that I am looking to hold over and beyond a ten-year horizon. And those are risks I want to take (at least today).

I do not want to own anything that looks like an index fund or long-only mutual fund. Think 2008. I want funds and managers that have an edge and have a hedge, preferably both.

I would not be long money-center bank stocks or bonds, not in the US and especially not in Europe. I have had private off-the-record conversations with Republican leaders. There is simply no willingness to do another TARP-like bailout of bondholders and shareholders. I believe them. As Hussman suggested, this time bondholders will lose. I just dont know which ones will be ready, and there are lots of other places to deploy assets. If you feel you have some special insight, then be my guest; but I just see too much risk for the potential reward, especially in large bank bonds that pay so little. That is not to say they are all equally bad certainly not the regionals with less exposure to Europe. But do your homework.

(Caveat: I do think even the GOP leaders will have to cave in and allow the government to be debtor-in-possession of the too-big-to-fail banks we allowed to exist under the really bad financial bill called Dodd-Frank, which needs to be repealed and replaced. We have to preserve the system, but not shareholders and bondholders, who will lose this time.)

Think through your business. Banking relationships are not what they used to be. Spend time now getting commitments. Remember the odd spike in 2008 in bank lending? It was from credit lines being drawn down. But no one got new lines at the time. What can you do if sales get tough? What can you do to increase market share when your competitors start to pull back? The winners in 2008-09 were the companies that increased innovation and did not pull back (according to a Boston Consulting Group survey).

If you plan correctly, the next crisis will be an opportunity for you and not a personal crisis. And you will be better able to help those who need it.

A special note. In a few weeks I will be sending out an email that will contain a link to a totally free treasure trove of business and marketing ideas you can use to keep your business at the cutting edge, whether you are established are just starting out. It is one of those things I can do that costs me very little, but that sometime may mean a lot to you. I am just glad to be in the position to help a little.

I know I sound rather stark at times, but I really dont want you to dig a hole and get in and cover yourself up. I do not. While we are perhaps somewhat more cautious, we are also looking for ways to grow and be more aggressive here at my business. I will keep repeating: look for the opportunities. They are there. Just gauge your risk appropriately.
What Can You Do About the Weather?
The answer is, not very much, but you can prepare. I have arranged for my readers to get the latest copy of the Browning Newsletter, written by Evelyn Browning Gariss, who I think of as one of the worlds greatest climatologists. Her letter is a monthly must-read for me, and it is a steal at $250 a year. You need to read it for a few months to get the feel for it, as you may find it full of new terms, but youll soon get the hang of it. There are in fact patterns. And this winter we are sadly being set up for what may be a repeat of last years weather in the Southern Hemisphere, and rain at the wrong time in the US, during harvest. You can read the latest issue at my website, http://www.johnmauldin.com/images/uploads/specials/browning-0911.pdf. (You will need to type in your email address to get it.)
Europe, Houston, New York, and South Africa
I leave in a few weeks for a whirlwind trip to Europe (London, Malta, Dublin, and Geneva) and then back. A quick trip to Houston for a conference (https://www.webinstinct.com/streettalkadvisors/) and then I fly to New York for the weekend, where I will be speaking at the Singularity Summit, which is October 15-16. This is an outstanding conference, and I am honored to be asked to speak. It is really a bunch of wild-eyed futurists (like your humble analyst) getting together to think about what the future holds for us. For two days I get to be an optimist, if only in the longer term! Ray Kurzweil is the guiding light, and he has assembled an all-star cast. You can learn more at www.singularitysummit.com/. For those who can make it, I think you will come back amazed and more positive about the future of our world. And you can see videos of previous conference presentations at their website well worth an evening or two or three, and the price is right. But if you can make the conference, you will enjoy the experience and meet new friends. And then Ill fly to South Africa for two nights, and head back home.

It is good to have Tiffani back in Dallas and home and in the office. She has been in Europe for most of the summer, staying with friends and working from there. Even with Skype, its just not the same. And she did bring the granddaughter back with her! And one of the twins and her husband have moved back to Dallas, so 6 of 7 are now local. The other is coming soon, I hope! Dad likes to have his kids near.

It has been a very hectic week. Can I get busier? And computer issues have been a plague. To deal with it, we purchased two new HP laptops, and one will now be a mirror, so I will not go down if my computer fails. It is just too cheap not to do it, and lost time is frustrating and costly. I am amazed at what you can get for $1250: 8 gigs of RAM, a terabyte of memory more power than I can use cool 17-inch screens, a fingerprint reader camera, and I think there is even a grill attachment somewhere.

And speaking of grills, we did get a new one for Labor Day. About 30 people were here, and I spent most of the day cooking. It was time for fun and family and friends. I need more times like that to remind me of the real values in life, and why we will get through all this hassle. The future was in my home, and what a future it will be! My plan is to hang around a long time to see them enjoy it.

This Sunday Rich Yamarone (of Bloomberg) will be here to brave a family brunch gathering. Then Barry Habib shows up on Wednesday for a day-long planning session on a new venture, ending with a great meal somewhere. (This food theme keeps recurring!) Have a great week. And find some great food of your own! Enjoy lifes pleasures!

Your actually losing weight in spite of the great food analyst,
John Mauldin
John@FrontlineThoughts.com

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yeeeeeeeeeeeeeeeeeeeeeeeehaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaa!!

dc note this + other paragraphs - which is why i am in big right now rrl rmp otc gkp (on weakness only) and others for later not short term - gl

'I am personally raising more cash in my business. I usually invest money as soon as I can. Now, I am still investing, and you too should still put money to work in places that you think have the potential to do well in a crisis. Go back and see what worked in 2008 and buy more of it! Long-only funds did not work. Those that were more nimble did.'

Just taken me an hour to read it .lol

lol - did the matchsticks help keep your eyes open :-)))

all relevant to todays situ... ubs take note!!

Every major financial crisis has been foretold by timely but ultimately ignored warnings. At the end of mania, the rush to secure more fees, investment performance and status trumps common sense. In the last few months, the drumbeats of warnings from financial journals (The Financial Times, Businsss Week and The Economist) and regulators (The Financial Stability Board in the UK, the IMF and the SEC) about exchange-traded funds (ETFs) have been sounding.

Few seem to be listening.

Too many advisors and investors fail to acknowledge the risks in ETFs and exchange-traded notes (ETNs), which are part of a larger category I will refer to as exchange-traded products (ETPs).

Rapid expansion of any financial product should be taken by advisors and investors as a cautionary sign. The expansion of ETPs to new areas has increased the inherent risks of their structure and created new risks that will not be apparent until it is too late to correct them.

The residents of Hamlin begged the Pied Piper to play his sweet music to lure away the rats, but they never imagined that as he kept playing, the towns children its future would be lost as well.

Background

It is doubtful if a financial product has ever grown as fast as ETFs have. The chart below shows the growth of the assets and the worldwide distribution of the products.



Starting with nothing in 1990, ETPs now control $1.2 trillion in assets, which is just shy of the total assets held by hedge funds. ETPs control about 5% of the total assets in the world. Assets are growing 40% per year! ETPs now represent 2% of global equity capitalization.

The product has grown to the point where there are in excess of 2,600 funds available worldwide. Since their introduction, ETPs have proliferated so that every investment sector, published or private index, almost every nation and all the actively traded currencies are represented by ETFs or ETNs. As the acceptance of ETPs has increased, the relatively simple structure of the first ETF has morphed into a huge collection of structures.

There is little doubt that the creation of ETPs has conferred a host of favorable advantages to investors and their advisors. Morningstar, which made its mark as the arbiter of all things concerning mutual funds, recently prophesied the death of the open-end fund.1 The growth of ETPs is even challenging the hold that traditional open-end funds have enjoyed on investor assets, as highlighted in a recent Business Week article. Even the mighty PIMCO is offering to duplicate its heralded funds with ETFs. While the blessings of ETFs are many and in some cases great, at this point in the growth of the funds the blessings have to be viewed as alloyed with risk.

A cynical warning

No product produced by the financial services industry is ever created with the primary objective of benefitting the investor. The biggest beneficiaries of ETPs are the creators and managers of the funds, and the existence of ETPs makes it easier to invest the real benefits flow to the sponsors.

Cynical? Yes, but no less true. The creators of ETPs are asset management firms whose purpose is to increase their share of assets under management and the fees that go with those assets. In a broader context, this desire to gain share, and therefore profit, has been the engine leading the nation into many a financial crisis.

Risks associated with ETPs

While ETPs have been a great success, their proliferation is creating new risks or masking existing risks. One of truths that I have learned during my time advising clients is that financial engineering does not remove risk it merely disguises it and moves it to another location.

Lets review some of those risks.

Structural Risks

Investors and their advisors must understand how the ETPs they use work. Not all of them buy and hold securities, and their methods create unknown risks.

Commodity Funds

Futures prices have two pricing structures: contango and backwardation. Contango is when longer dated contracts sell at higher prices than nearer ones. Backwardation is the opposite.

In 2008, many people invested in US Oil (USO) and were disappointed that its performance did not match the meteoric rise of oil to $140 per barrel. After all, the fund invested in oil futures so it should have tracked the price of crude, right? Not necessarily. The chart below shows what happened.



The reason for the tracking error was the funds structure. USO purchases the current month contract (called the front month) and rolls it to the next front month as its expiration approaches. When the markets are in contango, the next month contract will be at a higher price, and therefore the fund will purchase fewer contracts (assuming assets are constant) at a higher price. This is a prescription for losing money.


There are a couple of things to note in this chart. First is the consistent, large tracking error between the future and the ETF caused by contango. Second, in the parabolic movement in crude from May 2008 to mid-July 2008, the ETF fell behind due to the increasing losses from buying the front month at steeply higher prices. The steeper the move upward in futures, the greater the tracking error between futures and the ETF. Finally, during the plunge in crude from October to December the tracking error increased even further! This would not be surprising to anyone who read the prospectus, since while it was declining in price, the futures remained in contango. That is called being wrong every way possible.

The second structural risk is the increase in price of the underlying commodity as assets in the ETF increase. Funds such as Sprott Gold, IAU, GLD and a few others purchase and take physical delivery of gold. In doing so, they must be in the market each time assets increase. One of the blessings of ETPs is that they have made the ownership of some assets affordable. There is a vast difference between purchasing one troy ounce of gold at $1,600 and purchasing GLD at $160 per share. The demand for ETF shares transmits demand to the markets and exerts pressure on the underlying commodity price.

This price bias is being hotly debated in regulatory, academic and trading circles. Obviously if the ETF is affecting the prices of the commodity, then purchasers of the commodity will be attracted to using ETFs to gain access to the markets. This in turn creates a self-fulfilling prophecy of increased prices leading to increased ETF assets and so on, until someone or something pulls the plug.

The sponsors of the ETPs argue that they execute their purchases in such a way that the effect on prices in minimal. You would expect them to say nothing less. One of the justifications for the movement of money from open-end funds to ETPs has been that actively managed funds performance has been less than optimal. Even if those arguments are true, then arent investors merely transferring the active-manager concern to the party purchasing the futures contracts or physical commodity? Financial engineering does not eliminate risk; it merely transfers it.

Country Funds

Many emerging nations have restrictions on the ownership of stocks by foreign investors. China, for example, prohibits the holding of A shares by foreign investors. Yet the Market Vectors China A shares ETF (PEK) owns A shares. Since the fund is not registered as a Chinese broker, it is prohibited from owning the asset it claims to hold. Instead, it owns swap contracts issued by brokers who are registered to hold those shares. A swap contract is merely a contract that promises PEK the performance of the portfolio. Swap contracts are only as good as the counterparty issuing them, so there is a risk that one or more counterparties might fail, leaving the ETF without delivery.

In return for the swap contract, PEK gives the broker (the counterparty) the cash investors deposits with the fund. The broker is then free to do as it wishes with the cash until it is time to settle up the contract. So investors in this type of fund have no idea where their funds are invested.

A more arcane issue develops if an investor decides to sell PEK shares short. What exactly is being shorted the swap, the shares underlying the swap or the shares of PEK? What redress does the investor have in the doomsday scenario of systemic failure of the fund? Again, the risks are being transferred and obscured from the investor.

The industry will argue that the swaps require the counterparty to deliver collateral. But are the nature and marketability of the collateral known to the average holder? In 2007 and 2008, we saw brokerage firms and banks such as Bear Stearns, Merrill and Lehman who were holding and valuing collateral in the form of AAA-rated mortgage-backed securities discover that it was really junk in a nice wrapper. What appears to be acceptable or even alleged superior quality collateral may suddenly become unsalable at any price.

Another concern about country funds, perhaps the most obvious, is related to the link between ETF assets and prices. Many of the emerging markets are very thinly capitalized. The sheer volume of funds being directed at the country from ETPs may be many times the actual value of the markets. If lots of money flows into a fund whose mandate is to purchase the shares in one particular market, it will raise prices or the fund will quickly be effectively in control of the companies traded on the exchange.

When everyone decides to sell, there will not be sufficient liquidity. In todays markets the chance of coordinated selling of a particular market has increased, so this is a real condition.

Leveraged and inverse ETPs

Levered and inverse ETPs represent a natural progression from the plain-vanilla product. There are valid uses for inverse and leveraged ETPs, but there are risks that are not apparent. The following two charts, courtesy of Terry Smith of Fundsmith Equity Fund2, demonstrate the issue:

A 2x leverage Fund

Day One Day two Day three Day four
Index 100 125 90 103
Daily change 25% -28% 14%
Cumulative change 25% -10% 3%
Leverage ETF 100 150 66 85
Daily ETF Change 50% -56% 29%
Cumulative ETF Change 50% -34% -15%


In volatile markets, the index ended up above par (on day four) and actually produced a 3% return, but the ETF suffered a 15% loss! It did not recover the loss, despite a 29% gain on day two, which in most situations would be a tremendous daily return. Once these things get behind they have a hard time recovering.

Day One Day Two Day Three Day Four Day Five
Index 100 80 60 55 100
% movement -20 -25 -9.3 81.8
Short sale 120 140 145 100
Inverse ETF 100 120 150 162.5 29.5


In this case, the investor is short the index via an inverse ETF. The results are devastating. While the investor was very profitable on the fourth day, he was destroyed on day five, while the index was soaring. Those shorting the actual stock would have been even, except for costs.

Investors would be better served by executing bear spreads using options, shorting the actual stock or purchasing put options. This statement is backed up in the literature of the funds themselves. Below is an actual (but anonymous) fund companys description of its ultra-short 20-Year US Treasury ETF (emphasis in the original).

This ETF seeks a return of -200% of the return of an index (target) for a single day. Due to the compounding of daily returns, the funds returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their funds holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.

How many investors who own this fund have read the prospectus? How many of their advisors have? This lack of compounding is the reason that many of the brokerage houses dealing with retail clients are prohibiting their brokers from selling leveraged or inverse ETPs to clients.
ETFs augment their income and returns by lending securities to short sellers. While securities lending is a common practice, it can expose the lender to risk if the counterparty (the short seller, in this case) is unable to return the borrowed securities to the lender (the ETF). In the case of an individual stock, this is a low probability risk. Most funds are limited by law as to the percentage of their portfolios that can be lent. The short selling and lending process is very transparent, and since securities are fungible, a call for return of borrowed stock can be satisfied in a number of ways. Additionally, the short seller must deposit collateral to secure the short sale (usually the cash balance created by selling the shares). In the event of an unsatisfied return, the lender can liquidate the collateral.

In contrast to short selling, the risks from securities lending are many. Most financial firms, like banks, operate on the fractional reserve concept. They do not maintain assets dollar-for-dollar for each liability they incur. As long as not all liability holders demand their funds at the same time, all is well. However, should there be a run on assets similar to what occurred in 2008, when collateral was often unavailable or worthless, there may not be sufficient unencumbered assets to satisfy all the demands.

The failure of a significant counterparty was once considered unthinkable, but the events of the last few years have elevated this risk.

Another issue involves fees earned by securities lending. The return paid to the lender is ultimately based on the cost of money and demand from short sellers. The fee income from lending can be a significant portion of the return earned by some of the plain vanilla ETFs. Since interest rates are currently at historic lows, the returns earned from lending is down. While the fees are lower, the demand for lending is up, as the number of arbitrage and hedging firms has increased. Should the number of short sellers decline (as could happen as a result of the Dodd-Frank regulations), ETF income from lending would fall, leading to lower overall returns. Lower returns would reduce the inflow of new assets, and thereby fees, earned by the fund company offering the ETF. Fund companies would seek new ways to increase returns, which could lead to increased risk.

As we saw in 2008, the quality of collateral can be overstated or overlooked in a generally ebullient market. As demand for short sales and hedging increases, so does the risk that the value of collateral posted for short sales and borrowing may be incorrect. In a severe downturn, issues could arise with the short sellers collateral. If the short seller posts highly liquid securities there is minimal risk. But should the short seller use less liquid assets, in the event of a major market stress the lender will have difficulty liquidating collateral, a situation no lender wants experience. As business standards declined, as they always do in bubbles, banks would compete for business and the quality of collateral would decline.

Short selling of ETF shares

ETFs, like open-end funds, can and do endlessly create new shares, and like individual equities, the shares of an ETF can be sold short. Unlike stocks, however, there is no limit to the number of shares in an ETF that can be shorted. Many of the funds tracking indices carry a short interest greater than their outstanding shares.

In May of 2010, during the flash crash, market systems went haywire the averages dropped over 1,000 points in a matter of seconds only to recover most of the drop by the markets close. While the exact mechanism of that collapse is still poorly understood, one fact was indisputable: The exchanges cancelled trades made at unusual prices. According to the Economist, between 60% and 70% of the cancelled trades were in ETFs, a proportion far in excess of their weighting in the markets.

At the end of 2010, the Boston-based firm, Bogan Associates, released a popular paper questioning what would happen to a heavily shorted ETF if there were massive redemptions of the funds assets. In Bogans estimation, a number of shareholders would find themselves with a share that represented no claim on any assets, and the fund would blow up with unpredictable consequences for the average investor.

As might be expected, the Bogan paper was met with criticism. It was followed by less strident warnings from The Financial Standards Board in England and International Bank for Settlements about liquidity risks in ETFs that did not discuss the dangers of shorting.

Finally, in 2011 there have been a series of warnings from the Financial Stability Board (FSB) and some fund operators, followed by a series of columns by Gillian Tett of The Financial Time, who wrote that some ETFs reminded her of CDOs, a turn of phrase designed to send chills up the spines of risk managers everywhere.

As expected, the industry determined to protect its franchise and the tide of fees rolling in wrapped itself in the flag of investor protection and attacked the warnings. All of the major fund companies published white papers demonstrating how the dire warnings were misplaced. In January of 2011, Credit Suisse issued a report by Victor Lin and Phillip Mackintosh called ETF Mythbuster3, explaining the arcane world of shorts and lending to bolster their claim that a net-short ETF cannot fail.

The Credit Suisse argument rested on the conclusion that in the event of large-share redemption in a net-short ETF, arbitrage traders would step in to address the differences in prices created by the recall of lent shares4.

The failure of shorts to deliver was a regular event before the passage of the Securities Acts of 1933 and 1934. Prior to those acts, speculators could engage in naked shorting they did not borrow the stock they were shorting. The acts made this a felony and acted as a deterrent to predatory speculation for 75 years.

But now in some cases, those regulations are being ignored. Entities (such as a short seller, hedge fund or high frequency trader) can short and then delay delivery until they repurchase or find another way to deliver for example, with an option exercise. In other cases the shorts are not technically considered naked, as they might be secured with comparable assets or swap contracts.

My point is not to condemn naked shorting since its criminalization speaks for itself but to point out that in the new world of financial engineering, the old rules about shorting may not hold up. Massive short positions may not be recorded in the official short-interest data. This heightens the possibility of a failure of shorts to deliver.

A net-short ETF can probably not collapse as long as the redemption only involves one ETF. If multiple ETFs are involved, there may be a greater threat than we know. A massive liquidation in, say, a Russell 1000-emulation fund could rebound to other funds with a similar mandate in a contagion effect.

With a single ETF, the possibility of collapse is uncertain because of the opacity of arbitrageur and hedge fund operations and the complexity and lax enforcement of regulations. For a heavily shorted ETF to collapse, it would require a number of sequential and consecutive failures, which is highly improbable. But then, so was the collapse of housing prices in 2008.

Synthetic ETFs

Synthetic ETFs (SETFs) do not have much presence in the US due to securities laws, but they have become increasingly popular in Europe and Asia. Most of the ETF assets there are institutional, so the demands on the fund companies are different than in the US, where ETFs are offered as an alternative to actively managed open-end funds.

When Gillian Tett of the Financial Times warned of ETFs in her May 5, 2011, article, Why ETFs give me an uneasy sense of dvu, she was primarily addressing SETFs, as was the UKs Financial Stability Boards in its April 2011 paper. There are some frightening similarities between SETFs and the now-infamous CDO, CDO-squared and CDO-cubed structures that failed in the financial crisis.

SETFs may create the same risks as were posed by collateralized mortgage and debt obligations leading up to the 2008 financial crisis. The Economist5 laid out the issue:

Perhaps the biggest concern, and the one with the clearest echoes of the subprime crisis, surrounds synthetic ETFs and linked products known as exchange traded note (ETNs), and exchange traded vehicles (ETVs). An ETN is a debt security issued by an index provider or a bank and traded on the market; an ETV is similar, but the debt issuer is a special purpose vehicle.

The rationale for concocting this alphabet soup is the desire to create funds linked to illiquid asset classes. It may be too costly or impractical to replicate the targeted index completely. To synthesize it the ETF provider usually enters into a transaction known as a total return swap with a bank. The bank agrees to pay the provider an amount equal to the return on the chosen benchmark, say an emerging markets index; the provider hands over cash in return. The bank now has to manage the risk of replicating the index; the provider faces the risk that the bank might go bust. So the ETF provider requires the bank to provide collateral (see diagram).



Source: Financial Stability Board

All this is well and good except that the nature of the collateral and the strength of the swap counterparty could be doubtful.

The counterparty for the swap contract may be the same as the bank creating the ETF, raising huge conflicts of interest. It is unlikely that the bank creating the ETF will refuse collateral from the swap desks, since to do so would be injurious to the banks profits and condemn the collateral to permanent pariah status.

The collateral may also have nothing to do with the index being replicated. This is the most eerie echo of 2008. There is the high probability that the SETF may be a funding mechanism for low-grade and unrelated collateral that the bank may not be able to offload to another customer. The funding of illiquid assets can be very costly, since the bank has to maintain reserves against them, which can reduce the banks ability to engage in other business activities. If, however, the bank offloads those assets to a SETF, then the funding issue has been kicked down the road.

Swap contracts and collateral arrangements, which are the basis for creating SETFs, are tremendously complex and opaque, causing investors to take on additional risk. In the event of a bank failure, an investor does not want to be given a portfolio of illiquid junk that the bank could not value. No one ever goes into a financial transaction hoping to be in the position of liquidating collateral to get money back. Yet that is what SETFs are offering investors in the extreme case. The reason a bank would fill a swap with lower quality items is that it needs to get those items off their balance sheet since lower quality products increase funding costs. The collateral may not be high quality and in a crisis will be first to react negatively. If the bank can find a way to fund this and not take a loss it will do so and it will only sell it if forced to. The bank is not going to liquidate this collateral in anything other than the worst of times, so having the collateral does not guarantee the security of the assets it is intended to protect.


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the girls in the bank are buying shares .

What girsl...?

What shares...?

Tell Sid!