Vertical Pulse

Characterists That Add Value to Paintings

I am reading Discover Your Inner Economist by Tyler Cowen who also authors the popular economics blog Marginal Revolution. There is a very interesting section that discusses the attributes of paintings that add to their value. Professor Tyler writes:

Paintings with light colors sell better than paintings with dark colors. Happy portrait subjects sell better than widows. Horizontal pictures are easier to hang over fireplaces and sofas. Other market regularities include:

• Landscapes can as much as triple in value when there are horses or figures in the foreground. Evidence of industry usually lowers a picture's value.
• A still life with flowers is worth more than one with fruit. Roses stand at the top of the flower hierarchy.
• There is a price hierarchy for animals. Purebred dogs help a picture more than mongrels do. Spaniels re worth more than collies. Racehorses are worth more than cart-horses.

These are some of the issues that will be discussed at IncreMental Advantage's Intelligently Acquiring and Disposing of Fine Art and Collectibles Conference. More information is available at www.incrementaladvantage.com or by contacting Neomi Barazani at 609-919-1895 ext. 100 or neomi@incrementaladvantage.com.

Redemptions Are Not Easy to Obtain

The sub-prime imbroglio sunk Dillon Read Capital Management for $124 million; nearly wiped out two Bear Stearns hedge funds – one of which was bailed out at $1.6 billion; lost Queen’s Walk Investment Ltd. investors €108 million; lost Galena Street Fund investors about $100 million; and now four United Capital Markets Holdings Inc.’s hedge funds, which hold $619 million under management, stopped honoring investor redemptions. The fate of Queen’s Walk and the Bear Stearns’ funds are uncertain.

With this degree of turmoil in the world of hedge funds some investors are beginning to seek redemptions. However, redeeming investments in hedge funds is not so easy. First, redemptions are often only available at the end of the month or at the end of a quarter. Second, notice of intent to redeem must often be provided, sometimes as long as 90 days in advance.

There is some liability for redeeming interests in hedge funds. Investors who have received redemptions could be sued by bankruptcy trustees if the fund goes bankrupt. The bankruptcy trustee could argue that the hedge fund did not correctly value its assets and that therefore the investor withdrew more funds than he was entitled to redeem.

These are some of the issues that will be discussed at IncreMental Advantage's Hedge Fund Due Diligence Conferences. More information is available at www.incrementaladvantage.com or by contacting Neomi Barazani at 609-919-1895 ext. 100 or at neomi@incrementaladvantage.com.

New Iraqi Hedge Fund Open For Business

Amazingly, amid the daily carnage, machine-gun fire, bomb blasts, and other horrors that have come to symbolize Iraq, yesterday the Iraq Fund Management LLC was able to launch its first hedge fund, which will buy and sell the securities of Iraqi banks and state-owned enterprises. According to the Hedge Fund Lounge, Dave Packard, the fund manager, said, “The primary investment objective of the Partnership is growth of capital. The business of the Partnership is buying and selling securities of small to large capitalized companies, including stocks, warrants, rights and options of U.S. and non-U.S. entities. The Partnership seeks to engage initially and primarily in proprietary trading on the Iraqi Stock Exchange, focusing on the banking sector and State Owned Enterprises (SOE’s) of Iraq."

The story also noted that yesterday was the first day of trading on the Iraqi Stock Exchange. The hedge fund will be domiciled in Delaware. One hedge fund strategy that has seen a lot of growth in recent years is in emerging markets. Consider just yesterday that Threadneedle Investment Services Ltd. announced it has acquired emerging market hedge fund Convivo Capital Management Ltd. for an undisclosed price. According to Hedgeworld.com, Threadneedle launched its hedge fund business in 2000 and will now manage roughly $3 billion across nine strategies, of which three will be in emerging markets.

IncreMental Advantage is in the midst of planning a hedge fund strategies conference for sometime in January. The aim of the conference is to have top hedge fund industry sources talk about what they believe will be the best performing strategies in 2008. In the meantime, I am interested in hearing from you of what you think will be the most profitable hedge fund strategies in 2008. Click here to cast your vote.

Demand for Collectibles Remains Strong

Demand for fine art and collectibles remains extremely strong. Sotheby's reported that it sold $3.24 billion of fine and decorative art in the first half of 2007. During the first six months of 2007, Sotheby's said it sold 391 works of art for $1 million or more and privately brokered sales of $334 million in art.

IncreMental Advantage's Intelligently Acquiring and Disposing of Fine Art & Collectibles Conference in New York City on October 17, 2007 will provide insight into the requisite due diligence to make intelligent decisions when buying and selling pieces of fine art and collectibles.

Attention Bargain Hunters

As we all know by now there have been some big losses over the last couple months stemming from the sub-prime market. Big names like Bear Stearns, UBS, Sowood, and Goldman Sachs have been given jolt from the sub-prime storm. However, wise hedge fund managers and institutional investors can now find deals on mortgage-backed securities, which according to The Economist, goes for around 40 cents on the dollar. Some of these deals may be a bargain since an overwhelming majority of sub-prime borrowers are still making good on their mortgage payments.

There is no doubt that sub-prime market troubles have invoked a nascent credit crunch. Credit spreads, the premium that riskier borrowers must pay over government debt, have surged since June. That is a problem for companies and banks in the middle of doing deals. One can see how the sub-prime problem is spreading into other sectors of the market. Again, savvy investors will be lining up in the coming months to purchase, at a discount, the roughly $300 billion in corporate debt banks will be issuing. Make no mistake, there will be big losses, but there will also be big gains ... for some.

Emma Trincal, of Hedgeworld.com, wrote an interesting piece this past Friday exploring optimists' and pessimists' perspective over the current market. "The world seems split into two groups. There are those who think that the crisis—however painful—may be the remedy for a pernicious easing of credit that led to excessive risk, abuse of leverage and not enough hedging. ... The pessimists, on the other hand, believe that the sub-prime malaise is already the manifestation of a double-bubble burst in the credit and housing markets. For them, the credit crunch is already here and it is now spilling over to the equity market and the economy at-large."

The Wall Street Journal ran a story today about how credit default swaps may lead to financial ruin for some. "Investors and banks buy CDS contracts to hedge against risk. They also use them to make big bets on bad events happening. Because of these dual purposes, the CDS market could be a source of either calm or instability for the overall financial system. It is such a new market and it operates in such a murky corner of finance, nobody really knows. But it will become clearer as this credit crisis plays out."

Gary Dorsch, writing for The Market Oracle, made some provocative assertions about the reach of the Working Group on Financial Markets, commonly known as the Plunge Protection Team (PPT), created by Ronald Reagan to prevent a repeat of the Wall Street meltdown in October 1987. "The big question is whether US Treasury chief Henry Paulson and Fed chief Bernanke are pursuing a more active interventionist policy than what was originally mandated for the PPT? The turnover of interest rate, currency and stock index derivatives rose 24% to $533 trillion in the first quarter, and that's a big time bomb that can blow-up at anytime. It requires constant surveillance and 'vigilance' over the world's greatest casinos. Warren Buffett calls derivatives 'weapons of mass destruction.' If correct, then the PPT is 'watching the markets closely,' (Japanese code words for intervention) and Paulson and Bernanke aim to prevent a 10% correction at all costs. There are glaring signals in the marketplace that indicate when the PPT appears to be intervening in stock index futures, and these signals were revealed in the August 3rd edition of Global Money Trends, with plenty of cool charts."

These are some of the issues that will be discussed at IncreMental Advantage's Sept. 11 Profiting from Corporate Restructurings and Oct. 16 Hedge Fund Due Diligence conferences. For more information please visit www.incrementaladvantage.com.

Volatility Rattles Hedge Fund Cages

As we awoke today we discovered that central banks all over the world were busy last night pumping liquidity into the struggling financial markets in order to keep interest rates down. Also, for the last day and one-half we have been reading that credit hedge funds are not the only ones struggling. Several quantitative hedge funds are also contending with extremely volatile markets.

The Wall Street Journal made a tally of the most recent hedge funds whose performance has dipped during the sub-prime summer: A fund under Renaissance Technologies Corp., a hedge-fund company, has lost 8.7% so far in August and is down 7.4% in 2007. Highbridge Capital Management, announced its Highbridge Statistical Opportunities Fund was down 18% as of Aug. 8 and down 16% for the year. The $1.8 billion publicly traded Highbridge Statistical Market Neutral Fund was down 5.2% for the month as of Wednesday. Tykhe Capital LLC manages about $1.8 billion and has suffered losses of about 20% in its largest hedge fund this month. AQR Capital Management LLC, a $38 billion fund, has seen losses in its market-neutral strategies. Goldman Sachs Group Inc.'s GS North American Equity Opportunities has lost 15% between the beginning of the year and July 27. Goldman's $9 billion Global Alpha has liquidated certain positions, but denied the rumor that it is facing liquidation, calling it "categorically untrue." FINalternatives reported that Santa Fe, N.M.-based Black Mesa Capital, $3.8 billion AUM, is down about 9% this month through Aug. 8 and up 5% year to date.

Most of the aforementioned funds use market-neutral strategies. The New York Times' DealBook blog explained that the funds using this strategy employ the use of quantitative computer models to identify their key stocks. "But the markets’ roller-coaster ride of late has thrown off the models, which have been unable to accurately calculate the risk of the imploding sub-prime mortgage market," the blog author states. FINalternatives also reported that this "sub-prime implosion" prompted Black Mesa to inform its investors that "at least one very large fund or investment bank is liquidating 'massive' trading portfolios causing disruptions and triggering big losses among other market-neutral hedge funds." Is this the beginning of the "Great Unwind"?

May be, but may be not. Don't want to sound like a bear at this time. I think all investors have to do is a little due diligence before placing money with a hedge fund. The lesson of the day is that diversity pays off. In the words of comic blogger, Finbar Taggit (mind the pseudonym), "Despite the current market turmoil ... most hedge funds are lovin' it. A few 'eggs in one basket' amateur players will take a hit, some will die, but many will thrive. Hedge funds have had a good year and it is going to get better." Mr. Taggit's blog was reporting a rumor this afternoon that a DE Shaw hedge fund "is in trouble." Which segues into my investment product of the day, catastrophe bonds.

"Investing in 'cat' bonds can shrug off the sub-prime mortgage mess, the price of oil, or any other misfortune that might arise - except those caused by an act of God," an Aug. 4 Economist article states. Catastrophe, or "cat," bonds are asset-backed securities, which are issued by insurance companies. For years these bonds were only available to institutional investors, however, after the hurricanes of 2005 that caused $60 billion in claims and soaked up much of the world's available reinsurance capacity. Since then insurers have looked to share risk with the markets. In 2006 cat bond issuance amounted to $4.7 billion, more than double from the year before. The Economist reported that cat bonds pay a coupon of 12%.

These are some of the issues that will be discussed at IncreMental Advantage's Oct. 16 Hedge Fund Due Diligence Conference in New York City. For more information please visit www.incrementaladvantage.com.

The Birth Of Death Bonds

Two centuries ago when Adam Smith was writing his masterpiece, "The Wealth of Nations," he warned people about one dark side of capitalism, the speculator. When one reads about the recent invention of so-called death bonds, one has to admit that Mr. Smith was on to something. What the industry calls, life settlement-backed securities, are arrangements that offer people the chance to sell their life-insurance policies to investors, who keep paying the premiums until the sellers die and then collect the payout. Speculators bet on a quick death because more profit is then realized.

"It's as macabre as investing concept as Wall Street has ever cooked up," a July 30 BusinessWeek story states. The story went on to report that about 90 million Americans own life-insurance policies, but many of them find the premiums too expensive while others would simply prefer to cash in early. The transactions are conducted by local firms called "life settlement providers."

Once life settlement providers buy a person's life-insurance policy, through a broker of course, the providers resell the policy to hedge funds or investment banks who warehouse about 200 policies before turning the pool of policies into asset-backed securities, or death bonds. Returns on death bonds are expected to be around 8%. BusinessWeek states that a big death bond deal will happen soon in the U.S. along with an expectation that rating agencies will soon start rating these morbid ABS.  

According to BusinessWeek, about $10 billion worth of death bond deals were done in 2005, $15 billion in 2006, and that could double by the time 2007 is over. One source the publication cited said death bond transactions could become a $160 billion per year business in the near future. In a February 21 Wall Street Journal story that examined death bonds, it states that investors are showing interest in death bonds because they could serve as a tool to diversify firms' portfolios. "Insurance could fit the bill. The number of people who die prematurely or suffer disabling injuries has little connection to stock or typical bond prices," the article states, which adds that popular investors include hedge funds, pension funds, and other institutional investors.

Bets on death bonds could become risky however. For instance, mortgage-backed securities, are covered by the physical asset of a house. There is no equivalent in a life insurance policy. The returns depend on external circumstances, such as how many people die in a given year. "They are creating a very risky product," the ubiquitious Janet Tavakoli told BusinessWeek. "They may be planning to sell them to sophisticated investors, but they could be roping in people who don't appreciate the risk."

BusinessWeek describes some accounts where speculators take out policies on individuals' behalf, pay them something up front, cover the premiums, and then wait for the people to die so they can collect.

These are some of the issues that are discussed at IncreMental Advantage's conferences. For more information please visit www.incrementaladvantage.com.

In Hopes Of A Goldstein Victory

Hedgeworld.com reported today that Philip Goldstein, co-founder and principal of hedge fund firm Bulldog Investors LLC, was found in violation of Massachusetts securities laws that prevent hedge funds from soliciting non-accredited investors. Allegedly, Mr. Goldstein's firm had provided a non-accredited investor details about the hedge fund's performance, staff, and other information through an e-mail. Mr. Goldstein has appealed the decision to a higher state court and will use the First Amendment's free speech clause to argue his case.

The U.S. SEC has imposed a similar ban on hedge funds and other sophisticated investment vehicles from advertising their products to ordinary people (non-accredited investors).

Regarding actual individuals, the SEC defines accredited investors as a person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million and with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. This definition fits 8.4% of U.S. households. The SEC is currently toying with the notion of modifying the criteria used to identify an accredited investor, which would further reduce those able to invest in hedge funds to about 1% of U.S. households.

Since 1933 politicians have justified this law as "protecting" Joe Sixpack, who is not "sophisticated" enough to invest and possibly lose all of his or her money in risky assets. Let's interpret: if you don't have a million bucks your too much of a lame brain to contemplate such an investment. Rubbish, I say. Such legislative arrogance undermines man's and woman's faculty of reasoning and ability to engage in complex pursuits no matter their economic disposition, which philosophers during the Age of Enlightenment expounded on better than I am able to.

Why do Australian regulators give ordinary people the benefit of the doubt, where any citizen can invest in a hedge fund, unlike in North America or Europe. According to July's edition of Accredited Investor, a publication put out by Lipper Hedgeworld, two-thirds of Australian hedge fund assets come from retail investors. Many workers in that country have placed some of their retirement money into hedge funds, as well.

"Occasional fund blowups notwithstanding, that doesn't seem to worry Australians, in sharp contrast to complaints in the United States about the dangers of retail spread," the article states. "Wider choice for the masses has not led to any worse investment decisions than in other countries." It should be noted that Australian hedge funds are licensed and regulated under the country's securities laws. According to the Index of Economic Freedom 2007, Australia ranked third, right above the United States and below Singapore. I believe this is an embarrassment that hangs over the head of American government regulators, and which by the way, contributes to the growing gap between rich and poor.

Going back to Mr. Goldstein's case, he feels his chances are good at claiming a victory in Massachusetts Superior Court. "I really want to win on [the First Amendment] because I think it's going to have the greatest impact on the whole regulatory regime of securities law," Mr. Goldstein told Hedgeworld.com. "I think that the regulators have had a free ride, thinking that somehow … regulators and securities laws are exempt from the First Amendment."

Let us be thankful for the wisdom of our founding fathers.

Nardelli Back In The News

Robert Nardelli resurfaced in the news this week after a seven month hiatus when he left Home Depot as its chief executive in January amid criticism that his $210 million severance package was absurd. As we all know by now Mr. Nardelli will be taking the helm at Chrysler LLC to turnaround the ailing American auto-maker. Several months ago hedge fund Cerberus Capital Management acquired Chrysler through a classic private equity buyout deal. For the last several years executives have been leaving public companies (and the criticism that comes with it) to work for quieter, less noticeable private companies.

Shortly after Mr. Nardelli left Home Depot I wrote up a report for IncreMental Advantage that delved into the contentious issue of executive compensation. It explored some of the regulatory proposals aimed at executive compensation and why some executives were heading to privately-held companies. "As overall regulation and criticism mount, the media has reported on CEOs and other executives leaving public companies (or taking public companies private) for privately held organizations, and especially, private equity firms in the pursuit of making hefty sums of money without bearing public scrutiny. All of our sources who agreed to go on record said compensation and pay were of course a big factor in CEOs decisions for heading to private companies," the report states, which you can read in its entirety here.

Mr. Nardelli proved to be no exception to the trend. For months Mr. Nardelli had worked on the Chrysler deal for Cerberus, which has retained other big names like former U.S. Treasury Secretary John Snow, who serves as the firm's chairman. The Wall Street Journal today ran a story today about what Mr. Nardelli will bring to Chrysler, how the job may redeem his reputation, Chrysler's corporate strategy, and other issues surrounding the car-maker and its new boss.

These are some of the issues discussed at IncreMental Advantage's conferences. For more information please visit www.incrementaladvantage.com.

Who's To Blame For The Sub-Prime Meltdown?

The sub-prime shakedown continues to rumble through Wall Street and other financial centers around the world. The latest causality is not a hedge fund or investment vehicle, but Bear Stearns' co-President Warren Spector. Allegedly, Mr. Spector was pressured into quitting his job by long-time colleague, Bear Stearns CEO James Cayne. Perhaps, Mr. Spector will be seen as a scapegoat - as the big bank's stock has fallen 27% this year alone and because of the bank's losses in the sub-prime market - than as a practical move.

At the same time mortgage lenders continue to examine their relationship with non-bank mortgage brokers. The Wall Street Journal reported that NovaStar Financial Inc. will resume making sub-prime mortgages through mortgage brokers at a time when many lenders have halted such practices because of late payments and defaults.

Andrew Davidson, of Andrew Davidson & Co., Inc., recently authored a report in his company's publication, "The Pipeline," explaining what he saw went wrong in the sub-prime meltdown. He mostly explored the relationship between borrowers, lenders, brokers, and investors. "What went wrong in the sub prime mortgage market is that the people responsible for making loans had too little financial interest in the performance of those loans and the people with financial interest in the loans had too little involvement in how the loans were made," he wrote.

In his report, entitled "Six Degrees of Separation," Mr. Davidson identifies the actors involved in creating sub-prime mortgages: the borrower, broker, mortgage banker, "aggregator" (usually a broker-dealer who buy loans and then packages the loans into a securitization that is sold to investors), CDO managers, and investors. The Six Degrees of Separation report makes for an interesting read and can be viewed here.

One of the more interesting relationships that Mr. Davidson explores is the one between the rating agencies and CDO institutions. "In the CDO market, the criteria of the rating agency determines whether or not the transaction will occur. ... If the rating agency establishes criteria that allow the institution to borrow money at a low enough rate or at high enough leverage, then the CDO can purchase assets more competitively than other financial institutions. If the CDO has a higher cost of debt or lower leverage, than it will be at a disadvantage to other buyers and will not be brought into existence. If the CDO is created, the rating agency is compensated for its ratings. If the CDO is not created, there is no compensation. My view is that there are very few institutions that can remain objective given such a compensation scheme."

Amid all the bad news about the sub-prime market, it can be expected that politicians, who have written up regulations based on news headlines more now than ever, will want to control lending practices and underwriting standards. Critics have said, and in my view, that such regulations are not sincere in cleaning up the industry, but aim to score cheap political points. Lawrence Lindsey wrote a piece in last Friday's Wall Street Journal (Mortgage Madness) about some of the reckless proposals that Sen. Chuck Schumer and others are tinkering with.

In Mr. Davidson's report he also opined that such regulations clamping down on mortgage origination practices, such as limiting the types of loans allowed or establishing minimum underwriting requirements, would have dire consquences. "... underwriting requirements may be counter productive since they may limit the availability of credit to those who need it and deserve it." However, Mr. Davidson did believe that regulatory action should focus on the separation between origination and investment.

These are some of the issues that will be discussed at IncreMental Advantage's Oct. 16 Hedge Fund Due Diligence Conference in NYC. For more information please visit www.incrementaladvantage.com.