•Term Limits for CEOs and Board Members (2 Board Max)
•Risk Committee Members on Board•More Woman on Boards, 15% is Unacceptable
•Former CEOs as Board Members
•Smaller Boards: 2008 S&P 500 11.8 members vs. 6 or 7 needed
•More 21st Century Expertise: 1 of 16 Citigroup Board Members was in Finance in 2007
•Annual Time Commitment Needs to be Longer
•More Meetings: No More “Once a Month Finger Sandwiches Luncheons”
•Board Meetings Without Management
•Higher Compensation for More Time and Experience
Risk IndicatorsMacro
•High Yield Credit Spreads•Equities vs. High Yield•3 Month Libor / Realized Volatility of 3 Month Libor•Ted Spread / Ted Spread Realized Volatility•3 Month Euribor / 3 Month Euribor Realized Volatility•Interbank Overnight 10, 30, 60, 90, 360 day CD Market•2 Year Swap Spread / Realized Volatility of the 2 Year Swap Spread•Asset Quality in Repos and Money Market Funds•Investors Intelligence Bullishness / Bearishness Survey•NYSE Short Interest•Call Put Volume Ratio•High Yield Mutual Fund Inflows•Equity Mutual Fund Inflows•Capital Markets Issuer Power & Weakness•Corporate Default Rate•Stocks at new 52 Week Highs and Lows•Breakout in Correlation
Risk IndicatorsMicro
•Yes Men? Strange management changes: both Lehman Brothers and MF Global had their respective risk management heads replaced within 24 months of filing bankruptcy. Insecure CEO's often cannot deal with any intellectual challenges. Dick Fuld's entire top tier of lieutenants, were the ultimate yes men. If you were lucky enough and courageous enough to make his team it was the equivalent of hitting the lottery, $15-$30 million a year was your reward.
•Too much power? A CEO beyond reproach: Dick Fuld (Lehman), John Corzine (MF Global), Jimmy Cain (Bear Stearns), Jeff Skilling (Enron), Gary Wendt (Conseco), Al Dunlap (Sunbeam) all share so many personality traits. Yet above all, 12 months before their companies filed bankruptcy (or had to be saved), these leaders seemed invincible to the outside world. Sun Tsu in the Art of War said, "If an emperor lives in fear of his own men it's a sign of supreme incompetence.”
•Funding Mis Match: A high percentage of liability financing in the short term debt markets has brought so many companies to their knees. It's the time tested banking principle, never fund long term illiquid investments in the short term debt markets. Lehman, MF Global, Bear Stearns and almost Jefferies.
•Board of Directors out of their own Depth: a board with a high percentage of members who know little to nothing about the business as hand. Seems obvious but it's a deadly indicator, Dina Merrill?
•What's a CLO? Strange corporate positions of power.
•Imaginative Usage of the Repo Market: what do Repo 105 and Repo to Maturity have in common? Lehman, MF Global and Chapter 11.
•The Footnote Indicator: MF Global, Lehman Brothers, Enron, Calpine, Worldcom all had a healthy increase in the number of footnotes in their 10-Qs just prior to filing bankruptcy.
Risk IndicatorsMicro
•Difficult to Borrow List
•Aggressive expansion into new business lines: Lehman in 2007 had become a real estate investment trust with an investment bank on the side. In 2010, MF Global went from a riskless agency broker model to an investment banking model with a large focus on proprietary trading.
•Can you play Poker? Corporate actions designed to show strength and hide weakness. Late Q4 2007, 9 months before filing bankruptcy, Lehman Brothers was raising its dividend and buying back stock > $80 a share. Merrill Lynch and others were selling stock to raise equity capital. Didn't fool David Einhorn.
•Leverage: Lehman, AIG, Fannie Mae and MF Global were all levered 40+ times.
•Charlie Munger. A little too Cozy with your Auditor? Lehman had 4 CFO's from 2004-2008, two of them used to work for their auditor.
•Aggressive use of the Convertible Debt Capital Markets: Sino Forrest, American Airlines, Delta Airlines, Northwest Airlines, Lehman Brothers, MF Global, Enron, Adelphia, Calpine, Worldcom, Fannie and Freddie, Six Flags, Tower Automotive, Six Flags and Sunbeam all issued convertible debt securities just prior to bankruptcy.
•"Follow the Incentives" Charlie Munger. Fuld watched Pete Peterson and Steve Schwarzman become billionaires. Corzine watched Bob Rubin and Hank Paulson become Treasury Secretary.
•The Deadliest Trade: Long the Illiquid and Short the Liquid, Lehman, Bear Stearns & MF Global
•Breakout in Short Interest on the Charts.
University of Chicago Political Uncertainty Index
VIX Slayed by Fed and ECB Policy Blows
•The 50-Day correlation of S&P 500 stocks to gains or losses in the full index increased to a record 0.86 in October, according to Birinyi Associates Inc. It was 0.83 in the days around Lehman’s failure.
•A level of 1 would mean all 500 stocks moved together.
•August-September 2008 and Summer 2011, high correlation existed across all asset classes. A breakout in the ICJ, the CBOE S&P 500 Implied Correlation Index, which occurred on July 11th, 2011 & September 2nd, 2008, is very bearish.
•In the 1990s and 2004-2007 there was very little correlation amongst all asset classes.
High Correlation Amongst Stocks in the S&P 500
Correlation Near Multi Year Lows
CBOE S&P 500 Implied Correlation Index…
When near all time lows, beware of coming Risk Off train
Correlation in uptrend, is a solid Risk Off indicator
Systemic Risk and US Treasury Yields are inversely correlated, commodities as well
The Epicenter of Global Systemic
Risk.. Spain 2s / 10s Has Been a Spot On Indicator
On July 24th Spain’s 2 year note yield topped out at 6.6%, after Draghi hinted he had a Bazooka in the OMT, yield came in to 2.7%.
Over the last 3 years as this curve flattens, it makes sense to take down risk in equities.
July 24th 90bps Spread – Sept 5th 346bps Spread
European banks pledged to de-lever by $1.3 trillion last year but assets grew by 7% to $45 trillion, 3x GDP of $15 trillion.
Draghi’s new OMT & LTROs are looking more and more like the Bear Stearns bailout, Spanish and Italian banks should be de-levering but their not. MORAL HAZARD anyone?
Lehman Like Risk in Spain?
All Year, Spain’s 10 Year yield has been inversely correlated to US Treasuries.
Systemic Risk and US Treasury yields are at opposite ends of the see saw.
The US faces a 200 bps rise in long term rates when deflationary, depression like systemic risk is reduced in Europe.
Euribor Early Indicator
Euribor broke out on July 12th 2011.
From July 25th through September 2nd the S&P 500 lost 19%.
Just as in 2008, Euribor was screaming sell.
In 2012, she was saying buy. From its July breakout do the downside, stocks are up 9%
+17.97%
+1.27%
From July 14, 2008-January 27, 2009, HY CDX was +1.27%
+9.13%
Equities vs. High Yield
Extended period of equity out performance relative to HY. The more illiquid the asset class the better the indicator.
•3 Month Libor has always been a solid indicator of bank trust in one another, but looking at realized volatility of 3 month Libor gives you even more lead time to take down risk. There were significant spikes just before the 2008 Lehman & 2011 MF Global / Eurozone) crashes.
•Significant spike just before the 2008 & 2011 crashes.
July 1, 2008-May 31, 2009
April 1-October 31, 2011
Breakout
Breakout
Ted
Sp
read
Excellent indicator, significant spike just before the 2008 & 2011 crashes. When institutions would rather but there money in Treasuries vs. a financial institution look out. Early volatility is the key.
Realized Vol on Euribor
Today
Even with all the ugly headlines out of Europe, so far the LTRO love is paying off for Interbank Trust
•Both in 2008 & 2011 banks went from lending for a year to each other to just overnight in some cases
•In the Summer of 2011, several major European banks could not fund themselves for more than 10 days, yield spreads in secondary market trading of these short term loans went from 45 bps to 190 bps in just a few weeks.
Interbank Overnight10, 30, 60, 90, 360 Day CD
Market
Realized Volatility in 2 Year Swaps was breaking out 7 days prior to Lehman Brothers’ bankruptcy
2008 ELEPHANTS FOOTPRINTS IN RISK REDUCTION MODE
2 Year Swap Spread
30 Day Realized Volatility on 2 Year Swap Spread
•Demand for dollars especially from European Banks was a significant risk indicator in the Spring & Summer of 2011, as well as 2008.
•Demand for US dollars to buy US Treasuries.
•In June 2011, the 2 Year Swap Spread spiked 44% in a two day period before equities rolled over hard in July.
+44%
2 Year Swap Spread
January 1-October 31, 2011
EONIA in the Spring of
2011 & 12
Euro Overnight Index Average, effective rate of all overnight unsecured lending transactions in the interbank market
EONIAEONIA (Euro Overnight Index Average) is an effective overnight unsecured lending rate, transactions in the interbank market
Uptrends in 2008 and 2011 were reliable Risk Off indicators… Downtrend in 2012 was a bullish risk on preview
NYSE Short Interest Call/Put Volume Ratio
A breakout in short interest is bearish, the shorts should be listened to.
A breakout in short interest of one or more systemically important financial institutions is even more telling. This took place in the summer of 2008 & 2011.
According to the recent NYSE biweekly update, the short interest as of the end of 2011 was a modest 12.8 billion shares, a sharp drop from the 13.4 billion and 14.2 billion 2 and 4 weeks prior, and certainly a very far cry from the over 16 billion shares short which market the market bottom in late September.
Contrarian-sentiment measure known as the put/call options volume ratio. By tracking the daily and weekly volume of puts and calls in the U.S. stock market, we can gauge the feelings of traders.
While a volume of too many put buyers usually signals that a market bottom is nearby, too many call buyers typically indicates a market top is in the making.
When speculation in calls gets too excessive, the put/call ratio will be low.
When investors are bearish and speculation in puts gets excessive, the put/call ratio will be high. A breakout in the skew is even more telling.
Asset Quality in Repos and Money Market FundsIn late 2006 / early 2007 the asset backed commercial paper market was the first warning sign, major money market funds started to shun abcp, this market was screaming "Iceberg Ahead." Its all about convexity, the market with the most convexity (downside vs. upside) is always the first to de-risk.
"Are you long because you like it, or do you like it because you're long?” -Mike Gelband to Dick Fuld November 2006
Investors Intelligence Bullishness / Bearishness Survey When everyone is bullish it's time to take off some risk.
Sour Financials… In 2008, the XLF was severely underperforming, -27%, while SPX was down -13%.
•In 2011, the XLF was again severely underperforming, -5%, while SPX was +6%.
•The same applies if Financials are underperforming in Equities and Credit.
•Flashing Yellow…
High Yield Mutual Fund InflowsAs retail investors with a thirst for yield start piling into high yield bonds in a big way, this is a great contra indicator. In looking a this data in a basket with others and not alone, it helps solve another piece to the puzzle as to when de-risk.
Equity Mutual Fund InflowsBy themselves this contra indicator is not all that helpful. Equity inflows in size can go on for a long time. Extreme high levels of outflows are a good indication of a market bottom.
Safe R (5)Leans R (3)Tossup (8) Leans D (9)Safe D (8)
For control of the Senate, Republicans need to pick up 3-4 seats depending on whether President Obama is reelected. Republicans are likely to lose Maine, and must hold Massachusetts, Nevada, & Arizona. The margin for control is razor-thin.
Sequestration impact will begin to be felt at the start of the 2013 fiscal year, October 1st Debt ceiling resolution in 1Q 2013 will likely mitigate the full impact of spending cuts
Bush Tax Cuts may expire due to Congressional gridlock
Obama will shift focus if he wins a second term from short-term election objectives to long-term legacy objectives
Under current law, the federal government is scheduled to implement a fiscal tightening of unprecedented severity at the start of 2013. Over $400 billion of tax cuts roll off and more than $200 billion of spending declines, near 5% of GDP.
Expiration creates incentives for comprehensive tax reform in 2013 Expiration helps Democrats by allowing them to start negotiations with high revenues
AND by building in a stimulus in 2014 if tax reform succeeds U.S. sovereign credit rating is at risk of further downgrade without evidence of long-term
fiscal sustainability Withholdings from paychecks will go into effect immediately, unless a deal is reached by
year end Increased dividend taxes could increase volatility in income-yielding equities and may
Tax extenders – some provisions may be passed, others are allowed to lapse Uncertainty over 2012 retroactivity
AMT (Alternative Minimum Tax) is patchedPayroll tax holiday expiresUnemployment Insurance – expires or
continues to be reducedDoc Fix – a short-term (3-6 months) deal
Capital Markets Issuer Power & WeaknessIssuers of debt & equity gaining more power over investors is a classic risk indicator. In the spring of 2008, Lehman Brothers was able to issue $6 billion in convertible preferred stock and equity. On the convertible preferred, Lehman was able to get 7% up 35% terms in the public capital markets. Warren Buffett wanted 10% up 10%, he didn't get it as talks broke off. Covenant light deals were extremely popular in late 2007 at the top of the market as well.
Corporate Default RateMoody’s global speculative-grade default rate ended 2007 at 0.91% approximately 48% lower than 2006’s year-end level of 1.74%. The speculative-grade default rate finished the year at its lowest level since 1981 when it came in at 0.70%. The default rate for all Moody’s-rated corporate issuers fell to 0.31% in 2007 from 0.61% in 2006, also over a two-decade low going back to 1981. Danger Will Robinson!
February 4-December 2, 2008February 4-December 2, 2008
February 2-December 2, 2012February 2-December 2, 2012
“VIX Under 18!”
Stocks at New 52 Week Highs and LowsPeaks in NYSE New 52 week lows are a classic buy signal.
The near 2000 all time record after Lehman, hopefully will never be broken.
More telling is the MACD on New Highs / New Lows, when the 50, 100, and 200 day turn negative, it’s a solid sell signal.
+21.49%
+13.93%
From March 31-May 1, 2009, Equities were only +13.93%, compared with HY at +21.49%
Extended periods of High Yield outperformance relative to Equities is very bullish for stocks.
High Yield vs. Equities
The Infamous Last Words…
•“Smart risk management is never putting yourself in a position where you can’t live to fight another day.” –Dick Fuld, Former CEO, Lehman Brothers, April 2008
•“We finished the year, and we reported that we had $17 billion of cash sitting at the bank’s parent company as a liquidity cushion. As the year has gone on, that liquidity cushion has been virtually unchanged.” –Alan Schwartz, Former CEO, Bear Stearns, March 2008
•Just one week before futures brokerage, MF Global, filed for bankruptcy, the firm’s Chief Financial Officer told analysts at Standard & Poor’s that its capital position had “never been stronger.” –Henri Steenkamp, Former CFO, MF Global, October 2011
•“Today I want to send a message of optimism to all Greeks. Our road, our path, will be more stabilized. Our country will be in a better situation. We will be stronger.” –George Papandreou, Former Prime Minister of Greece, July 2009
•“We’re very proud to be part of the Eurozone. But this comes with obligations and it is crucial we show the world we can live up to those obligations. – George Papandreou, Former Prime Minister of Greece, November 2, 2011
•Portugal Prime Minister said that Portuguese bondholders will never face a haircut on their investment as it is happening in Greece, adding the country is doing everything in its power to fulfill all the requirements under its €78 billion bailout program. “Portugal’s debt is perfectly sustainable.” –Pedro Passos Coelho, Prime Minister of Portugal, January 2012
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