Wild Price Swings Could Implode Hedge Funds

I guess nobody has missed the wild swings during the first weeks of 2008 in the prices of just about everything that can be traded.

• S&P 500 stock index from 1471 down to 1388 up again to 1429 down again to 1270 up again to 1396 down again to 1317. A span of about 16%.
  
• Crude oil from 95 up to 100 down again to 86 up again to 92 down again to 87 $/barrel. A span of about 16%.
  
• Gold from 840 up to 912 down again to 860 up again to 930 down again to 885 $/oz. A span of about 11%.
• 10 year US treasury note yield from 4.05% down to 3.28% up again to 3.74% down again to 3.53% up again today to 3.74%.
• And so on...

These wild swings in prices of equities and commodities have been very hard to predict. Now, hedge funds all around the world are making bets all the time on the direction that certain prices will take, and these bets are often highly leveraged (i.e. they borrowed a lot of money to bet). This means that a number of hedge funds have probably made bad bets over the last few weeks, some of them maybe bad enough to "implode" the fund, because prices have quickly and unexpectedly moved in the "wrong" direction. So I predict that we will soon see a number of hedge fund failures, and some of them might be rather spectacular.
We have already seen an example of what can happen when big trades go wrong in the case of the "rogue trader" at the French bank Société Générale. The losses in this case were about €4.9 billion, enough to topple most hedge funds.

Oil and Other Commodity Prices

I haven't had time to write for a while, but now I'm back with this year's first post.

One of my favourite bloggers, Stefan Karlsson, wrote about rising commodity prices today. I feel I have to comment on what he said, but since this comment is much longer than his blog post, I post it here on my own blog instead.

Stefan says "anyone who tells you that the commodity price boom reflects the alleged 'peak oil' doesn't know what they're talking about". I would instead say they are parallel developments.

Now why does Stefan say "alleged" peak oil? Isn't Stefan Karlsson convinced yet about the imminence of peak oil? I'm not saying he has to believe all the doomer stuff you can read on many peak oil sites, but I do hope he has read enough facts to understand that peak oil is here, and will most probably have profound effects on our lives.

In my opinion, the oil price does (partly) reflect "peak oil", because demand has outpaced supply. Take a look at the second chart at http://oljepris.se/statistik and you will see that world production has been essentially flat since April 2005, after rising until then. Many experts who have studied oil production, e.g. Matt Simmons, argue convincingly that the world has passed peak oil and is now on a "plateau" of oil production. Even if the peak is a number of years away, most of the "easy" oil is already taken out of the ground. What is left is (on average) much harder to extract (e.g. in remote regions, have to use more advanced techniques to extract, under deep seas etc). Extracting a barrel of oil on average costs much more now than 10 years ago. There are also other factors involved in oil prices, e.g. military conflicts etc. But price action alone does not refute the fact of "peak oil". Not even when compared to other commodity prices.

But peak oil definitely plays a strong part in oil prices. The inability to increase production in spite of rising demand and sharply rising prices over several years confirms this. If you want more detailed analysis of peak oil, you can get all the information you want (and more) from The Oil Drum and Energy Bulletin.

So why have other commodities shown strong price gains too?

1. Just like for oil, demand has outpaced supply for many commodities (e.g. metals). Starting up new mines is a long process. It takes years of prospecting, government permits etc. The global economic boom of the last few years seems to have caught miners by surprise, with a demand for commodities that by far exceeded most predictions (remember, most "predictors" are notably bad at predicting things like this in advance).
2. Many other commodities are probably also near their global production peaks, e.g. platinum. The production of any finite resource can be Hubbert linearised to get an approximation of the production curve. A notable example of "peaked" commodities is uranium. Just take a look at a graph of global production and you will see that global production seems to have peaked in 1980, and since 1985 the shortfall in production has been made up by using military stockpiles (see for example the chart at the bottom of this article). The price action of uranium over the last few years confirms this situation.
3. Just like for oil, the "best" ores for other commodities have been extracted first. Take the example of copper. When copper was first discovered during the stone age, naturally occuring pure copper was used. Then somebody discovered how to extract copper from certain ores, and the best ores were mined first. Gradually over the years, ores with lower and lower percentage grades of copper have been mined. During the last century we have rapidly mined our way through most of the good ores for most commodities, at a pace never seen before in history.
4. As for food prices, we seem to have reached "peak food" rather close to "peak oil". It seems that the world is simply not capable of producing more food simply for reasons of ecological limits. Global grain stockpiles are now at something like 27-year lows. And population still growing. And demanding more and better food.
5. Increased affluence among large parts of the world's population has created a stronger demand for everything from meat to diesel to microwave ovens. This is actually strongly connected to number 1 above.
6. Food prices have become (loosely) connected to oil prices because of the grain-to-ethanol boom.
   

Now, even if we have passed "peak oil" (which I believe we have), that does not mean that oil prices cannot sink from current levels. Since the margins for world oil supply are so tight today, small differences in production or demand make big differences in price. With the coming recession, I think we will see a lot of "demand destruction", as it is euphemistically called. I therefore guess that oil prices will decline substantially later this year. $65/barrel is not impossible. This is of course blasphemy to many of my fellow "peak oilers", most of whom seem to be convinced that we will see $150 or $200 per barrel oil soon. But I predict that "demand destruction" over 1-2 years will be faster than production declines. Of course a swift economic downturn might also have a similar effect on many other commodities. Though not uranium, I suppose, because nuclear reactors will not be shut down, even if we have an economic crisis.

First Card of the CDS Game - ACA Downgraded to Junk

Now the whole house of cards built from Credit Default Swaps (CDS) is starting to come down. Yesterday the credit insurer ACA had its credit rating by Standard & Poor's cut all the way from "A" to "CCC". As I said last Friday the New York Stock Exchange announced they would delist them, so today's news was rather expected. A credit rating of "CCC" essentially means "bankrupt". This means that all the bonds they insured get their credit ratings lowered, and there will be big writedowns and maybe forced sales. Now we'll get to know who's been doing business with ACA. Canadian bank CIBC came out straight away and said that they have "insured" $3.5 billion of subprime loans with ACA. I suspect Merrill Lynch and Bear Stearns are feeling the heat too, because they have discussed "bailing out" ACA (to save themselves, I suppose). Even if this is possible, which I doubt, it would probably cost them billions. Then what happens when they have to bail out the next credit insurer that goes bust. FGIC, MBIA and Ambac are good candidates for this.
I started writing this post yesterday - and sure enough here we go today (the day after their AAA rating was affirmed by S&P) MBIA comes out and says that they "insured $8.1 billion of so-called CDOs-squared, which repackage other CDOs and securities linked to subprime mortgages". For those who don't know, CDO-squareds are considered very risky.
Things seem to be happening very quickly right now. What next? Will things quieten down over Christmas, or will we see more problems building up every day?

Potential problems in the CDS markets is something I mentioned already in my first post in August. Now it's starting to get serious.

The moral of the story is:
No insurance is safer than the insurance company itself!

Credit Insurers in Trouble

Reuters reports today that ACA Capital Holdings will be delisted by the New York Stock Exchange. ACA "provides financial guaranty insurance products to participants in the global credit derivatives markets, structured finance capital markets and municipal finance capital markets." In other words, it is a "monoline" credit insurer, just like MBIA and Ambac, that I have mentioned before on my "black list". ACA's shares have fallen from about $15 in June to about $0.50 today. Their latest economic report (from September 2007) is rather interesting - a net loss of about $-1 billion for the last quarter - total equity now about $-0.88 billion - meaning they are essentially bankrupt. The interesting thing is they have "insured" about $68 billion of "collateralized debt obligations" (CDOs), a form of repackaged debt. Now all that "insurance" is basically worthless. Who owns on all those "insured" CDOs? How did a company that had about $6 billion in total assets at the end of 2006 get to "insure" more than ten times as much in debt? It doesn't take a very high default rate on the underlying loans to erase the company. And who was stupid enough to pay for "insurance" from them? And by how many billions of dollars will they have to write their CDO assets down?
Now ACA is a comparatively small player in the CDS field. Ambac is one of the two biggest "monolines", and yesterday Bloomberg reported that Ambac reinsures $29 billion with Assured Guaranty Ltd., to "avoid the crippling loss of its AAA credit rating". On 5 December, Moody's basically gave Ambac and MBIA two weeks to raise more money or risk a credit rating downgrade. Ambac "guarantees" a mind-boggling $556 billion of securities, with total assets of only $22 billion and total equity of only $5.6 billion (as of September economic report). And they are losing money ($0.36 billion last quarter - I expect much more this quarter, cf. estimates for MBIA below). The deal with Assured Guaranty doesn't really change that much for Ambac - the riskiest debts are not included in the deal. And Ambac have so far not managed to raise any more money.
MBIA seems to be slightly better off - they managed to raise $1 billion from Warburg Pincus. MBIA "guarantees" $652 billion of securities, but their financial status is stronger than Ambac's - $45 billion in total assets, $6.5 billion in total equity and only lost $37 million last quarter. However, Barclays Capital expects MBIA to post losses of between $2.3 billion and $4.2 billion, which would of course make their financial situation precarious to say the least.
Now the string of credit insurers going bust seems to have started with ACA, and I expect Ambac to follow within a few months. MBIA could survive a year, perhaps. Some people might even think this is optimistic. According to Bloomberg "If all the companies were to falter, $2.4 trillion of insured securities would be thrown into doubt, costing as much as $200 billion". My guess is that cost is underestimated, as with all costs so far in this credit mess. However, the biggest risk if the credit insurers falter is that many of those who now hold the "insured" debt are only allowed to hold investment grade rated debt, or have a maximum percentage of non-investment grade debt that they may hold. This means that they would have to sell the "insured" debt if the insurers fail or are downgraded. This sudden selling would lead to lower prices for these classes of debt, thereby increasing losses, if buyers can be find at all in these frozen credit markets.
Ironically, Ambac announced yesterday that "International Securitisation Report (ISR) has named Ambac Monoline Insurer of the Year". Wow! Sounds really great, doesn't it? And it gets better: "Ambac has had an active year closing many noteworthy transactions. This award underscores the company's ability to use our in-depth knowledge and expertise to help issuers and financial advisors structure innovative transactions across a diverse range of asset classes and jurisdictions." It's a pity this award comes just as they seem to be on the brink of bankruptcy.

Norwegian Oil Production

The Norwegian Finance Minister Kristin Halvorsen is quoted today by Verdens Gang as saying "our oil can become worthless" because of "climate taxes" on burnt oil. She said this in Bali, where she flew for the climate meeting. Of course this climate meeting burns loads of fossil fuels just to get all the politicians there. But I suppose it is important that they get to discuss this, and shine a bit in the press before reality comes swooping in and they can't fly that much or that far any more. Later a spokesman for Halvorsen denied "considering cutting oil production for environmental concerns" and that "There is nothing in the government (program) declaration about a reduction in the pace of production" and "it was not an problematic issue".
However, reality says that the pace of oil production in Norway is problematic. Today Norway is the world's fifth largest oil exporter, pumping roughly 2.4 million barrels per day. However, production has fallen sharply since the top around the year 2000, and is not likely to reverse that trend. So even though what Kristin Halvorsen said was a bit confused, it is likely that they will have to use some kind of cover-up for why they are reducing their oil production.
Also, implying that their oil will become worth less in the future is pure nonsense. With world oil production probably in permanent decline, the remaining oil will on average just become worth more and more. Of course prices will jump up and down, depending on economic factors, but the main price trend for oil is up. It might even make sense for some big producer countries to voluntarily reduce their production in order to boost the price, thereby making even more money in the long run, and saving some of their reserves for hard times. So far, however, nobody seems interested in doing this, but time will tell whether we will see such policies in the future.

Shanghai Bubble Finally Bursting?

As I have mentioned before, the Shanghai Stock Exchange has had one of the biggest bubbles in history over the last two years. The SSEC index has gone up from a low of 1067 on 28 October 2005 to a high of 6124 on 16 October 2007, an increase of 474% over less than two years!

Click the graph for a larger version.
Since then it has declined to close at 4861 on 27 November. Is this drop of more than 20% the popping of the bubble, or just another false alarm? There have been two previous big scares for Chinese investors this year, the first one in February-March, the second one in June-July, but the Shanghai Stock Exchange recovered from both of them and kept on chugging upwards. However, this latest drop is bigger (percentage-wise) than any of the previous two. If it continues, we could very well see one of the most epic stock market crashes in history.

Internet Bubble Version 2.0

Don't think the Internet bubble of 1999-2000 scared all investors away from hyperinflated Internet stocks. I'm thinking of for instance Google, currently trading at $660 per share. Alright, down a good bit from the top of $742 two weeks ago, but still dizzyingly high at a price/earnings of about 52. This means that if they manage to keep their earnings as high as now and give all of their earnings back to their shareholders (which they of course don't), it would take about 52 years for a shareholder to get his money back in dividend. Now, what if earnings start dropping, with a recession coming on? Other Internet bubble stocks right now are Amazon, with a price/earnings of about 93 (!) and Yahoo, with a price/earnings of about 50. Price/earnings this high of course means that the markets expect the earnings to increase, but just how many more advertisers want to advertise with Google or Yahoo? Or are they going to pay more for advertising there? And how many more books and CDs can Amazon sell per year? Or are they going to take higher profit margins on each sold book?
For comparison, Microsoft and Cisco both have a p/e of 22, which is still considered to be on the high side. How long would you like to wait to get your invested money back? 22 years? Make that 10 and it starts to sound like a reasonable investment.