Some more links on the faltering of the US housing market (or "bubble" as some people have it):

Via Calculated Risk, the Wall Street Journal notices that the supply of money for subprime mortgages is drying up. (See last week's post on property CDOs.) HSBC has sacked two senior US executives, which the Australian traces to the bank's losses on its subprime portfolio. And Nouriel Roubini rounds up a list of last week's (gloomy) news on the ABX decline.

Is this going to be limited to a single sector, or is it the trigger for a general downturn in the US? Is it unexpectedly sudden - and if so, so what?

The extremely high-powered President's Working Group on Financial Markets has taken a look at the private investment business and concluded that everything is just fine - no need for more regulation. The onus is on the investors to be careful about where they stick their necks.
Also in today, an analysis (pdf) of why hedge funds fail, with advice on which areas should receive particular scrutiny. (Fraud, basically.)

As for what happens when the principle of caveat emptor meets the real world, James Hamilton at Econbrowser has taken a look at one of the investors in Amaranth - the San Diego County Employees' Retirement Association, which ended up over $200 million in the hole. Worth a read.

"From my point of view, as a French speaker", a Johannesburg-based banker told me rather plaintively last week, "it is very strange to see all the economy in Africa led from the south, rather than the [francophone] west and north." Strange but true: in equity terms, it is South Africa first and the rest nowhere.
Attracting foreign investment to Africa has often been seen as a good development tactic - but we may have been going about it the wrong way. In a paper published by the Centre for Global Development (via Economonitor), Todd Moss and colleagues point out that there is no need to postulate a market failure to explain the lack of foreign investment in African stocks - the country's markets are just too small and too illiquid to attract much more investment.
This is bad news for the investment-push school of development economics - if there were a market failure, at least it could be corrected. Instead the answer seems to lie with South Africa - channelling investment through the region's economic superpower into the rest of the frontier markets, and using the successful Johannesburg exchange to list more companies from other African nations.

In the forthcoming March issue, Risk will again focus on South Africa: see our last South Africa supplement from October 2006.

Nothing good, apparently. Dresdner Kleinwort is unhappy about the prospect of CDOs based on US home equity loans being repriced. Joseph Mason and Joshua Rosner (via Economonitor) are even more unhappy, and at far greater length (pdf).
The CDO market has become crucial to mortgage providers - although it only supplies a small share of the funding, that share is highly leveraged and crucial to the overall mortgage-backed securities busines. No CDOs means more expensive MBS and more expensive mortgages - which means decline in the construction business and overall economic downturn.
And CDO funding is terribly fickle - already mortgage lenders, who kept volume up last year by taking on riskier loans, are seeing a wave of defaults which could easily scare off the CDOs.

Interesting discussion, too, at the Hudson Institute, which published the paper.

I've been looking at the carry trade for our forthcoming South African supplement, and it's an interesting area. There's a particular worry over what could be about to happen to the yen - if Japanese interest rates go up, or if the yen appreciates for some other reason, a vast amount of carry trade positions could be unwound suddenly. Result: possible chaos, Nouriel Roubini predicts - as the positions are dumped, leverage collapses, turbulence, global recession, divers alarums.
Or, possibly, Reuters says, not.

Both these forecasts make the point that the 1998 crisis involved the yen carry trade as a central element - one forecast dismisses the similarity, the other emphasises it. Is the trade a risk-amplifying practice that will help tip us over the edge of the next financial crisis? And if so, what if anything can be done about it? The carry trade is notoriously difficult to regulate or even to monitor.

SIDENOTE: an open question for the weekend: what's the biggest single source of financial risk that can't be hedged with market instruments, and how could you hedge it? I'm going for liquidity risk - could you construct an event swap that triggered in the event of low liquidity on another market? How would you measure liquidity? - but what are your thoughts? I've opened a Forum thread on this one here.

Moving on (finally) from hedge funds to the other major source of gloom - global warming. The CME is preparing to launch hurricane futures, based on a new index of hurricane size and speed which it says is superior to the old Cat 1-5 system we all got to know so well during Hurricane Katrina.
Last year, you may remember, HedgeStreet tried something similar - the contracts aren't listed any more, presumably because the 2006 hurricane season was actually fairly quiet and there wasn't enough volume traded.
(UPDATE: I've looked into this a little more now - the season was pretty quiet, but HedgeStreet will be listing the contracts again this year. I'll write about this in more detail soon.)
Those were based directly on the amount of damage done, as assessed by the US insurance industry.

In general, weather derivatives seem like a terrific idea. Hurricanes, like other extreme weather events, kill far fewer people in the industrialised West than elsewhere in the world for the same severity of event, but they cause much more damage in financial terms, simply because, to put it crudely, there is more expensive stuff to break. (And more every year - the damage done by a hurricane of a given size increases 2.5% every year, as more and more infrastructure is built on the coastline.)

So it's not just that a hurricane risk market will help insurers on the US east coast; once the markets have been developed and the risks ironed out, the technology can and should be transferred elsewhere, to help insulate poorer economies against the risks of, for example, cyclones and floods. This would be a great place for international organisations like the World Bank and prominent aid NGOs to get involved - as the WFP has already in the Horn of Africa. Hurricanes/cyclones strike me as a good place to start - reliable windspeed and size data is more easily available from satellites than it is for, say, rainfall.

It's not my intention to jab at hedge funds every day, but this rather attracted my attention: an article outlining why the hedge fund bubble is close to popping, with reference to previous bubbles (chiefly 1929 and 1999). Four sensible if non-quantitative points - IPOs are attracting hysterical interest, the general obsession with hedge funds is growing, etc - followed by this:

Television shows are often excellent signs that a bubble is popping. In 2000, Darren Star, who had developed the zeitgeist-capturing show Sex and the City for HBO, rolled out The $treet on Fox, a show that chronicled the hot goings-on at a brokerage firm. It was canceled a few months later, when the American public suddenly fell out of love with stocks... Now, Doug Ellin, who developed Entourage for HBO, is making another HBO series based on a hedge fund.

Meanwhile, Lars Toomre remains on top of yesterday's liquidity risk story, continuing to argue that hedge fund returns are not sustainable.

Via Lars Toomre and FT Alphaville: over the weekend a report from Dresdner Kleinwort has leaked its way onto the internet, predicting what its authors call "the Great Unwind". (Possibly "the Great Unwinding" would have been more grammatical; but never mind.) The kernel of the argument is this:

"A clear majority of hedge funds can be thought of as leveraged sellers of deep-out-of-the-money put options. They employ long-short strategies - removing market risk with what are essentially spread or arbitrage bets with a relatively low return. To boost returns they employ extensive leverage. These spread positions do produce what look like low-risk returns most of the time — but, once in a blue moon, what are effectively options written by the hedge funds will get called. Think LTCM."

This is basically a no-free-lunch analysis of the hedge fund industry. Returns seem to be abnormally high - what's the secret downside? The answer, the authors suggest, is non-apparent correlation risk, liquidity risk, and tail risk. In other words, the big crash will be far more serious for hedge funds than prices indicate - but the fund managers are forced to take these risks, amplified by leverage in order to meet their investors' expectations for profit and their own management fees.

Lars Toomre makes another good point:

Do not readers already know how dependent the large investment banks have become both reliant on and very much like the hedge fund and private equity industries? A substantial portion of the investment banks' profits -- in new and highly profitable businesses like prime brokerage, mortgage-backed securities, credit default swaps, equity derivatives and investment banking fees from private equity funds -- are a direct result of the growth of hedge funds and other alternative investment funds.

In other words, a hedge fund crisis would hit banks very, very hard indeed.

So what are we in at the moment? It looks as though we're in a race - either hedge funds will cool off and become less fashionable, as their tactics spread across the industry and investors start to be more conscious of the difference between good and average managers;

or there'll be a credit crunch, and lots of hedge funds will go under and take a lot of the rest of the financial services industry with them.

with Merrill Lynch unveiling an automated index intended to reproduce a volatility arbitrage strategy on the S&P 500, as used by several hedge funds, but - key point here - without having to pay great big fees to hedge fund managers. Full report here. The bank says it has more indexes, covering other cross-asset-class strategies, in the pipeline for later this year.

A couple of points: first, obviously, good news for investors, bad news for hedge fund managers, who will see cheap ETFs based on these and similar automatic strategies taking away their backers; second, this is going to continue the erosion of the boundary between hedge funds and other sorts of (supposedly more conservative) funds by making hedge-fund-ish strategies more easily accessible. People like the ECB, who are trying to put especially tough regulations in place on hedge funds, are going to find it ever more difficult to draw the line.

The pessimistic view of global warming from Robert Samuelson - even now the problem has been recognised, it's still too expensive to do anything meaningful about it.

But there was a more optimistic view from Barclays Capital's Tim Bond yesterday, when I dropped in on the launch of the bank's annual Equity-Gilt Study. He pointed out the International Energy Agency's estimate that the next thirty years will need to see a 50% increase in energy generation capacity, at a cost of $20 trillion (in 2000 dollars). As well, the world will need to reduce its reliance on fossil fuels, which currently supply 80% of energy. (These two tasks overlap to a certain extent; half that $20 trillion represents replacing worn-out infrastructure, which in a lot of cases could mean substituting clean nuclear or renewable sources).
There are no new sources of oil to be found. Continued dependence on fossil fuels will mean continually higher prices - a conclusion borne out by the shapes of the forward curves for the fuels, which are deeply in contango and have been for some time. Clearly no one expects the oil market to slacken soon. Clean energy is backwardated, which Bond interprets as showing that no one expects demand to pick up much - it could also represent an anticipated increase in supply, but that's less likely.
At the moment, there still isn't a clear enough policy environment on clean energy; the EU's emissions trading scheme comes to an end in 2012, far too soon in planning terms, and the US has yet to decide on anything. (At this point Bond, in a rather bemused way, pointed out that things have improved now that the party that actually believes global warming is happening is in control of Congress. 80% of conservative Republicans don't believe in human-caused climate change, a group which until recently included the chairman of the Senate environment committee!)

Bond got really optimistic, however, talking about the benefits. He compared the coming decade to the 1970s, when the energy crunch meant that almost the only sector to make good returns the energy sector. The same will be true again - but that doesn't mean we'll see the same economic stagnation, he says. "Every major technological change was accompanied or followed by faster economic growth", and the railway and IT booms will be emulated by the coming clean energy boom, he predicts.

I confess I'm slightly less optimistic; after all, cleaning up energy production will have an element of the broken-windows approach to it, with regulation rather than market forces compelling spending. Though as energy prices rise - and returns focus on energy - market forces will come into line.

Mark Thoma has more links, including the Chinese government very helpfully sticking in its oar in its usual emollient and diplomatic style.

The New York Times reports that the SEC has launched a large-scale trawl for insider trading on the New York markets. Reportedly, mutual fund managers have been complaining that their brokers are conspiring with hedge funds to front-run their deals. The novelty is that the SEC isn't looking at one suspicious trade: it's pulled in all trading data for the stock and derivatives markets for the two weeks before the end of quarter in September last year. This will be a massive data mining exercise, but it's more likely to catch more exotic insider trades - the credit derivatives market in particular has come under scrutiny in the past.
In Britain, the FSA started to look at this last year.

Hedge funds are in worse shape that you thought - thus a report from Deloitte & Touche (see the entry on Risk News). Normally with fairly small staff headcounts, hedge funds have been skimping on risk management, failing to run proper stress tests or implement concentration limits, and generally exposing themselves to far too much risk. The report lists nine risk management red flags calling for urgent action; at least 50% of the hedge fund managers it studied have at least one flag showing.

It's all very well arguing that this is just the downside of their being the racy, daring, high-alpha-generating predators that they are - but, really, they aren't all that. Hedge fund returns have been falling for some time, and papers like this one are just going to make more people ask the two questions that hedge fund managers least like to hear: why, exactly, should I give you any of my money to invest; and why, exactly, should you get to keep so much of it?

According to the FT this morning, quoting a report from Tabb Group, 10% of all US equity trades last year went through private platforms - and the use of these "dark pools" is going to continue to grow. We've covered this before, with interbank developments such as Project Turquoise seeking to compete with existing exchanges.
Now, there's a good argument for this on commercial grounds - cheaper matching of orders, faster processing, avoiding exchange fees and so on. But there are a couple of real conceptual problems as well.
First, conflicts of interest. The great thing about stock markets is that they are neutral - the LSE doesn't really care who trades with whom at what price, as long as it gets its fees. But if a bank sets up an exchange, some of the biggest traders on the exchange will also be the bank's biggest customers in other areas. This is a massive conflict of interest situation. Remember what happened in the 1990s when investment banks noticed that their equity research divisions could be used as a marketing tool? Imagine using execution speeds and pricing for the same purpose.
Second, there's the problem of oversight. It's a lot easier, as the FSA points out in the FT article, to watch one exchange than six - a handful of small exchanges provide more room for fraud and market abuse. At the very least, regulators will need to grow to match their new responsibilities.

Yes, say Nigerians: the local money market association reckons that, as well as the obvious benefits for farmers and the raw materials industry (especially important in Nigeria, which is basically an agro/raw materials economy), a robust derivatives market would help stabilise the financial system and boost savings and investment rates. The NSE doesn't list any yet, but is considering them, according to its last annual report.

Maybe not, say Indians: there are rumours that futures trading in staples like wheat and sugar could be banned in order to reduce prices and keep inflation under control. (Vocabulary note: urad and tur, mentioned in the article, are black lentils and split peas respectively; jeera is the Hindi for the spice cumin.) The NCDEX says that "there has been no decision per se - just speculation" on banning the trade, but the exchange will issue no new wheat or rice contracts until further notice.

It seems like a retrograde step - crop futures are the oldest financial instrument around, and have proved their worth in stabilising prices (and the Indian trade was tiny anyway). And

If you haven't seen it already, read this in the FT. Columnist Tony Jackson, after defending the private equity industry against charges of job-cutting ("not necessarily harmful" is his rather entertaining judgement) and opacity, turns on its use of credit default swaps.

it is perfectly possible for private equity to load a company with excess debt, then strip the cash out as a dividend. If this is done on a big enough scale, the fund can profit handsomely even if the company goes bust.
In previous cycles, there was an obvious safeguard against this: the banks would not lend more than a company could bear. But that has all changed with the advent of credit derivatives.
Today, a bank can grant a leveraged loan with impunity, since it can offload the credit risk...