$45 Billion in Less Than 1 Second

Today we should all be cheering.  The Dow closed up 121 points — a new (yawn) record high.  But all is not well in stock-land.

Pity poor Anadarko Petroleum Corporation (APC).

At 3:59:59:10 p.m. this afternoon, APC was worth $45 billion.  50 milliseconds later, the company was worthless.  As evidence, I present the following chart courtesy of Bloomberg:


The area circled in red shows the value of APC dropping from over $90/share to $0/share in 50 milliseconds.

Neat trick.

We may laud the great bull market of 2013, cheer the daily all-time highs, and toast the 120% gains achieved since the market’s nadir in 2009.  But when you sweep away all the celebratory confetti, you see a system that is extremely vulnerable.  This flash crash was not in some $2 stock with 32, 000 shares trading each day.  It was Anadarko-freaking-Petroleum — a stock with an average daily volume of nearly 4 million shares.

But, no worries.  I was just notified by DECS that all trades below $87.56 “will be busted.  This decision cannot be appealed.”

Hey!  Why fix the system when you can simply bust trades that occur because your system is a joke.

Speaking of jokes…  Two HFT algorithms walk into a bar…



The POMO Show-mo: If I could animate, it would be in Slow Mo, but that’s a WordPress No-No.

Permanent Open Market Operations.  POMO.

That’s government-speak for the Fed buying gobs of Treasuries and Agency Mortgage-Backed Securities (MBS).

I’ve used this tiny podium in a handful of older posts to present my opinion of the grand experiment known as POMO.  Repeat readers will recall that my pet peeves generally fall into two main categories of fully-intended (but oft-denied) consequences:   1) Financial Repression – punish savers until they move into risk assets, and 2) Market Distortion – levitate the stock market to create a wealth effect and consumer confidence.  As to point #1, it’s self-explanatory and not worthy of much deeper analysis.  As for #2, I’ll let the following graph do the talking.  The orange line is the S&P 500 while the white line is POMO. (Click on chart to enlarge)


Today, however, I’m adding #3.  Witness the mREIT.  An mREIT is a mortgage-based Real Estate Investment Trust.  In simple terms, they borrow money at low rates (usually via repo) and invest the borrowings in higher yielding long-term mortgage securities and profiting from the spread.  mREITS come in two flavors:  Agency mREITS and non-Agency mREITS.

The distinction is huge.  We’ll circle back to it in a minute.

Monetary policy is holding down the cost of short-term borrowing at nearly zero – an advantage in the borrowing costs for both Agency and non-Agency mREITS.  With such cheap borrowing, mREITS have bloated the amount of mortgage assets on their books.  The bloat allows huge dividend payments to mREIT investors – a cool drink of water in an otherwise yield-parched world.   And the short-term kicker for Agency mREIT’s specifically was the amount of Agency MBS the Fed would be purchasing as part of POMO.  To provide some perspective, they will be buying $26 billion this month.  These purchases increase the value of MBS which, in turn, resulted in increases in the stock price of Agency mREIT’s.

What more could a yield seeking investor want?  Big dividends, rising share price, and an implicit government guarantee on the underlying investment.

Then came the AGNC earnings report.  AGNC is a large Agency mREIT.  During the first quarter, AGNC had a huge earnings miss driven by two factors; both of which are related to Fed activity and POMO.  First, the high-priced MBS on AGNC’s books (higher due to POMO buying) tumbled by $837 million ($2.21 per share) as the market began to anticipate an end to QE and POMO due to stronger economic reports.  Second, spreads fell from 1.63% in 4Q2012 to 1.52% this quarter.  Despite the market pricing down MBS, the constant buying by the Fed via POMO continued to compress the spreads.  Viewed YOY, spreads declined from 2.31% in 1Q 2012 to 1.52% as mentioned above.

The impact of these dynamics was further expansion of financial repression.  Investors needing yield who moved into Agency mREITS were delivered these returns for the day:

AGNC                                    -7.3% (it was down 9% at its day low)

NLY                                        -2.6%

CYS                                         -1.5%

ARR                                        -1.7%

And this on a day when the S&P 500 closed up 1.05%

To paraphrase the most interesting man in the world, “I don’t always seek yield, but when I do it’s always hedged.  Stay cautious my friends.” – LL


Tale of Two Euros

The past two weeks of the Cyprus banking crisis have been chaotic at the least, and challenging known economic theory at the worst.  The most recent developments, in my opinion, may be creating the biggest risk the unified currency has faced at any point in this crisis.

The first steps involving “resolving” the banks are exactly as they should be:  Burn up the stockholders, then the bondholders, then the uninsured depositors.  Moral hazard is removed from the equation and risk is compensated in the accepted hierarchy.

The next step, however, is the source of my concern.  That step involves implementing capital controls.

Implementing capital controls is neither a new nor unilaterally negative phenomenon.  Their use has ebbed and flowed throughout history.  They were prevalent during World War I, eased in the years leading up to the rise of the Nazi party, and returned in forms such as the tax imposed by the Nazis on the Jews attempting to leave Germany to avoid oppression.

During John Maynard Keyne’s heyday (the Bretton Woods era), capital controls were widely implemented and were considered a lynchpin in controlling the breakouts of banking crises.  The history of that era would certainly validate that correlation (although not necessarily proving causation).

August 15, 1971 marked the end of Bretton Woods when Nixon abolished the gold standard.  From that point until the most recent financial crisis, capital controls were largely eliminated – first in the developed countries and later in the emerging markets.  Lack of capital controls accelerated globalization while, at the same time, increasing the likelihood of banking crises.

Then came the 2008 financial crisis and the Great Recession.  Suddenly countries pined for the good old days of Bretton Woods – or at least the financial stability capital controls brought to that era.  Keynesian economic policies began being implemented across the West with bond-buying programs and the manufacturing of money being the perceived saviors from the crisis.  Perhaps it was a natural progression, then, that Keyne’s other belief – the usefulness of capital controls – would surface at this time.

Which leads me to my confusion about the controls about to be implemented in Cyprus.

Capital controls don’t exist in a vacuum.  In fact, one model of capital controls involves the idea of the “Impossible Trinity.”  Basically, the Impossible Trinity says that countries desire three fortuitous things:

  • Free capital flows (no capital controls)
  • A fixed exchange rate
  • Sovereignty over monetary policy

The rub, however, is obtaining all three is an impossible trinity.  A country can only have two at the expense of the third.  Graphically, it works like this:


A = Free capital flow and fixed exchange rates; therefore, there will be no sovereignty in monetary policy

B = Free capital flow and sovereignty in monetary policy; therefore, there can be no fixed exchange rate

C = Fixed exchange rate and sovereignty in monetary policy; therefore there will be no free capital flows

Flipping the formula for “C” over, implementing capital controls leaves you with two desirable levers:  Fixing your exchange rate and implementing monetary policy as a sovereign.  Unfortunately for Cyprus, neither of those two desirable levers is at their disposal as part of a unified currency.

I think that puts Cyprus in uncharted territory.  In a way, having no levers puts Cyprus at the full mercy of the decisions made by the monetary union as a whole.  The union has free capital flow (for now) providing it with flexibility in exchange rates and monetary policy.  Cyprus, on the other hand, is now singly focused on stemming the exodus of cash when its banks reopen.  But that cash is denominated in Euros.

By restricting the mobility of Cyprus Euros, do you not create a second class of Euros – those that are mobile and those that are restricted?  And shouldn’t the restricted class of Euro’s be worth less than those maintaining their mobility?  And since Cyprus has no fortuitous levers at its disposal to find equilibrium, won’t this imbalance persist?  And, by the way, doesn’t whole idea violate the European treaty forbidding the use of capital controls by any country within the monetary union?

To me, this is a troubling crack in the facade; both from monetary and a legal perspectives.  History may look back at these “Hail Mary” attempts to save the common currency as the very seeds of its demise.


The Mouse That Roared

By now, most everyone is familiar with the weekend bail-in of the Cyprus banks.  Cyprus…  that little mouse of an island with about 1 million citizens.

From Goldman Sachs, here is a bullet-point summary of the action:

  • Over the weekend, Cyprus and Troika agreed on a rescue package with the following key points:
  • €10 billion total rescue package.
  • A tax on deposits, expected to yield €5.8 billion, which has the following characteristics:
    • 6.7% tax on deposit amounts < €100, 000.
    • 9.9% tax on deposit amounts > €100, 000.
    • Deposit amounts are recorded as of Friday close (March 15) and apply to all deposits in Cypriot Banks in Cyprus (across currencies, type of customer account). They do not apply to customer deposits of Cypriot banks held outside of Cyprus (the two large Cypriot banks both have a presence in the UK, for example).
    • Cypriot bank operations in Greece will be taken over by Greek banks, at no cost to the Greek tax payer. This is important as the large Cypriot banks operate a substantial portion of group assets in Greece.
    • In exchange for the tax, the impacted depositors will be granted shares in the Cypriot banks.
  • Tax changes, where (1) the corporate tax rises to 12.5% from 10% and the income from deposits to be taxed at 20-25%.
  • Bail-in of junior debt is expected to take place, however overall impact is limited by a low balance of outstanding securities.
  • Commitment to downsize local banking sector towards EU average size (in relation to GDP) by 2018.
  • A privatization program which is expected to contribute €1.4 billion.
  • Russia will participate, but to a small extent (exact amount / type unclear).

As a result of these actions, even deposits falling below the deposit insurance maximum will be taking a haircut.  ATM’s in Cyprus are empty and the banks are on holiday until Thursday at the earliest.

General reaction in the media has run the gamut from moral indignation to righteous rage.

  • How can government force savers to disgorge a large chunk of their savings?
  • What do you have left when the rule of law can be overturned by edict?
  • What are the implications for property rights of the individual?
  • How can we accept this financial repression of middle and lower class savers?

Feel sorry for the Cypriots.

Except the above questions were not intended to apply only to Cyprus.  They should have been asked years ago when the US Federal Reserve decided to hold interest rates at zero.

Zero nominal rates means negative real rates; forcing savers to disgorge their savings to inflation.  Artificially forcing interest rates to zero is an edict by an unelected central bank.  Hardly the rule of law.  And what are the implications for property rights when inflation backhandedly chips away at your property’s value? Finally, here, in the good-ol’ US it is the lower and middle class saver that is being financially repressed by being paid nothing on their savings.  Think of the retiree trying to make his savings last for the rest of his life.

I somehow missed the moral indignation and righteous rage when these policies were implemented on our shores.

I guess if you implement financial repression quietly and over time, few people notice or care.  Yet, if you overtly and immediately bring about the repression, you make global headlines and become the target of global derision.

So Cyprus is the mouse that roared.

Pay no attention to the whispering gorilla.


Of Hydrogen and Stupidity

It’s been said the two most common elements in the universe are hydrogen and stupidity; and stupidity has a longer half-life.  Not being a scientist, I’ll withhold comment on the 1937 zeppelin reducer.  Sitting in an office that plays CNBC all day, however, I can certainly attest to the widespread availability of stupidity.

This is the channel featuring pundit after pundit bleating out priceless nuggets like “at the end of the day, ” “fiscal cliff, ” and “wall of worry.”  If it weren’t for the cliché’s (and the constantly running ad in which a guy dramatically impales his eardrum with a Q-tip) the programming day would be about 90 minutes long.

But, during those 90 minutes, we’d be treated to some of the most repeated and inaccurate comments imaginable.  During the past few weeks, the topic du jour has been a listing of the reasons the market rally will continue.

 1.      “There is a ton of cash on the sidelines.”

This is commonly cited as a catalyst for increasing stock prices.  While there may be 2, 000 pounds of cash on the wrong side of the chalk line, its existence alone is… well… meaningless.  To make the point, follow this example:

Let’s assume that the entire stock market is made up of three people.  Here are their current holdings:

  • Andy holds $450 in cash
  • Billy holds $451 in cash
  • Carl holds 1 share of Apple (AAPL)

That means our market contains $901 in cash and 1 share AAPL.

Both Andy and Billy want to buy a share of AAPL.  Carl sells his share to the highest bidder, Billy, and collects $451.  Once the trade is completed, our investors hold the following positions:

  • Andy holds $450 in cash
  • Billy holds 1 share of Apple (AAPL)
  • Carl holds $451 in cash

$901 remains on the “sidelines” and 1 share of AAPL rounds out our market.

Look familiar?

There is an identical amount of cash on the sidelines after the transaction as there was before the transaction.  The only difference is that the holders of the sideline cash have changed.

What matters is not solely the amount of cash available for investment (with the exception of initial and secondary offerings), but the velocity in which the cash moves from person to person.  In other words, inflation in security prices is driven by the same factors that drive overall economic inflation:  

Money Supply x Velocity = Inflation

 As our national economy is illustrating so well, money supply can be increased indefinitely, but if velocity is zero, inflation is zero.  Stock prices are driven higher when a group of buyers look to increase the velocity of the cash they hold.  As velocity increases per unit of cash, prices inflate.

  2.      “Retail participation in the stock market is far below what it was in the 1990’s.”

While this statement is unquestionably accurate on its face, the implication that the participation deficit creates room for the markets to grow is misleading.  Here’s why:

  • Baby Boomers:  People born between 1946 and 1964 are typically defined as Baby Boomers.  In 1999, the oldest Boomers were 53 and the youngest were 35.  Arguably, this giant population bulge was smack-dab in the middle of the investment phase of their lives.  Presently, that population spans ages 49 to 67.  At that age demographic, particularly post-crisis, it is likely that the Boomer appetite for equities has diminished at least as much as their appetite for Big Macs.
  • Generation X:  people born during the 1960’s and 1970’s constitute this class.  Gen X arrived at the investment phase of their lives right between 2000 and 2010.  From January 2000 through January 2013, the stock market (S&P 500) has delivered a 0.15% annualized return with two major collapses (the worst being 52.6% peak to trough).  This is a generation that has never seen wealth accumulated via the stock market, yet they witnessed the near collapse of the global financial system.  Many lost their jobs as a consequence.    Convincing this generation that buying stocks is a good idea is a very tall task, indeed.
  • Pensions:  In the 1990’s, defined benefit pension plans were prolific – assuring a steady and predictable flow of cash into equity markets.  In the 20-odd years since, defined contribution plans (like 401(k)’s) have become a much larger share of the retirement savings market.  Participation in these plans is voluntary and the allocation to equities is up to the individual investor.    This problem is compounded with high unemployment and low participation rates constraining the number of plan participants.  Circling back to Gen X, it is unlikely we’ll see contribution levels like those that existed in the 1990’s.
  • Lower levels of personal wealth:  After the financial crisis and housing collapse, personal net worth in the aggregate has taken a massive hit.  And while the stock market has regained all of its 2007 – 2008 losses, it is unlikely that equity investors’ en masse held on through the bad years in order to fully participate in the recovery.  More likely, they sold out on the way down and failed to reinvest on the way back up.

 The evidence?

 There is a ton of cash on the sidelines.

  3.       “We are witnessing a rotation out of bonds and into stocks.”

This is the first derivative of “There is a ton of money on the sidelines.”  In the interest of time, I won’t go through the entire example, but here is how it sets up:

  •  Andy holds $450 in cash
  • Billy holds $451 in cash
  • Carl holds 1 share of Apple (AAPL)
  • Dave holds 1 Treasury Bond

No matter who sells what to whom else, the owners change but the market remains the same.


If I’m forced to hear these memes too many more times, I may very well impale my own eardrums…  if for only the sake of my sanity.