Saturday, June 11, 2005
MDL borrowed $7 billion?!?!?! More heads to roll
Today's news seems to provide further evidence to support our theory that in the Mark Lay/Terry Gasper (MDL and BWC CFO, respectively) investment scheme, the only way to account for the size of the loss they incurred with their hedge ($215 million) was if they created a "pyramid" of short bond positions.
In yesterday's post, we offered the following scenario:
That fact that some two-bit (in the world of finance) fund manager could expose the State of Ohio to a multi-billion dollar liability for a loan is unfathomable and probably illegal. With this turn of events, the resignation of Conrad and the handful of others is going to turn into a parade of pols and political hacks that should (and will) be forced out of office and likely put behind bars.
The admission that they borrowed at least $3.5 billion suggests that they may have 10 or more layers to their pyramid.
Questions for reporters:
For eager beavers - try googling "Value At Risk."
In yesterday's post, we offered the following scenario:
- MDL/BWC believed that medium and long-term bond prices would rise due to increases in rates by the Federal Reserve
- Based on this belief, MDL/BWC liquidated its long bond positions and used the proceeds to purchase short bond positions
- MDL/BWC used these short positions to engage in an extremely risky gambit. They used these investments as collateral to borrow funds to purchase additional short positions, and repeated this cycle through many iterations. The purpose of leveraging the original short positions was to take advantage of the characteristic of "duration" that applies to bonds and that directly influence the return of bonds. Leveraging changes the effective duration of bonds.
- Lay and Gasper's belief turns out to be wrong: medium and long-term bond rates do not rise significantly. MDL/BWC have to settle their short positions, which because of excessive leveraging, create of loss of $215 million.
But in 2003, former bureau Chief Financial Officer Terrence Gasper signed what the bureau has called an unauthorized contract at MDL's request to engage in riskier borrowing and bond-selling as a "hedge" against rising interest rates.But we think the Dispatch and others buried the lede, because you have to get half way through the story to get to the revelation that:
Petro said the MDL Active Duration Fund far exceeded its borrowing limit which the bureau's financial consultant has said accounted for 85 percent of the losses then "lied about it to the bureau."
James McLean, the bureaus chief investment officer, has said MDL was authorized to borrow up to $150 million but actually borrowed between $3.5 billion and $7 billion before the investment was ended last fall.Holy shit! $3.5 billion to $7 billion??? How is the possible?
That fact that some two-bit (in the world of finance) fund manager could expose the State of Ohio to a multi-billion dollar liability for a loan is unfathomable and probably illegal. With this turn of events, the resignation of Conrad and the handful of others is going to turn into a parade of pols and political hacks that should (and will) be forced out of office and likely put behind bars.
The admission that they borrowed at least $3.5 billion suggests that they may have 10 or more layers to their pyramid.
Questions for reporters:
- Who loaned MDL the money?
- Does the loaning entity(s) have any political connections?
- What did MDL present as the basis of the loans?
- What were the conditions of the loan?
- Will BWC release a copy of the loan documents?
- Who signed the loan documents?
- Has the loan been totally repaid?
For eager beavers - try googling "Value At Risk."
Friday, June 10, 2005
MDL losses reveal deeper, broader fund problems
The reporting on the revelations of the $215 million losses racked up by MDL for BWC have been an eye-opener for a lot of folks, but there is much more - outside of the political shenanigans that seem to be behind some of this - to this than meets the eye.
First, some of the reporting on MDL has been a little flawed. Specifially, we think it may be wrong to call MDL or what it created a "hedge fund."
Hedging 101
Hedge funds, at least in their normal business usage, are like a mutual fund that tend to be concentrated in derivative investments. In brief, derivatives - like equities - are based on some underlying asset, but are really based on either a component of the asset or based on a bet that the asset is going to move in a certain direction. Derivative markets were created to allow businesses to "hedge" their business bets. Stock "options" are a form of a derivative. So are "short" positions, "futures" and "forward" contracts. There are many, many types of derivatives and more are being invented each year, and many are termed "exotic" because the can be complicated and difficult to follow.
Why would someone want to hedge a business bet? Good question. Take Southwest Airlines for example. Long term, it plans on suceeding in business by being the best-run, best-managed airlines. Part of it's management plan is to try to eliminate economic effects that it can't control, e.g. jet fuel prices. So, unlike some airlines, Southwest purchases jet fuel futures contracts as a form of insurance that it won't be put out of business by a sudden spike in fuel costs. Thus, if Southwest loses money because fuel prices go up, the value of it's future contracts should go up by an equal amount. The two offset each other. Southwest buys just enough future contracts to cover possible fuel increases. As in this case, most derivatives are invented as some form of insurance for a business.
Finally, it should be noted that many derivatives often have the characteristic of reacting more dramatically to economic changes than the underlying asset, itself. For example, if someone is holding a short position on a stock when it soars, the losses could be enormous and virtually unlimited.
Hedge funds, then, are supposed to be a collection of various derivatives. In fact, however, a lot of so-called hedge funds are far from pure and may even have equity holdings.
MDL, on the other hand, appears to have been a strickly pure "hedge." We don't know all the details, but from the press reports it appears that MDL was purely invested in bonds. It also appears that MDL and Terry Gasper, the CFO for BWC, hatched a plan:
We think we do, and we'll try to keep it simple in order to keep it short. We think that Gasper understood that the BWC investments, as a whole, were suffering because of higher interest rates. One relatively easy way to hedge the effects of higher interest rates is through the bond market.
Bonds values react inversely to interest rates. If interest rates go up, the value of bonds that you hold go down. If the quote above is accurate, MDL/BWC was originally "long" in bonds, ie, it owned bonds and believed they would grow in value. But, because the Federal Reserve for the last two years has been raising interest rates, conventional wisdom was that being long on bonds was not a good thing. So, apparently MDL/BWC sold their bonds and used the money to buy short positions on bonds.
But an unusual problem occurred. From the Blade:
Now, as noted above, short positions can be extremely dangerous. In order for individuals to engage in that kind of trading through our Ameritrade (or whatever) accounts, brokerage houses require that one sign off on a huge number of releases, waivers, etc., that serve to both notify the investors of the extreme danger they could face and to hold the brokerage harmless.
Short selling is extremely dangerous and risky even when done by the pros. Clearly, the ability to engage in short selling would require an explicit policy approved at the Oversight Committee level. We have not seen any reports that indicate that BWC had such a policy in place. And, if there was a policy, it is unimaginable that the policy would not require and spell out in detail the responsibility and supervison that would be required.
We think that's part of what Tina Kielmeyer, the interim adminstrator, means when she says that “it’s questionable” whether the investment fit into the parameters of the bureau’s investment policy.
But, we suspect that only part of what she means. We think there must have been something even riskier going on.
To explain, there is a difference between the dangers of short selling with bonds than with stocks. That's because equity prices could suddenly jump if, for example, a drug company suddenly announces a new discovery. Stock prices could conceivable double or triple in value in a matter of a day.
However, not so for bonds. Interest rates don't move that fast or in large jumps. So, the likelihood of the magnitude of MDL/BWC losses just don't make sense if they were holding simple short positions.
There have been a couple of references to MDL/BWC engaging in improper leveraging, with no details. Assuming that's true, what we think MDL/BWC did is a little mind-boggling and essentially took a gambit that was risky to begin with and than multiplied that risk with some clever financing.
For those interested, we think that what MDL/BWC did is the exact inverse of the infamous 1994 Orange County, California debacle where the county treasurer gambled on bond prices - gambled wrongly, that is - and suddenly lost $1.6 billion, enough to cause the county to go bankrupt.
Bob Citron, the Orange County treasurer, thought interest rates were going to drop. So, he bought bonds. Then he used the bonds as collateral to get a loan to buy more bonds. Then he used those bonds as collateral to buy more bonds. And so on, and so on. By creating this investment pyramid, he took a relatively modest investment and magnified its effects by several factors.
Besides increasing the size of his investment, there was another purpose to Citron's actions that gets very difficult to explain to lay people. This has to do with the term "duration." We don't want to go into the messy details of explaining the concept of duration, but regarding duration:
First, some of the reporting on MDL has been a little flawed. Specifially, we think it may be wrong to call MDL or what it created a "hedge fund."
Hedging 101
Hedge funds, at least in their normal business usage, are like a mutual fund that tend to be concentrated in derivative investments. In brief, derivatives - like equities - are based on some underlying asset, but are really based on either a component of the asset or based on a bet that the asset is going to move in a certain direction. Derivative markets were created to allow businesses to "hedge" their business bets. Stock "options" are a form of a derivative. So are "short" positions, "futures" and "forward" contracts. There are many, many types of derivatives and more are being invented each year, and many are termed "exotic" because the can be complicated and difficult to follow.
Why would someone want to hedge a business bet? Good question. Take Southwest Airlines for example. Long term, it plans on suceeding in business by being the best-run, best-managed airlines. Part of it's management plan is to try to eliminate economic effects that it can't control, e.g. jet fuel prices. So, unlike some airlines, Southwest purchases jet fuel futures contracts as a form of insurance that it won't be put out of business by a sudden spike in fuel costs. Thus, if Southwest loses money because fuel prices go up, the value of it's future contracts should go up by an equal amount. The two offset each other. Southwest buys just enough future contracts to cover possible fuel increases. As in this case, most derivatives are invented as some form of insurance for a business.
Finally, it should be noted that many derivatives often have the characteristic of reacting more dramatically to economic changes than the underlying asset, itself. For example, if someone is holding a short position on a stock when it soars, the losses could be enormous and virtually unlimited.
Hedge funds, then, are supposed to be a collection of various derivatives. In fact, however, a lot of so-called hedge funds are far from pure and may even have equity holdings.
MDL, on the other hand, appears to have been a strickly pure "hedge." We don't know all the details, but from the press reports it appears that MDL was purely invested in bonds. It also appears that MDL and Terry Gasper, the CFO for BWC, hatched a plan:
But in September, 2003, the bureau agreed to a suggestion from MDL to create an “active duration fund,” which would act like a hedge fund. Mr. Gasper reallocated $100 million from the long-bond fund into the ADF fund. Later, another $125 million was moved into the hedge fund for a total of $225 million.This requires some translation, and clearly the business writers for the Blade and the Dispatch still don't exactly understand what was going on.
We think we do, and we'll try to keep it simple in order to keep it short. We think that Gasper understood that the BWC investments, as a whole, were suffering because of higher interest rates. One relatively easy way to hedge the effects of higher interest rates is through the bond market.
Bonds values react inversely to interest rates. If interest rates go up, the value of bonds that you hold go down. If the quote above is accurate, MDL/BWC was originally "long" in bonds, ie, it owned bonds and believed they would grow in value. But, because the Federal Reserve for the last two years has been raising interest rates, conventional wisdom was that being long on bonds was not a good thing. So, apparently MDL/BWC sold their bonds and used the money to buy short positions on bonds.
But an unusual problem occurred. From the Blade:
The Federal Reserve and Chairman Alan Greenspan raised short-term interest rates 2 percent over the last two years. If markets behaved as they have in the past, longer-term interest rates would have followed.So, MDL/BWC had gambled that interest rates would climb and make bonds drop in values. Then, their short positions would allow them to make money. But, instead, the opposite happened. Bond values increased, and MDL/BWC was forced to pay the difference.
But that didn't happen. Instead, long-term interest rates fell. Speaking this week on the subject, Mr. Greenspan said the development is "without precedent."
Now, as noted above, short positions can be extremely dangerous. In order for individuals to engage in that kind of trading through our Ameritrade (or whatever) accounts, brokerage houses require that one sign off on a huge number of releases, waivers, etc., that serve to both notify the investors of the extreme danger they could face and to hold the brokerage harmless.
Short selling is extremely dangerous and risky even when done by the pros. Clearly, the ability to engage in short selling would require an explicit policy approved at the Oversight Committee level. We have not seen any reports that indicate that BWC had such a policy in place. And, if there was a policy, it is unimaginable that the policy would not require and spell out in detail the responsibility and supervison that would be required.
We think that's part of what Tina Kielmeyer, the interim adminstrator, means when she says that “it’s questionable” whether the investment fit into the parameters of the bureau’s investment policy.
But, we suspect that only part of what she means. We think there must have been something even riskier going on.
To explain, there is a difference between the dangers of short selling with bonds than with stocks. That's because equity prices could suddenly jump if, for example, a drug company suddenly announces a new discovery. Stock prices could conceivable double or triple in value in a matter of a day.
However, not so for bonds. Interest rates don't move that fast or in large jumps. So, the likelihood of the magnitude of MDL/BWC losses just don't make sense if they were holding simple short positions.
There have been a couple of references to MDL/BWC engaging in improper leveraging, with no details. Assuming that's true, what we think MDL/BWC did is a little mind-boggling and essentially took a gambit that was risky to begin with and than multiplied that risk with some clever financing.
For those interested, we think that what MDL/BWC did is the exact inverse of the infamous 1994 Orange County, California debacle where the county treasurer gambled on bond prices - gambled wrongly, that is - and suddenly lost $1.6 billion, enough to cause the county to go bankrupt.
Bob Citron, the Orange County treasurer, thought interest rates were going to drop. So, he bought bonds. Then he used the bonds as collateral to get a loan to buy more bonds. Then he used those bonds as collateral to buy more bonds. And so on, and so on. By creating this investment pyramid, he took a relatively modest investment and magnified its effects by several factors.
Besides increasing the size of his investment, there was another purpose to Citron's actions that gets very difficult to explain to lay people. This has to do with the term "duration." We don't want to go into the messy details of explaining the concept of duration, but regarding duration:
Citron's main purpose was to increase current income by exploiting the fact that medium-term maturities had higher yields than short-term investments. On December 1993, for instance, short-term yields were less than 3%, while 5-year yields were around 5.2%.Back to MDL/BWC, we strongly suspect that Mark Lay and Terry Gasper built a pyramid of short bond positions using the first purchases as collateral to buy additional ones. Like Citron, we believe that they thought they were being clever by manipulating the differences between "duration" and yields of short-term and long-term bond maturities.
Coingate rehash
Our recovery-induced hiatus unfortunately came as Coingate news suddenly became mainstream. Sheesh - now everybody is an expert.
Seriously, we do believe in power of the collective to really accelerate the investigation. The editors at the Dispatch are still playing catchup with the continuing great work of the Drew Crew at the Blade. Add to that the fact that even the BTB (big time bloggers) like Atrios, Josh Marshall, and John Aravosis are now advancing the story. Kos diarists also deserve a tip of the hat. And someone has even created a special Coingate page to keep track of the stories and timelines.
In brief, the avalance of coverage and blogging has been great and far better than we could have done. Props to them all for fanning the flames while we have been absent.
One gripe about bloggers and Coingate - there is an awful lot of posting that is sheer repetition of the latest news to come from the Blade or whereever. Boring, boring, boring. Why blog if you have nothing NEW to say? Jim Drew and the Blade do not need a publicity service. Their work stands by itself, especially now. We do not wait with baited breath for a blog to tell us the most recent story. Guess fucking what? We can go to the Blade's page, too!
What we need are more people with inside knowledge and contacts to suggest possible links and routes of investigation, not bloggers who can't go any further than being the Readers Digest of Coingate.
Seriously, we do believe in power of the collective to really accelerate the investigation. The editors at the Dispatch are still playing catchup with the continuing great work of the Drew Crew at the Blade. Add to that the fact that even the BTB (big time bloggers) like Atrios, Josh Marshall, and John Aravosis are now advancing the story. Kos diarists also deserve a tip of the hat. And someone has even created a special Coingate page to keep track of the stories and timelines.
In brief, the avalance of coverage and blogging has been great and far better than we could have done. Props to them all for fanning the flames while we have been absent.
One gripe about bloggers and Coingate - there is an awful lot of posting that is sheer repetition of the latest news to come from the Blade or whereever. Boring, boring, boring. Why blog if you have nothing NEW to say? Jim Drew and the Blade do not need a publicity service. Their work stands by itself, especially now. We do not wait with baited breath for a blog to tell us the most recent story. Guess fucking what? We can go to the Blade's page, too!
What we need are more people with inside knowledge and contacts to suggest possible links and routes of investigation, not bloggers who can't go any further than being the Readers Digest of Coingate.
When things fall apart . . .
. . . like ourselves, something's got to give. Apparently the thing we've learned (and the reason for our lack of posts) is that if our body is a temple, we are apparently somewhat late on the mortgage payments.
