In financial markets, stocks are like celebrities — they garner way more coverage than they deserve. In the popular press, whether you read MarketWatch, TheStreet.com, or the NYTimes, equity markets dominate the headlines. This is puzzling to me, given that we are in a credit crisis, where the real interesting stuff is happening in debt; and Interest rates and currencies are the world’s most liquid and largest markets.

So why do we focus on equities? In the meantime, please enjoy this graph — equity v debt primary issuance according to BBG.

Many people talk about complex financially engineered products as “lipstick on a pig.” They are right — but the people applying the lipstick are the rating agencies, not the investment banks.

It is no news that investment banks love to whip up some financial magic to create derivatives with all kinds of bells and whistles and push these on their clients. Since the heyday of Bankers Trust, excesses of this sort are well documented. No one really fully trusts, nor should they, the bankers.

The creation of structured credit products, then, should come as no surprise. They extend a class of derivatives, credit derivatives, which themselves hardly constituted a blip on the financial radar 10 years ago. However, along with their vanilla CDS brethren, CDOs exploded in popularity in the last few years. When pitching these products to clients, banks had all kinds of fanciful new charts, analysis, theories and formulae.

Given the history of banks, why on earth would venerable and conservative institutions like pension funds, insurance companies and other asset management firms pour trillions of dollars into such structures?

The reason lies not with the impressive investment banks’ sales force or with the stupidity of their clients. Rather, it lies with a fundamental conflict of interest in a tragedy starring S&P, Moody’s and Fitch with supporting roles played by the banks, the regulators and industry bodies, and the asset managers themselves.

Real money institutions for years have relied on rating agencies to assess the creditworthiness of companies. Companies, in turn, would take care to maintain healthy financial ratios to preserve their ratings. Analysts would dig through companies’ books, meet with management, and assess their business and give out ratings. Essentially, asset managers were outsourcing their due dilligence to rating agencies.

In fact, the rating agencies were so trusted that their ratings had seeped into the regulatory framework and the investment guidelines of asset managers. Pension funds were able to claim more regulatory capital benefit from higher rated assets, and many asset managers were required by their guidelines to invest a certain portion in “low risk” AAA assets.

Early this decade, the rating agencies found that they could collect million dollar fees from banks by rating their new fangled credit derivative products and asset backed securities. Through a little bit of wizardry, banks structured these instruments to pay an additional 10 or 20 basis points over other AAA investments. Investors loved it.

The for profit, private rating agencies, forming part of the regulatory framework, were paid by the sellers (banks) but relied upon by the buyers (investors) to do due dilligence on complex products. Everyone was happy — the investment banks got paid big fees to structure these products and shared a little bit with the rating agencies while the investors were able to meet their investment guidelines and regulatory requirements and get paid a nice little spread over other similarly rated products.

Make no mistake, although the banks may have been able to sell a few of these financial concoctions, the large asset managers were really buying the rating. Without S&P and Moody’s blessings, CDOs would have probably gone the way of the LaserDisc — fun and promising at first, but with no real need to fill, fizzled away.

With banks being able to pawn off risk so easily, credit spreads went into freefall from 2004 to mid 2007, and end users, whether corporations or individuals, were able to spend freely on easy and cheap credit, creating what was first a credit bubble, and now a credit crisis.

My own little cynical illustration is below. The subprime borrower forges some documents and gives it to the mortgage broker. But the mortgage broker doesn’t care! He just takes a fee and sends the hot potato (the risk) off to the local bank. The local bank doesn’t care either, he just takes his collection and maintence fee and shoots the hot potato off to the investment bank. The investment bank collects all the potatos, feeds them to a pig, and pays the rating agency to apply a bit of makeup to the pig.

The investor, the one who ultimately sits on the risk, just looks at the lipstick. That’s his due dilligence. The guy who was paid to make sure the assets are safe were Moody’s and S&P. They hold the ultimate blame.

Two recent articles in Bloomberg point to the current divergent nature of world equity valuations today:

Asia Brings Share Value Unfathomable to Vanguard on Aug 18

U.S. Stocks at 25.8 Times Profit Means Rally May End on Sep 2

Published two weeks apart, the first article points to Asian markets, which are the cheapest in 13 years after steep drops in equity valuations since the market peaked in October 2007. The MSCI Asia Pacific Index was trading at just 13.9 times earnings. Even the requisite counterpoint, provided by Gordon Tan of JPMorgan, isolates Japan where “the economy shrank at a 2.4 percent annual rate last quarter and more than 60 percent of the 4,004 listed companies have market values that are less than their net assets.” This certainly isn’t the case in Asian economies of interest, like China, India, Indonesia and Vietnam.

The next article claims the “rally” may be over. The article is referring to the tiny 7% rally from the Jul 15 lows, where the market still remains 17% below its peak. In days where 1.5% and 2% daily moves are not uncommon, this hardly seems to qualify as a rally to me. Regardless, even with falling equity markets, corporate profits are falling much faster, creating the highest PE valuation in five years. In the long run, valuations seem to settle just under 20 times the PE ratio. Granted that financial institutions have faced huge losses, but the technology heavy and finance light NASDAQ has even richer valuations than the S&P.

The disparity between the valuations is compounded by the overall economic growth rates. With the US struggling to avoid recession and key emerging Asian countries growing at around 5% or higher, it seems that the better long term equity investment is emerging Asian economies as opposed to the United States.

In another tell tale sign of the times, more traders and bankers are looking at bank’s writedowns as opposed to deals. According to this recent Bloomberg article …

WDCI, the Bloomberg function introduced less than five months ago to track the writedowns, has overtaken LEAG, which ranks bond and stock underwriters, in viewers per day.

You know that fear has overtaken greed when bankers are more interested in not losing money as opposed to making it.

Another popular Bloomberg function is BANK, which displays the leading banks along with their CDS spreads equity performance. CDS contracts are essentially bets on the probability of default of the underlying. Lehman, which actually gets cut off, and Merrill are the closest banks to default. Ignoring the agencies, BNP and HSBC have held up best (even though HSBC ranks fourth in terms of total subprime writedowns). The six most likely to default banks are all American while six least likely are all European.

These screens are displayed below. Bloomberg terminals are dedicated computers that allow traders and salespeople to view market activity.

One of the major trends of the first half of the 21st century is a gradual shift of power towards emerging markets — especially economic power. The recent financial crisis has sped this phenomenon by creating a unique opportunity for cash rich Asian companies to purchase struggling Western assets. The headlines have highlighted purchases of large swaths of equity of venerable* financial institutions by Middle Eastern and Asian sovereign wealth funds. But a recent deal caught my attention because it truly exemplified how times are changing – India’s state oil company, ONGC, agreed to purchase Britain’s aptly named Imperial Energy. Is this the age of reverse economic colonization.

From Dealbook

On July 28, Merrill Lynch released a press release where it describes a sale of “$30.6 billion gross notional amount of U.S. super senior ABS CDOs to an affiliate of Lone Star Funds for a purchase price of $6.7 billion.” These CDOs had already been marked down to $11.1 bn, resulting in a further loss of $4.4 bn.

Additionally, “Merrill Lynch will provide financing to the purchaser for approximately 75 percent of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction.” Because the loan is backed only by the CDOs, as is lucidly visualized in this diagram, the effective equity Merrill Lynch received was $1.7 bn, or 5.5c on the dollar, for its CDOs.

Of all the attention thrown on Merrill Lynch on this sale, relatively little has been given to Lone Star’s spectacular deal.  Though no details are available, the attachment point on super senior deals tends to be 30% or higher and goes all the way to the bottom of the portfolio. Lone Star has effectively purchased an option on the CDOs with a 5.5c premium for an upside of about 72.5c.It may be anyone’s guess what the losses on the portfolios actually are, but Lone Star’s tranches have not been hit.

Lone Star’s Carry

Super senior tranches orginiated at the height of cheap credit usually paid not much more than 10 bps over Libor. For this analysis, I have conservatively assumed the CDOs pay a spread of zero. Though details have not been released on the cost of Merrill Lynch’s funding, it could come in at the same spread as the CDOs are paying out. If this is the case, the deal enables Lone Star to significantly leverage its carry on its equity investment. Per $1 notional, expenditure on ML’s funding for 16c offsets with another 16c of carry Lone Star would receive, leaving about 67c of carry of which Lone Star is only investing 5.5c. Effectively, Lone Star is able to leverage the carry on its investment at 12x (67c / 5.5c)!

If 3m USD Libor is currently 2.80%, then Lone Star is earning an annual return of 33.92%, without factoring the upside on the principal.

The big assumption here is that Merrill is funding at Libor flat (or the spread the CDOs pay). Even if this is not the case, Merrill would need to charge a spread of a whopping 1000 basis points over Libor for Lone Star to receive no excess carry!

All in all, this looks like an absolutely fantastic deal for Lone Star with enormous upside and little downside. I wonder if they could put my $1000 to work …

Further Reading

• Merrill Lynch – Merrill Lynch Announces Substantial Sale of U.S. ABS CDOs, Exposure Reduction of $11.1 Billion. Jul 28, 2008.
• Alea – Merrill Number Crunching – Ultra Short Edition. Jul 30, 2008
• Seeking Alpha – Merrill Lynch: Unafraid of Contradictions by Graham Summers. Aug 5, 2008.
• Bloomberg – Merrill Gives Up Gains, Is ‘On Hook’ for CDO Losses by John Glover. Jul 30, 2008.
• Seeking Alpha – Why Merrill’s CDO Sale Doesn’t Mean Big Writeoffs Elsewhere by Tom Brown. Jul 31, 2008.
• The Economist – Thain takes the pain. Jul 31, 2008.
• Seeking Alpha – Merrill CDO deal: How can they book it a sale? by Whitney Tilson. Jul 29, 2008.
  
• Seeking Alpha – Merrill Cleanses Itself – We Think by Dear John Thain. Jul 29, 2008.

In March 2007, the City of London commissioned the Z/Yenconsultancy to rank the world’s top financial centers. The ranking consists of two main sources – other indices and surveys of senior financial professionals. The idea is to create a dynamic index whose changes reflect the economic and financial winds. Factors that are taken into account include competitiveness, the regulatory environment, market access, customer access, tax regimes, infrastructure, personnel, and more.

The third version of the biannual index was published in March. The top five have remained unchanged since the beginning of the index. However, there is still a lot of volatility in the rankings due not really to changing times, but more to changing methodologies and survey response rates that make up the GFCI. Still, the index is a very interesting take on who holds weight in the financial world, and if you are a professional yourself, where the opportunities lie.

New York v London

New York and London are the runaway leaders of the pack, and here in New York, there was a bit of press about its second place ranking. The first survey came out when New York was already worrying about its place in the financial world, with Goldman’s international revenue surpassing 50% of its total for the first time and only one of the top 24 largest IPOs listed on a New York stock exchange in 2005.

Though I am not convinced that New York has ever been above London as the most influencial financial center in the past twenty years, I think there are two worrisome factors that are preventing New York from reaching its full potential: a) the regulatory environment, particularly the burden of SOX and b) the difficulty of obtaining work visas for foreign workers.

Of the two, I think the far more potent problem is the immigration policy of the United States. I personally know many very smart people who choose to go to London over New York because of the certainty of their immigration situation, and I also know a number of top performers in New York who had to leave the country because of difficulties obtaining H1-B visas. Comparatively, these people have little problem working in London or Hong Kong. New York’s loss.

Back to the survey .. some key points are:

• New York and London are the only bona fide two global financial centers. There is a wide gap between them and third place Hong Kong, which is considered an “international” financial center, emphasizing its cross border but not quite global reach.
• Middle Eastern centers are showing huge growth, led by Dubai, Qatar and Bahrain.
• European cities make up over 50% of the top 50 centers.

The Top Ten

Further Reading

• The Global Financial Centres Index 3 – Published in March 2008 by the City of London Corporation
• The Global Financial Centres Index 2 – Published in September 2007 by the City of London Corporation
• The Global Financial Centres Index 1 – Published in March 2007 by the City of London Corporation
• City launches new Global Financial Centres Index – City of London’s March 2007 press release
• Is New York No Longer the World’s Financial Capital – New York Magazine explores the topic, published along with another interesting article, though not quite on topic. From March 2007.
• London: Financial capital of the universe?- International Herland Tribune examines the issue in October 2006, before the publication of the indices.
• London’s edge over New York eroded- The Financial Times examines the latest GFCI in this article in Feb 2008. These rankings show London’s lead eroding due to the percieved UK regulatory failure in Northern Rock.
• Hong Kong Gaining Prominence as Leading Global Financial Center – From Money Morning in May 2008.
• Exploring London as a Global Financial Center- A comprehensive wiki – check out the Relationship to other financial centers page.