Chris Hynes comment on flash trading

Chris's comments on this blog on August 7th appeared in the WSJ today on In Defense of Flash Trading. If you get a chance get onto the comments section of the journal. There is quite a buzz that Chris has created with his comments. Not that they were controversial but it sure is a subject of different opinions.

Private Equity Environment for Middle Market

Talked to some lower middle market private equity guys last week--they said they were having trouble borrowing more than 2 turns on anything--and that is based on recession-reduced EBITDA. They are considering doing deals, taking the 2 turns, praying for a refi opportunity within 12 months so they can keep the excess equity for additional deals. A private wealth sales guy confirms that he's just not seeing new liquidity from business owners--they don't want to sell to private equity firms at the low prices implied by the lack of financing.

In the boom years, the math was interesting. Guy sells a business for $20 million, pays $3 million to the US Treasury, puts $10 million in public equity and $7 million in munis or other bonds. P/E firm put up $7 million in equity, $13 million in debt. Result was more new debt issued than funded. Tody same biz might get $7 million in debt with same EBITDA, or less if cash flows down. Even with 50% equity, P/E firm has a better deal than last year if the growth resumes--same equity, less debt. This only works if current owner takes a haircut,and most of them can wait.

Our Dallas presenter says MI Developments (NYSE:MIM) keeps rolling along. The stock is trading at a large discount to book value and near-term events could unlock significant value.

This fall hostin Xmas shopping previews

we are looking to walk malls in New York, Boston and San Francisco early in the Christmas season. We are hearing very lukewarm back to school is making this an even more important tim ethis year.

China and Banks

Looks like shortly we are going to get a better handle on the China markets. Starting with alternative energy, health devices and consummables and environmental products we are going to be working with a Chinese partner to offer experts on both sides of the pond to talk in these spaces. On a side note I talked to a banker last night who said after all the smoke and mirrors his bank is literally out of the auto and bank business. They were #3 or #4 in the state prior to last summer in both spaces. He said year over year they are doing a fraction(less than 10%) of what they did last year at this time. He was not including refinances which as he said"really distorts" total loan #s.

Decoupling: Has the Time Come?

Decoupling may have finally arrived, a little too late for the believers of two years ago. The "this time its different" crowd argued that the emerging markets could stand alone without the US and Europe. It didn't work that way, and emerging market equities were hit even worse than those in the developed markets. Lately the Asian emerging markets have been moving up faster than the US market, but it also seem the economies are as well. And, funny thing, the Eurozone is growing faster than the US--at least for now. There should be concern for the Chinese market after the big rally--lots of IPOs, bank loans up at high rates, and maybe some of that money flooding into stocks. Global banks are considering listing in Shanghai and floating stock there. Of course, hot foreign markets are always the last place Wall Street goes to sell junk, when they've run out of locals who haven't heard the news. While playing the Chinese market in the short term given the current liquidity bubble is not for the faint of heart, especially with the government warning against speculation and bank loans finally slowing, continued economic decoupling may lead to returns exceeding those in the developed markets over a longer horizon.

Increase in SEC Enforcement Activity

The SEC is increasing enforcement efforts due to the spate of Ponzi schemes. So effective August 11, SEC has made it easier for their staff attorneys to issue subpoenas. They will no longer need formal approvals, just an approval from their senior supervisor. This means investment managers might be more likely than in the past to get a subpoena. So while there might be less reason for alarm, still a good idea to bring in counsel before responding. This bodes well for commercial real estate, as those law firms will be hiring again...We need to get used to the new America, where it's tougher to interrogate suspected terrorists and easier to question businesspeople.

The release authorizing this action can be found here: http://www.sec.gov/rules/final/2009/34-60448.pdf

Mark to market

Now that the government eliminated(albeit temporary) the mark to market rules how would they reinstitute right now? i thought they were going the other direction to get rid of mark to market

Potential New FASB Mark-to-Market Rules

FASB is looking at a further expansion of mark-to-market rules. One of the concepts being discussed is marking all loans to market. This seems like a very difficult task in the absence of much of a securitization market, which we're all rather sour on anyway due to the moral hazard. When a bank makes a loan to the corner drugstore (if it still exists in the future) who else would want that loan the next day? So what would the loan be worth? If banks have capital accounts of about 10% of their assets (wishful thinking these days?), if the marked-to-market loan suffered a 10% drop in value the day after it was made, the imaginary capital assigned to that loan would be wiped out. Anyone care to own a community bank under these conditions?

In the past, if examiners "classified" a loan, there was a capital haircut. This facilitated small business lending. Imagine a bank has a niche in lending to these mythical corner drugstores, a long experience of loan-to-value, credit risk, etc. It's a profitable business, and someone leaves the bank and starts to compete. Being new, corners are cut, rates are lowered and higher risks are taken. Yet the old bank loses some share but doesn't relax it's standards. When the new bank becomes illiquid and has to sell the loans, now the old bank may need to write theirs down to the distress price, even though their portfolio is higher quality. In the past, this sort of marking process was reserved for assets that traded, not all assets.

Now that the government owns stakes in big banks, it's time to look for the moral hazard--a regulatory climate that subtly favors the government-owned enterprises. Big banks might actually be able to securitize loans and have a more favorable mark than an unsecuritized loan from a small bank. The financial products czar, who's supposed to approve products, is another potential change in the environment. Upstarts typically compete on service or product innovation. If a product czar inhibits product innovation, doesn't that bode well for branded service providers over the upstarts?

Axcelis (ACLS) is another pick from our recent small cap forum in NY. This manufacturer of ion implantation equipment for the semiconductor space has been hurt by the severe downturn in the industry, but has signed several important deals in the recent months and its unique products are winning important new customers, particularly in Asia. The upside could reach 200% or more based on the value of assets. With the stock currently trading at cash, the downside appears to be limited. The presenter believes there is a fair chance the company could be acquired in the next 6-12 months.

Our NY presenter still likes Walgreen. The big issues raised in his presentation last year, a slowdon in store expansion plans and reduction in operating expenses are finally playing out. The company is generating excellent cash flow. The stock is undervalued here, in his view, with the upside into the high $40's.

Moving the Economy Forward

This earnings season, estimates have generally been exceeded, but it's been done by lowering costs, and revenues have often disappointed. One could make the inference that biggest cost cuts usually come on the labor line. If that's true, it would lend support to the argument that the worst of the jobs recession may be over. If companies are lean, will they hire if business recovers a little? Supposing they do, the next question is where will they hire? Domestically, or abroad?

There are some factors affecting this decision that are in more than the usual state of flux this cycle. First, there is the uncertainty of a government far more favorable to big labor than we have seen in years. Second is the potential of higher labor costs due to health care reform, although there is an argument that the costs may actually fall on the very rich and small business, and that big business may actually get some relief.

But direct labor costs are not the only factor to consider when siting employees. The cost of land, or the rental prices of office, retail and industrial space are also important. The real estate crash is a positive for businesses seeking to add new facilities. Local governments may now be in a mood to encourage job creation through tax breaks and administrative simplification. When considering overseas hiring, views of future transportation costs are a factor as well as the outlook for relative future labor price increases and the dollar.

I've thought for years that nationalization of social costs like retirement advantage mature, slow growth industries, who avoid the full cost of these issues on their older workforces. At the same time, young industries are relatively encouraged, as they are not saddled with any costs but their own. It struck me that this might be one of many reasons the US did well with innovation, while we exported jobs in mature industries to other countries. If we start nationalizing a larger proportion of social costs, do we risk eroding these advantages for new industries?

Since growth is a product of the growth of the labor force times the growth of productivity, how do we get real growth by encouraging mature industries, where it's harder to get productivity growth? As we pointed out in an earlier post on China, the Chinese economy gains substantially when labor leaves the farm and comes into the city to join the industrial work force--that worker's contribution to GDP can triple. without any true productivity increase. It's simply a portfolio effect. The US needs to make sure it can get a positive growth effect from shifts in our labor portfolio. National policies need to encourage this process.

Our New York presenter recommended Cleveland BioLabs. This small biotech boasts an impressive pipeline, with the leading drug candidate potentialy offering a fast-acting antidot against radiation, a space where there are no effective treatments currently available. The company has partnerships with world-class research organizations, including Roswell Park Cancer Institute and Cleveland Clinic. As any small biotech, CBLI is a speculative play, but early test results show great potential. The company is also developing a family of anti-cancer agents.

Health Care: Unintended Consequences?

A lot of the debate on a new health care system is based on costs. But what's the impact of 40 million new customers on the system's ability to deliver services? First, a lot shorter wait in the ER as uninsured patients learn to stop using the ER for anything that comes up. But where do those people go, and what happens to their resource usage? The way our health care delivery system is structured, they would go first to primary care providers. Of course, these are the people being most economically squeezed by the current system, and it seems that there's already a bit of a squeeze--that many doctors have decided to become specialists for financial and lifestyle considerations.

If 40 million new customers spent an hour per year with a primary care provider, that would require about 20,000 more primary care providers. Looking at 2006 data on physicians, it looked to me as if there are about 300,000 doctors who could fill this demand. So the new demand would require about a 7% increase in the number of doctors devoted to this service. Since it's plausible that the uninsured have a backlog of unmet preventive care needs, and possibly a greater need for consumer education, time demands could be greater. It's interesting that Massachusetts, which requires health care coverage of its citizens, is also the state with the largest number of doctors relative to the population. There are many states with substantially fewer doctors per capita. Their resources may be more fully utilized. Anecdotally, many of us have experience with primary care physicians who aren't taking new patients.

Complex legislation almost always has unintended consequences. This may be one of them.

Our NY presenter still likes IFSIA and ASCMA as long-term holds, but is not recommending either name at current levels. In his view, both stocks have run up too much too fast.

Flash Trading and Private Property Rights

The investment management industry has a lot at stake in the flash order controversy. The freedom to acquire and dispose of one's property is a fundamental right, and property owners must be allowed to determine the methodology by which they will acquire or dispose of their assets. Have you ever been called by a real estate broker who tells you a home you are interested in will be coming on the market soon? That's a form of flash trading. Long before we had electronic trading, we had block desks. These desks often called customers they believed might have the other side of an order before sending the order to the floor. That's a form of flash trading. On the NYSE floor, a floor broker might decide to leave a small bid on the public order book, but whisper to the specialist that he has an interest in size. The specialist might discreetly shop that interest, or discreetly begin to acquire shares in "stabilizing transactions" in order to accumulate enough shares to make an offer in size. Sounds like flash trading, doesn't it?

After the PC was developed, portfolio managers were able to use optimizers to generate hundreds of orders at a time. The original electronic dark pools, POSIT and The Crossing Network, sprang up to help traders defray the cost of executing these orders. Typically, the order list was shown to the dark pool, and the residual was taken to the floor for execution. Dick Grasso at NYSE argued this created fragmentation (the "F" word) and was bad for markets. We electronic traders argued it was the "S" word--segmentation, or "different strokes for different folks." Investment managers, with a fiduciary obligation to obtain best execution, began to have an increasing number of alternative venues on which to place their orders, and the ability to decide which one was best for each of their orders.

Senator Schumer's "little guy" benefited from this enormously. Years ago the little guy called a broker, who took his order over the phone, then walked it down to the wire operator, who sent it to the exchange. Eventually a report came back to the branch, and hopefully the broker called his client to provide the report. Today's little guy sends the order in on his PC and gets a report as fast as browser can switch to the order status page. And instead of quarter-point spreads, the little guy is paying a penny or two in large-cap stocks. A more robust system for handling institutional orders might mean that a 200,000 share order creates less market impact, which protects the little guy, who apparently can't stand the volatility these orders create. In any case, the little guy's feedback loop on an order today is at worst a few seconds longer than an institution's, rather rather than several minutes.

Thirty years ago, most of the trading happened at the NYSE post or in the upstairs market. The upstairs market was fragmented and tricky, as traders had to figure out who really might have the other side of the trade: Goldman, Morgan, Jefferies, or Cantor, etc. If you guessed wrong you could be embarrassed as someone else found a seller first and sopped up the liquidity you were looking for. That's no less an issue today--which dark pool or ATS has the other side? Flash orders are a legitimate technique for finding the liquidity you need. Any trader knows they aren't for all situations, just as any homebuilder knows some jobs take a hammer, while others take a screwdriver.

I'm dismayed by the knee-jerk reaction by the SEC to all of this. Mary Shapiro must have spent too much time at CFTC, where futures exchanges was monoploy contracts could change the rules at will and the customers were stuck with them. Stocks can trade anywhere, and if the SEC is disregards economic necessity and prohibits what are essentially long-standing, sensible trading techniques, that trading could easily move offshore. It's all a matter of where the servers are. And Shapiro was an SEC commissioner from 1988 to 1994, when the electronic markets were first developing. She should understand that traders are for the most part evolving electronic trading structures that replicate techniques developed in the old Analog" days.

Bottom line--I think it's important that the industry stand up for the fundamental freedom of having the right to acquire or dispose of property as you see fit. If you agree, write your Congressman and the SEC, and maybe let Senator Schumer know you're thinking of moving your firm to New Jersey or Connecticut, or at least moving your executions out of state. If you disagree, let me know why. Maybe you're right and I'm not.

Many worries about China this week. Jeremy Grantham, always a force to be reckoned with, says his analyst worries that China is "dangerously
unbalanced and very likely to come unhinged in the next few quarters." http://www.gmo.com/websitecontent/JGLetter_ALL_2Q09.pdf
Additionally, investors such as Marc Faber and Jim Rogers are also concerned. There is clearly a liquidity bubble in China. Bank loans this year are up dramatically, despite indications the economy isn't that hot. As money will do when the real economy can't absorb it, it seems to be finding its way into stock and real estate markets. The central bank is warning banks not to make speculative loans. There is a great deal of discussion about toxic assets in state-owned enterprises, new buildings with only 20-30% occupancy, etc.

This makes perfect sense in the short term. It isn't easy running a growth company, or a growth country, in a big recession. Traditionally, you have to build facilities ahead of your need, anticipating the increased worker base you'll need with business up 10-20% every year. When the music stops, you have a lot of empty offices. You'd better be well financed. From an external standpoint, China is well financed. But I can think of another country, across the Pacific from China, that also has toxic assets in state-owned auto companies and banks, plenty of empty office buildings and warehouses, and tons of debt both internal and external. This country has a political system that can't say no to any special interest that can round up some voters, and its provincial governments are in a heap of trouble trying to pay for all the pork. Soon the national government will need to rethink its agenda--the central bank is now buying its bonds, not truly as instruments of monetary policy, but seemingly as a buyer of last resort. While the Chinese still have some racial unrest, especially in provinces that are now part of China but whose native tribes don't really feel like full-fledged members of society, that other nation still arrests minority constitutional law professors on their front porches for dubious reasons.

The point is, nobody's perfect. Not companies, and certainly not governments. If you can get reasonable execution, and you have competitive advantages, you can do well long-term. When you look at China, you see plenty of cheap labor, and plenty of international credit to buy the capital equipment to make it more productive. You also see the massive investment in infrastructure to facilitate commerce. Meanwhile, the developed world seems to be very interested in raising the cost of labor even more. This has always been a prelude to the export of jobs. And the Chinese have the workers and the capital to take those jobs.

I''m not sure I want to invest heavily right into the teeth of this liquidity bubble. But I think there are too many reasons not to ignore China over the next decade. What do you think?

CIT exposure

Word is that some of the big retailers are already notifying vendors that they will assist in financing the holiday buys. This is a BIG issue. CIT needs more cash to finance lines and players like Urban Outfitters have major exposure from smaller suppliers like CIT type customers.

Cant help but weigh in. I thought I had a clunker but it got to many MPG. But just heard junkman tell me he crushed a 2002 Hummer in perfectly good shape with 34,000 miles. The guy traded it in for a 2009 Hummer and says he is trying to sell it $2000 below sticker for a $1500 profit. Only in America.