Arbitrage, Margins, and Efficient Markets

Markets clearly overreacted in the months following the Lehman bankruptcy. The same thing holds true for other financial crisis, such as the 1987 crash and Asian/Russian/LTCM crisis. Market overreaction is not limited to dramatic macroevents. If one looks at implied option volatility, it is clear that market participants predictably overreact/underreact to different types of news. This overreaction is one of the cornerstones of behavioral finance.

Behavioral finance is often seen as the antithesis of the efficient market hypothesis (EMH). One of the premises of the field is that markets cannot be efficient considering markets' tendency to overreact. As behavioral finance as a field of study has boomed in the last two decades, so has rejection of the EMH (a poll showed a strong majority of CFAs reject the theory). Much of the hysteria about the EMH comes from the fact that much financial theory is premised on an efficient market. But behavioral finance should not necessarily threaten this theory outright. The value of the behavioral finance perspective is it helps us figure out which markets are inefficient and why that might be.

It is generally accepted that efficient markets are good for investors. In an efficient market, a buyer can be sure his purchase is at fair value. Markets love certainty. Investors cannot trust markets if they are not efficient. (Check out this recent article in the Financial Times.) For that reason, there should be efforts to create structural changes in finance to make markets more efficient. In the last year, derivative regulation is a step in the right direction. The change in fair value accounting was a move in the wrong direction.

But one structural aspect that has not been addressed is the role of arbitrage. Arbitrage is a driver of efficiency in markets. It is an example of the beautiful way in which the invisible hand of mutual self-interest creates a surprisingly fair market. But in times of stress, arbitrage is no longer a source of efficiency, but a source of inefficiency. This inefficiency comes from the wrong premise that arbitrage requires no capital.

Consider the following example. A hedge fund decides to take advantage of a price differential between S&P500 futures on two different exchanges, buying the cheaper futures and selling the overvalued ones. From an economic perspective, he has locked in the spread between the two exchanges since they are fundamentally the same thing. However, if after the trade the differential increase, technically the transaction has a mark-to-market loss. Because the original price differential was miniscule in the first place, the trader probably levered up to get a better return. As markets are behaving irrationally, the differential could grow further, triggering more accounting losses. These losses require posting collateral, which is why arbitrage is not capital-free. As Keynes said, "the market can stay irrational longer than you can stay solvent," meaning eventually collateral calls can lead to default. (Schleifer and Vishny 1997)

LTCM manager John Meriweather described his arbitrage fund's strategy as "picking up nickels all over the world." Many of these nickels need to be picked up. They make the streets of finance more transparent. When the price differential between S&P500 futures on different exchanges increases, traders should be able to increase their positions and lock in more guaranteed profit rather than having to liquidate trades to post margin. When interest rates on treasuries go negative, as they were briefly after Lehman and during the Great Depression, market participants should be able to clear the nickels and bring yields to reality.

Considering most financial crises are exacerbated by an irrational market causing caustic margin calls, it is interesting to look at how policymakers have fought this effect in the past. The best example comes from the Panic of 1907. The Panic of 1907 was very similar in nature to the 2008 Financial Crisis--caused by a lack of trust in financial institutions, bringing stock prices down 50%. The issue in 1907 was liquidity--bank runs were draining money out of the system. J.P. Morgan famously locked the most important bankers in a room to come up with a solution. The solution was to replace clearinghouse deposits (basically mark-to-market margin) with bonds so banks would have enough cash.

What if this model could be adapted to modern day liquidity crises? (Leveraged) arbitrage is similar in nature to fractional reserve banking. In commercial banking, if every consumer demands their deposits at the same time, the bank will be insolvent. Similarly, if all arbitrage trades go wrong at the same time, a firm will not be able to post margin on all of its trades even though they are economically viable. This example illustrates that for arbitrage to be an effective driver of efficient markets, there must be a mechanism in place that guards arbitrageurs against bank runs. One good step would be counter-cyclical margin requirements like those seen in 1907.

Argentine Credit Indicator

A delegation from Argentina is heading to Europe and the US this week to pitch a debt swap that would extent maturities on $2.3bn inflation-linked bonds. It will be interesting to watch how this is received by creditors. In 2005, many investors rejected Argentina's debt restructuring, leading to lawsuits that have limited Argentina's access to debt.

Adam Smith's statement, "When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and compeltely paid," applies especially to Argentina. Argentina has defaulted on its debt 6 times since 1800 (1830, 1890, 1915, 1930s, 1982, 2001). If the market is willing to lend money to Argentina, then that should be a good indicator that credit is flowing at normal levels.

Natural Gas Price Outlook

Natural gas prices dropped to a 7-year low today, as NYMEX Henry Hub futures (for September) fell 17 cents to $2.95, breaking the $3 barrier. Natural gas has taken a drastic turn in decoupling from the price of oil after the financial crisis. Historically, a barrel of crude oil has traded at a 6-10 multiple of the price of one mmbtu of natural gas. However, during the last half-year, the price of oil has re-inflated to $70 while natural gas has languished at $3/mmbtu due to negative fundamentals.

The drop in natural gas seems strange considering the number of rigs drilling for natgas have dropped by 58% since September 2008, according to Baker Hughes. With conventional production dropping, how come the US department of energy expects stockpiles to reach a record 3,800 mmbtus in November? The reason, according to BoA/ML Energy, is unconventional production from shale has become more profitable. Some producers report being able to find costs as low as $1.5/mmbtu, allowing them to lock in substantial margins with January 2010 futures trading at $5.47/mmbtu.


Considering these economics, natural gas is likely to fall further in the short term as inventories continue to swell. But this cannot go on forever. Due to the difficulties of storing natural gas, storage space is very limited. As inventories rise, the price of storage will rise, pressuring the natgas forward curve towards backwardation. Another risk is regulatory action from the CFTC. The CFTC is holding hearings on whether to limit some dealers' positions in natural gas. This could cause temporary selling pressure as funds decrease their positions.

While there are strong reasons for low natgas prices in the short term, there are good reasons to be bullish on natgas in the long term. One of the best reasons is cap-and-trade. Climate change legislation promises to raise the price of coal and oil relative to gas (gas has lower carbon emissions). In terms of electricity generation, the price per MWH for natural gas will converge closer to that of coal, increasing demand for natgas. In terms of transportation, increased use of liquefied natural gas (as the Pickens Plan promotes) instead of oil will obviously raise demand, as will the increased use of electric cars. I would not be surprised to see natgas trading at $6-7 /mmbtu in 2010, though the long-term future of natural gas ultimately depends on the sustainability of the economics of shale production.

Obesity Panels Instead of Death Panels

The US healthcare debate can best be characterized as confusing and misguided. The opposition is obnoxious and incoherent and the Obama administration fails to stay on message. Most importantly, healthcare reform advocates have not successfully addressed the glaring misconceptions of many outraged Americans. One prominent example is the question of "death panels." This term comes from Sarah Palin, who used it to refer to the rationing of healthcare. Many believe the state would be able to "pull the plug on Grandma."

Putting it in this perspective isn't quite correct, but there is a modicum of truth to it. Under a government healthcare plan, there would be some rationing, but only of truly expensive and invasive procedures. It is ridiculous to think this would lead to an Orwellian system. Rationing is economically necessary. The US does not have the best healthcare system in the world (ranked #37 by the World Health Organization) yet it pays 50% more per capita. A third of healthcare costs are incurred in the last few days. As long as there are government insurance programs like medicare, rationing to a certain degree is a must. Everyone must come off dialysis eventually.

In my opinion, the healthcare debate is painful to watch from all sides. The Obama Administration has a powerful argument that hasn't gained much traction with the public, which has focused on emotional issues. The best case for healthcare reform is that the cost curve is too steep because of demographic trends (agining baby boomers). Without healthcare reform, we will have out of control budget deficits. I mentioned in a previous post Morgan Stanley's chief economist Richard Berner's prediction that a huge deficit would "lower our standard of living" and "imperil economic and financial stability."

While Obama's logic on healthcare is sound, his approach is misguided. Obama seems to repeatedly pick the wrong battles. Not only has he upped the ante in Afghanistan, where much larger Soviet and British forces failed miserably, now he is bogged down in a healthcare quagmire, where every president since Truman has failed. A better approach would be to vigorously attack another factor of spiraling healthcare costs: obesity.

It is no secret US obesity rates are ridiculously high. 41% of American women are obese. Men are not far behind. The Obama Administration may be right when it says the current healthcare system is inefficient, but 70% of healthcare costs are related to lifestyle diseases. Even making a small dent in these statistics--such as moving obesity rates to 30%--would have a significant effect of lowering the cost curve. The Milken Institute estimates America's obesity problem costs $1 trillion a year.

There have been no substantial government programs addressing this issue. Japan, a country not known for its overweight population, has done much more. In 2008, Japan enacted a law that forced everyone from age 40 to 70 to be measured at the waist as part of their annual checkups. If ones waist was bigger than the allowed amount, one would have to enroll in a nutrition program or face financial penalties (Check out NYTimes article here). Though politically unfeasible with an obese population of 40%, such a program would be a step in the right direction.

Industrial Recovery/Balance Sheet Malaise

Markets have rallied since the middle of July on better than expected economic data and 2nd quarter results. However, a closer look indicates much of the good news is coming from an inventory correction and government stimulus. There have been no positive signs signalling an end to a balance sheet recession, suggesting equity and credit markets are likely headed for a pullback as these problems become more pronounced.

The world has seen the beginning of an industrial recovery. US job numbers came in better than expected, though not as good as they seem. US GDP was better than expected. Most surprisingly, Germany and France showed positive growth of .3%. Germany's exports (46.9% of GDP in 2007) increased 7%. Perhaps the most insightful data comes from the Purchasing Manager's Index (PMI). The PMI reflects purchasing manager's assessments of new orders for manufactured goods. The index is on a scale of 1 to 100, with 50 representing economic equilibrium. Anything less than 50 signifies a contraction and anything more than 50 indicates an expansion. The PMI for July showed stronger demand for manufactured goods as the index for most regions headed back to 50, approaching its January 2008 level. Also, the Fed Reserve released last Friday that industrial output increased .5% this quarter, the first increase since last October.

The growth in industrial production has led many to say the US economy is out of recession. The reasoning for this is that, historically, industrial output has been the best evidence of a recovery. There is a fundamental difference between an inventory correction and structural balance sheet deficiencies. The inventory correction is now coming to an end. However, balance sheet problems persist over a much longer period of time. It takes a while for firms to run out of cash and credit. This has been evident in past recessions, as bankruptcies and restructurings will continue even when markets have long recovered.

When one looks at the recent good news from a balance sheet perspective, the news no longer looks that good. US GDP came in better than expected but much of this came from cash-for-clunkers and other government spending. Consumer spending actually fell 1.2% annualized, twice more than expected. As wages fell an annualized 5%, it is hard to see how the consumer spending numbers will improve. (Remember consumer spending is 70% of US GDP.) Perhaps the only negative surprise in the last month has come from consumer sentiment surveys. The University of Michigan Consumer Sentiment survey came in significantly worse than expected, giving markets a quick reality check, though it didn't last long. The markets also ignored the fact that most of the "good" second quarter earnings came from drastically lower revenues, especially for retailers.

It is important to note the negative US consumer spending comes from the high amount of consumer debt. In France consumer spending actually increased 1.6%. At the same time, a forward-looking German consumer sentiment index showed positive change for August. When consumer sentiment recovers in Germany before you, you have a problem.

A New Kind of Peace Process

A consensus seems to be emerging on a new kind of peace process. Many of the most prominent meetings and summits meant to bring about peace have failed, even when at first both parties were optimistic--for example, the 1993 Oslo Accords or South Korea's Sunshine Policy. The reason these talks failed was due to internal strife within the separate entities, usually due to radical groups unwilling to compromise. This is underscored by the assassination of Israeli Prime Minister Rabin by a radical Israeli group after signing the Oslo Accords, and the assassination of Egyptian President Anwar Sadat after the Camp David Accords. This trend is also clearly evident in the recent 2007 Annapolis Conference, when Israeli Prime Minister Olmert and Palestinian President Abbas agreed on a two-state solution and outlined a way to settle the conflict over the next coming years. However, after the 2009 Israeli elections, the Annapolis Agreement holds little importance. Prime Minister Netanyahu is not committed to a two-state solution. In fact, within 8 hours of taking office as Foreign Minister, ultra-conservative Avigdor Lieberman reversed 2-years of progress by stating the Annapolis Conference held "no validity."

But the ineffectiveness of peace agreements is nothing new. What is new is diplomats attempting a fundamentally different peace process that is less of a process and more of an event.

North Korea

This new kind of peace agreement is most evident in Bill Clinton's recent "surprise trip" to North Korea. Though overtly a non-political rescue mission for captured journalists, the Obama administration was heavily involved. Korean media reported Clinton delivered a message from Obama to Kim Jong-Il. The last time an ex-President made a surprise visit to North Korea, former President Jimmy Carter returned with a nuclear deal called the "Agreed Framework" which de-escalated tensions between the two countries. The Agreed Framework eventually failed for the same reasons the Oslo and Camp David Accords failed, though North Korea benefited from US concessions in the meantime.

Many speculate Clinton proposed to Kim Jong-Il (with whom he had dinner) Obama's "comprehensive package" deal. The comprehensive package is a new kind of peace agreement because it is all-or-nothing--the West would recognize N. Korea and in return N. Korea would cease its nuclear efforts. Past agreements such as the Agreed Framework or Annapolis Conference were based on an action-for-action format, allowing entities to back out of the agreements. The action-for-action format leaves peace agreements susceptible to domestic political opinions that often derail these processes. The all-or-nothing format is designed to eliminate these risks, though we will not know for some time what actually occured in Pyongyang.

Israel-Palestine

The Arab-Israeli negotiations are also increasingly taking the all-or-nothing format. The driving force behind this is the Arab states, which have been badly burned by step-by-step negotiations in the past (which I discuss here).

Prince Saud of Saudi Arabia said July 31st after a meeting with the US Secretary of State, "Temporary security, confidence-building measures will... not bring peace. What is required is a comprehensive approach that defines the final outcome at the outset and launches into negotiations over final status issues." The next peace agreement to come out of the Middle East is likely to come unexpectantly, propelled forward by domestic Israeli sentiment (since they are currently the bottleneck regarding settlements and there is already some evidence of Israel moving away from its position on this issue, see here), and brokered by US envoy George Mitchell. The next question is whether there will be anyway to ensure an all-or-nothing deal is not broken by radical domestic pressures the same way the action-by-action agreements were derailed.

The Israeli-Arab Stalemate

It seems anti-American sentiment in the Middle East has been gradually diminishing since Barack Obama was inaugurated. Syria has taken steps to weaken its ties with Iran in favor of more cooperation with Saudi Arabia and the US. Hezbollah suffered a surprising defeat in the recent Lebanese elections. Even Iran has exposed its less radical side. Consider the following data from a Gallup poll:

In face of these developments, it seems strange that Israel would move in the opposite direction, antagonizing its Arab neighbors by authorizing a further expansion of settlements. The settlement issue is of crucial importance to Arab leaders because it represents the Arab's greatest concern regarding Israel. Perhaps the greatest spark for Israeli-Palestine tension is Israeli demographic trends. Arabs generally don't have a problem with Jews in the Levant. They have a problem with a rapidly increasing Jewish population. In fact, great demographic expansion correlate to more violence between Jews and Arabs. Saudi Arabia, the most important Arab voice on this issue, has stated if there is a settlement freeze, "we will be ready to talk to the Americans about taking this forward."

Obama finds himself in a difficult position. The US has stated Israel must halt expansion of settlements, yet expansions continue. At the same time, Arabs will not negotiate until these expansions halt. This stalemate is likely to continue until an external shock changes the geopolitical balance between these nations. A change in the position of the US is unlikely, as that is completely unacceptable to Arab states and because US public opinion is not as pro-Israel as it used to be.

The stalemate is likely to continue for the following reasons. Israel cannot discontinue settlements for domestic political reasons. Israel has a strong conservative movement that will not allow compromise, unless they get something substantial in return, such as state recognition or a peace plan. On the other hand, the Arabs will not compromise until they get a significant concession first. The Arabs were badly burned during the last peace process, and are more skeptical this time around, the reason why they are insisting on a freeze to settlements before negotiating. As the FT points out here, Israel reaped a large peace dividend during the last major peace process without actually concluding a peace. During this time, from 1992 to 1996, diplomatic recognition of Israel went from 85 countries to 161 and the number of settlers increased by 50%. Also during this time, almost a million Jews from the former Soviet Union emigrated to Israel. Saudi Arabia was also burned in 2002, when it painstakingly had its Arab-Israeli peace plan endorsed by the Arab League (which cost Saudi Arabia a lot of soft power on the Arab street), only to have Israel reject it.

In conclusion, while Obama's soft power efforts in the Middle East have made a difference, there is little chance any progress will be made towards Arab-Israeli peace. The stalemate between Israel and Saudi Arabia will most likely be broken by an exogenous shock. One possibility is another attack from Hezbollah. Hezbollah has been steadily increasing its military position along the Lebanon-Israeli border. Israel could opt to attack Hezbollah to get to Iran, Hezbollah's backer, as Israel's options to stop an Iranian bomb are diminishing.