As Gross Says, The Fed Provides 'Return-Free' Risk

Most people are familiar with the concept of risk-free return. Today I want to tell my personal anecdote about return-free risk and how I should have seen the liquidity bubble forming back in 2006. Don't be alarmed by the mention of arbitrage spreads, cost of capital, and short rebates - the concepts are simple.

When I was on the buy side of the business - working for an internal hedge fund at a major sell side firm - we ran a large merger arbitrage portfolio. Merger arb is simple in theory: When a cash acquisition is announced (ie, ORCL buys JAVA for $9.50 per share), you buy the shares in the target company if the risk vs reward payout being priced by the market is favorable (in your opinion). If and when the deal closes, you make the spread between where you bought the stock and the acquisition price. If the acquisition is an offer for shares in the acquiring company instead of cash (ABC is buying XYZ, and giving XYZ shareholders 2 shares of ABC stock for every share of XYZ that they own), you buy shares of the target (XYZ) and short 2 shares of the acquirer (ABC) for each XYZ share that you've bought. If and when the deal closes, your long XYZ will be converted into an ABC position that will cover your short hedge, and you'll have captured the spread, and be left with no stock positions.

Now, there are other costs and considerations as well - dividends you will pay (on short positions) and receive (on long positions), and more importantly, the cost of carry. The cost of carry is the opportunity cost on your money - the risk free rate that you could otherwise be earning, or your "cost" of borrowing money. At my "fund," we had access to a large amount of capital courtesy of the bank's balance sheet. The catch was, each dollar we used we paid for. In other words, I could buy $100MM in stock, and they'd charge me for that money - say, 5% annualized.

Thus, when calculating the return on merger arb deals, I had to back out the cost of capital. For cash deals, this meant basically subtracting 5% from the annualized return that the market was pricing in. For stock deals, it's a little more complicated, but don't fret, it's not rocket science: When you short stock, you usually earn a "rebate" on your short position. This is a fancy way of saying that the proceeds from the short sale earn interest for you - although not quite as much interest as you have to pay on your long position. Thus, in calculating my cost of carry I need to add the cost of buying the long position, and deduct the rebate that I earn on my short position. In stock for stock deals where the company I'm shorting (the acquirer) is an easy to short, top rebate level stock, the impact on the cost of carry will be small - since the rebate on the short stock will be very close to the cost of funds for the long stock.

Anyway, fast forward to "ideas dinners" where a bunch of merger arb hedge funds get together and talk about their best ideas in the field. We'd have 20 supposedly smart guys from different firms sitting around a table, and talking about arb spreads. "the ABC-XYZ spread is 5% - it's a layup," one guy would say, and I'd raise my eyebrow.

"It's not 5%, it's 0%. You have to adjust for the cost of your funds," I'd say.

"We don't pay for funds," he'd respond, as others in the room nodded. See, most hedge funds just have a pool of client money that they're investing - they don't have to pay to borrow it from their firm.

Now my other eyebrow would go up, and I'd say "Are you guys serious? Even if you don't actually get charged for the funds, you still need to deduct the risk-free rate from your return profile." I mean - this is finance 101.

Amazingly, most of these traditional hedge fund traders didn't look at it this way - they way they looked at it was that they had $100MM to invest, so if a deal returned 5%, they were making 5%. Never mind the fact that US Treasuries returned 5% also - they were earning their 5% of RETURN-FREE RISK. ZERO excess return (above the risk free rate) with risk included! Where do I sign up! Of course, it's not entiely return free, as there were a number of merger deals in 2005 and 2006 that saw bumps or increases in the bid price to a higher price.

Shockingly, in stock for stock deals, these same guys would add back in the rebate they earned on their short position to make their "return" look even higher - STILL without accounting for the cost of capital on the long side! In a room full of twenty people, there were maybe 2 others in the same boat I was who approached me after the events to explain that they understood my point.

I'd return from the events and explain to my boss that the Street was batshit crazy, and that they were absolutely mispricing the risk in these deals. Every time a broker called us and said "Check out XYZ-ABC - it's 5% annualized," my boss would just mutter "don't educate them," and we'd say "thank you," and hang up the phone. Obviously, you know how this story ends: The merger arb world blew up in 2007, and guys who were recklessly putting on every spread at rates which didn't compensate them for the risk they were taking on got wiped out.

How does this relate to today? If you read Bill Gross's monthly piece today, he talks about the Fed's efforts to reflate the market by keeping rates so low that investors are almost FORCED to plow their funds into riskier asset classes to avoid earning a near 0% return on their money - which is what the risk-free rate is now paying.

"The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until."

If you're wondering why the stock market (not to mention the government bond market, oil market, gold market, corporate bond market, junk bond market) seems to be rising without logic, it's because of all this liquidity that is MANDATING the devouring of risk assets. In my opinion, this can only end one way... badly.

Comments

[fwi]

Thanks for a really great article. THe image of the "smartest" guys sitting around the table blowing off risk considerations was priceless. Sounds like a Treasury or FMC meeting.

2009 Nov 19 07:27 PM

[The Geoffster]

And this is better than doing nothing?

2009 Nov 19 07:40 PM

[untrusting investor]

Good article. ZIFP basically amounts to "legalized theft" from the most conservative sectors of US society being savers, pensioners, and fixed income investors. Congratulations Mr. Bernanke, one can only hope that yourself and the rest of the Fed have all their assets in money market funds also earning almost zero as well and devaluaing by the day..

2009 Nov 19 09:40 PM

[DougM]

Great article, but could you close with some possible courses of action? Ends badly as in massive inflation may still argue for grabbing all the assets you can, now, even with borrowed money. Ends badly as in massive asset crash when interest rates start back up, argues for just sitting tight and taking the punishment BB's laying down.

2009 Nov 19 10:47 PM

[swissfrank]

That's got to be a personal call, surely. Apparently the Fed aims to get thru at least 2010 with zero interest rates (its 'extended period'), which would push investors to seek better than zero returns in riskier asset classes. As money flows into stocks and commodities there will be an increasing disconnect between those values and the sluggish performance of the real world economy. That could give you your 'massive asset crash' well before your longer-term 'massive inflation' scenario plays out.


On Nov 19 10:47 PM DougM wrote:

> Great article, but could you close with some possible courses of
> action? Ends badly as in massive inflation may still argue for grabbing
> all the assets you can, now, even with borrowed money. Ends badly
> as in massive asset crash when interest rates start back up, argues
> for just sitting tight and taking the punishment BB's laying down.

2009 Nov 20 02:38 AM

[Ad Orientem]

Spot on. There is only one rational explanation for the concurrent rise in the bond market, equities, and commodities... and that is the ocean of liquidity that is desperately looking for a place to go. What we are witnessing is just the tip of the inflation iceberg.

The next time someone says there is no inflation ask them what is driving up all of these different and often opposed asset classes at the same time.

2009 Nov 20 03:03 AM

[American in Paris]

The Fed did exactly the right things. Without low interest rates and quantitative easing the US output would still be declining and unemployment would probably be several percentage higher.

The Fed is not looking to maximize profits. If it did, we would be in real trouble ....

However, it is important to regulate funds and limit leverage.

Many countries places limits on leverage. In France the law stipulates a minimum down payment on real estate. In China they just raised the minimum the minimum down payment to 30%.

Similarly, leverage needs to be limited.

The real danger is the the laissez mentality, not the Fed.

It is liquidity and very high leverage that cause bubbles.


On Nov 19 07:27 PM fwi wrote:

> Thanks for a really great article. THe image of the "smartest" guys
> sitting around the table blowing off risk considerations was priceless.
> Sounds like a Treasury or FMC meeting.

2009 Nov 20 07:14 AM

[wozdan]

Spot on. The FED actualy is creating a situation for the benefit of Geithner's buddys and other crooks in which the most prudent, vulnerable (savers, penisoners) will be forced to buy assets at inflated prices or face a rapid depreciation of their current wealth. The crooks cannont sell the assets now, as it would cause a crash, they need to create demand for these assets. Others will be buying thanks to cheap credit and liquidity. In the end the Wall Street oligarchs will unload the assets and keep the cash, pensioners will be long overvalued assets in an inflationary environment and those that took cheap money will be in addition in debt. I just wonder why Americans cannot see or protest against FEDs/Treasury's policies and elects Obama - WallStreet/GS operative? Where does this indifference (or stupidity) come from? Maybe the Americans are the new homo sovieticus? The quasi-capitalist or as we can now see almost communist economic system (99% of home loans backed by government) certainly fits them.

2009 Nov 20 08:08 AM

[GeminiAtlas]

exactly, and as everything goes up, the diversification of the risk becomes moot. I could take the WSJ and some darts and start picking stocks that way, and then come out looking like a genius stock picker because everything I would pick is going up. Yeah, happy times are here again!!
On another note, not that I'm into conspiracy theories, but it does seem to me there are those banks and institutions on the "inside" (ahem, GS) with everybody else left outside of the loop. Classic "pump and dump" exercise, except that if it is the mob that does it, they go to jail, but if it is the Fed helping out a few friends, it's "sound monetary policy."


On Nov 20 03:03 AM Ad Orientem wrote:

> Spot on. There is only one rational explanation for the concurrent
> rise in the bond market, equities, and commodities... and that is
> the ocean of liquidity that is desperately looking for a place to
> go. What we are witnessing is just the tip of the inflation iceberg.
>
>
> The next time someone says there is no inflation ask them what is
> driving up all of these different and often opposed asset classes
> at the same time.

2009 Nov 20 08:13 AM

[JMBishop]

Thanks Kid Dynamite for educating us. Keep up the good writing.

2009 Nov 20 09:45 AM

[501327]

It is a perverse world where savers (who are providers of high quality funding in the form of deposits) are paid zero interest in a bid to force them into risky assets while banks are guaranteed fat spreads as a reward for bad behaviour so they could build their capital base and instead they choose to reward themselves with fat bonuses claiming those trading profits from the FED gravy train required smarts and acumen. Shareholders' get somewhat better treatment than the poor depositors (who count their blessings that at least their deposits were insured if depreciated) because banks do need to pay lip service to their private ownership nature to ensure that the ponzy scheme can continue unabated. All in the name of free markets and capitalism.

2009 Nov 20 01:53 PM

[K Smith]

wozdan wrote:
"I just wonder why Americans cannot see or protest against FEDs/Treasury's policies and elects Obama - WallStreet/GS operative? Where does this indifference (or stupidity) come from? "

The lack of foresight, indifference and stupidity come from the same place Kid Dynamite's "smart guys" got theirs - what we all erroneously refer to as education.

In order to reach Kid Dynamite's realization, you have to know how to think. Public schools and our university system do not teach people how to think independently. They teach people how to follow formulas - formulas created by the oligarchs.

If the masses only follow, a smart leader can gain control over them, take thier weatlt wihtout them knowing it, and lead them anywhere.

I had a similar realization to Kid Dynamite's' in 2005 regarding the mortgage market. I knew based on the wacky mortgages terms I heard people were getting - family, friends, and associates - that at some point it would all just blow up.

It is also important to be mindful of the fact that it does not matter which party we elect. The leadership of both parties has been co-opted by the oligarchs, and the banksters control the Fed and the Treasury Department no matter who is power.

This is why Sarah Palin is such a treat to them - she did not rise to thru the ranks and is not beholden to anyone. I am not a fan of Sarah Palin. I am just pointing out that those who are not groomed for leadership within the 2 party system are a threat, and will be hammered and discredited by the oligarchs.

2009 Nov 21 08:32 PM

[kcr357]

I'm guessing you'll
have your answer in a year or so....


On Nov 19 07:40 PM The Geoffster wrote:

> And this is better than doing nothing?

2009 Nov 22 01:39 PM

[jeffgroove]

Rarely do I make personal attacks, but you seem really clueless with your doublespeak about capitalism and government. Have you ever looked up the definition of laissez fair capitalism?

Here is the wiki, I would suggest reading before submitting further comments.
en.wikipedia.org/wiki/...


On Nov 20 07:14 AM American in Paris wrote:

> The Fed did exactly the right things. Without low interest rates
> and quantitative easing the US output would still be declining and
> unemployment would probably be several percentage higher.
>
> The Fed is not looking to maximize profits. If it did, we would be
> in real trouble ....
>
> However, it is important to regulate funds and limit leverage. <br/>
>
> Many countries places limits on leverage. In France the law stipulates
> a minimum down payment on real estate. In China they just raised
> the minimum the minimum down payment to 30%.
>
> Similarly, leverage needs to be limited.
>
> The real danger is the the laissez mentality, not the Fed.
>
> It is liquidity and very high leverage that cause bubbles.

2009 Nov 23 01:04 AM

[Hillsfar]

OK. You've convinced me. So where do we little invest?

2009 Nov 23 05:41 AM

[Danny Furman]

Fun read, thanks for the insight.

2009 Dec 09 08:57 AM

[dieuwer]

No.
Why should stocks, bonds, gold, commodities, etc., be "more risky" than cash? That is such a 90's mindset.

I pose that the concept of "risk" is misunderstood, because people always seem to forget about "purchasing power".
Say the FED keeps interest rates at zero, but the REAL RATE < 0.
Then what is more risky? Cash or everything else?
The correct answer is cash. Not because there is "risk of return"...you will get your money back. The risk is in the diminishing purchasing power through REAL inflation.

2009 Dec 29 07:41 PM