Friday, February 27, 2004

Although I couldn't find the story online today, ABC News reported last night that transit authorities would be charging an additional $1 monthly "user fee" to holders of EZ-Pass. Granted, the charge is minimal, but this contradicts cheaper tolls- one of the main reasons for the EZ-Pass system in the first place.

EZ-Pass has erred more to the side of difficult than easy since its inception. A few years ago, there was a problem with the scanners, and thousands of customers were receiving fines in the mail for unpaid tolls. On top of that, if you've ever experienced the "cannonball run" down to the Jersey Shore on a summer Friday, the EZ-Pass system doesn't increase the flow of traffic during periods of high congestion. Sometimes, in fact, its quicker to go through the pay tolls! If 1 out of every 20 motorists doesn't know how to use EZ-Pass and slows down to under 10mph to go through the toll, it causes congestion. It is due to these problems that we need to overhaul the entire system.

I feel that we should abolish "toll roads" in New Jersey and have residents of the state pay an additional tax to upkeep the roads, similar to most highways. The benefits of less traffic, thereby a quicker commute, outweighs the cost of the additional tax.

I will agree that revenue collected from the tolls goes to upkeep the roads, however, what percent goes to upkeep and pay the toll collectors? In a sense, motorists are not only forced to pay tolls, but it slows down their commute as well! One of the reasons we installed toll roads in the first place was as a source of employment for NJ residents, however, the toll collector is being replaced by the machine. NJ needs to seriously rethink its policy.

A solution to the high cost of roads would be to take away the control of upkeep and maintenance from the private sector. The increased competition, as contractual engineers have the opportunity to bid on certain projects, would cut the costs of fixing the roads. The system of paying workers for the amount of work done rather than an hourly rate would greatly increase the efficiency of work, and lead to lower costs in the long run.

Thursday, February 26, 2004

The following is a list of concerns in the JPM/ONE deal:

1. Single A-rated corporate finance spreads are too tight vs their 4-year historical mean. In the last 4 years, the spread between 10 year single A-rated finance debt and 10yr US treasuries has been as wide as 221bps (12/8/00) and as tight as 107bps (9/12/03). The spread has averaged 149bps, and currently trades 38bps tighter than the mean at 111bps. Simply for a mean regression trade, I like the short side. Its safe to assume that's why these deals originate in the banking department, not the trading floor.

2. Liability "Hot Potatoe". The combined entity will have a combined $125 billion of outstanding balances from US credit cards, nearly $20bln more than industry leader Citigroup. Now here's the bad news- consumer debt has doubled in the past 10 years to a record $1.98 trillion in October 2003. Meanwhile, the nation's savings rate dropped to 2% of after-tax income in the first half of the year. The first law of thermodynamics states that "matter cannot be created nor destroyed", and this also applies to debt. Likewise, it doesn't take a rocket scientist to see the kind of pass the "hot potatoe" game that US banks have been playing to the tune of low interest rates. Regardless of the amount of securitizations, hybridizations, and mutations, someone winds up holding the bag. The banks lend like crazy (to businesses and consumers), securitize these assets (asset-backs and CDO's), and then distribute them to the capital markets. However, just like any game of "hot potatoe", an economic setback or a spike in interest rates, will cause the music to stop. I fear the scalding that banks have coming by the nuclear potatoe they've been cooking and passing over the past decade.

3. ONE's fumble on interest rates last year. In 2003, earnings took a hit when Dimon gambled that interest rates would rise in the first half of 2003. It appears old habits don't die easily, as ONE's debt portfolio is heavily loaded with floating rate liabilities. In a rising interest-rate environment, floating rate debt maintains its value as the coupon rises along with the underlying rate. The issuer suffers as they are forced to pay a higher rate. Fixed-rate debt depreciates in a rising rate environment as investors demand higher yields, therefore lower secondary market prices. The general consensus is that the fed will remain on hold the first half of the year, as interest rate futures are only pricing in an 8% probability of a 25 bp rate hike at the May 4 meeting, and a 28% chance of a hike in June. However, recent Fed-speak has pointed to signs of a strengthening economy and a better jobs picture. With the dollar rallying against the Euro and the Yen, it makes one wonder how long the Fed will continue to remain on hold.

The following is a table of financial institutions and the percentage of floating-rate debt:
Bank % of floating-rate debt
NCC 69
CMA 61
KEY 55
ONE 50
USB 40
WB 30
MER 22
WFC 20
C 19
BAC 18
PNC 18

Also of note that 25% of ONE's outstanding debt matures within one-year.

4. Jaime Dimon is as overrated as Alan Houston. Fox, Pitt, Kelton financial analyst Reilly Tierney (who has been critical of JPM) thinks Dimon brings "instant credibility" to JP Morgan's struggle to become a top-tier global investment bank. Granted, ONE is 66% higher since Dimon took over in March 2000 (including today), however, competitors have seen similar returns, such as BAC (+77%), USB (+47%), HBC (+53%), NCC (+95%), WFC (+57%). So is the 3-year return (which was only +45% pre-merger) a function of Dimon's leadership or merely an ebbing interest rate tide which has consequently lifted all banks?

5. The 900-pound derivative gorilla. The combined entity will control 50%, or $36 trillion, of the derivatives market in the US. "JP Morgan is the 800-pound gorilla in the derivatives market, and with this deal, it's putting on another hundred pounds or so," says Frank Partnoy, ex-Morgan Stanley derivatives trader and securities-law professor at Univ of San Diego School of Law. This oligarchy has caused Greenspan to warn about "the concentration of derivatives among a few banks creates a risk that the failure of a single firm may disrupt financial markets." The lack of risk-transparency may cause some concern with regulators. Notable disasters in the derivatives market recently- LTCM (hedge fund that lost $4bln) and FRE (under-reported income by $5bln).

6. JPM's history of lending problems. JP Morgan dominates syndicate lending, with a 30.6% market share. However, this position leaves them vulnerable to a rising-rate environment, when borrowers are less inclined to be found at the teller window. Goggle-ize a financial crisis over the last 10 years, and JPM is sure to come up in your search. Whether it be LTCM, ENE, WCOM, TYC, or any Emerging Market calamity- rest assured, JPM will be in the middle of the mess. And when the credit bubble eventually pops, as all bubbles do, it makes one wonder how well-positioned a JPM-ONE will be...

Wednesday, February 25, 2004

From Bollinger bands and stocastic-oscillators to sentiment readings and put/call ratios, there are a myriad of complicated methods to forecast the markets. I looked at the simplest economic function- supply/demand. In the face of a robust quarter for new equity issuance, I compared this quarter's projected equity and equity-linked issuance with the previous 20 quarters. Quarters with higher issuance where investors become saturated should lead to lower prices in the S&P, thereby lower returns. The reverse should also be true, quarters with light equity issuance should lead to higher returns in the following quarter.

The following table is a list of total issuance by quarter (expressed in millions), dating back to 1999. Something of note is the rise in equity-linked issuance, which accounted for 22% of total issuance in '99 and 52% in '03.

tot iss (M)/ equity/ equity-linked/ %eq-linked/ s&p return
Q1 33830/ 27946/ 5884/ 17/ 4.64
Q2 47723/ 40362/ 7361/ 15/ 6.10
Q3 35445/ 26525/ 8920/ 25/ -7.11
Q4 63173/ 45893/ 17280/ 27/ 14.16

Q1 87159/ 65084/ 22075/ 25/ 1.99
Q2 47168/ 35355/ 11813/ 25/ -2.93
Q3 39337/ 30417/ 8920/ 23/ -1.24
Q4 36927/ 23667/ 13260/ 36/ -8.09

Q1 47381/ 25448/ 21933/ 46/ -12.11
Q2 74396/ 39297/ 35099/ 47/ 5.52
Q3 31756/ 16904/ 14852/ 47/ -14.90
Q4 62959/ 35024/ 27935/ 44/ 10.54

Q1 54831/ 24987/ 29844/ 54/ -0.06
Q2 43937/ 31890/ 12047/ 27/ -13.67
Q3 16820/ 14060/ 2760/ 16/ -15.80
Q4 26176/ 17478/ 8698/ 33/ 3.76

Q1 23240/ 9578/ 13662/ 59/ -3.59
Q2 59641/ 18422/ 41219/ 69/ 13.51
Q3 40508/ 24554/ 15954/ 39/ 1.38
Q4 41878/ 27114/ 14764/ 35/ 9.20

2004 (projected- as of 1/21)
Q1 73,015/ 35,052/ 37,973/ 52 ('03 ave)/ 2.9 (so far in '04)

Performing a statistical analysis using the 20 data points of total amount issued, we arrive at a mean of 45,710M and a standard deviation of 17,400M. 14 of the data points fall within one standard deviation of the mean (28,310 - 63,110). Two of the data points sit just about one standard deviation away (Q4'99 and Q4'02). The remaining four points lying outside of one standard deviation are of interest (Q3'02, Q1'03, Q2'01, and Q1'00).

The following is a table of these data points versus the next quarter's return in the S&P:

Quarter/ Total Issuance (M)/ S&P (current quarter)/ S&P (following quarter)
Q3'02/ 16820/ -15.8/ +3.76
Q1'03/ 23240/ -3.59/ +13.51
Q2'01/ 74396/ +5.52/ -14.9
Q1'00/ 87159/ +1.99/ -2.93

It is notable that an extreme lack of new issuance leads to a positive return in the S&P. Conversely, in a quarter where the issuance runs at a higher level than normal, the following quarter produces lower S&P returns.

The amount of priced equity offerings (non-equity-linked) for Q1'04 as of 1/21 totaled 21,360M. Extrapolating this number forward gives a projected amount of 35,052M for the quarter. Adding in the average of 52% equity-linked securities from 2003, amounts to a total issuance projection of 73,025M- which is over 1 standard deviation away from the mean, and the 3rd highest quarter in the last 5 years. Quite simply, the principle of supply/demand would dictate caution in the equity markets for next quarter.

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