All posts by Nejat Seyhun

Dr. H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally recognized authority on financial issues and Derivatives.

Are Treasuries Overpriced?

Dr. H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally recognized authority on financial issues and Derivatives.

All I read these days is how much Treasuries are overpriced.  At the beginning of 2011, Bill Gross, the famous bond fund manager at Pimco, predicted serious losses for Treasury investors and he publicly announced that Pimco had sold its massive Treasury positions.  In addition to fund managers and newspaper columnists, recently some well-known economists have also joined this chorus.  Their argument is simple and appealing:  At an annual yield of 1.9%, with actual inflation running over 2%, these experts are telling everyone that expected real Treasury returns are negative and that anyone who buys Treasuries is likely to be disappointed over the next ten years or longer.

Inflation worries are certainly real.  Some suggest and worry that faced with a massive and ever-increasing debt, the U.S. Government is likely to inflate even further in the future to reduce the real debt burden similarly to what it did in the 1950s by pegging the interest rates below the inflation rate.  In fact, Charlie Plosser, president of the Philadelphia Fed, has also publicly expressed his inflation worry. If the Fed were to carry out such monetary policy, this would further erode the real returns to long-dated Treasuries.

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A Free Lunch in a Perfect Storm

Dr. H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally recognized authority on financial issues and Derivatives.

As we welcome 2012, it is a good idea to take stock of the lessons of the roller-coaster stock market of 2011. The year ended on a mixed note.  The Dow Jones Industrial Index was up about 6%, S&P 500 index pretty much flat and Russell 2000 down about 4% for the year. Overseas, European and Asian stocks fared worse.   MSCI Europe ETF and iShares S&P Asia 50 Index ETF were both down about 15%.

Investors’ concerns in 2011 were about existential issues.  They worried about a possible collapse of euro, wide-spread European sovereign and bank defaults, and possible global depression.  Investors also worried about disorderly Greek, Irish, Portuguese, Italian and Spanish defaults.  A new term was coined, Private Sector Involvement (PSI), to euphemistically refer to private investor’s losses on their European sovereign debt holdings, a concept that would have been unthinkable a year earlier.  Consequently, the prices of European periphery sovereign debt plummeted and their yields skyrocketed.

Against this dooms day scenario, a surprising bright spot was the U.S. economy.  The U.S. economic picture steadily improved during the year.   The U.S. GDP growth rate rose from 0.4% in the first quarter to 1.8% in the third.  Retail sales increased about 8% year-on-year and unemployment declined from 9% to 8.6%.  Forecasts of S&P 500 stock earnings in 2012 surpassed $100.

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Corporate Insiders are Turning Neutral on the U.S. Stock Market

Dr. H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally recognized authority on financial issues and Derivatives.

As we enter a New Year, it is a good idea to review our stock selections and risk exposures. It is well known that legal insider trading by top level corporate executives in their own firms can help provide useful investment signals (Seyhun 2000, Investment Intelligence from Insider Trading, MIT Press.) Sustained insider buying in their own firms indicates a bullish signal while sustained insider selling indicates a bearish signal. Insider trading patterns provide useful signals not only for individual stocks, but also for industry sectors as well as the aggregate stock market.

The historical average value of the insider buying index is around 34. Above this level, I consider insider activity to be bullish. Below this level, I consider insider activity to be bearish. Insider trading patterns over the past six months indicate that insiders have regarded the European sovereign debt crisis and its potential impact on the U.S. market to be temporary. As the stock prices took a dive during July and August of 2011, insiders have regarded the depressed levels of stock prices as a good buying opportunity. Consequently, at a reading of 56 in August 2011, insider sentiment reached its highest level in over two years. To find the previous high, one has to go back to March of 2009 when stock prices had reached a trough and insider buying rocketed to twice the usual levels. Index levels of 60 and above on insider sentiment around March of 2009 appeared to be extremely timely as Dow Jones Industrial Index has increased more than 80% since then.

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August Jobs Report is Discouraging

H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally recognized authority on financial issues and Derivatives.

The Bureau of Labor Statistics announced last Friday that on a seasonally adjusted basis, total private employment increased by 154,000 while the overall total nonfarm employment increased by 117,000 in July (expectations were for an increase of 75,000).   Similarly, the overall unemployment rate went down to 9.1% from 9.2%.  Expectations were for no change from June.  Since both figures were better than expected, the stock market increased by about 150 points inreaction prior to the opening bell.

On closer inspection, however, there is a lot not to like in the August report.  First, the civilian non-institutional population increased by 182,000 from June to July, while the overall number of employed actually went down by 38,000.  Since the overall working-age population growth has been about 1.8 million over the past year, the economy on average needs to add about 140,000 new jobs to prevent the unemployment rate from increasing.  The net additional payroll figure of 117,000 increase is certainly not satisfactory from this perspective.

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The U.S. Budget Problem

H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally recognized authority on financial issues and Derivatives.

The current U.S. Budget deficit and the projected growth rate of the deficit, if it remains at the same level, is clearly not sustainable.  According to the Congressional Budget Office, the U.S. is currently spending about $3.7 trillion while taking in about $2.2 trillion a year a difference of $1.5 trillion or almost 50% of spending.  The four big budget items are healthcare ($820 billion); social security ($720 billion); defense and wars ($700 billion) and income security, interest, and federal pensions (totaling $840 billion).  The sum of these four items already equals about $3.1 trillion – representing 141% of revenues.  Simply speaking everything else adds up to about $600 billion meaning that even if we were to literally cut these “miscellaneous” expenditures to zero, we only get a 16% reduction in spending and the U.S. will still face huge and unsustainable budget deficits of $900 billion a year or about 6.5% of GDP.

At current projections, budget deficit in 2015 is estimated to be about $2.3 trillion (or 13.5% of the estimated $17 trillion GDP in 2015), while the U.S. debt is on track to reach $23 trillion.  We currently are pointing a finger at Greece and accusing them of irresponsible fiscal policy, yet this deficit level would surpass that of Greece, and is therefore not sensible.  The debt level in 2015 would equal 135% of the GDP.  Any loss of confidence and associated increase in U.S. interest rates on $23 trillion of debt would truly present a serious risk to the U.S. Budget and the economy.

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Debt-Ceiling: Is It Armageddon, Really?

H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally  recognized authority on financial issues and Derivatives.

 

The budget and debt-ceiling negotiations between the White House and Democrat and Republican leaders of the Congress have not been especially fruitful so far.  Based on Treasury estimates, the United States Government will run out of money sometime around August 2 unless the $14.29 trillion debt ceiling is raised.  According to many financial market commentators, the consequences of a United States default are nothing less than catastrophic. If a default occurs, U.S. will not be able to pay principal plus interest on some maturing debt.  In addition, it will not be able to fully meet its payroll obligations.  Yet, in spite of all the potential doomsday scenarios, we are within three-weeks of August 2, and the 10-Year benchmark Treasury Note has barely budged.  It is actually yielding slightly less today (at about 2.91%) than a month ago (2.95%).  Even the 30-year Treasury bonds have hardly moved.  The yield on the 30-year Treasuries has only increased from 4.20% to 4.30% over the past month.  What explains this curious phenomenon?

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Insider Trading in the Post-Rajaratnam World

H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally  recognized authority on financial issues and Derivatives.

Hedge Fund billionaire Raj Rajaratnam has been found guilty of all 14 counts of securities fraud and conspiracy charges against him.  The case now goes to 2nd Circuit appeals court.  If upheld, Mr. Rajaratnam is facing the possibility of a maximum 190 years in prison, though he is likely to receive about 7 to 8 years based on the precedents.  Based on press reports, Mr. Rajaratnam may have spent $40 million on his defense, while government has spent $30 million to prosecute Mr. Rajaratnam.  Clearly, litigation required immense resources on both parties.  Meanwhile, the government has charged almost 50 people ranging from traders, hedge fund managers, lawyers and experts with similar crimes over the past year and a half.  What are the likely takeaways from these trials for investors, hedge fund managers and students of the market?

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Anatomy of an Insider Trading Trial

H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally  recognized authority on financial issues and Derivatives.

The insider trading case of billionaire Raj Rajaratnam who has been charged with 14 counts of securities fraud and conspiracy in lower Manhattan federal court is now in the hands of a jury, which has been deliberating since Monday.  Government claims that Mr. Rajaratnam made over $60 million in abnormal profits using illegally obtained inside information.  To prosecute its case, the government indicted 26, obtained 21 guilty pleas, and taped over 1,000 private telephone calls.

The stakes are obviously high for both sides:   If the jury convicts on any one of the fraud charges, Mr. Rajaratnam could be facing more than 10 years in prison.  While losing his freedom after having his hedge fund business destroyed is obviously important to Mr. Rajaratnam, the stakes are also high for the government.  The government invested massive resources to prepare and prosecute this case.  If the government fails to obtain a single guilty verdict in any of the charges in spite of its massive effort and expense, this case will once again underscore the difficulty of obtaining convictions for insider trading cases and jeopardize government’s current and future efforts to limit insider trading.

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Understanding Derivatives: Beyond Good and Evil

H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally  recognized authority on financial issues and Derivatives.

Derivatives are often viewed as mysterious and dangerous instruments and they are much maligned these days.  The most famous investor, Warren Buffet, referred to derivatives in Berkshire Hathaway’s 2002 Annual Report as ‘I view derivatives as time bombs, both for the parties that deal in them and the economic system.’ Buffet continued:  ‘The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.’  These are strong words from a wise man.  Since we cannot put the genie back in the bottle, we have no choice but to deal with the genie. Continue reading Understanding Derivatives: Beyond Good and Evil

Remedy for Future Market Meltdowns: Require Margins for Over-the-Counter Trades

H. Nejat Seyhun, the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance. Ross School of Business, University of Michigan. With his permission we publish this article that is also at http://bit.ly/dBdyda U of M News and Media

In the year and a half since Lehman Brothers failed, we have heard a chorus of urgent calls for new regulations to prevent a repeat of the financial meltdown of 2008. Despite many proposals, however, no new regulations have gained traction toward enactment into law.

These proposed reforms have included requiring additional fees for banks, restricting the size and scope of banks, separating banks’ depository functions and trading activities, and stripping the Federal Reserve of its authority over banks and creating new regulatory institutions to oversee them. Yet, the Fed complains that it needs additional policy tools to manage the economy.

There is a simple, time-tested solution that would prevent a repeat of the recent financial crisis — a margin requirement for over-the-counter transactions (private transactions between banks or other parties).

In the aftermath of the 1929 stock market crash, the margin requirement for stock ownership (the amount that an investor must deposit in a margin account before buying on margin or selling short) was raised from 10 percent to 50 percent. This simple requirement has served us well for the past 80 years and has controlled excessive risk-taking in the stock market by individuals. Unfortunately, the margin requirement applies only to the stock market and exchange-traded products. There have been no margin requirements for over-the-counter transactions, where the bulk of trading takes place.

I propose that we immediately implement a margin requirement for all financial transactions, including over-the-counter transactions. The initial margin would be set small, even as low as one or two percent, and adjusted over time as needed, similar to exchange-based transactions. In addition to initial margins, maintenance margins would be required to take into account gains and losses on a day-to-day basis. To facilitate posting of the margins, a clearinghouse would be required to act as a counterparty to all transactions. In the United States, the Federal Reserve is well suited for this purpose. If it chooses, the Fed can pay interest on the margins, thus acquiring an additional policy tool.

Will margin requirements for over-the-counter transactions prevent a repeat of the financial meltdown of 2008? The answer is surely yes.

  • Margin requirements would apply to all firms, financial as well as nonfinancial.
  • Margin requirements would be flexible and subject to change by the Federal Reserve. If systemic risks increased, the Fed can simply increase the margin requirements, thereby stepping on the brakes and requiring de-leveraging. If the economy cools or goes into a recession, the Fed can reduce the margin requirement or temporarily set it close to zero, thereby encouraging greater risk-taking.
  • Margins would automatically control both the size and risk of all institutions and eliminate moral hazard problems. Firms experiencing losses would have to post bigger margins to cover their losses. To do so, they might need to liquidate their risky money-losing positions before they become too large, thus automatically reducing their size and risk levels.
  • Margin requirements would provide continuous updated information flow to the Federal Reserve, allowing it to monitor all financial institutions.

We already have a margin requirement in the stock market — the initial margin is 50 percent while the maintenance margin is 25 percent. We have margin requirements for all exchange-traded products. We have an informal margin requirement in the housing market, although this has not always been observed and should be made into a regulatory mandate as well. A simple way to achieve this objective is to require that all home buyers put down 20-25 percent of the purchase price as a down payment. Having a required margin in the housing market would prevent both housing bubbles as well as control the system-wide risk levels.

A saying goes that necessity is the mother of all invention. One benefit of the crises of the past is that they taught us expensive lessons on how to control risk. Let’s use our hard-earned knowledge and implement a margin requirement for all financial transactions.

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H. Nejat Seyhun is Professor of Finance and Jerome B. and Eilene M. York Professor of Business Administration at the Ross School of Business, University of Michigan, where he has twice served as the chairman of the finance department.  He holds a Ph.D. in finance (1984) from University of Rochester, Rochester NY. Professor Seyhun’s research has been quoted frequently in the financial press including the Wall Street Journal, New York Times, Washington Post, Newsweek, Business Week, Bloomberg Business News, and Los Angeles Times.   Among his past consulting clients are Citigroup, Towneley Capital, Tweedy, Browne, and Vanguard.