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Saturday, August 4th, 2012
out of control

The travails of Knight Capital Group (KCG) have reignited concerns about equity market structure.  It is all front-page news, adding another brick in the wall of investor concern about a financial game that seems out of control.

No use repeating the particulars here.  There was, in fact, a “runaway algo,” one prospect mentioned in my posting last year about our collective journey to algo city.  Most of the stories about KCG describe it as a stalwart of the trading world Wednesday morning which within an hour was fighting for survival.

You can see the damage to its securities above (the chart starts a year ago).  The stock rebounded on Friday after getting crushed, as did the convertible bonds — the only public debt the firm has.  In the parlance of convertibles, it is “busted,” trading as a straight bond to yield 13.3% to its March 2015 maturity.

The third line on the chart shows the price change for something called FLOATING RATE STRUCTURED REPACKAGED ASSET-BACKED TRUST SECURITIES (STRATS(SM)) CERTIFICATES, SERIES 2005-2.  As long as they have that service mark, we’ll just call them “Strats,” as Floyd Norris did in his excellent piece about them in the New York Times.  Wells Fargo (WFC) gets the credit for their creation.  Read the story for all the painful details.  The star indicates the return based upon the value that owners will now receive.

Since the chart shows price returns, you can add around 3% to the Strats and close to 6% for the converts to cushion the blow.  KCG stock does not pay a dividend, so no cushion there.

I put these different situations together because they seem symptomatic of today’s world.  We are promised wonderful execution in the markets, but can pay a tremendous price when the machinery doesn’t work correctly.  Desperate for yield, we buy the sausage from the structured finance factory and don’t know what is in it, liking the taste of the income and not paying attention to the poisoning that might come our way.

The game is out of control.  We have engineered in everything except common sense.  (Chart:  Bloomberg terminal.)