Are There Big Traps in the Credits and Foreign Exchange Markets?

Serving on numerous non-profit boards, investment and finance committees as well as being investment advisor to various wealthy investors and financial institutions provides me with the advantages of having a wide source of information, opinions and talents. By regulatory definition these clients qualify as “sophisticated investors.” As each investment pool is designed to meet the specific needs of an account, there is only a minor degree of overlap in investments. Thus when I hear from different groups the desire to add a specific type of investment product or strategy, these desires become an important trend to consider.

Recently this development occurred when members of diverse groups from both coasts wanted to add investments in credits to their portfolios. They were not focusing primarily on bonds, except those that were in distress. Instead, they were focusing on mortgages, asset-backed loans, bank loans and other credits perceived to be in trouble. My concern is that both the credit and FX markets have similar characteristics which have been troublesome in the past. These are:

• Over-the-Counter trading without central price reporting and settlement of trades


• Unfamiliarity to most institutional and individual investors


• The availability of high margin (up to 99% in some cases)


• A largely unregulated global market without fixed market hours


• Apparent hedging through complex derivatives


• Trading requires specific skills and broad networks


• Many, but not all, of the players are working for unfamiliar names

Note that often these credits are not in the form of securities and may not be under the aegis of the SEC. In most cases the search for such investments leads to managers who are not used for high quality investments and are often engaged with low fees. None of the managers have relevant track records, but all share the characteristics of wanting high fees and/or profit participation roles.

Certain aspects of this market may offer a prescription for high level, leveraged, and operationally intensive, price and fraud risks.

I have no doubt that there will be some money made in credits in the months and years ahead. (My definition of “money made” is the aggregate withdrawals that can be made after relevant taxes without invading inflation-adjusted principal.)

The search for credit opportunities is almost exclusively institutional in nature. The retail equivalent of this search is Foreign Exchange (FX). FX exists in the global 24-hour market whose heavy, cable-advertised drumbeats may mask some of its toxic nature. While there is a bit of institutional interest in trading FX directly, FX trading in size is usually conducted through bank channels. Many investors have learned to their dismay that price risk, with its relatively small movements, is not the only risk. In the credit and FX markets, counterparty risk should be examined; the other side may not be good for its trade. To many, the Lehman Brothers’ bankruptcy exposed the unfathomed depths of counterparty risk. The critical interrelationships of these markets are underscored by the name which many brokerage firms identify this combined market group: “FICC” standing for Fixed Income, Currency and Commodities. This group is traditionally a major user of its firms’ capital and a generator of profits, and more recently, large losses.

I am not advocating that one totally avoid investing in either credits and/or currencies. What I am suggesting is that instead of being a strategic reserve element to a portfolio, that these investments can prove to be high risk/high reward elements that should cause lowering the potential loss of permanent capital in other parts of the portfolio.