Archive - Feb 2010

Much has been said on these pages and elsewhere about the dangers embedded within quant groupthink, in which an ever increasing prevalence of fewer performing factors means that more and more speculators (note: not investors) line up on the same side of the trade pushing up offers, only to experience a regime change based on some heretofore unexpected exogenous event which renders existing signal translation models useless, and causes all former buyers to join the sellers. Whether that would result in a bidless market remains to be seen. If October 1987 is any indication, all signs point to yes. Yet in a sign that at least the bigger bankers may be anticipating just such an outcome, the Economist has disclosed that JP Morgan, in addition to reserving for general loan loss provisions on its balance sheet, has now taken a $3 billion reserve against quant error (yes, quants can be wrong... and for a lot of money at that). Just how many other investment banks demonstrate this kind of prudence? Without any specific regulatory guidelines for quant capital provisioning, we have no idea. While the bulge brackets may have joined JPM in a comparable form of "insurance" it is a certainty that the thousands of newly cropped up quant trading firms not only have no such reserves, but should a dramatic market reversal transpire, it is inevitable that wholesale asset dumping will have to take place to cover losses. And this assumes no leverage. Is the market prepared for such a contingency?

Several thought it important to begin a program of asset sales in the near future to ensure that the Federal Reserve’s balance sheet shrinks more quickly and in a more predictable manner than could be achieved solely by redeeming maturing securities and not reinvesting prepayments; they judged that a program of asset sales spread over a number of years would underscore the Committee’s determination to exit from the period of exceptionally accommodative monetary policy in a manner and at a pace that would keep inflation contained without having large effects on asset prices or market interest rates. A few suggested that the pace of asset sales, and potentially of purchases, could be adjusted over time in response to developments in the economy and the evolution of the economic outlook. The Committee made no decisions about asset sales at this meeting. - FOMC Minutes

Investors are growing more risk averse as they question the macroeconomic outlook as the government withdraws its support. Moreover, as last year’s sugar high continues to wear off, what we can expect to see is a return to what can only be described as heightened volatility in the markets, and the need to shift towards less cyclical and more defensive and income-oriented strategies that work well in a period of increased economic uncertainty. Overall, if the primary trend for the economy, credit and equity prices is down and 2009 was indeed a countertrend bounce, then the appropriate exercise is to consider ways to capitalize on the spectacular rally in risk assets off the lows last March and determine how we can all still make money in 2010 on a risk adjusted basis.- David Rosenberg

The barrage on Greek financial institutions continues, with Moody's downgrading Greek bank hybrid securities. Those impacted include National Bank of Greece, EFG Eurobank Ergasias, Piraeus Bank and Alpha Bank. The rating agency mainains a negative outlook on the bank's Baseline Credit Assessment, whatever the hell that is. The basis for the rating action is presented as follows: "Prior to the global financial crisis, Moody's incorporated an assumption into its ratings that support provided by
national governments and central banks to shore up a troubled bank would, to some extent, benefit the subordinated debt holders as well as the senior creditors. The systemic support for these instruments has not been forthcoming in many cases. The revised methodology largely removes previous assumptions of systemic support, resulting in today's downgrades. In addition, the revised methodology generally widens the notching on a hybrid's rating, based on the instrument's features." Is this a preamble to yet another general downgrade by Moody's on the country? Should the Greek Moody's rating drop to A1 or below, the Titlos SPV downgrade cascade consequences, as discussed previously, could come to the fore very promptly.

Goldman's Alec Phillips provides some perspectives on why the recent announcement that the GSEs will purchase 120+ day delinquent loans will not be a major impact to either the overall MBS market or to the Fed's QE tactics when it comes to stabilizing the market. Furthermore, in addition to not being a material mitigant to the Fed's massive balance sheet holdings, some direct implications as pertains to end borrowers include a greater incentive to foreclose, a greater emphasis on non-modification strategies, and more aggressive modification efforts. Yet the major issue, the one addressed by the Fed's Hoenig yesterday when discussing the urgent need to commence selling Fed assets asap, will likely be completely sidestepped, in essence stressing the need to find a legacy replacement through to QE when it expires in just over a month.

Have you noticed lately the behaviour of the put/call ratio? Once you read the next few lines, you will agree with us that it is a rare event. We have tracked this interesting behaviour since 2007. It is a compression event taking place in the ratio. The put/call ratio is usually defined between a mathematical range. The best example is provided at the left of the graph. The ratio will bounce around from the mean to +3 standard deviation on a sudden drop of the Dow Jones, taking it to under 13,000. That would be normal behaviour. In our present circumstances, something very different is happening.

The dollar just closed yesterday's gap. And here we were hoping that Dubai, er, Greece, and all that stuff was contained. Now that the (record) weak hands got shaken out of their euro shorts, it's time to back the truck up. And time to focus on that other STUPID member, Italy, where storm clouds have so far not been gathering. Then again, with Moody's just downgrading Greek banks' hybrid securities ratings, something tells us the Boot has just bought itself an additional temporary reprieve.

Goldman's distinctly feminine A. Joseph Cohen is out with the latest prognostication. Punxsutawney Abbey must have not seen her shadow yet again, resulting in a call for 6 more decades of Dow at 36,000, or in this case S&P hitting 1,300 by the end of the year. The fact that blind monkey, with a penchant for dart (and/or feces) throwing have had a more successful track record than AJC is irrelevant, yet disturbing . To wit: On a CNBC appearance in March 2008, she predicted S&P 500 at 1550 by end 2008, In an August 10, 2007 appearance on CNBC the Oracle of nothing predicted the S&P 500 would rally to 1,600 by December; In December 2007 A. Joseph predicted the S&P 500 index would reach 1,675 in 2008 (the S&P 500 traded to less than half, or 741.02, in November 2008).

For anyone who thought that Greece's double digit budget deficit as % of GDP (or is that triple digit? We don't know - remember all the numbers are false) was the actual cause for the need to bailout Greece, you are about to get a rude awakening: see, it was all the fault of six speculative US and UK hedge funds. Dow Jones reports that French Finance Minister Christine Lagarade has said that "six financial institutions have been singled out for speculating on Greek debt during the ongoing crisis." Heaven forbid such a thing as a somewhat efficient market exists, and Greek yields were merely an indication of the country's otherwise perfectly default status. Nah, surely it is all just speculation.

RANsquawk 17th February US Morning Briefing - Stocks, Bonds, FX etc.

Yesterday we first pointed out the rotation at the top of foreign US debt holders, with China selling $34 billion in USTs (shifting to a longer duration exposure by selling Bills and buying Bonds) to a new total of $755 billion, and giving up the top US debt holder position to Japan, which with $769 billion in UST holdings regained the top spot for the first time since August 2008. Overall, total foreign debt holdings in 2009 increased by $538 billion, with two unexpected buyers emerging in the face of Japan and the UK, which combined accounted for 58% (or $314 billion) of all 2009 purchases. We say surprising, because it has been long publicized that both countries have their own internal funding issues to grapple with: Japan an uncontrollable deflation and a demographic shift, which would make JGB's a better buying proposition than chasing micro yield in the US, while the UK is engaged in its own version of Quantitative Easing. With the BOE taking on excess supply one wonders how the UK can spare the dime to purchase our own debt (of which we have plenty more to issue in the future)?

Spain's 15 year €5 billion 4.65% offering has priced at 99.831, as expected 85 bps over midswaps. The issue is rated Aaa/AA+.

I thought the folks at ZH who could not attend last month's talk by yours truly sponsored by the Columbia University Center for Financial Engineering & NYU Courrant Institute of Mathematical Sciences would like to listen to the audio file. The link below downloads an 8MB WAV file, so don't try to listen on your PDA/cell phone.

Nobel-winning Columbia professor Robert Mundell, considered the "father of the euro" provides some biased views on his creation, and how it is impacted by Greece (spoiler alert: this will only make the EMU stronger). To be sure, he sees no risks of Greece spillover into the broader eurozone, and in fact is calling for the adoption of the euro by Britain. Probably not worth holding your breath on that one. What he does highlights is that Greece is not the powderkeg - Italy is. This is inline with Bank of America and others' warning that the biggest concern in the eurozone crisis is indeed the Boot. "I think it would be very difficult to bail Italy out. I think we have to make sure that whatever is being done to Greece, and possibly to Portugal and maybe Ireland has to also save Italy. Italy has got to be worried...Right now I think they should let the euro ever, for the next 10 years, rise above $1.40." We are confidence Bernanke and Shirakawa will miss that particular memo.

It appears as if the market declines of 2008 and early 2009 are being treated as nothing more than a bad dream, as if the investment industry has gone right back to business as usual. This extreme brevity of financial memory is breathtaking. Surely, we should attempt to look back and learn something from the mistakes that gave rise to the worst period in markets since the Great Depression. In an effort to engage in exactly this kind of learning experience, I have put together my list of the top ten lessons we seem to have failed to learn. So let’s dive in! - James Montier, GMO