Archive - May 2012 - Story

As suspected, yesterday's report that the Troika may be caving on Greece appears more and more as a red-herring trial balloon, leaked by the Greek press without substantiation, and which sought to lighten the tension ahead of a trading week which is already looking rather askew. Because not even a full 24 hours later, Germany fires right back with an article in the Spiegel which not only anticipates the Grexit, but what happens the day after: namely that Greece would receive further aid from the EFSF if it exited the euro. It also notes that the EFSF aid to service bonds would continue. Greece would continue to get aid as EU member as every other member state. While it is unclear if this article is in response to the WiWo piece we noted yesterday which tried to quantify the costs of a Greek impact, and which has now ominously been picked up by Die Welt, in which Germany was finally starting to get worried about the hundreds of billions in sunk costs should Greece exit, the punchline here, needless to say, is not only the contemplation of a Greek exit but that Greece would be "all taken care of" even as the newly reintroduced Drachma lost a few hundred percent in value every day as Greece stormed its way back to FX competitiveness. Spiegel's punchline: "This is to the consequences of a possible €-egress will be mitigated." Hopefully the market agrees.

Europe is heading for a showdown and in a number of places; that much can be acknowledged with certainty. The first, and perhaps the most important, is the stand-off between France and the European Commission. The EU budgetary office is demanding that France reduce its deficit to 3.00% for 2012 while the projection is for 4.50% so that the Commission is threatening France with large fines. Mr. Hollande ran his campaign upon a reduction in the retirement age, more generous pensions, shorter work hours and more governmental spending so that the budgetary miss is likely to be larger than forecast; somewhere around 5.2% in my estimation. France then finds itself, one way or another, with a larger budgetary deficit and if the EU then imposes fines and sanctions Paris may thumb its nose at Berlin/Brussels in what could be a rather nasty affair with unknown consequences. Mrs. Merkel in one corner and Mr. Hollande in another slugging it out will not make for harmonious relations. Then there are the issues of Greece and Spain and the Socialist reaction is bound to be very different than the Austerity imposition as demanded by Germany. Jawohl!

Unbelievable.

That is the only way to express this author’s utter bewilderment that former Federal Reserve chairman Alan Greenspan is still given an outlet to speak his mind.  Actually, I am surprised Mr. Greenspan has the audacity to show his face, let alone speak, in public after the economic destruction he is responsible for. It was because of Greenspan, of course, that the world economy is still muddling its way along with painfully high unemployment.  His decision to prop up the stock market with money printing under any and every threat of a downtick in growth, also known as the Greenspan Put, created an environment of easy credit, reckless spending, and along with the federal government’s initiatives to encourage home ownership, the foundation from which a housing bubble could emerge. It was moral hazard bolstering on a massive scale.  Wall Street quickly learned (and the lesson sadly continues today) that the Federal Reserve stands ready to inflate should the Dow begin to plummet by any significant amount.  Following his departure from the chairmanship and bursting of the housing bubble, Greenspan quickly took to the press and denied any responsibility for financial crisis which was a result in due part to the crash in home prices. 

Hedged natural gas contracts have protected many producers from the full wrath of today's rock-bottom prices. They've been able to sell their production at relatively high prices... even while the spot price collapsed. But... for a lot of producers, these higher-priced hedges are about to expire. Encana, Canada's largest natural gas company, is a good example. The company had prudently hedged lots of the gas it sold over the last six months. This means it was still realizing $4 or $5 per MMBtu on its sales. Now, those hedges are expiring... and the new hedges are at much lower prices. Encana's cash flow and its economically recoverable reserves are going to plunge.

As Nassim Taleb described in The Black Swan these kinds of trades — betting large amounts for small frequent profits — is extremely fragile because eventually (and probably sooner in the real world than in a model) losses will happen (and of course if you are betting big, losses will be big). If you are running your business on the basis of leverage, this is especially dangerous, because facing a margin call or a downgrade you may be left in a fire sale to raise collateral. This fragile business model is in fact descended from the Martingale roulette betting system. Martingale is the perfect example of the failure of theory, because in theory, Martingale is a system of guaranteed profit, which I think is probably what makes these kinds of practices so attractive to the arbitrageurs of Wall Street (and of course Wall Street often selects for this by recruiting and promoting the most wild-eyed and risk-hungry). Martingale works by betting, and then doubling your bet until you win. This — in theory, and given enough capital — delivers a profit of your initial stake every time. Historically, the problem has been that bettors run out of capital eventually, simply because they don’t have an infinite stock (of course, thanks to Ben Bernanke, that is no longer a problem). The key feature of this system— and the attribute which many institutions have copied — is that it delivers frequent small-to-moderate profits, and occasional huge losses (when the bettor runs out of money).

And so it all begins anew: "The so-called troika of the European Union, the International Monetary Fund and the European Central Bank is willing to make six important changes to Greece’s financial aid agreement if a pro-European government is formed in the country, Real News said.  The Troika is willing to extend by one year to end 2015 the time for Greece to cut its budget deficit as well as to proceed with a restructuring of loans, the Athens-based newspaper reported in its Sunday edition preleased today, citing “well informed” sources at the European Commission."

First came the rhetorical jawboning, where following announcements by Fitch, European politicians, and finally Germany's finance minister, the scene was set to prepare the general public that despite protests to the contrary, a Greek exit from the euro would not really be quite the apocalypse imagined. Now comes the actual quantification part, whereby in addition to adding numbers and determining what the further sunk costs to a Greek bailout will be (hint: much, much greater than anyone can conceive), Germany has finally understood what we have been warning for over a year: that contingent liabilities become very real liabilities when a threshold event forces the transition from "off balance sheet" to on, and the piper has to be paid. According to an analysis released hours ago in Wirtschafts Woche, Germany "would only absorb losses of 76.6 billion euros in Germany. This amount results from bilateral aid loans, the liability of Germany's share in credit rescue fund EFSF, Germany's share of losses of the European Central Bank (ECB) and the German share of liability to the credit support of the International Monetary Fund (IMF)."

Many, if not most, people would agree with the general use of subsidies in a vertical equity fashion, or the efficient redistribution of wealth for a common social purpose: social justice to provide shelter for those who need it. It is subsidies in housing designed to support a political and not a socioeconomic purpose that bother me. Subsidies as they continue to exist in the US in housing follow in this category – much in exclusivity these days to the subsidies in other developed nations the world over, at least in quantifiable terms.

After sell-side analysts had been begging for it, pardon, predicting it for months, the PBOC finally succumbed and joined every other bank in an attempt to reflate, even as pockets of inflation are still prevalent across the country, although the recent disappointing economic data was just too much. Overnight, the Chinese central bank announced it was cutting the Reserve Requirement Ratio by 50 bps, from 20.5% to 20.0%, effective May 18. The move is expected to free up "an estimated 400 billion yuan ($63.5 billion) for lending to head-off the risk of a sudden slowdown in the world's second-largest economy" as estimated by Reuters. "The central bank should have cut RRR after Q1 data. It has missed the best timing," Dong Xian'an, chief economist at Peking First Advisory in Beijing, told Reuters. "A cut today will have a much discounted impact. So the Chinese economy will become more vulnerable to global weakness and the slowing Chinese economy will in turn have a bigger negative impact on global recovery. Uncertainties in the global and Chinese economy are rising," he said. The irony, of course, is that the cut, by being long overdue, will simply accentuate the perception that China is on one hand seeing a crash in its housing market and a rapid contraction int he economy, while still having to scramble with high food prices (recall the near record spike in Sooy prices two weeks ago). In the end, the PBOC had hoped that it would be the Fed that would cut first and China could enjoy the "benefits" of global "growth", and the adverse effects of second hand inflation. Instead, Bernanke has delayed far too long. When he does rejoin the race to ease, that is when China will realize just how short-sighted its easing decision was. In the meantime, the world's soon to be largest source of gold demand just got a rude reminder that even more inflation is coming.

We knew something was different about today. The following graphic neatly captures it. It shows the 15 minute average percentage of quotes considered excessive each minute (over 500 quotes per second per stock) between January 2010 and 11-May-2012 (plotted as thick red line). Note how this line was persistently high the entire day relative to trading days in the past. This probably explains the crazy high quote rates and prices shown in the charts below.

By now everyone knows that Chesapeake is a slow motion trainwreck: whether it is internal management issues, which eventually will culminate with the long overdue termination of the company's head (something the company had much control over and could avoid, but didn't, and should result in the sacking of the entire board for gross negligence), or plunging gas prices (something it had far less control over, but could have hedged properly, yet didn't), what is absolutely certain is that the firm's cash flow just isn't what it used to be. In fact, according to some, it is quite, quite negative. What, however, people do not know is that under ZIRP, when every basis point of debt return over 0% is praised, and an epic scramble ensues among hedge for any yielding paper no matter how worthless, the balance sheets of companies just do not matter. In other words, for companies that have massive leverage, high interest rates, negative cash flow, which all were corporate death knells as recently as 2008, the capitalization structure is completely irrelevant. We said this a month ago when we cautioned, precisely about Chesapeake, that "to all those scrambling to short the company: beware. CHK has a history of being able to fund itself with HY bonds and other unsecured debt come hell or high water. If and when the stock tanks, the short interest will surge on expectations of a funding shortfall. Alas, courtesy of the Fed's malevolent capital misallocation enabling, we are more than confident that the firm will be able to issue as much HY debt (unsustainably at 10%+, but that is irrelevant for the short-term) as it needs, crushing all short theses. What this means, simply, is that anyone who believes traditional fundamental analysis will and should work in the CHK case is likely to get burned." Sure enough, we were again proven right: Chesapeake just announced, following today's epic drubbing, that it is refinancing its secured debt facility (with its numerous restrictive covenants) with $3 billion in brand new Libor+7.00% unsecured paper (courtesy of Goldman and Jefferies). In doing so, CHK just got at least a one year reprieve.

From 1981 to 2007, the amount of debt required to produce $1 of GDP growth crept higher, and it ranged from a low of 3 cents in 2000 to a high of $2.25 in 1991.  In only eight of those years did it take more than $1 of debt to produce $1 of GDP growth—1982, 1986, 1990 to 1993, 2002, and 2003.  On average, it took 79 cents of debt to produce $1 of GDP growth.  In other words, the increase in GDP was nearly 1.3 times the increase in debt. Along came the Great Recession.  Since 2009, the traditional relationship between debt and GDP growth has been turned upside down.  Each $1 increase in GDP has been accompanied by, on average, a $2.50 increase in debt.  Before the recession, an increase in debt generally generated a greater increase in GDP, but now it takes an enormous increase in debt to eke out a small increase in GDP.  At some point, the amount of debt required to generate even modest GDP growth will suffocate the economy and trigger another financial shock.

Curious how the world's most important trading desk saw the action today? Here it is.

Update: now S&P is also one month behind Egan Jones: JPMorgan Chase & Co. Outlook to Negative From Stable by S&P. Only NRSRO in pristinely good standing is Moodys, and then the $2.1 billion margin call will be complete.

So it begins, even as it explains why the Dimon announcement was on Thursday - why to give the rating agencies the benefit of the Friday 5 o'clock bomb of course:

• JPMorgan Cut by Fitch to A+/F1; L-T IDR on Watch Negative

What was the one notch collateral call again? And when is the Morgan Stanley 3 notch cut coming? Ah yes:

So... another $2.1 billion just got Corzined? Little by little, these are adding up.

BTFD/STFR Deja-Vu - check. Credit underperforming - check. USD higher - check. Treasury Yields lower - check. Ask an equity guy how today was and you'll likely get a shrug of the shoulders (unless he owns JPM or CHK); ask a credit guy (if you can pull him away from the bar) and you'll get a very different response. Investment grade credit markets were crushed today on the back of pressure on JPM's hedge and unwind expectations - this was across pretty much all the indices that are out there (with over 90 names in the IG9 index also in the on-the-run IG18 index - the numbers simply reflect the series or portfolio that is being referred to). This was the worst week in IG credit of the year and lifted spreads to 4-month wides and at the same time (until late in the day) high-yield and high-beta credit did not follow suit (very unusual and very indicative of the dramatic positioning in the IG indices that JPM has basically blown up). Treasury yields have now fallen for the 8th week in a row - the longest streak since 1998! Away from pure equity and credit, risk assets remained wildly unimpressed by the incredible 8 sigma rip-fest this morning in stocks as commodities all close lower from yesterday day-session closes - though bounced to end around their European open levels on the day (except for underperforming Copper). The USD leaked higher all day with a small interruption thanks to CAD strength on their jobs data this morning (AUD, EUR, and GBP all close at the week's lows). A horrible end to an ugly week as S&P 500 e-mini futures ended very close to their 50DMA on above average volume though low average trade size (which we suspect was dominated by algos in the rip this morning). The losses JPM faces from today's index shifts are already large and with risk managers everywhere asking their traders if they hold any of that 'trash', we suspect more selling and unwinds are to come; and while JPM got all the press, Morgan Stanley is now down year-to-date.