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The Next Leg In The European Crisis? Money Markets Lead The Way With Puttable CDs
From Nic Lenoir Of ICAP
I am sorry I did not send anything yesterday, I had nothing intelligent to say other than a few Elliott Waves consideration on Gold that I will share in my next update. Today however money market developments and what our cash desk and some other money market traders were kind enough to share with me caught my attention tying in some currency observations I made Tuesday.
Basically what strikes when looking at the recent sell off from 1,125 down to 1,006 is that EURUSD actually moved up during that period. One could say it's just a break in correlation, no big deal. I beg to differ. The last sell off occured because data was bad, and that made those who doubted realize that the top in economic activity is in and we are now rolling over. That is contrarily to the previous sell-off which was due to credit deterioration. Now a bad credit market always comes with a squeeze in USD funding which puts a bid behind the currency. Thus when I saw the lack of correlation between equities selling off and EURUSD, I immediately called a friend who happens to be a very smart credit trader who confirmed that credit was drastically outperforming equities during the move.
This is what bothered me in terms of the bear case. We have all the seeds for a proper credit collapse, we get the economic roll-over which is what will invariably trigger the refinancing difficulties and possibly defaults, and all of a sudden credit rallies. I feel a bit cheated. Clearly it cannot be the European stress test giving investors confidence, they can't possibly be that stupid. The test is made to be passed obviously so it's a farce "a la Geitner". However this is were talking to money market insiders helps. The last few weeks there have been a whole bunch of puttable CDs being issued by European banks, and overall apparently that has given money markets some confidence and money is being put to work. That also explains why people have been buying EDU0 99.50 and 99.625 calls or the future outright, a thawing of the funding market would clearly lead to lower Libor, and the Fed which had started pulling liquidity away has basically stopped with global liquidity indicators showing signs that cash has been added to the system. Those puttable securities allow money market funds to treat it as a trade of maturity the put notice, rather than the full duration of the CD is the option is not exercised: you basically get a 1Y rate for a 7 day deal yeeeehhaaaaw! So Money Funds love it, and even though the banks don't get credit for full duration liquidity but instead liquidity that has the put notice as duration, it allows them to fund themselves. No wonder European banks love it too. It then makes complete sense to see EURUSD doing a bit better even when stocks sell-off, and we get compressing swap spreads and lower vol as well (helped by both selling of the optionality by money market funds who only really care about going around their new SEC regulation not buying options, and a slew of agency issuance being digested).
That trend should probably continue and as a result I would not be surprised to see Libor come off a little bit, or at least a rally in the front eurodollar contracts. The 61.8% retracement in equities comes in at 1,080 and if credit keeps helping equities up that's where I would see the resistance come in. Ater all if the economy is rolling over there is just so much rallying in equities we can have...
Now for the bigger picture, I think these structures are poison. The remind me of the abominable auction rate securities. For those not familiar with this turd, auction rate securities were basically long term bonds (30 or 40 years in some cases) paying a rate decided at an auction every 28 days in general based on the demand at auction. Because supposedly auction never fail the rate was that of a 28 day deposit, so you get 40 year cash at a 28 day price. Everybody thought it was the most awesomest thing ever (actually as a trader I was asked to build a book of that stuff and I refused saying we were better off lending money for 28 days and rolling it... I never got a thank you note from my former employer). You were supposed to be paid a penalty rate if you could not sell it at the auction when you wanted to get rid of it like Libor + 120 basis points. Only thing people forgot to consider is the day when no one shows up at the auction getting Libor + 120 from a company which is most likely struggling to get cash is pretty crappy and your bond is worth 15 cents at that point. Sure enough the day one failed they quickly all did and a lot of people lost a ton of money. Now please meet the puttabe CD, a great proof that you can fool people many times contrarily to Georges W. Bush's belief. Now the day one of those gets called, and it will invariably happen because one of the toxic European banks is bound to go under (can you spell caja?): there is just so much you can extend and pretend, they will all get called into a giant tsunami which will be the modern financial engineering version of a run on the bank, except all the banks will get whacked at the same time. I wonder whether the guys will indeed get their money back... better be the first one to ask for it! So we are planting the seeds for a nice blow up, and until it happens, be sure to see a lot of these puttable CDs being issued and bought as it allows money funds to go around the new regulation and European banks to get funding. Be sure that absolutely nobody at the SEC understands any of this by the way, they will wait for the audit led by Congress post blow up to give it a thought.
Now because I have spoken of the EURUSD, I owe you a few charts. First we see on the weekly that we have almost come to retest the H&S neckline at 1.2750. Then on the daily chart we see that line joining the tops comes in around 1.2730. We have bearish divergence on the hourly chart, and on the 20 minute chart we see something that looks a lot like and ending triangle. I would suggest selling around 1.27 with a stop on a daily close above 1.28. The C=A extension since the lows comes in at 1.2750 as well, so we have a nice cluster of resistances here. I think we have moved quite a bit from the lows in EURUSD and even though as we discussed it is because of money market transactions in part, with the details of the European joke of a bailout coming up could be a good way to play buy the rumor sell the news.
Good luck trading,
Nic
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. Greece has a giant union problem. Aside from the government and its agencies, the Greek public sector includes a variety of enterprises in various sectors of the economy. Some of these concerns enjoy monopoly status, such as the Public Power Corporation, the Greek Telecommunications, and Olympic Airways, which alone operates domestic air travel. Other public-sector enterprises, most notably national banks and manufacturing companies owned by them, coexist with private firms in their field of activity. They need to be dismantled, not negotiated with.( All you wanted to know about the Greek public sector and unions.)
2. It is politicly impossible to make the budget cuts that are need for an “internal devaluation”, which is a code for deflation. If Greece is to stay in Euro they need to cut wages by 30%, and that includes the government sector.
3. The bond market doesn’t agree with the politicians, and as the last two years have shown the bond market is usually right. With a 10 year note at over 10%(!) And falling domestic demand no economy can survive. Businesses can’t borrow money to expand or even stay in business
Source:
Why the Euro Crisis Is Far From Over
This is tough to understand. Can anyone sum this up in a simpler fashion?
Credit is fallaciously improving due to yet another CB reach around manuever which is destined to fail in due time. Now we can all get back on our unicorns and live in the pipedream for a little longer
"For those not familiar with this turd,"
Personally, I'm not offended by this.
That said, if Nic is right, and I certainly have no reason to doubt him, he has crafted a plausible fundamental explanation for the meteoric rise of the Euro. As for his conclusion, I'm sure he's correct here, too. "Pretend & Extend" will only work for a period of time and when the music stops, the disaster will be breathtaking.
Oh, don't worry, when this fails they'll just come up with something else, ad nauseum. The Central banks are God, so harken unto the Lord !
Is it just me? Screw modern finance! It's killing us and our children. Kids, do somthing useful with your careers. Stay away from finance.
Meanwhile - huge "miss" on consumer credit: http://finance.yahoo.com/news/Consumer-borrowing-down-apf-369803114.html?x=0
-$9.1B (vs. expected of -$3B)
May also revised down sharply (-$14.9B vs. +$1B)
Bullish, I'm sure.
OMFG, did they intentionally cook those numbers last month to hide the pull back in consumer spending last month??? What will the revised figure be next month?
Does anyone remember how bullish that was last month???
Financial bomb making at it's best.
Looking for something witty to say but all I got for you is ... Huh? Say What?
Can you give us those Elliot wave thingies on Gold instead? Thx
O so neat - so much resembles the sham market in auction rate securities, the second any trouble bank has to redemm all them puttables and has liquidity crisis part 2. Wunnerful....
Why don't these rocket scientists start playing with atomic bomb designs? It would be much safer for the rest of society, and do far less damage. With the added benefit of possibly removing them from the gene pool.
I shall do my best to summarize what Mr. Lenior is getting at:
You have money market funds who are buying Euro bank CDs with confidence because the securities are structured in a way where one can also buy/sell puts on them. Without the put option there is no reason money market funds or euro citizens would want the CDs because the lack of transparency/uncertainty along with unnecessarily low yields.
This part has confused me the most: "Those puttable securities allow money market funds to treat it as a trade of maturity the put notice, rather than the full duration of the CD is the option is not exercised: you basically get a 1Y rate for a 7 day deal"
So in addition to the put option there is some kicker that the money market funds that in the tradition of our financial engineering projects the appearance of higher reward for less risk. Taking those factors as a given one can further extrapolate that the 400bln Euro roll we were worried about was a non-event largely because banks were able to raise cash through these puttable CDs. This kick-started a mini virtuous cycle where strain came off the interbank lending markets and the Euro got a little pop.
BUT the first time one of these puts are exercized it will sour market for all these instruments and we'll face the reckoning that should have come the other day. Again, just trying to summarize Mr. Lenior and hoping to get a lil clarification from the more experienced among us.
Stay Classy ZH
Basically, they were all out of ways for banks to get cash, no one wanted to lend to them, so they invent an insurance policy( kinda like PMI on a mortgage, that obviously doesn't pay either, ask AIG if you want to) to make people think their risk is covered. The problem is AIG blew up didn't it? SO will these instruments. It is nothing more than financial engineering at its finest. Instead of fixing the problem the right way, its more of the same cover it up and hope we can work our way out of this mess.
So they have inherently, tripled down their bets now to save a fraudulent system that is collapsing on them. What usually happens when you keep doubling and tripling down at the blackjack table?? You end up going home broke off of one single bad hand.
So let me see if I have this straight.
They bought CD's on crap banks. Sold Puts on same CD's in the hope that they would never have to pay out on the Puts?
It seems like a gift that keeps on giving until it doesn't.
The worse part is, the ones who bought the CD's will take the brunt of the losses, not the ones gambling on the puts. And the bank of course, gets backstopped by the ECB. When you buy a CD you expect a return and a safe investment, and they just turned bank CD's into a MBS/derivative fraud. I told you guys that the accounts lady at the bank said these scum bankers were dreaming up ways to make sure they get their bonuses. This is just another form of it. How long till we see this in the U.S. ? I'm sure its just a day or so away.
See thats the quesion i'm looking to answer. Is it the money market funds who are buying these CDs who are then writing puts against them for the enhanced yield? I did not get that impression from Nic's piece, though I also am not sure one would be able to write naked puts on these CDs either. The impression I got was this put protection made the CDs more appealing because it was another way to guarantee return OF capital, rather than the put writing ability providing a kicker of extra income.
Auction Rate Munis ring a bell? Brilliant.
You get an interest rate more reflective of the counter-party risk for a longer dated piece of paper, but can carry it for accounting purposes as short term (maturity restrictions on MMF's) because the bearer can put it back to the issuer.
Right.
Like the market is not efficient enough to recognize the structural risk. Just the issuer and each specific holder understand the deal. The issuer is giving something away to the one issuer because he's liked. The buyer thinks that he's the only one getting the deal?
Nope, no free lunches. The differential in the rates is accounted for by an options pricing of the event of default within the proscribed time horizions (put versus maturity) and premium associated therewith (rate differential).
Standard money market instrument fare (dripping sarcasm) which unbeknownst to all, best surfaces its head during times of relatively low rates or associated with ungainly creditors. The proverbial quest for yield.
Is it denominated in Euros, too? Joy of Joys!
Help!
I second the earlier poster who said. ("This is tough to understand. Can anyone sum this up in a simpler fashion?")
Ok, there is no such thing as derivatives, or arb for dummies, but could someone smarter than me (many here qualify) run by me this one more time. (slowly)
In short, another ponzi scheme to hide failing banks.....that when it blows up in there face like all the rest of their engineered products have...they will have to be saved again by the ECB/FED .....see above for a synopsis.
I guarantee Reggie could put this in terms where even Palin could understand with examples of what happens when it blows up in their faces. What say ye Reggie?
Thank you.
Re-read your post above.
Re read the article. Couple of more questions.
How big is this? I mean how much are we talking about here? Who exactly are we talking about here? Which banks?
The idea that the ECB will back stop this nonsense ... I dunno. People in Europe are getting pretty pissed off with this imposed austerity crap.
I have a friend in Ireland who has taken a 30-50% haircut on the value of his house, 600 euros a month paycut and the bank call him before his credit card bill is due. I told him not to buy the house btw.
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