Bond

Reading a 901 page Goldman document production (cover to cover) at 36,000 feet has proven to be both relaxing and quite productive. Among the plethora of emails, documents and memoranda, we may have stumbled upon something that could prove to be an even "bigger short" for John Paulson than RMBS: a $2 billion position in Bear CDS initiated prior to January 2007, as well as all other financial firms. Additionally, we discover that arguably the world's richest hedge fund manager (for a reason) was prophetically putting on bank counterparty hedges as early late 2006, up to and including Goldman Sachs itself. Most relevantly, in what could be damaging disclosure by Fabrice Tourre, the Frenchman notes that as a result of Paulson's mistrust of Goldman's counterparty risk, the Abacus AC1 deal was structured in a novel way in which "they would be acting as protection buyer, facing the ABACUS SPV (as opposed to a structure where Goldman is protection buyer as is usually the case)." This little legalistic variation could make a world of difference in an Attorney General's hands. It may be time to very carefully read the indenture of AC1 and compare it with those of 2006 and earlier "Abaci."

Moody's analyst Sarah Carlson, who by no means is a disgrace to her job, and is fully justified in keeping an A- rating on a country whose 2 Year debt was trading north of 20% until yesterday, when Europe decided to use US tapxayer money to bail out its own, finally finished the special olympics marathon (no pun intended), only a couple of years late. We wonder if any of the Moody's analyst corps will be offered as a (not so virgin) sacrifice to placate the angry gods of Berkshirehathawaya. We hear Buffett has a soft spot for the XX (chromosomes), even if it derives from companies in which he has already decided to liquidate his entire stock position (but slowly... slowly... don't forget uncle Warren is just the nicest guy in the world and would never take advantage of the market's stupidity).

Now that moral hazard has been adopted everywhere, and the fate of the entire western world is determined by the successful issuance of hundreds of billions of dollars each and every month (we have gotten to the Maginot line where even a hint of a failed US auction would immediately blow up the global capital markets), it is prudent to take a detailed look into a topic that few have covered previously, namely what does the auction demand curve imply. We refer to the distribution of the Low-Mid-High yield break points in each and every treasury auction and whether they can provide some addition insight into the demand picture behind US sovereign debt.

Good thing the ECB (and the IMF) no longer cares about what the Geiger counter reading on its collateralized assets is any longer. The rating agency which also has the last A-rated Greek rating is reviewing the Greek sovereign rating for further downgrades. Mortgage covered bonds of NBG, Alpha, Marfin and EFG Eurobank downgraded to A1. All on review for further possible downgrades.

Hands down, our favorite quote on investor’s lack of historical memory comes from Jeremy Grantham who said: “We will learn an enormous amount in the very short term, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent.” In this spirit, we highlight the lessons that should have been learned from the turmoil of 2008, complements of Seth Klarman. The excerpt below is from his annual letter. While most market participants have immediately forgotten these lessons, more prudent investors (who may still suffer from short term memory loss) should consider dusting this list off on an annual basis!

• Asian currencies gain, bond risk drops after Fed pledges to keep rates low.
• Asian stock markets little lower, on concerns of a spread of sovereign debt risk in Europe.
• Australia raises excise duty on tobacco by 25%, ends advertising.
• Australia poised to force tobacco companies to sell cigarettes in plain packs, a world first.
• Brazil lifts benchmark rate to 9.5% from 8.75%.
• European stocks rise after the IMF promises to increase the aid for Greece to 120B euros.
• Fed restated their intention to keep benchmark interest rate near zero for “extended period”.
• Global stock markets mixed as European debt crisis continues to unsettle investors.

The ongoing Greek debt crisis has revived the old arguments that all national governments need monetary sovereignty. So, what if Greece had stayed with the Drachma, and never switched to the euro? Would this debt crisis be averted?

A massive arbitrage has developed in European sovereign CDS, where the differential between local and foreign-denominated (euro and dollar most typically) CDS has jumped to record spreads. Case in point Germany, where €-denom CDS trade at 30 bps, while the $ equivalent is 43 bps, a 30% spread differential. The reason for this is obvious: as concerns of pan-european defaults have hit the euro, getting paid off on euro-denominated default protection seems increasingly less attractive. Should, say, Germany default, €10MM worth of protection on a German credit event would be worth much less at default which would certainly be accompanied by an almost full devaluation of the euro, resulting in a huge hit to the "at converted" currency, presumably dollars (as the euro would no longer exist). This has led to a major drop in demand for EUR-denom German (and other European) protection, with the differential hitting the abovementioned 30% margin. As Fitch discloses, this spread was just 7% in January. As this is a second derivative play on both currency devaluation/vol and increasing default risk, arguably the most profitable way to bet on a the confluence of factors that impact the eurozone could be a simple quanto swap trade, which could reap massive rewards should peripheral or core European weakness persist.

There is no question now that the complacency about Greece and the peripheral European implosion is identical to the Bear->Lehman->Financial collapse pathway that the US experienced between March and September 2008. And just like back then Bear was small enough to bail out, soon we will hit a country that not even the IMF's half a trillion rescue facility will be sufficiently large to prevent from teetering over. At this point it is nothing but a waiting game. However, unlike the US, when after Lehman the Fed scrambled to throw $24 trillion of Fed signed paper at the fire, expecting a comparable coordinated and rapid response from the Eurozone is ludicrous, especially with Goldman shorting it. So those who believe they can time the market melt up until the next unsustainable sovereign blow up - good luck (of course here we refer to the daytraders who take their guidance from the Momo Money brigade, whose refrain for 60 minutes each day is "it will go up because it is going up." Brilliant). For everyone else, we present a short primer from UBS on how to play the sovereign crisis, at least until the point when playing anything is futile and the global scramble for cash crashes the Keynesian dream.

Notice how many central bankers, analysts, pundits, banks and politicians said the debt problem was not only contained to Greece, but was also solved and all should move on. Uh huh...
I believe what we are seeing is just the beginning, and what the world saw with the collapse of Lehman was simply a microcosm of what happens when actual sovereign states threaten to fail!

The drama continues following S&P’s slice to Greece’s debt rating (to junk status of BB+, a three-notch decline, which prompted a surge in 2-year bond yields to a Zeus-like 15%) and the two-notch decline to Portugal’s rating, to A- from A+. The Euro has bounced back this morning and the flight to higher quality German and French bonds has partly reversed course as the markets are swirling with speculation that the IMF is about to announce a stepped-up aid package (yet again!) and the ECB’s Trichet (“Mr. Euro” himself) is set to make a trip to Berlin to meet with German parliamentarians today. (In the U.S., the huge rally in Treasuries has subsided too as the bond market braces for $42 billion of fresh 5-year T-notes today). JGBs have rallied all the way to four-month lows, in terms of yield, to 1.28% — talk about a switch to defense (not to mention a slap in the face to the conventional wisdom that JGBs are an accident waiting to happen)

Help those most in need
Yes, you read that correctly! Greece killed its own banks. You see, many knew as far back as January (if not last year) that Greece would have a significant problem floating its debt. As a safeguard, they had their banks purchase a large amount of their debt offerings which gave the perception of much stronger demand than what I believe was actually in the market. So, what happens when these relatively small banks gobble up all of this debt that is summarily downgraded 15 ways from Idaho.

Improving California state finances make its municipal bonds a “buy.” With California in the heat of primary elections, this is good news no one seems to want to talk about. Inconvenient ties to the “vampire squid.” With taxes about to skyrocket everywhere, tax free municipal bonds are about to become more valuable. What’s this movie, "Fight Club", all about, anyway? (VCV), (NCP), (NVX).

Spreads were considerably wider across the board today as the peripheral European nation contagion, that we have discussed, started to spread. The scrambling of debt investors dominated any macro data or earnings today as risk appears to be getting repriced fast and furiously and Main traded wide of IG (for the first time on record) as dispersion rose, low beta underperformed, breadth was terribly negative, and movements were considerable in single-name CDS.

The funding crisis is finally becoming a stock market crisis. Greek bond pricing service HDAT has suspended all bond trade indications.The banking sector is now down 17%. We will keep you updated on the Lehman, pardon, Greek collapse.