Capital Markets

A month and a half after the SEC took a much-deserved break from watching taxpayer-funded pornography, and stumbled on the scene with its latest pathetic attempt to scapegoat someone, anyone, for its years of gross incompetence, corruption, and inability to prosecute any of the true perpetrators for an event that wiped out tens of trillions in US wealth, by suing Egan-Jones for "improperly" filing their NRSRO application in what was a glaring attempt to shut them up, the only rating agency with any credibility has done what nobody else in the history of modern crony capitalist-cum-socialist America has dared to do: fight back. We have only three words for Sean Egan: For. The. Win.

That former San Fran Fed chairman Janet Yellen would demand more easing is no surprise: she used to do it all the time. That Fed Vice Chairman, and Bernanke's second in command, Janet Yellen just hinted that she is "convinced that scope remains for the FOMC to provide further policy accommodation either through its forward guidance or through additional balance-sheet actions", and that "while my modal outlook calls for only a gradual reduction in labor market slack and a stable pace of inflation near the FOMC's longer-run objective of 2 percent, I see substantial risks to this outlook, particularly to the downside" is certainly very notable, and confirms everyone's worst dream (or greatest hope assuming they have a Schwab trading platform or Bloomberg terminal) - more cue-EEE is coming to town.

The ascendency of behavioral economics over its “Classical” cousin is one of the more notable effects of the market turmoil of the last five years.  Simple constructs like “Every marginal dollar has utility” have given way to more nuanced explanations that incorporate how human beings really make decisions about the tradeoffs between money and deeply held emotions and beliefs. But even with this realization, academia still seems to have a choke hold on the studies that expand our knowledge of this new discipline.  Nic Colas, of ConvergEx, adds to the discipline’s canon with some examples of common street scams around the world. The comparisons he makes to recent events in the capital markets are fairly obvious, whether they be failed IPOs or the strategies used by weaker sovereign nations to negotiate with stronger ones.  The point here is not to call out anyone as inherent ‘Criminal.’  There are plenty of laws – and diligent regulators - surrounding the capital markets, after all.  Rather, the examples here are simply a lens that allows us to examine the nuances of human behavior with greater understanding. As the old saying goes, 'The proper study of mankind is man.'  Even when it is a con man.  And in the case of behavioral economics, perhaps especially so. 

First Moody's cut the most prominent Austrian banks, and now it is Germany's turn, if not that of the most undercapitalized German bank yet: "The ongoing rating review for Deutsche Bank AG and its subsidiaries will be concluded together with the reviews for other global firms with large capital markets operations." Punchline: "Frankfurt am Main, June 06, 2012 -- Moody's Investors Service has today taken various rating actions on seven German banks and their subsidiaries, as well as one German subsidiary of a foreign group. As a result, the long-term debt and deposit ratings for six groups and one German subsidiary of a foreign group have declined by one notch, while the ratings for one group were confirmed. Moody's also downgraded the long-term debt and deposit ratings for several subsidiaries of these groups, by up to three notches. At the same time, the short-term ratings for three groups as well as one German subsidiary of a foreign group have been downgraded by one notch, triggered by the long-term rating downgrades."

• Spain Seeks Joint Bank Effort as Pressure Rises on Merkel (Bloomberg)
• Banks Cut Cross-Border Lending Most Since Lehman: BIS (Bloomberg)
• Shirakawa Bows to Yen Bulls as Intervention Fails (Bloomberg)
• Merrill Losses Were Withheld Before Bank of America Deal (NYT)
• Investors Brace for Slowdown (WSJ)
• China's lenders ordered to check bad loans (China Daily)
• Obama Seeks Way Out of Jobs Gloom (WSJ)
• Noda Reshuffles Japan Cabinet in Bid for Support on Sales Tax (Bloomberg)
• China to open the market further (China Daily)
• Australian Industry Must Adapt to High Currency, Hockey Says (Bloomberg)
• Tax-funded projects to be more transparent (China Daily)

If the U.S. Federal Reserve were a hedge fund, its phones would be ringing off the hook with prospective investors wanting fresh allocations and Ben Bernanke would be zipping around the French Riviera in a gold-plated helicopter.  The Fed’s multibillion-dollar position in Treasuries is nicely in the money with the recent moves to record lows risk-free yields, after all.  But it’s policy outcomes, not returns, that the Fed is after.  By that measure, the current record low payouts in “Safe Haven” bonds (U.S., Germany, U.K, for example) are troublesome.  There is, of course, the worry that they portend a global recession.  This concern cannot be waved away with the notion that a worldwide flight to quality totally upends the bond market’s historical function as a weather-vane of economic expansion and contraction.  Beyond this concern, however, Nic Colas of ConvergEx sees two further worries.  The first is that the Fed has needlessly compromised its independence by pursuing bond purchases that, in hindsight, were unnecessary in the face of the current economic outlook and investment environment.  The second is that interest rates have been demoted to a supporting role in kick starting any global economic recovery. As with unfriendly aliens unpacking their bags at a landing site, the move to record low rates around the world is a truly menacing development. Historically, low interest rates have generally sparked economic recovery.  In the current environment, this gas-down-the-carb approach seems to have simply flooded the engine of growth.  Other factors are at play, as I have outlined here. The real answer is simply more time.

Excuse a rant...

To be clear, the Fed, indeed, Global Central Banks in general, have never had to deal with a problem the size of the coming EU’s Banking Crisis. I want to stress all of these facts because I am often labeled as being just “doom and gloom” all the time. But I am not in fact doom and gloom. I am a realist. And EU is a colossal mess beyond the scope of anyone’s imagination. The World’s Central Banks cannot possibly hope to contain it. They literally have one of two choices:

1. Monetize everything (hyperinflation)
2. Allow the defaults and collapse to happen (mega-deflation)

All you need to read

With so many countries vying for the dubious honor of “Sick man of Europe,” ConvergEx's Nic Colas looks at some of the academic literature related to how doctors make sound diagnostic decisions.  The medical profession suffers from many of the challenges we all face in making sound judgments, fighting off inherent biases and shortcuts to make consistent decisions based on the facts.  The one difference is that medical professionals must often make their decisions “On the fly,” with life or death often in the balance.  In contrast, European policymakers have, thus far, had the luxury of time in addressing the region’s challenges.  But if the pace of crisis picks up in the coming months, the ECB/IMF as well as other monetary and fiscal policy bodies will have to move more like an army field surgeon than careful diagnostician. The ongoing challenges in Greece, Spain, Italy and other European countries could be considered either economic malpractice or misdiagnosis. Will they see “Austerity” as the cure for every ailment, or will they remain flexible?  Will they remain overconfident and (potentially) overplay their hand? It is tempting to say that policymakers should follow the Hippocratic Oath and “First, do no harm.”  Sadly, the situation in Europe is beyond that simple recommendation. 

Update: It appears that when a company calls the market's bluff with a forced strategic alternatives announcement coupled with the phrase "challenging financial performance", the market does not like it very much. Stock now down 13% and sliding.

RIMM stock was just halted, preceding an announcement that JPM and RBC have been retained for "strategic purposes", as well as an operating loss warning for Q1 and notification of major headcuts. In other words, the endgame for RIMM is here: either the company finds a suitor or it may well be game over. For the benefit of RIMM longs we sure hope FB is eager to spend some of its cash soon if not quite soon.

Experienced investors try to avoid the "confirmation bias" trap by asking what supports the other side of the trade. Confirmation bias is our instinct to find data to support our position once it is taken. To counter this bias, we must attempt to build a plausible case against our position. If the effort is sincere, we gain a fuller understanding of the market we are playing (or perhaps avoiding). That the global economy is going to heck in a handbasket is self-evident. If you over-weight anecdotal "on the ground" evidence and fade the ginned-up official statistics, it is obvious the global slowdown is picking up speed in Europe and China, two of the world's largest "linchpin" economies.

Exit from the Euro would be very painful for Greece. Cut off from the ECB’s liquidity facilities, the Greek banking system would face collapse. And, as foreign lenders cut their credit lines to Greece and depositors struggled to extract their deposits ahead of the banks’ failure, the Greek financial system – and with it the Greek economy – would seize up. Given the costs of exit for both Greece and other Euro area countries, a powerful incentive exists for the two parties to reach a compromise that permits continued Greek membership of the Euro area but in the meantime the pan-European game of chicken continues and with each iteration of this game, the political cost to the two parties involved has increased. Goldman sees three key scenarios from this: Muddle Through (this is their 'Goldilocks' base case and implies continued Greek EMU membership, and ECB funding for Greek banks, but also continued pressure on Greece to reluctantly implement reforms while at the same time the remaining Eurozone countries very gradually deepen their policy integration) - which is modestly positive (though likely more range-bound) for equities and bonds with weak growth and Fed QE3 potentially pushing EURUSD up to 1.40; a Fast Exit (the least likely and most bearish scenario with Greece walking away unilaterally potentially knocking 2 percentage points of Euro-area GDP - even assuming substantial central bank counter-measures - and if the firewall were ineffective, a Euro-unraveling and an associated double-digit fall in Euro-area GDP); and a Slow Exit (Greece excluded once firewalls are in place - with pan-European deposit guarantees now front-and-center as opposed to simple banking bailouts to avoid the now-critical bank-run's contagion - which constitutes modest GDP impacts and compression in risk premia - and appears to what the market is discounting as likely). Simply put CB counter-measures are assumed to save any dramatic downside unless Greece surprises unilaterally.

Last week, when we reported on the then brand new record number of EUR non-commercial short contracts as reported by the CFTC, we said: "with such a massive surge in shorts in a short period of time, this means that the likelihood of major short squeezes is substantial on even the most innocuous of news, such as a G8 summit which promises much but delivers nothing, or China once again saying it will gladly focus on growth (as opposed to what? non-growth?), or some DieBold-inspired leadership change in the Greek pro/anti-bailout polls. Our advice to FX trading readers: be very careful with EURUSD stops: it is very likely that in their pursuit of short covering squeezes, (BIS) algos will take the pair substantially into the offer-side stop limit buffer just to force short hands out, which in turn may initiate short-term covering ramps." As of last Friday, the record number of net short contracts (-173.9K), just rose to a new all time high of -195.4K. The result: something as worthless and meaningless as uber-volatile Greek political polls (which had Syriza with a 4 point lead last Friday, which somehow dissolved and is now in second place about 24 hours later), was enough to send the EUR higher nearly by 100 pips overnight. Obviously, with ever more record shorts in the currency, expect the desperate continent to come up with nothing but more flashing red headlines in attempts to spook weak hands and incite even more very transitory short covering.

Back on March 27, following the epic disappointment that was the BATS IPO, we presented a detailed forensic analysis courtesy of Nanex, which demonstrated step by step how a Nasdaq-borne algo may have been the culprit shattering BATS' hopes of ever going public. Fast forward two months later to the most anticipated IPO in recent history, in which FaceBook's even more epic, if not quite as stark, implosion has set back the general public's faith in capital markets decades back. The irony, of course, is that FB didn't do anything that many weren't warning about: it simply plunged which would make perfect sense in a normal world. This in turn was the spark that provoked the public ire - had FB simply doubled since IPO day, nobody would care about what really happened on May 18. Alas, it didn't. And now the lawsuits come. The problem is we don't transact in a normal world, but one dominated by central banks and algorithms - which is why the most pressing question for those who grasp the real new normal is how come in a market as controlled and manipulated as the central bank-dominated venue we have now, was FB stock allowed to plunge? For what may be the actual definitive answer, as opposed to now trite philosophical ruminations on valuation, ethics, underwriter and shareholder greed, we once again go to Nanex, which has caught the perpetrator red handed once again... As Nanex' Eric Hunsader tells us: "Turns out just before Nasdaq's quote crossed and became non-firm, one copy of the same quote (crossed) was marked regular, and I think that caused other algos to react and immediately sell off the stock. When that crossed quote from nasdaq appears, bid prices from other exchanges suddenly evaporate and that causes the NBBO spread to explode from 1 cent to 70+cents in 1/10th of a second! Nasdaq's quote started doing this when the stock approached 42.99 -- that effectively prevented the stock from going higher (a few spurious trades right at the open came from BATS for 44 ~ 45 etc, before Nq's quote was in play). So these stupid Algos effectively short circuited the stock for Facebooks IPO! Unreal."