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Naked In Europe
From Peter Tchir of TF Market Advisors
Naked in Europe
So Europe is getting closer to announcing some form of ban on naked CDS. What they hope it will accomplish and what it will actually accomplish are two very different things.
First, let's look at the mindset. It about a ban targeted at entities that buy CDS (go short the credit). It doesn't target those who are selling protection. Why is it fine for an institution to sell protection? If the goal is to support the bond market, ban the sellers of protection. Anyone who sells protection is doing that rather than buying bonds. If an institution couldn't sell CDS "naked", and they wanted exposure to the sovereign risk, they would have to buy bonds. Isn't the contagion risk and counterparty risk all related to those who sold CDS? Yes. Wouldn't an exchange or full clearing help this without hurting the market? Yes, but somehow that is "off the table" as too complicated.
Anyways, so what do they hope to get by banning naked shorts? They expect CDS to tighten. That will likely be the initial reaction. They expect a tightening in CDS to lead to improved purchases for bonds. That is unlikely to occur.
Let's take a close look at Italy to show why their expectations are likely to be disappointed. First, it is important to remember that CDS on Italy trades in $'s and their bonds are denominated in Euros. That is a key difference. If you buy (or sell) CDS on Italy, the flows are in $'s. So as Italy widens you make money on the CDS. You would also make money being short Italy in the bond market. If the correlation between Italy widening, and Euro weakening is high, the CDS is a better way to be short. This creates a basis that is far more complex than a straightforward CDS where the CDS is denominated in the same currency as the underlying bonds.
Italian 5 Year Bond Yields, Spread to Bunds, and CDS
It is easy to see that there is relatively little correlation between Italian bond yields and CDS. Spreads are in many ways more important, but at some level it is the yield a country is paying that matters. It is also true that as a country becomes deemed to be a real credit risk it no trades on a spread basis, it trades on a yield basis, and ultimately moves to trading purely on price. Investors in Ireland and Portugal are looking at yield now. Those countries have moved past the point where anyone thinks of them in terms of spread to bunds. Greece has moved purely to trading on price. No one really cares what yield they are getting, it is all about price. It is also useful to note that yield is not well correlated with CDS because much of what is being discussed as part of a European “Solution” would cause German yields to increase – partly as the flight to safety bid dissipates, and partly because they will be shouldering a larger debt burden to prop up the rest. In any case, if any politician is expecting Italian yields to move with CDS, there is very little historical data to support that.
CDS and the spread to bunds are more correlated.
The spread to bunds and CDS are definitely more closely tied together. This chart at least gives hope that if the EU can get Italian CDS to go a lot tighter, the bonds could trade tighter. Working against that argument is the fact that the CDS is already trading at a wide basis, so some of the tightening in CDS would just normalize the basis, and as mentioned earlier, some of the spread tightening will be offset by rising German yields (absent a massive rate cut by the ECB). So at least from this graph, there is some reason to believe that collapsing CDS levels would help the problem in the EU, but even here it is not horribly compelling as they seem to move inline more often than not (CDS isn’t a clear leading indicator) and the basis right now is quite high anyways (the correlation between Euro Credit Spreads and FX rates at very high right now).
The next chart might be the most interesting. The ECB entered into two big bond purchase programs, last fall and August of this year. It is interesting to see how bond spreads tightened as they were the direct beneficiary of the ECB intervention, but the CDS market relatively ignored the intervention. It is also worth noting that after the period of intervention the bonds drifted back to their fair market value rate.
I would expect a similar reaction to intervention in the CDS market. The CDS market would react as it is the “beneficiary” of the government intervention, but the bonds would not blindly follow CDS tighter. The bond market would realize that the CDS move was artificial. You would likely see some initial move tighter as investors scramble out of bad hedges, but then what? Expecting bonds to respond to a manipulative intervention is a bad idea.
Move and Countermove
Let’s assume the EU bans naked shorts in sovereign CDS AND lets the ECB or EFSF sell protection. This is even more than is mentioned in the current rumor, so the market should respond amazingly well, right? Not so fast.
CDS will tighten. Potentially tighten dramatically. I could easily see Italian CDS trading from 440 to 200 in the short run if naked shorts were banned and some EU entity started selling CDS. The big question is how much of that spread tightening will transfer to Italian bonds? My guess, and it is only a guess, is that bonds will tighten by less than 100 bps, and possibly less than 50 bps. The CDS market largely ignored the intervention in the bond market the two times that was in full throttle. Why would this be different? Don’t forget, the CDS market is tiny in comparison to the bond market. The net outstanding CDS on Italy is only about 2% of the bonds outstanding. Talk about the tail wagging the dog. Manipulating a small fraction of the market will do little to instill confidence and will only take away a source of pricing.
What will happen to German Bund yields? It is hard to see them reacting well to this. At the very least some of the premium built into German bunds as a flight to safety will disappear. Depending on the rest of the “Grand Plan” Germany will become more risky and may need to borrow debt (or crowd out its own direct issuance with all the guarantees they are providing). So for Italian bond yields to fall, the impact of the Grand Plan and CDS manipulation will need to impact spreads more than German bund yields rise. That is possible, but I suspect the results will disappoint and Italian 5 year debt will struggle to get below 5%.
Well, the ECB could slash rates to zero. That would lower the yield of bunds (the closest Europe will have to anything resembling a risk free borrower by that point). That lowering of yield should translate to Italian bond yields, though as we are seeing in the US, it is hard to push certain assets below a threshold yield. Investment grade bond spreads here have become more volatile recently in part because they cannot move in line with treasuries when treasuries do better. Operation Twist caused IG spreads to widen, at least in part, because too many investors can’t afford to own corporate bonds with such a low yield. A part of the recent move tighter was just this unwinding. Look at how stable LQD has been relative to TLT.
So now the EU will have banned naked CDS, sold CDS, cut rates to zero, announced a Grand Plan and Italian 5 year bond yields could still easily be above 4.5%. What have they accomplished? They will have accomplished very little and certainly nothing that is sustainable. What happens the next time the Italian government votes down an austerity package or the deficit comes out worse than expected? I think just like when they ban anyone being short stocks, they will regret not having the short covering bid on the next down leg.
The New Short
Since nothing mentioned does anything to actually fix the economies or balance sheets that are in trouble, it is reasonable to assume that some investors will remain bearish or become bearish at these new levels. They might buy some CDS depending on how tight it is, it may be worth doing it, although they will be concerned about not only price intervention but some form of legal intervention as the EU seems willing to at least consider bending the rules to avoid triggering Credit Events and the ECB seems willing to say and do anything to ignore their mark to market losses. But at some level the basis will become worth at least putting some risk capital to work. Some investors will want to short bonds, putting that pressure on the bond market. That would clearly be banned quickly and borrowing sovereign debt to short would be scary as the rules could be changed. Then what? Short bank stocks? No, you can’t do that. So then what? Shorting indices and playing the FX markets will be the only option. Expressing a view on sovereign credit will have to be done through other markets. That could cause pain for the shorts, but also could create a spiral in the stock market. If the wealth effect is so big and the confidence from a rising stock market is so important, this could backfire. Now policies could be made that make the market look cheap or to help earnings. Money could be printed. Lots could be done, but as you can see, all this does is shift the battleground and make it ever more complex.
Until something is done to demonstrate that Europe is on a sustainable path to being able to pay back debt, or the ECB prints money and takes a chance on unleashing inflation, little manipulations will not help. In fact they will likely hurt in the long run.
Unintended Consequences seems to have taken on a new meaning. Unintended consequences means to me, that a lot of thought went into the consequences and the end result surprised. I no longer believe that significant thought goes into the potential consequences. The analysts see what they want and get tunnel vision on the series of consequences they want to see, rather than really trying to figure out what might happen. Europe is not only behind the curve, they act like they are playing checkers with a 4 year old, when the markets are a game of chess, and they should be seriously analyzing the moves and countermoves that can occur before determining their next move. They also have to remember the risk side. So much focus is on the possible benefits of a “Grand Plan” that no resources are being devoted to what happens if that plan fails. Maybe they should strive for less potential upside to the plan in order to sure that this isn’t the last plan they can try.
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"naked in europe" used to have different connotations to me before I started reading ZH!
*sigh*
maybe than moneybags guy can insert some much better pictures :)
Beware! I use a psudoname! I could be the guy on the street. I could be a mad and furious taxpayer. I could be a hedge fund dangling out information. I could be the head of a prop desk. And I am in Europe and nak...uhm, no. Try to regulate me, Mister Martin.
There is no way that the financial mess in Europe ends well. Until the <a href="http://www.athomeforless.com/juno-frost-pendant-kit-disc-glass-pkh328fro...">light</a> goes on in peoples heads, the long term prospects of the stock market are bleak. Stay short equities and long volatility. With the SPX around 1400, you have a pretty good entry point.
It is far too late to ban naked CDS, great damage has already been done or should I say lots of financial criminals have made their fortunes off of CDS.
is this the way you want to leave this world for your children and grandchildren?
by saying that it's too late for this year? you do have a short horizon, eh?
BAN CDS (AGAIN)
They NEVER should have allowed CDS's in the first place. They've been gasoline on the financial world's fire.
they WERE banned
they should not have been reallowed
Here we go. All selling will be banned. Removing cash from large banks will be banned, capital control. Excellent, I have seen this playbook before and know how to hedge accordingly. awesome. All your assets is belong to us.
Fine they can just sit there in the corner by themselves from here on out.
Exactly. The only way to not lose money in a rigged game is not to play sheepdog.
Eventually these fuckers have to eat, and I am in agriculture. Bring it.
As a Brit I can confirm that your post is wholly correct. Europe is in the mess that its in today because of its addiction to public expenditure to the cost of enterprise. The one good thing that the imminent collapse of the Euro and possibly the EU with is bringing is that people are now starting to question their previous benefits and welfare habits. Politicians who campaign for office on a message of something for nothing (such as health care) from now on are going to get short shrift in this uncertain new world. sciatica treatment
All the horses and cattle have stampeded out of the barn a couple years ago? Hey Ive got an idea, lets deadbolt the barn door, that should fix it.
show me evidence that only entities which own bonds buy CDS and I'll relent (perhaps)
otherwise it's the same story again: BAN CDS (AGAIN)
Folks will just find a way to go synthetically short. They really cant stop it. The system will sieze up either way unless the real issues are addressed. In the meantime, just more musical chairs.
exactly - so why not put them on an exchange. That instantly removes the bankers threat of `we dont know who has what exposures in the CDS - the fallout of a default is not calculatable` This threat which Deutche/Ackerman keep making is pissing of the Van Rompoys and Merkels of the world. Put the CDS on an exchange, bring them into the light - problem solved. Remeber how Dimon fought to keep them OTC -it was not just so that JPM could gouge their customers, it was also because the threat of catastrophe is a card he wanted to keep.
Ban selling stocks and bonds
sell me insurance on the life of your kids
I'll come for them and your money
Really?
I don't have kids. But let's say I did.
What if I had two boys that were Navy Seals? I would sell all the insurance you want, and then they'd kill you.
If you have a strong economy, strong balance sheet, strong business model why would I buy naked CDS? I would lose money. The only reason I would buy naked CDS is if you were full shit and I thought your economy/business model was shit. Why do you think investors aren't rushing out to buy naked CDS on AAPL or Microsoft? Using your thinking you could bankrupt aapl/msft, but in reality you'd go broke.
strong economy, strong balance sheet, strong business model
all this you can't find very often with sovereigns, what they have is a bloody tax base - little buggers that will have to pick up the tab
by buying Italy's CDS, for example, you are betting on Italian and French citizens and banks not buying Italian bonds anymore
do it enough with enough firepower and voilà, mission accomplished, without any "reality" having to touch base
and again, why would you want to bet on a foreign country's ability to pay at a certain yeld? and moan if someone does not allow you to do it?
I thought so...
touched a nerve?
so when it's foreign countries is OK (they don't really exist, really) but if you do an example with your kids then it's baaad?
wake up, there are kids living in those foreign countries and your "trading" touches them
what if your kids were Navy Seals and I would make bets on their survival?
You didn't think shit. Read my above again homeboy and let it marinate.
Homeboy? ;-)
in 20 years would you rather dig up a treasure chest full of Euros and European bonds? Or chest full of Gold bullion?
OK, yes, I'd rather dig up a chest full of silver ( or gold ) .
But I would still like to have at least one Euro note, to go with my Zehn Millionen Mark note from 1923, which is really small, and only printed on one side.
That would be cool.
cheapskate
I have a "Fünfzig Millionen Mark" from September 1st, 1923
Ah crap. See -- mine's only from 22 August. Things were moving fast by then.
< shiver />
Wow.
Somebody just walked over my grave.
yep... they did it and you can not change nothing. yacht charter zadar
Italy/France will push for Eurobonds or some kind of equivalent. Germany will resist until either i) the choice is made for them ii) The German sheeple realize they're on the hook.
What's that Tyler line: "He who defects first..."
you got the countries wrong
"US & UK will continue to push for Eurobonds..."
If no default event in Europe is to ever count as a CDS-triggering event, why is there still a CDS market to begin with? That's what I don't understand...
because right now JPM and the other big boys are selling their hedges...they have time, they know the hedges don't work, but some banks will be a few months behind and will buy it all up from them...
If credit card debt is never going to be repaid why do they keep letting people charge their cards?
It's all variants of the Ponzi. Everyone knows the CDSs can't pay out in the event of a big default but so long as there's a new fool coming along to buy a CDS the ponzi can keep going.
The whole damn world is being run like a ponzi scheme. Once you get your eye in you see it everywhere you look.
So, if your an institute that can borrow from the Discount Window
(Individual Centrak Bank), your Accounting shows your ratio's disply your not out of balance.
So.... all the demand on the long-side that is partially hedged on the short-side will just exit the market entirely.
Brilliant.
Yeah so I should read posts. It's naked CDSes, not protection.... Nevermind =X
LOL defending GAMBLING with it's pseudonym of "investing".
Yes, even sports betting has a legitimate function to society.
Yeah....that's the ticket.
I guess with China doing the actual productive work for the world, what else do the rest of the people have to do but gamble for a living?
I think this is one of the most important weeks this year - major trend reversals to come:
http://hammystradingcorner.blogspot.com/2011/10/hammy-sticking-his-head-out-and-red.html
Legalize the buying and selling of life insurance on paulson, dimon, blankfein, paulson, et al, payable to bearer.
sorry but .... surely naked shorts are counterfeiting ....betting wiith money you do not have..why worry.. banning surely well overdue ... what have i missed
what about equity puts? can you only buy a put on a stock you own?
'CDS on Italy trades in $'s and their bonds are denominated in Euros.'
How bizarre is this? If your insured house in Rome burns down, you get paid in euros. Why shouldn't default insurance work the same way?
Between the gratuitous currency risk and the political risk of 'voluntary' events which don't trigger default (despite haircutting value), one has to think that Credit Default Swaps are one of stupidest speculations on the planet.
BURN, YOU SINNERS!
because no one who is short italy wants to get paid in euros!
Because, largely, the CDS was, is and will continue to be(Largely) an American invention, going through(Largely) American Firms via (Largely) American owned Exchanges... even if off shored. Propped up by the U.S. Federal Reserve[Central Bank/Dollars]
Wrong.
Imagine a catastrophic event like a huge country failing. One would expect the EUR currency to fall hard, and thus to not get burned on currency translation, youd want to be paid in something that would be less prone to fluctiations during said event.
You don't get the point, eh?
Reality detachment - psychopaths think this way, too.
Quite a bit too many credit derivatives experts on comments these days. Im not interested in what you think of the actual financial product.
Do you think about the "actual financial product"?
Take the live granades off the children's hands, they don't know what they are doing.
As usual, gold getting hammered as bank problems are now accelerating
I was hoping for a bad day for gold today. It's payday and a little discount helps.
I have to sympathize with the basic premise of banning naked CDS. You should theoretically have to have an interest in the thing you're insuring. You can't buy life insurance on random people or fire insurance on your neighbor's house. No one bitches about that, because we don't want a rash of "accidents" to crop up.
But if they do this, the next thing you'll know is that they'll start banning put options on equities without owning the underlying, and Reggie will lead a march on Wall Street.
unless one has shares s/he intends to sell at a specific date in the future buying puts is just gambling in a crooked casino.
Nked CDSs are like unregistered stock shares,, who knows whom authorized them in an opaque market.. or will they be stood behind.
If I'm not mistaken, you can use 3rd party risk insurance as collateral in the US.
Naked short selling should be banned everywhere - short selling is a legit trade - lets be clear
i have mentioned this every chance i get on every cds/credit posting i see, but seriously, why isn't this on an exchange? it is getting close to 4 years since bear!!!!
because deciet is the hallmark of advantage.
Sounds like they found a bunch more of that junk and are not telling. Ha Ha. Crap, I hope they don't ban big breasted beer garden women. That would be truly depressing.
Talking about naked, the selling of naked silver shorts continues today ... down to £31.60/oz.
October 18th is the position limit decision at the CFTC.
Well I'm having fun watching merger Monday as insiders rapidly see their stock value double in one day and in some cases like biotech they get to see an increase of 250% overnight. Really? a company losing millions should be bought for over 250% of the current market value of its stock.
I also love all the $700 a share Apple calls. Does Apple really deserve a $650 billion market cap? Just a hypothetical, but if Apple ever went bankrupt what assets do they really have? Other than a giant patent portfolio they created granted for thousands of common use ideas. Do they even have assets that could be valued above $1 billion? How much is the real estate of their headquarters worth?
General Jim's TRX getting destroyed.
Having to fly back to Africa unexpectedly was not a good sign.
So when NFLX was destroyed where did you fly?
Brussels Politburo approves nationalizition of Dexia...
http://www.guardian.co.uk/business/blog/2011/oct/17/eurozone-debt-crisis-live
One of many, many more to come.
Got puts?
naked shorting is so non-europeon
I wanna bet on my neighbours house burning down, anybody wanna take other side of that bet? just kidding, but naked selling is bit like that, because if you have enough money, you can make any country bankrupt. still, all this is just a show to keep everybody guessing what is really going on, while we are getting screwed in many ways.
Robo dissed again yet I totally agree. Look at that 1-year GLD chart - a tepid crawlback from the plummet a few months ago . . . does not look well. No way do I add at this level, Au or Ag.
SP500 daily chart now gives bearish signal, warning of a new leg down. Weekly chart reverts to neutral.
http://stockmarket618.wordpress.com
Naked CDS need to be banned everywhere in the world. The systemic risk and moral hazard they create far outweigh any benefit.
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I wanna bet on my neighbours house burning down, anybody wanna take other side of that bet? just kidding, but naked selling is bit like that, because if you have enough money, you can make any country bankrupt.
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