Mark To Market

We have spent a great amount of time recently discussing both the re-hypothecation debacle and the 'odd' moves in CDS - most specifically basis (the difference between CDS and bonds) shifts and the local-sovereign-referencing protection writing. Peter Tchir, of TF Market Advisors, provides further color on the latter (as the 'Ultimate' trade) and in an unsurprising twist, how the former was much more critical during the Lehman 'moment' and will once again rear its ugly head. Exposing the underbelly of these two dark sides of the market must surely raise concerns at the fragility of the entire system - as we remarked earlier - but the lessons unlearned, on which Peter expounds, from the Lehman period are reflective of regulators so far behind the curve that it is no wonder the market's edge-of-a-cliff-like feeling persists.

As Macbeth said, It is a tale told by an idiot, full of sound and fury signifying nothing. Fading the "Grand Plan" rally worked very well.  There was a couple days of pain and then generally the market followed a nice path lower.  Last week the market had felt oversold and was looking for a reason to rally.  I thought that Monday was overdone, and that Wednesday was extremely overdone, but I started cutting shorts yesterday, and am now getting long. Everyone seems to understand that the "globally coordinated rate cut" plan was not a big deal in of itself, yet the market didn't give up any of the gains.  Even some of the perma bulls downplayed the move.  I think the move was meant to be more pre-emptive than a strong show of future support, but Ben is not dumb, and he has seen the outsized impact such a simple move had. Cracks will appear in this rally, and we will ultimately figure out the problem with the current attempts to fix Europe, but right now it is too vague to fight, positioning has been too extreme, and Bernanke and Draghi have to see the opportunity to push things forward while the market is behaving positively.

Buy the rumor, sell the news? Investors bought the rumor, then sold the lack of news, I think you are supposed to sell the news again, as there is nothing in this document that provides evidence that they get it, or that any scale can ever be achieved, and if anything, it makes you wonder if they will even get to the 440 billion of support the market thought they had back in July.

Time to start stocking up on those long term, OTM armageddon puts yet?

“Asset Swaps” make it more difficult for banks to sell. Banks will often buy a fixed rate bond and enter into an interest rate swap to “effectively” turn it into a floating rate asset.  It should come as no surprise that banks that rely the most on rolling over short term debt are the ones most likely to asset swap bonds – yes the “weak” banks are the ones that hold bonds in this form.Asset swaps work fine so long as the underlying bond never becomes a “credit” problem.  So long as it moves more in line with rates than with credit it is a sensible strategy.  As Italy and Spain have become credit problems, they are no longer moving with rates, and these positions are adding to the problem.

Earlier we asked some simple questions regarding BlackRock's sovereign debt exposure. Multi-trillion asset manager BlackRock responds:

• BLACKROCK RESPONDS TO QUESTIONS ON ITALIAN DEBT HOLDINGS
• BLACKROCK COMFORTABLE WITH INTERMEDIATE ITALIAN BONDS
• BLACKROCK ENCOURAGED POLICY MAKERS ADDRESSING CHALLENGES
• BLACKROCK CHIEF INVESTMENT OFFICER RIEDER COMMENTS IN A NOTE

Hopefully this response will satisfy the market and make it comfortable with BlackRock as an intermediate-term going concern. Then again clarifications such as this one by other Blackrock professionals, namely that the market is wrong, probably will not help:

• BLACKROCK'S ROVELLI: ITALY SPREADS DON'T REFLECT FUNDAMENTALS

So, what happens if the spreads do reflect fundamentals? Will Blackrock apply Mark to Market to its Italian holdings? And perhaps BLK can follow in Jefferies' footsteps and be so kind to break down it gross and net exposure for all to see? After all, there is nothing to hide among its "nominal exposures."

We are sure we will hear a lot more about leverage ratios for banks in the coming days. Some of it will be correct and some of it will be wrong. If a bank issued 100 million of equity and then went and used some of that money to buy 1 billion of old 10 year bunds versus shorting 1 billion of new 10 year bunds, what would be the leverage ratio? The accounting answer seems to be 20, though some say it is 10. So being long a bond and short a very similar bond has more leverage than being just long a bond? In other cases leverage will be massively understated. It does seem sad that the way financial institutions report their numbers are generally opaque and not consistent - even something like DVA seemed to be treated very differently at each and every institution.

When we were hitting 1100 the market was in deep fear mode.  Investors were on the verge of panic.  Default was on the tip of everyone's tongue.  Now at 1250, we are all waiting patiently for some positive announcements.  There is little (if any) fear out there. Up here, I would want to be much more credit, and even bond specific.  Italian 5 year bonds at 7.5% yield more than HYG (7.1%) and certainly have a lot more people trying to help them.  I'm not sure I would put that trade on, but it may crowd out some investment in the high yield space, especially as we see some defaults rise.  It is a credit pickers market here, not a broad asset class decision (particularly from the long side).

...it is only 5 hours until noon, when Europe closes and we can resume the rally based on anything that sounds remotely positive.

It seems like history is accelerating. Momentous events have been occurring regularly since 2007. Our political and financial leaders are blindsided on a daily basis by each new crisis. The majority of the American public continues to be apathetic, willfully ignorant, and constantly absorbed by their array of electronic gadgets and mindless drivel spewed at them by media conglomerates. Rather than think critically, most Americans allow left wing and right wing mainstream media to formulate their opinions for them through their propaganda and misinformation operations. Linear thinkers, who make up the majority of the political, social, media and financial elite in this country, believe the world progresses and moves ever forward. In reality, the world operates in a cyclical fashion, with generations throughout history reacting to events in a predictable manner based upon their stage in life. The reason the world has turned so chaotic, angry and fraught with danger since 2007 is because we have entered another Fourth Turning. Strauss & Howe have been able to document a fourfold cycle of generational types and recurring mood eras in American history back 500 years. They have also documented the same phenomenon in other countries.

The entire fractional reserve banking system rests on the premise that the short currency long assets/loans trade works, by creating a future economy that provides real greater output to sustain the circulated currency, because expunging it through deleveraging is a dangerous process for bank balance sheets and a deflationary event. The great question at the present time is: Has the recent credit expansion provided the US or Europe with an economy which can sustain the currency stock in circulation with it's accruing interest or has the malinvestment been so bad, that the currency amount in circulation is unsustainable and the resulting deflation will be met by central bank debt forgiveness to the currency shorters. When banks create currency on their balance sheet and trade it for an asset, they sell something they do not have and which they have to repurchase in the future! This mechanic in an environment of latent deleveraging, and massive policy intervention by central banks and governments generates 'Risk on, Risk off' and the banking systems gyration towards selling short currency or covering versus all possible assets is pushing all correlations to 1.

What is going on in Greek CDS is extremely important to watch, and take advantage of. Somehow CDS always attracts analogies to home insurance.  It is most often written about in terms of being able to buy insurance on your neighbor's house and then set it on fire.  I never thought that was a particularly good analogy, but now we have Greece on fire, and the insurance is potentially being cancelled. I remain bearish and doubt that this rally has much staying power since the plan doesn't actually fix anything, and it isn't even yet clear if it actually works in the near term.  The sentiment has also changed dramatically and there are far more bulls than just a few days ago so the market is potentially now overbought.  But for some long positions that play the technicals to maximum advantage I would target selling CDS where dealers are most vulnerable and the realization of what has happened in Greek CDS isn't fully priced.

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. 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. 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.

As talk about an actual restructuring of Greek debt increases, the EU continues to think avoiding a CDS Credit Event is a good thing. More and more stories and leaks indicate that a real restructuring of Greek debt is on the table, with write-offs of as much as 50%. Whether it will be real, permanent reductions in principle this time, or some other form of principle protected rollover with a subjective NPV calculation like the 21% haircut, remains to be seen. In any case, the EU continues to head down the path of bending over backwards to avoid trigger a CDS Credit Event. They are wrong to be avoiding a Credit Event on the Hellenic Republic. If they are really pushing for a true restructuring where banks and insurance companies are for all intents and purposes forced to accept a big haircut, they should want to trigger a CDS Credit Event. They are allegedly avoiding a credit event because it “could unleash a cascade of losses” according to a bloomberg article. That just makes no sense. It also seems that pride plays a role as the EU doesn’t want to be impacted by the stigma of a default – a 50% write-off is even, but they don’t want to be called defaulters. That is plain silly. They also seem to want to punish speculators, and this is where they really have it wrong, not only are few hedge funds short Greece via CDS at this time, the problems this creates for bank risk management desks is big and will have long term negative consequences for sovereign debt demand.

Update: For those curious to learn more about this phenomenon, here is ZeroHedge's first take on this paradox from April 2009!

Stocks added to their rally today when Gasparino leaked news that MS was going to have a "solid" quarter and they were going to beat GS. Morgan Stanley has $187 billion of public debt according to Bloomberg.  Just eyeballing it, the average maturity looks close to 4 years, but let's be conservative and assume it is 3 years. So MS 3 year bonds widened by over 300 bps during the quarter.  3 year MS CDS widened by 380 bps (from 113 to 493), so the move in bonds actually outperformed the move in CDS. Is MS planning on taking a massive gain on marking their own bonds?  There were stories of MS buying back their own bonds - a great move if they though they were cheap, but a critical move if they were planning on taking a gain and didn't want to have to give it back in the future if their credit spreads tightened. Goldman has slightly less debt at $178 billion, but the spread widened far less. Is this why the MS CEO is so confident they will have a good quarter and beat GS?  I honestly hope not.  If the CEO of MS is playing accounting games (totally legal, but stupid) on their own spreads and thinks the markets will respect that, than I am very nervous about what is going on there.