Mark To Market
As gold loses its 200DMA once again (along with Silver weakness) as the USD rallied post FOMC and stocks were starting to limp lower, Jamie saved the day and the stock market had that most embarrassing of affliction - premature exuberation. While it seemed to have come as a shock to some that banks passed the stress test, the market's reaction (given only recently markets were worrying over NIMs, trading revenues, and real estate) was incredulous. The US majors were all up 6-7% (apart from Morgan Stanley which managed a measly 3.8% on the day!). With XLF now up more than 37% from its Oct11 lows, financials remain the major outperformers in this rally and we note that credit markets are missing the fun - the last time JPM stock was here, its CDS was trading 25bps tighter. Credit and equity moved in sync and tore higher on the JPM news. Gold (and Silver) which had been falling managed a decent bounce into the close while the USD closed at its highs post FOMC as did Treasury yields as for the first time since the 2011 bubble popped, the NASDAQ closed above 3000 (thanks in large part to AAPL's 3% rally over $568).
CDS is once again (still) in the spotlight. We have moved on from debating whether or not a Credit Event has occurred in the Hellenic Republic, to concerns about whether the CDS market will settle without a problem. There is a lot of talk about “net” and “gross” notionals and counterparty risk. What I will attempt to do here, is build a CDS world for you. We will look at various counterparties, the trades they do, and the residual risks in the system. It will be loosely based on Greek CDS but some liberties will be taken. None of the institutions are real world institutions (in spite of how much they sound like some people we know). It is a simplification, but to make it useful, it has to be robust enough to give a realistic picture of the CDS market/system.
While AIG FP often made the contracts look like insurance products, the banks were very careful to make sure that the products were “credit derivatives” because they needed the regulatory capital relief provided by them. Didn’t the Fed at some point get concerned about the counterparty exposure to AIG FP? Isn’t counterparty risk something that the Fed is responsible for monitoring (or the ECB in the case of foreign banks)? When the Fed let MS and GS become bank holding companies and get the ability to use Fed lending programs, didn’t they ask about the AIG FP exposure? Goldman, which always claimed it was hedged, must have had a massive short position in AIG CDS to be hedged – again, no one at the Fed noticed this? CDS may be unregulated, but when virtually every big financial company in the world has large notionals on with AIG, huge mark to market gains on those positions, no collateral from AIG, and big shorts in AIG CDS, couldn’t someone do their job? This should have been noticeable in 2007!
Even With Back Dated Deals Featuring Only One Party, One Can't Escape Greece's Problem Shared By Much Of The EUSubmitted by Reggie Middleton on 03/08/2012 13:34 -0500
Even With Back Dated Deals Featuring Only One Party, One Can't Escape Greece's Problem Shared By Much Of The EU. Let's look at some nasty consequences...
We know how AIG and MF ended, as of yet we don't know how LTRO will end. Lots of "carry" trades have worked out well, but when they don't, the result is pretty ugly. Now we are seeing margin calls from the ECB starting to occur and we noted yesterday that MtM losses will start to evolve in some of the carry trades as risk is unwound very recently - perhaps we are getting a sneak peek at the cause of the next vicious cycle crisis.
Now that the hype of LTRO is over (for now) people are starting to focus on the details and some of the potential consequences. This is a first cut based on bits and pieces from various LTRO documents released by the ECB. We haven’t seen anything that resembles a document fully describing the current LTROs, but are trying to find it, and will refine this analysis as more details come to light. Between early maturity possibilities, the floating rate nature of the loan, and now the variation margin we discussed last night, it seems LTRO may rightfully be the driver of the 'stigma' extensively noted here previously.
The latest quarterly report out of CoreLogic is as usual full of curious insights about the state of US housing. Key among them is the finding that "negative equity and near-negative equity mortgages accounted for 27.8 percent of all residential properties with a mortgage nationwide in the fourth quarter, up from 27.1 in the previous quarter. Nationally, the total mortgage debt outstanding on properties in negative equity increased from $2.7 trillion in the third quarter to $2.8 trillion in the fourth quarter." In other words, courtesy of no Mark To Market, there is at least $2.8 trillion in debt held by investors (read banks and GSEs) that is marked at par and should be impaired. And one wonders why Fannie lost $16.9 billion in 2011 (up from $14.0 billion in 2010), and needed another taxpayer injection of $4.6 billion in Q4: it is so banks can pretend reality exists, and in the process avoid evicting tenants who live in these underwater homes, and who can pretend they don't have to pay their bills, but can spend money on iGadgets instead. Yet the scariest data point is that if one is currently in Nevada and looks at three houses right this second, two of them are underwater, or said otherwise, have negative or near-negative equity.
So, yesterday it was revealed that both Goldman and JPM had about 145 billion of “gross” notional outstanding on CDS related to the PIIGS. That means they each had roughly 145 billion of purchases and sales. They spoke about various netting agreements that makes the real number lower. They also mentioned with collateral and on a mark to market basis, the real exposure is far lower. Fine, though I wonder why they don’t execute the “master” netting and get the gross notionals down? Wouldn’t that help the system? If these were cleared or on an exchange, all they would have a single net exposure for each country. The collateral and netting would be handled at the central clearing or exchange. Wouldn’t that be simpler? Safer? The e-mini S&P future contract seems to be able to trade that way just fine, and it is more volatile than CDS on most days. Italian CDS is in 25 bps today – seems like a lot, but the up-front payment to buy or sell Italian CDS has changed by less than 1%.
Somehow, following three years of defaults, the world has only now figured out that the ISDA CDS trigger determination committee is made up of the same bankers, who stand to lose everything in the case of global out of control contagion, such as that which may occur if an unwelcome CDS trigger sends the house of cards collapsing, and force mark to market losses on all those institutions which hold impaired debt at par (all of them). As a result, the ISDA meeting which is currently in process is expect to find absolutely nothing, and we agree, however not for that particular 'conspiratorial' reason, but because ISDA is waiting for the PSI outcome for a realistic finding on a credit event. Because after all ISDA is not stupid: they don't want to appear like a pushover - remember how vehemently ISDA had opposed a Greek CDS trigger in the days when Europe still was not prepared for this outcome - but on the other hand wants to preserve some CDS market credibility, which would disappear if none of the recent events in Greece were to trigger CDS. Yet more Greek creditors are getting impatient. Even as the first ISDA meeting has to find (that there has been no CDS trigger), the association's determination committee has just released that it has gotten a second question whether a "Restructuring Credit Event occurred with respect to The Hellenic Republic?" We find it rather odd (or not really) how suddenly quite a few requests are springing out of the woodwork by creditors who obviously are interest in a Greek default. As such the PSI gets quite interesting, because if the pre-PSI action is any indication, quite a few creditors are rather interested in triggering just the event they now consistently badger ISDA with.
Everyone and their mum knows by now that Italian bonds have rallied since the first LTRO and we are told that this is symptomatic of 'improvement'. While we hate to steal the jam from that doughnut, we note Peter Tchir's interesting chart showing how focused the strength is in the short-end of the bond curve (which we know is thanks to the ECB's SMP program preference and the LTRO skew) but more notably the significantly less ebullient performance of the less manipulated and more fast-money, mark-to-market reality CDS market as we suspect, like him, the CDS is pricing in the longer-term subordination and termed out insolvency risk much more clearly than the illiquid bond market does, and perhaps bears closer scrutiny for a sense of what real risk sentiment really looks like.
While the now scheduled Irish referendum on the fiscal treaty, which will likely not pass successfully absent major concessions on behalf of Europe, will not precipitate a failure of the recently agree upon compact, as 12 out of the 17 contracting parties need to support the Eurozone, it will have an impact in that it would impact future bailouts of Ireland courtesy of preset European bailout mechanisms. In other words, should things take a turn for the worse, and they will, in the near future, Ireland will have to rely on itself to save itself. As a reminder, it took Europe 2 years to (supposedly) firewall itself from default and a collapse of its banks. How long will the same take for Ireland, because while the country may be standalone, its banks most certainly will not be. Remember that money is fungible. So are massive unrecognized Mark to Market losses. Morgan Stanley explains.
The real world revolves around cash flow. Families across the land understand this basic concept. Cash flows in from wages, investments and these days from the government. Cash flows out for food, gasoline, utilities, cable, cell phones, real estate taxes, income taxes, payroll taxes, clothing, mortgage payments, car payments, insurance payments, medical bills, auto repairs, home repairs, appliances, electronic gadgets, education, alcohol (necessary in this economy) and a countless other everyday expenses. If the outflow exceeds the inflow a family may be able to fund the deficit with credit cards for awhile, but ultimately running a cash flow deficit will result in debt default and loss of your home and assets. Ask the millions of Americans that have experienced this exact outcome since 2008 if you believe this is only a theoretical exercise. The Federal government, Federal Reserve, Wall Street banks, regulatory agencies and commercial real estate debtors have colluded since 2008 to pretend cash flow doesn’t matter. Their plan has been to “extend and pretend”, praying for an economic recovery that would save them from their greedy and foolish risk taking during the 2003 – 2007 Caligula-like debauchery.
Debt default means huge losses for the Wall Street criminal banks. Of course the banksters will just demand another taxpayer bailout from the puppet politicians. This repeat scenario gives new meaning to the term shop until you drop. Extending and pretending can work for awhile as accounting obfuscation, rolling over bad debts, and praying for a revival of the glory days can put off the day of reckoning for a couple years. Ultimately it comes down to cash flow, whether you’re a household, retailer, developer, bank or government. America is running on empty and extending and pretending is coming to an end.
An explicit contagion path chart, since you probably won't get info like this anywhere else...
While we have done our best to explain what the implications are of the actions of the various parties in the Greek/German/ECB/Euro swap/default/CAC/PSI/Austerity events, it is perhaps worth one more try to address how we see this playing out and exactly what the ECB just did. The weakness in GGBs today along with the rise in the cost of Greek basis packages (a hedged bond trade that looks to profit from a credit event or compression) suggest markets are beginning to wake up to reality but the dead-currency-walking behavior of the EUR (and ES) since last night's close suggests many remain sidelined or have all their chips on the constantly-tilting table. In the end every private holder will write-off 50 percent permanently and those that live in a mark to market world (fewer and fewer live in that world in Europe) probably lose another 20 points or so. CDS will be triggered and we will be told how great it was that Greece avoided a default and that it is an isolated case. Is that scenario priced in?
Markets are rallying on the back of Greece’s approval of the austerity measures, and all I can think of is the ill-timed 1938 speech by Neville Chamberlain. But analyzing that leads to dark places, far too dark for a Monday morning when the markets are up. So I’ll try and lighten the mood, and only think about a book with talking animals – Animal Farm:
Do not imagine, comrades, that leadership is a pleasure. On the contrary, it is a deep and heavy responsibility. No one believes more firmly than Comrade Napoleon that all animals are equal. He would be only too happy to let you make your decisions for yourselves. But sometimes you might make the wrong decisions, comrades, and then where should we be?
Why do I find it so easy to imagine those words coming out of some technocrat’s mouth? Why are the Greek people faced with bailout or chaos? There has never been an alternative to the bailout since no politician has worked on one. There is plenty of historical evidence showing that countries can default, and not just survive, but thrive.