The Ultimate "All-In" Trade

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.


What exactly is this -> BNP Paribas Sold $2 Billion Swaps on France, EBA Says

Either: Basis Unwinds or the BSC trade?

[A Basis trade - as we have discussed here - is an arbitrage strategy that looks to profit/earn carry from the difference between CDS and Bond market pricing of credit risk. Typically it is created by buying bonds and simultaneously buying CDS protection (a hedge) to lock in a perceived valuation difference]

Is this the basis unwind we predicted after the October 27th summit where banks were going to be forced to restructure debt without triggering CDS?  (it has happened yet, but that's another story).  So if banks were selling bonds and selling hedges, then it would show up as reduced bond exposure but increased CDS exposure (they sell bonds, and sell CDS).



That is one possibility, the other is that they are running the "all-in" strategy at the expense of the taxpayers.  During the final days of BSC (before they were bought for $2 on a Sunday night and had their swap lines guaranteed) two distinct markets for CDS had developed, especially on indices and financials.  There was a price where BSC would sell CDS and the price where a counterparty that was likely to be around next week would sell protection.  On IG8 (I think that was the on the run index at the time), BSC was often offering it 3 to 4 bps tighter than anyone else.  You could buy IG at 176 from them, or 180 from a bank.  It made the market more confusing than ever.  Who would buy protection from them?

Well, if you had sold protection to them, then maybe you buy it from them to cover.  It was simpler to have offsetting trades, plus you could book that 4 bps.  If you had already bought from them, you were between a rock and a hard place.  Their "bid" for protection was low.  Selling to them meant a mark to market loss.  So you could either buy more index protection from somewhere else or you could buy protection on bear.  Many were comfortable doing that as they were in such trouble.   It was a real issue, anyone who had sold them protection was happy to cover, especially at below market prices.  Those who weren't long credit via them had a problem.

The same happened with clients, but they had an extra tool.  They could buy protection from them and try and "assign" another dealer.  That dealer didn't want to face bear, but some clients had a lot of influence, some salespeople had a lot of influence, some firms weren't well run, and there seemed to be pressure from the regulators to pretend it was business as usual.  So a firm that had managed their exposure well, had a potential problem because a big client came in, demanding that the protection they had purchased from bear, be "assigned" to you.  Legally you could say no, but there is always relationship pressure at times like that.

But why would BSC be so willing to sell protection?  Well, the markets were very wide because of the fear that they would default.  You sell as much protection as possible.  If you default what do you possibly care?  Your stock is wiped out, your job is gone, and your strategy is totallly explainable to future employees.  If you don't default all this massive amounts of protection screams tighter and you have your best year ever. No brainer for the firm, an issue for the market.

So, why are French banks selling protection on France like it is going out of style? Why are Italian banks doubling down on Italy?  Because if the bailouts work, it is free money.  Huge tightening on top of the spread income until the bailout finally wins.  If the sovereign defaults, is the bank really going to be around anyways?

It is the ultimate trade. 

If you make money, you get paid.  If you lose money you were screwed anyways.

Who would buy from them?  Banks with silly risk management departments, or those who had sold to them when they were in hedging mode, and now are unwinding.  That would create the bid for bank CDS that we see (as people need to hedge purchases of CDS).  Some of these banks may qualify for no collateral from banks they trade with.  Then they don't even need to come up with cash even if the market moves against them.  Not posting collateral would be a huge deal, and I'm not sure how true it is, but I would bet someone like BNP has very big lines with most other banks, before the mark to market loss gets bad enough that they have to post.

This may be the ultimate moral hazard trade.  Heads I win, tails, I don't care because I'm dead.  This couldn't happen if CDS was exchange traded (they could sell, but they would take mark to market margin call risk), but our regulators, have decided that putting CDS onto an exchange can wait.

On a slightly separate, yet related note, the "re-hypothecation" story done by Thomson-Reuters has been attracting some attention.  Maybe now is a good time to remind people about Lehman.  For all of the talk about Lehman and CDS, that actually settled pretty smoothly.  There were far more problems with simple repo agreements.  No one wanted to pay attention at the time. Whenever I mention it, people look at me as though I have lost it, how could super complex CDS have had less problems than repo trades in a Lehman bankruptcy?  Well, it did, and MF Global and this article show why.  Yet another example of regulators dropping the ball.  Many of these problems occurred with Lehman, but the Fed has been so busy QE'ing and talking about the "Lehman" moment, no one addressed the repo market, and cross border collateral, and custodial responsibilities, that were laid bare with Lehman.

It is far more fun to talk about the daisy chain risk of CDS, yet it was the problems in basic things like repo and custodial accounts and segregation, and adequate capital by entity, that froze liquidity in 2008.    If you can't find a copy of the article, zerohedge has it posted.  At the very least it is worth checking out as it could be another round forced deleveraging.  I have also heard that it is re-hypothecation that has slowed the transition of derivatives to exchanges as some people estimate banks would need to raise a trillion of money to make collateral calls that they either don't have right now (because of one-way collateral agreements) or because they meet them by re-hypothecating client collateral.