Traderbill's Financial Markets Weblog

The timing of this piece relates to options expiry on Friday! Today is the last day for those who use T+3 settlement to trade. Note the decline in options volatility to below 30 on the VXN which has been badly beaten up while VIX is just above 25. Options volatility typically plunges as we approach expiry, especially when you have had moves of the recent magnitude.

…we all have options but the ones today are of the financial kind. Prior to 1976 (yes, TB was there), there were no financial futures. Commodities were things like bellies, corn, etc. traded on the CME and the CBOT in Chicago. But in 1971, Milton Friedman was commissioned by the CME to write a treatise on financial futures which was delivered in 1972 and that was the birth of financial futures. Still, it would take another four years before the most basis of these, T-Bill futures, would begin trading.

TB can clearly recall his mentors sitting around over coffee saying we shouldn’t turn over the market to a bunch of guys in Oshkosh bibs with hay straws in their mouths to control the treasury market…that was clearly the purview of the Fed. Of course, their objections were overruled and we soon had futures on not only T-Bills but T-Notes, T-Bonds, Eurodollars and the MOB (spread of muni’s to treasury’s).

By the early 1980’s, after some of the best government traders had lost money speculating in these futures (right, John?), they figured out the way to play them. Suddenly, technical analysis which had been dismissed by most investors was suddenly in vogue (TB had always thought technical analysis was useful if coupled with sound fundamental analysis-whatever that is these days), in fact it was crucial to making money. In 1983, both Fannie Mae and Freddie Mac introduced the first collateralized mortgage obligations (CMO’s). What this did was allow ‘tranches’ to be created that were attractive all across the investment spectrum rather than just long term investors…essentially like the municipal bond market.

Without the CMO, we could never have had the housing boom that we have seen over the past 26 years. Then came the exotic derivatives. The first was the interest rate swap, put together by the World Bank and entered into with IBM and then adopted by Wall Street as counterparty between mainly US and Japanese banks. These were great tools for limiting risk where one party wanted to pay LIBOR and receive the yield on a 5, 10, or 30 year treasury and the other wanted to hedge playing the other side of the trade. They frequently made the news negatively over the misperception of the press that the notional amount of the swap was the risk and it was huge, when in reality it was merely the spread between the fixed and floating rate sides. It was a good way to hedge risks and allowed mortgage and other fixed rate loans to continue to be made, especially given the high level of interest rates we still had in the wake of Paul Volcker’s surprise tightening…TB recalls talking with others and we could not visualize inflation under 5%…ever! (It was Bill Gross that correctly perceived that the Fed would have to recapitalize the banks…just like they will now…and made his mark by investing heavily in 5-10 year treasury notes…where the banks buy.)

Then came more options, swaptions, options on futures, single stock options on futures…you name it. The most important of these was credit default swaps (CDS) which first appeared in 1995. Once Wall Street got its hand on these, after an inauspicious start they grew exponentially. A major drawback is that unlike rate swaps which were between two known counterparties, and canceled when they were no longer useful, CDS grew since they were open contracts…and hedge funds wanted them that way so they could spec trade them…this is the problem…an instrument with significant hedging value morphed into a trading tool and grew to over $6 trillion! Consider that just before the GM downgrade, 90% of the credit default swaps were in that name!…true, it was the largest corporate issuer but not even 20% of the corporate bond market. When Parmalat collapsed in 2003, nobody knew who held the ‘risk.’ Today it is much worse than that…and what may seem diversified isn’t. Now with SIV’s and ABX etc. we have no idea where the next shoe will fall and that is exactly the problem we now face. How can you invest in anything if you don’t know what land mines are buried inside it? Who would have thought a little town in Norway could almost bankrupt itself and not know the risk they were taking?

So now we are to the present and what do we have?…a mess! Furthermore, the equity bulls are trying to rally stocks even though we are only one month into a recession! Also, financial stocks remain well above 25% of the market…at the peak must have been about 32%. As Merrill’s David Rosenberg said: “The stock market peaks 3-6 months before a recession and rallies six months after it begins – not one month.” Why are we so obsessed with calling a bottom in the wake of the biggest financial disaster of our time and ever from the perspective of magnitude. By the way, Goldman Sachs after being +7.9% (8.6% w/divs) in 2007 is now off 25% since the 10/31 peak (Halloween) and -10.5% since Feb.1! Even Schwab which was up 30% in 2997 and has NO exposure to risk is -20% from the 12/31 high That is what window dressing will do to your performance! 

So those are the reasons TB is bearish on stocks, especially most financial stocks and even the good ones as we saw from Schwab are vulnerable…there is no safe harbor…except cash in a sound money market fund. Now some other tidbits:

*BofA’s Ken Lewis is disgusting! First, he appointed a retail banker to head up Investment Banking with a mandate to grow the business…then he fired him over the subprime debacle…certainly it wasn’t Ken’s fault, right? Then he made a bad bet on Countrywide by not waiting and pumped $2B into preferred only to have to put up another $2B when the situation worsened…of course they had their people go in and examine every loan…uh huh. But now this egomaniac has hit rock bottom: he has fired just about everyone associated with the subprime area including the sales force who did nothing wrong. He reportedly called them in, told them they were fired with two weeks severance only…no other form of compensation even for those with commitment letters…what a guy. Well, you know what? They are banding together in a class action and going to sue and he is going to wind up with egg all over his face!

*The junking of the investment grade financials market. PIMCO’s Bill Gross says that new issues of financial stocks like Citi are attractive (that means he already bought them and the operative word here is ‘new’). That is not to be confused with the crap that has been peddled to the retail buyers such as trust preferred which is a misnomer. They are not true preferreds and they are vulnerable. TB wants to reiterate his earlier stand on FNMA/FHLMC preferred: although the mortgage backed and senior debt of these two mega GSE’s can be considered too big to fail that is strictly a moral obligation with no legal standing. Raising the conforming mortgage level to a maximum of $729k will only worsen their problems and need for capital. Common stock, preferred (in whatever form they want to call it) and subordinated debt does not get any protection. TB asked this on a conference call with FTN’s Chris Lowe who confirmed TB’s opinion. Question: how can the government guarantee the preferred when last year they issued a lot of it for…stock buybacks? Wouldn’t that then be a bailout? Also, there is precedent from the 1984 collapse of Continental Illinois (due to ties with Penn Square so see how even a small bank can bring down a big one)…at the time of the collapse it was the 14th largest bank and had been 7th in 1982…at the end it was upstreaming 50% of its income to the holding company. The Fed bailed out the bondholders of the bank and of course the investors but no other investors.

*An article by TB’s friend and Bloomberg reporter Mark Gilbert attributes the emergency rate cut by the Fed to Societe Generale. SocGen says they became aware of the problem on Jan. 18, confronted Kerviel the next day and figured out the scale of the problem on Jan. 20, the day they informed the Bank of France…who didn’t bother to inform the ECB. The next day (MLK Day in the US), CDS protection on SocGen which had hitherto traded within 1 basis point of rival BNP Paribas, widened to 21 basis points…a huge move and quite profitable if you are on the right side of the trade (the widest it had traded was in August at +4 basis points).

Now get this: six days before any announcement to shareholders, SocGen board member Robert Day and his foundation sold 45M euros of the stocks…amazing how prescient he was as this was on Jan. 18…the day they became aware of a problem! At least we have an SEC to protect us from this…don’t we? TB isn’t really that sure. TB’s only argument with Gilbert’s conclusion is that TB feels the Fed easing was not do to this…in fact if it did we are in serious trouble…the Fed trying to assist a French bank when the ECB didn’t even know of a problem? No, the more likely reason was that they knew how bad the employment data would be since while they may not have had the data, they did know the size of the benchmark revisions and revisions to the two prior months…you decide. 

 *Monoline insurers should be avoided. The announcement of Buffett’s Berkshire Hathaway and MBIA is a case in point…Buffett is merely buying a portfolio of the $800 million muni insurance…in other words the only profitable and clean part of their business…didn’t TB say this would happen? Yep. But the derivative insurance problem remains and that is a problem for Citi, BofA, and JPMorganChase among others. Why people keep buying into these stories defies logic…hasn’t anyone ever heard of dilution? Non-performing assets? Apparently not…also rather than outright buying it is more likely shortcovering.

The MSFT/YHOO saga continues…can the four horsemen continue their fading rally from the depths?

That should be enough to keep you pondering for awhile  …hope you find it useful.

A good day to all! TB