Monthly Archive for March, 2009

You’ll need to read all of David Goldman’s post carefully — this is a very interesting arbitrage example:

Bank protection has gotten very pricy during the past month, despite the Geithner plan. The cost of insuring Citigroup’s 5-year senior debt has jumped from LIBOR +300 bps to LIBOR +600 bps between the end of January and the end of March, while Bank of America has jumped from +200 bps to +400 bps.

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As I said earlier, Citigroup is like Schroedinger’s Cat, in a superposed state of being dead and alive at the same time.

Citigroup Stock Price vs Credit Protection, Past 12 Months

A simple way to think about the implications of the hockey-stick diagram described by the equity-credit scatter graph above is how important volatility is. The volatility sensitivity of an option increases as it gets closer to the money. Credit default swaps are an option, and the extreme volatility of bank stocks makes options more valuable. Again, they will either go up a lot or go down a lot. Volatility reconciles widening credit spreads and higher stock prices.

[From Hedge fund arbitrage in bank stocks and credit protection (or: Schroedinger’s cat revisited)]

In his 1 April post David elaborates on the option logic that accounts for this equity/bond behavior.

Theory really does work. The trouble is that there isn’t much of it. Option theory is the one really cool contribution to finance that practitioners can apply daily. It makes sense of seeming anomalies in market performance that seem to have stumped some of the pros. My post yesterday on why hedge fund players buy bank stocks and buy credit protection could use a bit of elaboration.

The WSJ Market Beat blog called attention to the discrepancy between performance of bank stocks and bank bonds during the past month: stocks up, bonds down (spreads wider). A minor-league bank strategist is quoted to the effect that credit predicts and equity confirms, so that the poor performance of bank bonds presages another drop in bank equity. In other words, the fellow trading credit default swaps knows something that the fellow trading equities doesn’t know. Considering that at hedge funds these are almost always the same people, that suggests a theory of generalized multiple personality disorder in the marketplace, in which the two sides of the personality don’t talk to each other.

As I wrote yesterday before the WSJ item came out, this has nothing to do with differing market views. It is an elementary problem in option valuation. Stocks by definition are an option on the future cash flows of a company (Merton). In the absence of dividends, e.g., the present status of C and BAC, the stock is nothing but an option on possible future cash flows. If there is extreme uncertainty — the stocks could zero out but could also dectuple — they are worth MORE, not less. If C is trading at $1 a share, as it did at the bottom, an investor could lose $1, or gain $1.5 to $2 with a very small change in its prospects. The greater the volatillity, the greater the upside vs. the downside.

Not so in credit. The opposite applies. Greater volatility means a greater chance of zeroing out. Even at 70 cents on the dollar, a Citigroup bond has more downside than upside. Preferred shares, on the other hand, at 30 cents on the dollar had more upside than downside, and traded up. It’s all about options and the effect of volatility on valuations.

With bank spreads in the hundreds and bank stock prices in single digits, the option component of equity valuation is huge, and the default option embedded in bank bonds is close to the money. Both bank stocks and bank bonds have a very high sensitivity to volatility or vega in option-speak. The signs are opposite: at very low valuations bank stocks benefit from volatility and bank senior debt loses. And that is why bank stocks go up and bank bonds go down.

No optimism whatsoever from Simon Johnson

The G20 summit is headed for disaster. The Europeans have circled their wagons and determined that no sensible policy proposal shall pass. The background briefings indicate (a) the US has given up on global fiscal stimulus (”declare victory and retreat” springs to mind), (b) and the manifest failures of financial regulators will be addressed through, well, a manifest of failed regulators.

None of the important issues are on the table or even allowed in the building: changing the European Central Bank’s monetary policy, persuading European politicians to acknowledge they were and largely still are asleep at the wheel, and the future of big banks everywhere.

The summit will begin with dinner on April Fool’s Day. The organizers have clearly not thought much about the symbolism.

Yet, there is still a slim chance that President Obama can snatch victory from the teeth of West Europeans. He has to stare them down on substance, pushing hard the line that the US is doing everything it can, while Europe is largely standing idly by.

It’s an uphill struggle to force Europe to save itself, but with the discussion around the IMF, the President has a chance to move things in the right direction — and to back Secretary Geithner with actions as well as words (for more on this, see TNR online from March 28). The Europeans do not respond to sweet talk; only tough pressure will bring results.

As I suggest in my latest piece (this morning) in The New Republic online, the Europeans have left themselves open to effective confrontation on a key point; if the President can seize the day and really push the Europeans hard on this dimension – and tell me if you see other ways he can make European complacency painfully evident – we might actually make some progress.

[From Obama Against The Odds]

An excerpt from Robert Samuelson:

…To Geanakoplos, we’re suffering the harshest leverage cycle since World War II. Three years ago, he says, homebuyers could put down 5 percent or less. Now they’ve got to advance 20 percent or more. Hedge funds, private equity funds and investment banks could often borrow 90 percent of security purchases; now borrowing can be 10 percent or less. “Deleveraging” has caused prices to plunge to lows that may be as unrealistic as previous highs.

Grasping this, you can understand the idea behind Geithner’s hedge fund. It is to inject more leverage into the economy — not to previous giddy levels but enough to reverse the panic-driven price collapse. Details remain unsettled, but the plan would allow 6-1 leverage ratios in some cases. Here’s an example. Private investors put up $5; the Treasury matches that with another $5. This equity investment could then be expanded by $60 of government-guaranteed loans. The entire $70 could be used to buy assets from banks.

Sounds simple. In practice, it won’t be. Given all the deleveraging — a record 15 percent of hedge funds closed last year — the market prices of many securities have been driven well below prices that seem justified by long-term cash flows. Geanakoplos mentions one mortgage bond whose market value has dropped by roughly 40 percent even though all promised payments have been made and, based on the performance of the underlying mortgage borrowers, seem likely to continue.

If banks sold this and similar credits at today’s market prices, they would have to record huge losses. (“Banks Face Big Writedowns in Toxic Asset Plan,” headlined the Financial Times.) Their capital would be depleted, and they’d have to raise more or request more from the government. Presumably, the government-supplied leverage would enable investors to pay higher prices. After all, that’s the purpose. Still, whether sellers and buyers ultimately agree on prices is unclear.

I think this is a paper representative of the Geankakoplos thesis.

Well, this left Seekerblog speechless as well. I cannot vouch for the credibility of any of these sources. If there is even a possibility of market manipulation, readers need to be aware and cautious. I am still looking for serious rebuttals of Andy Kessler’s thesis of CDS-leveraged reputation destruction – I have not found any objections so far.

Zero Hedge is rarely speechless, but after receiving this email from a correlation desk trader, we simply had to hold a moment of silence for the phenomenal scam that continues unabated in the financial markets, and now has the full oversight and blessing of the U.S. government, which in turns keeps on duping U.S. taxpayers into believing everything is good.

I present the insider perspective of trader Lou (who wishes to remain anonymous) in its entirety:

“AIG-FP accumulated thousands of trades over the years, all essentially consisted of selling default protection. This was done via a number of structures with really only one criteria – rated at least AA- (if it fit these criteria all OK – as far as I could tell credit assessment was completely outsourced to the rating agencies).

Main products they took on were always levered credit risk, credit-linked notes (collateral and CDS both had to be at least AA-, no joint probability stuff) and AAA or super senior portfolio swaps. Portfolio swaps were either corporate synthetic CDO or asset backed, effectively sub-prime wraps (as per news stories regarding GS and DB).

Credit linked notes are done through single-name CDS desks and a cash desk (for the note collateral) and the portfolio swaps are done through the correlation desk. These trades were done is almost every jurisdiction – wherever AIG had an office they had IB salespeople covering them.

Correlation desks just back their risk out via the single names desks – the correlation desk manages the delta/gamma according to their correlation model. So correlation desks carry model risk but very little market risk.

I was mostly involved in the corporate synthetic CDO side.

During Jan/Feb AIG would call up and just ask for complete unwind prices from the credit desk in the relevant jurisdiction. These were not single deal unwinds as are typically more price transparent – these were whole portfolio unwinds. The size of these unwinds were enormous, the quotes I have heard were “we have never done as big or as profitable trades – ever“.

As these trades are unwound, the correlation desk needs to unwind the single name risk through the single name desks – effectively the AIG-FP unwinds caused massive single name protection buying. This caused single name credit to massively underperform equities – run a chart from say last September to current of say S&P 500 and Itraxx – credit has underperformed massively. This is largely due to AIG-FP unwinds.

I can only guess/extrapolate what sort of PnL this put into the major global banks (both correlation and single names desks) during this period. Allowing for significant reserve release and trade PnL, I think for the big correlation players this could have easily been US$1-2bn per bank in this period.“

For those to whom this is merely a lot of mumbo-jumbo, let me explain in layman’s terms:
AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam.

In simple terms think of it as an auto dealer, which knows that U.S. taxpayers will provide for an infinite amount of money to fund its ongoing sales of horrendous vehicles (think Pontiac Azteks): the company decides to sell all the cars currently in contract, to lessors at far below the amortized market value, thereby generating huge profits for these lessors, as these turn around and sell the cars at a major profit, funded exclusively by U.S. taxpayers (readers should feel free to provide more gripping allegories).

What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were a) one-time in nature due to wholesale unwinds of AIG portfolios, b) entirely at the expense of AIG, and thus taxpayers, c) executed with Tim Geithner’s (and thus the administration’s) full knowledge and intent, d) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.

For banks to proclaim their profitability in January and February is about as close to criminal hypocrisy as is possible. And again, the taxpayers fund this “one time profit”, which causes a market rally, thus allowing the banks to promptly turn around and start selling more expensive equity (soon coming to a prospectus near you), also funded by taxpayers’ money flows into the market. If the administration is truly aware of all these events (and if Zero Hedge knows about it, it is safe to say Tim Geithner also got the memo), then the potential fallout would be staggering once this information makes the light of day.

And the conspiracy thickens.

Thanks to an intrepid reader who pointed this out, a month ago ISDA published an amended close out protocol. This protocol would allow non-market close outs, i.e. CDS trade crosses that were not alligned with market bid/offers.

The purpose of the Protocol is to permit parties to agree upfront that in the event of a counterparty default, they will use Close-Out Amount valuation methodology to value trades. Close-Out Amount valuation, which was introduced in the 2002 ISDA Master Agreement, differs from the Market Quotation approach in that it allows participants more flexibility in valuation where market quotations may be difficult to obtain.

Of course ISDA made it seems that it was doing a favor to industry participants, very likely dictating under the gun:

Industry participants observed the significant benefits of the Close-Out Amount approach following the default of Lehman Brothers. In launching the Close-Out Amount Protocol, ISDA is facilitating amendment of existing 1992 ISDA Master Agreements by replacing Market Quotation and, if elected, Loss with the Close-Out Amount approach.

“This is yet another example of ISDA helping the industry to coalesce around more efficient and effective practices, while maintaining flexibility,” said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. “The Protocol permits parties to value trades in the way that is most appropriate, which greatly enhances smooth functioning of the market in testing circumstances.”

And, lo and behold, on the list of adhering parties, AIG takes front and center stage (together with several other parties that probably deserve the microscope treatment).

So – in simple terms, ISDA, which is the only effective supervisor of the Over The Counter CDS market, is giving its blessing for trades to occur (cross) below where there is a realistic market bid, or higher than the offer. In traditional equity markets this is a highly illegal practice. ISDA is allowing retrospective arbitrary trades to have occurred at whatever price any two parties agree on, so long as the very vague necessary and sufficient condition of “market quotations may be difficult to obtain” is met. As anyone who follows CDS trading knows, this can be extrapolated to virtually any specific single-name or index easily. In essence ISDA gave its blessing for below the radar fund transfers of questionable legality. The curious timing of this decision and the alleged abuse of CDS transaction marks by and among AIG and the big banks, is striking to say the least.

This wholesale manipulation of markets, investors and taxpayers has gone on long enough.

[Thanks heaps to Zero Hedge]