Saving the Financials

Plus ca change, plus c'est la meme chose. Given the ongoing travails of the financials, particularly the Agencies, it's tempting to simply re-issue this post from early last month. However, there are a few fresh developments in the never-ending saga of financial institution distress that merit comment.

Most notable of these is the Fed's decision to import monetary policy from China, which in some ways is a welcome change from standard operating procedure. Although the PBOC has hitched its wagon to the Federal Reserve in terms of setting the level of the Chinese currency and interest rates, regular China watchers will know that credit there is allocated largely by administrative diktat rather than supply and demand.

Apparently, the Fed has adopted the same model, at least if the Wall Street Journal is to be believed. That the Fed has given CS a "nudge, nudge, wink wink" hint that they should continue to trade with Lehman isn't particularly surprising, and in many ways is justified as a pragmatic measure to avoid systemic risk.

But it seems fairly obvious that some well-known financial institutions that currently exist will, at some point in the not too distant future, cease to do so, at least in their current guise. One would hope that there are more comprehensive policy prescriptions in place than "gee, it would really be swell if you didn't pull their line" moral suasion should such an outcome arise. On current form, however, there don't appear to be any.

In that vein, your humble scribe is pleased to offer the "Macro Man Plan to Ensure That People Keep Trading With Institution X". While some of his suggestions may seem outlandish, please bear in mind that his recent modest proposal to reduce the US government funding gap appears to have resonated with the Governor of New York.

At the heart of the Macro Man Plan is that financial institutions adopt the incentive programs offered by other service industries such as retailers and minor league baseball. To encourage ongoing business relationships, banks and agencies (and maybe even the odd hedge fund or two) should offer the following suite of incentives to potential counterparties:

1) Loyalty cards. In a scheme familiar to supermarket shoppers around the world, counterparties would be issued with loyalty cards and accrue bonus points for each transaction that they conduct. Once certain thresholds are reached, these could be redeemed for goods at the bank's affiliate partners, such as Amazon, Tesco, Wal-Mart, etc. In exchange, these latter firms would receive free investment banking advice.

2) Buy one, get one free! Lehman, Merrill, Fannie and Freddie: maybe you could sell more (or, more to the point, any) of your RMBS portfolio if you offered potential counterparties a "buy one, get one free" deal. Think about it......

3) Free oil! For every ticket that generates more than $250k worth of VAR, offer counterparties one free barrel of oil. When your £170,000 sports car only gets 11 mpg, every little helps....

4) A free T-shirt with every ticket! Every time you trade with bank X, they send you a free T-shirt! In fairness, this would really only appeal to very junior traders fresh out of university, but hey; we at Macro Man Industries want to cover every demographic.

5) 1000 free shares of stock with every trade! Every time you trade with Bank X, they'll give you 1000 shares of their stock absolutely free! You win by getting free stock, they win because the infinitesimal revenue that they book from each trade will labeled as "new capital" on the balance sheet, and they can announce to the world that they have raised yet more capital from eager investors. Of course, if the stock price goes down, then you incur a mark-to-market loss. On second thought, maybe they should offer free puts on 1000 shares with every ticket....

Elsewhere, a brief follow-up to yesterday's post. One of the things that Macro Man does in his real job is to run indicators that attempt to determine which fundamental themes are driving currencies at any point in time (don't ask, he's not going to be more specific than that.) And what's interesting about the recent dollar move is that none of the fundamental themes that traditionally drive exchange rates has been in play during this dollar move.

This morning he quantified this into a combined "thematic strength" indicator, wherein a high reading indicates that currency markets are trading very thematically, and a low reading suggests that so-called fundamentals are not driving FX.

And what we can observe is that this is the least thematic market since the summer of 2003. It appears to have been micro (idiosyncratic decisions and/or momentum), rather than macro, that has driven the recent dollar rally. So if you've struggled to understand why the buck is up, don't worry; it's taken a lot of people by surprise.
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Anonymous
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August 21, 2008 at 11:28 AM ×

From where I sit a stronger dollar has been synonymous with the unwindng of risk for the last eight years. Leveraged speculators are selling their Ruble asset, Asian currencies etc etc and repatriating the proceeds into USD.

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Macro Man
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August 21, 2008 at 11:33 AM ×

Up to this time last year I would have agreed with that, except Q1 of this year saw all sorts of unwinding trades accompanied by a dollar shagfest.

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Anonymous
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August 21, 2008 at 1:47 PM ×

LOL when reading your incentive ideas and maybe they will be adopted as "get out of trouble" moves. As you mentioned, Gov Patterson of NY has adopted your timely "sell fixed assets" advice. (Apparently, folks are lining up to buy NY state highways.) The issue of counterparty incentives took me back to my experience in setting counterparty risk lines. Those lines, set in meetings every morning in every financial capital, determine whether the counterparty risk of a weakening player will be accepted. From that viewpoint of counterparty risk, I think that the jury is already in. The quasi Fed institutions have beeen bailed. ML appears to have raised sufficient liquidity to survive even its massive self-inflicted wounds. Lehman, however, won't get a Fed bail out and has only its asset mgmt business to sell. After that cash goes, I presume that folks in those counterparty risk meetings will further cut Lehman's lines, with the inevitable result. Did they not win your dead bank poll? Re the USD, I will read your on-going analysis and forecasts with considerable interest. At present, I am baffled by the USD's apparent departure from fundamentals-- or maybe, as you say, the macro issues aren't the drivers in this recent move. For Macro Man, and for us all, these are essential questions. Best- Anon

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Anonymous
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August 21, 2008 at 2:18 PM ×

Bucky's strength may be due to too many central banks with bazookas in their pockets. This reminds me of shortly after Paulson came to the treasury and oil fell like a rock and the equity market took off in 05, of course China seeing a bunch of hedgies blow up causing commodity prices to fall, some of which have demand which is greater then supply may also be the case. Although the view of a deflationary spiral scare as credit tightens and the banking system is acting like a black hole sucking capital in with nothing coming out.

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tyaresun
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August 21, 2008 at 3:37 PM ×

Maybe the US gov't can offer "Get out of Jail Free" cards to executives for trading with Bank X.

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Macro Man
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August 21, 2008 at 3:40 PM ×

Very good, tyaresun. One Monopoly card that w can probably all safely retire at the moment is "Bank error in your favour."

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Anonymous
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August 21, 2008 at 4:36 PM ×

MM - Hows your NZDUSD coming along? Its taken quite a swing over the last few days....

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Macro Man
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August 21, 2008 at 6:07 PM ×

Funny you should mention it....I was assigned today on an option structure that I'd put in place to hedge my position whilst on hols. It more or less had me out of the bulk off my directional exposure to kiwi midway through my first week...at least until it started squeezing up again at the end of last week.

To paraphrase Dean Wormer: Son, sick, stressed, and short gamma is no way to go on vacation.

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bank analyst
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August 22, 2008 at 2:07 AM ×

Macro-man,
I hope I am not overstepping my bounds, but what is the mean of that fundamental theme indicator of yours? Also, what % of the time has the indicator spent below zero? Thanks. Good to see you back in the office. Your wit and wisdom was missed.

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vlade
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August 22, 2008 at 9:08 AM ×

Mr.M, the second point was already taken and bettered on with the buy-one, get two free deals also known as "buy it at our price and we'll give you 66+% cashback"

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Anonymous
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August 22, 2008 at 11:35 AM ×

My poor Macroman, you left comments on Nassim Taleb on a site that are LIES and DEFAMATORY so I hope you understand that you can spent some time in court as he can be tenacious. (A freidn of Taleb)

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Macro Man
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August 22, 2008 at 12:15 PM ×

Friend-of-Taleb, if your buddy plans on suing everyone who suggests that he had failings as a fund manager, he'll bleed his personal fortune even more consistently than he lost his investors' capital.

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Anonymous
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August 22, 2008 at 12:24 PM ×

:)
(things can get funny with detractors)

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Anonymous
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August 24, 2008 at 11:45 AM ×

A preliminary look at your chart suggests going long vol and/or gamma when the market is not trading according to fundamentals (at least over the last year). Would you agree? Keep up the good work I think this is one of the most interesting financial blogs around.

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Macro Man
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August 24, 2008 at 11:59 AM ×

Anon, agreed. Having been short gamma for the first 2 weeks of August , I switched to long gamma last week.

Although the theta bill for this long weekend is a bitch, I still know which one I prefer!

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