Monday, September 08, 2008

Checkmate?

Having recently re-read Arturo Perez-Reverte's excellent Flanders Panel, last night Macro Man played chess with Mrs. Macro for the first time in at least five years. He discovered to his chagrin that it is very difficult to play chess with one eye on a Blackberry; the missus dusted him twice with surprising swoops that caught him badly off guard.

This morning's parallel with financial markets is obvious, of course. The announcement of the Agency bailout/rescue package/whatever it is has wrong-footed risk asset shorts, and the early anecdotal reports suggest that a few punters may be facing checkmate. Macro Man will leave the in-depth breakdown of the mechanics of the rescue to others, and instead focus his thoughts on what it actually means for markets and his portfolio.

After Friday's appalling payroll data, it looked like we were all systems go for an equity and FX carry meltdown. It certainly seems like the market deployed a lot of risk shorting stocks, EM, and yen crosses, at least during European trading. In retrospect it certainly looks like someone had the heads-up about the GSE bailout, given the sharp bounce in equities into the close. With Paulson's close ties to Goldman Sachs and Morgan Stanley having advised the government on what to do with the Agencies, Macro Man is left to wonder if the Chinese walls are actually of the Japanese paper variety.
Regardless, now that Bill Gross and foreign CBs have been made good by the US taxpayer...err....Treasury, we need to figure out what happens from here. It seems almost axiomatic that financials (ex FNM and FRE common, naturally) and broader equity markets will continue to rally for a few days. However, in Macro Man's view today's action doesn't necessarily alter the medium term dynamic.

The greatest impact of the weekend announcement will be psychological; it will do relatively little in the near term to clear the inventory of unwanted houses in the US, it could put pressure on regional banks via a hit to their holdings of preferred Agency stock, and does nothing to assuage the weak US labour market. Further afield, of course, Europe is still in a world of hurt, particularly with the financial Calvinists running the policy show.

Next week sees GS, LEH, and MS release Q3 earnings, and none of them will be helped by yesterday's announcement. Perhaps there is room for good news if Lehman can find a buyer, and of course GS will beat estimates like they always do. But overall, Macro Man would expect a fairly dismal set of figures.

Moreover, there is plenty of precedent not to expect too much support over a three month time frame from the bailout. Consider some of the "substantial" policy actions taken last year: point A on the chart shows the first discount rate cut in August (also leaked to the market a day in advance), whereas point B shows the introduction of the TAF (which was supposed to fix all the funding problems.) While each of these prompted a knee-jerk rally in equities, ultimately the fundamentals and drove stocks lower.

Perhaps more relevant is the precedent of the Resolution Trust Corporation, formed in 1989 to be the buyer of last resort of assets held by the S&L industry. The RTC's formation occurred into a decelerating economy...but the SPX didn't bottom until October 1990. It wouldn't at all surprise Macro Man if the SPX didn't bottom until next year.

While Macro Man is still organizing his views, here is a simple summary list of his thoughts on the market implications of the GSE takeover:

1) The short European equity trade should be changed to a short Europe/long US equity trade, reflecting the different policy settings.

2) US Treasuries should sell off and spreads should tighten; the Treasury is selling government bonds to buy MBS.

3) FX carry should do pretty well. We've already had a gap higher in NZDJPY, and no doubt CTAs/carry models/Mrs. Watanabe have more demand in the pipeline.
4) Macro Man isn't really sure what it means for the dollar. While he can accept that a policy response can be construed as dollar-positive, he can't help but observe that the dollar did pretty well when everything looked horrible. A "heads I win/tails you lose" scenario always makes him uncomfortable, and he's frankly happy to be largely out of currencies at the moment.

5) It wouldn't surprise to see more pain in commodity equities, if there are any more stale long energy/short financial trades out there. Macro Man doesn't have a good feel for this one.

In any event, views are likely to evolve in real time, and for equity shorts like Macro Man today is all about damage limitation. His decision to put on some short long bond deltas on Friday hasn't saved his bacon entirely, but it has at least mitigated today's pain. Once again, his policy of "hedge when it looks like you least need it" has come in handy.

Having a back-up plan and protecting key assets are of vital importance in both markets and chess. And frankly, Macro Man will take a checkmate from Mrs. Macro every time if it means that he's mounted an appropriate defense of his portfolio and lives to fight again another day.

21 comments:

Charles Butler said...

Hi MM,

Spectacular as this morning's +4% might be, the move has basically only undone the last 9 and a half hours of trading of the prior week. The possibility that this move on the part of the treasury, rather than the saviour it is touted as, is merely the first in an interminable series of epiphanies weighs heavily on the effort. Kinda like the Republicans selling themselves as revolutionaries.

Particularly in Europe, it's scale-into-shorts time.

Anonymous said...

Almost lunch time in Central Europe... risk appetite growing?

AT

Anonymous said...

Your post gives the best size-up I have seen. I especially agree with the observation that Treas should sell off and spreads tighten. Also have taken to heart the -- hedge when you least think you need it-- advice. The Chinese wall/ Japanese paper comment seemed spot on. After Paulson's meetings with the GSE's on Friday, the word of the takeover appeared to reach the markets very quickly. You know what is said about the rate of travel of good news.

Anonymous said...

Lunchtime in central Europe...Well in the UK it at least provides something of a welcome relief from the thumb twiddling, seems 4% to the upside in the UK is even unbelievable to the software running the show.

Macro Man said...

I have to say, I am really surprised that with 45 mins to go before the US opens, Spoos are basically on their highs, but long bonds are a point off their lows and FX carry has also come off quite a bit.

I wonder which, if any of these will "snap back."

Ben Bittrolff said...

Heads up. This 'bailout' just triggered $1.47 TRILLION in Credit Default Swaps on Fannie and Freddie.

The clowns that wrote these CDSs are probably dead. No way this is spread out enough over the entire system to avoid at least some implosions...

Fannie and Freddie: CDSs, $1.47 Trillion Triggered

Anonymous said...

having markets being speaking a lot recently about Hank's bazooka after thhe government commitment in july, i think that even if some "bonanza" on risk assets is understandable, most of it's effect was already priced in so i expect this relief rally to be considerably shorter than the ones before. Absence of strong action had to be much more painfull.

sick trader

Macro Man said...

While not wishing to downplay the impact of a CDS default event, my understanding is that recovery rates will be 95c on the dollar. That's a $75 bio loss, which is not insubstantial, but will likely be felt by insurance companies (who can take it) and HF (which will blow up.)

It could be good news for the brokers, who presumably hold a lot of this stuff (given they they are all calling it an event), and could get a bit of a windfall.

Anonymous said...

On the other hand, if you wrote protection on these instruments with the idea of collecting the premiums and never having to pay off (or trading back out of the position later), you're probably not looking forward to kicking in the full face value of the bonds to your counterparty and ending up long the underlying at today's historically low interest rates, a position you'd probably rather be on the other side of. Checkmate, indeed.

Anonymous said...

uInteresting news on CDSs; glad to see 95% recovery estimate. Rumor mill here running OT re HF redemptions/ death. See that the predicted spread narrowing is underway. Assume the Chinese are well pleased/ euphoric with the takeover. How do you say-- "They blinked"-- in Chinese?

Anonymous said...

Will the writers of protection really end up with bonds? I thought these were going to be settled cash not physical?

LFY

Macro Man said...

LFY, that's my understanding as well. From what I gather, there will be some sort of auction to determine settlement prices. No idea how it might workN tho....

the cds trader said...

From what I can see so far, it looks like both senior and subordinated CDS will have 100% recovery (this is pretty unusual), so basically all the contracts will just get torn up for "no cost".

I see "no cost" because what ends up happening is that if you've traded CDS in these names profitably, you'll actually be losing money, and vice versa if you were showing down on your CDS trades on Friday you're in for a windfall gain. This is because your profit in CDS is the Present Value (PV) of the future cashflows, but when a CDS triggers, the premiums stop getting paid so that PV you'd assumed is actually zero.

If thats not clear, here's a little example:

I buy FRE sub CDS, 5y, at 50bps in $100mm, a while back. Nice trade, since it then widens to 250bps, where I sell it in $100mm. What's my profit? Well, its 200bps a year for the next 5 years, discounted at the risky rate. 200bps = 2%, and lets say 5 years worth of that is worth 8% (not 10%, as we're discounting those future cashflows).

SO...my P+L is showing up 8% of $100mm = $8mm. Great, nice trade. EXCEPT...along comes todays event, CDS triggers, but bonds are all above par. So the PAR - RECOVERY payout (ie. getting paid 100 in exchange for "defaulted" bonds) is zero, BUT all the CDS contracts stop paying the premiums.

So now I have received no payments, but my CDS trade where I was paying 50bps has gone away, AND the CDS trade where I was receiving 250bps has also gone away, so now my P+L is zero. Unfortunately, I'd already taken my $8mm P+L, so what this means to day is that I've just LOST $8mm, and that was from trading well apparently!!

Quite a few people will get surprised by the effects of this today I think.

Oh, and hopefully once all this gets settled no problem, people might start to realise that the CDS market is actually pretty stable and isn't going to "meltdown" or "blow up" any time soon.

Rgds,
the cds trader

Macro Man said...

Very, very interesting CDS trader. So who do you reckon is most likely to receive a "windfall" P/L of bad trades going out worth zero, and who will lose their accumulated P/L?

At first blush I would think that the brokers' desks would take a hit, assuming an accumulation of profits from making markets over the past few years....and yet they are the ones calling a default event, which would hardly seem to be in their best interest.

Any thoughts?

the cds trader said...

exactly MM...any decent broker desk worth its salt should have made money trading GSE CDS, so they can kiss that goodbye. I can tell you that keeping an eye on your Mark-to-Market CDS P+L that is NOT closely followed even by experienced CDS traders, so there will be surprises. What usually happens is you'd just go and buy more CDS to protect your P+L, lets say you were up $8mm, and you assume recovery rates are around 40% (which is kinda the basic assumption taken in the CDS market), then you'd buy $20mm of CDS to protect your P+L, since you'd get paid out 100-40=60% on a default = $8mm, so protecting your P+L. However, this 100% recovery just threw that assumption out the window...

As for triggering the contracts, its pretty clear that its an event as conservatorship is explicitly in the documentation I hear (I haven't bothered reading it myself to 100% confirm this though), so the brokers can hardly deny it!

Anonymous said...

So as cds trader said, the companies who weather the credit crunch pretty well and benefit from hedging would see their profits unwind? If this is right, who are those companies? GS comes to my mind...

the cds trader said...

anonymous, not to be rude but honestly you have no clue from the outside who may be up or down on FNMA/FRE cds (I have no clue either!). I'd also say that correlation desks (ie the CDO hedgers) are probably going to benefit here, as usually they have negative convextity and are forced to sell protection as it tightens and buy it as it widens. So they'll have a negative P+L on those trades which will now disappear. So there could be upside there for dealers.

I'd also say that this situation of defaulted bonds being worth par or above is very unusual and does NOT translate across to hedging of other financials. If/when a large bank defaults, you can pretty much guarantee that bonds will be trading at a discount.

mikarsky said...

I knew my communist school teacher was right: nationalization is the way to go! It seems the communists were only a few years off when predicting the fall of American capitalism! Erm.. should we get the Champaign??

Anonymous said...

CDS trader, are you familiar with the default of Dura Automotive in 2007? The reference bond on Dura CDS rallied hard for several days prior to and after the firm defaulted. I thought it was analogous to a short-covering rally, as everyone scrambled for the Cheapest To Deliver (CTD) bond. Why is this not the case with GSE CDS?

Macro Man said...

Anon, I believe it is because it's been agreed that the GSE CDS will be cash settled- ie, there will be no need to tender bonds to receive payment. This makes sense if all the bonds are settled at 100.

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