Tuesday, September 09, 2008

It's tricky

It's tricky to rock a rhyme
To rock a rhyme that's right on time
It's tricky tricky tricky

-Run-DMC

Macro Man had to kick it old school on the iPod this morning to buck himself up after a bewildering day in financial markets. After all, if the Kings from Queens found it tricky to rock a rhyme in the mid-80's, when they were at the height of their powers, it's perhaps understandable that a (lower case) macro man might find it difficult to navigate the treacherous waters of the current stress-laden financial environment.

Where to begin? Yesterday's game plan proved as useful as a dodgy sat-nav, as Macro Man's road map left him off course, scratching his head, and wondering whether to ask for directions.

If the Agency bailout really were a panacea, it seemed reasonable to expect that equities would open high and rip higher throughout the day. In fact, yesterday's trading was enough to give Macro Man whiplash; while it may have been a day trader's paradise, it left Macro Man riding an emotional (and, to a much lesser degree, P/L) roller coaster. There were no fewer than 6 intraday moves of 1% in alternating directions....and that's not counting the opening gap higher. For those like Macro Man who went home Friday short equities and were forced to cover on Monday morning, watching the SPX oscillate was like walking a tightrope between fear and greed. It was all too easy to buy high and sell low yesterday in the name of "risk management" and "keeping some skin in the game."

Fixed income markets are equally confusing, at least to Macro Man. His position in US 30 years has gone all kinds of wrong....how the hell could USZ8 close yesterday at a higher level than it closed on Friday (and, incidentally, nearly 2 points above the levels prevailing when Macro Man woke up yesterday)? There's been some suggestion that the huge rally in MBS is forcing convexity buying of Treasuries; however, this convexity buying is, as far as Macro Man is aware, normally concentrated in the 5 and 10y sectors of the curve. Yet since Friday's close, 5 year yields are 1.5 bps higher while 30y yields are 3.5 bps lower. WTF?
As for FX carry, ugh. The good news is that Macro Man has largely reduced his FX positions and so avoided another source of heartburn yesterday. The bad news is because conviction is low, when he dabbled in selling a bit of carry yesterday, he dropped half a percent on his trade in five minutes and stopped out...only to see a two percent sell-off later in the day. The difficulties of trading FX are exemplified in the EUR/JPY chart below, which ends with yesterday's price action. While Macro Man understands the principles of candlestick charting, he doesn't know the name of lots of the patterns, including that in the red box below. What do you call a two-day pattern where prices extend sharply to the downside, then sharply to the upside, put in a 5% or so range, and then end unchanged?
If none exist, allow Macro Man to suggest the "Twisted Fork", the "Red Hot Poker", or "Satan's Finger" as alternatives.

Meanwhile, the Law of Unintended Consequences may rear its ugly head as a result of the Agency bailout. Stories are circulating that bank MBS books have received a windfall profit of $20 billion from yesterday's furious GSE bond rally, which was surely an intended consequence of placing FNM an FRE into conservatorship.

FX reserve managers and PIMCO are also quids in, of course. Given how swiftly the bailout followed Bill Gross' pleas for the Treasury to deploy its checkbook, Macro Man is left to wonder: when Mr. Gross orders a pizza, does the CEO of Domino's deliver it personally?

In any event, there is likely to be some unintended downside from the bailout. Regional banks, who have been large holders of Fannie and Freddie preferred stock, have just seen those shares collapse in value. Word on the strasse is that at last a dozen will go under shortly.

More interesting is the fact that Agency credit default swaps are triggering, as the conservatorship is technically a default event. Now, no one knows exactly how many CDS have been traded on FNM and FRE paper, but the size appears to be very considerable indeed.

While the CDS will be cash settled, there could be some rather nasty P/L surprises for heretofore successful traders of these products. From poster "cds trader" yesterday:

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.

While it seems unlikely that this impact will make or break many institutions, on an individual trader basis there could be a lot of unhappiness as this gets resolved. Moreover, the potential for back office error and out-trades would appear to be relatively high, if some of the anecdotals about back office technology and practice are correct.

In any event, Macro Man finds himself swiftly arriving at a high-conviction long term view. Anyone who finds themselves out of a job at year end should high-tail it to law school as swiftly as possible. The lawsuits resulting from this whole sordid era are likely to persist as far as the eye can see. Being one of the vultures picking at the financial system's carcass would appear to be an easier way to make money than trading, which today is once again proving to be very, very tricky.

28 comments:

dblwyo said...

Macroman - that's a nice long post and quite helpful despite it being about confusion :) ! While not a trader myself it's been helpful in the recent chaos to get you guys perspectives. Yesterday in particular was a wild ride to nowhere, just as you describe. Doing a bit of my own blogging I know how much work this is.
May I offer up a suggestion for consideration. We're in a transitional period where Mr. Market on the whole has ignored fundamental economic realities - which to be fair have been less than clear. But as a return to classic business cycles and lead/lag structures re-surface he appears to be re-factoring his thinking rather rapidly though chaotically. This might be at least a partial explanation for
a) the sudden jump in the dollar, i.e. the de-coupling meme was killed and is being replaced by an equally erroneous one of US recovery first, which'll be killed off and sent to Memehalla soon,
b) yesterday's display of paranoiac schizophrenia after the largest financial rescue since the Great Depression could be Mr. Market wrestling with reality instead of believing all things for the best as he has in the past rallies
and so on. Try it...you may like it. FWIW my attempts at weaving these threads together is here:
Be Afraid, Be Very Afraid: Five Things to Know About the Economy.
http://tinyurl.com/5qae55
Good luck today.

Anonymous said...

Perhaps what happened yesterday morning might be as simple as the following: shorts hedged their positions Sunday night by going long stock index futures. Monday morning they closed their shorts and their futures long positions.

Macro Man said...

Dblwyo...thanks for the link, it's an interesting site.

Anon, that was actually my original plan...but seeing Spoos rally in low liquidity at 11 pm London time, I decided to wait for the panic buying to subside...only to find that they were another 3/4% higher at 5 am London time. So maybe that's what happened...but I would have thought that core positions and hedges would be taken off at the same time....unless everyone else out there is a much better intraday punter than I am.

Kevin said...

from john mauldin (highly recommended you read his newsletter if you don't already).
"Gretchen Morgenstern reported last week that there are - drum roll - $62 trillion (with a "T") in credit default swaps written against Fannie and Freddie debt, or somewhere near 12 times the actual debt."
I believe that most of that is written against the 19 billion dollars of subordinated debt. I was under the impression that the bailout of the subordinated debt would not trigger a default.

Anonymous said...

ill try to rhyme the rock

henry dropped the dime on fred-fanie
it was their time

but now cds is causing some burn
it a credit event ISDA says fur certain

amount of CDS outstanding is 1.5 trillion
gretichen can't count
she was illin in accounting

looks like cash settle about 70 billion

thats a lot of bling to be swinging, if you already in the poor house with the debt man screeming

ok that was bad but point is--some more stink bombs going to go off as cds settles over next 2 weeks

hope the number help most big legal temas have copies of the isda discussions and determinations from yesterday

Damian said...

You had me when you used Run-DMC.

Anonymous said...

To be honest, I turned to my partners and said "I wonder if we will see ‘them’ come in and defend the market again" as has become so commonplace of late. It seems that the worse the economic data, the more powerful a futures-led rally materializes, one that we actually partially hedged our short positions in front of.

And lo and behold! The magical rally materialized, led by none other than the large banks such as Wells Fargo. I must admit that the market has a way of squashing one’s ego, but the "I don’t care what I pay for futures in the face of incredibly lousy economic statistics" has become a bit insulting of late. I could go on and on and tell you who I think it is buying these futures without a fear of loss, but I shall leave it up to your imagination who I feel it might be (Hint: Who is spending other people’s money and doesn’t have to answer to anyone or have a ‘P & L'?).
http://www.minyanville.com/articles/C-citigroup-bank-jpm-fre-fnm/index/a/18846

I found this interesting and at the same time it is what I see as well, seems that more then a few traders acknowledge this also. Sure one can make money I guess but it's a game I don't care to play.

mickslam said...

"Satan's Finger" !!

I like it, I really like it...

Anonymous said...

Thought- provoking post and comments. Intrigued by the many references to market behavior not adding up and implicit references to the unseeen hand. (Some may recall the Dead Science lyric--" I see the plan of the unseen hand...") Assuming that the unseen hand is at work in these markets, creating world a la Lewis Carroll, where nothing is what it seems to be, what is the indicated trading strategy?

Anonymous said...

It's tricky to make a bunch
To make a bunch with the credit crunch
It's tricky tricky tricky

Just trying to hold onto my positioning until the market makes its mind up. Thanks for the cds colour, didn't know about the 100% recovery. Wonder if the cash traders who are booking p&l with the spread tightening were talking to their deriv counterparts about scenario playouts and basis plays. One thing's for sure, it's a fascinating time to be trading! Cheers, JL

Macro Man said...

Anon @ 3.26...the most obvious analogue to "Team 1250" is in Japan, which in the wake of the Nikkei/property bust engaged in a series of "price-keeping operations" in the early 90's. (Cassandra, do you recall when it started?)

Given that the Nikkei didn't bottom until more than a decade later, I think that we can probably conclude that official equity demand can't overcome overwhelmingly negative fundamental and credit conditions.

OTOH, the HKMA bought Hong Kong equities will pretty good success in 1997.....I'll leave it to you to judge whether the second largest economy in the world or a city-state is a more apt road map for Team 1250.

Anonymous said...

My dad traded commodities most of his life. He often told me some of his best trades came from sitting on his ass watching choppy markets.

How can anyone trade these markets?

Macro Man said...

I have sat here for the last two hours watching just about everything on my screen move tick for tick with the Lehman share price...which has about a 40% range today (and at its lows was down more than 50% from yesterday's open.)

I have ALL my risk in options (long, natch)....and i am still finding it difficult to watch!

Anonymous said...

Sounds an awful lot like the markets are on a Lehman deathwatch if they use that company as a weather vane.

mikarsky said...

Satan or State finger? The best trading strategy is useless if governments and their banks intervene all the time. It really reduces the fun-factor. Like: you’re right but for political reasons, no we can’t let it happen. I’d wait until the smoke clears.

Commentators here (CH) are saying how bad all that bailing out is only to add that the US gov has "no choice" and it would give us (foreigners) "a bit time" - for what? Pulling out with grace? Erm... no comment.

Let’s quickly put the Rural-AntiObama-NRA-Hat on: the US is bankrupt and creditors are seizing everything they get hold of. The Fed’s dollar intervention* supports foreign dollar assets, not the US economy. Yesterday’s nationalization gives relief to foreign holdings. But all these (and future) interventions cost taxpayer money that could have been spent in the US (=growth).

With Mr. US President’s track record of snubbing the international sister- and brotherhood of women, men and others, why not just smash the US credit standing along with its moral standing? After nationalizing half of the credit market, why not just declare all its debt worthless? The Chinese suffer hardest but be sympathetic knowing that the route to state capitalism requires making sacrifices.

There’s a choice Mr. President: just let the financial system blow up and click restart – just like Iraq. Think: How can the fin system woes feed into the real economy? Only by making credit more expensive. Now, what’s worse for the real economy: Having problems borrowing NEW money (=reduced growth) or taxpayer bail-outs burning existing money (=eliminating the substance for future growth)?

The DOW says it all. Absolutely NO confidence despite interest rate cuts, bail-out, nationalization... Within the existing policy framework, each of these steps is by itself a rational choice – the only plausible response to the problem at hand. But taken together, these steps are a concatenation of atom bombs that eliminate US spending power and thereby the substance for future growth.

*
http://siliconinvestor.advfn.com/readmsg.aspx?msgid=24833658
http://www.chrismartenson.com/Central-Bank-Intervention

Dr.Dan_Quant_Number1 said...

Dear MM,

I worked in canary wharf for a long time. Every time I walk into the tube station from my office (past All Bar One), I envy the LEH building.

Little did I know that someday it will be up for sale and I could potentially bid for it.

STRANGE BLACK SWAN WORLD THIS

Anonymous said...

Interesting observation by MM that LEH seems to be this week's canary in the coal mine. Some may to be counting on a Neuberger Berman sale to be LEH's salvation, but I fear that liquidity problems can move too quickly to be remedied by asset sales. Lots of talk here about HFs cutting fees dramatically to stave off redemptions. Is this being seen outside of US?

Anonymous said...

"an equally erroneous one of US recovery first, which'll be killed off and sent to Memehalla soon"

Beware the beast man...and consensus views put out by investment banks.

Anonymous said...

Fear and greed sums this up best. LEH at $9 would be market cap of $6-7Bil, their asset management Co. is worth at least that and so the market is currently valuing their real estate at zero?!?

Macro Man said...

Well, if it's marked at par and its true value is 90, for example, and they hold $70 bio on their books...there's the remaining market cap wiped out.

One for the conspiracy theorists...perhaps Team 1250 stepped in on Fannie and Freddie because they thought that Lehman might come under the cosh this month, perhaps terminally?

If so, it would be a shame: most of the LEH people I've come across have been really top drawer, and I quite like a lot of them. I would not like to see them get chucked out on the street, but unfortunately this market isn't taking any prisoners with the fniancials.

Steve said...

Here's a puzzle for you: Why is the Dow Jones Real Estate Index doing so well? It is hanging tough at recent highs...

Anonymous said...

$70bn at zero in the dollar????? Would put SPX where?

Macro Man said...

Anon @ 6.36, well, LEH can only go bust once. Even if the property book was worth zero in absolute terms, the firm's creditors would still be left to fight over what tangible assets remain...all the more reason to believe lawyers are among the few who look set to prosper on Wall St, near term.

Steve, dunno, but the chap who sits next to me has been banging the drum about the steady rise in the homebuilders over the past several months. Is it short covering? A real bottom in those stocks as some of the macro housing data becomes slightly less awful? Bear fatigue? I really don't know, and am staying away.

Anonymous said...

Your prediction of a bull market for lawyers seems to be spot on. Already the former Fannie Mae execs got targeted by a class-action lawsuit.

Macro Man said...

In fairness, I don't think that you had to be particularly prescient to see that coming.

Anonymous said...

It's hard to explain why bond futures were up... but here's a stab at it. Just because they "guarantee" agency debt, doesn't mean that they've suddenly taken on a bunch more debt. Earning OAS to agency at very wide levels on the retained portfolio can't hurt too badly. And so far no major capital infusion from the govt yet. Secondly, they've theoretically "stabilized" the entire financial market right? Well guess not looking at today's moves. Certainly everyone who thinks convexity hedging will come through has been wrong so far... Perhaps servicers are hedging to treasuries instead of swaps now? therefore swap spreads are wider??? who knows... ready to throw in the towel.

Anonymous said...

the comments on investment banks losing money on fnm and fre due to lost pnl on market making maybe true, but they miss an area which is paying out big for the ibs - structured credit. Most structured credit desks have sold fixed recovery structures including those names, and clients who bought are now on the hook for the fixed recovery value not 0-5% that is on standard cds. The numbers credit structuring desks have made of this are not small...

Bonds for You said...

There are three important things to know about any bond before you buy it: the par value, the coupon rate, and the maturity date. Knowing these three items (and a few other odds and ends depending on what kind of bond you are buying) allows you to analyze the bond and compare it to other potential investments.. Therefore any type of bond not suit you if you want to invest in bonds.