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.