Tuesday, December 08, 2009

Remember That Thou Art Mortal

In the days of the Roman Republic, the imperator of a particularly successful or important military campaign was occasionally awarded a triumph. This festive ceremony featured a parade of captured bounty and prisoners, interspersed with Roman soldiers signing bawdy songs about their commander, who would wave to the cheering crowds from the back of a chariot. And behind the chariot would walk a slave, whose sole job was to whisper in the ear of the conquering hero "Remember that thou art mortal."

At the risk of beating a dead horse, 2009 has, in aggregate, played the role of the slave in Macro Man's investment career. As if he needed further proof, a couple of the trades that he cut yesterday have come roaring back today. It's a slap in the face, but not altogether unexpected, and Macro Man has to laugh (if only so he won't cry.) In any event, those trades are done with, and there's no utility to be gained from crying over spilt milk.

Anyhow, while Macro Man is in wind-down mode for the year, he is still keeping a watchful eye on things. One little item that has caught his notice is the relative outperformance of Korea in the aftermath of the initial Dubai flare-up. For the two months after late Sepember, the Kospi couldn't buy a friend, and badly underperformed the rest of global equities. Since "Dubai", it has surged, even breaking out of its downchannel resistance. Does it mean anything? Macro Man isn't sure...but it is interesting.
Also of interest is the swirling talk around sovereign risk. Te Nakheel bond maturity is rapidly approaching, and while there have been some mumbles about ad hoc support from the government, there's been nothing concrete announced. Similarly, Greece continues to get pummeled, with 5 year CDS widening out beyond 200 bps this morning.

The Big Kahuna(s) of soverign risk, however, are G4 countries. While Japan is its own special case, the US and UK have come under renewed scrutiny, and not simply because it's the time of year whn banks roll out their "year ahead" research products. Today's WSJ carries a story noting that Moody's has changed its language on the US and UK, possibly opening the door to a downgrade by 2013.

While that's still an unlikely outcome (doom-mongering to the contrary), it does highlight the risks posed by the fiscal situation in both countries. Macro Man had to laugh at a recent story that the Obama adminsitration would use some of the TARP money to pay down the deficit. It really highlights the absurdities of US government budget accounting, because it seems to be common sense that the best way to "use" the TARP to reduce the deficit would be by...err....not using it! In any event, US CDS has started to tick higher again, though it remains well below the panicked levels of last year. Still, it's worth keeping an eye, particularly in the context of shaky performance by the peripherals.
In the UK, meanwhile, we get the Government's "go for broke" mini-budget that is widely seen as a last-ditch effort to revive Labour's sagging electoral fortunes. The other day, Macro Man wondered to himself what Mr. Darling would propose if he were actually interested in a goal other than saving his own political skin, then chuckled at the absurdity of the notion. In any event, expect some focus on windfall taxation of banking bonuses, which will no doubt raise howls of protest from the Square Mile and satisfied taunts of "Unluggy!" from the other 94,525 square miles of the United Kingdom.
In any event, UK sovereign risk is likely to remain in focus for some time, given the forthcoming election next year and the potential for a hung Parliament. Macro Man doesn't know how it will play out and is happy to remain on the sidelines. Trying to guess how this will play out would likely provide him with aanother slave-like reminder.....


Anonymous said...

hold on to your hats, rest of the week is gonna be a wild ride!

Anonymous said...

What does anyone think about the possibility of another emerging market debt crisis? Dubai, Greece, Romania... rest of Eastern Europe could be contaminated?
Could this be the "next wave" of the credit crunch?

Anonymous said...

Anon 11.24
I was just drawing the same conclusion..are you watching the banks as well?

Gregor Samsa said...

Anon 11:32, just like you, I can only guess. I believe that most of Eastern Europe didn't take out credit only to buy gadgets, they tried to build their economy as well. On the whole, I believe it will turn out well for EE in the long run.

Skippy said...

It may be an obvious point to many here, but Korea is often used as a proxy to short/hedge Asia/EM as it has the most liquid futures market. Some of that pressure may have eased (for now).

GS will tell you that Korea is no longer a leveraged play on G3 demand, but the equity market correlation suggests otherwise.

Korea is at the pointy end of the global cycle, hence it is a very interesting market to watch..

Anonymous said...

anon @ 11.39

i keep harping on about this, but conditions have started to tighten for 2 months now ... its not just about base rates.

the liquidity fueled bubble will unravel precisely according to those who have benefitted most and are furthest away from fair value ... banks, poor sovereign credit, useless inflation hedges such as gold and oil and the like.

its just gonna take time to pan out. but once the domino effect starts, its hard to stop ... this time precisely because its central bankers that are easing off the liquidity/money supply pedal despite trying to keep rate hike expectations low.

KGB said...

I guess we have reached that time of year where risk takers are not happy to add and become vulnerable to pain. Fridays price action in many 'risk on' positions was out of step with what the market has come to expect and I fear we have entered that time of year where we play hunt the hunt the pain game. This morning we have had some China comments, Dubai stocks, bank shares and the Dollar all adding to a feeling of pain to come. None of it is very new but that appears, now, not to be the point. If it is owned it is vulnerable.

Skippy said...

In contrast, Hong Kong appears to be forming a H&S top (not confirmed, of course). Chinese stocks are not taking the possibility of weaker loan/money growth very well.

Anonymous said...

lets put it this way, the notion that those sectors (economy, nations whateiver) which got bombed out the most will lead us out of this mess is absurd.

PJ said...

I've been short the banks for several months and wondering when the bad news will hit their share prices ... MBS prices have been declining since Q3 ended, meaning banks will face big losses in Q4 ... now Obama is forcing share issuance in order to get the TARP funds back ... surely with this double whammy banks will drop significantly in advance of earnings reports?

Acc'yronym said...

@ PJ 12:36

I'm still expecting the powers that be to keep adding more elasticity to the IASs and GAAP to ensure the year is ended on a positive.
JPM Q3 should have a permanent spot in the Tate.


abee crombie said...

does anyone here actually trade CDS? I have heard the accuracy of Bloomberg data for CDS (especially single name corporates) is very poor. I wonder if gov't is similar

Just a thought

der Tillman said...

Tons of negative news out today. But what if SPX holds on? Sure there are lots of reasons to be bearish. But most (if not all) the factors that began this risk asset rally are still in place: namely, loose monetary policy, improving economic fundamentals (albeit from a low base), em strength, blah, blah, blah.

So, here’s a bit of Voodoo…i.e. Technical analysis

As mentioned in previous comments, Korea is probably still important and it has consolidated but has not yet broken down. And when a perfect Head and shoulders top fails to confirm (looking at the kospi since 7/31), the textbooks tell us that the rally off the uncompleted pattern can be parabolic. If kospi rallies, other risk assets probably will too.

So, don’t forget about the possibility that equities and risk assets could be primed for one final F U rally. I think that’s the pain trade. The head and shoulders bottom on SPX projects to ~1230, which is also 61.8% retracement of down move.

Something to consider.

Long risk asset exposure into year end with downside protection is warranted.

Gary said...

This is just my humble opinion, but I question the basic models that underlie most CDS pricing (Bloomberg or elsewhere). It is not obvious to me that the assumptions behind the models are sound (I am on the fence here). But it is very obvious that the data necessary to calibrate the models does not exist.

Then you have sovereign CDS... I asked two happy sell side credit analysts to explain to me why the f### I should buy insurance denominated in USD to protect against default of the US government. Its a lot like buying insurance from AIG against a default by AIG... the two analysts gave me an answer that sounded like something a member of Congress would say; lots of words, zero meaning.

CDS are essentially insurance contracts and insurance is about pooling risk. You need a big pool of **independent** risks, you need statistics about how/when those risks turn into negative outcomes. Life insurance companies pay vast sums to actuaries to determine life expectancies, and (usually) one person's death has no correlation with others. With property insurance, one guy's house burning down doesn't have any correlation with other houses burning. They are independent risks.

With credit risk, the risks are not independent. When (not if) you have a recession, the probability that defaults will be correlated is huge. In today's environment, where every CEO seemingly operates with a "me too" strategy, many distinct companies are exposed to the same economic factors. In short, they are not independent risks -- the "insurance company" cannot reduce risk via diversification. In political terms: systemic risk trumps entity risk.

And the long term data to determine default probabilities? Most data sources have obvious survivor bias.

What is the recovery rate you can expect on a defaulted asset? It depends on how a court will resolve all sorts of off balance sheet credits against supposedly "senior" credits.

And beyond all those model risks, you have the added problem that the CDS seller of protection is likely an over-levered financial institution who will go bankrupt right when everyone needs to make an insurance claim (eg AIG).

CDS are a very flawed product -- way worse than CDOs

Anonymous said...

surely not, a bullish view? here? Prepare for the onslaught, or if everyone agrees, maybe it really is the top...

Deniz said...

i might be wrong but i think US cds is settled in EUR. not that there will EUR left is US defaults.

Gary said...

I don't know if some US govt CDS is priced in EUR now, that story with the two analysts is from about 2yrs ago.

But it doesn't matter. A big reason why the USD remains the global reserve and trade currency is that there isn't a viable alternative. EUR has its own flaws (too many to list here), Rembi/Yuan is illiquid and not convertible, JPY is issued by a geriatric state deep in debt, and so on.

Whatever currency you denominate G-4 CDS in -- its still garbage.

Any event that would trigger a G-4 default would almost certainly also bankrupt CDS sellers of protection, making the "policies" worthless.

And that's before you get into all the structural problems like risk independence, model assumptions and calibration problems, and credit risk of the "insurer"

Anonymous said...

Gary, CDS is not usually a default insurance trade, its a spread trade and thus an easy way to implement a leveraged view on the creditworthiness of sovereigns without having to mess around with cash bonds and rate risk. Obv settlement under default is a major issue but that doesn't mean its impossible.
I too think SPX has held in well today, am enjoying the fall in gold, but not that in EUR$. It's a messy month and has been mentioned most desks are prob risk lite rather than on or off.
My 2p, JL

hear today guanno tommorrow said...

US sovereign CDS is quoted in either US or EUR tho mosylt traded in EUR. point is, u don't just need default for trigger on to tarde these. credit migration or a missed coupon should do you well. so what if this a technical default. who cares. its not as though the currency will cease to exist.

Anonymous said...

To DGDF bugs: So Greece bankruptcy worth about 2 big figs on the Euro? How about Spain? How about Italy? I'm sure German and Dutch taxpayers will love bailing out the Greek government or guaranteeing its debt with their savings and/or future taxes. How long the PIGS governments will allow unemployment to be 15% amid collapsing competitiveness and crushing debt loads without the devaluation option is the question of day...

Gary said...

Anon 5:49

Yes, I know many traders trade CDS based on "spread" and not for default ... but you are just proving the point that the basic product is flawed.

The underlying reason for the spread is to pay for the risk of default; hence my reasoning applies to how that spread is priced, even if default doesn't happen. That is why they are called credit ***DEFAULT*** swaps. Default, even if it doesn't happen, is the basis for any economically based price.

The fact that insolvent banks are trading these things essentially like casino chips (with zero attachment to underlying economic value) is why the product is hopelessly flawed.

No solvent bank would sell protection at these "spreads" (or they wouldn't remain solvent). No intelligent consumer would buy protection from an "insurance company" that won't be there in the event of a claim.

Hence, trading in CDS casino chips is left to people who trade only with other people's money.

Its a bad product, just waiting for a blowup

leftback said...

I know how you feel, MM, also took off a trade yesterday and it just kept rolling today. Can't discuss what it was, though, too controversial... but it wasn't a DGDF trade.

Shorting miners and materials seems like it might be a good trade at some point if this dollar rally is for real. Experimenting with that today. Once again the 3-mo T bill to 2 bps action yesterday was consistent with a little overseas turmoil. LB usually gets short risk assets when that happens, seems to be reliable.

Our Man in NYC said...

LB -- Shorting miners has already been a good trade (points to FCX's post Dubai performance as a good example).
That said, you're playing with the tail end of the whip and can't hang around when they turns else it gets ugly (as OM's boss mentions every hour to him, following burned fingers in October!)

PJ said...

Gary - Here's the only model I need: if the sovereigns default no banks will be able to pay up on the CDS.

CDS are like paper tickets or tulip bulbs, they have value because people willingly accord them value. In a true crisis, they would underperform. But in the meantime, they can trade much like Fannie Mae, Freddie Mae, and old GM did this summer.

leftback said...


Had a good week already with another trade that cannot be mentioned here. My usual "DGDF trade" is long energy, so that will probably be employed when the time comes. The leashes on all such beasts are short, for now, and in any case most of the portfolio is dull - dividend stocks, IG corporates and Ts. LB does not heart risk here.

PJ said...

Looks like the Chinese are spooked ... The two things Chinese stimulus funds have been buying, Chinese equities and gold, are down the hardest.

Where's Nemo?

Gary said...

PJ -- I agree with you 100%... CDS are casino chips with no real value.

As long as the crazed masses want to trade tulip bulbs -- they will have a pretend price. The instant a critical mass of people realize the CDOs / subprime / FNMA / CDS are nothing but swamp water ... they will simply cease to trade.

Then some corrupt banker will whine to a corrupt treasury secretary about an imaginary "liquidity" problem in tulip bulbs and CDS ... that "no one could have foreseen!"

Trading CDS is exactly like going to Foxwoods or Mohegan Sun (both casinos in Connecticut FYI). If you go to a casino with a set amount that you can afford to lose, see a show or have a great dinner, etc -- no problem. Its entertainment.

But if you are foolish enough to think it is a sound business model and bet more than you can afford to lose outright...

And that is what the banks are doing with taxpayer money

Anonymous said...

So now this stupid George Bush wanna-be president plans to spend our way out of debt!

There is no way this recession is even close to over

leftback said...

Gary: You are 100% correct, and the government is intent on backstopping the tulip trade at the same time. Once the folly of this policy is realized there will necessarily be another "repricing of risk".

Gary said...

LB -- the problem I see going forward is that the govt is running out of money and credibility.

When Obama is facing election / referendum next year, or facing actual election in 2012 ... will he opt to make good on bullsh!t banker promises?

Or will he spend on infrastructure, welfare, tax credits, etc that voters can see?

Wait!! before you answer, consider that the resentment of the masses is becoming so obvious that even the CEO of Goldman is starting to see it. Heck, voter resentment is so friggin obvious that even (gasp!) members of Congress are noticing and asking Bernanke about it

Wait!!! Bailing out mortgages is one thing, voters want a house. How the heck are Congress members going to explain bailing out a CDS trade? What's a CDS trade anyway? Isn't that the AIG toxic waste that Henry Paulson used to bail out Goldman Sachs? And then Goldman went and paid $20 billion in bonuses?

I would not want to be one of the suckers counting on yet another big government bailout.

leftback said...

Gary, in what can only be described as a conversion similar to that of Saul on the Road to Damascus, there has been a transformation - we agree completely. Macro Man, are you witnessing this miracle?

On another note, LB points out that this week has seen an example of a VERY RARE technical pattern that may have been spotted by other flamingo hunters - the CLAVADISTA d'ORO.

Skippy said...

LB, if my rough translation is correct (I may be wrong), "CLAVADISTA d'ORO" means "golden-cliff-diver", but I am not familiar with the technical pattern. Please englighten us.

Anonymous said...

OK, so Obama's idea of paying off the Mastercard bill with the visa card didn't go over to well with people who can do math...

On to the next idea: Cash for Caulkers (no I am not making that name up). Home owners can get up to $12,000 to buy various energy efficient appliances made in South Korea or China (stoves, A/C, refrigerators, etc) ... OR ... as the headline suggests, for insulating and caulking their homes.

At the local Home Depot (hardware store), a canister of caulk (made from petroleum products) costs USD $4.95

So that means Obama wants us to buy 2,400 canisters of caulk for our home? Maybe we can make the entire house out of caulk?

Or, similar to the cash for clunkers program bailing out Honda and Toyota, we can now bail out the only compressor factory in the world (in South Korea) or maybe buy a new stove from LG (South Korea again) or one of the "name brand" models (GE, Maytag, Whirlpool, etc) that are outsourced to China.

And this is going to stimulate the US economy!

The recession is not even close to over ... but I am starting to miss the stupidity of George Bush

Anonymous said...

I found most surprising the grilling BB got at the hands of Congress. It was like they actually cared or something. Maybe their staffers have been hitting the blogs.

One way or t'other, TPTB in Washington seem to be figuring out that all the QE isn't actually helping the US economy at all, but is simply fueling new bubbles in EMs, commodities, and of course providing for record bonuses at GS.

Naturally, their own deficit spending is another matter entirely. While the masses may be looking about for pitchforks on the sinking dollar, they've not yet figured out how the deficits are mostly lining the pockets of Democratic stalwarts, to be recycled as campaign contributions, nor that what doesn't find its way to those worthies is, as noted here, flowing into the pockets of foreign suppliers of imported necessaries such as petroleum and flat-screen televisions.

Put the two together and what do you get? BB under pressure to defend the dollar, while at the same time massive new issuance of US govt debt will need to be priced to catch a bid in the real market from the same foreign buyers who are running around looking for ways to dump their dollars. What does that suggest for US interest rates? Can BB possibly keep the pot from boiling over for the 2 years necessary to skate past the option-ARM reset bubble and the commercial RE loan rollovers?

leftback said...

Skippy, "clavadista d'oro" in fact refers to the chart showing a precipitious fall in the price of a certain instrument of late. LB is forbidden to discuss this further in the interests of investor harmony.

Skippy said...

Thanks LB ;)

Anonymous said...

Something to think about: