Con-tango

CDS ratings

From this Bloomberg article, I thought it would be interesting to see a list of companies with their CDS prices, which shows how the market is pricing their relative risk to a debt default.

In other words, if I wanted to insure $10 million of General Motor’s debt, I would have to pay upfront $6.7 million, plus a yearly premium, in the order of $800,000.

The scorecard

Courtesy of Prophet

From this Bloomberg article I learn the tally on the markets pain, so far…

Stock markets and commodities have tumbled along with currencies this year amid growing concern that governments, central banks and finance ministers are powerless to counter eroding corporate earnings and a global recession.

Oil-producing nations haven’t escaped the carnage as crude plunged 56 percent from its July peak to $64 a barrel.

More than $10 trillion has been erased from the market value of equities so far this month, accounting for about one-third of the total value wiped off stocks this year. MSCI’s index of developed and emerging stock markets plunged 48 percent in 2008 and is heading for its worst year on record as credit-related losses topped $660 billion.

The Standard & Poor’s 500 index is down more than 40 percent this year, poised for its worst annual retreat since 1931. The S&P 500 has lost 26 percent since U.S. investment bank Lehman Brothers Holdings Inc. declared bankruptcy on Sept. 15, while the U.K.’s FTSE 100 has fallen 25 percent, Japan’s Nikkei 225 has tumbled 37 percent and Germany’s DAX has dropped 29 percent.

Staggering losses

I'm trying to make sense of this BIS September report, so, please bear with me and my ramblings.

Toni, from Prudent Investor had this wonderful piece about the size of the derivatives markets, which for December 2007 stood at $596 trillion –what an alarming figure!

It's important to understand that these are notional values, which are leveraged with good faith deposits of around 1.25%, or $7.2 trillion for each side of the trade.

Trouble is, that the 4 to 7% daily movements that we have been experiencing lately in the underlying stock markets, send shocks of 3.2 to 5.6 times their derivative stakes in one day! Worse, CDS involved in debt defaults, which are occurring at a brisk pace, represent much larger payouts, in the order of 833 times!

Now, if you've been paying attention, the above $596 trillion are the more shadowy counterparty OTC derivatives, which do not include an additional $84.3 trillion from the less riskier exchange traded derivatives (from page A108 Table 23A).

Another salient issue is that the interest rate derivatives are the
heaviest item weighing in the derivative's total, with $393 trillion
outstanding notional value, and a net trade stake of $3.6 trillion by
the end of last year.

Courtesy of Economagic

If (the short term) Libor violent movements are a reflection of the interest rate sector derivatives, with an enormous 170% rate increase during the last month or so, then, holder's of interest rate derivatives are making a 136 (170 / 1.25) times profit or loss –depending on the holder's side of the trade, which if outstanding deposit volumes had unwound an estimated 50% to $1.8 trillion by September, would represent a $244 trillion payout to clear these trades (= 136 x $1.8 trillion).

Of course I'm thinking out loud. But, the above figures are reasonable. If these numbers are close to reality, then, someone has been either clearing their positions out of $200 trillion or so, has gotten horrible margin calls, or is praying to all gods and the devil that these rates come down while holding to what can only be called staggering unrealized losses!

In any case, it's definitely a mess out there.

Update October 24:

Ok, so $244 trillion is too much. On a spike in voltage, breakers should go off. Since we can't  tell where these stop limits or margin calls are, let's suppose an average stop at 10%. Then, losses would be in a more sanish $14.4 trillion (= $1.8 trillion x 10 / 1.25), which is quite distressing anyhow.

US government commitments

Reading the comments on this excellent Brad Setser post, I found this amazing NYT graphic depicting the US government commitment to the crisis so far, which stands at $1.5 trillion, guaranteeing an additional $3.6 trillion in investments and deposits. Wow!

US Government Financial Commitment

Courtesy of The New York Times

What’s most amazing to me, is to see the progression from a non despicable initial $8 billion loan to banks, to what appears to be an unfathomable sum of money, maybe: $5,100,000,000,000.

And according to the same NYT article,

Under the plan, the government is seen as a “silent partner” in the banks, without board seats. But analysts expect the government to be more quiet than silent, operating as an adviser that must be consulted.

Should the bank sell these mortgage-backed securities for 10 cents on the dollar today or wait a few months and hope to get 40 cents on the dollar? A discrete call to the Treasury or the Fed, analysts say, would
seem in order.

Now, what is really being asked here is a much larger question: will banks risk taking us all under to save 30 or 40 cents on the dollar?

If banks do not buy their way out of their CDS soon, mistakenly thinking that the government support will avoid being dragged into hot waters again, then, they may be taking us all under with them, $35 trillion in outstanding CDS only, which doesn’t include the potential black-holes in the remaining derivatives.

I would advice the government to put a little pressure on the idiot bankers to hurry and clear their wrong sided CDS trades, their assumptions may be wrong once again!

Let me be very clear, the weakness remains, and the temptation is huge, as long as the CDS on the $35 trillion are not cleared from the system.

Idiot bankers

I found this wonderful piece in the FT, which confirms my remarks from my previous post “Lehman was killed by Sharks”.

And, although calling bankers idiots is quite a harsh thing to say, I’m sure bank shareholders, and most of us that got hurt with the banking fiasco, would certainly agree.

But, they’re not my words, but Andrew Lahde’s, a high rolling hedge fund manager with a 1,000 % return record, making tens of millions for himself playing the other side of the banks trades, who has decided “to spend more time with his money”, taking a permanent leave of absence from the markets.

Indeed, he was not nice to bankers, here are some highlights of his remarks, in his must read goodbye letter:

“The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking.

These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy only ended up making it easierfor me to find people stupid enough to take the other side of my trades. God bless America.”

Like I mentioned before, banks —like Lehman— stupidly exposed themselves, mostly through the unbridled selling of CDS. But, some noticed this weakness, and acted accordingly, good for them!

Is GM next in line to default on its debts?

But there’s more, he has some dire predictions:

“I have no interest in any deals in which anyone would like me to participate. I truly do not have a strong opinion about any market right now, other than to say that things will continue to get worse for some time, probably years.

I am content sitting on the sidelines and waiting. After all, sitting and waiting is how we made money from the subprime debacle.

I now have time to repair my health, which was destroyed by the stress I layered onto myself over the past two years, as well as my entire life – where I had to compete for spaces in universities and graduate schools, jobs and assets under management – with those who had all the advantages (rich parents) that I did not. May meritocracy be part of a new form of government, which needs to be established.”

And some advice… in reference to Soros and the government:

“My suggestion is that this great man start and sponsor a forum for great minds to come together to create a new system of government that truly represents the common man’s interest, while at the same time creating rewards great enough to attract the best and brightest minds to serve in government roles without having to rely on corruption to further their interests or lifestyles.

This forum could be similar to the one used to create the operating system, Linux, which competes with Microsoft’s near monopoly. I believe there is an answer, but for now the system is clearly broken.”

And some very interesting remarks on marijuana…

“The evil female plant – marijuana. It gets you high, it makes you laugh, it does not produce a hangover. Unlike alcohol, it does not result in bar fights or wife beating. So, why is this innocuous plant illegal? Is it a gateway drug? No, that would be alcohol, which is so heavily advertised in this country.

My only conclusion as to why it is illegal, is that Corporate America, which owns Congress, would rather sell you Paxil, Zoloft, Xanax and other addictive drugs, than allow you to grow a plant in your home without some of the profits going into their coffers.”

In conclusion, an independent thinker. I like that.
Wish you well Andrew.

Volatility

I wanted to show this amazing volatility chart. Almost two years ago, I showed a chart with volatility VIX of 12, which is synonymous to tranquil waters with a certain uneasiness, they were uncharted waters. The current reading of VIX 70+ is not encouraging either, it’s quite unusual, and worse of all, stock indexes align themselves inversely to changes in the VIX, confirmed by the direction of the major indices.

But, the movement has been fast and extreme, which tells me two things: there should be a regression to the mean, but, the momentum has been too strong in the bear direction, hence, the bleeding should continue for quite some time…

How long?

Paul Krugman. Economist
Courtesy of The Rolling Stone Magazine

Congrats to Paul Krugman on his Nobel prize. Now, this is his view of what’s coming:

Just this week, we learned that retail sales have fallen off a cliff, and so has industrial production. Unemployment claims are at steep-recession levels, and the Philadelphia Fed’s manufacturing index is falling at the fastest pace in almost 20 years.

All signs point to an economic slump that will be nasty, brutish — and long.

How nasty? The unemployment rate is already above 6 percent
(and broader measures of underemployment are in double digits). It’s now virtually certain that the unemployment rate will go above 7 percent, and quite possibly above 8 percent, making this the worst recession in a quarter-century.

How long? It could be very long indeed.

I also have a pretty dim view of what’s coming…

It’s only natural that if credit liquidity dries up, economic activity slows down. And, we are coming down from the most expansive credit peak that history has ever known, fueled by the exuberance of some derivatives, but, of one ‘credit default swap’ gem of a financial instrument, in particular.

I can’t get myself to shoot the CDS bastard in the head, as my feelings demand. Unregulated, uncovered insurance, exerting unbridled exuberance bank lending, all the way to $62 trillion USD. This wretched financial contraption brought out the worst from traders, bankers, insurance companies, and why not, mongrels of all sorts that must’ve taken insurance on their companies debts with full knowledge that their companies were doomed.

The criminal possibilities involved are better understood if you think of a CDS as an insurance on a house mortgage debt, –which by the way, do exist.

First, since nobody had ever offered this kind of insurance before, it was one hell of a profitable business to collect premiums at an average 2.5% of the value of the debts, or $1.5 trillion premiums off a $62 trillion debt. And, the cherry on the cake: there was no collateral requirement to sell this type of insurance.

Second, it’s one hell of a payback to take an insurance on a house, pay the premium, light it up, see it burn to cinders, and collect the insurance. And, as I’ve explained, this was the weakness of the banks involved in selling CDS, which attracted shark attacks, whom shorted bank’s stock as well as bought its CDS to collect the huge insurance involved in a bank debt default, as in the Lehman case.

I also want to stress that the insurance of debts has a wonderful side, it makes credit cheaper. So, CDSs are in fact a gem of an instrument, within the regulations and oversight of an appropriate exchange.

But, I’m getting sidetracked. The underlined issue is that world
liquidity is contracting from dizzying heights, so economic activity
must contract accordingly.

Although, there is the question of how far will the waters rise as a consequence of the central banks spigot opening?

My first thought is will the US consumer purchase of Chinese low price exports, and Chinese buying of US Treasuries cycle stop? I don’t think so, because the original low Chinese labor price condition persists.

If this is the case, then a good percentage of this CB infussion of liquidity should end in places like China, India, Malasya, Thailand, Vietnam and alike countries; where there’s still plenty of this cheap resource, without the western companies entanglement in expensive legacy union negotiated labor contracts –where GM and Ford are good examples.

So, deterioration in the west should continue, through periods of inflation and depression, till the arbitrage in the east-west labor prices adjust to equilibrium. In the meantime, we build houses… I’m sorry, we repair roads and infrastructure funded by the government…