Con-tango

Short selling

Black Swans

Last night’s lifting of the short ban was an unwise and extremely preoccupying move. What were they —the Fed and the Treasury— thinking?

I’ve been about to write about short selling for awhile. In most cases, the disadvantages outweigh the benefits, it’s a situation akin to hyenas preying on the weaker members of the herd, mostly destroying the younger ones, which could’ve otherwise had a good chance to contribute to society’s well being.

Getting back on track, the first thought that comes to mind is of ‘black swans’, or those far into the tail events, which were enlivened by Taleb’s trades —waiting and bleeding for long periods of time, for those rare moments that would make his trades go north.

But, it’s something else, that I recall struck me the most from Taleb’s statements, the fact that maybe most great traders were not such good traders, but, a reflection of the probabilities involved —where a few had a minute chance of striking gold.

Buffet would fit the bill — he seems to have lost his Midas touch since his $6 billion bet against the USD, and he’s losing on his GS $5 billion purchase too.

Could it also be that Paulson was also a fluke and is also losing his touch, or his marbles?

I know the benefits of short selling are hard to digest. Shorts are quick to denounce deceptions from troubled company execs —it’s good to have these watchdogs shortening the leash on this misbehavior.

But, they also speed the demise of companies in trouble, and, we don’t need this right now —markets need a respite to calm themselves.

And I repeat, it was an unforgivable mistake to lift the ban on short selling.

Isn’t it obvious that the markets are in a fear-stricken justified free-fall, and not the moment to add the weight of a short rock on the market’s neck?

My 12 year old understands that frail creatures have to be treated with care, why doesn’t Paulson get it?

Update Oct 10: The major exchanges have what I think is an excellent proposal.

From this article:

The New York Stock Exchange and Nasdaq Stock Market may
file their proposal with the Securities and Exchange Commission
as soon as today, said three people who have seen a draft of the
rule. Under the plan, a stock that ends trading with a loss of
at least 20 percent would be protected from short sellers for
the following three days, the people said.

(…)

“This makes a lot more sense,” than prohibiting bets that
a stock will fall, said James Angel, a finance professor at
Georgetown University in Washington who studies short-selling.
“By doing something on a stock-by-stock basis that only kicks
in during times of market turmoil you allow short-selling to do
what it does under normal circumstances, but you prevent it from
exhausting liquidity.”    

A tough spot

I’ll be thinking out loud about the tough spot of a seller of a distressed CDS. I’m trying to figure out how the Lehman auction would transpire.

Let’s see an example of how swaps trade:

ABC Corporation may have its credit default swaps currently trading at 265 basis points.
In other words, the cost to insure 10 million euros of its debt would
be 265,000 euros per annum. If the same CDS had been trading at 170
basis points a year before, it would indicate that markets now view ABC
as facing a greater risk of default on its obligations.

Let me get myself into a seller’s shoes.

If I’m in trouble because I’ve been selling CDS swaps (insuring companies’ debts) like there’s no tomorrow, and collecting the fat annual swap (premium) income, the only way I see that I can extract myself out of the bind I’m in –supposing companies are defaulting on their debt–, is to buy back enough swaps of the same company to cover my fannie.

I also know there are a lot more swaps out there than needed to cover the debt –something like ten times, so there is a good chance I can get my hands into the few that I desperately need to get out of the corner I’m in.

Trouble is buyers are sitting pretty, in what may be a freight-car full of cash, if the company bonds go under –and, they know it.

Trouble for the swap buyer is collecting, if I go under, they collect ‘nada’.

Now, what the heck is the Fed going to do with all my swap contracts?

Ok. My bulb is dim, but beggining to produce the goods. In essence through the price discovery of the swap auction, the Fed will discover how much it will cost to buy the swaps to get me out of trouble. Considering a mix of bad apples and not so bad ones, there will be a final tally of the cost to clear my swap obligations, and I would expect at this point that the Fed will require my soul in exchange –or the same as prefered stock– and will lend me the rest to survive, if the price of my stock is so degraded.

Fair enough.

Fed acts as middleman II

This morning the Fed released the following statement:

The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF).
(…)
The CPFF will provide a liquidity backstop to U.S. issuers of
commercial paper through a special purpose vehicle (SPV) that will
purchase three-month unsecured and asset-backed commercial paper
directly from eligible issuers.
(…)
The commercial paper market has been under considerable strain in
recent weeks as money market mutual funds and other investors,
themselves often facing liquidity pressures, have become increasingly
reluctant to purchase commercial paper, especially at longer-dated
maturities. As a result, the volume of outstanding commercial paper has
shrunk, interest rates on longer-term commercial paper have increased
significantly, and an increasingly high percentage of outstanding paper
must now be refinanced each day. A large share of outstanding
commercial paper is issued or sponsored by financial intermediaries,
and their difficulties placing commercial paper have made it more
difficult for those intermediaries to play their vital role in meeting
the credit needs of businesses and households.

By eliminating much of the risk that eligible issuers will not be
able to repay investors by rolling over their maturing commercial paper
obligations, this facility should encourage investors to once again
engage in term lending in the commercial paper market. Added investor
demand should lower commercial paper rates from their current elevated
levels and foster issuance of longer-term commercial paper. An improved
commercial paper market will enhance the ability of financial
intermediaries to accommodate the credit needs of businesses and
households.

Sounds good to me.

Freddie Krueger’s CDS

Elm Street’s Freddie Krueger

A Credit Default Swap is a very simple financial instrument. But, when I go over its wiki definition I can’t avoid thinking that Freddie Krueger must’ve been involved in the creation of this nightmarish contraption:

A credit default swap (CDS) is a contract in which a
buyer pays a series of payments to a seller, and in exchange receives
the right to a payoff if a credit instrument goes into default or on the occurence of a specified credit event
(such as bankruptcy or restructuring). The associated instrument does
not need to be associated with the buyer or the seller of this contract.^[1]

In other words, there is no requirement on the seller to guarantee and provision his side of the contract in case of a default. I repeat, no requirement, as in nada or none.

Continue reading…

Fed acts as middleman

The Pied Piper of Hamelin.

I just read this Bloomberg article. To start with, it’s an interesting piece because people are hanging on it all sorts of Fed intentions —they’re even stating that the Fed has introduced a stealth lower target rate.

But, before I get too stranded away from reality, let me copy the relevant paragraph of what this new rate encompasses:

The Fed requires banks to keep a level of reserves at the
central bank. On those funds, the Fed will pay a higher rate
equal to the average target rate over a one or two-week period
less 0.10 percentage point. For excess reserves, the rate is the
lowest FOMC target over a period less 0.75 percentage point.    

The Fed said it would raise or lower the spread so the New
York Fed trading desk can keep the federal funds rate near policy
makers’ target “based on experience and in response to evolving
market conditions.”    

So, let me translate for you. If the Fed target rate is 2.0 %, the Fed will now pay a 1.9 % interest on bank reserves, and if banks want to further park their spare change at the Fed, they will only get a 1.25 % interest rate on these additional funds.

I don’t see where this could be a stealth target rate. The Fed is evidently increasing a tad the liquidity of the banks through the payment of the tiny 1.9 % interest rate payment on reserves. But, what I do see important, is that the Fed is opening a door, so banks may deposit with the Fed their extra cash, instead of hoarding it.

If banks follow the Fed’s pied piper, taking their deposits into the Fed, then the Fed —acting as the middleman— may lend these funds to other banks, to thaw the current bank seizure.

Smart thinking —I hope playing the flute works.

House passes bill

On the edge of the abyss, as French Prime Minister Fillon puts it, the House approves the bailout bill by an overwhelming vote of 263-171.

$1.25 Trillion out the Fed door

Brad Setser. Economist.

From Brad Setser’s blog I get the scoop that, at least, –there could be an extra $520 billion in swaps–, already, $1.25 Trillion USD have been pumped out from the Fed’s balance sheet to put back some liquidity to the banking system –or to cope with the silent worldwide run of the banks.

The stock market continues to bleed away and high short term rates persist in their seizure mode.

From this

The Standard & Poor’s 500 Index fell 46.78, or 4 percent, to
1,114.28. The Dow Jones Industrial Average declined 348.22, or
3.2 percent, to 10,482.85. The Nasdaq Composite Index slipped 4.5
percent to 1,976.72. Almost 14 stocks retreated for each that
rose on the New York Stock Exchange.    

The S&P 500 has slumped 24 percent this year as the subprime
mortgage crisis brought down banks including Lehman Brothers
Holdings Inc. and made borrowing more expensive. The index lost
8.1 percent over the past four days and is poised for its worst
weekly retreat since the markets reopened after the Sept. 11,
2001, terrorist attacks.    

and  this Bloomberg bailout concerns articles:

The two-year swap spread climbed to as high as 167.25 basis
points from 156.25 yesterday. It had widened to 166.38 basis
points on Sept. 24, the most since Bloomberg began compiling the
data in 1988. A basis point is 0.01 percentage point. The swap
spread, which is a gauge of credit concerns and partially driven
by expectations for the London interbank offered rate, or Libor,
is the premium charged over Treasury yields to exchange floating
for fixed-rate payments.    

I gather the market is pessimistic about the 12 votes needed to pass the bailout.