Con-tango

Lehman auction II

Herd going over the cliff

According to this post  from the DTCC (The Depository Trust and Clearing Corporation), I learn that only $6 billion are left as open positions on the Lehman credit default swaps, so I correct myself, the deals to close the positions have been going on for some time, and only a tiny portion of $6 billion needs to clear by the October 21 settlement date.

But most importantly, it gives us an idea of how brutal it must have been out there in the swap world, since Lehman’s demise. It’s still my estimate that swaps outstanding before bankruptcy were $4 trillion, or 10 times Lehman’s $400 billion bond debt, which have been closing at a breath-taking pace since then.

An extraordinary event, which would in itself explain the lack of liquidity that we have been witnessing, and consequent fear and seizure of all banks.

The good news is that this hurdle is over.

The bad one… well, let’s hope that the IMF members plan, as well as the Eurozone action plan, do their magic. If not, tomorrow promises to be one more painful step over the edge.

Finally, I also learned that the total volume of CDS has been coming down, to $35 trillion as of October 9  –about $5 trillion per month since June.

The Lehman auction

Fed Toxic Waste Removal Vehicles

It's Sunday and I've got a list (a mental one) of to dos in the house, but, the wife is away, so the mice have a few minutes…

First, let's resurface and underline that Lehman is bankrupt, which means it doesn't need nor will ever pay its debt obligations (update on October 15: derivative contracts receive special treatment under the Code and are free to terminate contracts and seize collateral to the extent they are owed money).

So, the Lehman bond auction was a minor first step in settling the final amount that Lehman swap sellers will have to pay October 21, to settle the Lehman insured debt, which hovers around $400 billion. Some are saying that quite a bit of this insurance payment is already hedged, so the pain or upheaval come payment day will be minor, in the order of 5% or $20 billion.

I can't agree with that statement, because the reality is that there are an estimated 10 times of Lehman swaps for every Lehman bond issued. In other words, the above Lehman sellers face a $4 trillion settlement on the 21st –some serious money, hedge or no hedge.

If you haven't dropped the ball yet, you'll understand that hedging has no bearing here, because somebody has to –finally– come  up with these $4 trillion –akin to LLoyd's men having to pay the insurance claims on a catastrophic storm event, as the last insurer in the chain. Let's pray that the sellers of last resort are a widely spread out group.

BTW, according to the auction, this payment settlement is steep: Sellers of credit-default protection on Lehman will have to pay holders
91.375 cents on the dollar, setting up the biggest-ever payout in the CDS
$55-trillion market.

And unfortunately, there's more bad news, Lehman itself was also a seller of CDS, whose obligations were left uncovered because it went bankrupt. In other words, there are a myriad of bond holders and swap buyers whose hedge has disappeared.

And the solvency question remains, who are they, and how many of these bonds are in trouble or at the verge of default?

So, this confirms the Paulson-Bernanke position and stresses the urgency to remove the trash. Banks will continue to hoard capital, until all toxic waste has been removed from the system. If, they themselves, can't even tell how bad their exposure is, how can it be expected from them to tell their counter-parties toxic exposure?

Continued here, here and here. 

Greenspan’s flawed trust

Alan Greenspan
Courtesy of Light and Liberty

From this article in the NYT:

In his Georgetown speech, he entertained no talk of regulation,
describing the financial turmoil as the failure of Wall Street to
behave honorably.

“In a market system based on trust,
reputation has a significant economic value,” Mr. Greenspan told the
audience. “I am therefore distressed at how far we have let concerns
for reputation slip in recent years.”

Greenspan’s excuse baffles me, a Fed chairman expecting futures traders –or any kind, for that matter–  to act with honor?? Are we all supposed to go home quietly now, knowing that regulation on uncovered CDS debts worth $55 Trillion was not imposed because of… honor amongst traders??

Reality is so much more interesting than fiction.

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.

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