FED Feeding the Markets – Will it Work?

I understand we have seen a 3-week rally of proportions not seen since 1938 in the US. On a weekly basis the Dow closed up 6.8%, the S&P 500 6.2% and the NASDAQ 6%. On a monthly basis till now the Dow is up 10.1%, S&P 11% and the NASDAQ 12.2%. The real push came when FED announced that it would buy $300 billion in Treasuries from the market over the next 25 weeks or so to help support the economy and spur lending. Also the program to buy housing agency debt and mortgage-backed securities was extended to about $1.45 trillion.

Following this the Treasury prices surged and 10-year yields plunged about half of a percentage point, the biggest drop since the 1987 stock market crash. Also the US dollar plunged. This resulted in commodities mainly base metals and oil to move up and as the shorts covered the up move was magnified. The Giethner plan to handle bank toxic assets was also received well which gave more teeth to the rally.

Some concerns came back when as a Market Watch report says:

“On Wednesday, concerns were sparked after the United Kingdom failed to get enough bids to sell the full amount of 40-year gilts it offered, the first time this has happened in 14 years. Later in the day, a U.S. government auction of $34 billion of 5-year notes drew only tepid interest from foreign investors.”

The basic issue that arises is that will the huge funding required for the various avtars of the bailout plan succeed apart from the question marks on the plans success itself. In fact the reason for FED announcing the buyback of existing treasuries is in a way to make the Treasury sales successful. While one arm of the government buys keeping the upward pressure on prices the other sells. The deficit in 2010 is expected to be of the order of $1.25 trillion.

Says the above mentioned report:

"If the Fed is done six months from now, the Treasury market will be looking at the fiscal deficit and a huge amount of supply to come without the Fed being there" as a buyer”,…”

So the question now arises as to who buys these treasuries. Foreign buyers have become extremely wary (and many have their own set of equally grave issues to handle be it Europe or the Gulf countries) and the noise being made by the Chinese on a new world currency would be a cause for concern. Will China sell to FED and reduce its exposure? It is a certain possibility as it restructures its policy to focus inwards to the local economy and reduce dependence on exports.

This could also mean upward pressure on interest rates as the report mentioned continues:

“Ten-year yields now at 2.65% are likely to end the second quarter, in June, at 2.55%, according to a MarketWatch survey of 15 of the 16 primary government security dealers required to bid at auctions and that trade directly with the New York Federal Reserve. One firm did not reply to several requests for information.

That yield will rise to 2.84% by the end of the year, according to the survey.

Such a rise would mean investors, who in the past year have pumped more of their money into ultrasafe Treasuries and out of stocks and corporate bonds as a series of shocks rocked the U.S. financial system, would pull their money out of this corner of the bond market. Those freed-up assets could be good news for other parts of the financial markets that have lost out in the past year's flight to safety - such as stocks.”

Now here is the catch. On the one hand this would mean funding the bailouts is going to be more and more difficult and expensive while on the other hand liquidity will find its way to other asset classes. While the short term shift in liquidity to stocks and other assets may move these markets, sooner than later the reality of high interest rates and the inability/difficulty of funding the bailouts other than through FED buying more and more treasuries (printing money or quantitative easing) will become apparent. This we have experienced many a times is a sure shot formula for asset prices to finally form a bubble and lo! we are back to square one.

To me the market players should not get euphoric with current move. The players shifting their liquidity to the market to create such sharp moves would be actually shooting at their own legs. A measured slow consolidation is required and sharp move in asset prices will put the medium to long term sustained recovery in jeopardy. This whole process will be time consuming – running into number of years and the market player’s own action on a collective basis of how they handle this liquidity is going to determine how long the markets may take to make a long term sustainable up move.

Disclosure: No Positions

Copyright © 2008-09 Tradesense

CDS, AIG & the rally in financials

For the uninitiated here is a Wikipedia snapshot of CDS:

"A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.

CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the specified events occur. However, there are a number of differences between CDS and insurance, for example:

-- the seller need not be a regulated entity;

-- in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract;

-- The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event. Generally, to purchase insurance the insured is expected to have an insurable interest such as owning a debt."

According to a Bloomberg report:

“Credit swaps were created by JPMorgan Chase & Co. more than a decade ago to hedge against losses from bank loans. As dealers made the contracts more standardized, hedge funds, insurance companies and asset managers began using them to speculate on the creditworthiness of companies, sending trading in the swaps up to $47 trillion in 2008, according to the latest data from the New York-based International Swaps and Derivatives Association. “

How CDS would incentivize more bankruptcy?

“Amusement-park operator Six Flags Inc. and automaker Ford Motor Co. may be pushed toward bankruptcy by bondholders trying to profit from credit-default swaps that protect against losses on their high-yield debt.

By employing a so-called negative-basis trade, investors could buy Six Flags bonds at 20.5 cents on the dollar and credit- default swaps at 71 cents. If the New York-based chain defaults, the creditors would receive the face value of the debt, minus costs. In a Feb. 27 note, Citigroup Inc.’s high-yield strategists put that profit at 6 percentage points, or $600,000 on a $10 million purchase.

Investors who bet on the collapse of a company are pitting themselves against traditional debt holders at a time when Moody’s Investors Service projects defaults will more than triple this year to the worst level since the Great Depression. The clash may stall restructuring efforts to prevent bankruptcies, as basis traders may be less inclined to participate in distressed debt exchanges….

“Before, you really had to worry mostly about where you were in the” company’s capital structure, he said. “Now, you have to consider the possibility that you might have this large holder of CDS incentivized to see it go into bankruptcy. It’s something that’s going to come up more and more.”

More here...

Why CDS holders can be paid ahead of bankruptcy creditors?

As per an informative article in TPM

"…the knowledgeable people already know this. But it turns out that one of the features of the US 2005 Bankruptcy bill was to put derivative counter parties at the front of the line ahead of other creditors in bankruptcy proceedings. Actually … they don't just go to the head of the line… They got to skip the line entirely. As the Financial Times noted last fall, "the 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company's assets until a court decides how to apportion them among creditors." As the article notes, ironically, this provision which Wall Street pushed for and got to protect investment banks actually ended up hastening the collapse of Lehman and Bear Stearns last year.”

Does it have anything to do with non-disclosure of AIG’s counterparties?

TPM explains it thus:

“If AIG were to go down, derivatives counterparties would be able to seize cash/collateral while other creditors and claimants would have to stand by and wait. Depending on how aggressive the insurance regulators in the hundreds of jurisdictions AIG operates have been, the subsidiaries might or might not have enough cash to stay afloat. If policyholders at AIG and other insurance companies started to cancel/cash in policies, there would definitely not be enough cash to pay them. Insurers would be forced to liquidate portfolios of equities and bonds into a collapsing market.

In other words, I don't think the fear was so much about the counterparties as about the smoking heap of rubble they would leave in their wake.

Additionally, naming AIG's counterparties without knowing/naming those counterparties' counterparties and clients would be at best useless and very likely dangerous. Let's say Geithner acknowledges that Big French Bank is a significant AIG counterparty. (Likely, but I have no direct knowledge.) BFB then issues a statement confirming this, but stating it was structuring deals for its clients, who bear all the risk on the deals, and who it can't name due to confidentiality clauses. Since everyone knows BFB specialized in setting up derivatives transactions for state-affiliated banks in Central and Eastern Europe, these already wobbly institutions start to face runs. In some cases this leads to actual riots in the streets, especially since the governments there don't have the reserves to help out. If you're Tim Geithner, do you risk it? Or do you grit your teeth and let a bunch of senators call you a scumbag for a few more hours?”

So what does all this mean?

According to various sources on the Internet:·

--- The recipients of the largesse appear to be Goldman Sachs, Morgan Stanley, Merrill Lynch and Deutsche Bank.

--- News and banks analysts’ reports suggested that Goldman Sachs got about $25 billion of the government bailout of AIG and that Merrill Lynch was the second largest benefactor of the government largesse.

--- The earlier payouts as per The Wall Street Journal of December, citing a confidential document and people familiar with the matter, revealed that about $19 billion of the payouts went to two dozen counterparties between the government bailout in mid-September and early November. As previously reported, nearly three-quarters went to a group of banks, including Société Générale SA ($4.8 billion), Goldman Sachs Group ($2.9 billion), Deutsche Bank AG ($2.9 billion), Credit Agricole SA's Calyon investment-banking unit ($1.8 billion), and Merrill Lynch & Co. ($1.3 billion), the Journal reported at the time. A lot more has been doled out since then.

More than $170bn. has been committed till now and the reason why more is being committed is becoming clearer. Apart from receiving bailout money directly these very ‘super-financial-organisms’ could have their financials dented further if this route was also not kept flowing. Normally these institutions would have received only pennies on dollar on the CDS if bankruptcy was allowed. So what the government is protecting is further loss of tangible equity of these ‘hearts’ of the global financial system which can keep the ‘blood’(funds) circulating – trying to avoid a much bigger and more unbearable blood on the street. If my understanding is correct AIG’s CDS obligations exceed $500bn. And with CDS incentivizing bankruptcies be prepared for much more than the $170 bn. committed.

But the flip side is that it is preventing these ‘hearts’ from a heart attack. Apart from the technical factors the current rally in financials has after all got a fundamental perspective too!!

Is there a way out?

This Market Watch report makes it an interesting reading:

…“Bernanke said the counterparties made "legal, legitimate, financial transactions" with AIG and presumed at the time that the contracts would remain private. "That is a consideration we have to take into account," he added.

Sen. Mark Warner, D-Va., suggested that AIG's counterparties should have to take a "haircut," rather than be made whole, because some of them probably didn't do enough due diligence on whether the insurer was financially strong enough to be selling such protection.

"In effect, what we're saying is, consequently, folks who bought these instruments and that, at some point in their process, should have been doing some level of credit analysis of what AIG was selling who didn't do that credit analysis are going to still come out whole for their lack of appropriate due diligence or responsible behavior," he said.

"I'm as unhappy as you are about that, senator," Bernanke replied. "I just don't know what to do about it."

Given the current rally in the financials one can only hope despite this treatment (the largesse) to prevent a ‘heart/s attack’, its side effects do not make it fatal.


Disclosure: No Positions


Copyright © 2008-09 Tradesense

The beginning of the bottoming process

The headlines are becoming so depressing and it’s ‘given up’ tenor is making me believe that the bottoming process has started. By no means am I trying to predict the bottom or for that matter say that the worst for the markets is over. I’ am starting to sense now that the second half recovery theme is history. The tone of the optimists is tending to sort of say – ‘we probably underestimated the depth of the problem.’ And now the depth of the problem and the issues, to me, is getting a slow but definite over extension to the other side. The sense of gloom being predicted smells of converts and the conversion rate is accelerating. Sample this:

1. Financial Crisis sparks unrest in Europe
Read about a series of unrest in this region. I'am sure other regions too are reporting such instances.

2. Gold – Haring away

One is reading/hearing ‘Gold’ every where. Sure signs of panic are emerging.

“People have long viewed gold, rightly or wrongly, as a hedge against high inflation and a weak dollar. So when the gold price briefly broke through the $1,000 mark in March last year, it was easily explained by fears that rising commodity prices (and, in America, a weak dollar) would feed inflation. An earlier run-up in gold prices, between 2002 and 2005, coincided with a sustained fall in the dollar. But now gold is strong even as the dollar thrives and economies face deflation.

“Gold is something you buy if you have something to lose,” ... What links today’s gold fever with the 1970s rush is negative real deposit rates. Many savers now prefer a claim on gold in a vault to one on cash in the bank. There is less risk that a counterparty blows up, and the “carrying cost” of gold in terms of lost interest is, in any case, vanishing.

How high might the gold price go? Gold bugs talk excitedly about it reaching $2,300, which would match the January 1980 peak in real terms…”

3. Next Stop for Gold $2,000 Per Ounce!

“How high can gold ultimately go? Mark my words... gold will hit $2,000 per ounce or even higher.

Recently gold has been on an absolute tear as investors are piling into the yellow metal as a safety hedge. People are still quite concerned about the current economic crisis and are unsure what will happen in the future. The financial downturn we’re experiencing has crushed conventional investments like stocks and real estate and gold has shined throughout this downturn.

Gold is certainly in full bull market mode right now. Recently it headed higher on worries of both inflation and deflation. Surprisingly, central bankers are in favor of higher gold prices because it suggests their attempts to head off deflation are starting to work.

Now, the average person is not worried about inflation or currency debasement. They are worried about the money in their bank account. That’s just one reason that gold prices are rising. People are turning to safe havens because they think their banking system is on the brink of failure and they see the stock market is in the toilet.”

4. Stress Test Mess

The idea of ‘Tangible Common Equity (TCE)’ is bizarre. These sudden discoveries are just an exhibition of the fear factor. Tier I capital was what all bankers/regulators for long have looked at - through most good and bad times.

“Judged by tier-one capital, a common measure of adequacy, America’s ten biggest banks by assets appear in reasonable shape. Typically, their ratios of tier-one capital to risk-weighted assets exceed 10%). However, the quality of their tier-one capital has crumbled. Only about half now consists of tangible common equity, the purest and most flexible form of capital which bears the “first loss” when an asset goes sour. The rest is largely preference stock, much of it government-owned, which is not truly loss-bearing. For example, the dividends on Citigroup’s government preference shares can be deferred but not cancelled, unlike those on common stock. The original Basel rules on capital adequacy sought to limit such “hybrid” capital that sits between equity and debt. But most governments like preference stock because it does not carry votes, and thus avoids nationalisation, and because the more secure dividends protect taxpayers, providing the bank does not go bust.”

Just by transferring the money from one pocket to another you cannot create more cushion for loss provisions except for the dividend flow that you may save through such conversion to common stock.

While a bank is definitely obligated to pay interest on its borrowings – it makes money/profit or not – as regards preferred to the best of my understanding the bank is obligated to pay only if it can i.e. it has sufficient reserves and/or profits to do so. If it cannot, then it can cumulate based on the terms. And if at maturity it still cannot pay – period it cannot pay.

First there is a clamor that TCE is not sufficient and then when it is provided through some level of nationalization then the allegation is that you have moved away from the ‘Right’. So this ‘damned if you and damned if you don’t’ attitude shows the paranoia in the market where all logic seems to have been lost.

5. Even the best like Mr. Buffet who has sown the seeds of success on others fears and reaped the benefits from others greed has stated in his annual letter to shareholders that:

“During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt. … Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.

We're certain, for example, that the economy will be in shambles throughout 2009… and, for that matter, probably well beyond … but that conclusion does not tell us whether the stock market will rise or fall.

Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.”

Such desperateness and pessimism shows that even at such levels of knowledge, experience and expertise doom and gloom conversion is happening. A definite positive sign.

Read this conversation too.

6. The protectionists mess up is starting.

“President Barack Obama’s proposed removal of tax incentives for American companies outsourcing jobs could mean that large outsourcing customers such as GE and Citibank might have to pay certain taxes on their income from international markets, making it less attractive for customers to send IT projects to cheaper offshore locations…

However, experts argue that such protectionist measures are short-sighted because many US companies derive significant revenues from outside the country, and any protectionist stance could lead to a backlash in other markets. For instance, Citigroup in 2007 generated 52% of its revenues outside the United States, and over 60% of its workforce operated from abroad, as its banking business spanned 100 countries. Citigroup’s international revenue streams kept pace through 2008, despite the financial crisis, and amounted to a whopping 74% of the total revenues.”

These signs are by no means are exhaustive but do provide some vital pointers. As I see it we are some where close to beginning of the lower part of U and the bottom formation may run for a reasonably long period and may take a more flattish shape. How long, depends upon how the politicians across the globe play their cards.

Disclosure: No Positions


Copyright © 2008-09 Tradesense

Decoupling – have the seeds been sown?

The decoupling theory – Asia and Asian markets (sans Japan) decoupling from the rest of the world – keeps surfacing from time to time – specially when the markets in Asia tend to perform better than those of US and Europe. It happened in the first two weeks of February when the Chinese and Indian markets seem to have started outperforming the US and European markets. However as the US market indices have started to challenge the November 08 lows the perception seems to be altering again. So is decoupling a possibility at all?

Prima facie it appears to be a difficult proposition. The reasoning is very sound:

“Basically, there are two stories to tell here about the sudden downturn in the global economy.

The easiest to understand is the collapse of industrial production in East Asia, where the supply chain starts in places like Taiwan and Vietnam and moves through places like China and Japan before cars, shoes, computers and flat-panel TVs arrive at stores in the United States, Western Europe and everywhere else.

… the 40 percent decline in Taiwan's industrial production at the end of last year was the "canary in the coal mine" of Team Asia's formidable export machine. At about the same time, Japan's exports fell 35 percent, Korea's 17 percent, and China's fourth-quarter gross domestic product was essentially flat -- no economic growth at all.

… never seen declines this fast and this steep, even during the Asian economic crisis ... It all reflects not only the sharp pullback in discretionary consumer spending around the world but also an equally sharp pullback in the flow of foreign investment that was used to build factories and shopping centers and has been an important driver of growth in the region.

Demand for Asian exports will pick up again before too long, but it will be a long time before they reach the levels attained at the height of the bubble economy. And it will be longer still before foreigners will be eager to invest in expanding capacity again.

Ideally, Asians would respond to this challenge by reducing their heavy reliance on exports and foreign investment and reorienting their economy more toward domestic consumption. But … that's not as simple as it sounds.

For starters, the things Asians might want to consume aren't necessarily the things they produce to export, so production would need to be reoriented and workers retrained and redeployed. And to replace the foreign investment, these economies would need to develop financial institutions that can raise and invest risk capital, which right now they don't really have. Most significantly, Asian governments would have to create safety-net programs like Social Security so people don't save so much and spend so little.

In short, the Asian downturn is probably manageable, particularly now that the Chinese government has responded with a massive stimulus package. But it will take time for the region to make the necessary adjustments to get the region humming again.”

As I see the lessons learnt/being learnt during this severe downturn will have a lasting impact as these Asian countries now re-orient there industrial and fiscal policies to ensure that over dependence on exports is reduced in the years to come. Also trade within the region will now be a much greater focus as two of the most populous countries in the region ‘Chindia’ look to push their growth with policies that are much more domestic investment and consumption oriented. India always was domestic consumption story (save the IT and IT enabled services and Generic Pharmaceutical industry) and now can be regarded as a great advantage.

As the quote above points out - the reorientation will be challenging and will take time – a decade or so. But as the US and European consumption story sees its twilight in years to come it is the Asian and some of the resource rich countries such as Brazil that will need to fill-in. And as this re-orientation sees initial success foreign capital (US and European savings) will start seeking these countries and the capital required to sustain a reasonable growth rate will find its way. The seeds for this shift – possibly a power shift too - appears to have been sown.

Disclosure - No Positions


Copyright © 2008-09 Tradesense

Warning Signal

Last week’s market reaction is attributed to the lack of details in Giethner proposal. The basic issue revolves around the valuation of the bad /toxic assets. A low price while taking the asset of the bank balance sheet will also cause further charges to be taken and may require further capital. Bloomberg quoted an expert saying that … “Through this whole process, it seems as if the government needs to take a course in marketing.” It is unclear if he will come out with the details.

Thursday’s movement of US stock prices will tell us a lot about it! Just when one thought that the supports were to give way the market rebounded and bulls took-off.

And there appears to be some tactical work behind this. As one writer put it –

“I figured out why Geithner was so vague in his speech Tuesday... now each time the market is weak and about to fall off a cliff they can release another piece of "salvation" - this methodology could last for months. Why shoot your load all at once?? Genius! I tell you there must be an army of technical analysts employed somewhere in the bowels of government. Their timing is beyond impeccable; below S&P 800 and the panic would have begun.”

Any major move by the market on the down side is likely to be manipulated with timed releases/leaks it appears. Well the market will turn out to be savvier. If it reads the emerging situation is not to its liking and decides to go down – it will! Experience tells me it can find its way if that is what is right in its perception. It will probably consolidate downwards instead of making a big move.

There was a feeling that the markets were stabilizing and credit in some measure was beginning to flow. Some liquidity it appeared had started flowing towards to the equity markets as players booked profit in treasuries - treasury yields improved. But last week’s market behavior probably indicates that some more turbulence is likely. This Bloomberg report brings out the point:

“Ten-year note yields fell the most in two months as investors, disappointed at the lack of details in Treasury Secretary Timothy Geithner’s bank-bailout plan and doubtful a stimulus package will spur growth, sought the safety of government debt. Stocks tumbled. The government, meanwhile, sold a record $67 billion in notes and bonds.

The benchmark 10-year note’s yield dropped 10 basis points, or 0.10 percentage point, the most since the five days ended Dec. 19, to 2.89 percent, ... Yields on the two-year note fell three basis points, the most since the week ended Jan. 9, to 0.96 percent. Thirty-year bond yields slipped two basis points to 3.67 percent.

The 10-year note yield touched 2.04 percent, the lowest according to data going back to 1953, on Dec. 18, the same day the 30-year bond yield fell to a record 2.51 percent. The declines came two days after the Federal Reserve cut its target overnight rate to a range of zero to 0.25 percent and said it was considering buying “longer-term” Treasuries to lower consumer borrowing costs and stimulate the economy.

On Feb. 9, as the government readied the week’s auctions, the yield on the 10-year note reached 3.05 percent and the yield on the so-called long bond touched 3.76 percent. The yields were the highest since November.

The sale of 10-year notes on Feb. 11 drew a yield of 2.82 percent, while the yield at the 30-year bond auction on Feb. 12 was 3.54 percent. The sale of three-year notes on Feb. 10 drew a yield of 1.42 percent.

The Fed’s custodial holdings of Treasuries for foreign institutions including central banks rose 0.5 percent to a record $1.743 trillion, central bank data show. The holdings had slipped the week before to $1.735 trillion, the first decrease in 24 weeks.

Custodial holdings of agency securities dropped for the first time in two weeks, decreasing 0.3 percent to $817.9 billion.”

The liquidity moving to treasury securities and gold’s current behavior is definitely a warning signal.


Disclosure: No Positions


Copyright © 2008 -09 Tradesense