Is This as Good as it Gets Liquidity Wise?

Friday, March 22nd, 2013

Fund Managers Are Alarmingly Bullish!

by Short Side of Long

Last time I updated the ever popular Merrill Lynch Fund Managers Survey was in late January. A common occurrence was the high levels of risk taking, a non-desire for market protection, high expectations of growth in China and finally a trend of overexposure towards equities. In the February report, the pro-risk theme continued as an extremely low number (1 in 10) of fund managers saw an increased risk towards a recession (usually a great contrary sign that we are on the cusp of one). Complacency was further noticed with the report stating that:

“Managers clearly want companies to pursue growth: 48% say companies should use cash to increase capital expenditure (capex) versus just 12% demanding debt repayment.”

If one was to place these numbers into a historical context of the survey, the last time we saw this many managers wanting a capex increase was in April 2011 – just as all global markets peaked and corrected by around 20%. Furthermore, the last time we saw such a small number of managers wanting debt repayments (balance sheet improvements) was in the middle of 2007 – on the cusp of a global financial crisis. As we refocus towards the March 2013 survey, a risk taking theme is not only clear, but has now become euphoric. Let us go through some of the charts I have put together:

Chart 1: Is this as good as it gets liquidity wise?

Source: Short Side of Long

While the survey was started in the early 2000s, Merrill Lynch only started tracking perceived conditions like depth and volume, narrowness of bid offer spreads and ease of execution as of 2007. The chart above shows that the current liquidity conditions are at record readings. Retail investors love the good days, but us contrarians should know that when it gets as good as it currently is – the end is near.

Chart 2: Cash levels are at complacent lows

Source: Short Side of Long

For the first time since February 2011 (major market peak), global fund managers are now underweight cash. Furthermore, cash balance levels have fallen towards 3.8%, from the highs of 5.5% about a year ago. The above charts shows that the majority of funds are now close to fully invested.

With that in mind, it is definitely worth finding out where fund managers have exposed their capital?

Chart 3: Are fund managers investing in Bonds? No.

Source: Short Side of Long

According to the March 2013 survey, global fund managers hold a 53% underweight exposure to the bond market. This is now the lowest exposure since April 2011, just as equities and commodities peaked while bonds bottomed. Therefore, we can safety assume that managers have been selling bonds towards extreme levels of underexposure and rotating capital into other pro-risk assets.

Chart 4: Are fund managers investing in Commodities? No.

Source: Short Side of Long

The recent survey also noted that global fund managers hold a 11% underweight exposure to the commodity market. Managers are bearish on commodities and hold the lowest exposure since the June 2012 bottom. Of high interest to Precious Metals investors, the survey asked managers to rank what is likely to occur first within the current macro economic environment. Over 40% think the Yen will keep falling, close to 20% think the US will suffer another downgrade and Spain will be bailed out, while only 2% of global fund managers believe Gold will reach $2,000. As a PMs investor, I personally like to be on the other side of the boat.

As a side note for those who still remain invested in the PMs secular bull market, it is also worth noting that the March 2013 survey shows that global fund manager’s expectations of a further US Dollar appreciation, reached record high level (dating back a decade of survey data).

Chart 5: Are fund managers investing in Stocks? A big YES!

Source: Short Side of Long

Exposure to global equities has now reached euphoric levels, last seen in February 2011 during the QE2 days. A net 57% of managers are now overweight equities, which is extremely high relative to the 4% underweight exposure seen in June 2012. More importantly, exposure of fund managers has been at extreme levels (1 standard deviation above the ten year average) for three months in the row and forced liquidation could occur quite easily.

Chart 6: Weighting spread between stocks & bonds are at extremes!

Source: Short Side of Long

According to the survey, it seems that global fund managers have been selling bonds (and commodities), while overexposing themselves to equities. The spread between long equity overweight and short bond underweight is now reaching levels last seen during the 2007 and 2011 market peaks.
Chart 7: We are now on the cusp of a recession

Source: Merrill Lynch & Short Side of Long

The Bottom Line

Most investors are probably looking at the charts above and admitting that a correction is possible. They agree that managers have overexposed themselves to equities and one should prepare for a pullback.

I tend to agree that overexposure towards assets creates corrections from a contrarian point of view, as many circles show in various charts above. However, I would like to remind investors that overexposure towards equities at the end of the business cycle (refer Chart 7), usually leads to a bear market (a sell off of 20% or more) rather than just a quick corrective process.

Finally, Merrill Lynch reports that allocations to alternative investments such as art, wine and so forth, are now at close to 5-year highs (last seen just before the Lehman Collapse).

What I Am Watching

Copyright © Short Side of Long

Tags: liquidity, short side of long
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Knight’s Berserk Algo Bought $2.6 Million Worth Of Stock Every Second

Wednesday, August 8th, 2012

While we already presented, courtesy of Nanex, the modus operandi of the Knight berserker algo, there was one outstanding question. What was the bottom line. And no, not how much the loss on Knight’s Income Statement would be as a result of this glimpse into what really happens in the market: we already knew that would be $440 million. The question is what is the notional amount of stock that this algo bought in the 45 minutes in which it was operational. We now know: $7 billion. Or $155 million per minute. Or $2.6 million per second. Or, assuming the algo impacted just 150 stocks as previously reported, it was buying on average $17,333 in each name every second. Or, assuming an average stock price of the universe of 150 stocks of $30/share, the Knight algo lifted the offer roughly 600 times each second. For 45 minutes straight! That’s right – the market making algorithm of a designated market maker which is responsible for 10% of the order flow in the US stock market, entered a pre-programmed mode (because the computer was told to do whatever it did by someone, and not without reason) that saw it buy up $2.6 million worth of stock every second.

Now there has long been speculation that HFTs are a central planner’s best friend because they traditionally provide not only a floor to the stock market, but a gradual levitation bias especially in a low volume environment (as well as liquidity its advocates claim, but that is total BS – HFT only provides volume and churn – liquidity disappears at the drop of a bat when real selling pressure appears). They do this not because they are evil instruments of Bernanke collusion (although who knows) but simply because they accelerate and accentuate legacy momentum bias, which at least historically, has been up. Now in the aftermath of the Knight debacle we can also extrapolate what would happen if, say, reality were to creep in one day, and all those mutual and hedge funds which have carbon-based life forms making the buy and sell decisions suddenly decided to sell. Well, at $7 billion in 45 minutes, or 1/10th of the trading day, this means that had the Knight algo been running all day, it could have bought $70 billion worth of stock. Throw in the remaining flow routers, aka DMMs in the market which account for the remaining 90% of order flow, and we get a total of $700 billion in vacuum tube mediated purchasing power.

In other words, this is the market “worst case” shock absorber, or inverse escape velocity, that Bernanke has at his disposal if things turn sour. That said, with hedge funds, aka fast money, holding about $3 trillion in unlevered assets, and about $6-9 trillion with leverage (ignoring plain vanilla slow mutual funds), and one can see why not even the HFT levitation bid would be sufficient to offset a wholesale market dump.

There is one last open question remaining on Knight: what discount did Goldman extract out of the firm to rid it of its residual position which as the WSj explains declined slightly from its peak as “traders worked frantically Aug. 1 to sell shares while trying to minimize losses due to a software problem, ultimately paring the total position to about $4.6 billion by the end of the trading day” (one wonders if the market would have just blown up if the Knight algo were to run in reverse, and just take out layer after layer of bids to unwind the inventory asap). We now know thanks to the WSJ:

Knight avoided that scenario by agreeing in the early morning hours last Thursday to sell the portfolio to Goldman Sachs Group Inc.,  after rejecting an offer from UBS.

 

The terms sought by the banks reflected how dire Knight’s situation was: UBS wanted an 8% to 9% discount on the position, according to people familiar with the matter.

 

The equities trading desk at UBS, headed by Mike Stewart, bid for the portfolio around 6:30 p.m. Wednesday, people familiar with the discussions said. Mr. Stewart was a former colleague of Knight Chief Executive Thomas Joyce’s at Merrill Lynch. The talks with UBS fell apart later that night.

 

Goldman ultimately negotiated buying the portfolio at a 5% discount, or about $230 million less than the value of the stocks, the people said. That amount, not previously reported, represents more than half the loss Knight disclosed on Thursday that it incurred as a result of the technology errors.

 

The deal with Goldman allowed Knight to move ahead. Last weekend, Knight negotiated a rescue package with six financial firms that injected $400 million in capital in exchange for securities that can convert to ownership of 73% of the trading firm.

And now you know why having cash on your balance sheet in a ZIRP environment may well be the best investment, because just like Goldman, one never knows just where a slam dunk distressed opportunity could come from in exchange for an immediate 5% pick up.

More importantly, the Goldman deal demonstrates what the true liquidity cost is in this market when one wishes to do a wholesale stock transaction (either BWIC or OWIC): it is not less than 5% and tops out at 9%.

Keep that in mind, because if and when the day when VWAPing in and out of positions is no longer possible, each and every fund will have no choice but to assume a guaranteed 5% minimum (up to 9%) haircut on one’s entire portfolio of allegedly liquid stocks.

We dread to think what the wholesale implied liquidity premium is on less liquid products than stocks, which nowadays is virtually everything…

* * *

Finally, we leave readers with yet another transformative animation from Nanex, after our first rendition of the “rise of the machines” back in February left many speechless, and which recently appears to have been rediscovered by some of the slower elements in the blogosphere. Why: because it’s pretty, and we feel like it. And because it once again confirms that only vacuum tubes with infinite balance sheets should be gambling in this loaded market.

Tags: 6 Million, Advocates, Algorithm, Berserk, Bias, Central Planner, Collusion, Debacle, Glimpse, Hedge Funds, Hft, Income Statement, Levitation, liquidity, Notional Amount, Programmed Mode, Speculation, Stock Price, Us Stock Market, Volume Environment
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HFT Algo Goes Totally Berserk And Serves Knight Capital With The Bill

Thursday, August 2nd, 2012

We all know something went horribly wrong in various NYSE-traded stocks today between 9:30 am and 10:15 am. So wrong in fact that the NYSE had to step in and cancel numerous trades in 6 symbols. However it did not DK millions of other trades in 134 other symbols, the vast majority of which we assume traded errantly due to the market making of Knight Capital (as admitted by the company), which today saw its biggest drop ever since going public on volume about 60 times greater than its average. We also all know that one should buy low and sell high. At least that is what human traders are taught, and that is what they attempt. Because if one consistently does the opposite, one will simply run out of money. Well, the opposite is precisely what the berserk algo in Knight’s Market Making group may have done if Nanex, which has done a forensic analysis of one of the trades in question, is correct. In other words, instead of at least attempting to provide liquidity via limit trades, Knight’s algorithm acted as a market order… gone horribly wrong. As the third chart below shows what the algo did with furious repetition and steadfast consistency was to buy at the offer, and sell at the bid, in other words buy high and sell low. Over and over and over and over. As Nanex laconically notes, “In the case of EXC, that means losing about 15 cents on every pair of trades. Do that 40 times a second, 2400 times a minute, and you now have a system that’s very efficient at burning money.” Which also means that by not DK’ing several hundred million prints, the NYSE may have just thrown Knight under the bus, because the market maker is suddenly on the hook for tens if not hundreds of millions in inverse market making profits.

Here we will assume that readers are sufficiently familiar with market structure to know that market makers only participate in the market in order to collect liquidity rebates, i.e., to be the limit on the bid which is hit, or the offer which is lifted. What Knight did was effectively the opposite, and it also collected the opposite of a rebate: i.e., it paid someone else for no reason at all… well technically to withdraw liquidity. However liquidity that led to creation of losses not profits.

Naturally, when the entire logic of trading was perverted courtesy of Knight’s busted algo, everything went Bizarro Day, and stocks went higher, because they went higher, and the higher they went, the greater the incentive for the algo to keep pushing the stock higher. This explains not only the volume surge, but also the shocking price moves in some stocks such as China Cord Blood which exploded several hundred percent higher before someone had to finally step in. And what is most notable is that because there were neither fat finger trades, nor busted algos that took out the entire bid or offer stack in one trade, thus triggering circuit breakers, but a slow methodical bleed, there was no reason under the current SEC order cancellation methodology to bail out Knight and its berserk algorithm.

Simply said: today may be the single worst day in Knight’s market making history. And sadly, as the NYSE already noted minutes before the market close, the decision to not cancel any more trades is “not subject to appeal.”

From Nanex:

What really happened, or how to lose a ton of money, fast.

What follows should strike you as crazy. If it doesn’t, read it again, because it is.

The following 3 charts plot non-ISO trades (regular trade condition) reported from NYSE in the stock of Exelon Corporation (symbol EXC). By plotting and connecting only regular trades from NYSE we get a clearer picture of the nature (some might say horror) of this event.

1. EXC One second interval chart. Circles are trades, the blue coloring is the NYSE bid and ask which is mostly covered by gray lines that connect the trades.

2. Zoom of above chart showing about 27 seconds of data. Now the gray lines connecting trades are more clearly visible. NYSE’s bid/ask is the blue shaded area (the bid price is the bottom of the shading, and the ask is the top).

3. Zooming in to a 1 millisecond interval chart, we can see one second of data which shows 39 trades.

Note how the trade executions ping pong from bid to ask. As if someone is buying at the offer, then 10 ms later selling at the bid, and so forth. It turns out, the gray shading you see in the first chart of EXC is from this alternating between buying and selling. That’s right, almost all these trades alternate between buying at the offer and selling at the bid, which means losing the difference in price. In the case of EXC, that means losing about 15 cents on every pair of trades. Do that 40 times a second, 2400 times a minute, and you now have a system that’s very efficient at burning money.

Tags: Algorithm, Chart Below Shows, Consistency, Exc, Forensic Analysis, Hook, Human Traders, Hundred Million, liquidity, Market Structure, Money, Nyse, Prints, Profits, Rebates, Repetition, S Market, Stocks, Tens, Trades
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The Education of a Mortgage Bond Manager, Part I

Saturday, July 21st, 2012

by David Merkel, Aleph Blog

You might remember my “Education of a Corporate Bond Manager” 12-part series.  That was fun to write, and a labor of love, but before I was a corporate bond manager, I was a Mortgage Bond Manager.  There is one main similarity between the two series — I started out as a novice, with people willing to thrust a promising novice into the big time.  It was scary, fun, and allowed me to innovate, because in each case, I had to rebuild the wheel.  I did not have a mentor training me; I had to figure it out, and fast.  Also, in this era of my career, I had many other projects, because I was the investment risk manager for a rapidly growing life insurer.  (Should I do a series, “The Education of a Financial Risk Manager?”)

One thing my boss did that I imitated was keep notebooks of everything that I did; if this series grows, I will go down to the basement, find the notebooks, and mine them for ideas.  When you are thrust into a situation like this, it is like getting a sip from a firehose.  Anyway, I hope to do justice to my time as a mortgage bond manager; I have been a little more reluctant to write this, because things may have changed more since I was a manager.  With that, here we go!

Liquidity for a Moment

In any vanilla corporate bond deal, when it comes to market for its public offering, there is a period of information dissemination, followed by taking orders, followed by cutoff, followed by allocation, then the grey market, then the bonds are free to trade, then a flurry of trading, after which little trading occurs in the bonds.

Why is it this way?  Let me take each point:

1. period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to seven minutes.
2. taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed.  When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?”  After that, you panic.
3. cutoff — it is exceedingly difficult to get an order in after the cutoff.  You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
4. allocation — I’ve gone through this mostly in point 2.
5. grey market — you have received your allocation but formal trading has not begun with the manager running the books.  Other brokers may approach you with offers to buy.  Usually good to avoid this, because if they want to buy, it is probably a good deal.
6. bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds.  If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand.  They might allocate more to you in the future.
7. flurry of trading — many brokers will post bids and offers, and buying and selling will be active that day, and there might be some trades the next day, but…
8. after which little trading occurs in the bonds — yeh, after that, few trades occur.  Why?

Corporate bonds are not like stocks; they tend to get salted away by institutions wanting income in order to pay off liabilities; they mature or default, but they are not often traded.

By this point, you are wondering, if the title is about mortgage bonds, why is he writing about corporate bonds?  The answer is: for contrast.

1. period of information dissemination — depending on how hot the market is, and deal complexity, this can vary from a several weeks to a few days.  Sometimes the rating agencies provide “pre-sale” reports.  Collateral inside ABS, MBS & CMBS vary considerably, so aside from very vanilla deals, there is time for analysis.
2. taking orders — you place your orders, and the syndicate desks scale back your orders on hot deals to reflect what you ordinarily buy and even then reduce it further when deals are massively oversubscribed.  When deals are barely subscribed, odd dynamics take place — you get your full order, and then you wonder, “Why am I the lucky one?”  After that, you panic.
3. cutoff — it is exceedingly difficult to get an order in after the cutoff.  You have to have a really good reason, and a sterling reputation, and even that is likely not enough.
4. allocation — I’ve gone through this mostly in point 2.
5. grey market — there is almost no grey market.  There is a lot of work that goes into issuing a mortgage bond, so there will not be competing dealers looking to trade.
6. bonds are free to trade — the manager running the books announces his initial yield spreads for buying and selling the bonds.  If you really like the deal at those spreads and buy more, you can become a favorite of the syndicate, because it indicates real demand.  They might allocate more to you in the future.
7. no flurry of trading — aside from the large AAA/Aaa tranches very little will trade.  Those buying mezzanine and subordinated bonds are buy-and-hold investors.  Same for the junk tranches, should they be sold.  These are thin slices of the deal, and few will do the research necessary to try to pry bonds out of their hands at a later date.
8. after which little trading occurs in the AAA bonds — yeh, after that, few trades occur.  Same reason as above as for why.  Institutions buy them to fund promises they have made.

Like corporate bonds, but more so, mortgage bonds do not trade much after their initial offering.  The deal is done, and there is liquidity for a moment, and little liquidity thereafter.

Again, if you’ve known me for a while, you know that I believe that liquidity can’t be created through securitization and derivatives.  Imagine yourself as an insurance company holding a bunch of commercial mortgage loans.  You could sell them into a trust and securitize them.  Well, guess what?  Only the AAA/Aaa tranches will trade rarely, and the rest will trade even more rarely.  The mortgages are illiquid because they are unique, with a lot of data.  You would have a hard time selling them individually.

Selling them as a group, you have a better chance.  But as you do so, investors ramp up their efforts, because the whole thing will be sold, and it justifies the analysts spending the time to do so.  But after it is sold, and months go by, few institutions have a concentrated interest to re-analyze deals on their own.

And so, with mortgage bond deals, even more than corporate bond deals, liquidity is but for a moment, and that affects everything that a mortgage bond manager does.  More in part 2.

More … /

Tags: Aleph, Big Time, Bond Manager, Corporate Bond, Desks, Financial Risk Manager, Firehose, Grey Market, Hot Deals, Information Dissemination, Investment Risk, Labor Of Love, Life Insurer, liquidity, Merkel, Mortgage Bond, Novice, Public Offering, Similarity, Sip
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A Brief History of Bond ETFs

Thursday, July 19th, 2012

by Matt Tucker, iShares

With the volume of headlinesthat bond ETFs capture these days, it’s easy to take for granted the fact that these innovative products haven’t been around that long.  In fact, it was ten years ago this month that iShares launched the first bond ETF (the iBoxx Investment Grade Corporate Bond ETF – LQD), along with three others.

At the time, there was certainly a business case for developing a new way to access fixed income. The over-the-counter (OTC) market – where traditional fixed income instruments trade – can be opaque, hard to navigate, and prone to unnecessarily high expenses (I’ve talked about this at length here on the blog).  Putting bonds into an ETF vehicle would give investors the best of both worlds: targeted bond exposure with exchange liquidity and transparency.

Although the idea clearly had merit, there were still some questions about how it would all work.  Was it possible to put the OTC fixed income market on the exchange?  How would liquidity be created for these products?  What would a hybrid bond-equity product look like?  Bonds had been listed on the NYSE and other exchanges for years, but had never garnered much interest from traders or investors.  Would an ETF suffer the same fate?

Over 500 funds and $290 billion in assets later, the global fixed income ETF market’s success speaks for itself.  So what were some of the key developments that brought us from those first four funds launched in 2002 to the plethora of bond ETFs available today?  As I see it, there were three main stages that accounted for the market’s exponential growth:

1. Creating a new market (2002-2006). In the first few years of fixed income ETFs, there were still only a handful of funds available, with slow and steady growth and usage by investors.  Since the building and launching of these funds required a re-thinking of the ETF structure itself, only one other provider outside of iShares was willing to take the bet.  By the end of 2006, there were still only six fixed income ETFs available with about $20 billion in assets.  However, we knew it was only a matter of time before the concept would catch on.
2. Additional providers enter the market (2007-2008). By 2007, there was a growing understanding that the “experiment” had in fact worked.  The steady growth and acceptance of the fixed income iShares line-up had proven that there was investor appetite for buying bonds on an exchange.  More importantly, investors were hungry for more.  When the SEC standardized the fund structure and listing process for FI ETFs, a flood of new funds entered the market.  By the end of 2008, the size of the market had almost tripled to $56 billion in assets, spread across 61 FI ETFs from eight providers.
3. The hunt for liquidity accelerates usage (2009-2012). During the financial market implosion at the end of 2008, trading volume in markets like corporate bonds fell by as much as 50%.  Why?  Liquidity in the bond market is supplied by broker/dealers, and since many of these firms were struggling to stay afloat, they pulled back from making markets in bonds.  Because of this, many investors discovered an alternative way to access bonds – through fixed income ETFs.  FI ETF trading volumes spiked, increasing 800 to 1000% for some funds.  And with increased volumes came increased asset flows and even broader investor usage.
   

Where does the fixed income ETF industry go from here?  We believe the market should continue to grow for several reasons.  First, changing demographics in the US and abroad are going to result in more and more investors seeking income-producing investments, and since ETFs provide an efficient way to access fixed income, they should benefit significantly.  Second, as global bond markets continue to evolve, increasing the investment opportunity set for investors, vehicles like ETFs that allow them to access challenging markets are likely going to be a vehicle of choice.  And finally, ETFs are still being discovered by many investors.  Despite all the growth of the past ten years, the ETF market is still tiny compared to the individual bond and mutual fund markets.

Given that ETFs are not just another way to buy fixed income, but are transforming the fixed income markets themselves, the sky is the limit for these game changing products.

Matt Tucker, CFA is the iShares Head of Fixed Income Strategy and a regular contributor to the iShares Blog.  You can find more of his posts here.

Bonds and bond funds will decrease in value as interest rates rise.

Tags: Best Of Both Worlds, Bonds, Brief History, Business Case, Corporate Bond, ETFs, Exponential Growth, First Few Years, Fixed Income Instruments, Fixed Income Market, Handful, Innovative Products, Ishares, Key Developments, liquidity, Lqd, Matt Tucker, Nyse, Otc Market, Plethora
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3 reasons Eurozone’s investors love Danish bonds

Sunday, July 15th, 2012

by Sober Look

Would you pay Denmark’s government 0.6% to hold your money for two years? Sounds strange, but that’s exactly what investors are now doing. Denmark’s government paper yields just hit new lows. And it’s not only the short-term bills with the negative yield (short term bills sometimes go negative when investors seek immediate liquidity). The 2 and 3-year notes are now also comfortably in the negative territory as Eurozone’s investors simply can’t get enough.

Denmark’s 2 and 3-year government yields

Why do the Eurozone investors love Demark’s bonds so much that they are willing to lock in negative yields for 2-3 years? Here are 3 key reasons:

1. Eurozone based investors are not taking much FX risk because Denmark keeps EUR-DKK exchange rate tightly pegged.

DKK per 1 euro

2. Investors love Denmark’s economic fundamentals, particularly the relatively low government debt and deficit.

Source: Bloomberg/BW

3. Keeping funds outside the Eurozone may provide a hedge against potential problems associated with the monetary union’s stability.

Bloomberg/BW: – If the euro crisis worsens, foreign capital may keep pouring in, negative rates or no. Says Ian Stannard, chief European currency strategist at Morgan Stanley in London: “For an international investor with euro zone exposure, buying Danish assets can be a hedge against the extreme scenario of the euro breaking up.”

SoberLook.com

Tags: Bloomberg, Bw 3, Currency Strategist, Demark, Dkk Exchange Rate, Economic Fundamentals, Euro Zone, Extreme Scenario, Government Debt, Government Paper, International Investor, Key Reasons, liquidity, Lows, Monetary Union, Morgan Stanley, Negative Territory, Stannard, Term Bills, Zone Exposure
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One Sided Balance Sheet and Solvenquidity (Tchir)

Wednesday, June 13th, 2012

One Sided Balance Sheets

I’m seeing a lot of negative headlines about how much more debt Spain is adding. How much subordination there is going to be for existing creditors. That is in spite of a lack of detail. I’m not here to cheerlead this deal, but at the same time, falling prey to the easy headlines is dangerous.

No one seems to be talking about the “asset” side of this program. The FROB will borrow money and it will buy assets. The proceeds from either repayment or sale of those assets would be used to pay back FROB’s borrowing. If everything FROB buys is worthless, than yes, the Kingdom of Spain will owe a lot of money under those guarantees. If the FROB made great investments, all the debt could be repaid by the investment and no claim ever made under the guarantee.

Once again, the answer is likely to be in between. The U.S. has done okay on TARP. Since the U.S. forced some of the better banks to take on money, the recovery/repayment rate is artificially high but at least worth looking at. The IMF involvement is a good sign here. If Spain was completely in control of investing FROB’s money, I would quickly assume the assets would wind up with no value. That might be unfair to Spain, but I would not for a second trust them to make decent investments with the FROB money. The IMF, I will grudgingly admit, does seem to actually try and run numbers and make sane decisions. They seem less likely to lose all the FROB money.

When I see everyone talking about all the great points of the deal, I will reconsider my view, but right now, I see simple headlines and negative reactions to those simplistic headlines. I don’t see this deal as a game changer on its own, but I don’t think it is as bad as some are pitching it right now, and more importantly, am very scared as a potential bear that there are more ideas and programs in the global pipeline.

Solvenquidity

Solvency and Liquidity are usually two different concepts.

A “liquidity” problem is when a solid borrower who for some reason cannot get access to money at a particular point in time. There is usually some reason that the company cannot borrow, and it has less to do with the creditworthiness of the borrower than on the market as a whole.

A “solvency” problem is when a creditor is so weak, overleveraged, that they have no way to borrow because they are on the verge of default.

Typically those two situations are different. If some entity tried to address a solvency problem by lending more and more, they could do that, but eventually they would run out of money as the market would stop lending to them. If A is a horrible credit, B can choose to lend to B so long as B has money. If B is willing to lend cheaply and in ever increasing size, A can continue to avoid default. It is the doubling down on an unlimited table theory in blackjack. In the real world, B will start having trouble getting money to lend to A because its creditors will see how stupid it is behaving. That mechanism is what separates solvency from liquidity.

What happens when the lender can print its own limitless supply of money? If you can print money and are willing to continue to print money you can use liquidity to avoid solvency for a very long time. I don’t condone that. I think it is horrible in the long run. I think we should have let more entities go bankrupt, starting with Bear Stearns back in 2008, and Greece in 2010, but for whatever reason the politicians have been petrified to do that.

Will they finally step up and let failure and bloated balance sheets run their course? I hope so, but I doubt it. I think we will see more activity, and for all the talk that you can’t solve a solvency issue with liquidity, you are right, but sadly a lender with virtually unlimited access to cheap money (since he prints it) can provide enough liquidity to address solvency for a long time. The end result is likely to be ugly, but that doesn’t mean the central bankers won’t try.

Tags: Assets, Balance Sheet, Balance Sheets, Creditors, Different Concepts, Frob, Global Pipeline, Guarantees, Imf Involvement, Kingdom Of Spain, Liquidi, liquidity, Negative Headlines, Prey, Proceeds, Repayment Rate, Solvency, Spite, Subordination, Tarp
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Central Banks, Spanish Banks, and 2 JPM Banks

Friday, June 8th, 2012

by Peter Tchir, TF Market Advisors

Yesterday’s price action was about par for the course. Markets were higher on Chinese rate cut and that Merkel said something other than “austerity now”. Stocks dipped as Ben didn’t provide any immediate plans for QE. Then stocks rallied because no one had believed Ben was going to do much anyways. Finally, into the close, consumer credit and news that a strike might affect the timing of the Greek election helped push everything to lower on the day. It is worth noting that HY bonds and EM debt managed to close higher yesterday in spite of the late day stock slide.

Asia followed through with more weakness, and Europe has bounced up and down a little. The latest news is that there will be some sort of a call or a conference of a “virtual summit” this weekend to deal with Spanish bank recapitalizations. I doubt we see a “direct” bailout though I’m not sure the difference between direct and indirect is meaningful as others seem to think it is. If Europe follows its usual course of action, it will do something, but it won’t be enough to take the problem off the table for long. The best outcome would be to wipe out the equity and sub-debt of these banks and truly nationalize them. That would require the least amount of new money. That would likely spook the markets initially seeing equity wiped out, and all bank share prices would probably drop, but once the market figured out which banks wouldn’t need to be nationalized we would see them bounce back, followed by the market at large, because that would actually help convince people the banking problem was “solved” for longer than the usual month or two.

The global scenario remains the same, weakening economic conditions partially offset by the risk of central bank and policy intervention. Left alone the market will continue to sell off as the global economy continues to weaken. Some huge intervention in terms of liquidity or actual money printing can reverse the growth picture (at least temporarily) and spur another round of yield and risk chasing.

The “whale” story at JPM seems to be finally running its course. The daily hype around it has died down and now we are getting into the finger pointing and government soundbite stage. The complete lack of disclosure remains depressing. The fact that every investor must now realize they don’t have enough information to analyze a bank’s fair value has also hit home, yet nothing seems to be happening about that. Yet, I wonder what would happen if JPM split into an investment bank and a commercial bank. The investment bank would do all the trading, all the “sexy” business. I suspect that every good employee would want to be part of the investment bank. Ironically, for all the complaints about “risk taking” most investors would probably want to own the investment bank and not the commercial bank. The funniest thing to me would be listening to people complain that it is unfair that the investment bank went private and shareholders can’t get a piece of the action. Seriously, for all the TBTF arguments, for all the complaints about the risk JPM took, what part of the business would you want to own?

I expect a reasonably quiet, but positive day, with Europe already preoccupied by football and bears being cautious heading into the weekend with the threat of some near term quasi resolution to the Spanish banking problem. Credit is likely to outperform, particularly as investors seem comfortable with U.S. high yield once again.

Tags: Austerity, Bailout, Bonds, Central Banks, Consumer Credit, Economic Conditions, Global Economy, Global Scenario, liquidity, Merkel, New Money, Policy Intervention, Qe, Share Prices, Spanish Bank, Spanish Banks, Spite, Stock Slide, Stocks, Tf
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Killing Vampires, Werewolves, and Zombie Banks (Tchir)

Thursday, June 7th, 2012

by Peter Tchir, TF Market Advisors

We all know how to kill a vampire and a werewolf. For vampires you need to either trap them in sunlight or drive a wooden stake through their heart. For werewolves, you need a silver bullet. Or at least you did before the Twilight series came out. But killing a zombie bank isn’t necessarily as easy.

We all get caught up in the moment. Every tick down in the stock market adds to the fear and anxiety. Every tick up sends waves of relief through the economy. The reality the stock market and economy move at dramatically different speeds, and that is the case for bank failures as well.

While it is true that occasionally banks or companies default overnight or in very short order, that isn’t the norm. Even Lehman was a known problem for ages. Its debt traded very wide off and on for a year ahead of the eventual default. It was on the cusp when Bear Stearns got saved. Lehman got saved that time without a dime being given to it. It squandered its chance and failed to raise money in the 6 months after Bear, but it did last a long time.

Weak banks can linger for a long time, especially if someone is willing to provide them liquidity at non market (stupid) rates. Rescap affectionately known as Rescrap, although not a bank is a great example.

A solvency problem can’t be solved by liquidity, but if there is a lender willing to provide as much liquidity as it takes, and rates that make no sense for the risk, the default can be pushed off for a long time. It can be delayed much longer than we think and in some cases, avoided all together. While Rescap finally met its fate it should probably have met in 2007 or 2008, MBIA seems to have turned the corner.

MBIA has lasted this long because it didn’t require much funding and time has given it the chance to earn carry and avoid payouts.

While neither Rescap nor MBIA are banks they are decent examples of how long it can take to play out.

In the U.S. only Lehman and Washington Mutual failed. At the last moment Bear Stearns and Merrill were “saved”. Others have lingered along in various states of disrepair for a long time with full government support.

That is the key when looking at the crisis in Spain or at Bankia in particular. A solution of lots of fresh equity capital tomorrow would be ideal. But just because we don’t see capital injections tomorrow doesn’t mean it is about to default or go into full unwind mode. Unlimited 3 month LTRO and other ECB and Spanish facilities can keep it alive for quite some time, so expecting it to be an immediate catalyst to a huge down move is as likely to be true as those that hope for some magic plan from the ESM to make it all better.

Time is the key, and horrible headlines aside, it is easier to kill a vampire or werewolf than it is to kill a bank with an unlimited supply of cheap money.

Central Bank Activity

Our scorecard from yesterday continues to fill in. We didn’t get global swap lines, but we did get a China rate cut, so +1. We didn’t get a rate cut, so -1/2, but they did mention some members had voted for a rate cut, so take that as a zero, with a running total of +1.

Unlimited 3 month LTRO, wasn’t on our list but call that a +1/2. 3 year would have been better, but the focus on unlimited was good. So we are at +1.5 so far in total.

Away from that, the ECB didn’t really do much else, but Germany or someone floated a rumor that the EFSF or ESM could lend to some Spanish entity other than Spain which could then recapitalize the banks. I don’t know the source and it is so convoluted that it is unlikely to work, yet convoluted enough it seems likely some politician is really looking at it. Call that +1/2 max, but when coupled with further rumors that ESM will either get a banking license or have a lots of ECB support, lets call all the rumors and “wink wink” signals as a +1 in total. That gets us to 2.5.

The ECB did put it back on the politicians, but not as belligerently as they could have so only -1/2.

Extremely dovish Fed comments added back at least +1, giving us a current total of +3 heading into Bernanke’s testimony.

After yesterday’s comments, by Yellen in particular, it is hard to imagine anything other than an actual announcement by Ben doing a lot for the market and he could easily undo the work done by Yellen.

Still Targeting May 11^th Prices

In addition to the central bank push encouraging risk on, and the overreaction to the Spanish banking crisis, I was surprised that the Spanish sovereign debt auction got done. I suspect that the banks were told to buy and some CDS short covering bids were put in, but it is still a minor positive and far better than pulling the auction.

I was also surprised just how short the market seemed to trade. I thought we were oversold, but the market traded even more short than I would have guessed.

I think the banks can be a catalyst for yet another leg higher. Clearly I’m getting nervous back up at these levels, but I think we can achieve the May 11^th prices. Everyone again seems to be fading this rally or too bitter that we are moving up on a Chinese rate cut. No one has embraced the trade off the lows and too many funds seemed to have gotten whipsawed that the pain of this up move isn’t quite over.

Look for a continued bounce in HY and EM debt denominated in dollars. U.S. treasury rates aren’t going up any time soon, the search for yield will resume, and high yield will benefit from a sluggish, but stable economy, and EM will benefit from the “reflation” trade the central bankers so desperately want to see happen.

Copyright © TF Market Advisors

Tags: Bank Failures, Bear Stearns, China, Cusp, Fear And Anxiety, How To Kill A Vampire, Lehman, liquidity, Mbia, Norm, Rescap, Silver Bullet, Solvency Problem, Stock Market, Tick, Twilight Series, Vampires, Werewolf, Werewolves, Wooden Stake, Zombie
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Eric Sprott: The Real Banking Crisis, Part II

Friday, June 1st, 2012

by Eric Sprott and David Baker, Sprott Asset Management

Here we go again. Back in July 2011 we wrote an article entitled “The Real Banking Crisis” where we discussed the increasing instability of the Eurozone banks suffering from depositor bank runs. Since that time (and two LTRO infusions and numerous bailouts later), Eurozone banks, as represented by the Euro Stoxx Banks Index, have fallen more than 50% from their July 2011 levels and are now in the midst of yet another breakdown led by the abysmal situation currently unfolding in Greece and Spain.

EURO STOXX BANKS INDEX

Source: Bloomberg

On Wednesday, May 16th, it was reported that Greek depositors withdrew as much as €1.2 billion from their local Greek banks on the preceding Monday and Tuesday alone, representing 0.75% of total deposits.¹ Reports suggest that as much as €700 million was withdrawn the week before. Greek depositors have now withdrawn €3 billion from their banking system since the country’s elections on May 6th, seemingly emptying what was left of the liquidity remaining within the Greek banking system.² According to Reuters, the Greek banks had already collectively borrowed €73.4 billion from the ECB and €54 billion from the Bank of Greece as of the end of January 2012 – which is equivalent to approximately 77% of the Greek banking system’s €165 billion in household and business deposits held at the end of March.³ The recent escalation in withdrawals has forced the Greek banks to draw on an €18 billion emergency fund (released on May 28th), which if depleted, will leave the country with a cushion of a mere €3 billion.⁴ It’s now down to the wire. Greece is essentially €21 billion away from a complete banking collapse, or alternatively, another large-scale bailout from the European Central Bank (ECB).

The way this is unfolding probably doesn’t surprise anyone, but the time it has taken for the remaining Greek depositors to withdraw their money is certainly perplexing to us. Official records suggest that the Greek banks only lost a third of their deposits between January 2010 and March 2012, which begs the question of why the Greek banks have had to borrow so much capital from the ECB in the meantime.⁵ Nonetheless, we are finally past the tipping point where Greek depositors have had enough, and the past two weeks have perfectly illustrated how quickly a determined bank run can propel a country back into crisis mode. The numbers above suggest there really isn’t much of a banking system left in Greece at all, and at this point no sane person or corporation would willingly continue to hold deposits within a Greek bank unless they had no other choice.

The fact remains that here we are, in May 2012, and Greece is right back in the exact same predicament it was in before its March 2012 bailout. Before the bailout, Greece had approximately €368 billion of debt outstanding, and its government bond yields were trading above 35%.⁶ On March 9th, the authorities arranged for private investors to forgive more than €100 billion of that debt, and launched a €130 billion rescue package that prompted Nicolas Sarkozy to exclaim that the Greek debt crisis had finally been solved.⁷ Today, a mere two months later, Greece is back up to almost €400 billion in total debt outstanding (more than it had pre-bailout), and its sovereign bond yields are back above 29%. It’s as if the March bailout never happened… and if you remember, that lauded Greek bailout back in March represented the largest sovereign restructuring in history. It is now safe to assume that that record will be surpassed in short order. It’s either that, or Greece is out of the Eurozone and back on the drachma – hence the renewed bank run among Greek depositors.

Meanwhile, in Spain, bank depositors have been pulling money out of the recently nationalized Bankia bank, which is the fourth largest bank in the country. Depositors reportedly withdrew €1 billion during the week of May 7th alone, prompting shares of Bankia to fall 29% in one day.⁸ The Bankia run coincided with Moody’s issuance of a sweeping downgrade of 16 Spanish banks, a move that was prompted over concerns related to the Spanish banks’ €300+ billion exposure to domestic real estate loans, half of which are believed to be delinquent.⁹ The Spanish authorities were quick to deny the Bankia run, with Fernando Jiménez Latorre, secretary of state for the economy stating, “It is not true that there has been an exit of deposits at this time from Bankia… there is no concern about a possible flight of deposits, as there is no reason for it.”¹⁰ Funny then that the Spanish government had to promptly launch a €9 billion bailout for Bankia the following Wednesday, May 24th, an amount which has since increased to a total of €19 billion to fund the ailing bank.¹¹ Deny, deny some more… panic, inject capital – this is the typical government approach to bank runs, but the bailouts are happening faster now, and the numbers are getting larger.

The recent bank runs in Greece and Spain are part of a broader trend that has been building for months now. Foreign depositors in the peripheral EU countries are understandably nervous and have been steadily lowering their exposure to Eurozone sovereign debt. According to JPMorgan analysts, approximately €200 billion of Italian government bonds and €80 billion of Spanish bonds have been sold by foreign investors over the past nine months, representing more than 10% of each market.¹² The same can be said for foreign deposits in those countries. Citi’s credit strategist Matt King recently reported that, “in Greece, Ireland, and Portugal, foreign deposits have fallen by an average of 52%, and foreign government bond holdings by an average of 33%, from their peaks.”¹³ Spain and Italy are not immune either, with Spain having suffered €100 billion in outflows since the middle of last year (certainly more now), and Italy having lost €230 billion, representing roughly 15% of its GDP.¹⁴

Tags: Bailout, Bank Of Greece, Banking Crisis, Banking System, Bloomberg, Business Deposits, Collapse, David Baker, Depositors, ECB, Emergency Fund, Eric Sprott, Escalation, Euro Stoxx, Greek Banks, Infusions, liquidity, Reuters, S 165, Sprott, Withdrawals
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