There Is No Risk Left… Anywhere

Friday, April 12th, 2013

Many have argued that sovereign CDS markets ’caused’ the problems in Europe – as opposed to simply ‘signaled’ what was in fact being hidden by cash market manipulation. But as the IMF notes in a recent paper, there are times when the CDS market leads the cash bond market and other times when it lags. But as far as looking at risk in Europe and the US, based on a wonderful model that uses Markov-switching to predict what the probability of the world being in a low-risk or high-risk state, we are as ‘low risk’ as we have been since the crisis began. Each time that level of complacency was reached before, equity markets have rapidly sold off. What is perhaps most notable is the systemic compression of every risk indicator, first VIX (Kevin Henry and the fungible excess reserves of every prime dealer whale), then the liquid SovX index (via Greece CDS auction uncertainty and ‘naked’ short bans), then the Euro TED Spread (via LTRO), then individual Sovereign CDS (via Draghi’s ‘promise’). The result, the ‘free-market’ signal of risk is non-existent.

Look carefully at the Nov 2011 period onwards and the step by step compression of each risk indicator (from high probability of high-risk to low probability) – crushing the free market’s signals…

The last three times the ‘model’ was so complacent about risk, Q3 2008, Q2 2010, and Q2 2012, the S&P 500 rapidly lost around 40%, 17%, and 11% respectively.

Charts: IMF

Tags: Imf, risk
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Bond Model Positive = Risk Off

Tuesday, August 7th, 2012

by Guy Lerner, The Technical Take

Our bond model turned positive one week ago, and since the bottom in March, 2009, this has generally meant “risk off” for the markets.

Figure 1 is a weekly chart of the SP500.  In the lower panel is an analogue representation of our bond model.  Currently with the value “up”, the bond model is positive and we should expect higher bond prices and lower yields.  Looking at the SP500, I have put buy and sell signals on the price bars that corresponds to those times when the bond model is positive.  As you can see, the bond model was positive during the market tops of 2010 and 2011.  In each instance, rising bond prices was forecasting economic weakness that ultimately led to QE2 and Operation Twist.

Figure 1. SP500 v. Bond Model/ weekly

Since March, 2009 with the bond model positive (i.e., falling yields), the SP500 has gained 14.99% on a cumulative basis, and as you can see, the majority of the gains occurred in the initial thrust from the lows.  Since 2010, buying equities when the bond model is positive has produced a little gains for your efforts.  But there has been a lot volatility.  Clearly, this has been the “risk off” period.  In contrast, since March, 2009 with the bond model negative (i.e., rising yields), the SP500 has gained 39.04% cumulatively.  All 9 trades have been winners.

In summary, our bond model is positive.  Over the past 2 years, this has coincided with economic weakness and an equity market top in 2010 and 2011.

Copyright © The Technical Take

Tags: Analogue, Bond Market, Bond Prices, Cumulative Basis, Economic Weakness, Figure 1, Guy Lerner, Initial Thrust, Lows, Market Tops, Qe2, risk, S&P500, Signals, Trades, Volatility
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Solving the Global High Yield Puzzle (Video)

Wednesday, July 18th, 2012

In the hunt for income, high yield bonds continue to be of interest to investors willing to take on the extra risk.  However, there are more ways to play this asset class than simply US high yield bonds.  In this short video, Matt Tucker explores the pieces that make up the high yield puzzle and how they might fit in a portfolio.

Tags: asset class, Extra, Global High Yield, High Yield Bonds, Income Bonds, Investors, Matt Tucker, Puzzle, risk
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LIBOR: Everything You Want to Know, but were Afraid to Ask

Wednesday, July 4th, 2012

by Peter Tchir, TF Market Advisors

How is LIBOR calculated?

The BBA provides pretty detailed analysis of the process. The key here is what the rate is meant to be. The contributors, are supposed to submit a rate for each currency they contribute for overnight, one week, two week, and monthly out to a year. The rate is meant to be:

“At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”

This is a bit like self-reporting your weight. The bank is supposed to submit a rate where they think they could borrow, not where they actually borrowed or where they would lend to other contributors. Right from the start the question raises questions that have been discussed for years.

How can a bank “know” where some other bank will lend them money? Can’t they use transactions? Can’t they get firm “offers” from other banks? Why not have the banks submit levels where they would lend to other banks?

The very nature of the question used to solicit rates tells you all you need to know. LIBOR has always had an element of “gamesmanship” if not outright lying.

In general, banks will tend to submit lower rates and attempt to artificially lower LIBOR. There are two reasons for this:

• Signaling Effect – banks don’t want to say it would cost them more money to borrow than their peers because that would be admitting to weakness and may cause their lenders to pull back and create a financing freeze. Each contributor’s LIBOR indications are published so if a bank shows up with a particularly high estimate of what it would cost to borrow, it would attract unwanted attention. It may be the truth and should be evident in the CDS and bond markets, but for some reason banks remain concerned about the signaling impact and tended to skew LIBOR submissions lower than they should have been
• Risk and P&L Impact – The big banks always have a lot of risk associated with LIBOR. It will affect their borrowing costs, it will affect what they receive on floating rate loans and it will affect the value of their interest rate derivative books. It might have other secondary impacts, but those 3 areas are big. It is probably safe to say that banks in general benefit from lower LIBOR, but that won’t be true for all banks and won’t be true for all days. There are occasions where banks may benefit from a higher LIBOR. If they have a disproportionately large amount of floating rate loans resetting on that day, they may benefit by having LIBOR higher that day, thus locking in slightly higher income for that period. Someone at the bank will know their exposure to the LIBOR setting on any day, and it would be hard to believe that on days when the exposure is large either direction, the group that submits it would be unaware of the potential P&L impact.

That is a dangerous concoction. A question that leaves a lot of wiggle room, and banks that may have strong incentives to use that “wiggle” room.

Controls and Actual Calculations

For me, the single most important rate is the 3 month USD LIBOR rate. It certainly impacts Americans more than any other rate calculated by the BBA. Here is yesterday’s submissions, and the calculation.

There are 18 banks that submit U.S. LIBOR. The 4 lowest rates and 4 highest rates are thrown out for purposes of the setting. Then LIBOR is set as the average of the remaining 10 rates.

You can see the wide discrepancy in rates. HSBC and Barclay’s clearly think they have easy access to money. SocGen and BNP seem to think it would cost them a lot of money relative to the others. There is no indication how much borrowing and lending is occurring in the interbank market, so there is no easy way for an outsider to tell if this reflects reality or not. JP seems conservative given that their 5 year CDS trades at 125 which is similar to HSBC’s 120 level. Barclay’s 5 year trading at 205 would indicate a possibly optimistic view of where they could get short term funding, and Citi and BAC barely behind JPM again seems a bit optimistic given their CDS trade at 235 and 250 respectively.

So by throwing out the outliers, and using a relatively large pool to calculate the average, the BBA attempts to mitigate the risk of any one bank skewing the setting. The problem is that it doesn’t do much if multiple banks collude to manipulate the setting.

If multiple banks have the same incentive to skew their own submission, and worse yet, communicate that to “friendly” banks, then the BBA methodology breaks down further.

The problems with the BBA methodology is there is no confirmation that the rate submitted is reasonable, and nothing is done to protect against group rather than individual bias in their submissions.

Lawsuit Heaven?

I don’t think this will turn into lawsuit mania. In spite of the huge notional amount of contracts and loans outstanding based on LIBOR, it may be difficult to pursue a case. We will go through the cases that might make the most sense in a moment, but here are the main reasons that I don’t think this will snowball into a massive amount of litigation

• Individuals and Many Corporations benefitted from lower LIBOR settings. To the extent the bias was to artificially lower LIBOR, the direct impact would be to reduce amounts owed on floating rate borrowings. Anything where individuals as a class were hurt would expose the banks to big problems, as they would be getting sued by a group that would have a lot of jury sympathy. But in this case, individuals that had any LIBOR exposure, typically directly benefitted from any bias to make the rates low, as they borrowed in LIBOR and little of their investment income was based on LIBOR.
• The duration of LIBOR is short. Even if you have a 10 year swap where you paid fixed and received floating, you would likely have to demonstrate that on each reset date, the bank colluded to move LIBOR setting against you. Maybe you can argue that the overall trend was enough to impact your mark to market, but that may be a stretch. Having to show that at each quarterly reset, on the day your contract resets, there was collusion, could be very difficult. The duration also comes into play on the damages side. Let’s assume you had a $10 billion swap (a reasonably big trade). If the banks all colluded against you on a particular setting and managed to move LIBOR by 10 bps (a big differential) your “loss” would be $2.5 million or 0.025% of notional. Not small, but another example of how the short term nature of LIBOR makes it hard to build a big claim.
• The complexity of the process helps the banks as a group. How would you prove you were hurt by a particular bank? If a bank submitted a “bad” price, but was already in the outlier group, it would be hard to make a claim since it didn’t affect the calculation. If a banks “bad” price moved it from the calculation group to the outlier, it is only the difference between what would have been fair for them, and what the bank that is now being used submitted. It is really hard to show how much 1 bank affected the outcome. Larger groups caught in the act would be required, but this will be more difficult to find consistently, and remember to prove real loss, you would need that group collusion on each reset date. Then those banks would split the cost. That is ignoring the difficulty of proving what a “bad” price is. The question certainly allows for the defense tactic of “well, that’s what I thought it would be”, especially during periods where interbank activity went to zero and the banks were relying heavily on central bank funding.

It is easy to salivate over the potential lawsuits and the losses the banks might have, but a dearth of sympathetic victims, the rolling nature and short duration of LIBOR based products, the lack of a test to determine if a submission was “bad” and the complexity of the setting process make it far harder to bring successful lawsuits than the headlines might suggest.

The Consequences

I would expect more firings at banks. Clearly Barclay’s was not acting alone. In this environment, no bank is going to support an employee who was involved in this. The banks will defend themselves in court against lawsuits based on the letter of the law, but at this stage, none are going to fight to save staff that participated in schemes to move LIBOR (or at least those dumb enough to use e-mail and other recorded forms of communication).

Will other big heads roll? That to me is less clear, but is a possibility. I’m assuming like in most other things at big banks, if the people in charge are well-respected with no big internal rival, they survive, but if the person has been on the edge and has a group happy to force a regime change, we could see one.

Ultimately the LIBOR setting process will have to change. The current process is too vague. There have been some calls for an alternative to LIBOR, but with so many contracts outstanding, I think that is unlikely. It will be far easier to just amend the methodology and try to improve the existing LIBOR process rather than starting an entirely new rate series.

There will likely be some cases brought that get settled and cost the banks some money. If anything, I suspect municipalities might form the best class action. I think many did enter into pay fixed, receive floating swaps, so as a group they might have the size and sympathy to pursue something, though I bet the lawyers for the banks will gain the most, with lawyers for the plaintiffs coming in a close second, and the plaintiffs and banks wondering how they got sucked into spending so much on legal fees. I could be wrong on the lawsuit side, but even the evil side of me, has trouble figuring out how to make a strong case with big potential payouts.

E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts

Tags: Amp, Attempt, Banks, Bba, Bond Markets, Contributor, Currency, Element, Firm Offers, Gamesmanship, Lenders, Libor, Nbsp, Peers, Reason, risk, Submissions, Tf, Truth, Unwanted Attention
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Why Investors Persist Hanging on to Long Treasuries at Such Low Yields

Monday, July 2nd, 2012

Some readers have asked if other fixed income asset classes could be just as effective as long term treasuries for an equities portfolio in hedging an equities book (discussed here). Here the comparison is made to municipal bonds, investment grade corporate bonds, and HY corporate bonds. Long term treasuries are still superior in reducing the portfolio volatility – at least based on the last couple of years. That’s because muni and corporate spreads tend to be inversely correlated to equities, reducing the hedge effectiveness of these instruments.

Again, the x-axis is the percent of the portfolio invested in the S&P500, with the rest of the portfolio being in one of the fixed income asset classes. The y-axis is the combined portfolio daily volatility over the past two years.

That is the reason investors are willing to take asymmetric risk and dismal current yield to hold long term treasuries. Whether this relationship holds going forward remains unclear. A scenario in which both treasuries and equities sell off some time in the future is not unrealistic.

SoberLook.com

Tags: Amp, Asset Classes, Axis, Bonds Investment, Corporate Bonds, Current Yield, Fixed Income, Investors, Municipal Bonds, P500, Portfolio, Reason, Relationship, risk, Treasuries, Volatility
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Bill Black: JPM’s “Wild, Crazy Insane Gamble” Puts Economy at Risk [Video]

Thursday, May 24th, 2012

Tags: Bill Black, Economy, Insane, Jpm, risk
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Has JPMorgan Already Unwound Its Losing Trade?

Sunday, May 13th, 2012

On Thursday night, after it became clear that JPM has lost at least $2 billion on what is most likely an IG9 Index skew (Index less Intrinsics) trade gone horribly wrong, we first predicted (and promptly were piggybacked on by other various financial blogs) that based on various factors, there is about $3 billion more in the pain trade coming in JPM’s general direction, once IG9 blows out to catch up to a fair value not supported by JPM(artingale’s) infinitely backstopped prop desk. Sure enough, by closing on Friday, IG9 (and the entire IG curve), had blown out wider, by a whopping 10 basis points: one of the biggest intraday moves in nearly a year. In P&L terms, by close of Friday, all else equal, JPM had lost another $2-3 billion on the same trade it had lost over $2 billion since the beginning of April. We expect to hear confirmation of this shortly. Which however brings another question: has JPM closed out its losing trade, or is the entire move in the index (and to a far less extent in the intrinsics) due to hedge funds who have piggybacked on the “crush JPM” trade? The truth is we don’t know, and until we get the latest weekly DTCC data on CDS notional outstanding we won’t know. However, our gut feeling is that it would have been virtually impossible for JPM to lift every single offer in unwinding a $100+ billion notional position without sending the entire IG curve multiples wider. Which is why keep a close eye on the IG9 10 Year skew – this is where, as ZH first noted, the action is. If the skew soars, it is likely that the runaway train will keep going and going, until JPM issues a formal announcement that the firm is fully out of the trade, together with a final tally of its losses, which will probably be double the reported loss as of Thursday. At which point IG9/18 will see an epic ripfest as those short risk will scramble to cover.

As the chart below shows, as of Friday, the index was still 7 bps rich to intrinsic, however the spread collapsed by nearly 50% from the day before. If and when the skew goes positive, would be our all clear to get out of dodge. Until then, JPM will likely see far more pain, even if, technically, it won’t, following rumors its entire London CIO desk may be now in jeopardy, meaning it will be up to the middle office to unwind, at an even greater loss to the firm. And compounding the issue will be the general risk off nature in capital markets over the next few days, following a plethora of European sovereign bonds, and, oh, the little issue of the Eurozone potentially falling apart in a few weeks. All of which will likely see the continued widening in various IG points, until JPM issues at least some more color on its current involvement in the trade.

IG9 – 10 Year Skew: ripfest, but still a ways to go:

Someone else who believes that the trade is now over, is Peter Tchir. We don’t quite agree, but we do believe IG9 (and 18 by proxy) longs should be careful – very soon covering an IG long CDS position may well be the pain trade.

From Peter Tchir of TF Market Advisors

The Coolest Trade I Ever Saw!

On the coolest trade I ever witnessed, I was an unwitting participant. In the end, I don’t know if any of it is true, but this is the story I saw and was a part of, and the firm’s P&L seemed to back it up.

I only mention it now, because I can’t help but think Jamie Dimon is pulling something similar.  With Sarbanes Oxley and everything else, I’m not sure he could be, but there is a nagging doubt in my mind about “piling on” being the right trade.

I also can’t help but remember back in 2008, where Citadel had a conference call.  That was unusual enough.  More unusual was how easy it was to get the number.  Ken went on about the basis (long corporate bonds vs short CDS).  I remember liking the basis at that time, even had on a tiny bit, but I wanted to buy because I figured it was at ridiculous levels, the funding the Fed was supplying would help the market, and by the time Ken was so openly talking about it, you had to know the unwind was almost over.

So, anyways the trade I remember as the coolest trade was way back in the early 2000’s.  I was at DB at the time doing some HY CDS, Synthetic CLO’s, Total Return Swaps and a few other things that most people hate.  But the big story at the time was talk that the government would stop issuing the long bond.

The bond was going up almost daily.  There was talk about the scarcity and that it could go a lot higher in price.  The rumor was that DB was short.  It started as a small rumor, but got around.  One morning, the long bond opened up more than a point.  It kept grinding higher.  It didn’t matter who you were at DB, you were being asked by the street, by clients, by competitors about the trade.  Everyone thought DB was short and getting killed.  The size was supposedly large (by the standards of the day which are a fraction of what they are now).  I remember being nervous about my bonus.

What the heck was going on?

Then it happened.  Edson Mitchell or his assistant came out of “mahogany” row and called the head of rates (who oversaw treasuries) off the desk.  Myself and countless others were immediately on the phone and Bloomberg messages telling people what just happened.  Holy cr*p this must be bad.  The head of rates was called off the desk.  That NEVER happens.  And it was not to celebrate.  Wow.  The long bond spiked further, I think at one point it was up over 3 points – a huge move.  The rumors of losses were growing by the second.  People were wondering if they should trade with DB.  The “usual histrionics” that were blowing the situation way out of all proportion.

According to legend, and the P&L seems to have backed it up, the rates desk was actually LONG treasuries.  That extra 2 point gap made 100’s of millions of dollars for the firm.  Whether they had ever been short, I don’t know, but they had turned the position and were now massively long and profiting from the move.  How they didn’t just take the money  and be happy I will never know.  But to go through the charade of calling the head of trading off the desk and causing an immediate spike that they sold into, has to be the single coolest trading thing I’ve ever seen.

Be careful betting against JPM and the trade they allegedly have on and allegedly still need to unwind and might allegedly lose a lot more money on.  I’m not saying this is a head fake and I haven’t recommended closing the trades in TFMkts Best Ideas™ that benefit from the unwind, but I really don’t believe, that in spite of Sarbanes Oxley, we are getting the full story, and not possibly being played a bit.

Tags: Amp, Basis Points, Blogs, Bps, Chart Below Shows, Confirmation, Curve, Desk, Extent, Formal Announcement, Gut Feeling, Ig, Jpm, Losses, risk, Runaway Train, Soars, Tally, Thursday Night, Truth
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What Could Have Gone Wrong at JPM

Friday, May 11th, 2012

by Peter Tchir, TF Market Advisors

Well for once we don’t have to talk about Spain or Greece.

This is the end of synthetic CDO’s and may well be the end of CDS as an OTC product, but we have time to look at that later. There will be a lot of information and misinformation out there.

For now, the key is what is this going to do for the markets.

As best as I can tell, they were generally short High Yield risk. They were mostly short tranches, mostly in off the run, and had some curve trades on.

Against that, they were generally long IG, mostly tranches, mostly IG9, and had some curve trades on.

The positions, if we ever find out exactly what they were, are complex. At some level this disclosure has something to do with mark to model. Gp

So HY17 is lower on the quarter. If they were short, they should have made some money? Strange and in any case, a relatively small move.

IG9 10 year is wider. Was out 15 bps since the end of the quarter, from 112 to 127.

To lose 2 billion on a 15 bp move, that would be about 275 billion of notional equivalent.

Scary, but something very strange has gone on.

E-mail: tchir@tfmarketadvisors.com

Twitter: @TFMkts

Copyright © TF Market Advisors

Tags: Bp, Bps, Curve, Disclosure, E Mail, Gp, Greece, Ig, Misinformation, Money, Nbsp, Otc Product, risk, Spain, Strange, Synthetic Cdo, Tf, Trades, Tranches
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Asset Class Performance (April 2012): Another Good Month for Bonds

Friday, May 4th, 2012

The bar chart below, courtesy of Scott Barber of Reuters, shows the monthly performances of the principal asset classes.

“The “risk on/risk off” barometer moved back in the direction of “risk off” during April, as U.S. 10-year Treasury securities turned in the best investment gains (in U.S. dollar terms) during the month,” said Barber. “The 2.8% jump in the value of the Treasury securities came despite the almost universal perspective on the part of professional investors that the 30-year bull market for bonds is finally sputtering to a halt and that eventually interest rates will begin to climb. Investors displayed a clear bias in favor of assets that not only generated income but also offered them security – in other words, bonds of various kinds were the only major asset classes to end the month in the black.”

Source: Scott Barber, Reuters, May 2, 2012.

Tags: 10 Year Treasury, April, asset class, Asset Classes, Assets, Barometer, Bias, Bonds, Class Performance, Dollar Terms, interest rates, Investment Gains, Principal, Professional Investors, Reuters, risk, Scott Barber, Treasury Securities, Universal Perspective
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Eric Sprott: Paper Vs Physical Gold

Friday, April 20th, 2012

While Eric Sprott obviously has a modest axe to grind, his open and honest discussion with Charles Biderman on the difference between gold ETFs methods of owning gold, so-called physical vs paper gold, is noteworthy given the depth he goes into. After explaining the concerns of GLD, Pisani’s putterings, and tax-related differences, Eric goes on to discuss his and other physical trusts and how he started down this route. The latter end of the discussion shifts from the practicalities of owning ‘sound money’ or ‘hard assets’ to the thesis for doing so – the debasement of fiat currency and the printing press fanaticism being exhibited globally. Concluding with his thoughts on what could change this thesis, he sees the greatest risk that “we come to our financial senses” – a highly unlikely scenario given the dominoes likely to fall should that occur.

Tags: Assets, Axe, Debasement, Dominoes, Eric Sprott, Fanaticism, fiat, Fiat Currency, Paper Gold, physical gold, Pisani, Printing Press, risk, Senses, Sound Money, Thesis, Trusts
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