Saturday, January 28, 2012

Central Planners and Financial Engineers attempt to default Credit Defaults


Given my previous post, I wanted to discuss the implications of this totally unethical and convoluted maneuver designed to execute a default but call it something else and thus attempt to avoid triggering credit default contracts. The implications as I have said are dire. One of the key things our central planning financial engineers are doing is attempting to prevent these insolvency triggering contracts from bankrupting their buddies and revealing just how wide spread mismarking and accounting control fraud are in presenting an image of solvency when underneath lies a rotting carcass.

The situation as it exists in the markets, is now VERY similar to 2007 and 2008 when people realized that they could not execute on complex derivatives the way they expected. Only this time its MUCH bigger and its NOT just Greece that contains the issue. This last major phase of the ponzi scheme that has become our financial system has been constructed with leveraged accounting instruments. Every time someone needs to create more liquidity they can do it by creating arbitrary agreements with nearly no limits on leverage. Of course, the limits are "bankruptcy" and if you pocket a lot of coin before going BK then you are likely not to be that concerned with the bankruptcy part. Banks, in fact, are already generally insolvent, so these accounting tools allow them to present the masquerade that they are NOT. Reality, however, is that what is going on in Europe now is demonstrating that there is a much bigger issue than simply counter party risk. Its aggresive and desperate central planning and financial engineering risks.

Right now IF you own CDS, the clear and present goal of officials is to make sure that your premium becomes worthless and that you NEVER get paid the insurance. It does not matter that the Greece notional is not that large, what matters is the agenda. But this is what is happening as a result of the efforts of officials and the issues that I raised in the previous post. This is not that different from the credibility problem that the market has already suffered because regulators can not keep track of firms like MF Global even when they are in their offices for weeks and weeks before they manage to abscond with vast amounts of supposedly segregated capital.

One of the tenets of our financial system is supposed to be "trust". Officials from the Fed, ECB, IMF, IIF and other three letter acronyms are doing their level best to prevent too large to fail institutions from blowing up by playing havoc with trust needed to ensure that people believe that their contracts and accounts actually are what they appear and can be executed the way they say they can be executed. If there is a failure with these mechanics, the system fails - and especially since it is so completely overleveraged.

The meetings in Athens with the troika and IIF are conveluting and corrupting the basis of trust that hyper leverage via derivatives requires. Of course this is not the first time. The same thing happened in 2008.

The Disconnection of Trust...

Now we are staring down the barrel of a major disconnection within the financial system. A disconnection of trust. So, no matter what the officials and negotiators come up with this weekend, there is one clear result: Greece will have defaulted. The other result will be that officials will make clear that when push comes to shove, they have no respect for contracts in general and especially the contract based derivative financial instruments that are, in fact, the only thing allowing the system to pretend to be functional now. If you happen to own some of these instruments then you are faced with the same questions that many people who had money at risk in transactions with AIG, Lehman and Bear Stearns. Their answer was to short the stocks of these firms as hedges against their impending defaults. Of course, deleveraging and defaults are anything but orderly…so, the best laid plans tend to become something other than intended, and many were forced to resort to the less than elegant approach of selling these companies and other companies short as protection.

So, with the ECB and its cohorts willing to stop at nothing to make sure individual investors are mauled and tortured…what would you do if you could not count on your CDS to trigger or pay off due to counterparty or event risk? Why, you would probably look for another method, likely not so dissimilar to situation in 2008. This would lead you to short the EURO directly in order to execute what turns out to be a synthetic version of CDS.

Ironcally, this is in fact exactly what is happening. The huge increase in short interest in the EURO is not just speculation - its protection. So, despite the rally in the EURO over the last nine session the short open position has increased each week - currently at 197,818 contracts up from 181,662 contracts two weeks ago. It is not likely going to go away anytime soon. The central planners have done everything they can to force people into not being able to trust the most basic assumptions and truths that they needed to function in our or any financial system…so now the result is synthetic CDS applied via currencies and betting against the entire corrupt system as protection.

The Greek debt deal and backroom...

The news, especially apparently CNBC, is populated with tons prognostication and rhetoric about a Greek debt deal. I would like to make it clear that these prognostications and marketing attempts are simply that. They are hot air. Lets take a closer look at what is going on and then come to a conclusion that actually has relevance.

In recent history, bureaucrats have been trying to get various exceptions or adjustments into supposedly free markets for debt insurance - called CDS - Credit Default Swaps. The concept of a CDS is simple: in the event that counter party is unable to repay within terms CDS protection will compensate the buyer commensurate with the amount defaulted. Lets take a closer look.
A credit default swap (CDS) is an agreement that the seller of the CDS will compensate the buyer in the event of a loan default. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. 
In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan.  
Anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). If there are more CDSs contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less than the face value of the loan. 
Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA).
CDS’s are not traded on an exchange and there is still no required reporting of transactions even after the AIG debacle. Credit default swaps and other derivatives are unusual--and potentially dangerous--in that they combine priority in bankruptcy with a lack of transparency
Now lets look at what has been going on with the bureaucrats:
Oct 27, 2011 2:03 PM ET
The European Union’s ability to write down 50 percent of banks’ Greek bond holdings without triggering $3.7 billion in debt insurance contracts threatens to undermine confidence in credit-default swaps as a hedge and force up borrowing costs.
 
As part of today’s accord aimed at resolving the euro region’s sovereign debt crisis, politicians and central bankers said they “inviteGreece, private investors and all parties concerned to develop a voluntary bond exchange” into new securities. If the International Swaps & Derivatives Association agrees the exchange isn’t compulsory, credit-default swaps tied to the nation’s debt shouldn’t pay out. 
“It will raise some very serious question marks over the value of CDS contracts,” said Harpreet Parhar, a strategist at Credit Agricole SA in London. “For euro sovereigns in particular, the CDS market is likely to remain wary.”
So the pressure right now with regard to Greece is not a negotiation. It is not a haircut and it is not a restructuring of the existing bonds. It is in a desperate phase and its goal is to save the leveraged financial system. The consequences of the a credit event or a credit restructuring in Greece are not to be misunderestimated (thank you George Bush). They are DIRE.

If we were looking at a situation as it is presented with rose colored glasses via the main stream media, then we would ascertain that big countries like France, Germany and the US and a few select institutions control and own almost all the bonds issued by Greece and are thus able to agree to new terms or securities fairly easily. This, however, is a very convenient presentation of situation. However, reality is nothing like that. These bonds are held by Pensions, Hedge funds, Institutions, Central Banks, Individuals and other Sovereigns. 

The managers of the portfolios of many of these investors have bought CDS insurance for their portfolios. Many of them may have a PPM or offering memorandum that discloses their strategy very precisely…this means that many managers have a legally enforcable mandate to trade debt with CDS protection as hedges. 

Imagine if you will, that you are a client of one such a manager and he may have thousands of clients. This manager has a fairly simple scenario. Accept a haircut and restructing of some of his assets that may fall out of his PPM and by the way take 80% losses on principle…not including CDS premiums. The manager can call every one of his clients and get agreement to make an exception for these instruments or more than likely he can call you and say: 

  • PM: "Mr. Smith, Greece is offering us 20% of principle on our bonds, the CDS insurance that I bought is worthless and I think we should take the haircut.” 
I think that it is very easy to understand that your response will be very simple: 
  • You: "Why were you investing in crap bonds and what the hell were you doing buying worthless insurance with my money. Are you trying to tell me that we invested capital and then another 25% of principle on insurance premiums and we are only going to get back 20% on capital and with some of that coming years from now?”
  • PM: “Yes”
  • You: “Are you telling me that we have insurance that will pay me back the 80% of princinple that is being defaulted but you want to elect to NOT use that? or is the insurance a fraud?”
  • PM: "The insurance is good but officials are trying to get this not to be called a credit event so I am trying to comply with their wishes by simply agreeing to a haircut and tossing the insurnace and the permiums all together. I think its simpler that way, even though its outside our PPM.”
  • You: “How many other bonds have similar arrangements and risks regarding their insurance? I thought you told me that we were running a low risk hedged portfolio of sovereign debt…what have you been doing buying insurance that you don’t indend to actually use to get MY MONEY BACK?”
  • PM: “A lot of our bond portfolio is hedged with CDS but I think those are good…but you never know the outcomes of situations like this…right now I am just concentrating on trying to get the most principle repayed as fast as possible and not get this a resolution drawn out for years”
  • You: “Look is the insurance GOOD or NOT GOOD? if its good I want you to collect and get MY money back. After which I will be sending you my redemption request. What kind of operation are you running and what kind of crazy deals are you willing to make with MY MONEY. I just can’t believe you would buy insurance for 25% of the face value of the note and then elect not to use it and take 20% of face value back instead…
  • PM: “Look Mr Smith, please calm down, I am just trying to get an acceptable resolution for us all…”
  • You: “You are not succeeding...Hang on while I call my lawyer.”
So, what is clear is that IF there are  few large investors that comprise the biggest holders of debt issued by Greece for example they are accountable to thousands of other clients and will have to negotiate indemnity with all of them in order to agree to a deal that is a clear conflict of interest. One does not buy insurance and then simply ignore that one has it. If you are working for someone else and chose not to file a claim simply because you are being cooeerced to - you can count on getting nailed to the wall. In the case of our imaginary Portfolio Manage above…he stand much better chances with just letting the bonds default, attempting to collect the insurance and then when or if the insurance does not pay demonstrating to his clients that he is not culpable. He may have bought bad bonds and bad insurance but he followed his PPM to the letter and acted ethically at all times. The problem is the other guys who he can now sue…every last one of them…Greece, ECB, the CDS counter party and anyone else he can find. In this case, he can also simply wind down his fund and open a new one. In the alternate case, he will get sued by his clients but with no escape hatch and no one else to blame. Which would you chose if you were a PM? I would choose to follow my PPM and live with the consequences. I would find it far more productive to tell a client about a disaster than to try to force feed them an even bigger one and get all the accompanying liability and culpability.

A simple way to think of this is that you borrow money from a friend, say $100,000. You run into a financial difficulty and let your friend know that you need to restructure or default. In that case, you are dealing with just one person and its fairly easy for both of you to determine the implications. However, if your friend who lent you the money, used money from 20 other sources at $5,000 each to fund your loan…then this is no longer just between you and him…he has responsibilities to his partners or clients. Additionally, if he committed to them that he had purchased some sort of default protection, these participants will not be interested in hearing about how much he likes you or wants to avoid confrontation or the results of him getting kicked out the apartment he rents from you when you can not longer afford it because you are in default and he is required to collect. His partners will want to collect from you and the insurance…any interference or alternate scenario painted by your friend (in the PM) in this case, will result in much more conflict and risk for him than if he just attempts to collect and deals with the consequences. His 20 participants can accept if the insurance does not pay because the counter party risk blows up and that is not expected…however, the reality is they will ALL look at the insurance as a high probability asset and the restructuring as a much lower one. 
“It has always been understood that the restructuring definition cannot catch all possible events,” according to the statement. “If a creditor is hedging using CDS, and declines to participate in a voluntary restructuring, then the creditor would still hold its original debt claim and its CDS hedge.”
The implications of what is going on this weekend are huge…there is NO possibility that a reasonable solution can be negotiated if there are portfolios of individuals rather than taxpayers involved. The consequences are too great for the PM’s and the participants will want their protection that they expected and paid for to be executed and settled. The results of that however, will be total economic upheaval in Europe and will spread to the US. The CDS and derivatives overhang is a huge issue and will not go away anytime soon. Over leveraged balance sheets are supported entirely by assumptions made based on their derivatives hedges and the fact that they can and will be executed. What we are seeing is direct interference in the transactability of these contracts and that is notwithstanding the fact that the financial system does not have enough money to transact on them.

There is just no way to bureaucratically interfere with every deal or to entice people into participating in a far less attractive one. Certainly, it would be that much more challenging to get a deal even in discussion if risk markets were tanking…so, the January risk rally has been rather helpful, to say the least.

There will be no miracle deal…even if there is an announcement it will effctively be a default and WILL include a CDS trigger...if there is no deal and no possibility of a reprieve then Greece can not get its financing from ECB. Without that financing they can not make their next payments and moreover, the CDS market will execute, spread and prove just who is not wearing underwear in this 2012 version of our 2008 financial crisis.

The CDS and derivatives issue is absolutely stupendous. If Greece CDS will be forced to execute then it will be the same for Portugal, Belgium, Spain, Italy and a host of other countries not to mention institutions…the mad rush for cash and liquidity will happen much faster than people think and will run into a brick wall as people realize that the is not enough money in the system to settle the transactions. Did you buy your dollars yet?

Friday, January 27, 2012

Tribute to 2008


A look at our EURO bounce and COT position data...

The reality is that when BIG traders put on BIG size they have a reason for it and all the prognostications about what happens when they cover…is a waste of time…because these guys are driving the market and they cover when at lower prices…not higher ones…we recently established a new high in EURO shorts…contrary to popular belief this is NOT BULLISH in any shape of form at this point.

So the rule is: short the first bounce after Speculators and Institutions establish record short positions and do the reverse for longs.

Wednesday, January 25, 2012

Addendum…

The fed annoucement amounted to a pretty big downgrade of everything. The bond markets generally agreed…which should have meant that risk markets would have traded down - NOT UP…especially since the Fed took out specific language realted to QE and asset purchases from their official language. In Bernanke’s press conference he referred to the asset purchase programs but it was removed from the official statement. So, it seems the leverage in these markets and the financial system is creating tons of wacky decorrelations…there are quite a few going on now…hopefully we can get a real market soon.

One thing to keep in mind is that a fed reaction, especially of this type is usually wrong - and many times it is also a large emotional catalyst for a subsequent and usually fairly immeadiate reversal. Also, worth noting in today’s horrible market action is that the Dow just barely made a new high this afternoon and the Nasdaq100, even with Apple, was unable to eclipse the morning high.

Rates play out...dollar recoil continues...

Dollar puts in a 5th wave down to neckline support as treasuries rally as anticipated...and totally contrary to JPM and Goldman's calls. Similarly, the dollar will playout as anticipated after this drawn out episode is complete which it very nearly is.

Currencies at war...

Tuesday, January 24, 2012

All bought out…with no where to go...

The dollar will rally as the market and financial system dissolves from within. There is little more to add.

There is a feeling that there is, as a friend and client put it to me “Nothing but Blue Sky”…I beg to differ with that perspective. There is a mammoth selling event setting up NOW. As you may or may not know by now, that is something I am prepared for. The market does not belong here. It has not belonged anywhere near here and its not going to be back here for a VERY long time. There simply are very few market participants who are available to be buyers, very few reasons to buy and very little security in doing so.

The Fed and central planners may desperately want to do QE…but they can not with the results of their engineering on display showing false success within equity and risk asset prices. We have reached critical mass. I will not post charts…it is unnecessary at tonight…as nothing has changed fromt he previous ones I have posted.

The corruption of leverage...

The Italian tax police was in the offices of ratings agency Fitch in Milan on Tuesday to carry out checks ordered by prosecutors investigating rival agencies Standard & Poor's and Moody's, a senior prosecutor told Reuters. 
"Men from the financial police are at Fitch in Milan," said Carlo Maria Capristo, chief prosecutor in Trani.  
The Trani prosecutors are investigating possible crimes of market manipulation and illicit use of privileged information when Standard & Poor's downgraded Italy earlier this month. 
As part of the same probe, they are also investigating the impact reports by Standard & Poor's and Moody's on Italy and its banking system had on markets and whether any crimes were committed. - Reuters
It is apparent that the cause of leverage and the need for more of it have caused freedoms to be challenged. Freedom of option, no matter how late, accurate, right or wrong is no longer acceptable unless the desire for the credit addict is fixed. Ordinarily, an action like this would scare the pants off any self respecting business or citizen...it certainly would scare the markets. However, the markets are on a drug addicted hangover and are deleveraging so they are no longer effected by information such as this. It does not matter that this kind of conspiratorial effort to keep the truth suppressed by any means is coming to a place near you. Not only that, how can your business or work be safe when you can, at the whim of some bureaucrat, be a part of a trumped up prosecution and find your accounts seized, your business and/or home declared a crime scene and your employees, neighbors or vendors used under threat to provide evidence against you...

What's more the markets just don't care...

Monday, January 23, 2012

Can you say MARGIN CALL...

Today, as with the whole ride up…we got more deleveraging. This time not only were we dealing with margin calls in equities but also in rates. EuroDollar rates contracts indicate lower yields yet 30 year treasuries indicated higher yields…that my friends translates to quite a lot of stress for people who manage their portfolios with these instruments…and that equals MARGIN CALL in rates and the end of hedged/pair based margin calls/deleveraging in equities that have been perpetually driving prices higher - specifically this has been an unwind of the trading books of insolvent European Banks. Next we will get to find out who they are. Say hello to 2008 Part 2.

Other things of note, the Dollar held a higher low and the Australian Dollar over threw to secondary resistance, Oil barely budged and Silver and Gold are doing nothing…there is a lot of info out there that is precisely targeting these markets - yet they are relatively motionless.

The target of 1,318 has been hit and the top for Equities is in and now people will have to start to get used to significantly negative yielding TBills as they break down out of their declining triangle.

Dollar kissing 50 day and neckline

As JPM and Goldman send everyone shorting Treasuries and ECB officials try to generate any good will towards the EURO by attempting to force Iran to buy EURO…both Treasuries and the Dollar are coming into support and likely will be bruising people expecting the popular outcomes. AUD is hitting my resistance lines exactly which gave it just a smidgen of upside and rates are getting very ripe in their patterns too.
Meanwhile, Equities are at their 2008 tribute line - I would like to remind that 1,318 was the target for the ES futures…and it appears we are getting right into that zone…welcome to the world of leveraged finance and central planning.

...and a rather interesting video of the European bureaucrats attempting to avoid answer any question that is harder than "what’s your name?". Meanwhile, the same UNELECTED officials can effectively and single handedly declare war on Iran and force them to buy EURO’s at the sametime…this stuff is not funny.
 
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