A market fallacy

And now some graphs that are not funny at all:

You will have read that the press has reported with delight how short-selling has been banned by regulators in the US and the UK. Everyone is happy now. As if this was so simple!
True, a few hedge funds have been burnt and the margin/collateral calls at close today will be absolutely phenomenal, which means a nice injection of cash for the investment banks by the way, what a coincidence! Talk about taking from Peter to pay Paul?

The press, the politicians, the media, the regulators, etc, are now very satisfied that short-selling has been banned. But I can tell you just now (well, it is not me really, it’s those clever chaps at the FT.com Alphaville) that this is not going to resolve the current market turbulence. Not a chance.

Today was triple witching. Today people have rolled over contracts on the assumption that government support will continue. But it can’t and it won’t. When the whole thing explodes, it is going to be a bloodbath. This is quite scary.

Cartoon friday

Man: "If this crash had been caused by Bin Laden, right now we would be bombing out some Muslim country"
Woman: "Thank goodness that it has been caused by American patriots"

Spanish democracy revisited

Well, let’s not get the collapse of the financial system distract us from what the Spanish state does to those who challenge their (Spanish) nationalistic dogma.

In the last few days, the Tribunal Supremo, a legacy high court inherited from Franco’s regime has outlawed two political parties.

Yes, it is not a mistake. In a member state of the EU, political parties are banned. Particularly if they tend to be Basque pro-independence parties.

This is a strategy that successive Spanish governments have pursued for years. Outlawing political parties so support for independence, for a change of the status quo cannot be measured in the polls. By banning all political parties representing the pro-independence socialists, Spanish officials attempt to rig the electoral process, prohibiting a significant section of the Basque people to vote for the party of their choosing.

This is democracy, Spanish style.

I have written about it before.

February 2004
March 07 and again
July 07


For as long as Basque voters are denied to vote for a socialist pro-independence party, Spain is a half-baked democracy unfit to be a member of the European Union.

Yet, as I have written many times, fascist and neo-nazi parties are allowed to participate in the electoral process. What a fallacy: Spanish democracy.


Links:
Avui and Vilaweb (Catalan)
Publico (Spanish), again.

Risky times

Never seen this before in my life:

The graph above shows the overnight USD Libor rate. This is the annualised interest rate at which financial institutions lend funds to each other for a period of one day.
In one day, it trebled from about 2% to 6%.

It implies that the risk of default of A rated (or above) financial institutions that operate in this market has trebled overnight. Talk about efficient markets and rational investors.

Then, Morgan Stanley brings forward one day the announcement of quarterly results. And they look quite decent –if we trust the numbers, that is:

http://www.morganstanley.com/about/ir/shareholder/3q2008.html (PDF)

I know fully well the Firm is on the ball like no other outfit, but these results are surprisingly, suspiciously good. Share prices jumped about 20% in the after hours market, according to the FT. At exchange close however, they were down about 10%.

But the CDS 5Y tells a different story. After Lehman Brothers filed for bankruptcy, many financial CDS spreads have widened to below investment grade levels.
This is Morgan Stanley 5Y CDS curve:

Note: The graph is only upto yesterday's close. It does not include today's highs of 700bps.

It is a frighteningly similar curve to the one Lehman Brothers was exhibiting last week.

Tomorrow we will see what the market really thinks of Morgan Stanley's results.

Today the FED left the base rate at 2%.

In the UK, HBOS is on the receiving end of the market ire. Its 5Y CDS looks like that:

You will notice that the price of the CDS is lower than in many other financials.

HBOS recapitalised a few weeks ago to the tune of approximately £4bn.

The FT has a good article about it.

In my view, the loan/savings ratio is relatively high compared to peers at 177%. But is funding mix, is better than many others, with 55% of funding coming from retail deposits. The problem is going to be the refinancing of the debt maturing in the next few months. And that is the problem.

Given the recent market volatility, there is a real danger that insurance and fund management companies will pull out of the money markets altoghether. Money market is not only overnight or term deposits, Certificates of Deposit and Commercial Paper. It is also the crucial repo market, including the tri-party agreements now so common.

If money managers withdraw from the short-term money markets, firms like HBOS will find it impossible to refinance their short-term debt. It will be absolute pandemonium.

I hope that the ABI and the IMA, together with the Bank of England the the FSA and their international counterparts get together to draw a plan to prevent paralysis in the money markets. Otherwise, we are facing a financial crisis much, much bigger than The Great Depression.

Fasten your seatbelts

This is going to be more painful than we all thought: Lehman Brothers (LEH) has gone bust.

For the best, detailed coverage, read the FT.com website.

For a high level summary, get your news from the BBC News website.

This is the biggest bankruptcy in history.

• On Monday last week, you could have bought protection for Lehman Brothers at about 350bps. Sadly, I did not: I am not Nostradamus.
• On Tuesday it was about 500bps. I am not Nostradamus but I can smell blood.
  Rab said, "yes, I do".
• On Friday it was about 900bps but nobody was really selling. The game was up.
• On Monday, LEH files for bankruptcy protection, a credit event, letters are being exchanged and the CDS contract is triggered. In a few days, the post-default recovery value will be established by a panel of ISDA members. Bond holders will deliver the bonds, physically, to the protection sellers, and these will pay up the nominal value of the bonds. If you bought the bonds at discount to face value, the capital gain could well be over 10% of the nominal for subordinated debt.
• The seller of protection swallows the defaulted bonds in their balance sheet and becomes a creditor to LEH.
• As we say in Catalan, "bon vent i barca nova!" or "See youse later!"

And the question is: who is next? UBS, Deutsche Bank, Morgan Stanley, Barclays?

If your fund manager has not bought CDS protection by now, it's probably too late. Corporate bond funds overweight financial bonds are going to suffer capital losses in investment grade bonds. The credit rating agencies have proven to be incompetent and unfit for purpose. The EU will get their way and will ensure CRAs are properly regulated, like it should have always been.


This is not going to be a quick adjustment, a blip, as the usual cheerleaders of excess are claiming:

Our view: On balance, we believe that the worst is now over for bank
debt as an asset class, but this does not means that some individual
organisations may not come a cropper. Indeed, respected
US economist Kenneth Rogoff has stated that there is a high
probability of a "high profile casualty" amongst the US banks.

We just had two casualties in one weekend, all powerful Lehman Brothers (apparently the best algorithm trading and risk systems) and all-mighty Merrill Lynch (apparently biggest equity capabilities), and AIG seems to be next. For retail investors in open-ended vehicles, the pain of mark-to-market values of debt holdings will last for a while. If your fund is overweight financial equities, I am really sorry for your loss.

I believe we are going to see a reshaping of financial institutions that was unthinkable two years ago. Many of us, not least the FSA (as published in their Financial Risk Outlook 2007), were expecting a repricing of risk, and an increase in risk premia. We adjusted positions accordingly a long time ago. But this is just something else. Highly geared banks dependent on wholesale funding will see their value destroyed. Not even senior debt holders are safe. The CDS market is going to be tested in a way nobody predicted. Good luck to all those participants who bought protection without holding reference assets. The scramble for post-default bonds will push their value above recovery price. The promise of "best endevours" of cash settlement are worth as much as LEH shares. It is going to be a once in a lifetime event.

If you are lucky enough to have serious money (+£100k) invested in cash deposits and savings accounts, I would urge caution. Check out your financial regulator website and find out how much your national deposit protection insurance actually covers. In the UK for example, only the first £35,000 of savings held in a bank account are guaranteed. If you have much more than that with one bank, you should spread the risk by opening savings accounts with other institutions.

Russia’s way

The cat is out of the bag.

Let's recount.
An independent journalist, murdered. A bit of blackmailing regarding energy resources.
After a neat exercise of ethnic cleansing, follows an unnecessary invasion and occupation of a neighbouring sovereign state, and destruction of its military and civil infrastructure beyond the conflict area as a punishment. And a lesson for others: Ukraine.
You set out the rules of the game. States with Russian nationals are within the scope of Russia’s military activity. If I was the Ukrainian, Estonian, or Latvian government, I would be very worried indeed.
Another journalist, murdered.
A chilling threat.

I am no fan of the US foreign policy, as I wrote about in a previous entry. But Russia’s strategy and actions are frightening. Whatever the flaws about the USA’s government, standard of democracy and society cohesion, Russia is not the counterweight the world needs, despite the usual suspects' retorts. There are many people who are nothing more than resentful and bigoted souls whose hatred of the US blinds them to the authoritarian and antidemocratic nature of the Russian government. In their misguided ignorance, they think it is a “good thing” that someone is challenging America’s pre-eminent role in world politics and economy.

These are going to be difficult times.

If you are invested in an “emerging markets” mutual fund, either equities or bonds, I would encourage you to reassess your positions. Many of us have already done so.

If I had time, I would write what I really think about the term "emerging markets". A very nice euphemism for "undeveloped" or "mildly corrupt" countries.
Fasten your seatbelts.

Whose right is it?

Amidst all the noise regarding the events in the Caucasus and the Balkans, the western media is doing a very good job in dumbing down the Georgia-Russia conflict as if it were a simple choice between the goodies (the West obviously) and the baddies (Russians of course).

Many others have written endlessly about the authoritarian nature of the Russian government, and its lack of democratic credentials. We could write about the Georgian president and his miscalculation. We could write about the Ossetian militias and how Georgians have been driven away from Abkhazia and South Ossetia in a tidy exercise of ethnic cleansing. We could write how the Russian government caricaturises the Georgian President as some sort of crazy despot, despite Georgian elections being overseen by the OECD, unlike Russia. We could write how it is Georgia’s turn now, then it will be Ukraine and Crimea, then Poland’s energy dependency on Russia, and after that it will probably be the Baltic Republics’ (Estonia, Latvia and Lithuania) turn.

But not many people is paying attention to the key socio-political issue: the selfish manipulation by states of the debate on the right of self-determination versus the principle of territorial integrity.

In the last few months, we have seen how the Russian government comes out to defend the territorial integrity of Serbia, against the right of self-determination of Kosovar people. A few months later, they send troops well inside Georgian territory to defend the right of self-determination of South Ossetia and Abkhazia, without a care in the world for Georgia’s territorial integrity.

It is the exact opposite with the western states: support for the right of self-determination in Kosovo but deny exactly the same right in South Ossetia.

And the fact of the matter is that neither the West or Russia can claim the moral high ground. Both sides have switched from defending one right to supporting the other. Their positions are not based on a consistent ideological framework, but driven by geo-political and economic considerations.

The outcome however, has been the same in both cases: the right of self-determination has succeeded in both Kosovo and South Ossetia.

The lesson of the last few decades in Europe is that if there is "on the ground consensus", and some degree of external help, in the end it is the people’s right (self-determination) the one that prevails above the right of territorial integrity of states. It is also a confirmation of the politics of fait accompli: whatever happens on the ground becomes the new status quo and the new accepted reality.

But the right of self-determination does not always reign. If in doubt, ask the Kurds, who have no external support whatsoever for their cause and must be the largest and most fucked up stateless nation in the world jointly with Tibet. 

The question is: will the Russian government do the same trick in Crimea? My answer: yes, without a doubt.

An imaginary Russian tale

It feels a bit miserable to write about this, but it was always going to be a winner. In a perverse way, I feel quite smug.

Free financial markets training by Rab:

For a place like Russia, there is no need to hedge corporate bond exposure with its correspondent CDS; it is much cheaper to hedge it using Russian Sov CDS.







I am torn between my fiduciary duty to investors (wait before insulting me: it could be your pension) and personal ethics. Is it morally acceptable to indirectly profit from political risk (war) to directly benefit future pensioners? I somehow think, or want to think, it is, but what do you think? Would you be happy if your pension fund had benefited from the above strategy?

My actions have not been and are of no consequence to events in Georgia but I somehow feel uneasy. Why? Am I just being a pussy with a conscience or I am just trying to justify my own misplaced post-leftie legacy guilt by writing about it...

This communication is not directed at professional investment advisors, retail investors or any other market participants or pesky journalists. It should not be distributed to, or relied on, by private customers or anybody else for that mattter. The information in this article is based on my own understanding of the historical, current and future positions of the markets, and not that of my employer or my colleagues. The views expressed should not be interpreted as recommendations or advice by anybody or as an accepted or rejected house view.
Past performance is not a guide to future performance, but we only brag about it when it is good. The value of investments and the income from them may go down as well as up and is not guaranteed, and if you invest in Russia or any other emerging market you do need to think about hedging your risk in anyway you can because these places are generally a mess.
If you want to take a punt, just buy Euromillions tickets and do not gamble your money in the financial markets thinking that you are going to beat the market consistently over the long term.