The Insightful Trader


by on Jul.06, 2012, under Editorials

So now disgraced former Barclays chairman Bob Diamond claims that, at the behest of unnamed “Whitehall officials,” the Deputy Governor of Bank of England pressured him to go along with a scheme to get the headline Libor rate down below the lending rates banks actually charged. That’s right, the very day Diamond was to testify before Parliament in its Libor investigation, an exculpatory email just happens to surface.

For the moment, though, this email remains unverified. Deputy Governor Paul Tucker denied the story and offered to testify to his side of it.

If we assume Diamond is actually telling the truth (not always the right thing to do), then, I have at least two questions. First, which “Whitehall officials” would dare suggest to the BOE’s number two man, that he pressure bankers to commit what amounts to fraud? The Chancellor of the Exchecquer, or even the Prime Minister? If the email turns out to be genuine, we are talking about very big names rather than junior assistant flunkies.

Secondly, who would even come up with an idea like this? My money is on US Treasury Secretary Tim Geithner. Fed Chairman Ben Bernanke wouldn’t surprise me either.

This is pure speculation on my part, of course; as I say, the email is unverified, and neither of their names has yet come up in evidence. But manipulation of Libor would be very consonant with the Geithner/Bernanke policies of bailing out banks and keeping up confidence in the banking system.

Libor Certainly Matters Enough for Someone to Rig It

As many readers know, Libor (the London Interbank Offered Rate) is set daily by the British Bankers Association, from rate quotes submitted by the Association’s members. Many variable rate loan contracts worldwide, reset periodically based on the Libor rate. That’s why so many people have taken the scandal seriously.

I bring up Geithner for two reasons. First, he has certainly been a strong advocate for bank bailout policies both in the US and abroad. Second, a cornerstone of Geithner’s (and Bernanke’s) bailout policy, has been to make banks look more sound than they really are. In addition, low Libor is consonant with the Fed’s zero interest rate policy (ZIRP).

Manipulated Libor Rates Boost Confidence in Banking System

Bernanke and Geithner have done what they could to boost confidence in the banking system; that is what they were after, for example, when they ran the bank stress tests. They believe that if they can keep confidence up, the system will have time to heal itself. That’s one reason I would not be surprised if either or both of them acted to suppress Libor quotes.

Low quoted Libor rates exaggerate the confidence banks have in each other — they tell us that banks are lending to each other cheaply, rather than worried enough to charge a risk premium. That is a key point since financial contagion – the process by which financial distress spreads from one institution to another — has been policymakers’ number one nightmare since 2007.

Officials are keenly aware that contagion can spread, not only when one institution defaults on payments to another, but when the market begins to fear that might happen. Given that Geithner has opted to paper over the GFC rather than fix its root causes, he has ironically left the system far more exposed to contagion than would otherwise be the case. All the more reason, then, to encourage confidence any way he can.

Previous Attempts to Manipulate Confidence are Public Knowledge

Manipulation of the quoted Libor rate would also seem to be of a piece with the Fed’s manipulated “stress tests” that turned out to be a propaganda exercise proclaiming bank soundness, rather than a regulatory exercise to ferret out and correct bank weakness. And not just because monkeying with Libor is a similar confidence game.

After all, think about how a stress test works. The “tests” asked how banks would perform if the economy were to weaken again. And how do financial institutions fail? A lack of liquidity, the ability to pay bills NOW. In a crisis, when depositors withdraw funds en masse with just a few mouse clicks, liquidity gets squeezed rapidly. Low short term rates are a key indicator of liquidity. By artificially lowering Libor, bankers exaggerate the “liquidity” apparently available in the system. It’s another way for the bankers to say, “No problem, mon.”

Low Libor Rates Could be a Facet of ZIRP

Bernanke’s interest rate policy has been to create actual liquidity available to big institutions with his ZIRP. ZIRP has kept Treasury rates low across the curve. Low quoted Libor rates keep payments down for people who owe money based on Libor rather than on Treasury rates, even if they do not increase actual interbank liquidity.

Low Libor rates could also keep some bankruptcies from taking place during a crisis. So a low Libor rate is something Bernanke could love; it’s of a piece with his zero interest rate policy.

Still, Suspicions about Bernanke and Geithner Remain an Educated Guess Until Proven Otherwise.

Only British Government pressure has been alleged (and not proven) thus far, regarding Libor rates. No evidence of American government pressure has emerged yet. Furthermore, no one has yet proven (or disproven) Diamond’s email.

I’m just saying, that government pressure to lower quoted Libor rates would be extremely consonant with the bank bailouts that are so central to American policy. That’s why I will be watching to see if the e-mail proves turns out to be authentic and if so, how the idea of Libor manipulation originated. And if our doughty US policymakers actually turn out to have had a part in this, well, you heard it here first.

Disclosure: No positions in stocks mentioned.

This post has been updated.



by on Jun.06, 2012, under Editorials

by Jonathan Bernstein

Before the ink dried on last Friday’s employment report, lots of people who should know better screamed that the Federal Open Market Committee is “absolutely” going to initiate a new round of QE June 20. Not so fast.

When we think about this from the Fed’s point of view, as opposed to what we might want to see as investors, a new QE launch in June appears unlikely. While I don’t claim to know what the FOMC thinks, I’d expect June action only if Greece’s anti-bailout party, Syriza, comes to power in the June 17 elections and a crisis results. That possibility seems to be fading right now.

New QE in June Would Look Like Ready, Fire, Aim at the Fed

The Fed is a large and somewhat tradition bound institution. Despite its new-found, post crisis penchant for decisive action,  announcing a whole new QE program before the current Operation Twist concludes at the end of this month would not exactly make the Fed look good. Why admit that Twist failed to generate a self-sustaining recovery before even completing it?

Secondly, before last year, the Fed hadn’t hadn’t done much “Twisting” since the early ‘Sixties. In the normal course of events, if that still exists, one would expect the Fed’s Division of Research and Statistics to examine what today’s Twist did and did not do, before launching a whole new effort.

I’m not suggesting that the Fed will wait for anything like a definitive study here, there’s no way they have time. After all, monetary theorists traditionally say that the effect of Fed action takes around 18 months to cycle through the system, and the Fed won’t wait until 18 months after Twist ends, to start assessing it.

But when the Fed moves next, they will look better if Chairman Bernanke can explain clearly why he had to move and what his previous moves accomplished. It would be easier to make the case for yet more QE, with a retrospective analysis of Twist in hand.

Fed Has Reason to Hold onto its Ammunition Rather than Use It Up Too Quickly

Third, there is a strong argument, that the successive incarnations of QE have produced less and less of an economic bounce. If QE is producing diminishing returns, the Fed would want to hold its fire as long as it can, rather than get too early to the point where it is less and less able to make a difference. (Other than maybe to stock prices, that is.)

Fourth, while I have argued since August 2010  that the crisis has only been papered over, and not fixed (and more QE would just be additional papering over) the current statistics show current GDP growth of  about 2%. That is the the so-called “stall speed,” but not outright recession. I’m not sure the economy is weak enough to force the Fed’s hand right now.

Don’t Count on Election Year Stimulus to Bail the Markets Out

So if the Fed isn’t about to move, shouldn’t people be long stocks because “it’s an election year and you can always count on politicians to do whatever it takes to goose the economy?” Not this election year. The Constitution requires all tax and spending bills to originate in the House of Representatives, which the Republicans control.

I can’t see the House Republican leadership allowing any kind of stimulus bill out of committee this year, much less to the floor, unless the economy gets so weak that preventing stimulus would embarrass the Republicans. Rightly or wrongly, the President gets the credit (or the blame) for the nation’s economic performance, and why would Republicans make Obama look good?

Nor do I think Bernanke really wants to bail out Obama; Bernanke is a Republican, even though he was so apolitical in his former academic career, that few of his Princeton colleagues knew what party he belonged to before George W. Bush appointed him.  That said, Bernanke’s record shows that he does bail out banks.

If he launches QE, he will do so in large part because the Greenspan/ Bernanke Fed has confused its mission to protect the safety and soundness of the banking system, with a mission to protect banks’ profits and bankers’ bonuses. My point is, Bernanke will move for his own reasons, and not because he wants to re-elect President Obama, even if Obama might become Bernanke’s incidental beneficiary.

Indeed, Bernanke has little personal reason to care who wins the Presidency; it’s a decent bet that he remains Fed Chairman either way. Obama re-appointed Bernanke when he had the chance to appoint someone else. Bernanke’s proven bank-friendliness and Republican credentials may also appeal to Romney.

Buying QE—or Election Year Stimulus — is a Sucker Bet Here

Bottom line: the Fed will likely act after it has had time to get its post-Twist bearings and enough weak economic data come in to support its case. Investors who buy now on the premise of QE3 in June run high risks of disappointment; buying for election year stimulus also appears foolish.

The only reason to buy stocks is the obvious one: if you have a proven approach and the stocks meet your criteria. Betting on political events this year looks like a mug’s game.

Disclosure: No positions relevant to this discussion.

This post has been updated.

1 Comment more...

New Greek Deal is A Black Hole for ECB, Not a “Ring Fence”

by on Feb.21, 2012, under Editorials

by Jonathan Bernstein

As widely reported, the ECB has tried to “ring fence” itself from potential losses if Greece restructures its debt. Assuming the deal gets implemented as planned, the ECB will exchange its Greek debt holdings for new debt that will be repaid in full, while private sector bondholders of the same debt issues will get, as of this writing, about 46.5 cents on the Euro.

The deal might well enable the ECB to escape losses on Greek debt in the short term. But in the long term, this deal will force the ECB to provide more support to PIIGS countries than would otherwise have been the case. That’s where the black – or blacker – hole will be.

New Precedent in Deal May Drive Private Investors Away from PIIGS Sovereign Debt

Before this deal, the universal rule was that all holders of a given series or class of debt receive equal treatment in a restructuring, unless one of them actually transfers new money to the debtor (which ECB did not do; the deal rolls over existing debt so Greece can “pay” the debt that comes due next month). By discriminating so blatantly against private investors, the ECB has ensured that going forward, the ECB will become even more the buyer of only resort for PIIGS sovereign debt.

To see just how damaging this deal is, let’s consider how investors in distressed debt actually think. Assume we have a company or country that has some predictable cash flow stream, but the debtor owes more than it can repay. Job One for the potential investor is to determine, how much debt of each lien (senior, subordinated, and so on in the capital structure) that ongoing cash flow can support.

In restructuring you assume that debt will be written down to sustainable levels, so from there you can estimate what the payout should be for each class of lender when the debtor restructures. Allow for expenses of the bankruptcy, estimated wait time for the payout, and a cushion for uncertainty. Then apply your desired rate of return and see what you might bid for such bonds.

But once you assume that ECB will be untouched in any PIIGS restructuring, that will leave decidedly less for other bondholders. Therefore future potential investors in the debt of any PIIGS country will factor in the ECB’s de facto seniority above that of all other creditors and drop their bids accordingly. Moreover, after a drubbing like this, private sector investors may fear that the Troika could come up with other ways of separating them from their cash, leading private capital to doubt that Euro bond risks can be estimated at all. Under that line of thought, one can expect private investors to just stay away.

This is exactly what the Germans say they don’t want. The Germans know all too well what hyperinflation looks like, so Article 123 of the Lisbon Treaty prevents the ECB from supporting governments, since that smacks of money printing. If the ECB forgave a portion of the debt owed by Greece, that forgiveness would could count as direct support. Which is why the current deal precludes debt forgiveness by the ECB.

As Private Capital Exits PIIGS Debt Market, ECB (and Maybe Other Government Backed Institutions) Will Have to Make Up the Difference

But now ECB will buy even more PIIGS debt (and print more Euros) than it would have without this deal; it will just do so indirectly. Which will eventually make Germany unhappy, since the Bundesbank has the largest percentage ownership share of the ECB.

Even more than before, the only natural buyer for PIIGS debt is the commercial banks domiciled in the respective debt issuing countries. That is, the principal buyers for Italian debt will be Italian banks, and so on. If Italy restructures, for example, its banks will hold distressed sovereign Italian paper anyway, so they might as well play along for now

And how will the banks pay for the new bonds? Well, they will continue to borrow from the ECB via Long-term Repurchase Operations (LTRO).  So ECB support for PIIGS sovereign debt  will be even more entrenched; but this way Angela Merkel can tell her constituents that ECB is living up to its mission by lending to banks not countries.  Her taxpayers won’t send one Euro to those deadbeat Greeks!

For the record, ECB owns about E 219 billion of peripheral countries’ debt; LTRO borrowings total E 499 billion. But as LTRO outstandings grow, what could stop the ECB from deciding that sovereign bond collateral held by commercial banks and pledged to LTROs, might also become senior to bonds owned by private investors? Nothing that I can see.

In the Long Run this Deal will Hurt the Euro and Help Gold

In the long run this ploy will be bad for the Euro (lower international private sector inflows, for starters) but since investors already know about LTRO, it’s hard to know how much of that effect has already been priced in. In sum this deal might be one more reason to short Euros when they bounce, assuming you can navigate the daily headline noise; the gold market seemed to like the deal today as well. No surprise there.

This post has been updated.

Comments Off on New Greek Deal is A Black Hole for ECB, Not a “Ring Fence” more...

To Understand (and Trade) Today’s Volatility, Look at the 1930s

by on Jan.12, 2012, under Editorials

by Jonathan Bernstein

Yes, it’s true, “headline risk” explains volatility, at least on the surface. But no other news driven market of recent decades, had anything like the volatility we’ve sometimes seen since 2008. Think 1989-91, which included Drexel’s bankruptcy, and Iraq’s invasion of Kuwait. Or even 1987, where volatility reached extreme levels, but didn’t stay that way for long. Or 2000-01, where the Nasdaq had some very volatile days, but the other indexes weren’t affected nearly so much.

Only the Thirties saw so many big daily fluctuations, because investor emotion plunged and soared in the extreme from day to day, just like it has recently – only much more so then than now.

Volatility was Greatest in The Thirties; Only 2008  Looked Anything Like It

 If you don’t believe me, here are some numbers. In the whole period of 1989-91, the Standard & Poor’s 500 (SPX) had a total of only five – five! – days in which the daily price range exceeded plus or minus 3%. In 1974,  the S&P had only nine days in which the S&P moved more than 3%. Pretty gentle, considering that the market fell about 45% in 1973-74. In 1987, the total of high range days was also nine. However, when we look at 2008, there were 42 such days, just for one year. Quite a difference.

Since the SPX began in 1957, I use the Dow for earlier history. Of the 20 biggest daily percentage losses in the Dow’s history, nine of them occurred between 1929 and 1933. And of the 20 biggest daily gains, 15 of them occurred between 1929 and 1933— and one more in 1939.

Of course part of the reason for the big daily percentage gains (and losses) of the Thirties was that large point fluctuations had an exaggerated effect on the calculation of daily percentage moves, since those fluctuations were measured against a smaller post-Crash base. On the other hand, the ’29 Crash took the Dow down almost to turn of the 20th century levels, and we didn’t see many big daily percent fluctuations in the years 1900-1928. Even though that period included the Panic of 1907 and the post WWI market break of the early Twenties.

And how about this chart? To my eye, it looks as though nearly all of the 5 year period 1930-35, the two hundred day moving average of daily ranges held firmly above 1.5%, and even touched 2.51%. These days 3% is considered a big daily move but then that was not that much more than the average for at least one two hundred day period.

Investor Emotion is Exaggerated When Economic Collapse is Feared

So what links the Thirties markets and more recent  markets, to account for today’s volatility extremes? My answer is that in the Thirties, investors feared that things might all come undone, and that kind of fear has surfaced occasionally since 2007.  As we know all too well, when people are afraid of a US credit crisis (2008) or European contagion, they just sell all risky assets. And when investors think the danger has passed, buying panics happen instead. Investors really hadn’t acted like this since the Thirties.

I read the News from 1930 blog every so often, because it illustrates at least some similarities of market psychology then and now. Each of the blogger’s entries centers on excerpts from Wall Street Journal articles written on one given day in the Thirties, to show readers what drove markets at the time. And a recent entry from that blog, which includes WSJ snippets from September 25, 1931, could almost be ripped from today’s headlines. Fears about a break in sterling, which was an issue not so long ago. Fears of the US losing its foreign exchange reserves, which then consisted of gold held at the New York Fed. Big fluctuations in silver, driven in part from demand swings in India. No wonder the Dow fell 7.1% that day.

If you scroll down you’ll see the entry for September 24, 1931, when stocks soared 6.0%. That’s right, the Dow notched a 6.0% up day on the 24th, followed by a 7.1% loss on the following day. We didn’t see numbers like that in 2011, nor did we so much even in 2008. History hasn’t repeated itself,  but it has rhymed.

What news drove the September 24th buying? Again, the headlines look eerily familiar – other than the re-opening of the London Stock Exchange after a two day shutdown, at least. The American Stock Exchange (remember them?) lifted its ban on short selling, foreign currencies rallied, US workers took wage cuts. The more things change…

Just as an aside, bank analyst Thom Brown recently said on Bloomberg, that the banking sector’s beta is now about two; ie., if the S&P moves 1% up or down, bank stocks will move twice as much.  My explanation of this: when collapse is feared, bank collapse is feared the most. And when panic lifts, investors pile back into bank stocks. It’s hard to believe that not too many years ago bank stocks were considered staid dividend payers.

Deposit Insurance Keeps Volatility Down, At Least When Compared to the Bad Old Days

Of course the bank bailouts and massive liquidity injections (of which there is much to dislike) helped the markets regain their calm within months of the Lehman (LEH) bankruptcy. Just as important, though, is the fact of deposit insurance. These days, a frightened investor can go to cash and park it in an FDIC insured account, something we now take for granted. But until the FDIC began offering insurance in 1934, investors had no such comfort. Hundreds of banks blew up each year in the Twenties and the flow accelerated into the Thirties. And back then when banks failed, depositors often came out with nothing. One could find safety only by stuffing cash or gold in the mattress.

If we go back to our numbers on daily volatility we can also see that big percentage moves got noticeably rarer starting in 1934. Coincidence? I don’t think so.

Due to the FDIC, and Treasury’s new money fund guarantee, the 2007 money market panic that broke out after the Reserve Fund “broke the buck” was a walk in the park compared to Depression-era liquidity panics. A bad day in the Thirties could vaporize your savings, even if you had them in the bank. On the good days, fear of ruin would give way to fear of missing the mother of all bottoms, since investors well knew how cheap stocks were then. Today we see at least an echo of this.

What Traders Should Do

 While volatility has fallen off in recent weeks, I don’t think it’s gone for good. No matter which way the markets go from here, volatility should rebound; it’s hard to imagine really calm markets until we resolve the overhangs of public and private debt, here and in Europe. Therefore, those who like to play volatility should think about buying volatility while the VIX sits in the low 20s. If the trade works,  lock in partial gains when you can and hope to sell the rest of the position near the VIX resistance levels of recent months. Of course if this rally just keeps going (and some recent rallies lasted longer than I thought they would) the trade breaks even at best.

All the related instruments I know of have their tradeoffs: the VXX has the problems common to leveraged ETFs; VIX futures entail contango risk at rollover time, and theta eats away at option positions. But I do like the risk/ reward here for volatility longs. Conversely, shorting the VIX near last fall’s highs worked out well, and could do so again.

This post has been updated.

Disclosure: No position in securities mentioned.



1 Comment more...

The Cat and Mouse Game of Newbie Traders

by on Dec.07, 2011, under Education

I recently ran across an excellent article by a young analyst at a multi-national bank,  who also trades for himself and was immediately struck by his wisdom and insight, something that many traders don’t ever achieve. With his permission, I’ve reprinted the article below from his site named Streetcoup below:

The cat and mouse game of newbie traders

by Matthew Hagemann

We are here to trade trends on a consistent basis by simply following them. An ubiquitous urge, particularly among beginners, is to predict how markets are going to evolve in a given course of time. In fact, having predictions subconsciously leads to trading them instead of actual market conditions. They become so inextricably enmeshed with a trader’s bias.

If I were to review your trades of a given day, I would probably find numerous trades coupled with little proceeds you got from them. Such activity points out that you have been trading an expectation which failed to materialize. Second thoughts forced you to close a position before the market turned against you big time.

While the market wiggles and you take one loss after another, the experienced trend follower has been staying in his position during the whole time. No action was taken at all, but yet the trend follower ends up with a more advantageous position than the one who is being assertive. Why is that so? That experienced trader listened to the market and is thus convinced of his strategy, his bias, his position, his stop, even himself. Be more convinced of yourself. To avoid fearful closing of trades, you have to know why you are opening a trade in the first place, based on objective observation of price action. What is your rationale for going long or short? Every single trade of yours should be planned out with great care.

The majority of traders who begin with futures trading, choose to scalp out of fear and are so focused on the tiny wiggles that everything looks like an opportunity. We witness this behavior in various trading forums and online chats. What’s happening is subjective trading out of gut feel and fooling oneself with regards to progress made. This getting in-and-out every minute never seemed to me a paradigm for success in the long run. Let me attempt to redirect you to the right path if you feel that you still belong to this majority of self-deceiving traders.

Trading with the trend

 The market is a master in tricking the average person. Since one cannot predict markets – or turnarounds for that matter – another plausible explanation for hyperactivity (besides prediction) is that a trader tries to catch up with the market. He missed out on the easy move down and is now at a disadvantage. Consequently, the only solution that he can think of is to buy into every spike. He is hoping to participate in the move of the century which is supposedly coming any time.

This show turns into real comedy after the market has actually turned around. Now the trader is feeling left out all over again. He subconsciously reverses his habit, and keeps shorting on the way higher. He is playing cat and mouse with the market all day long, only to lick his wounds in the end.

What is a Trend?

We need to acknowledge that markets do not move like elevators, but like waves within a current. Uptrends will always be interrupted by frequent sell-offs, whereas downtrends will witness just as many rallies. What we focus on, is the overall current in the shape of trends because this tells us the path of least resistance.

According to the Dow Theory, an uptrend is defined by a sequence of higher highs and higher lows. A downtrend is a sequence of lower lows and lower highs. Trends become most visible in the 1H time frame. Look at the ES, for example, and you will surely get a clear picture of trends that you can take advantage of.

If a market is still showing a series of lower lows and lower highs, one simply does not go long in this environment. Buying is a much more challenging proposition because a long position will most likely fail sooner or later. This is due to the strong underlying market forces that are able to break support areas sooner or later.

At some point you may be lucky enough to have caught the bottom, but is it worth it? Let’s be realistic. Even if you did catch the perfect bottom, you have most likely exited prematurely out of fear of another sell-off anyway. So much energy is expended on catching turnarounds, resulting in so little proceeds while you could have it much easier.

Trends take time to shift from bearish to bullish. You will notice a shift soon enough once sellers stop selling where they are supposed to and buyers are cracking a significant resistance area.

Alternatively, regard price action from a psychological standpoint: Imagine yourself in the position of the buyer, then in the position of a seller. What would you be thinking in each case? Would you be contented with what’s happening in the market? What would you like to see to stick with your bias? It is a chess game. This thought process is very powerful because it gives you a more objective view on the market and makes you reflect on the price action.

Listen to the Market

Beginners focus too much on the random moves intraday, than the actual trend in the broader perspective. Trade those, and you will witness far greater success. It is evident that a trader gets confused every single trading day anew. Randomness has no logic, so do not seek logic in randomness. Start looking at the forest for the trees. My favorite time frame is the 1H. I do not look at anything shorter term. Random profits also create the delusion of real progress in your trading. You get random rewards playing craps, too. But that does not mean that you know what the dice are going to do at the next roll.

To escape randomness, you must feel comfortable with holding your position over night, even several nights. It is a common misconception communicated among beginners that you need to close your trade within the same day. Trends last more than a single day. They last multiple days to weeks, sometimes months. Why? Because public sentiment does not shift from one moment to the next but takes a long time.

To trade such multi-day trends, you will need to figure out which support and resistance area is of real importance, and observe the price closely at those areas. They will stand out visibly as a trend unfolds and your eye will be trained to spot them by the time. A break of such zone is a potential entry for a new trade. By trading longer term time frame trades, you will not trade randomness, but trends that sustain themselves over multiple days. A welcome side-effect is that your broker commissions sink drastically.

Only take action if you observe clear evidence for a reversal. Otherwise you are better off doing nothing and letting the stop-loss order work for you. A stopout should happen where the original reason for your entry is no longer given due to objective observation of price action – not your gut feel.

I hope you enjoyed and take to heart Matthew’s post. It’s excellent advice for any trader. You can follow Matthew at He has many other excellent articles.

Comments Off on The Cat and Mouse Game of Newbie Traders :, more...

Sovereign CDS: Goodbye to All That

by on Oct.31, 2011, under Editorials

by Jonathan Bernstein


In my view, it’s a good thing that the recent Eurozone deal has basically ended the issuance of CDS on sovereign credits. Why shouldn’t big banks and insurers bring back the forgotten art of credit analysis, and look carefully at what they buy?

I know, there is an argument that CDS allow some borrowers who might not otherwise be able to obtain funds, to issue bonds. But in the end, lending money to debtors who can’t repay ends badly for all concerned.

Sovereign CDS Exist to Make Possible Loans that Really Shouldn’t Be Made

If the Eurozone wants to help its poorer members, it should do so with outright grants or other funding that is workable longterm, rather than go through a lending charade. If it doesn’t, tell the truth and move on.

As many readers know, the Eurozone structured Greece’s 50% haircut as “voluntary” so that banks writing CDS on Greek bonds would not have to pay off. Having seen that, investors won’t bother buying worthless CDS “protection” for sovereign bonds going forward. Therefore sovereign issuers who can’t sell bonds on the strength of their own creditworthiness, won’t be able to scrape through by having underwriters issue CDS to cover the risk.

 A centralized CDS Exchange Would Be More Transparent But Market Size Would Have to Be Limited

Writers such as John Mauldin and Barry Ritholtz, to name two, say that we could reform the CDS market by requiring that all CDS be traded on a centralized exchange. They make a good point – an exchange traded market would be safer than the current system — but I have difficulty envisioning a deep and liquid market for exchange traded CDS. I’d rather explore ways to wind down existing CDS and ultimately ban them, but if you are going to keep them, I think the exchange traded model is the best choice.

Of course if all CDS traded on one centralized exchange, risk would be decidedly lower than in the current model. CDS writers would have only one counter party, the new CDS exchange, whereas banks now hedge by making canceling trades with other banks. This exchange traded model would also increase transparency, since the exchange and financial regulators could monitor CDS writers’ exposure in real time. The trouble is, that such an exchange could not easily protect itself from default risk in size. Let’s see how this would have to work.

Suppose you are chief risk management officer of this exchange, call it the CDSE. You’ve lived through the AIG fiasco and the Greek restructuring, so you know this much: if a large asset class gets unglued (MBS in the case of AIG, or PIIGS sovereign debt) many of the banks exposed will all experience liquidity issues, simultaneously. Lending would slow down and a systemic crisis would result.

Therefore, as the CDSE’s CRO, what would you do? You would make sure that the exchange traded CDS contract allows for very strict position limits, not only by each credit, but by asset class being protected. In this example, you would probably limit CDS writing on, let’s say, all sovereign credits that are not backed by a printing press, rather than just Greece, or even just the PIIGS countries.  And these limits would stand in addition to the more traditional position limits for each contract that each CDS writer would have to abide by. The maximum hedgeable size of the sovereign CDS market might well be smaller than the current outstandings.

Without strict position limits, the CDSE couldn’t count on the ability of the CDS writer to buy back the CDS he wrote, or to post adequate collateral, during a systemic crisis; unlimited position sizes could get unmanageable. In crisis mode the cost of the protection would skyrocket to some amount commensurate with the expected bondholder haircut. Buybacks would be prohibitive if they could be accomplished at all.

Furthermore, in a banking crisis, you might have to jostle with bank regulators (like the FDIC and its foreign equivalents) to get your mitts on the amount of cash collateral you would need to feel comfortable. Therefore you’d have your own, independent credit analysts monitoring the exchange traded credits, and you would be raising margin requirements rapidly at the first hint of trouble. You can’t afford to be unprepared when real trouble hits, and your margin policy would have to be aggressively pro-active in order to protect the market before a crisis broke.

In this your model would be the way Goldman Sachs (GS) demanded collateral from AIG before the 2008 crisis was obvious to everyone. And like GS, you wouldn’t wait for S&P or Moody’s to downgrade anyone you are exposed to.

I don’t want to overdo the dark side, but I’m harping on crisis conditions for a reason. That’s when sovereign credits often go bad, and in the last 30 years, we have had three such instances: Latin America in the early 80s, Asia in 1998, and now Europe. If you are planning a CDS product to insure against sovereign risk you have to think about crisis conditions before product launch, not after.

Banks Like CDS Writing When they Can Shift the Risk

Banks don’t like the idea of exchange traded product, because it is commoditized and commands lower profit margins than the current model of over the counter, custom product. Nor would banks like the idea of tying up large amounts of cash collateral when writing the CDS under a risk regime that would work for any rational exchange.

In other words, the obvious way to make CDS profitable for the bank – or at least as profitable as banks would prefer — is to shift much of the risk onto someone outside the banking system. In the cases of AIG (and probably the PIIGS), that “someone else” turned out to be the nearest taxpayer.

Which brings me back to my opening statement. If you are going to buy bonds, know what you are buying, because in the event of systemic trouble, credit enhancement may itself become as worthless as the bonds being insured. GS and its ilk were lucky and got bailed out in 2008 when AIG failed. On the face of it the European sovereign bondholders were less lucky, and while they might get bailed out too if the coming European bank recapitalization turns out to be favorable, we don’t know yet how that will turn out.




Comments Off on Sovereign CDS: Goodbye to All That more...

China Trade Bill: We’ve Met the Enemy and He is Us

by on Oct.20, 2011, under Editorials

by Jonathan Bernstein

China Trade Bill

 The China Trade Bill would impose a tariff on Chinese imports to the US in an effort to get China to revalue the yuan. The purpose of the bill is to reduce the US bilateral trade deficit with China. Its boosters, including Senate Majority Leader Harry Reid, say the bill could create 2 million American jobs it if it becomes law.

The China Trade Bill sailed through the Senate but its prospects in the House are doubtful. Speaker Boehner has said he won’t allow it to come to the floor for a vote – because he knows it would pass easily if it did. (Ironically the House passed the bill in 2010 but the Senate did not.)

While I think it’s a poor solution, the China Trade Bill addresses a real issue. The Sino-American trade imbalance can’t go on forever. At some point – when China is less dependent on the US market – China will be less willing to accept US paper in exchange for Chinese goods. If we let the situation go, eventually China will “fix” it, and do so on China’s terms.

Having said that, the bill highlights a major fallacy in how America approaches the rest of the world. The China Trade Bill would in effect tell China to revalue its currency at America’s pleasure. Not a great idea, because the Chinese can peg their currency wherever they want to, and they don’t care to be pushed around by other countries. The bill represents a swell idea for Chinese politicians to stoke nationalistic fervor at America’s expense. China has also threatened a “trade war” if the bill passes.

On the one hand, China’s threat of a trade war is less fearsome than it may sound. If trade between the US and China fell to zero, China, which runs a big trade surplus with the US, would lose far more in exports to the US than America would lose in sales to China. America might lose access to some goods it no longer produces, but eventually America could rebuild the manufacturing infrastructure it has lost and would come out stronger after doing that. China might buy less US treasury bonds but then again – there would be no bilateral trade deficit to finance, and the dollar would be the stronger for that as well.

What We Can Do:

On the other hand, America could — theoretically at least  —  do much more for our trade balance, and our economy, without provoking a high profile confrontation with China. In my view, the problem is twofold.

First, we must support the industries that are important to our future, rather than let China pick off its American competitors. We have to care about what industries America will be in, or we won’t be in them anymore. For example, Evergreen Solar set up its manufacturing facility in Devens, MA, aided by a $43 million incentive package it received from Massachusetts in 2008. In 2009 the company started shifting production to China, and shuttered the plant earlier this year. Evergreen CEO Michael El-Hillow stated that Chinese state-owned banks and municipalities had offered unbeatable assistance. Even though labor is far cheaper in China, labor accounts for only a small percentage of total cost, El-Hillow said. The partnerships with banks and municipalities actually outweighed the labor cost differential.

In addition, Evergreen said that while it cut its cost per watt of solar capacity from $3.39/watt in 2009 to $1.90 in the fourth quarter of 2010. Yet the Chinese undercut Evergreen further and were selling panels at $1.60 by then, and could produce them for a cost of $1.35.

Now, some  companies – think SolarWorld, which filed antidumping complaints yesterday, October 19, against China – believe that China gives its solar firms incentives that violate WTO rules. In their view, illegal Chinese subsidies are decisive in helping the Chinese companies cut their cost so much. Maybe they are right, and sometime within the next year US agencies will decide whether countervailing import duties are in order.

My feeling is, who cares? A year is an eon in internet time, and by then the Chinese will have solidified their advantages even more. In any event, Massachusetts could only do so much to hold onto Evergreen, and without Federal help, efforts at the state level were doomed to failure. With the concomitant departure of First Solar (FSLR) to China, anything the US eventually elects to do will be in the realm of playing catch-up.

I could give lots more examples, but perhaps one of the most egregious is that Pfizer shut its famed R&D laboratory in Groton, Connecticut this year, along with its equally distinguished British lab, and will shift much of its R&D to Shanghai. For many years, outsourcing advocates have maintained that America will not suffer much if “low level” assembly and manufacturing work shift abroad, as long as the “knowledge work” stays here. Well, now the knowledge work is leaving too.  What has the Obama Administration done about this? Well, not a whole lot.

Closing the Groton lab will do more than harm American competitiveness. According to Medpage, Today, the abrupt lab closure will in effect throw away irreplaceable knowledge and expertise in the area of antibiotics and other treatments to fight infectious disease. While this move might improve Pfizer’s short term profits, just how wise is it, given the increasingly serious problem posed by drug resistant “superbugs?”

My point is, tariffs can only do so much, if we have not identified and nurtured our key national assets before the fact.  Yes, that is protectionism, but then again, protectionism is what nearly all governments do these days. Leaving US firms to compete individually against China in an industry that China wants to dominate, is tantamount to kissing the US firms goodbye.

I don’t know what the solution is to what I see as the second part of our difficulty: US managements, in many instances, simply favor outsourcing rather than producing in the US, even when US production costs are comparable to costs to produce elsewhere.  For example in mid-2009, when GE needed wind turbine parts, a company named ATI arranged a deal to set up a plant in Michigan to make them. When Chinese companies made a counteroffer to GE, ATI was able to match the China price. Yet GE decided to source the parts in China despite this. Similarly, a quick search online will yield plenty of results where consulting firms will tell companies how to get their “globalization policy” up to snuff and where the opportunities are to outsource various corporate functions. As anyone who has spent any time in the corporate world can tell you, consultants dream up solutions that “confirm” the existing biases of their clientele.

Even more importantly, in the early 1980s, key business lobbies such as the Business Roundtable and the US Chamber of Commerce, shifted their opinions from favoring US operations to favoring outsourcing. And after they did so, US policy shifted that way too, resulting in such agreements as NAFTA and the WTO. It was this rewriting of trade rules that made outsourcing workable. If Corporate America hadn’t wanted outsourcing, it simply wouldn’t have happened.

The contrast with Germany and Japan is striking. Both countries remain export powers even though their labor is far more expensive than is labor in China. The difference? Again, I would submit, is that Corporate Germany and Japan, Inc. care about maintaining employment in their home countries, while Corporate America does not.

In other words, if Corporate America wanted to produce here, we still would be, and we wouldn’t need a China Trade Bill.  And because Corporate America does not want it, the bill will almost  certainly not become law — neither the Republican leadership in the House nor President Obama would dare offend campaign contributors that way. The bill simply gave Reid a chance to grandstand, before going about the business of enacting more job export measures such as the “free trade agreements” with Colombia and South Korea.

Comments Off on China Trade Bill: We’ve Met the Enemy and He is Us :, , , more...


by on Apr.14, 2011, under Editorials

Matt Taibbi’s Rolling Stone piece proves that the Fed hasn’t just fallen down on its job as a regulator because it has come to worship the banks it is supposed to regulate. It is now nothing less than bagman to the world, an agent for siphoning off the wealth that America earned the hard way over the centuries.

Before Greenspan’s 1987 appointment the Federal Reserve, for all its faults, was renowned for its rectitude, and for the prestige of the large cadre of economists who work there. It was the kind of institution that was an honor and (pun intended) credit to the United States. It was the kind of place that few countries could imitate, and added to the aura of the US as an “exceptional” country.

Some of us remember how economists used to debate Fed policy. Was the Fed able to damp the violence of economic cycles as it intended, or was it actually exaggerating them, being “pro cyclical?” Should the Fed use discretion in creating money or should it follow a rigid rule when it added money to the economy? During recession, how much stimulus should the Government apply through fiscal means (say,  creating temporary jobs through public works programs, remember that?) and how much through the monetary system at the Fed? We cared about whether the Fed was right or wrong, but no one doubted that the Fed was a serious place. Ph.D. candidates looked forward to the opportunity to work there.

Then Greenspan instituted his “put” and took the Fed down several notches, but its status was still redeemable. Until, as Taibbi shows, 2008. The Fed usurped the FDIC’s job then; it lent incalculable sums to keep insolvent banks running when the FDIC should have shut those banks down. But not only that: the Fed became an agent of petty corruption. Through the Fed institutions like Goldman Sachs and Morgan Stanley became America’s dukedoms, their partners’ wives the Eva Perons of our time.

Now the Fed has become a mechanism by which the country’s treasure is plundered for the benefit of oligarchs around the world and by which the dollar is being debased. In 1987 under Volcker the Fed was custodian of the world’s unquestioned reserve currency; now the Fed destroys that currency’s value and the wealth of anyone foolish enough to hold it.

Read the excerpts and weep, but the whole thing is worthwhile.

“In August 2009, John Mack, at the time still the CEO of Morgan Stanley, made an interesting life decision. Despite the fact that he was earning the comparatively low salary of just $800,000, and had refused to give himself a bonus in the midst of the financial crisis, Mack decided to buy himself a gorgeous piece of property — a 107-year-old limestone carriage house on the Upper East Side of New York, complete with an indoor 12-car garage, that had just been sold by the prestigious Mellon family for $13.5 million. Either Mack had plenty of cash on hand to close the deal, or he got some help from his wife, Christy, who apparently bought the house with him.”


“It’s hard to imagine a pair of people you would less want to hand a giant welfare check to — yet that’s exactly what the Fed did. Just two months before the Macks bought their fancy carriage house in Manhattan, Christy and her pal Susan launched their investment initiative called Waterfall TALF. Neither seems to have any experience whatsoever in finance, beyond Susan’s penchant for dabbling in thoroughbred racehorses. But with an upfront investment of $15 million, they quickly received $220 million in cash from the Fed, most of which they used to purchase student loans and commercial mortgages. The loans were set up so that Christy and Susan would keep 100 percent of any gains on the deals, while the Fed and the Treasury (read: the taxpayer) would eat 90 percent of the losses. Given out as part of a bailout program ostensibly designed to help ordinary people by kick-starting consumer lending, the deals were a classic heads-I-win, tails-you-lose investment.”


“The impetus for this sudden manic expansion of the bailouts was a masterful bluff by Wall Street executives. Once the money started flowing from the Federal Reserve, the executives began moaning to their buddies at the Fed, claiming that they were suddenly afraid of investing in anything — student loans, car notes, you name it — unless their profits were guaranteed by the state.”

In short, between 1987 and 2008 the Fed went from paragon to a joke, along with America. I’ve long agreed with Ron Paul that when the Fed took its extraordinary actions in 2008 it needed to be accountable, to be audited. But only now am I beginning to wonder if we do need to abolish it and start over.



Two Sectors Worth Watching

by on Mar.14, 2011, under Market Commentary

One of my favorite activities when I’m doing analysis is to track various sectors, and the stocks within, as I start to see movement in their relative strength. Although I have many tools to set up watch lists, Finviz Elite has become one of my favorites due to intraday pricing and quick pop up charts. I can set up an unlimited number of portfolios that I can quickly scan during the day.

Two groups that have seen exceptional movement in the past several weeks have been the solar stocks and natural gas stocks. Although energy stocks have been one of the strongest sectors in the market this year, even allowing for the sharp sell-off the past week, solar stocks which tend to generally follow to some degree, have been getting annihilated. Natural gas stocks have performed very well considering natural gas itself has been relatively flat the past month.

Solar stocks have recently been hurt somewhat by certain legislation and changes in reimbursement policies in certain European countries. Because of that, certain companies have lowered guidance in the near term. However, it’s hard to believe that legislation in a couple of countries has accounted for the drastic sell-off we’ve seen across the board. As you can see from the chart below a portfolio of most the well known stocks is down nearly 19% in less than 30 days.

For a larger image –

My thoughts on this sector are several: What’s causing this extreme dichotomy in this sector versus energy stocks in general; Some of these stocks are nearing or are at intermediate support levels; With potential nuclear problems being manifested in Japan at the moment, will this help revive interest in this sector. Therefore is it time to be doing some selective buying in this sector for a potential bounce or are solar stocks just the leading sector in a potential correction in the entire energy sector.

One sector that has been improving in the energy sector is natural gas stocks. Just a few of many that I’ve been following are below:

Click here for larger image – 

As you can see this portfolio was created on the same date as that of the solar sector above, but with drastically different results. Even thought the SPX is down approximately 3% this sector has risen nearly 6% in the past several weeks.

Comments Off on Two Sectors Worth Watching more...

China, Where Foreign Owned Companies Go to Die

by on Jan.20, 2011, under Editorials

Corporate America thinks that China is the future, the place to make a fortune. They are dead wrong. China strongly prefers that Chinese, not foreigners, make money in China. The country’s usual practice is to require foreign firms to transfer valuable technology to Chinese partners, and then make life difficult for the foreign firm if not take over its business.

While some high profile US companies like Apple (AAPL) and Coke (KO) do well in China, at least for now, they are exceptions. Most firms looking to produce in China should remember this: casinos need some lucky winners to lure in the suckers.

China rolled out its trade policy in the Nineties when it established a modern aviation industry at the expense of McDonnell Douglas (remember them?). It’s a story worth recalling because the McDonnell disaster – or smashing victory, from China’s viewpoint – has been the template for the China “trade” ever since.

The McDonnell Douglas Disaster

When the US and China renewed their contacts in the Seventies, China coveted a world class aircraft industry. China’s own aviation technology was horrendously backward then. They even made airplanes out of steel.

Under Deng and then Li Peng, the Chinese planned to catch up. They would play the Western firms off against each other and get them to hand over to China a century’s worth of aviation know-how for the chance – just the chance – to compete for the “limitless” Chinese market.

Neither Airbus nor Boeing caved, even though each was afraid that the other might give up enough to get an inside track in China. There was a third, weaker player, though, which would give the Chinese what they asked for in exchange for one last shot at corporate survival: McDonnell Douglas, whose storied history had included the world’s first real commercial airliner, the DC-3, and the F-15, which for decades helped assure America’s air superiority.

McDonnell had already fallen behind Boeing to a weak number two position in the US when McDonnell Douglas China began producing airliners in 1985. Through the Eighties and early Nineties China dangled the possibility of big sales that McDonnell could make to Chinese customers. The deal between McDonnell and its Chinese joint venture partner went through several iterations as negotiations continued.

In the end McDonnell Douglas China produced a total of 35 planes between 1985 and 1994. And China got what it wanted: McDonnell taught the Chinese to build advanced commercial airplanes. Considering the amount of sales McDonnell got out of the venture, that deal was an absolute steal for China.

China had no compunction about squeezing McDonnell ruthlessly for even stiffer terms, though. China demanded, and got, a $5 million side letter under which McDonnell exported to China in 1994 a number of machine tools that fell under the category of sensitive military technology. Under the export license granted by the Commerce and State Departments, the tools were to be used to make only civil aircraft at Shanghai, but, in an episode one might characterize as James Bond meets Keystone Kops, things turned out rather differently. (Then again, who were we kidding when we exported such things to anyone other than a longtime ally?)

The tools ended up in factories located 800 miles southwest of Shanghai. The tools were so large they would not fit through factory doors; buildings had to be built around them. Not the sort of item that is easily misplaced. The Chinese went to that trouble for a reason.

According to a federal indictment handed up in 1999, McDonnell knew that China National Aero Import Export Corporation (CATIC) would divert the machine tools purchased from McDonnell to plants producing advanced weapons such as Silkworm missiles. A CATIC division pleaded no contest to charges of violating US export laws in 2001.

After the 1994 machine tools purchase, McDonnell Douglas China sputtered; nothing came of the “firm” order for 20 more planes McDonnell announced at the 1995 Paris Air Show. The paltry sales from the joint venture proved far too few to make a difference to McDonnell. Boeing acquired McDonnell – or what was left of it — in 1996. Even then China had the gall to protest the merger, saying it didn’t want a Boeing-McDonnell combination that would “exert market power” over the aviation industry.

The McDonnell Treatment as Standard Chinese Policy

The Chinese have used similar tactics ever since McDonnell got sold; no need for them to change a winning game plan.  Some headlines from just the last three months:

  • Train Makers Rail Against China’s High Speed Designs WSJ, November 17.  A virtual rerun of the McDonnell saga. China “invites” Japanese and European companies, into its high speed rail market, apparently misappropriates their technology, then gives the big contracts to domestic manufacturers.
  • China Wins in Wind Power, By Its Own Rules NYT, December 14. Foreign wind power generation equipment makers with plants in China slowly getting squeezed out of the market after having given their know-how to Chinese companies.
  • Then there’s the White House Fact Sheet on Commercial Relations (h/t Taylor Marsh) prepared for Hu’s state visit. It is a list of deals that will supposedly make money for Americans in China. The great bulk of them are agreements to transfer US technology to China in exchange for sales in China. Our President naively or cynically trumpets these deals as accomplishments for the United States. Just how do we expect those to turn out?

Some readers have told me that foreign companies “should transfer technology to China as a condition of market access, otherwise it is neocolonialism.” On the other hand, China is now the world’s largest economy when measured by purchasing power parity. It is itself arguably a colonial power by virtue of its Southern Hemisphere mineral reserve purchases. And China aspires, not just to power, but pre-eminence as it angles for the yuan to get reserve currency status. Why should China still receive the coddling customarily given to weak developing countries?

The Lesson for Investors

For investors the lesson is simple. Companies that manufacture in China risk their intellectual property and even their whole business. While China looks like a wonderful customer on the surface, in reality the Chinese play a very long game and the short term profits China offers to foreign suppliers can come with nasty surprises on the tail end. The “market access” they offer in exchange for technology transfer can prove to be as elusive as that green light Gatsby could never reach.

The NYT article details just how much trouble wind energy equipment makers got into when they went to China because they “just had to be there.” No, they didn’t. As McDonnell and countless others have learned, it may well be that “there’s no there, there.” Except if you are Chinese.

Disclosure: Avoiding companies that manufacture in China in favor of natural resource companies that sell to China.

1 Comment more...

Looking for something?

Use the form below to search the site:

Still not finding what you're looking for? Drop a comment on a post or contact us so we can take care of it!


Links That May be of Interest: - excellent articles about trading psychology and strategy has daily stock ...