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Everything is connected… and the wires are tangled

Sarkozy: Do we know what we’re doing? Merkel: Shut the fuck up…

About two days ago I had a friend ask me for some help for an interview he’s got coming up. The guy he’s been connecting with sent him one of his weekly write-ups about the current economic/market conditions and told him that’s the sort of thing he’d have to start knowing. Here’s basically what I talked to him about (this will be a long post, I’m trying to be in-depth so anyone can follow).

For starters, the sovereign debt crisis in Europe is the most important thing going on right now. I’ll get into how it affects the US in a minute. Greece is the most likely default case of anyone right now, as CDSs on greek debt have about a 450 bp spread (i.e., expensive as shit to buy those CDS’s, b/c there’s a very high probability of default). The ECB/IMF/EFSF (European Financial Stability Facility) are continuing to pump money into its bond markets, as well as Italian, Spanish, and Portuguese bonds. Whether they think Greece will ever be able to repay this debt is almost irrelevant (they won’t), so these cash flows are being used to keep rates from ballooning and to stop a full on default. Worst case scenario is Greece defaults, which triggers CDS payouts (not good for the US), margin calls, and significant flight from European sovereign debt. The last part of course could see defaults by more important countries such as Spain and Italy, but that is less likely (I refuse to say highly unlikely b/c as you can see this shit has never really been seen before). The main problem is European banks, who hold a huge amount of these sovereign bonds. If we see a restructuring of sorts, or huge drops in bond prices, these banks will have to make enormous writedowns. After this, further possible events include major drops in equity and bond prices of these banks as investors flee from fear the banks will have liquidity, or even solvency issues. This of course is a classic self-fulfilling prophecy: investors fear they’ll lose big from these banks, so they dump them, which of course causes the actual problem they feared in the first place.

The US comes into this directly in two ways. First, US banks have written a colossal amount of CDS’s for European banks over the past 3-4 years. As of early July, we’ve sold $34 bln, $54 bln, and $41 bln in Greek, Irish, and Portuguese debt CDS’s alone. That’s not even counting CDS’s on European banks. If there’s widespread default (again, unlikely, but possible), then the US will be losing BIG on those payouts. The second way is economic rather than financial. Europe is one of our main trading partners, and if they enter a recession (probably will), we’ll be taking a big hit in export losses and possibly face import shortages as production slows down there. This also ties into emerging markets (esp. China), as expectations are quickly rising that we’ll see a pretty hard landing in a year or two. In other words, nearly every country is facing stagnant (or negative) growth for a few years, which… is bad.

For those who’ve wanted to actually stay in a good mood, and therefore haven’t watched the news in awhile, the main political/economic topics right now are the US debt level, and our struggling economy. Before I get into this, let me make on thing clear: you cannot solve a debt crisis in a recession. Whether or not the media/politicians have been playing up the debt situation, I really have yet to see any issues arise from the ACTUAL debt level itself. Obviously the track we’re on is unsustainable and blah blah blah, but I’m talking over the course of a couple years. Our gov’t is having no trouble at all borrowing money; the 10YR Treasury is still sub-2%… from a buy&hold/investment standpoint that is absolutely outrageous. It just goes to show that when the world is freaking out, everyone looks to the US.

As much as I hate to say it, the real issue is the political system. I’m not saying we need to raise taxes or cut spending or whatever the buzzwords are right now, I mean the political process is absolutely KILLING our economy right now. It took over half a year for the debt limit to be raised, literally up to the last possible moment. The next day, BAM! Equities plummeted and Treasury yields approached record lows (and to my utter disbelief, reached those lows a few weeks later). This of course wasn’t expected, as the pundits had been chirping “yields will pop as the world realizes we can’t repay our debt!”. Bull. Fucking. Shit. This isn’t a series of graphs relating debt levels to interest rates or whatever, this is real life. What’s more, we have an entire year before election season, and you can bet your sweet ass no politician will be willing to make the tough decisions if it means pissing off their voters.

The debt ceiling squabble was one of the most atrocious displays of leadership I’ve ever seen, and I’m not exaggerating. The hard decisions weren’t even close to being made. If I remember correctly, we raised the debt ceiling by about $1.5 trillion and promised to cut about $2 trillion over the next 10 years. I don’t even have to do the math to see that $2 trillion over 10 years is a joke when we’re projecting a $1.5 trillion deficit in 2011 alone. If anything, all we did was push the decisions off for another few months. The debt level itself isn’t the immediate issue, it’s the perception that our leaders are unable to make the necessary decisions to get the US on the right path.

This perception is twofold. On one side we had non-stop political bashing occurring all summer long, with both sides bickering over what should be cut, what’s off the table, and who’s to blame for our national debt’s recent surge. On the other side, we have a country who is on the brink of relapsing into recession (sidenote: I don’t know why, but I think the term double-dip is so fucking stupid). Unemployment is STILL above 9%, and won’t return to normal levels for awhile. What’s more, I believe the drop we’re seeing in equities is due to people realizing the Fed has run out of bullets. Which is another way of saying that their policies aren’t doing what they said they would. Rant:

Let me get this straight. The Fed is making sure rates stay low, which is a good thing to have. But jesus christ have you not opened your eyes? I’m usually agree with the Fed/Bernanke, but what the fuck. Rates are at all time lows! And nobody is borrowing! Not only are rates at all time lows, but they’re there without your doing. People aren’t arbitraging Treasuries, they’re using them as a bank. If we have another international recession, Treasuries are gonna continue to be the safest asset. So what is the point of more bond buying? Does buying the 10YR down to 1.85 from 2 and the 30 from 3.1 to 2.9 really do anything? Rates are there. Save the ammo. God damn.

Alright back to the main point, bulls are currently pointing to corporate profits and equity levels as the main reason why we shouldn’t end up in a recession. I think that that is exactly why we’re entering a recession. Corporations are preparing for the worst by hoarding cash and laying people off. The majority of them will weather the storm to come, but people as a whole are left out to dry. If everyone is scared to lose their job, they’re gonna take whatever pay they get and hold onto it. Which, ya know… doesn’t help the economy grow. The uncertainty that’s clouding everything is all hanging on one major thing–Europe. People are waiting for Merkel/Sarkozy/anyone to come out and save the day. Obviously if they had the strategy to end all strategies for fixing the European debt crisis, we’d have heard about it already. As of today, Germany has said they’re capping their bailout funds at 221 billion euros, which gives the EFSF about 450 billion euros when recapitalization is needed (for both banks and the various countries who will undoubtedly need them).

I’m pretty lost right now, so I’m just gonna end this here. I’ll go back and go through each area more in depth throughout the next week(s), but this is a dece start. As you can see, everything is connected, even more so than 4 years ago. My prediction: we’re not gonna see an end to this until the EU is literally on the brink of collapse. That’ll be an interesting time… hopefully I have a job by then.

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Lesson on risk reversal positions

I was reading a Reuters article this morning, and they mentioned how euro risk reversals are at a 6-month high, presumably because hedge funds are shorting the euro. For the sake of news, the euro has been unable to break the $1.4500 mark lately, and is at $1.4169 after dropping 271 pips today (.0271 percentage points). Good news for those who think the Fed is trying to inflate away our debts, I’ll be doing a post on that bullshit sometime soon (basically people who think that are fuckin’ morons). BUT, just reading that one headline I realized I have no idea what a risk reversal is for. So, I did some fuckin’ readin’ and now I know what it is. And because I took the time to read up on what they’re used for… I’m gonna spread some god damn knowledge on ya ass. For clarity, I’m gonna explain it as if my friend, Petrone, is bullish on Microsoft stock (he heard they bought Skype and thinks they’re gonna gain like 20 fuckin’ points or some shit).

So, Petrone hears about the Skype buyout and gets all excited about Microsoft stock. It’s at about $24/share, but let’s assume it’s $50/share for this example. Petrone thinks Microsoft is gonna enjoy a big rally and wants to go long the stock. But, he doesn’t just wanna have a straight-up position in a market as uncertain as today’s. So instead of just buying the stock for $24/share, he’s going to enter into 2 option contracts, this is the risk reversal strategy.

First, a quick refresher on the options he’ll buy. Petrone will go long a call option. Buying a call option means you pay a premium (say $5) for the right to buy the underlying (MSFT stock in this case, $50 right now) at a specified future price, the strike price (say $60), at or before the expiration date (say 1 year). If you are the buyer of the option you don’t have to purchase the underlying, you just pay the premium for the right to purchase it before the contract expires. So, when Petrone is long a call option, he’s hoping the underlying current stock price (spot) will be greater than the strike price before the option expires. If that’s the case, he can turn around and sell the stock he just bought for the market/spot price. If the difference between the spot and strike is greater than the premium he paid, then he’ll make a profit. In our example, if MSFT is worth $70/share at some point before the expiration, Petrone will make a profit of $5 ($70-$60-$5=$5) if he exercises the option at that point. He pays the premium when purchasing the option and the strike price when exercising the option, then sells the asset at the market/spot price and hopefully profits.

Now, in the case of a risk reversal, Petrone is going to short a put option before he’s does the above. Much like buying a call option, shorting a put option means Petrone thinks MSFT’s spot price will rise in the future. Again, the buyer of a put option pays a premium (say $5) for the right to sell an underlying asset to the seller of the option, Petrone, at the strike price (say $40). So, the buyer is hoping the spot price will fall below the strike price by at least the value of the premium, because then he’ll be selling the stock at a strike that’s higher than the market/spot price and will profit. In Petrone’s case, he’s going to be the seller of the put option, so he’s hoping the spot price stays above the strike price (the buyer of the put option won’t exercise the option, and Petrone will make a profit of $5, the premium).

The reason Petrone shorts a put option first, is so he can use the premium he earns from it, $5, to buy the call option at $5. So, if the spot price is originally $50 and never falls below $40 or rises above $60, neither option will be exercised, and he’ll break even. If the spot rises above $60, then Petrone will exercise the call option and make a profit of the spot minus $60. For instance, if 7 months after he enters both contracts the spot is $70, he’ll make $10 (spot-strike-call premium+put premium; $70-$60-$5+$5=$10). If the spot falls below $40, the buyer of the put he sold will exercise the option, and he’ll lose the amount it falls below $40. For instance, if 7 months later the spot is $30, he’ll lose $10 ($30-$40-$5+$5=-$10).

So, instead of just buying MSFT at a $50 face value, Petrone can make a synthetic long position with both a long call and short put with very little money to begin with ($0 in our example). Risk is reduced big time as you can see, and so is the possible reward. The increased leverage he can use more than makes up for the difference in volatility. If there’s a lot of volatility (spot goes ±$10) there’s a fat possible gain/loss with big leverage, but if there’s low volatility (spot above $40/below $60) there’s very little cost, if any.

Back to the original reason for writing about this, euro risk reversals are at a 6-month high. A high risk reversal means that the call option is more volatile than the put option. In other words, long positions on the euro/dollar are riskier positions than short positions. So, the risk reversal levels are good indicators of where an asset’s price is going, especially on currencies. In this case, the euro is not going to be doing well in the future.

… That probably made no fuckin’ sense.

US banks’ CDS exposure to Europe

Read this. The author, economist Kash Mansori, had to do a shitload of research to get these numbers, but it shows how bad things could be for the US in the case of European credit event. It’s some hard evidence that US institutions have just as much on the line as Europeans from a default by one of the PIGS.