Wednesday, March 12, 2008

It's just a dead animal

Rumors that Bear Stearns was having liquidity problems sent the credit markets reeling on Monday, and briefly had Bear's stock bucking yesterday's dramatic rally. I heard (could not confirm) that Bear CDS briefly hit 1,100. By late afternoon it had settled down to about 600. On Friday Bear CDS was around 465.

Now I'm not here to say whether Bear Stearns has liquidity problems or not. The recovery in both the stock and bond market for Bear paper would indicate that they probably don't. But this kind of panicky trading is exactly why its hard to own financial bonds right now. I mean, anyone who had traded through bear markets knows that the rumor mill becomes very active. Right now everyone is nervous. The longs are nervous because they've been losing money and/or under performing their index for months now. I'm sure there are many portfolio managers and/or traders worried about losing their jobs over poor performance.

The shorts are nervous too. Right now corporate credit spreads are at all-time wides. That means that getting short a credit is expensive to begin with. For example, if you assume Bear Stearns CDS is at 600, that means it will cost you 6% of your notional bet annually to short Bear Stearns. In order to make up 6% in carry costs, you need something like a 175bps widening of the CDS spread. Now obviously 175bps of widening is possible given that it moved to 1,000 in a day, and if the move happens quickly then you don't incur the whole 6% in carry costs. Still, it comes to the point where you have to really bet they are going bankrupt, not just going to have problems.

On top of that, with spreads at all-time wides, the shorts know that spreads (speaking generally) are bound to tighten at some point. When this might happen is any one's guess, but its clear that the risk/reward of a generalized credit short is getting harder and harder.

So amidst all this nervousness, it seems that Wall Street starts giving more credence to rumors. In the last 5 trading days we've gone from a rumor that Treasury was going to guarantee GSE debt (scaring the shorts) to a rumor that Bear Stearns was teetering (scaring the longs) to a rumor that WaMu would get a capital infusion from Warren Buffett (scaring the shorts again). Look for more of the same in the coming months.


Anonymous said...


re: yr previous post on WaMu, do you still see any significant changes from what you wrote exactly 3 months ago?
Many thanks

Accrued Interest said...

The only thing that has changed for the better is persistent rumors that WaMu will either be bought or get a large capital infusion.

In general the housing market is worse since November and risk aversion is higher. Obviously the stock is lower and the bonds are worse.

I think the trust issue is still there. Did you read about the exec comp modification they made???

Anonymous said...

On a technical note, I will admit to a great deal of confusion regarding CDSs on CIT. The five year swap is now 1,000+ bp ... and try as I might, I can't find a good rationale for this in the financials. Elevated, yes ... 1,000bp, no.

I don't think it's insider knowledge of a credit-unfriendly restructuring - they've been too high for too long.

All I've been able to come up with is the idea that the recent spike is due to forced buying from insolvent CDPOs. Have you heard anything?

Accrued Interest said...

James: I really think a lot of companies are suffering from unwinds of various leveraged credit bets. I also think there is a lack of natural buyers of credit risk in the CDS market right now. Yet between fast money and leveraged unwinds, there are plenty of sellers.

There are lots of situations where the actual cash bonds have not moved in conjuction with the CDS. I haven't followed CIT enough to say whether this is the case with them, but it tells you that the day-to-day movements in credits have a lot to do with technicals and fast money and not a lot to do with real money trading.

Anonymous said...

Nothing the Fed has done to date has changed anything. Insolvent players are still insolvent -- if they can get a dealer to give them access to the Fed, they can remain leveraged for the time being... but remaining over-leveraged doesn't fix anything.

The markets went up basically because the Fed gave a bankrupt guy a new credit card? This speaks volumes about the state of denial the market is in.

There are still a lot of insolvent players, and they need to be allowed to fail. Any trading book will tell you NOT to answer margin calls and your first loss is your best loss.

The Fed inexplicably is doing the opposite -- in effect bleeding healthy financial institutions to death in a fruitless effort to save everyone, even the foolish who failed risk management 101.

People are complaining that CEOs get paid $30 million when they do a good job, and $29.9 million when they do a bad job -- pay for performance is just a big lie.

Wall Street is doing the same thing. If you trade well, you make a killing. If you don't, the Fed bails you out -- even if your mistake was gallactically stupid.

You cannot restore faith in capitalism by practicing cronyism.

Anonymous said...

when you say technicals are driving the market, you mean to say that they are driven by rumors and mood?

Accrued Interest said...

No by technicals I mean people buying and selling as opposed to fundamentals changing. For example, when a hedge fund liquidates their portfolio and it causes the market to move, that's technicals. Nothing fundamental has changed. Or a rally that's just short covering. That's technical, not fundamental.

Now one might argue that the hedge fund has to liquidate because the fundamentals are bad, so you can't just dismiss technical movements as meaningless. But you want to be careful putting too much weight on a technical move.

Anonymous said...

Are CDS spreads cointegrated with equity or option prices. I seem to recall Lehman had an 'ESPRI' model that showed equity prices can lead corporate bond spreads. Is there any relationship in the CDS markets?

insideout said...
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