Saturday, February 28, 2009

Bankrupt Lyondell Wins Reprieve as DIP Approved, Bondholders Doomed

On Friday afternoon Judge Bobby Gerber, who has yet to bitchslap his wife for showing up home late, approved Lyondell's DIP loan, preventing sure liquidation, but likely dooming unsecured creditors to zero recoveries on their claims. As expected, Gerber said "The debtors absolutely need the funding and without it they would liquidate." Curiously, Gerber gave an indication of the tsunami (to use the parlance of our times) of bankruptcies coming up, making the only condition to the DIP flexibility of when he will hold hearings citing “terrible economic times” that have increased his case load. It is a sure lagging indicator of a depression when bankruptcy judges have to work 24 hour days. Demonstrating some judgian humor, Gerber said "If lenders don’t like it, they can file me a new plan."

The biggest losers from the DIP approval were unsecured bondholders, who will now be crammed down under a mountain of secured debt, virtually eliminating the possibility of any recoveries.

Gerber also overruled objections from Lyondell’s committee of unsecured creditors. They had alleged that the loan wasn’t made in “good faith,” that the initial December maturity date is too early, and some financial covenants are “tripwires” for defaults that would hand control of the company to the lenders.The creditors also claimed lenders were trying to use the DIP loan to “stymie inquiry” into what may have been a fraudulent transfer involving Lyondell’s 2007 merger with billionaire Len Blavatnik’s Basell AF.
Seems much more soap opera is destined to come out of this case, which has all the elements: a Russian shady billionaire, bankruptcy, angry bondholders, a sarcastic if not pugilistic judge, lots and lots of deadly chemicals, and the usual murder of lawyers. Sphere: Related Content

Buffett Profit Plummets, Gives Bleak Outlook For 2009

The Tarrot Card Reader Of Omaha (and Charlie)'s Q4 net income fell 96% to $117 million, from $2.95 billion, for a fifth consecutive drop. Book value fell 9.1% of more than generally expected on declines in equity and fixed-income portfolios and writedowns in derivatives. Scary was the increase in liabilities on equity derivatives which increased 49% to $10 billion. It is likely that this number will keep growing as long as the market drops.

Key takehome "economy will be in shambles throughout 2009 - and, for that matter, probably well beoynd."

Here are some highlights from the letter (which is presented below):

During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt. … Furthermore, I made some errors of omission, sucking my thumb when new facts came in that should have caused me to re-examine my thinking and promptly take action.
* * *
By yearend, investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game.
* * *
We're certain, for example, that the economy will be in shambles throughout 2009 -- and, for that matter, probably well beyond -- but that conclusion does not tell us whether the stock market will rise or fall.
* * *
This led to a dysfunctional credit market that in important respects soon turned non-functional. The watchword throughout the country became the creed I saw on restaurant walls when I was young: "In God we trust; all others pay cash."
* * *
In poker terms, the Treasury and the Fed have gone 'all in.' Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects.
* * *
Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.
* * *
Amid this bad news, however, never forget that our country has faced far worse travails in the past. … America has had no shortage of challenges.
* * *
This means that our $58.5 billion of insurance "float" -- money that doesn't belong to us but that we hold and invest for our own benefit -- cost us less than zero. In fact, we were paid $2.8 billion to hold our float during 2008. Charlie and I find this enjoyable.
* * *
Berkshire is always a buyer of both businesses and securities, and the disarray in markets gave us a tailwind in our purchases. When investing, pessimism is your friend, euphoria the enemy.
* * *
Additionally, the market value of the bonds and stocks that we continue to hold suffered a significant decline along with the general market. This does not bother Charlie and me. Indeed, we enjoy such price declines if we have funds available to increase our positions.

Sphere: Related Content

Friday, February 27, 2009

Weekend Reading: The Social Dynamics Of The Trading Desk

Consider the following descriptions:
  1. No sooner did you pass the fake fireplace than you heard an ungodly roar, like the roar of a mob... the bond trading room of Pierce & Pierce. It was a vast space, perhaps sixty by eighty feet, but with the same eight-foot ceiling bearing down on your head. It was an oppressive space with a ferocious glare, writhing silhouettes... the arms and torsos of young men... moving in an agitated manner and sweating early in the morning and shouting, which created the roar.
  2. It's the size of three aircraft. And the reason for it is that it is a source of pride to the manager. It is difficult to see how traders can communicate shouting at each other across two aircraft carriers. At [Connecticut bank], what you'll find is chaos that looks grand.
  3. The key is [to avoid] social awkwardness. Two traders are talking to each other. A third needs a piece of information. He has to interrupt. "Can I interrupt? Can I interrupt?" The key there is the social cost of interruption. Part of my job is to keep those costs down.
Aside from being the descriptions of three totally different types of trading areas, these are among the environments that author Daniel Beunza analyzes to determine how a trader's immediate environment shapes his behavior, his interraction with others, and by implications his trading strategy.

This fascinating paper out of Columbia University which should be mandatory reading for anyone who has ever worked in a hedge fund or plans to run one, provides a scholarly analysis of just how the different things in a trader's daily routine: from the layout of open screens on a Bloomberg terminal, to the desk layout, to the screaming or whispering to discuss new information, to the social hierarchy implications of stacking monitors more than one level high... and so much more.

Focsuing on trading desks including merger arb, index arb, convertible bond arb, statistical arbitrage, and customer sales, there is something in this paper for everyone.

Columbia Paper - Free Legal Forms Sphere: Related Content

Two New Friday FDIC Bank Failures

The Friday FDIC bank bailout is becoming like clockwork. Two more banks went under this week, bringing the year's total to 16. The latest victims are Security Savings Bank of Henderson, NV and Heritage Community Bank of Glenwood, IL. Security Savings' deposits will be assumed by Bank of Nevada, Las Vegas, which at the time of failure had $175 million in deposits and $238 million in assets, while Heritage, with $219 million deposits and $233 million assets will be assumed by MB Financial Bank of Chicago. Sphere: Related Content

Why Citi Common Crashed And Why The Common-Preferred Arb Could Be The Next Volkswagen

(Please read update 4 for very important additional information)

The Volkswagen bandwagon idea de jour was a capital structure arbitrage in Citi preferred paired with shorting Citi common. As the government's term sheet proposed the conversion of Citi preferred stock into common at a price of $3.25, a huge number of accounts thought there was a significant arbitrage to be held here.

The math is roughly as follows: the face value of Citi preferred stock (C AA on Bloomberg) is $25, implying 7.69 shares of common to be received per preferred share (at $3.25). As C common traded at an average price of $1.60/share during the day, a preferred share holder would effectively arb into an implied value of $12.30 of common stock per preferred share. Citi preferreds traded down to a low price of $4.5 early in the day, after closing at $5.50 yesterday, however they quickly inverted and hit a high of $9.25 as people realized the potential arbitrage, before closing for the day at $8.05 on volume of 46.5 million shares. The trade could be boxed by shorting 7.69 shares of common for every share of preferred purchased, thereby "securing" a roughly 50% return. This (probably among other things) explains the persistent drop in Citi common over the day as hedge funds were locking in what they thought was a certain premium.

The problem that most however may have overlooked is a little footnote in the Citi illustrative example of how preferred to common conversion would take place, where Citi noted that the government will provide separate treatment for private and public preferred shareholders: "Ownership assumes conversion of publicly issued preferred stock is done at a significant premium to market, while the U.S. Government's and privately placed preferred are done at par."

Investors are now hoping that the premium for their publicly purchased preferred shares will be lower than the "guaranteed" 50% return they would pocket if they executed the trade at the end of the day, as otherwise they face massive losses on the conversion. As the Volkswagen example has taught us, and as the government has shown in its "white glove" treatment of private investors of all kinds, and couple that with some forced repo pulls by Citi common longs who may eventually realize their stock will skyrocket if they cause a forced squeeze, we wait with baited breath to see the carnage as the "Citi Arb Trade" blows up at some point over the next several weeks.

For people who want to dig through the most recent prospectus supplement to the Citi Series AA Preferred stock, you can do so here.

CreditSights has done an invaluable comparison of the 3 different classes of exchanging securities as part of the transaction, listing out the key terms for each tranche of securities. One of the relevant findings is that the gov't will exchange the balance of its existing preferreds (not exchanging to common) into 8% Trust Preferreds. The implication is current TruPS and eTruPS holders will be pari with the government, which is good from a security protection point, but risky in case the government decides to waive the dividend on the TruPS as all current TruPS holders will also lose dividend payments. The last is unlikely as it is the last form of dividend-paying security that taxpayers have remaining in Citi.

But what about all those toxic, toxic assets on the left side of the balance sheetreaders ask? Won't they drag the company down anyway regardless of what the government does on the liabilities side? What good is a technical play if the company is an AIG in the making?

The same people at CS put together a good analysis of what the key Stress Test metric of Tangible Common Equity/Risk Weighted Assets will look like in a severe scenario. And by severe Zero Hedge would use the term realistic. This analysis also presumes that all the potential converters in the preferred to common exchange go along for the ride as demonstrated in Citi's presentation:

The "severe" world is one in which:
  • unemployment is 10-12%
  • GDP is negative for more than 18 months
  • credit card receivable portfolios losses reach 15%
  • leverage loan marked down by -45%
  • losses on mortgage portfolios are:
  1. subprime: -40%
  2. optionARM: -50%
  3. second liens: -30%
  4. Alt-A: -20%
  5. first liens: -7%
  6. commercial real estate: -15%
  7. residential and commercial construction: -40%
Presuming things really hit the skids, the incremental equity generated by the exchange may just be sufficient to not let Citi fail, which itself has stated that based on its own internal stress tests the newly generated TCE "will be enough to let the company pass through this period." TCE/RWA will go from a precariously low 3.0% to 4.9% even in the Draconian scenario. Of course, whether it is pessimistic enough is anyone's call and the government may very well may be left with another AIG, however due to the lack of exponentially devaluing assets such as CDS contracts which become worth less and less with time, Citi's toxic assets may really only go down in value so far.

Disclaimer: ZH purchased Citi common at the end of trading Friday.

Update 1: Story is starting to spread... Picked up by Dow Jones at 10:18 PM...

Update 2: More interesting preferred tranches emerge. The spike in Series AA Preferred occurred with Series T 6.5% preferred as well. The stock, whose liquidation preference is $50 and should trade at double the price of AA by implication, closed at $15.75, a slight arbitrage most likely driven by liquidity.

The higher rated Series XV/XVI and other Trust Preferreds (BB-/BB vs CC+), which traded up to a 10% premium over AA/T comparable $25 liquidation parity closing around $8.80 (we are looking at the structural subordination issues regarding regular preferreds vs TruPS).

Update 3: Some legal perspectives on the deal.

Update 4: Some more math on the current equilibrium price for the preferred based on the very crude information provided by Citi in the conversion example slide:
  • As the lower right number indicates there would be 21 billion shares of common outstanding pro forma for all participants converting;
  • Current common shares out are about 5.5 billion;
  • The government's conversion of its total $25 billion worth of preferred shares would add another 7.7 billion shares of common (at $3.25)
  • As the slide shows, combined public and private ownership would be 38% of 21 billion or 7.98 billion. As the private preferreds hold 12.5 billion shares, this implies 3.85 billion of common, leaving 4.13 billion shares of common for public preferreds.
  • This allows to calculate what an implicit price for the public preferreds would be: taking 14.9 billion public preferreds translating into the 4.13 billion share of common gives a 3.6 conversion ratio, which is 47% of the unadjusted conversion of 7.69 shares pref/common. Assuming the Friday common closing price of $1.50 is used, we get a value of 3.6 x $1.50 Citi common giving a value of $5.40 for the $25 par value of public preferreds.
  • The Pref's closed at $8.05 on Friday. They are said to convert to significant premium to market. If one takes Thursday's closing price of $2.50 for Citi common, 3.6 share is equal to $9/share, which is a 9/5.5 = 64% premium to market to the Thursday preferred closing price of $5.50
  • The question is: Is 64% considered a significant premium to the government? The end number could be much lower (or higher). There is no definitive information yet. A "mere" 20% premium to Thursday's close is a $6.6 implied preferred price, a 20% discount to the Friday closing price, and an explicit 20% incremental value to the common as the arb has to be repriced.

P.S. We will not respond to individual emails requesting additional mathematical elaboration. All you need to come to the presumed conclusion is here.

Update 5: Next Bank Of America picks up on this theme and in a research note focusing on the Citi exchange cautions that the Public Preferred could be in trouble:

An important difference in exchange terms wording

We note that in the term sheet of Citi’s exchange offer, privately placed and government held preferreds are to be exchanged into common stock at “$3.25/share at par”. However, publicly issued preferreds (including the Series T 6.5% convertible preferred) are to be exchanged into common equity at “$3.25/share at premium to market”. We think this is an important difference for investors of those targeted publicly issued preferreds. In our view, “$3.25/shareat premium to market” opens up the possibility that those publicly issued preferreds are likely to be exchanged into common equity not based on their original par value, but based on their recently-depressed trading prices.

Implication for the Citi 6.5% convertible preferred

We are looking for Citi to provide additional details on the exact definition of the term “at premium to market” regarding the exchange of those publicly issued preferreds. In our view, “at premium to market” could be interpreted as an “adjusted par value that is based on past trading price of the preferreds plus a certain premium. Here, we offer our scenario analysis based on certain assumptions. The current trading range of the Citi 6.5% convertible preferred of $15 - $17/share (versus $1.50 C common price) implies an “adjusted par value” of about $33-37/share, which is about 65-74% of the original par value of $50/share and is a premium of 145-178% over the 30-trading price of the series T preferred. Assumptions and detailed scenario analysis are on the second page.

Importantly, investors should note that this is only one of the multiple possible interpretations of the exchange terms, and it could be very different from the more precise exchange terms that Citi may announce later. Investors are strongly recommended to look for Citi’s further clarification regarding this exchange announcement.

Additionally BofA present the following hypothetical conversion analysis on the Citi 6.5% Cvt Pfd (which has a liquidation preferrence of $50, so divide all output numbers by 2 to get comparable values for the Straight Preferred AA, E, and F $25 liquidation pref public preferreds). The question is whether the 45-78% implied premium conversion over recent pref trading prices is what the govt has in mind with its cryptic statement.

Sphere: Related Content

Moody's Takes MGM To Woodshed

Rating agencies just love reminding people they are still around. Oh well - for all CLOs who still base their investment strategy on these pentagram based reports, Moody's downgraded MGM Mirage's corporate family rating from B1 to B3, which "reflects the difficulty the company faces in shoring up its liquidity profile." Not at all surprising after this morning's revolver draw down news and the pounding MGM bonds have taken today (down 3-4 points). Some more harsh language here:
Moody's estimates that internally generated cash, net proceeds from the pending sale of Treasure Island together with the revolver draw and cash on hand will be barely sufficient to fund the company's operations -- including its CityCenter obligations -- and required bond maturities through year-end 2009. MGM faces bond maturities of approximately $300 million and $800 million in the second and third quarters of 2010, respectively. Additionally, the inability of the MGM and its joint venture partner, Dubai World, to raise the remaining $1.2 billion of the targeted $3.0 billion debt raise for CityCenter has exacerbated the MGM's liquidity situation.
We are all waiting for the day when the presidential suite in the Bellagio costs $99.95 including the bottle of champagne and the "personal attention" the suite is known to provide to its guests. Sphere: Related Content

GM Bondholders Aren't Gonna Take It Anymore

Developing story: WSJ reports that bondholders, tired of getting diddled by management and the UAW, will show everyone who is boss, and have demanded a meeting with Steve Rattner and his car task force. It was only a matter of time before Rattner would get buddy buddy with his old wall street crowd who will now demand bond security concessions and federal guarantees... Steve is however kinda stuck between fulfilling his political duties which demand GM above all else, UAW and bondholders included, and his collegial responsibilities to his bondholder friends. Sphere: Related Content

Some More Not So Good News

We tend to get accused of being propagators of pessimism porn. We will get you the good news as soon as we see it. In the meantime...
  • California announces state unemployment rises to 10.1%
  • Citi put on outlook negative by S&P.
Summary from the report:
The affirmation reflects our belief that, with completion of the proposed recapitalization, there will be a significant boost to Citi's capital adequacy. Through the exchange of up to $52.5 billion of hybrid capital issues of varying types--held by the U.S. government and investors--the loss-absorbing capacity of Citi's capital base would be strengthened, with capital quality and adjusted common equity levels improving markedly. Moreover, the drain on liquidity and capital from ongoing dividend payments would drop significantly.

Yet, the outlook revision reflects our concern that if, contrary to our current expectations, Citi's turnaround strategies (which entail significant execution risk) are unsuccessful, debtholders could eventually be required to participate in further government-led restructuring actions. The need for the current recapitalization-–which will massively dilute existing shareholders and likely make the U.S. government Citi's largest shareholder-–points up the magnitude of the company's past losses and the difficult prospects it faces as it seeks to revitalize its business franchise and return to profitability. We believe Citi will face a tough credit cycle in the next two years, which will likely result in weak and volatile earnings. Given the uncertain earnings outlook, we cannot rule out the possibility that further government support may prove necessary. Still, the ratings on Citi continue to reflect a combination of extraordinary external support from the U.S. government for highly systemically important financial institutions and the company's own credit characteristics. Specifically, the long-term counterparty credit rating reflects a four-notch uplift from Citi's stand-alone credit profile.

The outlook is negative. Particularly with the completion of the just-announced recapitalization plan, we assume the company's capital will be adequate, even if credit losses during 2009-2010 should be somewhat more severe than now assumed. However, we see some potential for earnings to be substantially worse than we now expect, making further government assistance a potential development. This raises the possibility that debtholders could then be required to participate in those further restructuring actions.
Sphere: Related Content

Don't Look Now But Market Going To 500

Or at least according to Robert Prechter, who had forecast the 1987 stock market crash, and is chairman of popular technical research firm Elliott Wave International. It is not like the Legion of Doom really needs any more groupies, but if that's the man's opinion we will take it.

My long term opinion is that the bear market has several years left to run, and stock prices will go a lot lower," Prechter, said in a telephone interview. "So any rally that happens is going to be a bear market rally."

The S&P this week broke below 745 points -- 19 months after Gainesville, Georgia-based Elliott Wave International had recommended shorting the benchmark index down to that level.

Now, Prechter said, the S&P index could fall by half from these levels over the long term, although he declined to give a specific forecast.

"We are less than halfway through it price-wise," he said. "The market is still overvalued, one reason being that companies continue to lower earnings."
But near term, the risk of a kneejerk rebound in stock prices has risen.

Granted, Prechter does admit that the "bear side has gotten a little crowded in the stock market." Prechter also goes to burst some other bubbles namely that of gold and treasuries:

Gold and silver should go significantly lower. Too many people now think owning them is a good idea. Remember when everybody thought owning real estate and stocks was a good idea?

Treasury bonds have started a bear market. Several scenarios could unfold to explain why: one of them is that government borrowing demands could go up and up and creditors could demand higher yields.

Curiously, to the more and more people who demand lynching for shorters and blame them as the reason for the market collapse, we recommend they read Eddia Lampert's letter in which aside from the substantial propaganda, he raises the valid point, that investors can only short shares because original holders allow the shares to be repoable by custodians such as Bank of New York. If everyone were to demand their brokers make their shares non-repoable, you might see the most insane short covering rally in the history of the market, although current short interest is actually lower than it has been historically (getting chart). Sphere: Related Content

Doomsday Expectations Growing

In a piece that would be hilarious if it wasn't serious, Bloomberg discloses that as a result of crushed consumer confidence, more and more Americans are preparing for the metaphorical (and literal) end of days.

"A growing number of Americans are stocking the basement with Spam and
marketable gold, while they peek out from behind the curtains with their firearm
of choice,” analysts led by Chris Mier in Chicago wrote in a Feb. 26 note.
“Hormel’s plants are now running on weekends to keep up with demand."
As a "bizarre indicator" of end of days, Bloomberg shows a chart comparing the YTD returns of gold, gunmaker Strum Ruger and Spam shares, compared to the S&P500, juxtaposing it with consumer confidence.

Solaris Asset Management CIO Tim Ghriskey says, “If people believe the end of the world is coming and we’re in for anarchy, people are going to load up on weapons and Spam for their fallout shelters." Not surprisingly, Strum Ruger Q4 revenue jumped 72%, with a comparable ramp up in sales for Smith & Wesson. One could argue Q4 sales increase on expectations of stricter gun laws by Obama, however as analyst Eric Wold says "In recessionary times, people get concerned about safety, concerned about potential break-ins. You see gun sales ramp up on that."
Some more random musing by Paul Kedrosky and his take on Pascal's wager in light of a possible apocalypse here.
Sphere: Related Content

GE Cuts Dividend to $0.10, Market Pops Then Drops

Shareholder trigger fingers twitching. Market bottom speculation looks to be delayed by yet another day. Curiously, GE CDS wider by 20 bps from 700 on the news, despite the cash conservation nature of the move... nothing makes sense anymore Sphere: Related Content

More Bad News For Bankrupt Lehman: CFO Resigns

The bad news for creditors of bankrupt Lehman Bros just keep coming. First, the bankruptcy judge presiding over the case James Peck gets arrested a month ago for mauling his wife, and is likely to be removed from the case, and now interim CFO David Cole, who came on board in October when Alvarez and Marsal was hired to run Lehman in exchange for something like $300,000 a day, has said he will resign to pursue other less mind-numbingly deranged ventures than liquidating the biggest bankruptcy in history. It is not clear if he will still remain at A&M where he is listed as a Managing Director, but we wouldn't blame him at all if he has decided he is totally done with finance in general. After charging $750/hour over the past 5 months for dismantling Lehman, we can easily see how retirement is a feasible endgame. Sphere: Related Content

CFTC Plays Catch Up To SEC, Copies Their Aphorisms

Today the CFTC, which Harry Markopolos had no choice words against in his congressional testimony, and so far has not seen a lot of public anger for lack of action and complacency, has started turning on the afterburners. First it announced it would investigate bubble ETF USO earlier today, and subsequently released a press release disclosing its first Ponzi charge of one Daren Palmer, who ran a $40 million Ponzi with unregistered Trigon Group.

Palmer did what every self respecting Ponzier does: lied about his record and promised phenomenal returns.

The CFTC complaint alleges that, from at least September 2000 through present, Palmer fraudulently solicited approximately $40 million from dozens of individuals and entities to participate in a commodity futures pool to trade commodity futures or options on commodity futures contracts. In soliciting prospective and existing participants, Palmer allegedly claimed that he was a successful commodity futures trader, that his pool had a successful track record, and that the pool achieves positive returns of as much as 7 percent monthly and 20 percent annually.
Wow... Another ponzier - who cares at this point (although we do feel for the investors who were duped by Daren). What is amusing is that the CFTC, due to lack of media exposure (which the SEC and FINRA have seen waaaay too much of), copies verbatim soundbites in this PR, with a comparable soundbite the SEC used a mere 2 days ago. CFTC acting director of enforcement Stephen Obie had this memorable quote in the PR "This is another unfortunate example of the maxim, ‘If it appears too good to be true, it probably is." Amusingly his colleague at the much maligned SEC Scott Friestad used exactly the same clip on February 25 when the SEC let all hell loose on James Nicholson of Westgate Capital: "It’s often said that if it seems too good to be true, it probably is."

One would think with the upcoming trillions in the U.S. budget deficit, these regulatory firms can at least afford to hire one or two interns who do not copy off each other's press statements. Although at this point, it should be perfectly clear to anyone, anywhere to run away from everything that "seems too good to be true" as FINRA still has to issue an identical statement, so they must be leaving no rock unturned for an opportunity to use this most abused cliche.
Sphere: Related Content

USO Investigated By CFTC Over Price Moves

The ETF bubble looks like it may be the next one to burst. WSJ just out that the CFTC is probing the USO ETF for price moves coinciding with trades in and out of crude-oil contracts. The USO has recently gotten prominent media attention over allegations that it is a perpetually value bleeding asset, and potentially a pyramid structure.
The Commodity Futures Trading Commission confirmed late Thursday that its enforcement staff is investigating USO concerning its so-called "roll" into a new contract on Feb. 6. The scrutiny is part of a broader probe into the oil market.

"The CFTC takes seriously issues surrounding price movements in our nation's vital energy markets," acting CFTC Enforcement Director Stephen J. Obie said.

USO has grown so large in recent months -- its holdings account for 20% of all April crude futures contracts on the New York Mercantile Exchange and about 30% of the contracts on ICE Futures Europe -- that it has a noticeable effect on oil prices when it moves in and out of contracts each month.

It is not clear what would happen to the USO in case impropriety is found and the fund is forced to shutdown and unwind its massive futures positions. Nonetheless, this could be a harbinger of increasing regulatory intervention in other ETFs which have seen a huge rise in trading in recent months. Sphere: Related Content

More Bad News Out Of Ford

Just what the auto industry needs: Ford, which may have foolishly avoided government aid so far, announced U.S. auto sales in February fell even more compared to January, when the annualized sales rate was the lowest since 1981. Ford sales analyst George Pipas also had this bleak comment to share "We don’t know where the bottom is." January's SAAR was 9.6 million and February numbers which comes out next week should further cement the case that U.S. automakers are simply unviable in current form. Sphere: Related Content

Yet More Deep Thoughts From Seth Klarman

Thanks to an intrepid reader who pointed out Seth Klarman's must-read 1991 book "Margin of Safety" is easily accessible on the internet, we are presenting the link to where it can be found on rapidshare. Sphere: Related Content

Berkshire Results Likely To Be Worst Ever

Fox Pitt analyst Gary Ransom says to be very wary when Berkshire posts earnings tomorrow, warning results may be the worst since Buffett took over the company in 1965. As a result of equity losses and writedowns on derivative bets, the Oracle of Omaha's book value per share, or intrinsic value may have dropped by 8.5%, which will be only the second time this metric has declined under Buffett's command, the only previous time being 6.1% in 2001. The biggest threat and concern to shareholders is the $35.5 billion of European Options Buffett has written which expire in 2019, and could be a latent time bomb assuming the market doesn't stage an impressive pick up before then.

Buffett's take on the ever critical in his view intrinsic value:

"Intrinsic value is an estimate rather than a precise figure,” Buffett, 78, wrote in the manual on Berkshire’s Web site. “We give you Berkshire’s book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire’s intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value."
As Berkshire's share price has slipped 44% in the past 12 months, matching the drop of the S&P, it is likely that the usual hordes of shiny happy people which invade Omaha every year for Warren's annual shareholder meeting, will be much less shiny and happy on May 2 this year.

In the meantime, Buffett has been migrating away from equities, investing in preferred and bond investments in companies such as Goldman, Tiffany's and Harley Davidson; at last check none of these were performing very well, especially the latter two, whose stock was trading near all time lows. Sphere: Related Content

MGM In Yet More Trouble

In an 8-K filed early today, MGM announced that on February 24 it had requested a full drawn down on its $4.5 billion revolver, which the banks satisfied yesterday. The reason for the request was "the continuing instability in the capital markets and uncertain state of the global economy" although we would add the even more atrocious state of Las Vegas operations was likely the most immediate culprit. As we reported previously, Kirk Kerkorian via holding company Tracinda, was separately pledging a bulk of his MGM stock as collateral under an MGM credit line. After considering the recent disastrous results from Wynn, this is further evidence of the utter collapse of the Las Vegas gaming market, and the increasing likelihood of a substantial liquidity crunch for all major casino owners on the strip.

The full text from the MGM 8-K follows:

On February 24, 2009, MGM MIRAGE, a Delaware corporation (the “Company”), submitted a request to borrow $842 million under its $4.5 billion senior revolving credit facility, which amount represented, after giving effect to $93 million in outstanding letters of credit, the total amount of unused borrowing capacity available under its $7.0 billion senior credit facility. The borrowing request, which was fully funded as of February 26, 2009, was made in light of the continuing instability in the capital markets and uncertain state of the global economy. The senior credit facility is governed by the Fifth Amended and Restated Loan Agreement (the “Fifth Loan Agreement”), dated October 3, 2006, by and among the Company, MGM Grand Detroit, LLC, a Delaware limited liability company, as initial co-borrower, and the lenders named therein, as such Fifth Loan Agreement was amended by Amendment No. 1 thereto (“Amendment No.1”) on September 30, 2008. The funds from such additional borrowings will be used for general corporate purposes.
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ISDA Open Sources CDS Model, Issues Challenge To White Hats Everywhere

In a historic event that went largely unnoticed, last night ISDA disclosed it is open sourcing JP Morgan's legendary CDS Standard Model which it got ownerships of on January 29, thereby issuing a challenge to the global community of financial white hats to decompile the code and figure out just what the voodoo is the wizards in JP Morgan's Quantitative Research group have put together over the ages.

The premise for open sourcing is "is to enhance transparency and to optimize use of standard technology for CDS pricing, thereby helping promote the development of the credit derivatives industry as a whole. We are very pleased to be able to provide this service freely to the entire industry." This occurs on the back of the decision to appoint Markit as administrator of the code, several weeks ahead of the March 20 transition of CDS trading as a standardized contract (i.e. pts upfront on every trade). ISDA has announced it will also disclose model inputs such as recovery value and yield curves in due course. Curiously, ISDA will also launch an "online discussion form, which will provide for community input."

That last bit should make people very, very nervous. ISDA is in effect disclosing the CDS model is imperfect, and likely has inaccuracies and inefficiencies. That would make sense: after all it was initially the rushed product of a few finance/math Ph.D. who with the input of a few credit traders had to cobble up something that they could use to give to accounts, who would in turn use it to trade CDS and pay JPM the bid/offer spread. Over time, overcaffeinated analysts had to make adjustments on the fly, likely with no second set of eyes supervising, due to the escalating complexity of the code. And as any first year IBanking analyst knows, taking a complex model and layering more complexity to it increases the likelihood of terminal errors in output delivery to a near certainty.

So white hats the world over are (or if they are not, should be) decompiling the code and trying to find where JPM goofed, in order to claim a stake in the financial hacker pantheon. After all the incentive to do so is huge - the most recent indication of the total gross notional size of CDS outstanding was roughly $25 trillion. Discovering an error that would lead to even a 1% mistake in CDS model output would imply a $250 billion correction to global P&Ls! And being all too aware of subconscious optimism bias, it is likely that the mistake will not be in the P category.

All those who can't wait to start going thru the code line by line can find it here.
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Frontrunning: February 27

  • Hungary wants $230 billion bailout package for Eastern Europe (Bloomberg)
  • Citi will need a bigger boat (PR)
  • Blackstone has $827 million Q4 loss, misses estimates, on real-estate asset writedowns (PR)
  • Rosy assumptions hold down deficit (WSJ) [we just blew through GDP estimates]
  • GM to need European aid within weeks or Opel is next (Bloomberg)
  • Lloyds Banking drops 25% on failure to announce asset insurance (Bloomberg)
  • All about the space trash (WSJ)
Sphere: Related Content

Market To Open With 6 Handle

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Q4 GDP Revised Down -6.2% From -3.8%

Economy's wheels are coming off. Sphere: Related Content

US Taxpayer Welcomes Citigroup To His Portfolio

Citi common diluted 74%. Fed converts up to $25 billion of preferred to common, as expected, however with the twist that other private preferred investors have to agree to terms. C shares down 42% post announcement... Did people not see this coming??? Although this was worse than expected. Government keeps making rules up on the fly.

Furthermore, the company increased its 2008 loss by 48% to $27.7 billion as it took a charge for horrendous acquired businesses, a bunch of Citi directors are dunzo and the dividend (of $0.01) is suspended until further notice.

Former chairman of the SEC summarized it best "This is another round of creeping nationalization. This country is going through no less than an economic revolution."

Treasury statement on Citi:

“Citigroup is planning to strengthen its capital structure through conversion of a significant portion of its preferred securities to common equity in a series of exchange offers.

“Citigroup requested that the Treasury participate in this exchange offer by converting a portion of its preferred security to common equity alongside the other preferred holders.

“Treasury is willing to participate in this arrangement to the extent Citigroup is able to reach agreement with its other preferred holders, under the following conditions:

- Treasury would convert its security to match dollar for dollar the private preferred exchanges.
- Treasury would convert up to the $25 billion of preferred stock issued under the Capital Purchase Program. Remaining Treasury and FDIC preferred issued under the Targeted Investment Program and Asset Guarantee Program would be converted into a trust preferred security of greater structural seniority that would carry the same 8% cash dividend rate as the existing issue.
- Treasury will receive the most favorable terms and price offered to any other preferred holder through this exchange.

This transaction does not increase the amount of Treasury’s investment in Citigroup.
Separately, the Chairman of the Board of Citigroup has informed us that the Company will be altering the Board of Directors so that a majority of the Board will be comprised of new independent directors as soon as feasible.

Citigroup will be taking part, alongside other banks with over$100 billion in assets, in the forward-looking supervisory assessment process announced on February 25, 2009 as part of the Treasury Capital Assistance Program. In connection with this program, Citigroup will be allowed to apply for additional Mandatory Convertible Preferred securities or request conversion of the remaining preferred held by Treasury into these securities, consistent with the terms of the program. ” Sphere: Related Content

Thursday, February 26, 2009

Overallotment: February 26

  • BofA served with bonus subpoena after Ken Lewis' 4 hour interrogation (Bloomberg)
  • 14,000 additional layoffs at JPM (Reuters)
  • The financial terrorist system to demand another $750 billion soon (Reuters)
  • Regulatory investigation into shady European "dark pools" (FT)
  • And speaking of financial terrorism... Fannie needs another $15 billion (FT)
  • FDIC poised to double bank fees as it realizes it actually has no money left (WSJ)
  • Angela Merkel calls for creation of global bond cartel (FT)
  • Indonesia (BB-) sells $3 billion of bonds at 11.25% (Bloomberg)
  • Sir Stanford's Investment chief Laura Pendergast-Holt arrested by FBI, charged with obstruction of proceedings (WSJ)
  • California to stop water deliveries to state farms for three weeks (Stormwire, Hattip Paul K)
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Textron Goes Divestiture Happy, Rumored To Be Selling Industrials Business

Rumor of the night, as reported by our friends at Debtwire, is that everyone's favorite private jet company Textron, which we brought to people's attention before anyone cared about it, has hired former Masters, now merely Janitors, of the Universe, Goldman Sachs, and makers of fine, fine left bank Burgundy, Rothschild to sell the businesses that make up TXT's industrial division. Textron has gotten caught in a perfect operational storm as its main products are Cessna private jets which nobody will touch with a 10 foot pole for years, military choppers and unmanned planes (alas the recent U.S. budget has eliminated all military expenditures in favor of outright acquisitions of AIG's "assets"), golf carts ( comment there) and on top of it all it owns a captive finance business (think GECC) which finances assorted purchases on behalf of its customers.

The reason for what will soon morph into a firesale of assets, is to satisfy the cash black hole caused by Textron's captive finance business, Textron Financial (CDS at 25 pts upfront), which according to Moody's will likely be the source of a liquidity crisis in Q4 unless sold earlier. The problem is that nobody in their right mind will want to have anything to do with Textron Financial, unless the government somehow decides its should "assume" this "asset" as well... However with the populist backlash against private jets, it would seem that the Obama administration is merely buying the vehicle to finance congressmen's "fact finding" missions and as such this idea would likely not fly (plus we are sure Frank and Dodd will somehow end up being very conflicted on the purchase). Textron, which is the most risky company of the IG11 index (it is certain to get booted at the roll to IG12), is thus stuck in a unenviable place and Goldman and Rothschild will really have to work their magic to save this company before it is too late. Sphere: Related Content

Lyondell Staring At The Abyss, Creditors Staring Back

The acrimony over the world's largest DIP is reaching fever pitch. For a second day in a row, Judge Gerber said he will listen to yet another round of arguments tomorrow before deciding whether to approve the Debtor in Possession loan. As we wrote previously, the fate of the company (at least over the next 6 months) hangs in the approval of the DIP, as without it Lyondell will proceed straight to liquidation. "I want to make sure I have my arms around this," said Gerber to DIP committee (ex ABN Amro) attorney Marshall Huebner of David Polk. The issue that non-DIP lenders have with the loan, is that, they allege, it gives the DIP lenders more protections than other pre-bankruptcy lenders. Huebner does not lack a sense of humor, and in his closing arguments said "creditors should be giving us a fruit basket" for agreeing to a DIP.

As we presumed earlier, Ed Weisfelner of Brown Rudnick, lawyer for the unsecured creditors, told Gerber there was no way the Company would be able to emerge by the loan's proposed December 15th date pointing out the $24 billion in total liabilities and 20,000 employees. Weisfelner is apparently also good in the repartee department, stating "We're here playing a fairly huge game of chicken. Your Honor has the choice of protecting general unsecured creditors, or lenders who have been fighting to fund the loan, which has been trending at or above par in the marketplace." Ah, ye old market test argument... never works in court but go for it. While we are against usurious loans, we don't see how the DIP committee doesn't fall apart if the Judge votes against the DIP, thereby dooming creditors to even lower returns. Sphere: Related Content

Ackman In Discussions To Nominate Target Directors, Sells 19.3 Million TGT Calls

Well, at least he didn't blow the 90% of AUM in his PSIV fund for nothing. In an 8-K just released, Ackman discloses he sold two sets of calls (not clear if new trades or unwinds) covering a total of 19.3 million TGT shares on February 10 and February 26, for which he pocketed $20,775,000. The first set of calls expires March 2010, which does not seem an on the run batch so it was likely a privately negotiated transaction. The second set of calls expires April 2009 and he pocketed a mere $145k for this sale. Judging by today's volume in April 2009 calls, these were likely some combination of the 25.00, 27.50 and 30.00 strikes.

As selling calls is a bearish bet with unlimited downside, the second transaction seems rather risky, as some other venegeful hedge fund manager (oh, there are a few), could easly run TGT's price up causing a lot of pain for the manager. Then again, these are covered calls as Ackman already owns 58.4 million shares of stock and option equivalent shares (purchased stratospherically higher). Bottom line is Ackman must be hurting big time to be playing with such amateur hour parlor tricks as covered call writing (at least it is not split strikes), unless he is merely selling existing calls in which case he must have booked massive losses due to alpha and theta.

The 8-K also carries the following cryptic language:
"Without limiting the generality of the foregoing, the Reporting Persons are currently engaged in discussions with the Issuer regarding the consideration by the Board of Directors of the Issuer of certain candidates proposed by the Reporting Persons as directors of the Issuer."
It is also kinda ironic to be nominated to the board of the company you are in effect shorting. Maybe he should have just shorted it out right from the very beginning and by now would have been able to buy it with the proceeds...

By the way, is it not a breach of some fiduciary duty or another to be short (through stock or options) the company you are about to become director of? Just asking... Sphere: Related Content

Deep Thoughts From Eddie Lampert

Letter to investors attached below, mostly as pertains to SHLD. We are going through this now, but at first read some very odd and disjointed ramblings...Eddie sure ain't no Howard Marks

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Ken Lewis Arrives At Cuomo Office To Testify On Merrill Bonues

The 61 year old executive claims "I look forward to the chance to speak candidly and forthrightly and honestly tell the story."

Um, if the story met all those criteria Ken would be out of a job by 6 pm today... Regardless, we look forward to hearing his story too and providing "objective perspective." Sphere: Related Content

AIG To Hand Over Main Property Insurance Unit To US

This is simply pathetic.

"Give me your toxic debt, your default mortgages, your huddled worthless assets yearning to be offloaded on the taxpayer's balance sheet"

PS: Send printing presses Sphere: Related Content

The Upcoming Hedge Fund Redemption Scramble

Huw van Steenis of Morgan Stanley out with a very sobering report on the hedge and fund of fund industries earlier, with the simple conclusion that hedge funds asset under management may fall from $1.2 trillion to $500 billion (in their bear case scenario; $950 billion in the base case). Aside from poor ongoing performance, the culprit will be escalating redemptions from both private clients, and the marginal (if any) role of fund of funds (90% of all Och Ziff redemptions came from FoF) and endowments (not to mention state pension funds) will play in the future. And while deleveraging may no longer be a critical force as we wrote before, further forced selling is likely to exacerbate the vicious circle of declining asset prices and redemptions.

Some charts:
  • Expectations of 30-69% redemptions in 2009 in base/bear case
  • Significant redemptions in H2 2008 post Lehman
  • Fund of Fund redemption in Europe are far ahead of the U.S.
  • US will, however, quickly catch up to Europe post March 31 and gate removal
  • Fund Of Fund AUM dropped 40% in 2008; FoFs accounted for 90% of OZM redemptions
  • Significant asset reallocations are likely to persist
  • Good performance in 2009 after bad 2008; inflows will focus on highly liquid funds with equity long/short, macro themes
  • Investable strategies and 2009 focus "buzzwords" (RIP SpecSit )

  • Modern asset managers still cheaper compared to traditional ones
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Just One Chart To Consider For All Who Are Buying Stocks Today

courtesy of Sphere: Related Content

Moody's Adds Insult To Gannett Dividend Injury

Moody's just piledrived Gannett and cut its bond rating to junk. The company which was downgraded to the lowest IG rating Baa3 on February 2, just got the last kiss as Moody's cut its unsecured debt rating to Ba2. Not as much harsh language as S&P has been dispensing lately, just the sad reality of the situation as Gannett enters Junkville.

The downgrade reflects Moody's expectation that changing media consumption habits and the heightened level of price and volume competition that Gannett faces as it seeks to monetize its strong local-market content positions in its traditional media and newer digital distribution channels will continue to erode operating cash flow. Moody's believes these pressures along with a deep cyclical slowdown in advertising spending and high operating leverage will lead to a weakening of credit metrics to speculative-grade levels for at least the next two years despite revenue-enhancement initiatives and significant cost reductions. Gannett's 90% dividend reduction will help cushion the pressure on free cash flow from operating declines and allow for meaningful debt repayment in 2009 and 2010, but is an indication of the near and long-term operating challenges. In Moody's view, the operating pressures are also diminishing Gannett's traditional ability to mitigate increases in leverage during cyclical downturns through debt reduction, a factor that in the past had supported a higher rating.

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AIG CDS Book To Be Backstopped By US

But, but...this was all contained the last time the company lied about its current state... Looks like US Taxpayer Capital LLC will need some CDS salespeople/traders as it is the unwitting recipient of a $300 billion CDS book.

Feb. 26 (Bloomberg) -- American International Group Inc. may get a backstop from the U.S. to protect against further losses on credit-default swaps, according to a person familiar with the matter.

The federal guarantees may be included in New York-based AIG’s restructured bailout, which the company plans to disclose next week with fourth-quarter results, according to the person, who declined to be identified because the talks are private.

The insurer provided protection on more than $300 billion of assets through credit derivatives as of Sept. 30. Credit- default swaps pay the buyer face value on their debt holdings in exchange for the underlying securities if the borrower fails to meet its obligations.

Michelle Smith, a spokesman for the Federal Reserve, declined to comment as did the Treasury’s Isaac Baker and Joseph Norton of AIG. Sphere: Related Content

The Upcoming Correction In HY Debt Prices

The surprisingly resilient HY and IG market over the last two months (and the reason why so many hedge funds outperformed benchmarks) is starting to crack. We have discussed how purely fundamental assumptions about recoveries in the upcoming wave of defaults will likely reprice risk substantially lower, however a mere glance at existing technicals imply the HY market, especially the single B rated tranche and single names, will soon experience a drubbing.

One of the indicators to watch is the BofA subindex of IG financial bonds, which has dropped recently to post-Lehman wides (the recent move of Citi CDS to points up front is very indicative of the fear in the financial market). Curiously, as fear and loathing has spread among IG financials, the broad HY master index has continued to trade in the low 1,600s after peaking around 2,200, although on Tuesday and Wednesday it did drop lower and is currently in the mid 1,700s.

The paradox is that despite significant weakness in both higher and lower ranked asset classes (IG and equities), HY has been rock solid. The recent widening in IG Financials spreads puts the HY recovery at risk. This is even more evident from the next chart, which shows that HY credit spreads are among the narrowest in the credit space, with Single B spreads trading the tightest (73%) in terms of post-Lehman wides, compared to 98% for IG Financials. There is little chance of leveraged corporates surviving unscathed as the too big to fail companies are seeing a rapid increase in market risk. The HY correction is further justified when compared to the ongoing weakness in equities. In summary, the equity markets are down 20% YTD, while HY is up 2.5%. Over the last year, the correlation between the two markets has been 91%, which implies HY spreads are trading at 2.5x sigma deviation from implied levels. The gap can and will only close through either a strong rebound in equities or a 20% widening in HY spreads. Investors can decide which is more realistic.

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Highbridge Assets Fell 32% Last Year

The house of Dubin and Swieca doubles as one of cards as well. Great investment by JPM also.

From Bloomberg:

Feb. 26 (Bloomberg) -- JPMorgan Chase & Co., the second-biggest U.S. bank, said its Highbridge multi-strategy hedge fund’s assets declined 32 percent in 2008.

The fund lost 27 percent last year, James Staley, head of JPMorgan’s investment unit, said at an investor day conference today in New York. Sphere: Related Content

Complete Fiscal 2010 U.S. Budget

McKinsey must have been paid $1 million to come up with that title...

I dare anyone making over $250,000/year to read the whole thing. After all you will have to fill the $1 Trillion hole...

US Budget - Free Legal Forms Sphere: Related Content

No More Student Loan Subsidies - Sallie Mae Plunges

Obama's (first) budget calls for no more student loan subsidies, which has caused SLM stock to plunge 40%. As Obama has no problem with spending a few hundred billion to address any and every shareholder's cry for stock price appreciation, we are confident the final budget will likely include subsidies as this was merely a minor fiscal prudence and rationality-driven oversight. Sphere: Related Content

Euro Nation Default A Matter Of Time Claims Ex-Bundesbank President

Karl Otto Poehl is pouring some major cold water on all the optimistic talking heads saying eurozone defaults can be avoided. According to the former Bundesbank president, a default of smaller member of the euro region is only a matter of time.

"The first will certainly be a small country, so that can be managed by the bigger countries or the IMF,” he said in an interview with Sky News. “I think there are countries in Europe which are considering the possibility to leave the eurozone. But this is practically not possible. It would be very expensive."
Poehl suggests that Germany or the IMF will be forced to deal with the default... However he does not account for just how much cash it would take to pick up the pieces after the intertwined European dominoes start faltering left and right. Last time we checked, Germany couldn't issue bonds to save itself, let alone the entire Eastern European region which is on the precipice every single day.

Curious is the comment about countries leaving the eurozone "In the case that a country would leave the eurozone, the foreign exchange rate would go down significantly -- 50 or 60percent,” he said. “Interest rates would go sky high as the markets would lose confidence in the system” and “in the countries that can’t maintain their membership."

And while practically speaking Germany bailing anyone out is a pipe dream, even the theoretical proposition is not assured. Former ECB Chief Economist Otmar Issing told Frankfurt Allgemeine Zeitunglast week that saving a profligate member would be“catastrophic” and undermine the monetary union framework. Current ECB Executive Board member Juergen Stark calls the no-bailout rule an “important pillar on which the European Union was founded.”

And some more bad news:
Former International Monetary Fund Chief Economist Kenneth Rogoff today predicted the default risk may rise once central banks start to raise borrowing costs from record lows. “Interest rates will rise in two to three years and countries like Italy may face rates of 11 percent again -- will they be able to pay?” he said in a speech near Reykjavik today.“I can well imagine that if we don’t have a large sovereign default, we will see some large sovereigns on the brink of it."
All of this should provide more ammunition for the contrarian "all is priced in" bulls as they take the market to new highs today. Sphere: Related Content

Budget Bubble: 2009 Fiscal Spending at $3.94 Trillion, up 34%

What was that president Obama, you will cut the budget deficit to $500 billion by 2012?

2009 deficit to be $1.75 trillion, 12.5% of GDP. It will be "eliminated" as the rich are taxed right into lower middle class. Sphere: Related Content

From Rumor Bag: Average Equity Hedge Fund Is 70% In Cash At End Of Each Trading Day

Explains why the market performs like a schizophrenic day trader, as investors try to game the greater fool in unison, running the market up and down especially in market leading sectors such as financials. As long as a fund is not the last man in, the first 50% in any wave are set to make profits. While this has long been the modus operandi for SAC and some other notable algo trading outfits (who love throwing around unmerited lawsuits for libel so we will just keep our mouth shut), the fact that it is spreading to most hedgies is shocking, as Buffett's mantra of buy and hold is officially now dead. Sphere: Related Content

RBS To Exit Leveraged Finance Lending

Developing story, but with such blockbusters as Lyondell and Continental AG one had to expect they would pull the plug sooner or later. Sphere: Related Content

New Home Sales Drop To Worst Level Ever, Market Spikes

New home sales tumble over -10% month over month to 309,000, on an expectation of a -2% drop. Market rips. Logical? Who cares. When horrendous news is fantastic news we advise everyone to pull their money out of the market for one reason - it is terminally broken.

In the meantime, a brief look at the real housing picture, and why anyone may soon be able to afford a Palm Beach waterfront house.

Thanks to the economic collape and likely impacted by the aftershock of the Madoff scandal, prices in Lee County Florida (adjacent to Palm Beach) have plumetted by 59% over the past year, with a median home price of $94,900 in January 2009 compared to $234,000 in January 2008.

Curiously even as sales transactions have picked up (758 purchases in 2009 versus 338 in 2008), the average price has kept on plummeting, reflecting the predicament of the inventory oversupply, which we have written about previously, which has over 12 months of supply currently in inventory.
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Moody's To Downgrade $680 Billion Of RMBS

After the prompt futures' rebound following the earlier horrific durables and initial jobless claims, we are 99% convinced the market is set on ignoring any pig that isn't smothered in lipstick (the technical argument goes pigs with lipstick are priced in), so the following piece of news will definitely not have any impact on the whole bunch of "leap of faith" focused investors cum Indiana Jones and The Last Crusade fans (best of the four by far).

But anyway, Moody's announced earlier that it is not only going to dwongrade $680 billion of subprime RMBS, totaling 7,942 tranches of 2005-2007 vintages, but it will increase the loss assumptions by 50%! from 22% previously to 32% currently. For those who actually care about stuff, this is a big deal as it takes out another major component of the lower rated RMBS tranches, but more importantly, it demonstrates the vengeance with which Moody's will try to overcorrect its blunder in CMBS realm as well.

What is shocking is that Moody's, in the blurb below, demonstrates a better grasp of the economic situation than the Obama administration:

Currently 42% of outstanding 2006-vintage subprime loans are at least 60 days delinquent, in foreclosure or held for sale. Moody's believes that, without intervention, nearly all of the already-delinquent loans will eventually default. This assessment is based on very high current observed roll rates to foreclosure combined with increasing unemployment and decreasing property values. By year end, one-third of borrowers who are currently paying on their mortgages will become delinquent and eventually default (19% of today's outstanding loans). Furthermore, Moody's projects that an additional 22% of today's non-delinquent loans would default after 2009 (13% of outstanding loans). This would imply the overall subprime default rate would rise to 72%.

The anticipated actions will vary by vintage, but based on our anticipated average loss projections, it is likely that the vast majority of mezzanine and subordinate certificates currently rated B or above would be downgraded to ratings of Caa or below, particularly for bonds issued in 2006 and 2007.

Full report below

RMBS - Free Legal Forms Sphere: Related Content

Early February 26 Headlines

  • Durable Goods: -5.2% vs -2.5% consensus, Jobless Claims: 667k vs 625k; Continuing: 5112k vs 5025k
  • More black hole... er bank rescue funds allocated as budget deficit hits $1.75 trillion (WSJ)
  • John Paulson "bearish on economy, bullish on opportunities ahead" (Bloomberg)
  • Shocker: GM posts $9.6 billion loss as sinking sales outweigh government benefit (WSJ)
  • Sears profit down 55% after holiday sales plunge (Bloomberg)
  • What Ken Lewis should expect in his interrogation today, from an insider's perspective (Clusterstock)
  • Revolt at UBS: CEO Marcel Rohner replaced with Oswald Gurebel (FT)
  • Banrey Frank alert: Bank of America sponsoring The Scream (AIC)
Sphere: Related Content

Wednesday, February 25, 2009

Late Wednesday Headlines

  • Capmark in default, hires Lazard to restructure balance sheet (PR)
  • Lyondell fails to win DIP approval, hearing to pick up Thursday morning after profuse objections (Debtwire)
  • Citi to announce agreement with government on Thursday (Reuters)
  • One perspective of the government's Prime Brokerage program aka TALF (Credit Writedowns)
  • As government focuses on D(efault)-3, auto-suppliers on "cusp of cataclysm" (Washington Post)
  • Mass extermination alert: now Novartis' meningitis C vaccine contaminated with Staph (Sky News)
  • Nassim Taleb's take on the flawed banking bonus system (FT)
  • Worst year ever at Conde Nast (NY Post)
Sphere: Related Content

The Inversion Of Corporate and Sovereign Risk, Or The Sovereign Basis Trade

The recent spillover of the threat of an Eastern European collapse, and its gradual spread into the Eurozone, has manifested itself best in the dramatic widening of sovereign CDS. The so-called socialization of risk had resulted in a tightening of corporate and bank default risk at the expense of the respective sovereign domiciles. Recently, however, the continued widening in sovereign risk has led to a more circular relationship with financial risk, as after the initial knee jerk reaction leading to financials being perceived less risky (or tighter) late last year, bank CDS have started moving wider yet again. And while non-financial corporates have seemed relatively insulated from a correlated move wider with sovereigns, the biggest threat of another significant risk flaring is probably concentrated the most in corporate risk. As we show below, there are many corporate CDS which trade paradoxically at levels notably tighter than their respective sovereigns, presenting an opportunity for daring investors to put on converging basis trades where a sovereign is the long-risk leg.

Why has sovereign risk skyrocketed?

As we noted last Friday, US Sovereign CDS for the first time ever passed the psychological barrier of 100 bps after trading in the 60s two months ago. The primary reason for this, at least domestically, has been the rapid increase in public sector debt to compensate for the deleveraging in the private sector. As credit risk has become more socialized in the U.S., the overall riskiness associated with leverage has shifted from the individual and corporation (which still have a lot of risk), onto the balance sheet of the sovereign.

And the U.S. is not alone, as it offloads private sector risk to its balance sheet: most foreign sovereigns are encountered with the same challenges and are responding as much as they can (many with the assistance of U.S. swap lines) by levering their own balance sheets. As the investing public has figured out this shift, trading in sovereign CDS has exploded and current outstanding gross notional and # of CDS contracts has hit record levels as seen in the table below (sourced from DTCC).

Empirically this is obvious when the historical progression of sovereign CDS trading levels is mapped out (again, the higher the number, the greater the perceived risk).

And for CDS traders out there, the structural difference between corporate and sovereign CDS, is that while both types of contracts include Failure To Pay, and Restructuring as credit events, Western European corporates account for Bankruptcy as the third gating event, while Western European sovereigns account for Repudiation/Moratorium.

Implications for non-Sovereign Risk

The two main categories here include financial companies and non-financial corporates. When the U.S. started opening up swap lines in October last year, and foreign central banks pledged huge sums to support a financial system in crisis, the immediate reaction was to bring financial risk significantly tighter. However, as the situation has not improved and more and more capital has had to be allocated in the form of senior debt guarantee programs and fiscal stimuli packages, the inverse correlation between sovereign and financial risk has disinverted, which is especially obvious over the past month, and the widening correlation has again become positive and approaching 1. All this is mapped out on the graph below: note the rapid rise in the orange line which represents the iTraxx Subordinated Financial Index over the past month, which is finally moving to catch up to the ever increasing sovereign risk.

Curiously, non-financial companies' risk has, to date, been impacted much less by deteriorating sovereign risk. The immediate explanation for this phenomenon is that while banks are again perceived as government risk, corporates are benefiting from the dramatic improvement in private capital raising in both debt and equity markets. The bottom line is that most corporates have not needed government support so far. The financial to non-financial divergence can be traced by looking at the opposite paths of the green and the orange line over the past two months in the chart below (green line represents the popular European HiVol index excluding sub financials).

One can argue that it is only a matter of time before non-financial CDS has a dramatic move wider as the weakness in both the government and the financial sector are understood to not be isolated threats. This is made much more obvious when once considers that there are numerous corporate names that have pushed tighter than their sovereign spreads! The table below lists all examples, but the biggest outliers are Telefonica whose 5 year CDS trades at 117 bps, compared to Spain at 148 bps, OTE is at 132 bps, compared to Greece at 254, Carrefour at 83 versus 91 for France, and Safeway at 55 versus 156 for the UK. Intuitively the thought experiment of having a UK sovereign default (for example) which would not implicitly or explicitly result in the bankruptcy of a company such as Safeway is unfeasible. But that's not all - the CDS to bond dislocation is evident in this love triangle as well: Tesco which also trades tighter to UK CDS (implicitly less risk than the UK), recently issued two bonds, both of which priced at 250 bps over Gilts. The confusion is complete: CDS and bonds of one and the same company imply it is both less and more risky than its sovereign!

The obvious trading implication would be to put on basis packages using the sovereign as the long-risk leg, and the corporate as the short-risk. The idea is that either corporates will quickly overtake sovereign risk as the credit markets continue thawing, or, in the worst case, will converge as default risk for the sovereign is perceived as the "lowest common denominator" below which all "less risky" names will also end up in default.

Sphere: Related Content