The Levered Steepener Trade Blow Up In Full Visual Glory

The chart below demonstrates the 1 year forward level on the 1 Year treasury. Someone really just went all in on Bernanke's bluff. 2Y/1Y flatteners anyone? Wait, what's that? Every prop desk had a steepener on and was highly levered into it? Basis trade blow up deja vu anyone? Wait for opportunistic hedge funds to be ramping into the flattener and killing who knows how many props on the wrong side of the trade.







hat tip Credit Trader Sphere: Related Content

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The Citi Market Barometer

When Zero Hedge first presented its thesis about a likely upcoming mega squeeze in Citi common concurrent with the bank's shares trading at $1, some readers expressed their dismay with our lack of intellectual capacity. Less than two months later, and $3 dollars higher, the situation has changed... at least for the Citi shorts.

However, has the situation changed for the bank itself? Citi, along with the the rest of the banking sector beat modest earnings expectations. But is Citi to be lumped into the JP Morgan and Goldman Sachs camps, the latter guilty of such Julian to Gregorian legerdemain that it makes the alleged $3 billion in commodity-related undermarks in December (and funneling them through FICC no less) and subsequent MTM reversion seem tame in contrast. Egan Jones, easily the best rating agency (which is not really saying much when your competition is the buffoonery conglomerates known as S&P and Moody's), had the following choice words in their developing analysis of Citigroup:

Accounting and government magic - the recasting of FASB157 enables financial institutions to defer the recognition of losses with the result that C's March trading profits swung from a $6.8B loss to a $3.8B gain. Another item worth reviewing is the decline in interest expense from $16.5B last year to $7.7B this year. Nonetheless, much more equity capital is needed. Beyond the conversion of preferred to common, watch the form of any additional capital. The Fed and Treas. have guaranteed $306B of C's assets, have injected $45B in preferred and converted to common leaving few additional options. The problem is that C has $2T of assets ($3+T including off balance sheet assets) whose values are depressed by 10% to 20%. C needs to be watched.

Egan Jones is not alone in their condemnation of Citi's grotesque Criss Angel-esque interpretation of reality. The consensus seems to be thumbs down for the bank, even though the latter, together with the balance of the worst companies in the S&P, has benefited mightily from the less and less connected to reality "crap rally" (but more and more connected to quant fund deleveraging and viability).

What happens now? The market has reached a very curious inflection point, which is eerily reminiscent of what happened to the basis trade in the post-Lehman days (just ask Boaz Weinstein for advice if the equity market is cheap now). Liquidity is disappearing - in fact with every market uptick more and more quants and L/S funds deleverage if they can, while some are stuck and have turned their phones off entirely. Ironically, the higher the market goes, the higher the probability that we will see not just a few small quants blowing up, but some of the big guys also taking a bullet to the temple. In a hypothetical case where a $100 billion+ provider of market liquidity ceases to function the market will break, pure and simple: this is not a directional bet, this is a volatility bet.

Ironically Citi common is now the basis trade reincarnated in the ongoing market melt up. As liquidity becomes scarcer and scarcer, Citi's stock price is likely among the best barometers: this manifests in lack of borrow, in high trading costs, increasing repo rates, as well as the threat, despite repeated promises to the contrary, of an adjustment in the common-preferred conversion rate. In an extreme example it is easy to see the stock skyrocketing to multiples of its current price, however when (not if) fundamentals take over, the way down will be quick and painful.

And while Jim Cramer likely top ticks the rally yet again, and Barney Frank wants to guarantee every risky asset in the United States in another misguided attempt of postponing the D-Day for all the fiscal and monetary insanity happening in this country, the FDIC announces that 2 more banks have failed (bringing the 2009 total to 25), which will cost the FDIC (aka taxpayers) $100 million and $143 million, respectively. And while we are on the topic: Sheila, maybe you can at least tells us if the FDIC's Depository Insurance Fund has finally gone negative, especially now that your brilliant actions have made it unneccesary for banks to use the TLGP and thus pay the FDIC the recently increased TLGP fee?

PS: Based on these headlines, maybe Messrs Dudley and Kohn can join Mr. Cramer in the Wall Street Top Tickers cheerleading camp (Zero Hedge to provide its thoughts on Mr. Kohn's misrepresentation of reality shortly). Then again, if even the market custodians of the Federal reserve are doing all they can to get every last retail investor to believe this bear market rally is for real and incite a market liquidity event, then there truly is no hope.

Fed’s Dudley Says Fears of Scrutiny Under TALF Are ‘Misplaced’

Fed’s Kohn Says Emergency Lending Isn’t Creating Taxpayer Risk Sphere: Related Content

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Updated Basis Trade Thoughts

Early Zero Hedge readers are aware that I have often discussed the benefits of the basis trade in the context of an improvement in overall market liquidity, especially at the pronounced mid/late-January negative basis initiation. I would caution readers who have established this position to be very careful in the coming days with any established bases, and prudent readers may do well to trim exposure here, and take the 200bps average pick over the past 3 months. As DE Shaw had put it poetically "selling puts on market liquidity" via basis participation, given recent Zero Hedge disclosures, has very unappealing risk/return parameters. There is likely easier money to be made elsewhere. Sphere: Related Content

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DE Shaw On The Basis Monster That Ate Wall Street

DE Shaw's quant Ph.D. geniuses are focusing on the topic de jour: the Basis Trade (to Boaz Weinstein's chagrin they are 6 months off). Always good to get one more perspective on the issue. Great bedtime reading for hardcores: enough new concepts here to find at least 5 brand spanking new ways to blow up the world. Particularly interesting section:

What's critical here is that the two risk factors most responsible for driving cash -synthetic basis-namely, the availability of financing and the positioning (long or short cash relative to synthetic) of levered players - inconveniently also two of the least desirable risk factors for a levered instrument vehicle like most hedge funds. Those factors' combined impact literally describes the terms of a classic common-investor liquidation crisis. By incurring heavy exposure to financing risk and the portfolio of other levered investors, a levered hedge fund is effectively selling a gigantic put option on its ability to finance its own positions. Moreover, this put option has characteristics that greatly increased the probability that the option will move in the money at the worst possible moment. If a levered investors suddenly finds itself facing heavy losses, it's not a stretch to suppose that, at the same time and for largely the same reasons, that investor's equity capital base is under pressure from redemptions, its financing position is weakening because of a credit crunch, and other similarly positioned investors are liquidating. Worse still, all of these phenomena lend to self-reinforce in pernicious ways. In such circumstances, it's imprudent to count on financing and trading counterparties to provide help because, as already noted, they're likely to be deleveraging at the same time.

Also, a great discussion on Berkshire abnormally positive basis. Hat tip purearb


DEShaw - Free Legal Forms Sphere: Related Content

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New Issuance Negative Basis Trades at All Time Wides

In another take on the previously discussed basis trade topic, a curious statistic that few have paid attention to is the significant premia new issues have offered to existing comparable CDS spreads on the same issuer. The definition of the new issue premium is the spread of the new issue versus the matched maturity CDS spread. Whether it is a function of the basis spread aberrations in the secondary market, or just a method to incite existing CDS holders, or any other potential purchasers to purchase new issues (with a free hedge) is not sure, but seems to be the norm over the past several months.

Empirically, new issue premia have increased over the past 6 months, and even as spreads have tightened overall, some of the most recent market new comes have come at record wides to their corporate CDS: John Deere priced 333 bps wide to its comparable CDS on January 19, and Casino Guichard priced 326 bps wide on January 22.

As Felix Salmon of Portfolio.com, pointed out it might make sense to entice the government to purchase these kinds of low- to mid-grade securities and not only in the secondary market via negative basis trades but in the primary market itself, especially as they can be completely hedged thru maturity, and on top of that make regulators happy by purchasing a non-naked CDS-cash bond pair trade.

Sphere: Related Content

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Was Merrill Casualty #3 of The Basis Trade After DB Prop and Citadel

In a bet gone very bad, that if true would make Jerome Kerviel's $5 billion loss at Soc Gen seem like amateur hour, the WSJ reports ($$$ link with hat tip to portfolio.com) that the main reason for Merrill's massive $15 billion Q4 loss was due to some very large basis trades gone horribly wrong. We wrote briefly about the basis trade here but now with attention turning more firmly to this topic, it is worth revisiting.

Before we get back to what potentially could be the culprit for over $30 billion in prop trading and hedge fund losses last quarter in all of Wall Street, let's reexamine the basics. As we mentioned previously, at its core, a basis trade is a hedged position where an account buys a bond (let's say with a 5 year maturity) and hedges it with a matched-maturity (or comparable duration) Credit Default Swap. In this way, the account is completely insured from default risk on the bond purchased since if the underlying company that issued the bond were to file for bankruptcy, the account would lose the principal value on the bond but would pick up the recovery from the CDS, ending up with a 0 net gain/loss at the time of default event (CDS settlements can be physical or cash as defined by the CDS OTC-clearing authority ISDA, we will write more about this at a later date).

When an account buys the bond, one also receives the cash flows associated with the coupon on the bond; when hedged in a basis trade, as CDS has a "negative coupon", or the quarterly payment associated with paying for the "insurance", the net recurring cash out/inflow to the account is known as the "basis." In the good old days, the basis would be usually positive, meaning that to hedge a position perfectly, there would be some, usually very minor quarterly cash outflow, usually to the tune of 5-10 bps on the entire notional exposure. Again, in the good old days, a "negative basis" was rare to find - these are positions that for whatever technical or fundamental reasons, would be net cash positive. In other words, an account would have no default risk thru the bond's maturity, and would be compensated to have it put on the books. It would be rare to find negative bases of -10 bps, so hedge funds and prop desks would immediately snap these up as they became available in the market and usually lever them up dramatically, sometimes to the tune of 100-to-1, using a gullible Prime Broker or other synthetic instruments, and end up with anywhere from a 5% to 10% risk free annuity for years.

Another basis trade 101: When looking at the basis of a bond and match-maturity CDS, the most relevant bond metric is its Z-spread, or the spread to Libor, not the more traditional spread to comparable treasury. When comping bonds and CDS, one cares mostly about the bond's Z-spread as that gives the most appropriate reference of whether the bond trades rich or cheap vis-a-vis a CDS. This is because a CDS spread is also relative to the appropriate metric on the Libor curve, not relative to Treasuries.

So back to the basis: the problem with the whole "risk free" concept is that it made one major assumption - that liquidity would be essentially infinite. As the Bear Stearns implosion and the Lehman bankruptcy showed, this is one assumption that would be promptly crushed, and would lead to dramatic aberrations in the basis trade. One major issue was the availability of CDS, or rather lack thereof, to hedge cash bond positions. As prime brokers rushed to conserve liquidity, they made it virtually impossible for accounts to take advantage of dropping bond prices, and increasing Z spreads. They did this by exponentially increasing funding costs on CDS: traditionally the margin requirements on CDS would be in the sub 1% range; after Lehman some counterparties raised the margin requirements as high as 20%, and others even asked for the whole margin to be paid up front. On a $10 million CDS position, which traditionally would only have cash outflows every quarter to fund the quarterly insurance payment, all of a sudden accounts would have to pony up to $2 million in margin just to put a trade on (or keep it on, leading to many basis forced unwinds). Of course, this made it prohibitive for many but the largest hedge funds to participate in the heretofore extremely liquid CDS market, thereby creating phenomenal dislocations and the great arbitrage of negative basis trades that would create 5%-10% and on rare occasions even 15% unlevered returns!

As this can be a handful to swallow at first, we have presented this graphically. We chose to demonstrate the negative basis trade currently available in CIT Group's 5.0% Notes due 2/2014, which we match with CIT 5 year CDS due March 20, 2014. On the graphic below, it is evident that the basis had been gravitating around zero for a while, initially starting off as positive around the time JPM was taking over Bear, then was roughly 0 for several months, but then became dramatically negative the day after Lehman filed. In fact the spread went from 0 to almost 1,500 bps (or 15%) almost overnight! And in the subsequent liquidity constrained market, the basis spread has fluctuated all over, and is currently roughly -500 bps.



This is just one example: most high yield and cross over names currently represent negative basis opportunities: some interesting outliers include Marriott Hotels, Home Depot, Temple-Inland and Omnicom, all of which are BBB- (or higher rated) credits yet present negative basis opportunities of 300 bps and wider. We would be very cautious with blindly purchasing these bases, as the liquidity premium in the market will likely be a key concern for along time, and as long as that is the case, there is no reason why the basis trade should collapse. In fact, if there are any more risk flaring episodes and liquidity becomes even more valuable, these spreads are likely to blow out to even wider levels.

So back to our original topic. How could Merrill lose $15 billion on basis trades? And not just Merrill: Boaz Weinstein's group at Deustche Bank lost over $1 billion on this same trade, and basis trades are the main reason why Citadel has lost over 50% in 2008. Anecdotally, basis trades on CDOs are the reason why AIG, and most of the U.S. insurance industry is in its current deplorable state.

How would one go about estimating the P&L impact to these asset managers? It is not difficult: as the basis explosion resulted in a mismatch of DV01, or dollar equivalent change in 1 bps point in both bonds and CDS, or, netted out via the basis trade itself, one can calculate what the adverse MTM impact was on any notional position. If we take the CIT example above, and we assume that Merill had a $10 billion notional basis position in the name (this is an oversimplification but it was probably true for their overall basis portfolio), and the spread blew out from 0 to 1,500 bps around the time of the Lehman events, Merrill would have experienced a roughly $6 billion hit on the position (an average DV01 of $4MM), which implies that a $15 billion loss could have been created as simply as experiencing a blow up on $25 billion on basis trades. And this assumes no leverage which is naive for the prop desk model: if ML had leveraged its prexisting basis trades even 10x, the total basis trade notional needed to create this loss would have been only $2.5 billion. Is it inconceivable that ML had $25 billion in basis trades? Not at all - after all they were a preeminent CDS trading powerhouse and had one of the most active basis trade prop desks.

This is merely another amusing anecdote of what happens when you have a very popular trade in which everyone had piled in, from hedge funds to prop desks to insurance companies, and one of the assumptions that had been taken for granted disappears i.e., liquidity. The outcomes are only now starting to emerge: so far they have cost the jobs of John Thain (while we are amused by his office decoration choices, if he had not lost $15 billion in Q4, we are confident he would still have his job), "prodigy trader" Boaz Weinstein, and soon possibly Ken Griffin. It seems nobody ever learns from the Black Swan parable even though Nasim Taleb has been pounding the table on this for over 2 years now. Just as the Volkswagen short squeeze caused Adolf Merkle his life, and many hedge fund managers their jobs, every time you encounter this type of overhyped, "hedge fund hotel"-type trade, you will inevitably see casualties.

We at Zero Hedge would venture to surmise that the current bubbly purchasing of Treasuries and corporate loans will be the cause for the next 2 black swan events. We do not know in what form yet (by definition), but would caution all investors from getting involved at this point. Sphere: Related Content

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Bloomberg Pitching Negative Basis Trade; Citadel Definitely Unaxed

In an amusing expose on the negative basis trade, Bloomberg has identified AllianceBernstein and TIAA-CREF as the winners in the trade where Deustche Bank and Citadel crashed and burned. In a nutshell, a negative basis is where you buy CDS and a bond at the same time while picking up carry, or a positive coupon, due to a dislocation of the prices. This is normally a "riskless" trade as you are technically protected from bankruptcy of the underlying asset for the period of time until the maturity of the CDS, usually 5 years. Problems arise when everyone and their grandmother is also involved, which is exactly what caused Volkswagen stock to hit a 1000 euros last year. When the stampede of other participants tries to unwind, the original basis which would have been as tight as 20-30 bps can explode all the way to 1000 bps, dooming all people who are still involved to some very brutal margin calls, potentially leading to fund shutdowns. This is exactly what happened with Boaz Weinstein's "SABA" group at Deutsche, and is the main reason why Citadel was down over 50% in 2008.
In 2007 every hedge fund would snap up even 5-10 bps of negative carry and lever it up 20-50x... Ah those were the times.

While in "theory" the trade is, as we said, riskless, if in the time between now and the end of the protection contract there is another episode of "deleveraging flaring", investors, who get involved now chasing the carrot of 4-6% in risk free return/year, may very well find themselves on the street once the negative basis goes from 400 to 4000, at least hypothetically. With the all too vivid example of Volkswagen still fresh in everyone's memory, very few brave souls will actually put the basis trade on now, for fear of what may happen tomorrow. So opportunities of risk free 5% will likely persist for quite some time. And if any further damnation is needed, Citigroup "strategist" Mikhail Foux is quoted as saying, “For those situations where there’s a risk of some sort, you should probably be putting on basis trades.” Well done Mikhail. Sphere: Related Content

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