Credit Default Spreads/Housing/Return of the Uptick rule
Market Commentary October 7, 2008
I watched with slight chagrin as the market slipped under 10,000. I looked somewhat whimsically at the "DOW 10,000" cap I received from Dick Grasso in 1999 after a lunch with him at his office in the Exchange. I had the Chairman sign the hat as a memento because I was sure we would never see that milestone again in the hopes that one day it would be valuable itself. I respect and appreciate the Chairman (he was very kind and helpful to me) and I kept my hat through the years on my bookcase in a place of honor. Unworn. I never thought it would be relevant in actual terms to our market again—we have almost erased a decade.
From this point the following factors are a drag on the economy: a. Housing values and prices, b. Continued short pressure, c. Interbank Lending, d.Counter party risk and the largest factor, e. Credit Default Spreads. On September 24, 2008 I first spoke on the Credit Default Spreads, in the 3Q-4Q Thesis CDS was Point 1, subject d.(see attached thesis). We stated that the market would fall off precipitously on September 30 and that there would be lots of volatility afterwards, followed by an additional drop after the package was determined to be insufficient in terms of funds. All of these things have come to pass. I have continued to call out points of value in strong financial companies and various ways to short the markets along with more obscure instruments like LDI's ,which pension funds use to manage risk while also generating returns, more on that at a later date. With that said the next point of value will be to call the upturn. To do that we have to outline what will be needed along with more insight on the credit default spreads (CDS) market. The CDS market will loom large over the horizon and along with housing prices will determine when the bloodletting will finally stop in real terms.
The bad news is that fundamentally the housing prices and the true value of assets on the banks books haven't been settled and they will not be for at least a year. This will slow down the flow of foreign money into our economy along with the other uncertainties in the marketplace. As the Euro declines and the risk in European currency accelerates—the European flood of money along with additional petrodollars from the Middle East—will wait for additional clarity before entering the U.S. stockmarket or real estate.
In terms of the CDS issue, some background information is necessary. These instruments were created as insurance policies to protect against default, if default occurred—the contract seller agrees to pay the buyer the face of the security. The securities were created by commercial banks as a way to transfer risk off their books. They were originally designed to be purchased by firms with a stake in the company's debt. A positive example of a Private Equity firm
using credit swaps was when TA Associates and Internet Capital Group invested in Creditex which was subsequently bought by Intercontinental Exchange. ICE paid TA and ICG $461mm in stocks and options upon acquisition. The problem is that people and entities with no ties to the companies began to purchase and use them to effectively short the company without any equity basis. This is what sunk AIG.
This market has been prolific...the CDS market started in the late 90's and grew to to $10.2T and in June of 2005 that began to mushroom to the current opaque market is over $55 Trillion dollars, the market has decreased over 12% from $62 Trillion in an effort to reduce exposure. This numbers seem and are huge but effectively only about 3.5% of the market is exposed at one time making the number a more manageable $2 Trillion.
Another factor compounding this issue is that this market is completely opaque and was only slightly regulated due to its connectivity to the insurance companies. A number of entities have stood up as possible solutions;Christopher Cox has volunteered the SEC to regulate the market which is half driven by his need to clean up his legacy and erase the bad decision of eliminating the uptick rule. The only problem is that the SEC doesn't really have the intellectual horsepower to understand the market and the savvy market participants will simply structure around the regulation or most likely go offshore much the same way that the reinsurance business did. The Governor would like to regulate 20% of the market—another less than platinum idea due to the fact that it would beg state to state regulation of a very complex market and create so many loopholes that the regulatory gaps would
become areas to exploit for profit alone therefore exacerbating the problem more. A more sensible option has been the Chicago Clearing Corporation, they have been named as an excellent place to clear these instruments and they have a storied history in this arena. The Chicago Mercantile Exchange's CEO was on CNBC Monday touting his firms readiness to list and clear the securities in an effort to assist in transparency and orderly regulation.
The tremendous negative pressure on the market is being caused by 1).The CDS pressure that was made exponential by AIG, 2) the counter-party risk that Lehman spread like influenza through out the world, 3) poor returns in the marketplace prior to hedge fund redemption which will lead to consolidation all place the market on the razor's edge and poised for a spectacular fall with the next future exogenous shock.
The following will need to occur for the market to move forward: 1)The Fed will expand their power and reach, 2) the Treasury will exercise their powers over the economy to artificially stimulate stabilization, 3)the return of the uptick rule to mitigate downward pressure and assure citizens to leave their money in the market, 4)the indefinite extension of the no shorting rule to inculcate equity strength.
Vixx volatility will decrease dramatically with the consolidation of the hedge fund industry. This will stop some of the violent swings due to the reduction of entities, but the sideways patterns will remain as the participants left will be larger in size, strength and assets due. These firms will have the highest returns due to survivorship bias and will gather more assets to leverage therefore concentrating their power.