The T Report: A Paucity of Change, Greece & CPDO

Posted by on Nov 5, 2012 in The T-Report | No Comments

On Election Eve and all through the house it’s as quiet as a mouse

Maybe it is just me, but the election already seems anti-climatic. After what seems like close to 3.5 years of campaigning, the election is finally upon us. Maybe it is the length of the campaign, or the after effects of hurricane Sandy, or that bankers are vilified by both sides, or that I don’t live in a “swing” state, but it seems like people don’t really care that much about the election.

The over-riding sense I get, is that most people expect the situation to remain basically the same no matter who wins. Maybe that is an overstatement, but many people seem to be coming to the conclusion that the system is not working. No matter who wins, there is little that can be done by the winner to materially change the direction of the country. Yes, each leader would have their own agenda, and the make-up of Congress will have an impact, but unless something unexpected happens, whoever wins will face a lot of roadblocks in trying to implement their dream.

One of the biggest hurdles for either party is our mounting debt and the rules we have in place to stop it. Maybe we will go full Krugman and not worry about debt. I won’t refer to it is as full Keynesian because that might be unfair to the man who isn’t able to say whether he agrees with the policies or economists that use his name in vain. If we go full Krugman and stop worrying about debt, maybe we will see some dramatic new programs. I hope we don’t go that direction, as I think debt does matter (ask the people in Greece and Spain), but I guess it could happen.

If we stick within our feeble and weak debt “ceiling” restrictions, then the president will face severe roadblocks every direction he tries to go. The debt is becoming a limiting factor in potential policy action.

Trading the Election – Conventional Wisdom is Wrong

I will likely fade any rally based on a Romney win. At one point, when the S&P was lower and Romney still had time to provide details, I would have thought he provides a meaningful boost to the market. Now, I’m far from certain about that. His claim that he will label China as a currency manipulator on “his first day in office” seems, less than smart to me. Picking on the largest holder of your debt, a country that has been slowly devaluing, and is critical to world trade, and actually has a massive amount of wealth (including being the largest non Federal Reserve holder of our debt) just doesn’t seem like a good idea. Yet he has painted himself into a corner. He is anti Ben. Fortunately, so many got their predictions on what QE would do for the markets wrong, but with a less dovish Fed Chairman we would probably see markets slide further. In the long run, I think the country would be better off, but the near term reaction would be negative.

So short a Romney rally.

Would I buy an Obama dip? No. Too much is going on and going wrong in the world to get excited about being long here for anything other than a trade.

Greece and the 300 Eurocrats

If 300 Spartans could hold off the might Persian armies and possibly save Western civilization, it is ironic that 300 or so Eurocrats might be able to destroy it.

It is hard for me to put in writing why the Greek situation is so troublesome, but it is all about the attitude and denial. The attitude and denial of the Troika, not the Greeks is what concerns me. The Troika tried to find a solution, but any solution required official sector losses, and those are being rejected. The Troika somehow thinks it can avoid taking losses. That they can design some program that works for everyone, but they can’t. The question is when and how they take their losses. That has been obvious for over a year now, but somehow the Troika is still in denial. That the ECB won’t accept purchase price, rather than par for their remaining GGB holdings is staggering. Only a central banker could buy something at 80 and claim it is a loss if they don’t get 100. Such a seemingly easy and simple step, yet they won’t take it. That is scary.

What is scarier is what this implies about how the Spanish bailout will work. Anyone who believes that the ECB won’t subordinate other holders when push comes to shove should just hand me money. I would say they should buy the Brooklyn Bridge, or some swampland in Florida, but they already have done that. You have to assume that

  1. The Spanish bailout will be underwhelming because the conditionality will be stringent enough that the continuation of the program will always be in doubt
  2. The “yield floor” won’t be as aggressive as the market would like
  3. By focusing on austerity of all types, and only putting money into the banking system in dribs and drabs, the economy will continue to flounder
  4. A Greek exit will put fear into any bond holder or depositor in Spain and Italy
  5. When points 1 to 4 play out, the ECB and IMF will secure their positions at the expense of any remaining private holders

I would be happy to see something that changes my mind back to being constructive on Europe and the ECB, but I do not see it right now.

Is the CPDO ruling meaningful?

A court in Australia today ruled against the CPDO. I have to read the ruling more closely to determine who will have to pay the Australian municipalities for their losses – the banks that structured and sold the deal or the rating agencies, but this is worth watching.

CPDO had a brief moment in the spotlight. It let you take the CDX indices, leverage them as much as you wanted, and get a much better rating than the index itself. It was a Frankenstein of a rating relying on “rolls and steep curves”, “mean reversion”, “short term default probabilities”, and “portfolio insurance” to justify the rating. It didn’t make sense to me from the first day and we spent time showing that historically, in 2002 for example, CPDO, would have defaulted in spite of being AAA. It happened in the crisis and now for the first time a court has ruled against the product. Maybe the Australians don’t understand that ratings are just “free speech” in spite of being nationally recognized statistical ratings organizations?

This is a chart of old IG indices. I think it was IG7 at the time. It traded at 28, and felt like it was going to zero. We now think IG19 at 95 is “expensive” but back in 2007 it felt like CDS was going to zero. There wasn’t a buyer in sight, and the CPDO machine had the potential to crank out infinite volumes. Normally leverage is viewed as increasing risk, but this product claimed it decreased risk, making the supply infinite. Someone who would only sell $1 billion of CDX could sell $5 billion of CPDO (since it was higher rated by far) and that would generate $50 to $75 billion of hedging needs for the structuring desk.

Maybe this will be a blip, but I think it is yet another reason to avoid banks. It may be a good time to sell the rating agencies as well. S&P led the way on this product, but Moody’s was quick to “reverse engineer” it and get on the fee bandwagon.

I can’t yet tell if this is just a little issue and should be treated as such, or if this has the potential to grow into a big problem and is just being ignored because it is in Australia, and we have our focus on Greece and our elections. This has the potential to be far bigger than LIBOR if the ruling can be extended into Europe and the US.