Reasons to stay flat?

From Morgan Stanley. I find this a reasonable one slide account of where the equity markets are, but that's just a personal take.

Discrete, discreet trading

One of the things I was concerned with many moons ago is the difference between the types of behaviours you can get in discrete and continuous time. Continuous functions are funky beyond belief, and the less you have to reason about them, generally the better. (For a sample of some of the pathologies, see this book.) Therefore I was particularly interested to read a suggestion by Michael Wellman on making equity trading safer (and, by disallowing order sniffing robots, more discreet) by making it, well, more discrete. Here's the idea: Wellman suggests

a discrete-time market mechanism (technically, a call market), where orders are received continuously but clear only at periodic intervals. The interval could be quite short--say, one second--or aggregate over longer times--five or ten seconds, or a minute. Orders accumulate over the interval, with no information about the order book available to any trading party. At the end of the period, the market clears at a uniform price, traders are notified, and the clearing price becomes public knowledge. Unmatched orders may expire or be retained at the discretion of the submitting traders.

This is really a nice idea. Real users would notice no difference between a market discretised in ten second blocks and a continuous one, but at a stroke bad high frequency trading would be eliminated. Add in a minimum (but low) bid/offer spread too, and the system becomes significantly more robust. The high frequency traders can no longer take your money off the table.

Instability and the cover rule

In the old days of equity derivatives, one of the main instruments was the covered warrant. This was a call option (usually - put warrants are uncommon) issued by a bank and traded as a security: it gave the holder the right but not the obligation to buy some number of underlying shares at a fixed price. This market still exists, and is reasonably active in some countries.

The term 'covered' come from the early regulatory framework. In order to prove to the exchange that the issuer of the warrant could meet their obligations, they had to keep some or all of the underlying. This position in the underlying was known as the cover: it ensured that if the warrant ended up in the money, the issuer could deliver shares to the warrant holders. (Obviously if a corporate issues warrants on itself, then there is no problem: an entity can always print more of its own shares. The issue arises when a bank issues warrants referencing shares in another corporation, often without that corporation's permission or support.)

The cover requirements were supposed to ensure that squeezes did not happen whereby the issuer was forced to pay higher and higher prices to buy shares against the warrants that they hold. This is an issue with less liquid underlyings, especially ones where most of the liquidity is controlled by a small number of parties. By forcing banks to buy the underlying before issueing the warrant, exchanges made market disruption much less likely.

There is definitely something that we can learn from this piece of market history. When derivatives traders are forced by regulation to have a matching position in the underlying, then:

• There is a natural limit on the size of the market;
  
• Both derivatives and underlying markets are more orderly; and
  
• The issuer's risk is automatically limited.

When that is not the case, things can get a little crazy. Let's look at two examples.

The first is the CDS market. I am a supporter of this market, and I view many of those who wish to limit CDS trading as uninformed, hysterical or both. (People called Gillian who have a book to plug may well fall into this category.) However, there is one reasonable objection to CDS, and that is that it sometimes allows the tail (the derivatives market) to wag the dog (the underlying bond or loan market). I have no objection to letting people short credits, but doing so by CDS can provide more protection sellers than there are bonds, creating exactly the sort of squeeze post default that the cover requirements eliminated for warrants. The lack of a borrow market for corporate bonds is the real culprit here. Perhaps one solution would be to keep the CDS market as is, but to require that naked shorts pay a credit borrow fee to a holder of a deliverable instrument. This fee would be in exchange for the bond or loan holder agreeing not to buy protection on it or lend it to anyone else: the fee would automatically ensure that no more CDS protection was sold than there were bonds (or loans) extant which would at least make it more likely that the CDS settlement was orderly.

Second, the commodities market, specifically oil. This post was inspired by a fascinating article on the oil market from the Oil Drum (via FT alphaville). One part of the author's arguments is that the existence of an enormous market in financial contracts on oil has resulted in considerable price volatility - perhaps even price manipulation - which is in the interests neither of producers nor consumers of physical oil, but which benefits intermediaries such as the investment banks considerably. Certainly if one believed that this is true - and the evidence is impressive - then again the solution is obvious: require all derivatives positions to have a physical hedge. If you are short, then you have to own the underlying. If you are long, then you have to borrow the underlying. A given barrel of oil can act as the hedge for just one contract. And you can only use deliverable oil - stuff in tanks - not oil that is still in the ground.

Introducing Algo

Given that I used to be a computer scientist, my knowledge of algorithmic trading, aka high frequency trading, is shamefully slight. Partly it's because the technology has improved vastly over the last five years: the algo guys used to be three or four nerds in the corner of a vast equity trading floor; now, everyone else is a small corner of their trading arena. If you are as behind on this story as me, you might find this article in the NYT helpful. It does at least make it clearer where the money comes from.

Is Goldman just a credit punt?

The Big Picture suggests that it might be, and provides this initially compelling illustration (which I have edited slightly to make it less confusing). However, I think that what we are really seeing is that both overall credit spreads and Goldman's stock price are driven by confidence. The more economic activity there is, the more money Goldman can make from the flow. A similar phenomenon was observable with the Merrill stock price in the 90s -- it acted like a call on the S&P, for similar reasons.

Update. Given ...the furore about Goldman's continued use of a SEC rather than FED VAR calculation, despite being a bank holding company, I am driven to wonder how big Goldie's IRC is. If it is just a giant credit punt, one might expect it to be enormous...

The world's least favourite airline

I'm still digesting the proposed changes to IAS 39 and to Basel 2 (you wait two years for major accounting and regulatory change then two of them come along at one), so for now I'll just quote a delightful Luke Johnson column in the FT. I read it on a plane, and I agree with this wholeheartedly:

BA has become an institution run not for the benefit of its customers – who provide its revenue – but for its staff and pensioners. Its shareholders, meanwhile, have long been forgotten.

If a firm like BA isn't a conviction short, I don't know what is.

Reality and perception in equity markets

The hard part about making market calls is not coming to a view on fundamental value. While that's difficult, it is still easier than the other part of making a trading decision, which is estimating current and future sentiment. It's particularly tricky at the moment: fundamentals suggest to me that most developed equity markets are over-valued. But sentiment is positive, and there is a wall of money still sitting nervously on the sidelines. If even a small fraction of that comes to the market, we could go significantly higher. The greater fool trade is always risky, so I'm flat equity at the moment and likely to remain so at least until either fundamentals improve or sentiment (and prices) turn down. Just my two cents: I wouldn't pay any attention if I were you.

Fixing monopolies

The monopolies and mergers commission has proved utterly ineffective in dealing with the large supermarkets. Tesco, in particular, plays far too large a part in the total UK shopping spend. They are a malign influence. So what can we do? With a bit of luck, we can get two birds with one stone, and cripple them by making them over pay for Northern Rock. If they can somehow me coerced into taking a few toxic bits of Lloyds too perhaps that will shut Neelie Kroes up too...

Most expensive cities for residential property

Via Infectious Greed, an interesting list of the top 10 cities globally by average residential sale price:
Hong Kong is a special case, being an island where much of the undeveloped land is owned by the government, but the others do certainly look like short candidates. Chinese property derivatives anyone?

Timing

Is it a good time to start an old-fashioned bank?

Chop the tail off a 911 or something...

Please accept my apologies for the scarcity of postings - I have been in Berlin. There will be more soon but meanwhile, here's a tip from the locals. Short Porsche. Porsche's short options position on VW expired on Friday, and it is thought that they escaped by the skin of their teeth, but the firm's debt burden is a serious problem.

A nice graphic on large bankruptcies

(Click for a larger version.)

Financial stability vs. cost of debt

Ten year government bonds are hitting highs in the UK and the US - strangely enough, 4% is the magic number in both countries.

Is this good? Clearly increasing yields make it more expensive to raise debt, and both governments have big deficits to service. So rising yields is a bad thing.

But... bank net interest income depends quite sensitively on the shape of the yield curve. If the curve is sharply upward pointing, as it is at the moment, then banks who borrow short and lend long make more money. Profitable banks rebuild capital fast. So rising ten year yields are actually good for financial stability at the moment.

The time for the curve steepeners may well be ending, though. This trade has given most of the juice it has, in my judgement. It might even be time to go short credit for the first time this year...

Is it a bird? Is it a plane?

A frequent correspondant pointed me in the direction of the recent IATA air passenger and freight statistics. They give a useful counterpoint to the Baltic Dry Index. Freight first:
You can probably guess what Passenger looks like, given BA's results:

My guess is that the freight index is a more useful guide to global trade than Baltic dry, simply because it reacts faster, and is not as badly distorted by the lag of fresh capacity coming on line.

Data audialisation

Via Alea, ten years worth of stock price as an audio file. Isn't that nice? More details here.

Who's right?

Krugman fears lost decade for US due to half-steps reports Reuters.

Elsewhere, George Soros leads growing chorus of 'green shoots' optimists.

I don't know who is right. I can't even make a good guess. But it is an interesting question. Opinions seem more divided now than at any time in the last six months - and divided opinions make for interesting markets.

On the curve

Bloomberg says Geithner Bets U.S. Can Avoid Japan Trap Through Bank Earnings.

For that bet to come off, US banks have to earn lots of money.

What's the major determinant of bank earnings that Geithner can control? The shape of the curve. Banks make money if their short term cost of funds is lower than the longer term rates that the loans they make price from.

So... pay 1m USD Libor, receive constant maturity 3 year swaps. Trade of the month.

Positions

A recent Bloomberg story reminded me that it has been months since I discussed the markets with a view to position taking. Sorry.

So... It seems obvious that high quality corporate credit (ex Financials) is a good place to be, especially with the decline of the Libor/govy spread. I tend to view medium durations, around 5 to 7 years, as attractive at the moment not least because they will profit from eventual curve flattening when things (finally, possibly after some years) get better. Fund short term if you can and you have a very high risk tolerance and _great_ liquidity risk management.

I'm not convinced equity markets offer anything at the moment. My gut is to be short, but there is a huge weight of money waiting to get into equity - goodness only knows why - and you could get crushed on a relief rally. So stay away.

In the ABS space, collateral is key. If you can do loan level analysis, then there are some serious bargains to be had, particularly at the top of the securitisation waterfall. The discriminating buyer, especially the discriminating buyer who uses the TALF, should make money.

In FX, I am still inclined towards short USD, despite the flight to quality risk. FX vol seems expensive: consider selling short dated vol.

That was your stupidly infrequent global macro update. Cheques behind the usual stone in Bishopsgate.

I want a new Porsche

No, not that car. I think they look horrible, and they seem to be driven entirely by idiots. The company. The following should be illegal. I guess that it isn't. But note that I have no idea if the sequence of actions discussed actually happened.

From the comments section of this post at FT alphaville, mildly edited for readability:

Porsche bought cash-settled call options from a number of investment banks.

The banks bought shares to cover their positions - thus reducing the free float.

The banks then lent shares to various hedge funds who were shorting the stock, apparently (rumour) with the encouragement of Porsche.

Porsche then bought the shares that the hedge funds were selling, thus completing the circle (but not falling foul of their claim that they hadn't sold [lent?] directly to short-sellers).

Porsche then announced their massively increased position and the stock price rose. The short squeeze was exacerbated by the fact that Porsche now had more of the stock than anyone thought and the majority of the rest was held by index funds who couldn't / wouldn't sell.

Remember, we don't know this was what happened. But if it did, it feels a lot like market abuse to me. So how come Porsche have been cleared? Ah, wait, could it be something to do with being a German hedge fund (that also makes ugly cars), rather than an American or British one (that doesn't)?

A recent trade explained

Why did I sell short dated Wells Fargo bonds at a small loss recently? Because as Bloomberg reveals today, Banks’ Bondholders May Be Next to Share Bailout Pain. Do I think that senior debt holders will take a haircut soon? Probably not. But probably not wasn't good enough, especially when Geithner can turn on a pin. If investors stay well away from bank debt of any kind until the dust has cleared, I wouldn't blame them. Of course, if they do that, then banks' funding problems will only get worse...