Insurance

Remember "Portfolio Insurance" from the '87 crash? Well, nowadays, we have CDS. The problem with CDS, however, is that no one who's reputable will write any more.
See "MBIA Writing 'Very Little' New Business." AIG, a latecomer to the business because they had a AA, not AAA rating, was hammered by the market today as they wrote down $11.2 billion. Anyone still writing in this market probably has an even lower rating. One of these days, the whole CDS market will just seize up. No one will be able to hedge any more. Unlike 1987, the Fed's already abandoned the dollar. A catastrophic plunge might deal the market an unrecoverable blow. As Mish has pointed out on numberous occasions, markets don't crash from overbought, they crash from oversold.

As far as my specific strategy goes, I'm looking for the VIX to go over 30 again. It's up halfway to 26.50 today from 23 earlier this week.

Daily Update

Should've sold AIG. It was down 11% from Wednesday's close. However, I didn't want to take on too much Wed. because I sold C short, and on Thursday, it had already dropped 5% and didn't recover as the day progressed. I decided I didn't want to be greedy.

The Yen just hit 3-year highs against the dollar, and shows no sign of stopping. Gold is up to 973. The Fed is flooding the market with liquidity to hold down short-term rates as the Treasury borrows $76B in 3-6 month notes. The Fed's afraid that the banks won't buy the notes if they don't finance the spread for the banks.

The scary thing here is that the stock market was not able to do much better than tread water the last couple of weeks. What will happen if the Fed starts tightening up after Monday's final Treasury auction?

The Big, Big, Big, Big picture: Everything that has happened over the past two years can be viewed as a giant margin call on the carry trade.

Trade

Sold short: C at $24.54. Why? Because is the story on VIE's is correct, then Citigroup is facing more writedowns. If they have more losses, they will need to raise more capital. However, the cost is going to be prohibitive because they agreed to reimburse their most recent investors for any lower price that they pay future investors. If they can't raise more money, they will be insolvent.

Also thinking about shorting AIG, possibly tomorrow. They announce earnings at the close. Amazingly, the analyst consensus is that they will earn $0.60 per share. The low estimate is for a loss of -$1.20. Here's what I'm thinking: I expect AIG's swap losses to be/get worse for several reasons. First, AIG is rated AA, not AAA. That means that they probably would've been tapped to insure riskier things than AAA rated paper. Who would go to AIG and ask them to rate AAA rated or insured paper? Also, they would've sold CDS to riskier firms that aren't required to hold AAA rated paper. Finally, they probably sold CDS later in the game, when the AAA monolines (MBIA, Ambac, etc.) started looking shaky.

Inflation vs. Deflation

For the past 12 weeks, the amount of gasoline bought nationwide was 1.5 percent lower than it was for the same 12-week period a year earlier, according to data collected by the Energy Information Administration, the statistical division of the U.S. Department of Energy. (Poten & Partners)

Is this inflationary, of deflationary? Right now, we have a combination of prices increases and decreases in various things. Equities and real estate are falling, while commodities are increasing in price. Why? Because as the credit crunch works its way through the global economy, those things that depend on credit to maintain their price will fall, while those that depend on cash will continue to rise. At this point, the only commodities I feel comfortable with are sugar and natural gas. The companies I hold (IPSU and PWE) both pay large dividends. Gold I consider in a class of its own, as I think both inflation and deflation will help gold. OZN is up almost 40% since I started buying it. I've added 1% of portfolio positions twice, using the following valuation: I've roughly estimated future share value at $0.50 for every $50 gold rises over $600. For example, I estimate future value of OZN to be $3.00/share with gold at $900/0z. I then halve the future value to get a current value and buy a 1% position if shares are below that price.

Since the Fed has juiced the markets again today, I want to look for some more shorts. Maybe DSL. The market is going to break hard one way or the other, and I'm betting on down. All that's needed is something unexpected to spook the herd.

Selling

into today's 100+ DOW rally. Homebuilders were up 5-10% across the board. That, together with fixed rate mortgages up year-over-year makes it a no-brainer. The only question was which one to short. I decided to find the most capitally impaired company I could short. On the list were DHI, PHM, HOV, and BZH. I calculated a debt to cash plus last year's operating cash flow ratio. Here's what I got: DHI, 2.2x; PHM, 3.7x; HOV, 33x; and BZH, 3.6x. HOV and BZH are overshorted, so that left PHM, which I sold at $15.61.

This gives me a rough portfolio allocation of:

Short financials: 33%
Short homebuilders: 24%
Long commodities: 12%
Short emerging markets/China: 12%
Long Yen/short dollar: 6%
Long safety: 5%
Short retail: 5%
Long gold: 3%

Deep Doo-Doo

Bernanke's rate cutting campaign is not working. Or at least, not for the housing market. With housing stocks surging today on inflation news, I will short one of them later today. 30-yr. fixed rate mortgages are currently at 6.08%. One year ago, the rate was 5.75%. Instead of making the housing market better, cutting rates is making it worse. Maybe we'd be better off if Bernanke raised rates. But that probably won't happen.

Trade

Sold RIO at the close today at $35.68. They got their 65% price increase from China. We've heard about "inflation" ten times a day for the last couple of weeks. We have oil, wheat, coffee, etc. at record highs. RIO's earnings are probably priced in. Even if they're not, I'd probably have to hold it until July or August, which I believe would be very foolish, given the current climate of market risk and volatility.

Another emergent trend I'm keeping my eye on is the draining of money from equity mutual funds. Barron's reports that withdrawals year-to-date have totaled $60-70B. I believe that this could be a result of 401(k) withdrawals. If consumers are so tapped out that they are selling off their retirement, that would be terrible news for worldwide equity markets.

Inflation

Inflation, is, I believe the next ploy by the smart money on Wall Street to unload stocks and try to get a commodity bubble going.

In reality, the next bubble will be long term treasuries. Which means that the flight to quality has a long way to go. When people start fleeing muni bonds for Treasuries, that will give them another bump up.

Budget Crisis in California

In Janruary, Governor Schwartzenegger announced a $14 billion shortfall over the next 18 months. Since then, $2.1 billion in cuts have been announced. However, the budget shortfall is now expected to be $16 billion. The cuts are barely faster than the growth of the budget shortfall. On top of that, Moody's has placed California's bond rating on negative watch. This will fall quickly, once it's too late.

The Philly Fed manufacturing index expectedly (for me) came in drastically under expectations (for media economists).

Treasuries are way up: 30-yr +2.52%, 10-yr +3.5%.

Bought TLT (Lehman 20-yr treasury bond ETF) Jan'09 110 call. Yield equivalent is about 3.85.

Inflation

Inflation was the word of the day, with gold up to 937 and oil over 101 to a new high. Stocks took off with the release of FOMC notes that revealed that the Fed plans to keep rates low for a long time. This creates blowback inflation pressure on the long bond, of course. However, the deflationary pressures are insurmountable. As economist David Rosenberg correctly pointed out, inflation is always a lagging indicator. Time to buy the long bond at 4.60%. Specifically, I'm looking at TLT calls 4-12 months out.

Comments on Mish's post + market update

The market shot up 170 points, but finished down 10 for the day. Oil jumped over $100, and the resulting inflation scare moved the long bond up 0.96% to 4.665% today. In the meantime, I'm just sitting on everything I have. Everything's been sliding in my direction for a couple of weeks now, but nothing's really broken down. I still expect more downside.

Mish has just posted the most incredible analysis I've seen in a while:

Common wisdom is that the Fed will "inflate debt away". I hear it
over and over. When pressed for details as to exactly how this would transpire, no one ever has any. Is it possible to inflate debt away? Let's take a look at both consumer debt and government debt to see what we can find out.

Why The Fed Cannot Inflate Consumer Debt Away

• The Fed cannot put dollars in everyone's pocket.
• The Fed cannot create jobs.
• The Fed cannot force consumers with no money to buy houses to drive prices back up.
• The Fed cannot change consumer attitudes towards debt
  and spending.
• The Fed cannot force businesses to go on hiring sprees.
• The Fed cannot force wages to rise.
• The Fed cannot do anything about global wage arbitrage.

In the grand scheme of things the Fed is pretty powerless when it comes to all of the above. Congress, on the other hand can do some of those. In fact, we are already seeing action with a $150 billion stimulus program. owever, the fiscal stimulus program is already dead on arrival. At best it will cause a .5% short term one time rise in GDP. Then what?Yes, there will be various job programs and other schemes, but the housing bubble followed by a commercial real estate bubble created far more jobs than any government programs are ever going to create. Housing is in contraction, and commercial real estate is headed there.Consumer debt is the big issue and the Fed can't do much about defaults that are are going to rise for the rest of the year if not longer. Expect to see rising defaults on auto loans, residential housing, and credit card debt. If that was not bad enough, add in rising defaults on commercial real estate, commercial and industrial loans, and corporate bonds. Increasing consumer and commercial defaults will impair bank's willingness and ability to lend. The Fed is powerless to stop this. Some propose alternative energy bubbles, infrastructure bubbles, or sovereign wealth funds, but none of those can create enough jobs to
inflate away debt or create a larger bubble.

Can The Fed Inflate Government Debt Away?

Inflationists make two mistakes when it comes to government debt. The first is in assuming government debt is more important than consumer debt. (It will be after consumer debt is defaulted away, but it's not right now) The second is that it's not so easy to inflate government debt away either. Those who think it's easy, need to answer a few questions:

• What would a "successful" inflation campaign do to future
  costs on unfunded medical liabilities?
• What would a "successful" inflation campaign do to future social security payments?
• What would a "successful" inflation campaign do to mortgage rates and cash strapped consumers already struggling to make mortgage payments?
• What would a "successful" inflation campaign do to energy costs?
• And most of all, what would increased inflation do to interest on the national debt?

By "successful" I mean produce a meaningful rise in inflation. Inflationists
act as if unfunded liability costs and interest on the national debt stay
constant. Also ignored is the loss of jobs and rising defaults that will
occur while this "inflating away" takes place. Tax receipts will not rise
enough to cover rising interest given a state of rampant overcapacity and
global wage arbitrage.Yet in spite of these obvious difficulties, the manta
is repeated day in and day out. Inflating debt away only stands a chance in
an environment where there is a sustainable ability and willingness of
consumers and businesses to take on debt, asset prices rise, government
spending is controlled, and interest on accumulated debt is not onerous.
Those conditions are now severely lacking on every front.

Who Benefits From Deflation?

• Those with no debt, few assets, and enough current income to get by nicely.
• Those with no debt and lots of cash to get by nicely.
• Those with a ton of debt and enough credit to be able to refinance that debt at much lower rates.

The government fits in that latter category.Ironically, with massive interest payments on the national debt, about half of which goes to foreigners, the US government would be one of the biggest beneficiaries of deflation if it could drive long term interest rates down to 2% or lower then refinance the entire national debt at those rates.The National Debt is $9.2 Trillion.

...

Suppose you want to spend more money this month than your income. This situation is called a "budget deficit". So you borrow. The amount
you borrowed (and now owe) is called your debt. You have to pay interest on your debt. If next month you don't have enough money to cover
your spending (another deficit), you must borrow some more, and you'll still have to pay the interest on the loan. If you have a deficit every month, you keep borrowing and your debt grows. Soon the interest payment on your loan is bigger than any other item in your budget. Eventually, all you can do is pay the interest payment, and you don't have any money left over for anything else. This situation is known as bankruptcy. Interest Expense on the National Debt is the third largest expense in the federal budget.The Interest Expense on the Debt Outstanding includes the monthly interest for:

• U.S. Treasury notes and bonds
• Foreign and domestic series certificates of indebtedness, notes and bonds
• Savings bonds
• Government Account Series (GAS)
• State and Local Government series (SLGs) and other
  special purpose securities

...

Interest on the national debt for fiscal year 2007 was $430 billion dollars! About half of that went to foreigners. So far in FY 2008 (October 2007 - January 2008) interest paid was $178 billion. Now think about what would happen if interest rates fell to 2% and the government could refinance all that debt long term at 2% or less. Short term deficit spending would likely soar in a steep deflationary recession, but the long term benefits on interest payments would be enormous.Couple a sharp reduction in interest on the
national debt with a sharp reduction in military and entitlement spending
and the dollar would go soaring while oil prices would plunge. Yes, a huge
reduction in military spending may be a pipe dream (short term anyway), but long term interest rates at 2%-2.5% is not. I expect the latter will happen.Thus contrary to popular wisdom, it's far easier to deflate debt away (even government debt), than it is to inflate it away. The irony is that
deflation is a huge long term benefit, but virtually no one sees it that
way.

Points I agree with:

• Long term interest rates going to 2%-2.5%. Could take 3-5 years, possibly as soon as 2.
• Deflation would benefit the Federal Government. I think this point is brilliant, and have never heard it from anyone else.

How will the Fed do this? Exactly how they're managing everything now: keep cutting rates, but always behind the deflationary curve. It remains to be seen what the next presidential administration will do.

Vale

Vale got a 65% increase in iron ore prices from Japan and Korea. China will have to pay up next. This is at the high end of an estimated 30-70% range. The concensus was that they would meet in the middle at 50%. Let's see how much Vale is up tomorrow. Russ Winter predicts that there will be some bailout of the monolines announced on Tuesday in order to separate the "good" muni bond business from the "bad" derivative insurance business. Russ predicts that they are just trying to unload muni bonds onto Aunt Millie because that will be the next shoe to drop, as tax revenues implode. I wholeheartedly agree.

Market Sentiment

Barron's today said that short interest is at the lowest levels since 2000. This is contrary to the prevailing sentiment that the bears are on the prowl. I think that the past couple of weeks can be explained by a lot of shorts being covered. What does this mean? I think that when the market starts to drop again over the next couple of weeks, the bears will come out with lots of ammo. On the other hand, margin borrowing is at very high rates. This may be a rash assumption, but I think that most margin borrowing is used for long positions, not shorts. This means that the bulls don't have much ammo.

I'm sticking with my shorts.

Weekly Wrap-up

This week, we saw the market sputter and move mostly sideways, after its rebound last week. The presiding fear was that the bond insurers would be downgraded. FGIC was, Ambac and MBIA remain up in the air. Like last week, we saw good stocks beat the market and bad stocks underperform. Perhaps that means that this rally has legs. However, I see downside risks underestimated. UBS was a case in point this week. They announced billions more in exposure to leveraged mortgage bonds and derivatives that are underperforming badly and losing principal at an alarming rate.
As the market took 15% off their value, they responded by warning that another $200 billion in writedowns face the entire banking industry.

I'm staying with my shorts and not cashing anything yet. The long weekend is just another chance for news to leak out, and chances are it will be bad. Of course, someone could start a rumor that the monolines have worked out a bailout deal, but I don't think that Governor Spitzer would take kindly to that sort of rubbish.

Trades

I tried to do a reverse carry trade today: long Yen, short Pound. Unfortunately, I was unable to short either the Pound (1.9726) or the Euro (1.4659). I will have to be content with Yen at $0.9243. This turmoil in the muni bond market could be a result of bank capital impairments. LIBOR's fine, but the one-week to one-month market is dead right now.

Trade Deficit

As I suspected, imports from China plunged in December, verified by this quote

Also contributing to the drop in imports was a 14 percent decline in purchases from China - Bloomberg

Actually, because consumer spending didn't soften until December, I was expecting a much smaller, single digit decrease. Since December's ugly holiday retail sales, I imagine imports from China have really fallen off the cliff. The rest of this year will reveal how dependent China is on exports. Last year, US imports from China were $321 billion. China's GDP was $3.43 trillion. That means we're over 9% of their economy. The loss of their export market will start a domino effect wiping out their economy. This year, they will have simultaneous collapses in their stock and real estate markets. Although it may never come to light, I believe that their currency reserves are also seriously impaired, given that most of the $1.5 trillion in toxic CDO's is still missing, and China was a huge buyer.

I think I bought FXP at the right time.

Turmoil in Muni Bond Market

Rates on $100 million of bonds sold by the Port Authority of New York and New Jersey, with bidding run by Goldman, soared to 20 percent yesterday from 4.3 percent a week ago, according to data compiled by Bloomberg.
Presbyterian Healthcare in Albuquerque and New York state's metropolitan Transportation Authority also experienced failures, officials said.
(Bloomberg)

This speaks for itself.

AIG

I thought that it would take at least three months for AIG to get hit by CDO losses. I was wrong. AIG lost 12% today as it filed this form 8-k. Let's look at the numbers: AIG reported on it's losses on CDS insurance written on CDOs by AIG Financial Products Group. Here are the unhedged loss numbers:

September 30: $352 million
October 31: $899 million
November 30: $5,964 million

With hedges and "structural loss mitigants, such as triggers that accelerate amortization of the more senior CDO tranches" the November 30 loss falls to (only) $1.6 billion. Further digging reveals that AIG insured $62 billion in CDO's, and has written $505 billion overall.

I wonder how AIG hedged their CDS's? I'm still worried about their investment holdings for their insurance division.

There Goes the Dow

"Dow Jones & Co. said it was replacing two of the blue chip index's 30 components -- Altria Group Inc. and Honeywell International Inc. -- with Bank of America Corp. and Chevron Corp., effective Feb. 19" (Yahoo). Let's follow up on this in six months.

MO: 72.58
HON: 57.28

BAC: 42.39
CVX: 79.15

DJIA: 12,137.99

What are they thinking? Rotating into financials and energy and out of safe companies.

On a Roll Today!

Important stuff first; trades: Sold PDC today. After it's recent lows around $11.00 I think it's time to cut my losses. They stand at 16%. Mostly, I sold this to make room for FXP. I think that with their support from the U.S. consumer crumbling at the same time they are paying record high commodity prices, their economy will be squeezed to the breaking point.

Next, more posts from the Winterwatch. I won't post what I'm responding to, the link will suffice for that.

"I don’t think that the current trend of price deflation in discretionary goods versus necessary goods is a result of labor supply/capital ratios. I think it has to do with the fact that price appreciation is being concentrated in the most basic and elementary materials of production. Let me explain myself another way. Two and a half years ago, we had the peak of the housing bubble euphoria. Now we have skyrocketing prices in coal and iron ore and plunging house prices. What’s the difference? Maybe it’s the added labor that goes into building a house. But if labor was the cause, I think we would see downward pressure on labor costs. Instead, wages are rising, especially in China which is the driver of coal and iron prices. I think that it’s more likely that basic materials are rising as the wave passes from end products to beginning materials. Give it a year, and the wave will move on and prices will be in freefall. Just like housing."

Big Picture

Just posted this on Winterwatch comment section:

The past couple of years of market watching has impressed me with the following trend: The speculative wave has progressed from housing to copper to oil to corn to iron and now to coal.

I don’t see this as a trend of all commodities rising. Rather, what is see is the progression to more and more basic and necessary things. At the same time, finished products are plunging in value and retailers can’t pass price increases along. What gives? Since I don’t understand it, I will bet (I think along with Russ, if I may be so bold) that this is a bubble resulting from malinvestment. Demand keeps getting more and more basic. The fact that it keeps getting sharper, I believe, is a distraction.

As a trader, I’ve played more and more basic commodities along the way. As an economic watcher, I expect that China will have awesome price contractions later this year. They can’t buy their own stuff, so when we and the Eurozone stop buying, they will have too much production and not enough demand. Then you will see the speculators abandon these plays like lemmings off a cliff.

I think this happens this year.

Deflationista and Proud of It!

What? Me Worry?

The WSJ reports that the investment banks are getting back into subprime. I have no comment, except, "what do you expect? These guys weren't so smart the first time around. They only know how to do one thing."

Stock blows up!

Hopefully, no one was killed. However, there were dozens of injuries following a serious explosion at the Imperial Sugar Company plant in Savannah, Georgia (Reuters). IPSU opened down 10%. If the market didn't look so shaky to me, I would buy more.

Makes Sense Now

The action in Markit indexes makes sense now. Moody's just downgraded XL Capital six levels from AAA to A3, according to Bloomberg.

Uh, Oh,....

Chart below says it all. (I wonder what the standard deviation is on this?)

Chart courtesy of Markit Indexes: http://www.markit.com/information/products/cmbx.html

This AAA rated index (used for hedging) has gone from 94 bips (basis points, 1/10000, 1% of 1%, or 0.01%) to 174 this week. All 27 of the CMBX indexes on Markit hit all time highs today, along with the CDX and LCDX indexes. It looks like someone needs protection fast. Maybe the monolines will be downgraded tomorrow.

I'm thinking of cutting my losses on PDC now that they've rallied, and taking my profits on IPSU.

Two Trends

I have identified two trends, one emergent, and one that has a long way to run. I want to lay out these trends and then think about how I may take advantage of them.

The first trend comes from a Financial Times article. It lists investment bank dependence on monoline insurance companies as hedges against CDO/CLO defaults. I found this quote interesting: "And one final point: having set up one negative basis trade, it hasn’t been uncommon for banks to take out a CDS against the CDS counterparty in that trade. As Paul J Davies points out in today’s FT, through negative basis trades, banks’ monolines exposures have often been hedged with other monolines." Brilliant! A self-sustaining object! Unfortunately, the bankers have not studied their metaphysics, because God is the only self-sustaining object. The only conclusion one can make is that the whole structure will fail spectacularly. How to profit from this? Go completely short the stock market. Buy 30-yr. Treasuries. Why? Because these credit default swaps act as $0 puts (if company defaults, stock is usually almost worthless). Trillions in puts creates a false sense of security in the market which props it up. The investment banks buy more because they believe that they have offloaded the risk onto someone else. In the past, default insurance has kept bond yields low (and prices high). As insurance becomes worthless, yields will soar (and prices plummet). Treasuries, as a safe haven will increase in value. As the credit default swaps are shown to be worthless, their value as a put on the stock market will also evaporate, making the market much more risky.

The second trend is "walking away." Mish has a great blog on this booming trend. He documents how this has started in housing and will continue in credit cards as people find a way around the bankrupcy restrictions. The loopholes are huge, and one thing Mish doesn't mention is that the current political trend is to give voters more loopholes. As Mish says regarding company layoffs and walkaways: if they can do it, why can't consumers? How to profit from this trend? Set up nonprofit to give empty houses to homeless people? I don't think that would really fly, but it would be nice. More practical would be to see if www.youwalkaway.com is hiring.

Two Emergent

The next shoe to drop?

CDO's or credit cards? Bloomberg reports that Fitch is downgrading CDO's on credit default swaps. "Sales of CDOs to investors fell about 11 percent last year to $491.6 billion, and probably will slide 65 percent this year." Hmmm... on the CDX index, investment grade is getting about 97.8% and high yield about 90.9%. Seven percent is a pretty big spread. On $491 billion, that's almost $41 billion. The investment banks are still choked up with $200 billion in leveraged buyouts that are stuck on the balance sheet because they don't want to cut their losses at 10 cents on the dollar. Big mistake. They need to get out while they still can. If their losses get any worst, they won't be able to hedge without taking huge losses on the expense of dubious coverage. Oh, and don't forget the monoline insurance companies. That shoe will drop as well.

So the question is, "What has three shoes?" Nothing. There must be a fourth shoe out there that isn't even in the picture yet.

last week's trades

were DRYS (sell), MCGC (sell), and COF (sell short).

First, DRYS. I sold it because I had two out of three reasons for holding it. It would have been greedy of me to hold it any longer. The first thing that happened was that the Baltic Dry Index bounced upwards, ending its freefall. The second thing was First Maritime's takeover of Quintana Marine. This was unforseen, but fortuitious, as it priced in a takeover premium across the industry. The second thing happened halfway. That was an agreement by Baosteel with BHP on a 70% increase in the amount of coal purchased, although there is still no agreement on price. Finally, the VIX dropped below 25 on Friday, closing out a great week for the DOW and showing some easing of fear and bearish sentiment. 42% gain.

Next, MCGC. Sold at $13.11 for a 5% gain. MCGC's been riding the financial bounceback all week like a rocket. I will look to buy it again when it drops below $12.00. I was thinking about selling my July $12.50 call as well, but I wouldn't even make anything after trading costs. I had been hoping to get $2.50 for it, but if I can get $1.50+, I'll take it.

Last trade, COF. I was thinking it was a good short over $51.50. I didn't have room for it in the portfolio earlier in the week. Also, the financials were still rallying too hard. However, Friday seemed like it may be a turning point in the market. At $56.99, COF was at the top of my list.

Other candidates were FXB, CMG, UA, DECK, FXI, and the highest bouncing homebuilders.