Market Update 11 29 11 _ Holiday Cheer

Yaaaay…it’s all better!

Yesterday morning we had snow here in Memphis, TN.  Normally just the forecast of snow would mean car crashes and snarled traffic in this town...but yesterday it was magical…there were no traffic problems at all and I arrived at work remarkably un-stressed from the commute.

After I parked my eco-friendly 5,500 lb, 4x4, V8 powered pickup truck I walked through the parking garage where I could see the snow falling outside and the intercom system was playing Bruce Springsteen’s “Santa Claus is Coming to Town” and the air was just crisp enough to remind you that it’s early winter.  I sipped my coffee as I walked and took in the sights and sounds and I felt very much in the holiday spirit for the first time this year.  I even passed a sign near the front door that read “Santa Parking Only”.  Geez…this is perfect.

For a moment I thought I had landed in Mayberry.  Then I came inside, sat down at my desk, and saw the headlines.  Troubles continue to rage in the Eurozone…a breakup is being rumored…businesses and governments are making plans on how to deal with the potential disaster.  A co-worker then pointed out what had to be the quote of the day.  It came from Poland’s foreign minister Radek Sikorsky.  He was giving a speech about the euro and he expressed that Poland’s largest threat wasn’t an attack by a neighboring country or rogue state…their biggest threat was the collapse of the Euro; and he viewed Germany as the one player that could avert that disaster.  He said:

“And I demand of Germany that, for your own sake and for ours, you help it (the Euro) survive and prosper. You know full well that nobody else can do it. I will probably be first Polish foreign minister in history to say so, but here it is: I fear German power less than I am beginning to fear German inactivity.”

I frequently joke that if I were Greece I would be very uncomfortable having my fate in the hands of the Germans due to historical precedent.  But that’s just little-ol-me…a fixed-income salesman and former Marine from Memphis TN with a dark sense of humor…nobody cares what I think.  Here, however, we have no-less-than the foreign minister of POLAND…the country that hosted Germany on their first away-game of WWII…saying something not too far removed from my quip on Greece.  Poland now sees Germany as its best chance of survival.  I’m starting to hear tones of Princess Leia ringing in his statement:  “Help us Obi-Wan, you’re our only hope”. 

So, yesterday went from “winter wonderland and Christmas music” to seeing the victims of the Blitzkrieg begging for help from the Germans of all people.   Just when I’m confident that this crisis can’t get any weirder this happens.

What a difference a day makes

Today we have a much different set of stories in the market.  On September 9th I wrote a piece titled “Smells like Coordination”.  That piece basically said that based on what I was seeing at that time it seemed like another round of coordination between Central Banks might be in the offing.  As it turns out it appears that they were in fact scheming along those lines…this morning we see the results…six Central Banks have announced coordinated efforts to help ease pressure created by the crisis in Europe. 

The Fed, ECB (European Central Bank), Bank of Canada, Bank of England, Bank of Japan, and the Swiss National Bank have all coordinated their efforts.  The short story is that they are essentially providing guarantees of cheap liquidity in a number of currencies through February.

European banks had seen their cost on dollar denominated loans increasing recently as potential lenders watched with alarm as problems in Europe escalated.  Fear not…the Central Banks are riding to the rescue with more cheap money.  This is a continuation of the recurring strategy of “buying time” that has come to define much of this business cycle.

It’s like Broadway

I don’t often go to see a “play”…you know…like on a stage in a theater.  I have however been to one or two in the distant past so any of you who like to call me completely uncultured will have to dial it back just a notch. 

Today’s market activity reminds me of the theater.  On stage right now I have a group of actors who are singing about a recovery.  The songs are all about the ADP Employment figures being higher, and Pending Home Sales rising, and Black Friday Sales going through the roof...and the Dow is up 400 and the 10-year is up to a 2.09%, and all of the actors are happy and singing and everything is great.   But backstage behind the curtain the stagehands (represented by the Central Banks) are fighting like mad to put out a fire that is threatening to burn up all of the props needed for the next scene…and maybe even the theater itself.

Seen from this point of view it’s difficult for me to get excited that the play is going to be a great one.  Normally what would happen is that during the intermission I could try to talk the wife into going to a sports bar instead of seeing the second half of the play…but I’m afraid this one will end like the others…I have no hope of getting out of watching the whole thing unfold.  Good or bad we’ll all have to stay here and watch the rest of the play.

If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

 

Market Update _ Grocery shopping and sector analysis

 

Last night I was in the kitchen when the wife came home from the grocery store.  As she was putting the groceries away she announced that she had just bought some special apples that taste like grapes.  Curious, I asked how much she paid for them.  She responded with “I don’t know…why?” 

 

“Because if they’re more expensive than grapes we just got robbed.” I replied.  After all, why would I pay up to get something that “tastes like” grapes if I can get the actual grapes cheaper?  She quickly brushed aside my economic commentary on our groceries and left the room.  Tough crowd. 

 

Many people will look at the “apples that taste like grapes” story as tale of a unique culinary/scientific achievement…but when I see these grape-flavored apples on my counter-top I see a sector-analysis story. 

 

Why do these funky apples remind me of sector analysis?  Because if I like grapes, but grapes are expensive, I might be able to find a really good grape-substitute in another part of the fruit world.  In this case if I can get the grape-flavored apples cheaper than grapes themselves then there is some value available there and I’m willing to purchase them.  Same grape taste in a little bit different package at a lower price?  Great…sign me up.

 

This in turn leads me to the investment portfolio.  If I’m an Agency Callable buyer, but callable yields have dropped, maybe I can find some yield in another product that has the same maturity/average life/price volatility characteristics.

 

How about an example?

 

A very recent example is in the world of Callable Agency bonds.  Consider the following numbers:

 

A 3 year non-call 1 year with a one-time call will bring you a 0.75% yield today

 

A basket of 3 year CD’s with no call options, and zero risk weight will bring you a 1.50% yield (with the convenience of DTC delivery)

 

You get a lot more grapes for your money with the CD than with the callable.  In fact you get twice as many grapes for the same price.  Supplies are limited on the CD side so there is a limit before you have to go back to buying callables but it shows that you can occasionally get some shots off at much better levels if you keep looking in all areas.

 

 

Another example would be:

 

A 4 year non-call 3 month brings 1.125% with -11.00% price volatility this morning

 

A 10 year 3.00% MBS currently brings 1.65% yield in the base case with -11.00% price volatility

 

Again we get more grapes for our money.

 

Wrapping it up

 

If you’re looking to put money to work as we head into the end of the year remember to look around and pick up value where you can find it.  Compare sectors and make sure you’re getting the most bang for your buck. 

 

If you have any questions or if there is anything I can be doing for you just let me know. 

 

Steve Scaramastro, SVP

800-311-0707

 

 

 

 

Market Update 11 1 11 _ Show me the money

 

If you’ve been following these Market Update pieces you have been reading about how the recent pullback has been a buying opportunity and how I suspected the Treasury yields might not last for long at the lofty and optimistic levels we had recently attained.

 

Two stories are impacting the market today

 

The first is that politicians in Greece are doing some things that are putting the rescue plan in doubt.  Despite the markets upbeat attitude toward Europe’s plans…reality is creeping back in.  The Greek government is considering putting the EU’s bailout plan up for a vote…which could cause the plan to be derailed.  I don’t understand politics in my own country so I won’t even try to guess how Greek politics work.  Perhaps the best summary I can find of what’s going on in Greece is the following quote from Societe Generale:

 

“What the Greeks are considering doing would result in about as disorderly a default as you can get. That threatens to return Europe to the maelstrom”

 

That should sum up things on the European bailout front.  A disorderly default will cause a lot of problems…it might cause the type of problems that make me glad there is an ocean between us.  Germany’s Angela Merkel openly warned of war coming to Europe if the Euro is allowed to fail.  When a head of state is making statements like that I tend to listen.  It would be different if it were the leader of some third world, ragtag, banana republic country…but this is the leader of Germany so you have to pay attention.

 

The second story is that the MF Global plot continues to thicken.  Before we talk about the problems at MF Global we need to do a quick review of “margin calls”.  A margin call is where a position has moved against you and your broker or counterparty calls and demands you put some more money into the pot to cover the increased loss/risk.  Normally you’d cover the margin call with cash or by selling something to generate cash.  Then you sit back and hope the position comes your way…if it moves against you again you get another margin call and you’ll have to raise more cash and/or sell more positions.  Many of you will remember this cycle from late 2008 and 2009 when the hedge funds were all getting destroyed.  Their trash positions were moving against them and they had to sell their high quality paper (GSE debt).  Spreads widened as supply was dumped on the market and we were all able to buy MBS at huge spreads as we took advantage of the geniuses that were running hedge funds.

 

Show me the money

 

This brings us to current day Wall Street.  MF Global began getting margin calls as some of their positions began moving against them.  At first they covered with cash…then they ran out of cash.  Apparently somebody notices that while the firm was out of cash, they still had a lot of customer money lying around.  I don’t know how the next chain of decisions gets made…but I picture it going something like this:

 

Trader 1: “Hey, we’re getting more margin calls on these European bonds…and I just used up the last of our cash.”

 

Trader 2: “Dude if we can’t meet these margin calls our counter-party is going to liquidate the positions and the losses will go from “un-realized and un-nerving” to “immediate and tragic”.  We are going to get canned.  What are we gonna do?”

 

Trader 1: “Well…there is a ton of cash sitting in these accounts that we manage for customers…they’re not using it right now, they’re just sitting on it.  They’ve been sitting on it for like two years…it’s just sitting there doing nothing.”

 

Trader 2: “Great idea…we just need it to cover until our positions come back.  Once things calm down and prices recover we’ll just pull some equity out of our positions and put the money back.  Their cash will be back in the account before anyone knows what’s up.”

 

Trader 1: “Sweet….grab me a few hundred million of it to cover these margin calls…then we can get back to surfing the net.”

 

Trader 2: “Done.”

 

I don’t know how the actual conversation went but I have no idea how you could get to a point where stealing customer funds to cover your own mistakes sounds like a good idea.  I’m tempted to ask “Where has “integrity” gone?” but in reality the people that do these types of things never had it to begin with. 

 

Many years ago the Marine Corps taught me that the quick and easy definition of “Integrity” is that “you do the right thing even when no-one is looking.”  That rule has served me well over the years…and it sounds like MF Global could have benefited from it as well.  Another big lesson that looks to be coming from this is that MF Global lacked appropriate controls…after all…integrity is great and all but when there is a lot at stake trust should go out the window and verification should take its place.  This leads me to another phrase that is famous in the military…”Trust me with your life…not your money or your wife”.  Trust is great…but verification is even better.

 

If hundreds of millions of dollars of customer cash are unaccounted for at MF Global it is just one more giant sign that things were poorly run.

 

Is this the first time a trader has stolen money?

 

The history of finance is littered with stories of theft and fraud.  Without having to look anything up I can think of several cases.  Barings PLC (Britain’s oldest investment bank) was brought down in 1995 by a rogue trader named Nick Leeson who was trying to cover losses and using the firm’s weak internal controls to do it.  In that case a single trader in a far flung branch office in Singapore was able to bring the entire bank down because of poor controls.  Leeson generated losses that were more than twice the amount of capital the bank had available.

 

More recently Societe Generale got smacked with a $7.2 billion loss by a rogue trader named Jerome Kerviele.  That one was so shocking that people internally thought at first that it was a joke.  Another was hedge fund Amaranth Capital that got torpedoed by one of their own natural gas traders who generated a $6.6 billion loss.

 

I guess it surprises me a lot that customer money could be misappropriated at MF Global after we’ve had so many big firms destroyed by employees operating in an environment with poor internal controls. 

 

Maybe I’m jumping the gun…maybe the hundreds of millions of dollars of customer money will show up…perhaps it was just put in the wrong drawer.  We’ll see how it turns out…but if you had money at MF Global I’d start making some calls to see if you’ll be getting it back. 

 

From the bad timing file

 

Another interesting fact from MF global is that a group of investors were so enamored with John Corzine’s leadership abilities that they bought $650 million in bonds from the firm just a few months ago.  In what has to be just about perfect timing, the firm will be bankrupt before they make their first interest payment on those bonds.  This reminds me of the scene from Vegas vacation where the guy takes Clark (Chevy Chase) to the second-rate casino’s that are “off the strip” and have some familiar games like rock-paper-scissors and flip-a-coin. 

 

Clark walks up to a table where the game is called “guess the number”.  He puts his money on the table and the dealer says “I’m thinking of a number between 1 and 10”  Clark says “seven”.  The dealer says “nope” and then promptly takes his money.  That scene just became a lot less funny to investors in MF Global debt. 

 

The end

 

So…MF Global and Greece are the latest news…its’ now “Game off!” and people are rushing to the sidelines with their money.  The 10-year Treasury is up over a point this morning, pushing its yield down to a 1.97% currently.  It’s yield has dropped 43 basis points in the last three trading days. 

 

People are starting to realize that things haven’t changed.  Anytime we see yields pop up with no change in the underlying fundamentals I think we should view it as a buying opportunity.  That’s all the news to report for now.  I think I’m going to call my broker and make sure he’s not inter-mingling my funds to cover his losses.  This should be a fun one.

 

If you have any questions or if there is anything I can be doing for you just let me know.

 

Steve Scaramastro, SVP

800-311-0707