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September, Thursday 22, 2011


DOW – 391 = 10,733
SPX – 37 = 1,129
NAS –82 = 2455
10YR YLD 1.71%
OIL – 5.39 = 80.53
GOLD – 64.90 = 1733.80
SILVER -.54 = 36.03
In August, the S&P 500 dropped down to 1,101, the Dow Industrials dropped to 10,604. Today the Dow went to a low of 10,597 and found support. The S&P made it down to 1,114 and found support.
The European markets set the tone for Wall Street this morning. We saw a gap down at the open. A reminder that a day like today can lead some traders to act or rather react; and the last thing you want to do is chase a gap down. If you want to short these markets, fine, but you really want to short before a gap down, not after a gap down. You do not want to sell into fear – just the opposite; you want to sell into greed.
Quite simply, yesterday we got the FOMC announcement discussing “significant downside risks” accompanied by Operation Twist. The results kicked the legs out from under the remaining bulls on Wall Street and confirmed a chart pattern that has been setting up for the past month and a half, a bearish flag pattern – Well this looks like the breakdown of that congested flag pattern. And just in case you needed further confirmation of a bearish move – there was extremely heavy volume today
Meanwhile, the results were bullish for bonds and the 20-Yr jumped 2.50% to challenge its multi-year highs set back in 2008 during the height of round one of the market’s credit and economic crisis. Now, remember that when yields drop, that means the price of bonds are moving higher – We haven’t seen a two day drop in yields this big since the markets were falling apart in 2008. Part of this is due to Operation Twist, the Federal Reserves plan to sell short-term Treasuries and buy long –term treasuries. Even though the Fed just made the announcement yesterday, I’ve been telling you about it for weeks; bond traders know all about it, and as a result, bond prices have been moving higher and bond yields have been moving much, much lower.
Now there is very little question that with the Federal Reserve stepping in and selling short-term and buying long-term – there is no question the Fed can drive prices on long-term Treasuries higher. What we don’t know is what effect that will have on the economy. Will lower rates on long-term treasuries force mortgage rates lower? Yes, probably. Will that jump-start the housing market? No, probably not. Will Operation Twist result in more jobs? No, probably not.
The Fed’s statement yesterday had one line that really caught everyone’s attention; they said the economy faces “significant downside risks” but what concerned me just as much or even more was the Fed announcing that it was going to step up its direct support of the mortgage markets. If you look at what the Fed actually did – the ZIRP, Zero Interest Rate Policy, and Operation Twist to force interest rates down in the market, and direct support of mortgage markets. You add it all together and it looks like the Fed is really afraid of a further downturn in the housing market.
Or, we can just keep it simple and say that there was a move to the safe haven of Treasuries today – and that is particularly understandable when we look at the mess in Europe, which looks like it will crumble at any moment. Now, yesterday, I talked with you about the idea that the United States really is NOT in any better condition than the many of the Euro countries that are staring down the face of default. If you look at the looming insolvency of Greece, really how bad is that debt problem? Well it is really bad. But guess what, the debt situation in the US is also terrible.
If we look at national debt compared to Gross Domestic Product; that is to compare Gross Government Debt to GDP we see that Greece has just over 140% debt compared to GDP. Italy is right at 120% debt to GDP. Ireland is about 104% debt. Portugal has 91% debt, and Spain is dealing with 78% General Government Gross Debt compared to GDP.
And here in the USA we are trying to deal with 103% debt to GDP. So we’re a little better than Greece and Italy and a little worse than Portugal and Spain.
That means that stabilizing the situation is not good enough. The PIIGS, the countries in Europe are looking at drastic austerity measures and bailouts – and the Eurozone is staring down the barrel of a credit crunch. Here in the US, we are in just as bad of shape.
Now, nobody is seriously talking about the United States defaulting. After all, we can just print more money. As long as the printing press continues to function at the Federal Reserve, we don’t really worry about default. But the situation is a bit different in Europe, and there is a very real probability of default for Greece and maybe for Italy, Ireland, Portugal, and Spain. The real question will be whether the default will be orderly or whether it will be a chaotic mess, that results in a credit freeze that results in bank failures that results in an even bigger, more chaotic mess.
Default is baked into the cake. Sovereign defaults are actually fairly common. A study of the last 29 sovereign defaults found that on average, when external debt reached 73% of GDP, the result was default. 73% – that number includes the PIIGS in Europe and it includes the US.
The problem is that debt becomes impossible to repay and the reserves are just IOU’s that aren’t really backed by anything, except the Federal Reserve printing more and more IOU’s. Currencies can collapse. It happens all the time. The US monetary system ahs fallen apart on several occasions. The real question is how the current mess will unfold: chaotic mess or orderly insolvency?
Last week, Turbo Timmy Geithner proclaimed “There is no chance that the major countries of Europe will let their institutions be at risk in the eyes of the market.”  Geithner did not say there would not be a default. He did not say that European banks would not fail. What he said was that the Eurozone governments should try to make the defaults and bank failures look as good as possible.
Do you remember the move, the Godfather. Marlon Brando, the Godfather does some favor for the local undertaker and he says someday I will ask you to do a favor for me. And then the Godfather’s son, Sonny – the James Caan character – he got shot up – and the Godfather goes to the undertaker and he says, use all your powers to make the boy look good, so his mother can view the body in the casket.
After that, Turbo Timmy flew to Poland and tried to tell the Europeans that they needed to make sure everything looked good, and the Europeans basically said, shut up you jerk. Now, why would they treat little Timmy so rudely?
Well, the European banks are trying to keep their doors open and trying to avoid the chaotic mess scenario, you know where you have depositors lining up on the sidewalks to demand their money. And so, the desperate European Banks are turning to the US banks to get some cash, just some short-term cash. It is a fairly common thing, and the market for short term funding is called the Repo Market, or Repurchase Market. Here’s how it works:
The Euro Banks put up some collateral for a short-term loan – usually about 7 days. When they repay the loan in 7 days, the collateral is returned to the borrower. But they don’t have to sell the asset that is left as collateral, and they don’t have to take a loss on the sale of that asset upfront. You can do it privately and spread the losses over the lifetime of the assets that are used as collateral. Basically, the Repo Market is serving the same function as a pawnbroker.
“Yea, sure, I’ll give ya a loan till next Tuesday. Leave your watch with me.”
The US banks have been exploiting the inability of the European Banks to fund themselves in dollars, charging much higher rates than normal, sometimes double that paid in money markets. The US banks argue that they are just trying to protect themselves.
“Yea, sure. I’ll give you a loan till Tuesday – but now that I know you’re in desperate straits, I’m gonna hafta charge you double. Just leave your watch with me – and I think you should leave your wedding ring, too. I’m just trying to protect myself.”
As the money market investor base started to shy away from funding some of the European banks, the foreign banks became more interested in getting deals done. So the US banks smell blood, and they demand an extra pound of flesh. Repo markets have always been a source of funding, but the question has always been about whether the price points work out for both parties.
We know that when countries have too much debt compared to their ability to repay – the result is default. Same thing for banks; when the debt service costs become too high, the result is default. And now the European banks can’t find short-term money from the US banks, and so they are going to the European Central Bank.
Now, in the very short-term, this means that US banks and investors are not putting money into the Euro, and so the dollar has been a little stronger, and some of those dollars have been parked in Treasuries, and because the Fed announced Operation Twist, the dollars are being invested in longer-term Treasuries (but don’t be fooled into thinking these are long-term investments. What we’re really seeing in defaults situations is currencies going up in smoke, or going down the drain – however you want to describe it – the money is gone. So, for now dollars are good. There is nothing wrong with cash in a deflationary environment.
If you’re looking for some ideas that might do a little better than cash, you just have to understand that anything – even the safe-have treasuries carry some risk. Remember that I started by talking about buying fear and selling greed. With rates so low, and bond prices moving higher so quickly, you have to think that some treasury holders are going to are going to be a little greedy. You have to think that China, which has a whole bunch of US Treasuries, is going to look at liquidating some of their positions. In the past, China has merely indicated they will diversify their holding of Treasuries. But this is not a trade for tomorrow. I think the Treasury market has a little farther to run. Right now, the Treasuries are the most bullish markets you will find anywhere.
Of course, you could always take advantage of the stronger dollar to increase your gold and silver positions. We are in an incredibly strong secular bull market for gold and silver. Buying the dips in a long-term up trend just seems to make sense. The next level of support for gold seems to be right around $1600. I don’t know that we get that low. I don’t know that we couldn’t break down below $1600, but as a long-term investment – you are real close to some good levels for adding to your precious metals positions.
Commodities erased this year’s gains. The Standard & Poor’s GSCI Index of 24 commodities dropped 4.1 percent, bringing the decline this year to 3.1 percent. Again, the decline in commodities is a reaction to the strength of the dollar.
If you’re looking for a more timely trade or more aggressive trade, none of the European markets are safe right now. Sure, the PIIGS, Portugal, Italy, Ireland, Greece, and Spain are getting all the attention but this situation is not good for the Scandinavian countries, the Baltics countries, Poland, even Switzerland, and for that matter the UK. I don’t see much upside anywhere in any European markets.
And we know this situation is nasty for the French banks: Societe Generale, Credite Agricole, and BNP Paribas, but the other Euro banks are ugly too. Deutsche Bank, UBS is walking around with a black eye, and the British banks, including Barclays.
Now, you know the problems in Europe are not going to be contained to Europe. If you are short the US banks right now, you are very happy. There are inverse ETF’s, or exchange traded funds. They trade like stocks but “inverse” means that you can use them like a short position. For example, the SKF is an inverse ETF for the financial shares, so when the financial shares go down in price, the SKF goes up in price.
Short-term trading is very tricky right now. An inverse ETF can do as much damage to your portfolio as a long ETF. Also, inverse ETF’s use derivatives to achieve their desired market exposure and that means there is counterparty risk 
If these problems in Europe turn ugly then we could be looking at a situation where credit freezes, where certain markets freeze. The Eurozone has already banned short selling of European banks. All sorts of funny things could happen.
So tomorrow, you have to ask yourself – Self, what am I going to feel comfortable holding going into the weekend?
Well, gold, silver – the actual metals – not the ETFs, and also cash, and treasuries. What else? What else?
And tomorrow there will be millions of people asking themselves about what investment or trades make them feel comfortable. And what do you think the consensus answer will be?

Morgan Stanley’s Exposure To French Banks Is 60% Greater Than Its Market Cap… And More Than Half Its Book Value

With French banks now a daily highlight in the market’s search for the next source of contagion, and big, multi-syllable words such as conservatorship and nationalization being thrown about with increasingly reckless abandon, perhaps it is time to consider the downstream effects of a French bank blow up. And we are not talking French sovereign troubles, which are about to get far worse with the country’s CDS once again at record highs means the country’s AAA rating is as good as gone. No: banks, as in those entities that are completely locked out from the dollar funding market, and which will be toppled following a few major redemption requests in native USD currency. Which in turn brings us to…Morgan Stanley, the little bank that everyone continues to ignore for assumptions of a pristine balance sheet and no mortgage exposure. Well, hopefully we can debunk one of these assumptions by presenting the bank’s Cross-Border Outstandings, which “include cash, receivables, securities purchased under agreements to resell, securities borrowed and cash trading instruments but exclude derivative instruments and commitments. Securities purchased under agreements to resell and Securities borrowed are presented based on the domicile of the counterparty, without reduction for related securities collateral held.” We’ll leave it up to readers to find the relevant number.
The one thing we will highlight is that $39 billion is about 60% more than the bank’s market cap and a whopping 65% (as in more than half) of its entire book (less non-controlling interests) equity value.
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