- Interestingly Merrill's partial financing of the purchase essentially constitutes a put underwritten by MER on its CDO exposure
- However, the short put represents only one leg of a complex three-part transaction which synthetically results in Merrill’s purchase of a protective put-spread for its CDO.
CDO sale = long ATM put
75% financing of purchase = short OTM put
Wednesday, 30 July 2008
Monday, 28 July 2008
Meltdown in Europe :Indicators point towards a worsening. Markets for the week ending 25-Jul.
Market commentary:
- Gains in financials continued as Citigroup Inc., JPMorgan and Bank of America Corp., reported second-quarter earnings that beat analysts' estimates. Investors are hopeful this may be the real thing, seeing a glimmer of hope within the financials.
European Outlook:
- German Finance Ministry reported that GDP shrank "considerably" in the second quarter and estimates to be released in August. Significantly deteriorating German business climate and outlook suggests that the economic upswing is coming to an end.
- Spain's manufacturing PMI set a new record low --> indicators point to Q2 growth around 0.2% q/q and then turn negative
- Ireland: Economic and Social Research Institute forecast that GDP growth in Ireland will be negative in 2008 at -0.4% from 5.3% growth in 2007. The Irish economy is likely to face its first recession since 1983 as the slump in housing construction is likely to wipe out all growth in rest of the economy
- The UK economy grew 0.2% in the second quarter of the year, as the credit crunch took its toll on the housing market and consumer spending. The figure is the lowest growth quarter-on-quarter for three years.
UK Banking
After a ridiculous rally in UK banks over last week's sessions from a very low level, we will soon have a better picture in the next couple of weeks as to their health.
(interim reporting period starting with Lloyds on Wednesday)
Scenarios:
A) over a year of writing off debt, market believes that they must be somewhere near the bottom
B) further credit writedowns as signaled by Citigroup cutting European banks to "underweight" from "neutral"
Interesting note:
In the four bear markets since 1973, rallies of 10 percent or more lasted an average of 54 days for a gain of 14.5 percent.
In every case, the S&P 500 fell again, dropping an average of 21.5 percent over 114 days.
The same pattern this time would send the S&P 500 to a peak in September before giving way to a slump that would continue until the start of 2009.
Eric Tan, London
- Gains in financials continued as Citigroup Inc., JPMorgan and Bank of America Corp., reported second-quarter earnings that beat analysts' estimates. Investors are hopeful this may be the real thing, seeing a glimmer of hope within the financials.
European Outlook:
- German Finance Ministry reported that GDP shrank "considerably" in the second quarter and estimates to be released in August. Significantly deteriorating German business climate and outlook suggests that the economic upswing is coming to an end.
- Spain's manufacturing PMI set a new record low --> indicators point to Q2 growth around 0.2% q/q and then turn negative
- Ireland: Economic and Social Research Institute forecast that GDP growth in Ireland will be negative in 2008 at -0.4% from 5.3% growth in 2007. The Irish economy is likely to face its first recession since 1983 as the slump in housing construction is likely to wipe out all growth in rest of the economy
- The UK economy grew 0.2% in the second quarter of the year, as the credit crunch took its toll on the housing market and consumer spending. The figure is the lowest growth quarter-on-quarter for three years.
UK Banking
After a ridiculous rally in UK banks over last week's sessions from a very low level, we will soon have a better picture in the next couple of weeks as to their health.
(interim reporting period starting with Lloyds on Wednesday)
Scenarios:
A) over a year of writing off debt, market believes that they must be somewhere near the bottom
B) further credit writedowns as signaled by Citigroup cutting European banks to "underweight" from "neutral"
Interesting note:
In the four bear markets since 1973, rallies of 10 percent or more lasted an average of 54 days for a gain of 14.5 percent.
In every case, the S&P 500 fell again, dropping an average of 21.5 percent over 114 days.
The same pattern this time would send the S&P 500 to a peak in September before giving way to a slump that would continue until the start of 2009.
Eric Tan, London
Downshift in global growth momentum. Markets for week ending 18-Jul.
- The coincidence of combined financial, commodity, and more recently corporate profitability shocks continues to hammer the global economy.
- Global growth having held up above trend for the last few years is now bringing serious capacity constraints to the global economy.
- Unwinding of the above constraints is rarely gradual or smooth, which suggests that a rapid deterioration is likely to lead to an intensification of the global slowdown well beyond baseline scenarios.
- We are now witnessing negative second round effects through trade flows.
U.K. inflation climbed 3.8 percent from a year earlier, more than economists forecast in June to the fastest pace in at least 11 years.
The high inflation number exceeds the government's 3 percent upper limit for a second month, putting pressure on the Bank of England to avoid cutting interest rates as the threat of a recession looms.
Short-run policy implication: unchanged fed funds rate for some time
Bernanke’s semi-annual Monetary Policy Report to Congress on Tuesday is that the FOMC views the current 2.0% Fed funds rate as appropriately calibrated to restoring acceptable growth and acceptable inflation over the medium-term given the information available today ?
Eric Tan, London
- Global growth having held up above trend for the last few years is now bringing serious capacity constraints to the global economy.
- Unwinding of the above constraints is rarely gradual or smooth, which suggests that a rapid deterioration is likely to lead to an intensification of the global slowdown well beyond baseline scenarios.
- We are now witnessing negative second round effects through trade flows.
U.K. inflation climbed 3.8 percent from a year earlier, more than economists forecast in June to the fastest pace in at least 11 years.
The high inflation number exceeds the government's 3 percent upper limit for a second month, putting pressure on the Bank of England to avoid cutting interest rates as the threat of a recession looms.
Short-run policy implication: unchanged fed funds rate for some time
Bernanke’s semi-annual Monetary Policy Report to Congress on Tuesday is that the FOMC views the current 2.0% Fed funds rate as appropriately calibrated to restoring acceptable growth and acceptable inflation over the medium-term given the information available today ?
Eric Tan, London
Friday, 11 July 2008
Another deleveraging scenario this summer? Markets for the week ending 10-Jul
Market Update: Standard & Poor's 500 Index fell into a bear market
The benchmark index for American equities plunged to a two-year low on Tuesday, bringing the loss since its October record to 20 percent.
Shares have been declining for five straight weeks, and a drop in the index of another 12 percent would match the average retreat of 11 bear markets since 1946.
Reasons suggesting another deleveraging scenario this summer:
- Nervous investors sell bonds, driving prices down; Traditional bond managers may start losing their clients if they have another poor quarter.
- Hedge-fund managers may find prime brokers cutting off funding if their positions deteriorate.
- Bank loans have been contracting at an annualised rate of 8% over the past 13 weeks to June 25th.
- Fundamentals for the corporate-bond market have worsened since last August.
- Expectations for corporate profits are being revised down, as margins come under pressure from slower growth and higher commodity prices.
- Headline inflation is well above target, so central banks are unlikely to ride to the rescue with interest-rate cuts, preferring to tighten monetary policy.
? Sell Signal : Financials
Fannie Mae, Freddie Mac, speculations runs rife
- Rising borrowing costs spurred concern that America's biggest sources of home-mortgage financing may not be able to fund their businesses.
- Fannie Mae and Freddie Mac fell to their the lowest since 1992.
With $5.2 billion more owed than its assets were worth in the first quarter, Freddie Mac would be technically insolvent under fair value accounting rules.
Implications:Until investors see what write-offs are going to be and second-quarter earnings of financial companies, they're not interested in buying at any price.
Word on the street is that it's been far too early to buy and the loan-loss reserves need to stabilize before investors return to the markets.
Worth noting:
Lehman-LEH put volume & volatility Spike; LEH down 12%
LEH is recently down $2.54 to $17.20. LEH call option volume of 15,588 contracts compares to put volume of 41,549 contracts.
LEH July option implied volatility is at 188, August is at 170; above its 26-week average of 75, suggesting larger risk.
Earnings announcements:
JPM : 17-Jul
MER : 17-Jul
Citigroup : 18-Jul
Eric Tan, London
The benchmark index for American equities plunged to a two-year low on Tuesday, bringing the loss since its October record to 20 percent.
Shares have been declining for five straight weeks, and a drop in the index of another 12 percent would match the average retreat of 11 bear markets since 1946.
Reasons suggesting another deleveraging scenario this summer:
- Nervous investors sell bonds, driving prices down; Traditional bond managers may start losing their clients if they have another poor quarter.
- Hedge-fund managers may find prime brokers cutting off funding if their positions deteriorate.
- Bank loans have been contracting at an annualised rate of 8% over the past 13 weeks to June 25th.
- Fundamentals for the corporate-bond market have worsened since last August.
- Expectations for corporate profits are being revised down, as margins come under pressure from slower growth and higher commodity prices.
- Headline inflation is well above target, so central banks are unlikely to ride to the rescue with interest-rate cuts, preferring to tighten monetary policy.
? Sell Signal : Financials
Fannie Mae, Freddie Mac, speculations runs rife
- Rising borrowing costs spurred concern that America's biggest sources of home-mortgage financing may not be able to fund their businesses.
- Fannie Mae and Freddie Mac fell to their the lowest since 1992.
With $5.2 billion more owed than its assets were worth in the first quarter, Freddie Mac would be technically insolvent under fair value accounting rules.
Implications:Until investors see what write-offs are going to be and second-quarter earnings of financial companies, they're not interested in buying at any price.
Word on the street is that it's been far too early to buy and the loan-loss reserves need to stabilize before investors return to the markets.
Worth noting:
Lehman-LEH put volume & volatility Spike; LEH down 12%
LEH is recently down $2.54 to $17.20. LEH call option volume of 15,588 contracts compares to put volume of 41,549 contracts.
LEH July option implied volatility is at 188, August is at 170; above its 26-week average of 75, suggesting larger risk.
Earnings announcements:
JPM : 17-Jul
MER : 17-Jul
Citigroup : 18-Jul
Eric Tan, London
Friday, 27 June 2008
Steady deterioration... markets for the week ending 27-Jun-08
Tightened credit standards since the last recession is making life harder for existing borrowers and with inflationary worries that are expecting to send interest rates higher again, the banks ability to be flexible is limited because of higher financing costs on the interbank market.
Troubled areas:
- Britain's untested areas of specialist lending, such as buy-to-let and self-certification mortgages, are coming under stress. Analysts expect 23% of the total stock of British mortgages by value is due to reset in 2008, against a mere 4% of stock in America last year.
- Car-loan defaults may grow as drivers decide to throw their car keys in the same dustbin as their house keys as record fuel costs are also guzzling more of consumer's disposable income.
- Untapped loan commitments to corporate customers continue to crowd out space on bank's balance-sheets, estimated $6 trillion overhang of committed lending facilities to be drawn down, most of it at more generous terms than borrowers could get now.
No surprise given the above, that some of the less well-capitalised UK banks ( AL/, BB/, HBOS) have fallen between 61-76% this year
Scenarios:
- Loan provisions increasing
- Credit cycle goes into a prolonged U-shape recovery instead of V-shape
- Flat or negative GDP growth for 2-4 quarters
- ECB and BOE raises rates due to inflationary pressures
- What more? Oil above $170? may not be impossible with summer round the corner.
Economic Update:
- The U.K. economy grew less than previously estimated in the first quarter, weighed down by the weakest services expansion in 12 years. Overall GDP rose 0.3 percent in the three months through March, the least in three years.
- Royal Bank of Scotland Group Plc, the second-biggest bank in Britain, had its credit rating lowered at Moody's Investors Service, which cited ``higher volatility'' in its securities unit and greater risk of loan defaults in the U.K.
Inflation stories:
- Spanish inflation accelerated to the fastest pace on record in June as oil and food prices surged. Consumer prices rose 5.1 percent from a year ago after increasing 4.7 percent in May
- Inflation in Germany, Europe's largest economy, rose 3.4 percent from a year ago after gaining 3.1 percent in May led by surging energy costs. (more than forecasted)
Eric Tan, London
Troubled areas:
- Britain's untested areas of specialist lending, such as buy-to-let and self-certification mortgages, are coming under stress. Analysts expect 23% of the total stock of British mortgages by value is due to reset in 2008, against a mere 4% of stock in America last year.
- Car-loan defaults may grow as drivers decide to throw their car keys in the same dustbin as their house keys as record fuel costs are also guzzling more of consumer's disposable income.
- Untapped loan commitments to corporate customers continue to crowd out space on bank's balance-sheets, estimated $6 trillion overhang of committed lending facilities to be drawn down, most of it at more generous terms than borrowers could get now.
No surprise given the above, that some of the less well-capitalised UK banks ( AL/, BB/, HBOS) have fallen between 61-76% this year
Scenarios:
- Loan provisions increasing
- Credit cycle goes into a prolonged U-shape recovery instead of V-shape
- Flat or negative GDP growth for 2-4 quarters
- ECB and BOE raises rates due to inflationary pressures
- What more? Oil above $170? may not be impossible with summer round the corner.
Economic Update:
- The U.K. economy grew less than previously estimated in the first quarter, weighed down by the weakest services expansion in 12 years. Overall GDP rose 0.3 percent in the three months through March, the least in three years.
- Royal Bank of Scotland Group Plc, the second-biggest bank in Britain, had its credit rating lowered at Moody's Investors Service, which cited ``higher volatility'' in its securities unit and greater risk of loan defaults in the U.K.
Inflation stories:
- Spanish inflation accelerated to the fastest pace on record in June as oil and food prices surged. Consumer prices rose 5.1 percent from a year ago after increasing 4.7 percent in May
- Inflation in Germany, Europe's largest economy, rose 3.4 percent from a year ago after gaining 3.1 percent in May led by surging energy costs. (more than forecasted)
Eric Tan, London
Friday, 20 June 2008
Update: basis risk and credit value adjustments as potential sources of losses
Lots of assets don't have a corresponding index so banks have to mix and match several indexes for your hedges. Some work, some don't.
However when a hedge goes wrong, i.e moves in an adverse direction, you are caught in a situation where you own protection that has cost you more than what's now available in the market place.
Implications
As the value of protections (that you would assume is equivalent to an asset) gets marked to market, hedge-related losses are looking ever more conspicuous as investment banks unveil their results
- Goldman Sachs reported roughly $500 million in losses related to its leveraged-finance positions.
- Lehman Brothers, the big shift in the underlying assets and their corresponding derivative positions played a significant role in its $2.9 billion worth of losses.
- Citigroup on 19-Jun warned of further large writedowns and credit losses in the second quarter
- Morgan Stanley reported $800 million in losses from trading and leveraged loans
Comments:
There's certainly going to be a lot more uncertainty facing the financial markets in the weeks to come. Banks are going to struggle with replacing the record profits made in the yester-years from fixed income structuring with new sources of income. So far, most have jumped onto the Commodities trading bandwagon and Goldman has done particularly well. but with the commodities market fast-becoming crowded and less of an alternative bet to equities/fixed-income, no one knows when the music is going to stop.
Eric Tan, London
However when a hedge goes wrong, i.e moves in an adverse direction, you are caught in a situation where you own protection that has cost you more than what's now available in the market place.
Implications
As the value of protections (that you would assume is equivalent to an asset) gets marked to market, hedge-related losses are looking ever more conspicuous as investment banks unveil their results
- Goldman Sachs reported roughly $500 million in losses related to its leveraged-finance positions.
- Lehman Brothers, the big shift in the underlying assets and their corresponding derivative positions played a significant role in its $2.9 billion worth of losses.
- Citigroup on 19-Jun warned of further large writedowns and credit losses in the second quarter
- Morgan Stanley reported $800 million in losses from trading and leveraged loans
Comments:
There's certainly going to be a lot more uncertainty facing the financial markets in the weeks to come. Banks are going to struggle with replacing the record profits made in the yester-years from fixed income structuring with new sources of income. So far, most have jumped onto the Commodities trading bandwagon and Goldman has done particularly well. but with the commodities market fast-becoming crowded and less of an alternative bet to equities/fixed-income, no one knows when the music is going to stop.
Eric Tan, London
More Inflation stories - Markets for week ending 20-Jun-08
- India's inflation accelerated to a 13-year high and stocks and bonds fell on concern the central bank will have to raise interest rates again. Wholesale prices jumped 11.05 percent in the week to June 7, after gaining 8.75 percent in the previous week
- India increased retail prices of gasoline and diesel this month, joining China, Indonesia, Malaysia and Sri Lanka, as a near doubling of crude oil prices pushed up costs
- China, the world's second-biggest oil-consuming nation, unexpectedly raised gasoline and diesel prices by at least 17 percent and increased power tariffs to rein in energy use, potentially driving up inflation.
Implications: Chinese refiners gained, airlines fell on narrowing margins.
Crude prices tumbled more than $4 a barrel on Thursday after the unexpected announcement that China would increase petrol and diesel prices by 18%.
- German producer-price inflation, an early indicator of price pressures in the economy, accelerated to the fastest pace in almost two years in May on energy costs.
- Mexico has frozen the price of 150 basic foods to curb inflation, in the government's biggest set of price controls in more than a decade.
Next week:
Wimbledon - 23 Jun
US June Consumer confidence - 24 Jun
US FOMC meeting - 25 Jun
Eric Tan, London
- India increased retail prices of gasoline and diesel this month, joining China, Indonesia, Malaysia and Sri Lanka, as a near doubling of crude oil prices pushed up costs
- China, the world's second-biggest oil-consuming nation, unexpectedly raised gasoline and diesel prices by at least 17 percent and increased power tariffs to rein in energy use, potentially driving up inflation.
Implications: Chinese refiners gained, airlines fell on narrowing margins.
Crude prices tumbled more than $4 a barrel on Thursday after the unexpected announcement that China would increase petrol and diesel prices by 18%.
- German producer-price inflation, an early indicator of price pressures in the economy, accelerated to the fastest pace in almost two years in May on energy costs.
- Mexico has frozen the price of 150 basic foods to curb inflation, in the government's biggest set of price controls in more than a decade.
Next week:
Wimbledon - 23 Jun
US June Consumer confidence - 24 Jun
US FOMC meeting - 25 Jun
Eric Tan, London
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