Update: and the hits just keep on coming, first Fitch and now... MF GLOBAL CUT TO JUNK BY MOODY'S... "At the end of the second quarter, MF Global's $6.3 billion sovereign risk exposure represented 5 times the company's tangible common equity. Moody's said the downgrade reflects our view that MF Global's weak core profitability contributed to it taking on substantial risk in the form of its exposure to European sovereign debt in peripheral countries." But other major US banks have no exposure whatsover right? Oh wait...They're hedged... Through "CDS".
Bloomberg has just broken that MF Global has likely just entered a terminal deathwatch after not only tapping its credit facility, but aslo exhausting it. From Bloomberg: "MF Global Holdings Ltd., the futures broker run by Jon Corzine, drew down its revolving credit lines this week as the firm reported its biggest quarterly loss and had its credit ratings cut, said three people with knowledge of the matter. The New York-based company exhausted its revolving lines, the people said, speaking on condition of anonymity because the move wasn’t disclosed. MF said in an Oct. 25 investor presentation that it had $1.3 billion in unused revolving credit facilities, without giving a date for the tally." This development means that instead of an M&A assignment as many were attributing the retention of Evercore bankers to (despite the dreary presence of David Ying in their midst), Jon Corzine's firm was far more likely focused on salvaging anything of value. However, now that traditional M&A is out of the picture (nobody in their right mind will pay anything close to market value for a company without cash), it is quite likely that the firm's bondholders, who most likely also have collateral exposure with MF global, whose plight started following the disclosure of extensive European exposure and which was downgraded to junk today by Fitch, will pull all liquidity and instead opt for a debt for equity conversion either in court or as a prepack. What is probably the biggest take home here is just how much of a capital drain European exposure (and we are confident MF was "hedged".... just like Morgan Stanley) can become, and how quickly a firm can become completely insolvent. As a reminder, the firm reported $710 million in cash as of June 30. Obviously all of that cash must have been burned through if the firm also not only tapped but exhausted its $1.3 billion in revolvers in the past quarter (which have rating associated rate step ups, which don't take too kindly to a junk rating). Net result: $2 billion in cash (or about 9 times its makret cap) burned in 4 months primarily due to "hedged" European exposure.
When reporting on the announcement of the math-free deus ex machina bail out that was announced last night, which nobody still has any grasp over, but it had a "trillion" in there somewhere so that alone sent the market scurrying, we suggested that it would take about 24-48 hours for reality to start settling in. It may have been considerably less. As the Telegraph reports, "A trillion euro bail-out to save the EU’s single currency is in danger of unraveling after Germany’s central bank warned that the rescue measure was too dependent on the high-risk deals that caused the economic crisis." So what did the Bundesbank do to send tremors that threaten to fracture the brittle nanometer ice-plated facade under which the most tempestuous riptide in European history is contained? Well, first it appears to have used a calculator, something nobody else in the European Council seems to be capable of. Second, it realized that heaping leverage upon leverage to fix a problem, something even a five year old (non-Ivy league trained) would tell you is lunacy, may not be the best approach to fix the problems at hand. "The concerns were led by Germany’s powerful central bank, which expressed fears that a plan to leverage a €440 billion eurozone rescue fund to amass a “fire power” of €1 trillion, or £880 billion, resembled the risky finance methods that triggered the crisis in 2008. Jens Weidmann, the president of the Bundesbank and a member of the European Central Bank, sounded the alarm over the plan to “leverage” the fund by a factor of four to five times without putting any new money into the pot. He warned that the scheme could be hit by market turbulence with taxpayers left holding the bill for risky investments in Italian and Spanish bonds." Does that mean that the "ironclad firewall" is neither "ironclad" nor walls off any fire? Especially since neither the object (Germany) of the bailout nor the subject (Greece) appear to have any desire to go along with the deus ex?
Remember the bear market? The 20% drop from the July highs to August and most recently October 4th lows has seen a major retrace in the last 3 weeks as we managed to gain 20.7% from the 10/4 lows to the highs of today. Risk was definitely on today though it felt much more like capitulation - especially in credit - than new longs being laid out. Everything was bid today so an end of day comment is somewhat redundant but we would note that HYG underperformed HY and equities (hedges being laid out again?), quality IG new issues were active (but not HY), and commodities tore higher. TSY yields smashed higher (especially post a weak auction) with everyone's favorite carry trade (2s10s30s) jumping once again. The EUR dominated FX markets with FX carry driving ES to a huge day but interestingly (for once), despite the huge up day in stocks, HY and IG credit outperformed - narrowing that gap. IG was the best performer (beta adjusted) overall - dramatically outperforming with a 14bps compression (over 5bps rich to fair-value). The similarities to both price action and sentiment from the March 2008 period are undeniable as investors once again decide whether the status quo has ben restored by more promises or is a larger and more scary reality being created.
GMO Does The Euro Bailout Math, Finds That Arithmetic Of "Sovereign Debt Crisis Is Daunting, But Not Insuperable"In a much needed white paper just released by GMO's Rich Mattione, title "Et tu, Berlusconi? The daunting (but not always insuperable) arithmetic of sovereign debt" the author does just that: an overdue deep dive into the maths of the European, and global, sovereign bail out. "Much needed", because everything we have heard over the past month leading to a 20% surge in the market in the past 23 days, has been full of broad strokes and completely absent of any details. Cutting to the chase, Mattione's conclusion is that "the arithmetic of Europe’s sovereign debt crisis is daunting, but not insuperable." Which means it can be done, at least in theory, but at great costs, and will need something that Europe has never demonstrated until this point: proactive planning and tackling problems before they develop into full blown systemic crises. How does he get there? Here are his key observations...
For some reason, investors' goldfish-like brains forget every quarter that time and again around 70% of names beat expectations and this fact is used as reason to buy buy buy. Certainly this time around, earnings beats are well within historical norms and furthermore are simply beating significantly lowered expectations. However, that is backward-looking and no matter what metric you use for valuation, the only one that really counts is how expectations are priced into the market. With regard to this, 12Month forward EPS expectations have started to roll-over quite significantly for the S&P 500 (at around a -8.5% annualized clip) - the last time we saw this was Q4 2007 and we know how well that ended.
As we come to terms with the new reality (or perhaps same old reality) that governments will do anything to maintain the status quo, Goldman Sachs took a step back this morning to consider what is worth focusing on in the medium-term. Obviously the European Summit proceedings impact their perspective, but less positively than one might expect as they expect slower global growth, a possible European recession, refocus on US data, Chinese policy responses, currency wars, and a balanced portfolio approach to risk. It certainly seems like Goldman remains less sanguine than an exploding US equity market might suggest and we tend to agree that ignoring the fact that the EU Summit conclusions leave more questions than answers, it may allow us to focus once again on the fundamentals and those fundamentals are not a rosy as many would have us believe.
Buying stocks with the confidence that all has been resolved and all open questions have been answered? Or just doing it because everyone else is doing it, and there is "career risk" for those who actually sit to think what the events over the past 24 hours mean? It's ok if it is the latter: everyone else is in the same boat. After all the whole purpose of today's rally is to get everyone exposed the same way, so when it all crashes again, nobody can be singled out for having been contrarian. Why are we so sure? Because when even Goldman Sachs has at least 10 outstanding questions on not only the structure of the European bailout, but the layout of the revised EFSF, it is safe to assume that few have the answers (which, incidentally, don't exist). So in between chasing VWAP ever higher, it may be worthwhile to read these 10 questions which nobody has the definitive answer to. At least not yet. And whose answer is assumed will be a satisfactory one...
China Lays Out Conditions Under Which It Will Bail Out Europe; Does Not Want To Be Seen As "Source Of Dumb Money"Back in September we noted that "Wen Jiabao Says China Willing To Extend Help To Europe... For A Price" the price in question being that, among other things, the EU should recognize China's market economy status, and to split Europe with the US on the topic of Chinese currency manipulation. Naturally, being the biggest import partner for China's goods, the topic of providing vendor financing to Europe has always been a critical one. Well, as was made clear overnight a key part of the European rescue effort is to get China on the same page, and to have it allocate capital to the EFSF. As the FT reports this may have happened, although with more or less the same conditions that China delineated 6 weeks ago. Only this time China has all the leverage. According to the FT: "China is very likely to contribute to the eurozone’s bail-out fund but the scope of its involvement will depend on European leaders satisfying some key conditions, two senior advisers to the Chinese government have told the Financial Times." So what are the conditions: "Any Chinese support would depend on contributions from other countries and Beijing must be given strong guarantees on the safety of its investment, according to Li Daokui, an academic member of China’s central bank monetary policy committee, and Yu Yongding, a former member of that committee." Obviously, Europe will promise the latter. As for the former it could be a tad problematic because as observed previously Brazil has voiced against rescuing Europe in the form of non-IMF participation. But there are more conditions: "It is in China’s long-term and intrinsic interest to help Europe because they are our biggest trading partner but the chief concern of the Chinese government is how to explain this decision to our own people,” said Professor Li. “The last thing China wants is to throw away the country’s wealth and be seen as just a source of dumb money.” Alas, that is precisely how the entire world sees China. As for the final condition: "He added that Beijing might also ask European leaders to refrain from criticising China’s currency policy, a frequent source of tension with trade partners." And this is how you declare political check mate and shut up all voices that threaten to protest against mercantilist policies. And since it is only a matter of time before China will have to rescue the US, we hope Senate enjoys the time remaining in which it can debate whether or not China manipulates the CNY. That time is about to end.
Auction Which Sends US Debt To Over $15 Trillion Has Very Weak Reception; Drags Treasury Complex Lower
Today's epic risk rally has been punctuated by something probably not all that surprising: a very weak $29 billion 7 Year auction, which has since dragged the entire bond curve even lower. The bond priced at a high yield of 1.791%, a notable 3 bps tail to the When Issued which was trading at 1.76 at 1 pm. But the internals are again where the action is: the Bid To Cover of 2.59 was the lowest in the series since the 2.26 back in May 2009! Additionally it appears that foreigners, either China or Europe, had very little desire to load up on this paper, with just 33.9% in Indirect Take Down, and a corresponding 86.9% hit ratio on the Indirects. So while Indirects came at the lowest since June, so the Primary Dealers took down the most since that month, at over half of the entire auction, or 54.15%. Directs also stepped up, bidding up 11.95% of the whole, compared to 8.95% last twelve auction average. And as the chart below shows, the disappointing auction has dragged the entire treasury complex lower in price. As a reminder, this bond auction brings total US debt to over $15 trillion, a number which would have resulted in a 100%+ debt/GDP using the Q2 GDP. As it sands, following today's update, the market has about $160 billion in capacity before that threshold is breached again.
It has been long in coming but finally the credit market is noticeably refocusing its attention to the two countries that are supposed to carry the burden of bailing out the world on their shoulders: Germany, and, that perpetual placeholder for global rescues, China. As noted yesterday, while following today's anticipated ISDA decision to effectively make price discovery in CDS null and void, and in the process also put the whole premise of sovereign debt insurance into doubt, CDS still provides a very useful metric courtesy of the DTCC, namely open interest, or said otherwise, gross and net notional outstanding in the CDS. And while we will reserve the observation that not only did ISDA kill sovereign CDS, but in the process it also ended bilateral netting effectively pushing up net CDS to the level of gross, we will highlight that as of the last week, net notional in both German and China CDS has hit a record, of $19.6 billion and $9.3 billion, respectively. This is occuring as notionals in the two most active countries to date, France and Italy, have been declining. In essence, what the CDS market is telling us is that while the easy money in French and Italian default risk has been made, it is now finally the turn of China and Germany to defend their credit risk and sovereign spreads. We expect that if China is indeed confirmed to be the backstopper of Europe through funding the EFSF in whole or in part, that while its CDS may or may not surge, net notionals will continue to increase as it means that ever more are laying insurance, as hobbled as it may be, on the country which recently was forced to bail out its own banking system, let alone Europe. Keep a close eye on China, which while the bulk of the market is taking for granted as the global rescuer of last resort with hard money, the smart money is already positioning itself for the next big disappointment.
For those who don't expect something for nothing...
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