We saw some interesting action yesterday – from serious pressure all day with some strong covering into the close. SPX actually closed up on the day. However, we still remained at the low areas and the pivot points. All of which means – more “hidden volatility” loading up into the indices. The pressure (odds) remain to more down side risk and the VIX remains in the mid to upper 20s. The skew is also fairly step (specially in the tech sector). Of course the talking heads (this morning on CNBC) are still debating if we are in a Recession or not (or if we will go into one) – for me it’s all academic and doesn’t mean much. I personally think the market is giving a fairly decent outlook as to economic conditions just by looking at metals, oil, commodities, and exchange rates.
I also read an interesting article about a NEW group of foreclosure types that CAN pay their mortgages. The article stated that there is a rise in foreclosures coming from homeowners that CAN afford their mortgages, but elect to walk away since the property value has significantly dropped. It said there is a higher likelihood for additional foreclosures in homes that have lost at least 40% of their value since purchase. The homeowner would rather foreclose than to make payments on an underwater investment. The homeowners mindset is that it’s a waste of money – throwing good after bad. It would seem that it’s feeding on itself – credit problem happens – those that cannot afford to pay their mortgage try to sell – lowering housing prices to a point that those that CAN pay don’t want to be invested in an asset that is underwater. The report concluded that this is a bigger concern that is now creeping into the foreclosure market – as laws vary from state to state and the costs for legal action by the mortgage companies is too make going after a homeowner that has “walked away” not attractive. There is a new term for these “walk away” homeowners (willing to be foreclosed on) it’s called “jingle mail”.
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Citigroup - their “Angel” is not happy
The Sovereign investment fund in Dubai that invested in Citigroup may feel they were duped – as losses are increasing and it seems that Citi is more of a bottomless pit. Maybe the transparency was a little cloudy or Dubai didn’t do the due diligence necessary. Either way – Dubai International CEO stated “It will take a LOT more than THAT to recue Citi and other financial institutions”, when referring to the additional $14.5 billion from investors (after already receiving $7.5 billion from Abu Dhabi.
The problem continues to go back to the “Write Downs” and illiquid assets. Many of the positions that Citi holds are illiquid (rated at Junk or Default) – there is NO ONE to sell them to – so their only options are to “Write them Down” – based on SOME market value. As Buffet likes to call it “Mark to Myth” – since there is no market. This is alarming as that the position values are uncertain as to ANY value. One analyst on Bloomberg last night went as far as to say Citi is technically bankrupt – they are just being floated with help from overnight lending from the government and some sovereign funds tossing some cash at them – however it is far from enough to cover the losses. The analyst further pointed out the massive leverage they have on their books. Citigroup does not have enough capital to cover losses from the leverage positions if they exceed anything close to the magnitude of the CDO write downs (ones that have NOT been written down) – furthermore it does not have enough to cover even 50% of the capital on deposit – should those elect to take a withdraw. The overnight lending to cover such losses or withdrawals would put them in violation without additional funds. Hopefully – the additional $14.5 billion can get them through this rough period, but as the CEO of Dubai International pointed out – it’s probably going to take a lot more. Expect to see Bernanke and Paulson create more special rules for borrowing at the “discount window” and more government back door help. Citi is going to need it.
Expect the banking sector to take some pressure today and going forward as more news continues to trickle out about credit and debt issues and their ability to raise money to stay solvent.
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Vallejo, California – the first big city to file for bankruptcy?
Vallejo is on the verge of bankruptcy - the first sign of state and local governments failing.
The typical strategy of many bonds that are raised is this (simple explanation – which may not be exactly the pickle that Vallejo is in – but pretty close):
Local Government raises money for a new building. They don’t need all the money now, so they invest that money into a “AAA” rated investment. Their expectation is that the “AAA” rated investment returns will surpass the low interest payments of the bond they need to pay. They THINK this is arbitrage (little do they know – by the way I had this argument with the CFO of Sarasota Hospital – who also thinks he is arbitraging). The reality is they borrowed money and invested in something else. Just because you pay interest on the bond and are receiving interest on another investment does NOT mean it is an arbitrage. The misnomer comes because they are paying and receiving interest. The problem is that the underlying investments are NOT off-setting (thus defining an arbitrage).
So there is two risks that they do NOT see or choose to ignore.
First – what happens if their investments in the AAA product lose money? They believe that MBIA or other bond insurers will cover (but they can’t) – additionally AAA is not suppose to fail – that is why it is AAA. But they are failing and getting downgraded fast.
Second – what happens if their bond’s interest rate gets set higher? This is not suppose to happen – these bonds are in the 3-6% range and the belief that because they are muni’s they are safe from default (just tax people more or ask the FED to bail you out). Well they did increase – because the auctions failed and the only people that stepped up to cover set rates above 20%.
So now you have it – they investment failed and their loan got reset to some crazy high amount. You could say it’s the perfect storm. Believe me – Vallejo is not the first to be treading water. More and more state and local governments, hospitals, and airports will all be in the very same predicament.
I asked the CFO of the Sarasota Hospital – why not break ground on the new building for which you raised the money for in the first place. His answer – we are making money in our interest rate arbitrage. Good luck!
As these stories increase – and if the FED has to start a bailout in this sector – expect more pressure on the dollar.
Watch the bond insurance sector today – this will probably put negative pressure on them since they will be expect to cover losses (but don’t have the money)
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Futures Pre-Open
The futures are getting hit pretty good going into the opening – a combination of Citi and Intel’s lower forecast. They are front-running the cash by about $2-4 points – we may see them slightly recover from ARB traders going into the opening, but after that it’s looking south-bound.
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Support / Resistance
We got a good retrace going into the close -but are still at those pivotal points.
INDU 12250 (It needs to hold here – bottom support, but not a place to get long. The only thing that will rally this pig is short-covering – meaning that if it does it will move up fast and hard. However 12250 will probably see some pressure. Expect a revisit to the 12,000 level – sooner rather than latter)
NDX 1725 (If we can’t close above this – while only a limited support area – then it’s 1700 and quick. Again – look for some possible short covering – the short interest is ramping – any pop could cause a massive covering rally)
SPX 1325 (Another area that needs to hold – these low points in the INDU, NDX, and SPX will only rally hard and fast out of here – if we get a fueled short covering rally. We will NOT be rallying based on any fundamental market news.)
RUT 700 (THIS IS SCARY ZONE – if the broader market can NOT hold – we could be visiting 650 fast! WATCH THE RUT very closely we need it to hold the 680 level and start moving towards 700 and above. If this thing breaks down today – we could be looking at a serious down day across the board!)
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Conclusion
We “hope” things get better – but it’s an election year, the Republicans hate McCain because he is not conservative, Bernanke is cranking the printing press, the credit/debt bubble is about to burst, the Dems can’t decide which National Socialist to elect, and President is on vacation in Texas. Great – a bunch a dolts are running the show and are more interested in bailing out their supporters than saving the economy. The Dems are no different than the Republicans – that is probably why they hate each other so much. Hillary attacked Obama for taking on $650k money from Energy and Oil companies, but she has egg on her face because she has received $750k from the same Energy and Oil companies. You really think Obama and Hillary CARE about the man in the street? – No- they are in bed with companies “promising to save them” during this economic hardship. You don’t get the board of Citigroup supporting Hillary – unless she gave them the Masonic Handshake.
So the concern here is volatility. We are going to see LOTS more over it going forward. The economy is in for a rough road and the dollar is only going to go down (with more rate cuts).
So traders – get ready for one hell of a great ride. Look for some great volatility in the tech, bank, and lending sector.
Strategies:
Ratio Spreads for Gamma.
Watch short Vega positions. Use flies to cover short Vega positions to eliminate delta risk.
Hedge ALL hard deltas.
Take BIG soft deltas for the huge fast and hard rallies and drops.
Investors (the few that read this): Hedge 1:1 at the very least!
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