7/9/08 (Sovereign Funds, Freddie & Fanny?)

Traders,

We saw a good bounce out of that area as the market finds a support area. The RUT got very close to that 650 level (651.92) yesterday – the March lows and held. It then rallied hard over 3.7% into the 680 level. The entire market got a good rally out of these areas as oil came off pretty hard (to the 136 level). The dollar also saw some strength. It also looks (from the futures in the pre-market) that we might get a follow through (at least at the opening).

I also got some positive feedback from the Pickens’s Plan email. It has some interesting ideas – but I think Pickens’s is right – regardless if it is his plan or someone else’s we NEED one now and as important – we NEED someone to lead that plan! Pickens’s has indicated he would help, but he also said yesterday morning he is too old and would not take on a roll in any administration – he would help in any possible way. He (like others) are very concerned about our future. When the U.S. premier oil man is concerned about our energy future and is looking at Wind, Natural Gas, and other items (instead of beating the drum for more oil or drilling in Alaska) well – that IS alarming. Most would think that because he is an Oil Man all he would be doing is say “Drill in Alaska”, “Drill on the Coasts”, “Drill, Drill, Drill!” – but he is NOT. That to me clearly indicates we are beyond hope that more drilling will solve the energy problem – we need to move NOW to alternative fuels. Again – take the time to visit the site if you haven’t – there are some interesting thoughts and ideas. At the very least it should help bring attention and open debate to the topic – rather than the political finger pointing at OPEC, Speculators, or Oil Companies as the only problem that needs to be solved. www.pickensplan.com

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Sovereign Funds licking their wounds….

You would think, because they have billions and back by governments, that Sovereign Funds are the smart money – but after the recent smack downs in Citi, BofA, Lehman, Ambac, MBIA, etc – they most definitely tossed good money after bad. In some cases they were trying to protect their investments, rather than make a value play. Additionally – they too were fooled as to the “The worst is behind us!” talk. Now they have pulled back and are not the easy fund raising (even if you do give them your first born) as they were only a few months ago. The tap is closing quickly – because more money that they have tossed at these firms has plugged the hole.
However, I was watching Bloomberg last night and a guest (forget the name) pointed out an interesting observation as per the Singapore Sovereign fund – they are looking for HARD ASSETS rather than just stock. And these funds will be forming new types of deals to secure those hard assets for long-term security. The HARD ASSET you ask? Property !!! Interesting – as the world’s property values are falling. However, I am starting to see their long-term thought process. Example: If they are only getting shares in a company (even warrants and dividends) they still have an underlying credit risk. I think they too are seeing that Moody’s ratings are not holding water. Now any deals will most likely included property ownership. The guest on Bloomberg pointed out the JPM takeover of Bear Stearns included the acquisition of the Bear’s headquarters (the large Manhattan office building). That is a hard asset that no one can deny – even if Bear fails. It is something tangible. This means that banks and firms looking for MORE Sovereign Funds will be giving up MORE than just stock, warrants, and bonds for deep discounts – they may also be giving up their actual real-estate.

The first being pointed out was New York’s Chrysler Building, just sold to the Abu Dhabi sovereign fund. While this is not part of a bank backing deal – it is clear that hard assets (even if they lose in the short-term) are something more tangible than stock whose value is based on a credit rating! Several banks and lending firms own large tracks of real-estate. These firms continue to need money – expect to see real-estate acquisitions are part of new deals going forward – if they want that money!
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Freddie Mac and Fannie Mae - default?


Freddie and Fannie rallied yesterday as regulators indicated they were well capitalized, but traders are NOT buying the regulator’s word. While Freddie and Fannie (both Congress mandated companies and backed by government guarantees) maintain their coveted golden credit ratings by Moody’s, derivative traders are treating the paper (pricing it) as if it is rated 5 levels lower. You would think that with the government guarantees they would not have issues with their credit ratings. However – these companies have a history of problems (accounting scandals) and have billions of dollars of junk paper on their books. They had recently be given an open check book to ease the credit problems and take on more crud paper – (instead they tried to get their own house in order – but that didn’t help).

Bernanke speaking as to increasing his responsibilities and power yesterday (mentioning both Freddie and Fannie) didn’t help the matter. It clearly indicates these companies have MORE problems. It also indicates that it will be harder for the Fed to tighten money flow if these two behemoths are still underwater in bad paper – the money will need to continue to flow and thus the possibility of rate increases diminish (if as Bernanke has indicated – he will be helping them out too).

While the Dollar did get a bounce on tough talk – it certainly didn’t convince the derivative traders that government backing held much value if inflation (even by CPI levels) will out strip bond returns. How much money do you have to flush into these firms to keep them going. We are not talking a few billion, we are talking about $1.45 TRILLION of debt sold by these two mortgage finance companies. The bond prices are trading at A2 levels and implies that Moody’s needs to get on the ball and lower the ratings by 5 levels. You would think it doesn’t make sense – because they are protected from default by the government – however at what price? A trillion dollar bailout (don’t forget where the bailout comes from – either more inflation through money printing and/or eventually more taxes). No doubt a bailout would put serious pressure on the dollar at those levels. The problem with the bailout – unlike traditional bailouts by other firms – is that there is NO financial firm that can take down that risk or paper (like JPM bailing out Bear) – meaning it would be a full bailout by the government (no one else COULD do it if they wanted to). Don’t expect the sovereign funds to step in (unless the government is willing to through in the White House – a joke).

The cost to protect these companies debt is rising fast – alarmingly fast. The Credit-default swaps on these government backed companies rose almost 40 bps since May 1st. While it may not seem like a lot for a regular company – these are government backed companies – their credit should be as safe as treasuries (right?). The price obviously indicates that traders do NOT have faith in the government (or maybe just the dollar and the Fed’s tough talk with no action).

It didn’t help that Moody’s kept AAA ratings on AMBAC and MBIA the two largest bond insurers as these companies have all but failed and have dropped from the high $50s to less than $5 a share. The companies bond insurance (over a $1 trillion) is pretty much worth the paper it is written on – cause they are fully tapped and don’t have enough to cover the losses.

I would have to say we live in interesting times if credit-default swaps on government guaranteed companies is trading 5 levels lower! True – Freddie and Fannie may never go out of business and may never default – but the mounting debt they are taking on leads to one question – how much is TOO much for the government to guarantee. I guess a trillion plus on top of inflation and low interest rates has traders concerned.

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Oil Up on Iran test

Oil made a pop this morning as Iran test fired a missile that could reach Israel. I guess the saber rattling continues – Israel mock bombing raids, Iran test firing missiles. Looks like we are back to normal in the Middle East. Expect more volatility in oil prices.


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Futures in the Pre-market

The futures got a good pop in the pre-open. The spread is front running the cash by a couple of points and we could see a little follow through at the opening. If the spread remains expect a pop at the opening as Arb traders buy the cash and short the futures.

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Support / Resistance

It looks like we have created a support area and the rally yesterday helped confirm that . We may get some follow through, but the Iran news combined with concerned about Freddie and Fannie may bring pressure to the market.

INDU 11200 / 11500 (We got a solid rally off the 11200 area – a place we had consolidated at – we could get back to 11500 if euphoric optimism continues. Hedge hard deltas.)

NDX 1800 / 1900 (Another great rally – 1900 a place to get flat.)

SPX 1250 / 1300 (If we can get more upside – we could touch 1300.)

RUT 650 / 700 (We got very close to those March lows and held. This as I continue to point out is the good indicator for general money flow. As long as we are above 650 we could continue to see some support in the broader market. Keep an eye on it.)

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Conclusion

The Freddie and Fannie story (being a trader) is the most interesting story for me this year. I have worked with pricing models and pretty familiar with derivatives. The skew seen traditionally in listed securities reflect default risk (or downside risk) – on the default swap side it is a function of Rho (or interest) taking inflation, interest rates, and most importantly the credit rating into consideration. As I pointed out earlier this year the story about MBIA and AMBAC maintaining AAA ratings when they are failing is a pretty big story – for one reason – HOW will derivative traders price default-swaps if they can NOT rely on credit ratings? Well – I think we are seeing it – but not where ANYONE would expect. These companies are government guaranteed! I mean come on guys – what is the risk to Freddie or Fannie?

I think they have pulled the credit rating out of the model and introduced their own – additionally I think they are putting more weighting on inflation vs. interest rates. We had a saying on the trading floor about running pricing models (and the function of setting volatility to get theoretical pricing) – “Garbage in, Garbage out!”. I think these default-swaps traders are starting to realize those AAA Moody’s ratings in the models = Garbage. It’s time they set their own ratings into the model. The value of Moody’s at this point is becoming a joke among financial traders. Additionally the Sovereign funds have caught on too. Remember these firms tossed billions at these firms – based on credit ratings and “the worst is behind us” – now they are licking their wounds.

No doubt we live in an interesting time when traders are (synthetically) down grading the value of the U.S. government’s credit worthiness and showing loss of faith in the dollar (regardless of current values).