Tuesday, August 9, 2011

Reducing 20% CDS Position: Is Ben 'Greenspan' crazy?

Earlier today I posted on Twitter that I had reduced 20% of the 'Long German CDS @ 40bp" trade entered in late May.
The trade was entered @ 40bps on May 23rd, for Sep16 CDS expiration.
The exit price, for this tranche, was at 80bps.

So PnL was +40bps, for the swap's duration of around 5.20 at exit = +2.08% for the position, plus the negative carry of 9bps, Total return = 1.99% for 50% of the NAV ~ 1.00%. (20% of a 250% of NAV total position).

There's still 2x the fund long this CDS... paying the cheap carry and exposing the book to its MtM.

Why get out of this position?
Basically reduce risk, pocket the money. Get room for more trades in the near future. Good opportunities seem to be coming to the surface.
Reducing this 20% of the position gives ammunition to be breaking-even on this same trade if Germany 5y goes to around 32bps. At 32bps I'd double the size of the original trade (5x the portfolio) if fundamentals remain as they are now.

Why? I do not think things will be solved in Europe.
But the recent decision to buy Italian and Spanish banks, in my humble opinion, casts a cloud over what will be done.
For the good and for the bad.
I think that this decision, at first, as shown by market prices (Periphery CDSs tightening and Germany widening) is still pro-trade, that is why I remain long the other 2x the portfolio.
This movement in the european CDS spectrum, coupled with the downgrade of the US also casts a cloud over the AAA-status of other european nations.

What will be of the EFSF if the europeans get a downgrade?
And who will fit the bill if the market pushes the ECB into buying more bonds, leveraging up its balance sheet, because the widening in Spanish and Italian bonds go on even after the first efforts this week?
Who is realizing a loss on the bonds bought by the ECB at 300-400bps over bunds, at 5.00%-6.00% in 10yr bonds?

I understand that policy makers do not want to see economic depression in Europe (and likely the world?) if the banking system busts.

But policy makers also aren't allowing the system to balance, even if slowly. They aren't allowing the system to get even close to equilibrium.
There has to be losses to someone in order to get things back in shape. There has to be losses to someone to teach lessons to risk takers and policy makers.
And for years now letting entities (banks, investors, corporations) incur losses is not on the radar.
I am afraid that the can-kicking system adopted by DM policy makers, and followed by EM policy makers, is creating such distortions in investing behavior that things will get only worse and worse.

Today at lunch with a friend of mine who is also a portfolio manager we even came up with a scenario where this behavior will just bankrupt every healthy sovereign balance sheet in the world. Every year the systemic risk is larger and more countries, after a recession, move to 0% interest rates, bail-outs, huge fiscal stimulus, etc, to avoid recessions.

Yes, there is nothing new in what I am saying. Jim Rogers slaps us in the face with his objective comments about bankrupt Europe, US, Japan and UK, etc every week on CNBC or the likes. The same with John Mauldin on his weekly letters. Or David Rosemberg. Or Niels Jensen. Or John Hussman. Or Albert Edwards, David Einhorn, Howard Marks, Kyle Bass, George Soros, etc, etc. It amazes me that even though these guys, who have been in the markets for years making good risk-adjusted returns, and journalists and others speak nothing new the group mentality doesn't change a bit. And policy makers don't change their attitude.

Anyway... we're here to preserve capital and try to profit from these dislocations. Be they positive or not.

Today's FOMC decision to outright say the cost of taking risk will remain at 0% for 2 more years and that they're ready to bail the globe out if necessary really got me thinking. Unbelievable.

*Disclaimer: charts and data are presented as I receive/see them. Sources are usually not checked for validation and my own calculations are of 'back of the envelope'-type. I am aware that some math that I do myself might be wrong and/or misleading to some extent. In financial markets the rate of change of economic data is often more important than the actual level and the perception of 'what is priced in' is more important than 'what is actually going to happen'. This is actually the way people pick entry and exit points. So... yes, sometimes you might say 'This guy is an idiot, this is way wrong!' with a high conviction, being right. Not to worry. Markets are made of expectations and the clash of conviction between its participants. Portfolio managers know that being an idiot is sometimes profitable and being smart is often a bad choice. It is all reality, sometimes good, sometimes bad. By the way: corrections to my analysis and intelligent debate is welcome. theintriguedtrader AT gmail do com

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