Derivatives Tail Wagging The Financial Market Dog

A: I'm going to keep this post a simple link out + few excerpts to what I considered to be an amazing read. ContraryInvestor.com discusses market observations and explains, with tough clarity (read it twice if you have to), why the equity markets are being driven by the derivatives unwinding and will continue to be during the prolonged cycle of deleveraging. This is not a post regarding the state of Manhattan real estate. This is a link-out for anyone trying to understand the credit markets, those who understand credit default swaps, structured credit traders, hedge fund traders, equity traders trying to understand the seemingly irrational behavior of recent stock movements, and anyone who is attempting to understand the derivatives effect on markets. A great read.

ContraryInvestor.com: WAGGING THE DOG

Few excerpts:

"...the evolutionary character of the credit markets is THE issue to focus upon, an issue that is clearly driving both broader financial market and real economic outcomes of the moment. It's our belief that a credit cycle of really generational proportion has now given way under its own weight to an elongated process of systemic deleveraging. A process that has really just begun."

"What occurred in the week after the Bear Stearns debacle was simply the dream levered hedge portfolio (long gold, log oil, long commodities, short financials, short brokers, short discretionary stocks, short the GSE's and housing related stocks) of the last six plus months being turned completely on its head. And what it clearly suggests as one potentially very meaningful driver of performance during that week was levered speculating community leverage unwinding. A leverage unwind that is not finished. As we're sure you already know, if indeed you were a levered fund either choosing or being forced to unwind a portfolio perhaps due to the heavily increased margin/collateral capital calls from the prime broker community in the wake of Bear's sudden submergence, the influence of collective levered portfolio unwinding (raising liquidity) might have looked exactly as is detailed in the table above. To delever you would have sold what you were long and bought what you were short. So although the CNBC fan club may indeed have tried to celebrate the big bear market bottom for the financial markets, what we may have indeed experienced is simply more significant major macro credit cycle reconciliation - levered investment position unwinding (the hedge and levered speculating community)."

"Alright, fine, so how does the credit default swap market relate to equity market sector volatility of the moment? It is absolutely clear that the "acquisition" of Bear avoided triggering Bear Stearns related credit default swaps and swaps against CDO, SIV, etc. positions they may have held (assuming a potential Bear BK would have forced a mark to market event), which would indeed have happened had Bear formally entered bankruptcy and their bonds/debt became potentially very meaningfully impaired. There is simply no question whatsoever in our minds that this was the key reason a theoretical acquisition of Bear HAD to happen. Remember the details. JPM took out Bear for a couple of hundred million at the headline $2 per share initial offer level, but concurrently announced it was going to need to charge off about $6 billion as a result of the so-called acquisition. Even at the ultimate $10 level (which is basically shut up money offered to help prevent litigation, which might also have led to asset price discovery) JPM was "telling" us Bear was worth far less than zero by the charge-off number alone. Of course the truth simply had to be that if Bear had filed bankruptcy and the credit default swaps written against their bonds/debt/asset positions had been triggered, the credit default swap liabilities in the market would have been well north of a $6 billion hit to whomever had written those Bear specific CDS contracts. Well north. And that simply could not have been allowed to happen."

"Now put yourself in the position of a meaningfully levered hedge fund who had purchased CDS contracts against Bear credit vehicles. You had levered up against what was continually becoming very profitable CDS positions or credits as Bear was heading nose first into the tarmac. Who knows, you might have even increased the position prior to the weekend based on info your fellow good buddy hedgies were feeding you about Bear's imminent demise. When those long CDS contracts against Bear credits/positions went to zero virtually the Monday after the JPM acquisition announcement, all you were left with was massively deflated CDS asset values relative to the prior Friday and still in place leverage. So what do you do when you get up in the morning on Monday after the Bear acquisition announcement (assuming you slept Sunday night, that is)? You start delevering (see chart above for asset price performance 1 week after Bear Stearns/JPM deal announced). You start unwinding in place inflation themed trade positions to raise liquidity. You sell what assets you can (gold, oil, commod's, etc.) and get less short those sectors you have heavily shorted (financials, brokers, consumer, etc.) to raise liquidity and decrease total leverage against a now immediately diminished asset base."

Read the whole article here if the above excerpts are your cup of tea in the ongoing quest for understanding what may be going on in this very complex credit market cycle.

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