Fallout of JP Morgan hedging loss.

In the light of JP Morgan’s stunning losses on derivatives with the full scope of total potential losses still not yet clear.  But the real losers in this turn of event are not limited to J P Morgan and its board but it covers many more.

1) CDS as an instrument: It has revitalized critics who have started talking against credit default swaps as unmanageable and its effectiveness as hedge instrument.  Critics are panning CDS down as an instrument but they are forgetting that, it was stupidity of position takers not the instrument itself which resulted into this loss. Taking such a big position on illiquid vintage CDX 9 series (current one is CDX 18) is recipe of disaster. Once market knows that you have such a huge concentrated position it will make exit troublesome.  It was excess of credit which brought financial crisis not access to credit, same way the  use to leverage their balance sheet  by financials like Lehman and AIG created problem not CDS since CDS is still an effective hedge instrument which diversify risk to broader set of investors.

2) Regulators:  In the spring, JP Morgan passed the Federal reserve test with flying colors.  The Fed agreed to let JP Morgan increase its dividend and buy back shares. There was no hint in the stress tests that JP Morgan could be facing these kinds of potential losses.  Since regulators mostly rely on model used by banks, which is generally designed by so called “Quants”.  There may be call to have a deeper look at those internal models, rightly so !

3) Regulation: There is a very thin demarcation line between hedge and prop trading, prima facie it looks like the huge position taken by CIO office was atleast bordering on the prop trading. Such activity will be illegal under Dodd Frank act (Volcker rule), and this incidence will reinvigorate the demand for more stringent regulation. However, in the aftermath of financial crisis we need smart regulation not more regulations.  Heavy regulation will curb credit which is required for economy to grow. So we need more prudent regulations and regulators.

4) More bad news to follow: Even though James Damien said "just because we were stupid does not other are also is not true" may be a very optimistic assessment of his peers and there might be a few more bad news to follow. Since in OTC market, it’s the herd mentality which rules.

5) Rating of Financials:  Rating agency "once bitten twice shy" may consider to take action on individual name or financials as a whole. Not a good omen for banking.

Sino Forest auction result

http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=SIFO

Creditex  and Markit conducted a credit event auction to facilitate settlement of credit default swaps (CDS) trades on Sino-Forest Corp. on May 9, 2012. Sino-Forest was the first credit event auction conducted to settle CDS trades outside of North America, Europe and Japan. Final price for the auction settlement was 29 cent on a dollar.

Marshall Plan not Merkel plan

Icarus in Greek mythology, the son of Daedalus attempted to escape from ‘Crete’ by means of wings that his father constructed from feathers and wax. He was instructed not to fly too close to the sun or sea since sun heat will melt wax or closeness to sea will wet feathers making it heavier and will not be able to fly. Icarus ignored instructions and soared through the sky, but in the process he came too close to the sun, which melted the wax. Icarus kept flapping his wings but soon realized that he had no feathers left and that he was only flapping his bare arms, and so Icarus fell into the sea. 

Fortunately it was a mythological tale which does not need to be true; on the other hand if we see the current situation in European Union we see an uncanny similarity. Two of the original core objectives of the European Economic Community were 1) the development of a common market, subsequently renamed the single market and 2) a custom union between its member states. However, the monetary union with such a economically diverse set of countries took the concept too far, I do not think even Mr. Monnet (founding father of European Unity) might have expected it to happen so fast. Single currency brought down the risk premium (spread over bund paid by peripheral countries), just before the financial crisis Greece was paying almost same rate of interest as Germany was even though Greece was in default for half of last 180 years. Magically, common currency mitigated the Greece credit risk and brought yield convergence. However, like Icarus Greece also became very ambitious and piled up debts and spent on social benefits far exceeding its means which made it to fall in European sea.  

Marshall Plan not Merkel plan

Now the focus of European Union is on austerity via fiscal compact plan ignoring growth, without explaining how it is expected to improve situation in peripheral countries. How can confidence be restored as the crisis economies plunge into recession? How can growth be revived when austerity will almost surely mean a further decrease in aggregate demand, sending output and employment even lower?. Elections on 6th May have shown voters in France and Greece have decisively rejected austerity measures. Now we have seen election after election incumbent losing power or change of guard taking place in Europe starting with England, Ireland, Spain, Greece, Italy, Portugal France and innumerable local election lost by Mrs. Merkel’s CDU party.

If history is a guide then Marshall Plan not Markel plan is needed, under Marshall plan United States gave $ 13 bn (US GDP in 1948, $ 258 bn) to help rebuild European economies after the end of World War II.

Europe as a whole is not in bad fiscal shape; its debt-to-GDP ratio compares favorably with that of the United States. There are alternative strategies. Some countries, like Germany, have room for fiscal maneuver. Using it for investment would enhance long-term growth, with positive spillovers to the rest of Europe.

http://shahzad-rsquared.blogspot.in/2012/03/must-read-refreshing-view-about-eu.html

European electorate across the continent has given their verdict that they are not happy with current situation focusing only on austerity, stifling growth (Greek economy contracted 20% from its peak just before the financial crisis). They need a policy in which they are offered growth in the short to medium term and sustainable fiscal discipline in the long run.

Short selling ban by ESMA and its effect

On 20 April, 2012 European Securities and Markets Authority (ESMA) published the last of its advice on the technical aspects of the Short Selling Regulation. The regulation, which defines the restriction on the short selling of shares, sovereign debt and Credit Default Swaps (CDS), applies from 1 November 2012 and is applicable both inside and outside of the EU. It overrides the EU national laws on the subject, including, for example, the German ban on naked sovereign CDS; however, national competent authorities retain the power to suspend the ban. The European Commission is expected to approve over the next three months. The European Parliament and the Council have the right to object to these decisions within three months. This process should not affect the 1 November date when the law becomes applicable.

The Regulation aims to improve the transparency of short selling by setting up a regime of notifications of significant net short positions in sovereign debt, shares and sovereign CDS. The calculation of what constitutes a net short must include sovereign debt, sovereign CDS, derivative positions and other sovereign debt correlated (70% or more) to the sovereign debt in question. The threshold above which a notification becomes necessary is defined as a percentage of the outstanding amount issued by the sovereign: 0.1% when the outstanding amount is €500bn or less and 0.5% otherwise.

Key highlights of regulation:

Ø  Only naked short CDS transactions executed prior to 25 March 2012 will be grandfathered and ay be held to maturity. Naked short CDS transactions executed following that date may need to be covered or closed out prior to 1 November 2012. There are no grandfathering provisions for uncovered short positions in sovereign bonds or shares.

Ø  Naked short positions in sovereign CDS are only allowed for market making and hedging purposes. With few exceptions, the sovereign issuer used as the hedge must match the geography of the asset/liability that requires hedging.

Trading sovereign debt and CDS: What is allowed?

From a trading perspective, the Regulation defines a new set of restrictions on net short positions in sovereign debt, sovereign CDS and shares. Essentially, uncovered shorts are banned, although exemptions apply. The main intent of the Regulation is to restrict short selling to market making and primary market operations and for hedging purposes, as follows:

Market making – The Regulation exempts market makers and primary dealers from the restrictions applicable to the short selling of sovereign bonds and CDS.

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Hedging – The Regulation allows short selling for hedging purposes with limitations as to which hedges

can be used. The naked short in sovereign CDS is permitted if it aims to hedge (i) the risk of default of a sovereign entity or (ii) the decline in value of an asset/liability, which is correlated to such sovereign. Furthermore, investors need to demonstrate (i) the correlation between the sovereign CDS hedge and the asset/ liability to be hedged and (ii) the proportionality of the hedge.

To be admitted as a hedge, the sovereign CDS must generally match the geographical location of the assets or liabilities the investor wishes to hedge. For example, French corporate risk with French sovereign CDS and no other CDS, subject to the few exceptions.

Exception to this rule is (i) when the relevant sovereign CDS is very illiquid; or (ii) when the corporate, or the risk that needs to be hedged, has strong links to a different sovereign (in terms of revenue, cash flow, or investment).

Correlation – Hedger will have to demonstrate the presence of a ‘meaningful correlation’, over a specified   time horizon, weighted to the most recent data (i.e. lastday’s weight is 1/250, second last is 2/250, etc). However, no minimum level of correlation is set. ESMA recognizes that there are several other ways to demonstrate correlation, ultimately allowing for considerable flexibility to ensure that sovereign CDS can be used to hedge a wide range of assets and liabilities.

Proportionality – The hedger also needs to ensure that the duration of the CDS is aligned as closely as possible to that of the risk

Effect of the regulation:

Relative value play –Proposed regulation in it’s current form diminishes the scope of sovereign CDS as macro hedges or relative value trades.

Short selling of bonds – The short selling of bonds, on the other hand, appears less stringent. First of all, an investor is deemed to be net short sovereign debt if after the addition of all sovereign debt (including sovereign debt from another member state that has a 70%+ correlation on the yields), sovereign CDS and related derivatives, the total position is net short. In this case, however, the regulation does not restrict a short sale provided that an arrangement with a third party is in place to ensure access to the bonds if and when needed.

Market implications – The main impact of the shorting restrictions for Fixed Income will arise, in our view, through reduced use of sovereign CDS. At present, there are four main user groups of the product:

1)      Dealers Market-makers take both long and short positions to provide liquidity to other market participants.

2)      Bank CVA, correlation and loan desks CVA desks use sovereign CDS to manage bank counterparty risk. Typically they are buyers of protection. Correlation desks use sovereign CDS to hedge the mark-to-market risk of derivatives which reference sovereign entities. Loan desks typically buy protection to hedge correlated, underlying loan exposures.

3)      Hedge funds take both long and short positions in sovereign CDS in order to exploit relative value opportunities across markets or to express directional views on a particular sovereign or basket of sovereigns (e.g. SovX).

4)      Asset managers may use sovereign CDS to sell protection to take a synthetic,long risk position as an alternative to buying specific securities, to buy protection to hedge underlying exposures and occasionally, to take long or short positions as part of a relative value strategy.

As we can see, various exemptions to the shorting ban will likely permit most forms of market making and hedging activity, while relative value use will suffer the most. However, meeting the hedging criteria for SovX will be difficult given the cross-border make-up of the index. Therefore, it is likely that liquidity in the SovX index may be the biggest victim of the shorting ban. Likely beneficiary of loss of SovX liquidity will be the use of single-name sovereign CDS as a valid, alternative hedge.

Please see the full technical details put up by ESMA

http://www.esma.europa.eu/system/files/2012-esma-263_-_final_report_on_technical_advice_on_short_selling.pdf

Hawker Beechcraft LCDS Auction final price 63.5

http://www.creditfixings.com/CreditEventAuctions/results.jsp?ticker=HAWKER-Acqui