With all this reflationary work by the central banks and governments, don’t you wonder what the new cash is buying?
Know anyone who’s getting a new Porsche? Suezmax tanker? Damien Hirst pickled shark? Semiconductor test equipment?
Didn’t think so. Neither do I. But the cash is going somewhere, such as into credit and credit derivative speculation.
A
few months ago, you might not have expected to see those words again,
outside congressional or parliamentary hearing transcripts. But that’s
what’s been going on since March.
The credit specs are back.
After all, if the dictates of style and tax auditors say you have to go
easy on conspicuous consumption, and if there’s no demand for the
products of real capital spending, then you might as well take your
cash to the track, or the corner credit default swap dealer.
Credit
hedge fund managers, and even the banks’ own desks, have uncoiled
themselves from their fetal positions, and are back taking advantage of
what are either risk-free arbitrages or value traps, depending on how
the next few months go.
If I were them, I might be taking the
money they made in the past two and a half months off the table. But
then I don’t have to be reaching to get past a high water mark.
“I am totally mystified by this rally,” says one friend of mine in the credit fund trade.
He’s
made money on both the downside and the upside over the past year, and
generally isn’t at a loss to describe the parallelogram of forces, as
they say in classical mechanics.
“Look, the system has taken out
some of its financial leverage, but the economy still has too much
excess capacity that will have to be dealt with. If we sit in the muck
for five years [low growth], then there will be a tremendous number of
defaults.” That isn’t being priced in to credit spreads.
Even
after they’ve been reviled by talking heads and politicians from here
to Ulan Bator, credit default swaps are still a very low cost way of
putting on speculative positions, as long as they still trade. And so,
thanks to the Geithner Treasury’s policy of reform, rather than
dissolution, CDS trading has regained a vampiric strength that the real
economy still lacks.
Some specific credit sectors have done
particularly well, such as retailers and chemicals. “They are just too
expensive,” says a German volatility trader. “JC Penney has gone from
800 or 900 over [the swaps curve] in the five year down to 190 to 200.
That shows not just short covering, but people jumping in after that.”
The consumer-dependent retailers and cyclicals such as the chemical
companies still have issues with real-world demand, but the credit
market people just see them as sources of cheap beta. For now.
The
intrinsic leverage of CDS trades makes it possible to hope that you,
the portfolio manager, might actually get paid a bonus some day.
For
five-year CDS on credits such as those back-from-the-dead names every
basis point on a $10m (£6.3m, €7.2m) position can be worth $3,500 to
$4,000.
Apart from going outright long “cheap” credit, there
are, once again, fun games such as the “negative basis trades”. That
is, you can own a corporate bond, or emerging market sovereign bond,
buy default protection on the paper with CDS, and collect interest
payments for taking no risk. That’s right: because CDS prices are
depressed, relative to the comparable bonds, you can collect money for
taking no risk.
A couple of years ago, someone might have said
there was a risk that a CDS counterparty, such as, hypothetically, AIG,
might get into trouble, and you would be unable to count on that leg of
the trade. Then a risk free arbitrage could turn into a money trap.
But
thanks to Hank Paulson, Tim Geithner, and the rest of Team USA, that
risk is no longer seen to be a problem. So you can now collect a couple
of hundred basis points of risk-free money, as long as you have a line
of credit with a dealer.
You may not be able to use the credit
markets to make reliably secured loans to auto companies, but the
system can be used to collect over 100 basis points of
fully-credit-risk-hedged income from 10-year Turkish state bonds.
To
be sure, not everyone has the nerve for this sort of game, risk free or
not. The big problem is that while you don’t have credit risk, or,
thanks to the taxpayers, counterparty risk, you do fatten up the
balance sheet in the process. As a recent Barclays Capital publication
put it: “Some banks are still holding back on bond financing in order
to shrink their balance sheets in advance of Q2 reporting, but
interestingly, some hedge funds that still have cash are taking their
places, seduced by rates of nearly 2 per cent over Libor and the
ability to manage counterparty risk through tri-party repo
arrangements.” In a perfect, or even functional, world, the Law of One
Price would prevent such fat arbitrages from opening up. Until that day
comes we have to make do with what’s at hand: Steve Rattner to run the
auto industry, and negative basis trades for credit portfolios.
