RCM Reprint: Karl Denninger on CDS and the Vicious Cycle

RCM Comment: The following explanation, while a little esoteric, offers unparalleled insight into a major component of the credit crisis:

Karl Denninger-

I buy a CDS on GE (a few weeks ago) for a couple hundred basis points ($200,000 per $10 million)The SELLER of that CDS protects against possibly having to pay by shorting whatever he can against that short credit position. This means he buys PUTs, he shorts the common, he does whatever he needs to in order to lay off that risk. He does this because if GE goes bankrupt their stock would presumably go to zero; therefore, if he has a potential $10 million exposure on the CDS he will short $10 million face value of the common stock, or buy enough PUTs to pay him $10 million if the stock goes to zero.

The PUT writer (assuming he buys PUTs), being a market-maker, will in turn short the common to lay off the risk as well. This hammers the stock price which then reflects into the pricing models for the CDS, driving them higher.This cycle repeats; unfortunately credit rating models include market cap as one of their inputs, which causes a credit downgrade (eventually.) That in turn adds more pressure. This cycle is repeated until the company is destroyed.

Why is this not a problem with options and straight short sales? Because with both straight short sales and PUT purchases the short side is required to post margin every night, and if the price goes the wrong way they get an immediate margin call and are required to buy that position back at a loss. That in turn puts pressure UPWARDS on share price and arrests the slide. As such the people selling short (whether stock or listed options) do not dare short in unlimited amounts, because if they get caught on the wrong side of a squeeze they are dead.

The enforcement of risk against the people betting on a bankruptcy through regulated instruments puts a natural limit on their activity and prevents an unwarranted "death spiral".

But in the CDS world there is no mark-to-market margin supervision, because there is no central counterparty supervising exposure and demanding it. As a consequence it is only the counterparty and the written document that can demand collateral posting and usually that is either on an infrequent schedule (monthly, quarterly, annually or on an "event") or in some cases not at all provided the writer maintains some specific credit rating criteria themselves!

Without nightly margin supervision on CDS short positions these vehicles have turned into the means to launch monstrous focused attacks on specific companies; the buyer has limited risk and virtually unlimited reward.

This is exactly like me buying fire insurance on your house, and in addition I can name the amount of insurance I want to buy, even exceeding the house's value!How nervous will you get if I buy $10 million in "fire insurance" against your $100,000 bungalow and then start stacking up gasoline cans in my driveway?As a direct and proximate cause of this ability to distort the market it becomes possible to create self-fulfilling prophecies almost on demand, with the people doing it profiting handsomely - at the expense of American workers and otherwise-sound companies.This form of exploitation of the market must stop.

News that Moves: Market Rally Sustainable?, Tedbits/Jim Rogers, Hedge Funds Turn to Gold & The ETF GLD Fraud

RCM Comments: As I write this, the equity markets are up over 5% and all the bobble heads on TV are trying to call a bottom. For days now, as the "Obama" bear market gained steam there was a rising tide of bottom callers, most of whom point to major oversold reading to justify a rally. While a rally can materialize at any time, the real question is sustainability. I won't begin to speculate on the answer, but I will say that while I agree we had major oversold readings on many indicators we also had surprisingly mixed sentiment readings that are not common at market bottoms. We will certainly need to monitor the situation closely, but I will say that this rally resembles other short covering rallies we have experienced over the last 7 months or so that have only led to new lows. Most often, markets bottom with capitulation or boredom. We have not seen capitulation, and by boredom I mean a reduction in volatility and sideways movement in a tight trading range that lasts for a while. The behavior of the market over the next few days will give us better insight as to the true direction; until then, here are a few thoughts from sources we respect that may help keep everything in perspective.

TedBits: The only reason they (Obama administration) are reducing the deduction for charity for those earning over $250,000 dollars, at a time when we need charity more than in the last 70 years, is so the people relying on charity will have to rely on government.

And...

Two hundred and fifty-two US commercial banks and savings institutions with total assets of $US 159 Billion were termed problem banks at the end of last year by the Federal Deposit Insurance Corp. The FDIC insurance fund has fallen to $US 19 Billion from $US 52 Billion at the end of 2007. It too is broke.

Obama’s Making It Worse - Maria Bartiromo interviewed Jim Rogers, and when she asked, “What do you think of the government’s response to the economic crisis?” he said . . . “Terrible. They’re making it worse. It’s pretty embarrassing for President Obama, who doesn’t seem to have a clue what’s going on - which would make sense from his background.”

Jim classically continued . . . “And he had hired people who are part of the problem. Geithner was head of the New York Fed, which was supposedly in charge of Wall Street and the banks more than anybody else. And as you remember, Summers helped bail out Long Term Capital Management years ago. These are people who think the solution is to save their friends on Wall street rather than to save 300 million Americans...We’re going to have social unrest in much of the world. America won’t be immune."

RCM Comment: I would like to take this opportunity to welcome the crowd to the investment theme of precious metals. Our core belief in this theme over the last three years has helped lead Rosenthal Capital Management's direction of the Fortune's Favor Family of Funds. That direction has resulted in a rather dramatic outperformance vs. the markets and our peers. For those of you who have enjoyed this theme with us I will offer a note of caution: With the crowd comes big upside opportunity but also even bigger volatility. So, as I have written before, "please hold on to the Bar."

Hedge funds turn to gold - FT FT reports Hedge fund investors who made money last year by betting against investment banks are now buying gold as a way of betting against central banks. The gold bulls include David Einhorn, founder of hedge fund Greenlight Capital... Other funds looking at gold include Eton Park and TPG-Axon, investors said. Investors such as Mr Einhorn are turning to gold because they are worried about the response of the US Federal Reserve and other central banks to the global economic crisis. A bet on gold is essentially a bet against all paper currencies. "The size of the Fed's balance sheet is exploding and the currency is being debased. Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed," Mr Einhorn wrote in a recent letter to his investors. "Our instinct is that gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself." Mr Einhorn's comments -- and the revelation he is buying gold itself -- are in line with the views held by other large institutional investors in Europe, according to bankers in London. The head of commodity sales at one major bullion bank told the FT that he had never been so busy dealing in gold for large investors in his life. (See 8:51 comment)

Bearish big investors catch gold bug - WSJ
WSJ reports large investors, including some who anticipated troubles for the housing and financial sectors, have been buying gold, concerned that moves by governments to shovel money at problem areas could cripple leading currencies. Cos such as Eton Park Capital Management, Greenlight Capital, Hayman Advisors and Paulson & Co. have been ramping up gold exposure in recent months, according to investors in the funds. Blue Ridge Capital and Highfields Capital Management also have been recent buyers, according to public filings about their year-end holdings. Some of these funds have become among the largest holders of gold exchange-traded funds, such as the SPDR Gold Shares ETF (GLD), while also buying gold futures contracts, swaps and even physical bars of the yellow metal. The recent purchases of gold by the hedge-fund investors, some of whom have top records, suggests they are coming to share deep worries about the health of global economies and how ongoing problems are being addressed.

RCM Comment: This story illustrates the crowds' disturbing negligent behavior with regard to gold investments. The crowd is evidencing an utter lack of due diligence when accumulating shares of GLD. In an effort to help my fellow man I will highlight some key issues in the hopes that the information may redirect the lemmings before they run off the cliff:

1) More shares of GLD have been created over the last few months than there has been gold traded on Comex. If GLD is supposed to be backed by physical gold how would this be possible? Answer: It is not possible, so GLD is not truly backed by gold bullion.

2) The GLD prospectus states that there will be no auditor of the fund. This should be a major red flag to all investors. If you have something to hide you don't use an auditor. Now repeat after me...Madoff.

3) Page 12 of the prospectus states that the assets of GLD are commingled and not set aside in a designated account. Hence, if the bank administering GLD should have a problem, for instance be nationalized, then GLD holders become creditors of the bank, not owners of bullion. Repeat after me...counter party risk. Last time I checked, counter party risk was at the very center of the credit crisis.

RCM Editorial: Obama's Budget Proposal: Sensible or Senseless?

I'm at 36,000 feet and on my way home after an epic snowboarding trip to Vail, Colorado. I have spent the last 4 days knee deep in fresh powder shredding the back bowls, but a thought has been tugging on my mind. Much to my chagrin, I have been unable to mollify this sinking feeling that our country is being run by a gaggle of neophytes. And so I feel I must put pen to paper, or fingertip to key as it were, and shed some light onto the deadly mold growing in the hallowed halls of our government. The growth of which I speak (whose obnoxious smell is fatal to our society) has a name: tax increases.

Those of you who read this blog know that we try to avoid a political discussion. We generally keep our thoughts focused on developments we feel are moving the markets. A political discussion seems really pointless due to both parties' phenomenal inability to do anything right. But, I suppose this is nothing new. Historically speaking our country has gone through periods of utter ineptitude in leadership and we always seem to pull through.

Today's missive will focus on the question of tax increases during a recession. Is it sound? Is it healthy? Is it smart to raise taxes during a recession? I know it is popular. If you are pandering for votes you will most certainly get a resounding applause in the town hall if you blame the rich and the big bad corporations. Forget about the fact that 'rich' is defined by this administration as an income of over $250,000 (a broad net that catches many struggling small businesses) and never mind the fact that corporations in fact offer jobs to the very same people applauding. Nope, use the biblical rally cry of 'tax the rich', 'tax the corporation' and listen to the adulation that pours out of your constituents. So we know it is popular, but is it effective? Is the Messiah going to lead us out of this recession with tax hikes, or simply into an economic desert for the next 40 years? We are hitting turbulence...No, I mean quite literally as we start our descent into Palm Beach International. I will pick this up tomorrow from the trading desk...

...O.K. I'm back at RCM headquarters, looking at the sun come up over the horizon, smelling the ocean and listening to the palm trees. It is good to be home, but we still have this little problem of Obama's budget package that is rife with tax increases. I would like at this moment to ask those of you who are reading to think if you can remember any time in history when tax increases helped any country get out of a recession. Please comment at the end of this blog with a concrete example of tax hike success. I would truly love to know as the knowledge may very well make it easier for me to sleep at night.

On the other hand, I can certainly come up with examples of tax cuts helping an economy recover. Take, for example, Ireland's dramatic cutting of corporate taxes to 0%. This decision led to an economic boom and a significant increase in employment for a country that had been a perpetual looser in both categories.

Would you rather stay Stateside? O.K., let's talk about the 1980s. Jimmy Carter's obstreperous tax and spend administration left us with a 90% top tax bracket, double-digit unemployment, an economy in a shambles and inflation soaring. Reagan, love him or hate him, dropped taxes across the board while closing loopholes that the rich employed to escape the egregious rates. This led to a serious increase in tax receipts, job creation and economic recovery. I'm going to go out on a limb and sight the Bush administration for a moment. Before you caterwaul at the screen take a deep breath and continue reading. We all agree the Bush administration was a disgrace. I will gladly concede the Bush stupidity seemed to be boundless, but as my Dad likes to say, "even a blind hog finds an acorn sometimes". The acorn: In 2004 companies were allowed to bring profits into the U.S. that they had earned and left abroad, paying a tax of only 5.25%. Prior to this one-time tax break, repatriated profits were taxed at the full federal rate of 35%. As a result, $312 billion was brought home leading to an $18 billion boost to government coffers. This cash infusion helped shore up companies' domestic operations.

So I ask again, why on earth is the Obama administration raising taxes? Must we repeat the mistakes of past administrations? The very definition of insanity is doing the same thing over and over but expecting different results. There is over $500 billion foreign-earned profits in overseas accounts today. Even a simpleton like Bush knew that dropping the tax rate on this cash horde would result in a boost to tax receipts. Am I wrong, aren't we trying to reduce the deficit? Wouldn't a quick $26.25 billion help?

When I questioned Obama's preparedness to lead, believers chided me for being obtuse and offered up the mantra that 'Barack is really smart and will surround himself with smart people'. Well, I ask the believers: How smart does he look now? How about the people he is putting around him, four of whom want us to believe they can't figure out the taxes they owe? Is this the type of change and leadership you were looking for? Please don't offer up the new mantra of 'he inherited a mess and it will take time'. While both of these statements may be true, neither answers my question. Leadership doesn't take time to evidence itself and choosing people to surround you who don't lie or cheat would be the first step.

I have taken time out of my trading day to address these issues because the budget proposal is clearly affecting the markets. The equity markets are leading indicators of the economic picture and they are speaking with every tick lower. As I finish this piece the S&P 500 is at new lows: down 5% with 15 minutes to the close. Instead of using the new budget proposal to show leadership by focusing on the credit crisis, Obama has acted like a child with a new toy and pushed his agenda without any regard for its effect on the real world. Example, his agenda blew out one of the remaining legs of the market; the medical sector. Without a doubt his proposals are hostile to capital on many fronts and instead of extinguishing the inherited fire he is adding fuel to it. As long as this path into the economic desert is followed we at Rosenthal Capital Management will continue to maintain our posture of defending capital that led to profits in 2008 and continues to generate profits in 2009 with our fund Fortune's Favor Precious Metals leading the charge.