Mumbai Terrorism: Short India Call is Intact

As the Asian markets await full details on the plot behind Wednesday’s terrorism in India’s principal business city of Mumbai (also Bombay), 5-year credit default swap spreads for 5-year government-owned State Bank of India widened to around 465 basis points, the cost of buying one US dollar breached the critical 50-rupee threshold and Indian equity futures quotes were dominated by selling interest in the Far East (the Indian stock markets were closed today).

 

In leading a recent charge to return to India, particularly after a 55%-plus drop Indian equity indexes, major mutual fund managers like Mark Mobius of Templeton Asset Management and Devan Kaloo of Aberdeen Asset Managers have been insisting that India’s democratic traditions are strong enough to withstand terrorism. But the crisis in Mumbai today cannot simply be explained away by the proposition that periodic acts of terrorism have only a limited and temporary impact on the Indian corporate spectrum.

 

On the contrary, the entire post-independence Indian social fabric is being gradually undermined by terrorism, separatist insurgencies, farm protests and far-left communist movements. It may be argued that India’s failure, over five decades, to make profound structural changes within its economy has now placed the country on the verge of a significant, and highly unsavoury, political transition in 2009.

 

The 2008 price lows in India-specific Exchange-traded funds (EPI, IFN, IIF, INP and PIN) are being widely touted as attractive buying opportunities given India’s 8% GDP outlook. And India ETFs did indeed hold up well in New York trading on Wednesday. But even before the Mumbai terrorist attacks, default risk perceptions on India have been rising; 5-year CDS coverage for sovereign risk is being priced at 310 basis points, and in the 800-900 bps range for ICICI and other Indian banks. The US$/Indian rupee “hawala” rate, the rate at which tens of millions of dollars worth of rupees are transferred in and out of India via non-banking channels on a daily basis, is edging towards 53.25. And US$/Indian rupee 5-year currency swaps are being priced at a whopping 42%-factor in favour of the dollar.

 

In the briefest of terms, the fundamental incompatibility between pockets of wealth on one hand and rampant poverty on the other has been held in check by 50 years of political promises backed by a series of 5-year national plans. Today, depending upon whom you ask, between 65 and 80 percent of Indians live below the poverty line, if the poverty line is calculated against a basket of living essentials. So, while the failure to remedy agrarian poverty has finally created powerful protest movements, urban unrest (and discontent) is being effectively translated into vote banks by religious extremists. On all present indications, a well-knit coalition of religious radicals will be in control of the New Delhi parliament within the space of a few short months.

 

History tells us that a government under the control and direction of religious extremists is not necessary unfriendly to private capital (e.g. Iran and Sudan). But, in the case of India, the ascendancy of right-wing Hindu entities will be no smooth business-friendly transition by any means, since it will be met by a sharp spike in separatist activity, by more militancy in the countryside and, most importantly, by a steady spate of deadly terrorism from indigenous or foreign Islamic radicals.

 

What all this means for consumer demand and corporate profits in the midst of a worsening global recession is certainly not an open question, as some analysts would like to believe. The fact is that bullish calls by Templeton and Aberdeen do not incorporate inherent political risk; for the record, medium-term or long-term political risk insurance contracts (as distinct from CDS-type insurance) for India are unavailable below 5.50% (per annum) today.

 

This writer’s call on India remains unchanged: sell on healthy India-ETF rallies from current levels, and short the Indian rupee.

 

www.quoteplatform.com

derivatives@shaw.ca

 

Emerging Market GDPs are a Trap

Prudent investors are correcting in wondering why the emerging markets need stimulus packages when they are growing at impressive rates. Either the Gross Domestic Product (GDP) numbers do not represent the true state of affairs within these economies, or GDP declarations by governments are largely deliberate misrepresentations.

                   

In reality, there is truth to both concerns, and those seeking to buy emerging market ETFs (EEM, GMM, VWO) on further price declines are well-advised to check what they are buying into. Because as available statistics stand today, there is no way of knowing. Firstly, is the GDP model a fair reflection of the well-being of a nation? And, secondly, if it is not, are the components of the forecasted GDP growth (e.g. India 8%, Brazil 3%, China 9%, Turkey 6% and Russia 6.2%) simply telling us that official growth rates are no indicators of real unemployment, inherent underemployment, consumer demand, credit delinquencies, income inequalities and poverty levels?

 

It may be useful to know that the creator of the Gross National Product (GNP) concept, the precursor to GDP, was primarily concerned with establishing a degree of precision only in measurements of the value of goods and services produced by American nationals in a highly fluid post-Depression environment. “The welfare of a nation can scarcely be inferred from a measurement of national income,” Simon Kuznets warned in 1934, as US authorities began using the GNP for policy-making purposes. The reasons for the cautionary statement are well-grounded, particularly in non-industrialized nations.

 

One reason is the powerful influence of the parallel (underground) economies on consumer, land and housing transactions on emerging market GDPs, ranging from 20% in China to nearly 35% in India. The other reason is the role played by defense expenditures on GDP computations; in India, the budgets for police and paramilitary organizations have also been rising in recent years, to counter separatist and Maoist insurgencies spread across 8-10 Indian states.

 

Then there are the huge investments in infrastructure projects which are either ill-conceived or corruption-ridden, or in work-in-progress mode well beyond targeted timelines. And, since few plans to upgrade crop yields and reorganize outmoded distribution channels have ever been implemented, the agricultural component of GDP is usually a direct consequence of either a bumper harvest (determined by rainfall) or commodity prices.

 

In brief, it is possible for emerging markets to show GDP growth in conditions where the prerequisites for sustainable equity valuations are being eroded. Moreover, despotic and politically corrupt governments are also claiming relatively impressive growth rates: e.g. Myanmar (4%), Khazakstan (10.5%), Iran (4.3%) and Uzbekistan (7.2%). For that matter, Iraq and Afghanistan are both predicting GDP growth of 8% in 2009!!

 

But of greater relevance for mutual investors are the startling facts emanating from the heavily favoured emerging market countries; only a few highlight examples can be provided in this forum, and investors are encouraged to dig deeper for a clearer picture.

 

Twenty-five percent of the Russian workforce is now experiencing serious delays in wage payments, and no-wage warnings having issued to another 15% of Russian workers. About 2 million workers in southern and central coastal China have been engaged in protests against factory downsizings and shutdowns. In Brazil, 130,000 landless families, living in camps and waiting land for land allocations from the government for 4-plus years, are now threatening to take their fight to the areas occupied by the critical biofuels sector.  In India, election officials recently monitoring applications in the mineral-rich state of Chattisgarh, found that 12% of the candidates were self-declared billionaires (in Indian rupee terms) but failed to render tax returns, another 15% who were publicly known to be billionaires said that they did not operate any bank accounts and paid no taxes at all, 4% were convicted criminals and 10% were facing criminal charges for murder, people-smuggling and extortion; for the record, human rights activists report that 58% of Chattisgarh’s population lives in poverty, including 37% in extreme poverty.

 

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derivatives@shaw.ca

 

  

 

 

IMF Needs Bailout Too, Now

Turkey is reported to be in negotiations with the International Monetary Fund for a $40 billion loan. Very shortly, the Baltic States and at least a dozen developing countries will be filing for IMF handouts. But how will the venerable lender of last resort fund itself?

 

According to a fact sheet posted on its website (www.imf.org) in October, the IMF had $200 million available for emergency loans to the third-world, and another $50 billion in “additional resources”. But the IMF’s liquidity is rapidly dwindling.  Between the crisis facilities concluded with Ukraine, Hungary, Serbia, Iceland and Pakistan, and the expected spate of new loan requests, the IMF should be running out of money within the first quarter of next year. Quite simply, unless the rich nations (including American tax-payers) can add to the IMF’s funding capabilities, the global recession will cause unprecedented havoc, chaos, hunger and turmoil in the world’s poverty pockets.

 

The IMF tracks the credit default swap market very closely, and one can only hope that somebody in authority is reading the signals. CDS spreads (5-years) for Russia (950 basis points), Romania (700 bps), Bulgaria (625 bps), Latvia (1030 bps), Lithuania (650 bps), Estonia (600 bps), India (475 bps), South Africa (520 bps) and Brazil (415 bps) are already suggesting more forthcoming IMF bailout applications, not to mention the continent of Africa and the troubled Latin American debt matrix. By conservative estimates, the IMF may be called upon for $700 billion (remarkably akin to the Wall Street bailout amount) during the course of 2009. Will it get the money in time? And, from where?

 

Latin American leaders like Hugo Chavez (Venezuela), Daniel Ortega (Nicaragua), Evo Morales (Bolivia) and Rafael Correa (Ecuador) periodically claim that the economic and fiscal conditions imposed on borrowers by the IMF ever since the early 1980s are themselves the root cause of the current recession in the emerging economies. President Correa, whose audit committee has just declared that $10 billion worth of Ecuador’s foreign debt is “illegitimate and illegal”, has cited the IMF’s willingness to provide funds to dictators, despots and plainly corrupt governments as being another significant factor which has enabled the continuation of high poverty levels and which has created major dislocations in the “natural” economies (i.e. traditional self-sufficient structures in the agrarian sectors).

 

But, regardless of the strong opinions of those presumably involved in Bolivarian revolutions, sovereign bailout candidates obviously have little choice but to cut spending, privatize infrastructure, implement unworkable currency baskets and adopt free trade policies. That is, as long as they get the funds requested.

 

British Prime Minister Gordon Brown, foreseeing that the IMF could become technically bankrupt in short order, has asked Saudi Arabia for assistance. And, for all material purposes, Saudi Arabia is perhaps the only country which might be able to afford tens of billions of dollars to boost the IMF balance sheet. Unless, of course, traditional IMF lenders (the G7), who are already incurring huge deficits on the domestic front, decide that they cannot risk a bankrupt IMF bankrupting, in turn, 50-odd sovereigns, and thousands of corporations operating under those sovereign umbrellas.

 

While the IMF is sorting out its near-term viability, CDS spreads for emerging market sovereigns will continue to widen, with spreads for Eastern Europe (Baltics in particular) rapidly approaching default territory within December. So check your mutual fund investments to see if your asset manager has been buying Eastern Europe shares and bonds in recent months.

 

Life After G-20. Check your emerging market portfolio.

Bretton Woods 1944 or London 1933? That is the question European leaders will be asked as the face their constituents this week. In other words, does the G-20’s six-point plan represent any fundamental change in the global financial outlook or is the two-part G-20 document issued on Saturday simply a collection of non-committal ideas?

 

The Bretton Woods summit (1944) did succeed in producing the architecture for the rebuilding of Europe and for the modern-day financial environment. The London Conference (1933) of Allied nations, on the other hand, failed to stem the widespread negativity of the Great Depression and, according to one school of European historians, strengthened fascism in Europe, and created political and economic havoc in former Ottoman dominions and in dozens of far-flung British and European colonies; six years later the second world war broke out.

 

Two days prior to the Washington gathering, French Finance Minister Christine Lagarde said that “we see friction between Anglo Saxon capitalism on one hand and European capitalism on the other.” Given the huge bailout schemes on both sides of the Atlantic, it is difficult to figure out who exactly is a genuine capitalist today, despite President Bush’s proclamation that the free market principles must not be compromised.

 

But, inn any event, the question of whether Washington 2008 will resemble New Hampshire 1944 or London 1933 is going to be answered by the fate of the developing world economies through the course of 2009; as far as the G7 nations are concerned, one can safely assume that the stimulus-after-stimulus process is ushering in a new era of state capitalism whose longer terms shape is highly unpredictable.

 

It is the emerging market fund managers and investors who now need to recheck their buy signals, keeping 1933 clearly in focus. Because the first visible signs on the horizon reiterate a sell-on-rallies call, a stay-out recommendation and a get-out alert.

 

Powerful voices from Latin America, Africa and Asia are pointing to the fact that the G-20 summit ignored the key challenge which is threatening the third-world economies with severe contraction, in real terms, regardless of GDP data: increasing levels of poverty, and a steady deterioration in living standards amongst the middle classes who contributed so significantly to the growth in consumer demand in recent years. In fact, emerging market political leaders continue to worry about currency devaluations, capital flight, declining foreign investments, shrinking exports and domestic interest rates, none of which are going to effectively counter political movements rooted in urban and rural discontent and in sheer frustration at five decades of plans, schemes and programmes promising better tomorrows.

 

This is not the forum to engage in a country-by-country analysis of the political formations (military and civilian dictatorships, political Islam and ineffective coalitions) which dominate the emerging market spectrum today. At this juncture, it is evident from the facts on the ground that those granted favoured-nation status in Washington (i.e. Brazil, India, China, Russia, Indonesia, Argentina, Mexico, South Africa, Russia, Turkey, Saudi Arabia and South Korea) are not in need of any monetary actions which prop up banks and industry; what they need deep within their economies are thorough structural changes: land reforms, rural-debt elimination, higher crop yields, revamped food distribution channels, efficient tax-collection drives, diminished underground (black) money pools and, most importantly, anti-corruption measures.

 

Mutual fund managers insist that, despite the persuasive general evidence, junior exchanges continue to offer selective, above-average investment windows. In that event, let them disclose the full extent of currency risk and political risk (as distinct from default risk) in their portfolios today.

 

www.creditdefaultswapslimited.com

derivatives@shaw

 

 

Goldman Sachs headed to $20

Those invested in Goldman Sachs today should be hoping for a share buyout offer, triggered by the dire need to take the Wall Street investment bank private, prior to thoroughly revamping its business model. Otherwise, questions regarding Goldman’s short and longer term viability will continue to linger, since management is still unable to publicly define a deleveraged business model suitable for a public listing.

                          

The old business model (essentially incorporating securities trading, risk arbitrage, M&A advisory and bond underwriting) has obviously collapsed. Some elements of the older version do possess the potential to generate profits once the domestic and global economy takes a decisive turn for the better. But the days of exponential gains from leverage-loaded activity are well behind us. And, when calculating returns on equity by any deleveraged measurement, it is indeed difficult to justify a share price above the $20-$30 range today for Goldman’s 395 million outstanding shares.

 

The $20-$30 range is not an arbitrary pick. It represents a number (market capitalization of approximately $11 billion) at which a significant investor would consider taking Goldman private from the perspective of a dividend yield of about 2.5% by early 2010. It also represents limitations on derivatives transactions like credit default swaps, collateralized debt obligations, foreign exchange and interest rate arbitrage and, finally, investment banking fees.

 

Not that the completion of the dual process of (a) deleveraging and (b) the recognition of inherent risks on outstanding derivatives will negatively impact Goldman alone; the sharp downsizing in profit forecasts as a consequence of that process, under way right across the financial spectrum, must also influence the balance sheets, and business profiles, of Morgan Stanley (MS), Citigroup (C), Bank of America (BAC) and a number of other candidates who, in part or whole, have been relying on above-average returns from within the investment banking matrix for the better part of this decade.

 

There is merit in the argument that Goldman’s management is more than capable of formulating a credible answer to the current recessionary environment, particularly with assistance from Warrant Buffett ($5 billion invested in GS). But capability is one issue, actual results quite another. Goldman shares will continue to be under pressure until investors have in hand a cogent business model, the absence of which has not been explained thus far. The short-Goldman proposition is not a commentary on where Goldman is headed; rather, it reflects uncertainty and lack of clarity in the face of hard economic data which dictates that Wall Street’s financial institutions will struggle to make money, from banking or investment banking activity, at least through 2009.

 

The situation is ripe for taking Goldman private, an event which will provide management with ample time to review and revise traditional assumptions, and to re-position an exceptional brand name, on the domestic front and internationally; Mr. Buffett, or somebody else with deep pockets, could well come up with the funds required. The alternatives are certainly grim, since it must be conceded that throwing a non-leveraged business model into the public arena at this juncture would invite widespread scrutiny, and possibly expose the weaknesses of the entire bailout exercise being currently undertaken by the Treasury and the Fed by revealing the inexplicable valuation inconsistencies being applied to rescue targets like AIG.

 

 www.creditdefaultswapslimited.com

 

derivatives@shaw.ca

 

 

Sell Into China’s Illusory Stimulus Package

As the Monday morning bullishness in Asia continues to impress traders in Europe and North America, buying interest in China shares (ACH, GSH, SNP), China indexes (CHXN) and China ETFs (FXI, PGJ, CAF) is certain to gather momentum today. But, on closer scrutiny, the $586 billion Chinese stimulus package which is triggering all the positive sentiment appears to be an illusion of the highest order.

                  

Chinese government officials stated that the stimulus package will focus on housing, infrastructure and post-earthquake construction over the next two years. And bulls seeking feel-good stories are making a number of assumptions on the back of that announcement. Some anticipate that China’s stimulus spending will boost copper, gold and oil prices. Others see a brighter future for Japanese building conglomerates and auto makers. Yet others are forecasting a turnaround in China’s domestic consumer demand. IMF Chief Dominic Strauss-Kahn thinks that the stimulus package will have a positive impact on the World economy. So far so good.

 

However, the bullish calls on China uniformly fail to take into account that fact that hardly any of the designated stimulus dollars (or yuan) will be spent in the foreseeable future, or even in the medium term.

 

In the transportation sector, for example, Chinese lawmakers have already legislated on a comprehensive 5-year spending plan way back in March 2006. The plan included (a) six new railway systems and the upgrading of five others, (b) fourteen expressways, including one from Beijing to Hong Kong and Macau, (c) the modernization of transit facilities at twelve Chinese ports, (d) dredging deepwater channels at the mouths of China’s major rivers and (e) expansion of at least ten regional airports. In addition, the Chinese government allocated to flood prevention measures, to the development of water resources and to gas pipelines from Russia and Central Asia.

 

As of today, each component of the legislation is well under way, albeit along uniquely Chinese timelines. Moreover, as far as post-earthquake rebuilding is concerned, city authorities in Chengdu (Sichuan’s capital) publicly acknowledge that the delays in implementing the relief agenda have more to do with bureaucratic hurdles than with a shortage of funds.

 

So, when, how and where will the stimulus money be spent? There is obviously no clarity from Beijing, and sceptics are already suggesting that the Chinese announcement is designed simply to stave off pressure at the G-20 Summit in Washington later this week. But whatever Beijing’s intentions may or may not be, equity markets are desperate for a dose of optimism, and there is no doubt that China-based shares, indexes and ETFs will attract robust buying over the next 48 hours.

 

Until, of course, reality dawns. The impending short window will not only be restricted to the China matrix. Copper and oil should also be ready for a pullback by Wednesday, if not earlier, once traders realize that China’s stimulus is not going to result in real orders any time soon. The biggest beneficiaries of Monday’s bullishness in Shanghai, Baoshan Iron and Steel (SHA 600019), Anhui Conch Cement (SHA 600585) and China Railway Construction (SHA 601186), should perhaps be avoided in the event that Chinese and Asian investors maintain their belief in the integrity of the Beijing announcement for a while longer.

 

 

Fitch Downgrades Reaffirm Case to Exit Eastern Europe

Finally, the rating agencies are seeing the light. Perhaps belatedly, Fitch has downgraded its ratings for Bulgaria, Hungary and Romania. The fact is that none of the economies of Eastern Europe (GUR, IEER.LSE) have succeeded in completing the socialism-to-free market transition. On the contrary, virtually all former Soviet Republics are well on their way to become basket cases when compared to their counterparts in Western Europe, with the possible exception of the Czech Republic and Poland.

 

Fitch Ratings stated that “Emerging Europe” is most vulnerable to the global recessionary environment due to high levels of debt and current account deficits. But, debt and current accounts apart, it is gradually becoming evident that the economic criterion applied to the break-up of the Soviet Union in 1990-1991 was influenced more by Cold War political considerations than on reasonable inferences governing the viability of the residual constituents as independent, modern-day nation states.

                                                                                

In fact, in view of the debacle in Ukraine, it was surprising that credit default swap traders were pricing the three downgrade targets below 500 basis points (5-year sovereign risk) just two weeks ago; Ukraine CDS prices, at that juncture, had moved swiftly, from 900 to 2,100 basis points within days.

                                                                                     

This is not the forum to engage history in any detail. However, it is relevant to point out that the economic status of Bulgaria, Hungary and Romania in 1990 was entirely a consequence of a heavily integrated economic system (i.e. the COMECON) established in 1949, and expanded in the 1970s to include Cuba and Vietnam. Besides trading amongst its own members, the COMECON had access to other major non-hard-currency markets, like India, for almost forty years.  

 

Most importantly for our present purposes, it is absolutely critical to recognize that specific multilateral agreements under the COMECON mechanism were designed to implement the concept of industrial and agricultural segmentation, e.g. trolley cars and heavy-duty trucks in Czechoslovakia (today’s Czech Republic and Slovakia), cotton in Uzbekistan, fruit and vegetable packaging in Hungary, light arms in Romania and steel products in Ukraine. The objective clearly was to avoid any unnecessary, and wasteful according to Karl Marx, competition amongst COMECON members, in addition to achieving efficiencies enabled by access to raw materials.

 

Naturally, the disintegration of the Soviet Union left the countries of Eastern Europe with the challenging task of adjusting to the free markets. Huge segments of industry and agriculture were rendered useless, almost overnight, in qualitative terms. Soft currency sales of goods came to a grinding halt. And, while the catch-all welfare net of communism was abandoned, real household incomes for the majority of the populations declined steadily. Over the last decade, pockets of extreme poverty have developed in Bulgaria, Romania, Ukraine, Hungary, Latvia, Lithuania and the Balkans.

 

The euphoria enveloping Emerging Europe equities and debt was founded solely in the belief that the “union with Europe” would set the former Soviet States on the same economic and social path as post-World War II Germany, Austria and France. Today, as the economic and financial fabric of the EU is itself disintegrating, it is not too late to exit Eastern Europe equities and ETFs, losses notwithstanding.

 

In the meanwhile, since CDS spreads for Estonia, Latvia and Lithuania are expected to widen this week, with Latvia leading the charge towards 700 basis points, the short call on Eastern Europe risk is compelling indeed.

 

 

 

Why GM Should Simply be Delisted

On pure technical and fundamental considerations, General Motors (GM) should rate as the perfect short trade today. But casting a shroud of caution over an aggressive sell recommendation is the fact that the concept of state capitalism is rapidly gaining currency in America.

 

The case for delisting GM shares, however, is overwhelming. The auto maker has $16 billion on hand, while it needs $11 to $14 billion to pay its monthly bills. There is little doubt that some type of rescue package will be forthcoming shortly. But that inevitability itself is proof enough of the collapse of the private equity profile within a free market.

 

In financial terms, all shares in GM should be written down to zero, a step which will ensure that an industry critical to the American job matrix is restructured in line with the broader economic reality. In practice, however, what we will see is the consolidation of the state-capitalism phenomenon, along the lines of Russia and China, arguably with some adjustments for domestic political constraints. It is indeed striking to note that the once-forceful voices of opposition to the Wall Street bailouts are now being driven decisively into the wilderness.

 

The capital formation process, at the core of capitalism, demands that a price must be paid when the assumption of risk turns into an unmitigated disaster. A disruption of that capital formation process leads to a serious impairment of the principles which have guided the post-World War II American economy. The consequences for the political framework are frightening, since lawmakers transform themselves into willing businessmen, in addition to being policy makers.

 

Russia’s Gazprom (OGZPY.PK, GAZP.MM) is a classic example of how state capitalism creates chaos in the risk measurement of private capital, and the consequent impact of the chaos on the pricing of both equity and debt. While Gazprom’s shares have been rising and falling in line with energy prices, most investors do not see any major downside risk from current levels, despite Gazprom’s shaky solvency position; Gazprom owes lenders $42 billion. That is because of both, the too-big-fail syndrome and the firm belief that the Kremlin will intervene to avoid a calamity.

 

Nevertheless, credit default swap traders are unimpressed. Late last month, CDS spreads for Gazprom breached 1,000 basis points. Regardless of a recent tightening, spreads are still expected to stay in the 1,000-1,250 bps range through the next few months. So, while equity investors have drawn their own worst-case scenarios on political grounds, CDS makers-makers continue to raise default perceptions on Gazprom bonds. This is the type of risk pricing inconsistencies a state capitalist system encourages.

 

In the European debt markets, Russian issuers like Gazprom are commonly called  in the “quasi-sovereign”, a category which Wall Street analysts are well-advised to establish (and propagate) in order to let institutional and retail investors recognize the compromise achieved in the most basic of capitalist premises, as such premises are conditioned by bailout money. Thus far, given that the bailouts are being driven by the perpetual preferred instrument, Treasury and Fed officials are denying that (despite the availability of warrants) the government will play any sustainable and influential role in directing corporate strategy. But, as questions regarding the use of tax dollars start to multiply, the duplication of the Russian experiment will become more than evident.

 

Going back to GM, the challenge of deciding whether Friday’s close of $4.36 represents a buy or a sell opportunity is squarely predicated on where government intervention, as early as this week, will leave equity investors. Without doubt, any public announcement of an emergency package will drive GM’s shares to $5 and above. That is exactly when put options are the logical answer, particularly during days when the implied volatility is relatively low.

 

    

The Virtue of Short Trading today

The fact that rating agencies are struggling to come to grips with the seemingly unending stream of guidance reports from the corporate and sovereign sectors can by itself justify an unequivocal sell-on-rallies market call. Because hardly any of the recent reports in the public domain have been founded in a sustainable interpretation of the size and length of the global recession. More importantly, none of the reports state how earnings will be impacted by the all-encompassing deleveraging process currently under way.

 

The Bank of England’s surprising 150 basis point rate cut on Thursday is perhaps the best indicator of overall uncertainty (and extreme caution) in an environment where the real value of family incomes worldwide (particularly in the emerging markets) are either declining in the face of higher food and energy prices or are being seriously threatened by job quality, or both. And the case to trade short is best made in a scenario where guidance documents are, at best, based on assumptions which themselves are subject to rapid change within the prism of economic data in forthcoming weeks and months.

 

That said, a credible sell-on-rallies call needs to be premised on specifics which can be challenged, where necessary, by cogent contrarian opinion. Those specifics are:

 

-         The urgent requirement for a downward adjustments in asset valuations in virtually all the emerging markets (EEM, EEB and ILF)), particularly in countries like Brazil (EWZ), Russia (RSX) and India (INP);

 

-         The influence of the rather inefficient deleveraging mechanisms in the developing countries on the balance sheets of American corporations who rely on foreign sources for more than 30% of their revenues, corporations like General Electric (GE) and Citigroup (C);

 

-         The fact that this deleveraging is an unprecedented event, defying analysts who believe in cyclical trends and who are thus engaged in picking the bottom.

 

Leverage works wonders when there is widespread optimism about the shape of tomorrow. But deleveraging wrecks havoc in the midst of recessionary conditions. The sell-on-rallies proposition is not only supported by the sorry state of the third world. Within the United States itself, there is still no recognition of a critical underlying fact: with few exceptions, all classes of loans (including mortgages) are heavily under-priced.

 

For instance, if the compelling benchmark+CDS price logic is applied to lending, 15-year mortgages should be priced well above 9%, not below 6%.  Under-priced loans imply leverage, since they fail to fully take into account potential delinquencies and default ratios. Of course, a few socialist measures, like government interference in the housing market, can destroy that argument altogether; but, at the end of the day, socialism is no substitute for pricing realities.

 

In the meanwhile, authorities in the emerging markets continue to generate statistics designed to show that they have contained the trend towards absolute chaos. But it is worth remembering that many such statistics are meant almost exclusively for public (political) consumption, not for institutional and retail investors who are risking money.

 

 www.quoteplatform.com

 

 

 

 

 

Short Citigroup, $8 in early 2009

The strike price for the warrants Citigroup (C) issued to the Treasury is $17.85. Fortunately for the tax-payer, however, the warrants are exercisable at any time over a period of ten years. Because if Citigroup’s third quarter financial report is any guide, the medium term outlook for its 5,342 million outstanding shares is rather bleak. Dilution above $18 is a non-issue.

                            

The $25 billion perpetual preferred stock issuance to the Treasury has certainly improved Citigroup’s Tier 1 capital adequacy ratio (8.2% prior to the bailout money). But what is at stake today is not Citigroup’s solvency but the medium-term viability (and sustainable profitability) of its business model.

 

The fundamental inconsistencies of that business model were comfortably hidden as Citigroup recorded impressive profits in an extended era of growth in its key business segments. Each component of that model is currently under threat; but it is also perhaps the appropriate time to question the logic behind the integration of such diversified components in the first place. By their very nature, investment banking, derivatives trading, consumer banking, housing loans and wealth management are each qualitatively distinct activities, bearing highly specific risk-reward profiles, requiring the preparation of activity-specific financial statements. Today, as the amalgamated business model has started to contract and, in some respects, disintegrate, questions surrounding Citibank’s profitability suggests that its shares should be headed towards $8 (and lower) within the first half of next year.

 

The accumulation of aggressive short positions at or above Wednesday’s closing level ($12.63) will be more than justified by the flow of hard facts governing the true nature of the global recession in forthcoming weeks and months. What we already know is that Citigroup’s credit costs in North America have risen sharply on the back of adverse unemployment, bankruptcy and housing statistics. This negative trend in domestic credit costs, which includes loan–loss provision, is expected to gather momentum shortly.

 

But Citigroup’s worst nightmare today is grounded in certain core developments in the emerging markets where it is safe to assume higher delinquency allowances in consumer credit and housing finance in the fourth quarter. Of particular concern is the turmoil in currency rates, interest rates and counterparty risk which will cast a darker shadow over Citigroup’s diversified banking model. It is common knowledge that Citigroup’s units in the emerging markets have been heavily involved in derivatives transactions and structured products in local currencies for nearly two decades.

 

An implicit acknowledgement of the need to rationalize traditional banking methodologies was evident by the recent linking of a Nestle (NSRGY.PK) standby facility to credit default swap rates. The incorporation of default risk into loan yields by Citigroup is certainly logical, even overdue; and that logic is supported by the extensive loan-loss provisions Citigroup made in its latest financial disclosure. But if that logic is swept right across the bank’s portfolio, a significant proportion of its corporate lending stands under-priced. If that is so, the capital adequacy ratio number is misleading.

 

Citigroup, in sync with the party-line on Wall Street, has not explained its exposure to the credit risk insurance marketplace, in North America and abroad. Nor has it fully disclosed how the risk on insurance-type contracts (credit default swaps, collateralized debt obligations or structured products) is calculated on its books. The better part of valour, therefore, is to read a healthy degree of bearishness into this uncertainty. 

 

Finally, the $25 bailout money may prove to be more toxic than the doubtful assets within Citigroup’s balance sheet. How the Treasury expects Citigroup’s to service the 5% per annum (first five years) dividend payment is anybody’s guess, in view of the huge pressure on the real cost of credit (and under-priced loans) in the foreseeable future.

 

www.quoteplatform.com