Sunday, April 26, 2009

The Debts of the Spenders: Bear Market Rally a Result of Frontrunning the CDS Trade?

After reading many knowledgeable posts from Zerohedge, Accrued Interest, Nakedcapitalism, and Urbandigs (kudos to all the commenters as well), I have come to the conclusion that the bear market rally in equities is the result of an extended short squeeze by quants and other institutional traders trying to do massive arbitrage trades in the most fundamentally weak sectors.

There are many variations of the arbitrage trade but the basic principle seems to consist of a) buying bonds on the company in question (at a substantial discount to par) w/CDS insurance; b) shorting the common equity; and/or c) buying the preferred issue*. The possibility of a big CDS payout is a longer term horizon play. But in the meantime the quants are also periodically short covering to (hopefully) make a profit. *The preferred issue is extra gravy sauce for those funds that want to generate less risky returns since they have historically (as of last September) been viewed as the default safety valve for govt bailouts.

But the best laid plans fell to pieces due to the unforseen extent of the invisible hand. Note that the equity rally has been led by the companies w/the WEAKEST fundamentals - casinos, financials, commercial real estate, luxury retailers, etc. This action suggests that one of two things is happening: a) the long/short arbitrage trade is getting crowded from everyone short covering at the same time to take profit; and/or b) other quants are running short squeeze plays of their own on the most heavily shorted issues by going contrary to the prevailing hedgie herd - e.g. buying the common equity (or more likely taking substantial intra-day futures positions to move the market).

There is also a final factor at play here - the US govt's refusal to accept any publicly traded corporate bankruptcy. So the CDS buyers keep on paying out every quarter and the CDS sellers continue to collect the premiums. Company insiders are also taking the opportunity to sell their common shares. Meanwhile, equity volume among traders is slowly evaporating. And industry shill such as Barron's and CNBC broadcast fund propaganda to the retailer buyers about how the bottom is in.

I don't have access to the kinds of insider data that zerohedge, AI, nakedcapitalism, urbandigs and other good bloggers are privy to. But the scenario I sketched above seems to comport w/what they have been saying in numerous posts since late February.

Thoughts appreciated.


Anonymous said...

Thanks for the info so in your opinion how/when does this end or will it continue until we hit so high that positions switch again?

In Debt We Trust said...

I don't know for sure. But after earnings season is finished would seem like a good time for prices to reflect fundamental reality.

twc2009 said...

Thanks for sharing your thoughts. Just some clarifications:

1. If this rally is "Frontrunning the CDs Trade, how do you explain the worldwide rallies?

2. Are the rallies coordinated worldwide?


Anonymous said...


All the central banks have turned on the monetary taps. The ECB just cut rates again. And yes, these banks all lend to each other, etc.

The sharp downturns in all the global indices was pretty synchronized so there's no reason this rally wouldn't be.

The more volatile exchanges - Japan, Canada and Hong Kong are way up despite bad news - I'm talking individual stocks as well as the indices. See Magna or Manulife - two of Canada's largest.
England is in serious trouble (they don't even pretend there's a recovery starting there) yet even their FTSE is sky-high.
Throw in oil prices too.

The big question is, how long can this all go on for?

Anonymous said...

Can you elaborate. How can you profit when buying bonds of the company and then shorting the stock on the stock market ?
Seems contra intuitive to me.
And at the same time you have to pay CDS premiums to whoever insured you ?

Anonymous said...

I get it. Make the squeeze and reap the CDS payout.

The only problem is that the quants playing this game are destroying companies to goose their own profits.

This is of course does nothing for the economy at large. Instead it is destructive.

Profits for the few at the cost of the many should be banned.


In Debt We Trust said...

The quants got greedy in April. Per DJ newswire article, 50% of XLF was still held by the shorts as of late April. That provided extra juice when the squeeze came.

The long preferred bank equity trade was profitable all by itself. There was no need to short the common stock. Of course, the hedge on shorting the common was buying calls.

SO in a perverse way it was a self-perpetuating mechanism.

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