We're Saved! Greek haircuts and market bliss

Below is this morning's Wall Street Journal front cover picture, The Italian Parliament going at it



Could you imagine if Orrin Hatch went after Chuck Schumer following a nice fiscal policy debate? Or perhaps John Kerry (good reach) taking a swing at john Boehner? Unquestionably there would be tears streaming. Sadly, our do nothing congress just isn't this entertaining. But who can really complain when all of our problems are solved?

Overnight a deal was done that puts a 50% haircut on Greek bonds. Without too much detail, this means that Greece will not pay all of their debt obligations, rather a portion thereof. This helped to send the markets into a state of euphoria as it was a sign of progress in Europe. The jubilation and soaring stocks (Germany up 5+ %, the Dow up nearly 400) are indicative of something I've discussed before; that it does not take much positive news out of Europe for us to rally like no tomorrow. Whatever your opinion of the news we rallied on, the chart and momentum has changed significantly as a result of it. Closing circa 1284, the S&P is now comfortably above the 1250 level considered to be the top of our "range'. In what has been a volume anemic market we started to see some real volume trade today (moves on heavy volume are more meaningful than light). To top it off, there are a lot of wounded hedge funds who are staring at a year of negative returns in which the stock market went positive.....eeek... here come the redemptions.... well... maybe not if we ratchet up some risk! But you want to short a market that rallies like this on news that doesn't even begin to address the real problems (Italy..Spain...)? Like I said when we were trading 1220 at the "top" of that range, your better off being long. So lever up and try to ride a wave up in hopes that you can save your precious hedge fund. Flows will start coming back to the equity markets (bonds got destroyed today) and we should push higher.

I had to mute the TV when I heard some analyst talk about how "I wouldn't enter now, I think we're going up, but there are better entry points". Come on, make a call. This is like when CEOs are "cautiously optimistic". What is that entry point? Support at 1250? So you think its worth waiting to get 30 points, and risk losing upside of 70 with this kind of momentum? And if support at 1250 doesn't hold, how can you justify buying then? Effectively, this double speak is nothing more than that. It is a recommendation to try to make the "perfect" easy stop out trade, and miss what could be setting up for a runaway rally. Buy here, don't wait. Stop yourself out below 1250, take your 3% or so loss if we fail, and call it a day. This seems far less risky than "waiting for a better entry point".

Talking to someone whose opinion I greatly respect a few minutes ago, it was mentioned that there's a lot of quiet negative talk out there, and we'll probably give back a portion of today's gains. Perhaps we will, but the hedge fund catch up scenario seems too powerful to me to wait. I am in no way positive on Europe. In fact, I think what happened today was nothing but a PR stunt. But you have to ask yourself if you put on trades because you believe in the fundamentals behind them, or because you believe they will work. I don't believe Europe did anything today, but I do believe the markets are going higher... so I'd rather my money be right than me.

Here is why I don't think anything was actually done today, and why it sets us up for a disaster scenario somewhere not too far down the road. The biggest concern in Europe is not whether Greece, or even some of these other countries can pay their debts. At least in the case of Greece, everyone knew that they could not. The issue is what happens to the banks who hold Greek assets. If you are a holder of Greek bonds and they default, what does it do to your balance sheet? MF Global is a sub 2 dollar stock for this very reason (more Italian debt, but Euro debt exposure more generally). So Greece didn't "default", their bonds just got nicely trimmed. For some reason I'm not nearly bored enough to examine now, this is technically not a default. This might not really matter to an outright bondholder. If your getting 50 cents on a dollar, 50 cents is 50 cents, it doesn't really matter if you call it a default or not. But then, there is a little something called CDS (Credit Default Swap). Why they haven't been made illegal yet is beyond me, but here is what is at stake.

CDS is essentially insurance on a bond. If I want to buy a bond because I think it is of good value, but want to protect against default, I can buy CDS on it. CDS is a separately traded contract all together. So buying such insurance is not an embedded option you get when buying a bond. So people who go short CDS (serve as insurance writers, betting that a bond will not default) likely don't have nearly sufficient enough collateral to make payments in the event of a default (if the letters AIG are coming to mind your not crazy). The famous "Greek Haircut" was done in such a way that those who are long CDS (bought insurance) will not get paid (consequently those who were short it, and likely massively leveraged in their short do not have to pay). I don't know what is on which bank's books, but I would lever up myself to bet that a significant amount of exposure that these banks have to Greece is in the form of Credit Default Swaps. But, because of technicality XYZ, the haircut doesn't trigger this CDS insurance, and the insurer, who is screwed won't have to pay. So there is progress in Greece, and the banks maintain their solvency. Pretty cool.

But somewhere, there is a team of investors who went super long Greek CDS preparing to make an entirely new type of investment... a massive lawsuit. There are one of two simple things that will come from this. Either there is some sort of resolution in which the CDS holders get paid, or no one will ever trade CDS again (barring an explicit change in rules). Greece has defaulted, and holders of that default insurance are not getting paid. If the lawsuit were to be successful, what would happen to the liquidity of these French banks with such massive liabilities? The speed at which such a liquidity crisis contagion could spread is nightmarish.

But for now, we're running hot. I'd rather jump on the bandwagon even if I didn't have any skin in the game. With a break in headline risk (unless this lawsuit comes forth soon) perhaps we can focus on the fact that q3 GDP for the US came out at 2.5% today, certainly not indicative of the recession the market had been pricing in.