Derivatives: The Great Unwind

The market was up strong yesterday. Other than the shares of bank stocks, you have to wonder why. The worldwide central bank bailout is not intended for the equity investor, or general public, or business, or you, or me. It’s intended for banks, ostensibly to spur lending, but more likely to keep them afloat through next week’s Great Derivatives Unwind connected with Lehman’s bankruptcy. This has got to be a big part of the motivation of the CBs to provide unlimited lending to banks.

Distracted by worldwide stock market crashes, attention shifted away from Lehman’s derivatives’ payout scheduled for October 21. Recovery value has been set at 8.625 cents per $1.00, which means that sellers of credit protection must pay 91.375 cents to the buyers (according to Creditex, www.creditfixings.com, the company that holds auctions).

More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman. The list of participants in the auction includes Newport Beach, California-based PIMCO (Pacific Investment Management Co.), manager of the world's largest bond fund; Chicago-based hedge fund manager Citadel Investment Group LLC; and AIG, the New York-based insurer taken over by the government, according to the International Swaps and Derivatives Association in New York.

According to JPMorgan, the largest foreign bank holders of Lehman’s derivatives are Deutsche Bank, Barclays, Societe Generale, UBS, Credit Suisse and Credit Agricole. Overall, as of June 30, 2008, the top ten US banks in terms of derivatives exposure were: JPMorgan Chase, Bank of America, Citibank, Wachovia, HSBC USA, Wells Fargo, Bank of New York, State Street Bank, SunTrust Bank, and PNC Bank, according to the Comptroller of the Currency Administrator of National Banks' Quarterly Report on Bank Trading and Derivatives Activities for the second quarter of 2008. http://www.occ.treas.gov/ftp/release/2008-115a.pdf Lots of other good information too, if you like this sort of thing, as I do.

And this is just the beginning. Few losses are expected from the failed GSEs. Fannie Mae’s senior debt settled at 91.51 and subordinated debt at 99.9 cents on the dollar; Freddie Mac senior debt was 94.00 and subordinated debt was 98 cents on the dollar. Washington Mutual could be another story. Its Credit Event Auction will settle, meaning prices will be determined, on October 23. Just last week there were credit events at the largest three Iceland banks, all of which have large quantities of derivatives outstanding. These are all financial institutions; industrials haven't started yet.

Nonetheless, the market’s up. For technical types, Mish Shedlock has a good and almost-understandable-by-laymen explanation of where the market is in terms of Elliott Wave theory. He says, “In terms of price, given the magnitude of today's move on top of the huge move up from Friday's low, the rally may be 65% over already. In terms of time, the rally likely has several weeks to a couple of months to play out.” See S&P 500 Crash Count at www.globaleconomictrendanalysis.com

In my opinion, the markets are still very fragile. Charts or no charts, it wouldn’t take much to trigger another cliff dive. We’ll see what happens next.

mg