To Get Those Twenty, They'll Destroy The Market

By: Michael Ashton | Mon, May 17, 2010
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A decline on Friday and on Monday? The equity market selloff threatened to enter a new phase, as stocks fell on Friday in fear of what might happen over the weekend, but then declined again on Monday shortly after the open despite the fact that no further bad news emerged from Europe.

Unless, of course, one counts the threat from the Greek Prime Minister, who promised to probe the role U.S. banks played in the crisis. It's amazing any of these banks ever existed, when you think about it. From what I hear, they caused the housing crisis, the subprime mortgage crisis, the European crisis; together with hedge funds they caused the California energy crisis a few years ago and the gasoline price gauging following Katrina. I heard they were involved in the Civil War, and there is a rumor that Pontius Pilate worked for J.P. Morgan. Is anyone willing to take responsibility for anything any more or is everything the fault of the banks? How, exactly, did the banks cause the huge Greek fiscal deficit? Good heavens.

To be sure, bankers are not angels and we saw another stomach-churning example of that today in a Bloomberg story about a particular issue of "reverse convertible" securities. A reverse convertible is a note, usually short-term, that pays a high fixed rate of interest and returns principal as long as certain conditions do not occur. The particular condition of interest in a reverse convertible is that the underlying equity security cannot fall more than X% on any day during the note's life. If those conditions do occur, then the investor instead owns the stock in question, usually at the original price (that is, the investor gets the entire decline of the stock). In this particular instance, JP Morgan issued a 2-month security that paid a 64% annual rate of interest as long as TIVO didn't fall 25% from the starting price on any day during the note's life. If TIVO did fall that far, then the buyer of the reverse convertible instead owned TIVO at the price it was at when the security was issued (in other words, an instant 25% or more loss).

The problem with this security is not the structure, which is fairly easy to understand as long as it is fully explained. The problem is that it is ridiculously hard to price - technically, the buyer of the note is selling a naked knock-in, in-the-money put option, which you as the investor have no chance at all of correctly evaluating. As a consequence, JPM not only makes its disclosed 1.75% selling concession - which is pretty egregious for a 2-month note, anyway - but also probably makes another 3% or more on the hedging of the option, and this profit is not disclosed. The fact that such a product is marketed at all with this sort of margin is unconscionable. Unlike CDS, interest rate swaps, and inflation swaps, each of which serves a clear function, it is clear this product is designed only for one thing: to separate fools from their money.

So, while I continue to object to the Volcker rule and all of the dangerous legislation that is currently being pushed through Congress, and I feel sympathetic for all of the good people on Wall Street who work hard to innovate useful products to help intermediate risk for their clients and who take a reasonable compensation for doing so, it absolutely turns my stomach that those people are being lumped in with the people who innovated, priced, and marketed reverse convertibles, as well as the legal and compliance architecture that said such a rip-off deal is okay. Wall Street confronts, unfortunately, rather the reverse of God's policy with Sodom: policymakers will destroy the city for the sake of the twenty wicked within, no matter how many innocents are brought low in the process.

Back from Biblical times to present day, the stock market ended +0.1% higher after clawing back from being down around 2%. It was an impressive comeback, but would have been more impressive had the market been down on bona fide bad news. Sure the Empire Manufacturing index was weak at +19.11, but this is a volatile series. I think that, since it is May data and it is plausible to imagine that European stresses could be reflected in domestic manufacturing data, it is worth watching other manufacturing surveys, but this isn't the reason the market plunged. Nor, of course, is the rise in the NAHB index, which is mildly bullish. That index went to post-crisis highs at 22, although as the chart below (Source: Bloomberg) shows this isn't really anything to write home about yet. Clearly, though, there is some improvement from Depression-level sentiment among home builders.

National Association of Home Builders Market Index
Construction Sentiment Is Improving (But A Long Way To Go)

While stocks ended up with a scratch, other internal signs give continued cause for nervousness. Inflation measures dropped another 3-5bps (the 1y inflation swap actually fell 13bps and is now at an even 1%), but even so the June 10y Note contract fell 6/32nds and the 10y yield rose to 3.48%. The combination of those two things implies that real yields rose, but they are so sharply negative as it is that I am afraid we can't glean much information from that.

Tomorrow, we get the first of the inflation numbers this week. That would be the PPI (Consensus: +0.1%, +0.1% ex-food-and-energy), which is generally an unimportant number to inflation people but fairly important to other people who think that PPI is a useful indicator. More interesting, to me, is the Housing Starts number (Consensus: 650k from 626k), which is expected to record the highest reading since 2008...but at a level which, like the NAHB index, is hardly cause for celebration yet.

I remain concerned about the near-term direction of the stock market and the medium-term direction of the bond market, although in the latter case I don't feel any desire to fade the downtrend in rates just yet.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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