"Whether you are a bull or a bear, please be careful out there" – Me, 9:30 this morning!
Wow – a little something for everyone today!
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09:30: 13,211
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09:36: 13,280 (+69)
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09:49: 13,159 (-121)
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10:20: 13,286 (+147)
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11:00: 13.135 (-151)
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12:35: 13,307 (+172)
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01:24: 13,173 (-134)
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02:05: 13,246 (+73)
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03:26: 13,146 (-100)
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03:56: 13,391 (+245)
That's 1,212 worth of Dow movement in just one day! Needless to say it was very exciting for us and we had a ball getting in and out of oil puts, and calls as well as index puts and calls on a day that was lots of fun but also reminded us why we are mainly in cash!
We had successful tests of both the S&P at our target of 1,440 and the Nasdaq at 2,525 but I thought the end of day movement looked a little forced so I remain in full-blown skeptical mode:
Oil came down just a bit today ($1.68), despite a large draw in crude inventories – hopefully it was something we said! Let's keep forwarding Tuesday's wrap-up to every politician you can get your hands on until we start hearing questions about crooked oil trading being thrown at the candidates!
I'm not going to say anything else about the markets just now other than the fact that I got a very disturbing call from someone in the mortgage industry and he told me that there is a liquidity crunch in the credit industry and margin calls are being made. I will warn you that this is, so far (10pm) unsubstantiated and it is unlikely I'll know until morning but what that means is this:
Higher credit risk is driving DOWN the price of bonds (you pay face or "par" value for a bond but the value of the bond fluctuates depending on whether the rate of interest you get is better or worse than the prevailing rates and the creditworthiness of the bonds themselves), causing those bondholders who bought on margin (Yen carry traders!) to get margin calls as the value of the bonds they are holding have declined significantly and no longer cover what the brokerage/bank/whoever was willing to lend against.
So, let's say a guy has $100M in bonds that were purchased with borrowed yen and also margined in a US brokerage at 50%. Let's say the bonds had an 8% interest rate, yielding $4M, so he has to pay $50M, which he borrows in Japan at 0.5% and then he uses that $50M in bonds to leverage his US broker to lend him another $50M at 4.5% to buy another $50M in bonds at 8%. It may not sound like much but the guy is looking to make $5.5M a year on pretty much entirely borrowed money!
As long as the dollar doesn't devalue too much against the Yen, it's a perfect plan (and that's why margining half in all dollars is attractive, despite the margin interest it mitigates the currency risk) EXCEPT – the bonds are mortgage-backed securities and the mortgages get revalued which causes interest rates (risk) to increase on new bonds which causes the old bond's value to drop (I know, headache!). Now the $50M base value of the bonds drops to $46M and the broker says "whoa buddy, margin call on $4M of what we lent you!" So what does our friend do? He sells bonds to raise the cash (and there is a penalty for selling early), which causes the value of other bonds to drop (including his own) which leads to a wider spread and even more margin calls which leads to more selling….
All this drives rates up and dries up liquidity (the bond is you lending money to a lender) which causes more people to default on their homes which causes the mortgage backed securities to be devalued which takes us back to that first margin call and round again! You won't see a quick change in the 10 and 30-year notes right away but you will see drastic changes on ARM and Jumbo mortgages as well as any other "exotic" lending instruments that can't be dumped off on quasi government agencies like FRE and FNM (who will make a nice put play with the Sept $55 puts at $2).
Usually I don't like to be an alarmist, but it just so happens that my June 7th short plays on FAF, FNF and LFG paid off in spades today, prompting Lithium Rocketbottle to say: "FAF FNF LFG – Thank you, thank you, thank you Phil." While I do love to be right, today's action was a little TOO right, which led me to think something bad was up in the mortgage world and a meltdown in the bond market does seem to fit the facts. Hopefully we'll have some clarity in the morning but meanwhile it's:
"Forward, backward, inward, outward, come and join the chase! Nothing could be drier than a jolly caucus-race. Backward, forward, outward, inward, bottom to the top, never a beginning there can never be a stop to skipping, hopping, tripping, fancy free and gay, I started it tomorrow and will finish yesterday. Round and round and round we go, and dance for evermore, once we were behind but now we find we are be-forward, backward, inward, outward, come and join the chase…"
Whoever said this would never come around to haunt us?
