Today’s tickers: FRE, FNM, VIX, LEH, WB, AIG, XLF
FRE– The market tumbled out of bed this morning to speculation of a possible government “conservatorship” of mortgage financers Freddie Mac and Fannie Mae, which own or guarantee nearly half of all U.S. home loans, bringing to mind the worst possible images of not only the impotence of the two chartered companies in their present form, but also the auxiliary effects through the broader financial sector if the companies were declared unfit to carry on. Remarks from U.S. Treasury Secretary Henry Paulson (who indicated today that the Feds’ current mission was to support the financers as they are presently structured) – seemed to rule out an imminent government takeover. This did little to assuage traders, who feel that a bailout would essentially value these shares at nothing and set in motion potentially very negative auxiliary effects in the larger financial space. Fannie Mae options are trading at nearly 4 times the normal level against a 22% drop in share price value to $10.39 – paring some of the pre-Paulson cataclysmic losses earlier in the session. Implied volatility has risen another 47% on the session to 267%, and comparing this shoulder-to-shoulder with the 123% degree of volatility shown by Fannie Mae shares historically tells us that the option market is pricing in about 117% more potential price risk to its shares over the next 30 days. In other words, the cost of insuring against price swings is rising appreciably as speculation over the future of the mortgage financers broadens. Puts at the July 5 strike have already traded at some 4 times the normal level, attracting buyers as well as sellers as the 45-cent premium on this contract reflects about an 11% probability of Fannie Mae shares halving in value again by next Friday.
VIX– Concern about the aftershocks of a possible forced socialization of Fannie Mae and Freddie Mac sent the S&P dramatically lower, leading the CBOE Volatility Index 10% higher by midday to 28.16. Intimations of “the other shoe to drop” in the broader market caused a rush among option traders to buy calls at the July 27.50 strike, where the $1.90 premium implies a move to at least 29.40 between now and next Tuesday. While the clear bias was to buyers at the 27.50 strike, calls at strikes 30 and 32.50 attracted buyers and sellers, and we wonder if selling pressure in August calls at strikes 27.50 and 30 may be evidence of traders cashing out of those positions to fund the purchase of front-month protection. The cost of protecting S&P-exposed portfolios against volatile price movement over the next 3 days is up more than 100% at most strikes in the July contract. In this environment, it would be no surprise to see traders resort to VIX call and calendar spreads, selling higher-strike positions to keep trade costs under control.
LEH– Brokerage names traded broadly lower on concern that a toppling of the mortgage financers would put a definitive kibosh on securitization; this despite observations from Sanford Bernstein analyst Brad Hintz that brokerage shares had already discounted an effective halt in securitization activities. But the bearish band plays on in Lehman rumor. Barron’s reported a Thursday regulatory filing that Lehman has some $21 billion in “mortgage and other asset-backed securities on its books,” the company doesn’t originate mortgages – sharply delimiting its exposure to a Fannie-Freddie crash as opposed to the regional or super-regional banks. Furthermore, yesterday’s assurances from Pimco and SAC Capital Advisors that they had no plans to revise their trading exposures to Lehman Brothers appears to have had no sedative effect on the barrage of malignant momentum surrounding Lehman, which is proving as hard to contain as a California wildfire. Implied volatility – the risk barometer used in the pricing of options – bounded 50% higher to 119.8%, more than 40 percentage points above the March 17, 2008 reading when the prevailing fear was that Lehman would actually suffer a Bear Stearns-like run on the bank. What’s certain is that option traders feel the risk to Lehman shares is especially acute over the next week, and we can extrapolate the implied volatility reading to the price of the front-month, at-the-money straddle ($15.00), which at $5.00 this morning suggests that option traders see the potential for at least a $5 up-or-down move (one-third of Lehman’s value as of this morning) from now to next Friday. Twice as many puts are trading as calls, with fresh volume at strikes of 15 and below, attracting bumper traffic from buyers as well as sellers as the value of these positions has more than doubled overnight.
Elsewhere, a cursory scan of the names in our top-50 list of top implied volatility gainers offers some indication of the companies option traders feel are most in the line of fire from a Fannie-Freddie failure.
WB– Wachovia shares have long been fingered by option traders as particularly vulnerable in light of its mortgage exposures, exacerbated by a disastrous takeover of California mortgage lender Golden West Financial. So it follows that a collapse of the country’s primary source for mortgage financing would raise Wachovia’s regional problems exponentially. We saw the redoubled risk outlook reflected immediately in a 46.5% increase to 158.8% today, dwarfing the already elevated 88.6% reading on the stock. Here as elsewhere in the financial space, there is a strong gravitation toward defensive put positions, which are already outranking calls by a factor of 2.3 in terms of volume. Front-month action shows these puts mainly being bought at strikes of 10 and 12.50 – the same strikes attracting buyers in the August contract.
AIG – Today’s move lower in AIG comes in swift succession to an 8% loss on concerns of a rating cut at its mortgage insurance unit, and real uncertainty about the company’s new management apparatus. Today its option implied volatility rose by another one-third today to read 119.7%, some two and half times the historic reading on AIG stock, as shares slid 8% to $22.09, distancing AIG even further from that freshly hatched 52-week low. It remains to be seen whether we’ll experience another six-figure put volume day in AIG options, but for now it looks like July 20 puts are trading heavily and on an implied volatility reading far higher than the reading for all AIG options (implying greater demand for protection at this strike). Interest has extended into the $20 strike in August and November as well.
SLM– Options in SLM Corp., the somewhat “incognito” initials of the student loan servicer Sallie Mae, are trading at triple the normal level today against a 5% decline for shares below the $15.00 mark. With shares hovering right around the 52 week low, the fact that 3 times as many puts are trading as calls suggests that traders are seeking protection for further erosion below these lows. In the front-month, July 15 strike puts have traded 9,000 times – amounting to more than half the open interest at that strike – at 95 cents per contract. Around midday we saw a 10,000-lot position bought on the offer at the July 10 strike, apparently reflecting a trader who expects Sallie Mae shares to surrender another one-third of their value between now and next Friday.
MER– Merrill Lynch’s implied volatility rose 22.5% to 109.5% as put volume eclipsed calls by 3-to-1 amid a 6% decline below the $27.00 mark for Merrill Lynch shares. Again , we can attribute this move to poor securitization prospects for brokerages on back of a larger failure in Fannie Mae and Freddie Mae – the Securities Broker/Dealer Index (XBD) has seen a 15% spike in implied volatility on that fear alone today. With puts outmoving calls by 4-to-1, most of the front-month action is occurring in puts at strikes 25 and 27.50, trading to buyers and sellers on sharply higher premiums. In general, Merrill Lynch puts at strikes 30 and below are seeing two-way traffic as the price of the 27.50 straddle suggests as much as a $4.79 up-or-down move priced into the options between now and next Friday. That’s more than 17% of Merrill Lynch’s current share price – a huge move.
XLF– Shares in the Financial Select Sector SPDR, meanwhile, are trading 3.7% lower at $18.50 on back of the Fannie/Freddie brouhaha. Earlier today we noted a heavy degree of buying pressure in July 20 calls, which have traded in excess of 30,000 lots, and wondered whether it might be protective hedge positions by traders shorting the financials even at current levels. At 29 cents apiece the $20 call seems an extraordinary bargain, and indeed it’s been stripped of more than a third of its premium value since yesterday.The buying here may also be indicative of traders positioning long of volatility via strangles with puts at lower strikes. A look at the price of the 18/20 XLF strangle indicates that traders can buy this position for a combined premium of 88 cents and obtain protection in the event of a break above $20.88 or a probe of even lower lows below 17.12. That $1.35 move below current price levels is less than the decline we’ve seen in the XLF since Tuesday.
