Monday, September 22, 2008

Some Notes on Bail Outs, Numbers, and the Long- vs Short-Term

Re: Bail Outs

Last week the Fed organized an $85 billion loan to American International Group (AIG). The loan allows AIG to post collateral against billions in claims from their financial products division. This doomed unit underwrote credit default swaps (CDS's) and other credit derivatives; it has almost single handedly brought down one of the largest insurers in the world. Given the Fed's predilection for stabilization, they had no choice but to extend the loan after the prospects of securing financing through a non-sovereign banking consortium deteriorated yesterday. Letting AIG go into bankruptcy would have been disastrous. To understand why, lets look at how insurers work.

Insurance companies underwrite policies against certain risks occurring. During "good" times, insurers collect premiums, pay out a small percentage of claims, and invest what's left in stocks, bonds and the like. This makes insurers as a group some of the largest investors in the world. AIG is one of the largest of all insurance companies, which means it owns at lot of financial assets.

If AIG had not received the $85 billion loan from the Fed, it would have been forced to start liquidating these assets until it had raised the necessary collateral to cover its derivatives losses. Since the market was already depressed to begin with this easily could have led to an all out rush for the door, with investors selling anything and everything. We saw a shadow of what could have happened last monday and wednesday.

Of course, the Fed is expanding its balance sheet by selling more treasury bills. This would be a problem if foreigners didn't eat our sovereign debt as quickly as the government can print it. But for now it seems the Fed has unlimited scope, especially with the dollar not deteriorating at any real clip Holding short term interest rates firm at 2% (instead of cutting) was perhaps the cause of this dollar strength.

Moreover, investors were so spooked by last wednesday's market action that they drove 3-month treasury bill yields negative. This means that people bid the price of a 3-month T-bill so high that buying it will actually earn you negative interest: YOU PAY THE GOVERNMENT TO LOAN IT MONEY.

The Fed either has the smartest people in the room or the luckiest, and which doesn't matter; I still want to stand next to them. This means that the government, even if yields go positive, is financing this AIG bailout for almost nothing. They are lending to AIG at approximately 12%. This might very well be the best trade in history. That's a positive carry of .12 * $85 billion = $10.2 billion per year. If AIG defaults the government will repossess one of the best property-casualty insurers in the world.

As former fed governor Wayne Angell said last week: "THE FED'S BALANCE SHEET IS INFINITE." This is especially true now that investors don't even demand interest to loan our government money...

Re: Numbers

It always amazes me the double reversals that can take place after numbers. Take the price of oil last wednesday after the 10:35am announcement of inventory data, which traded immediately down reversing an earlier gain, only to reverse again throughout the rest of the day; it was even so bold as to make a new high. The same thing happened last tuesday in the S&P 500 after the Fed rate decision was announced at 2:15pm. The market immediately tanked, only to spend the rest of the day going higher.

It has been my experience that opposing the knee-jerk reactions people have after numbers is the closest thing to a free lunch in this market.

Re: Long- vs Short-Term

Finally I want to stress the importance of planning long term and living short term. Planning long term goals and thinking about where the world is headed are noble pursuits, and it can bring us comfort to feel that we know where we're going. But we must remember
the Keynes quip that "in the long run, we're all dead," in addition to the fact that the short term can bankrupt you well before the long term saves you.
This doesn't mean you should ignore the long term, far from it, only that you should always be aware that in a market like this (especially if you are
using leverage) you must always be containing your short term losses. The moves have been so volatile
that you could be completely right long term, but blow out your equity waiting for it to happen. In this market it is best to dump any position that isn't going your way immediately and wait for a clean move that you nail from the beginning. In a market where there exists so much opportunity, there is no point in sticking to a bad trade and wasting your money.


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