Friday, August 24, 2007

"Get 'Em While You Can"

I spoke to a dealer who is on the front lines of equity derivatives trading yesterday and the very first thing he told me was that everyone now thinks markets are going to rush to new all-time highs, so the battle cry is "buy before it's too late". Pundits are already suggesting that smart money should get right back into the yen carry game, embrace risk, etc. Oh my, how quickly panic is transformed into greed... This vertiginous emotional roller-coaster is well known to yours truly, having observed it amongst speculators many a time.

Managing the rebound after a plunge like the recent one takes significant skill in market-making, particularly in dealing with the real money sell orders that come in mixed with the hot money buys. The skill consists of downplaying the importance of the sell orders in relation to the buys when arriving at the prices that cross the tape. It is not easy, but market makers are helped by the fact that real money investors usually place "limit" orders, whereas hot money always goes for "at market". The trick is to slowly work the "limit" sell orders, executing them against carefully controlled bids, while causing the "market" orders to be executed at once - as requested - but at ask prices that are immediately widened out. In this way prices jump more than the balance of buy-sell orders would suggest and specialists and market makers can usually recoup what they lost on the way down. Everyone is satisfied, except for the "market" buyers who see their fills come in higher than they expected. But they are usually so hot under the collar, they are still happy. (There always has to be a "sucker" in a "sucker rally", no?)

I vividly remember my first encounter with a NYSE specialist (the important members on the floor posts who make markets in stocks). The firm I worked for at the time had brought him in for one of our formal training sessions. He was impeccably dressed and groomed and while the head of training introduced him and explained his function on the floor as part antagonistic, part helpful to our customers' and firm's interests, he stood with his hands clasped and calmly scanned the audience. When the introduction was over he cracked a wide smile and let four Dracula teeth show through his grin - everyone burst out laughing and the point was well made: his function was to make a profit for himself, first and foremost.

He proceeded to hold a short simulation of how order execution takes place on the NYSE floor, with our hapless selves as floor brokers for our firm instructed to execute various market, limit, stop, etc. orders and himself in his usual role of specialist. We got.. whomped, to put it mildly. It was a very worthwhile initial lesson in how markets really work. There have been many more lessons since - I taught some of them myself.

Anyhow, what I am trying to say is be extra careful of wide price swings. "Real money" pros don't crash headlong through an ice cream parlor window, if all they want is a second scoop of vanilla. When the store is being trashed by a bunch of hungry yahoos, they are perfectly content to step out and wait until they all go away. The result of real money pulling sharply back can be best observed in the primary market, i.e. the issuance of new securities, which has now slowed down dramatically. Various announced but unfunded LBO deals can't sell bonds and plans from private equity funds to go public are being "delayed".

Finally, how about a top Swiss banker as commentator? Jean-Pierre Roth, the head of the Swiss National Bank (the country's central bank) had this to say: "We're certainly not at the end of the story. There are question marks surrounding the development of the American economy. Something unbelievable happened. People who had neither income nor capital got credit with very attractive conditions. Now reality is striking back".


  1. Great post, as usual....

  2. Hellasious, I am wondering about your quote on the previous article, and would appreciate you shed some lights on it.

    When the customer pledged say Sub-prime or AA (not tripple A) bonds as collateral for the banks, where is the bank getting the money from to grand the leveraged loan? I think the FED will not take anything less than AAA and backed by Fannie or Freddie.

    Say a customer has $100 million AA bond, and use it as a collateral for a $200 million loan from BoA. How can BoA "switch" this collateral from FED since FED would not accept it?

    From BoA customer's checking account?

    << The banks are supposed to take their customers' collateral (loans, ABS, CDO's, etc.) and back-to-back it with the Fed, thus becoming a "liquidity intermediary", since the Fed cannot deal directly with such riff-raff. In money broking this is called a "switch". >>

  3. Re: collateral

    The Fed will take a variety of collateral, including non-AAA asset backed paper, whole loans and mortgages, etc. They will even accept it if it does not have a market price...

    And that's why the banks don't want to do the switch...if the collateral was good in the first place they would lend themselves, directly. But if the customer pledges c*rap, which the Fed nevertheless accepts at face value, you can see why they would refuse to do it.


  4. Hellasious, thanks for the update.

    However, I have sources telling me that FED only accept AAA rated MBS from Fannie and Freddie.

    Is there any way you can show me the link to Fed website or anywhere that state FED accept the crap BBB rated MBS? Thanks!

  5. shawn,

    The link was on the previous post about the window ops.

    Here it is again:

  6. Can you comment on the the CNN-Fortune article on the Fed's letter to BOA-C dated August 20, 2007...The article was released at 4:31PM after the market close...


  8. Seen this?

  9. Edwardo,

    basically correct, or at least bundled Winnebago paper; I would only note that there's some history here.

    For example, in October 1999, there was an FRB
    memo New Asset Types Acceptable for Discount Window and Payments System Risk
    that, apparently because of Y2K 'contingency purposes', modified the "asset acceptable for Discount Window and Payments System Risk purposes" while also noting:
    "Looking ahead, the Federal Reserve anticipates approving additional asset types as collateral."

  10. Re: Fed bending rules.

    This is very serious and the amounts involved ($25 billion) are very large. This is what we get for doing away with Glass-Steagall.

  11. I think most traders are emotionally unstable, overpressed, almost arrogant, stubborn and very, very eager for action.

    It could be good qualities in any kind of business activity except trading.

    In investment, being stubborn and emotional is the best way to be separated from your money.

  12. The Feds said they will take boats as collateral. Docking soon at the NY Fed will be the Positive Carry. The owner is a hedge fund loser; the boat goes for around 1/4 billion bucks. So, there's 1% of the $25 billion.

    George likes to ride on big boats. The last one had a banner, "Mission Accomplished". This one will have only the word, "Mission Failed" as it's a smaller boat, and can't carry as many letters.