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Is there another cause for credit crisis?

Since two Bear Stearns hedge funds lost everything in July 2007 — acting as the proverbial canaries in the mine shaft — we have been writing about the subprime debt fiasco, resultant credit crisis and the housing valuations, which appear to be fundamental to our current tenuous economic condition. In the online version of the February issue, longtime forex expert Osman Ghandour asks, “Is anyone really convinced that subprime lending in Las Vegas caused the bankruptcy of Iceland? Or that flipping condos in Miami and widespread foreclosures caused the crippling of the global banking system?”

Ghandour points out that the price of crude oil went from $60 to $145 per barrel and back to below $50 in a period of 18 months and notes, “There must have been a source of almost limitless funds that generated such a round trip and caused the havoc witnessed in the world’s financial fabric.”

That source, Ghandour believes, is the carry trade. The carry trade entails borrowing in the currency with the lowest yield and buying the one with the highest yield. Ghandour explains how, with funds at hand and high relative returns, hedge funds would turn around and speculate in stocks, commodities and in numerous other strategies using the carry positions as collateral.

He points out that the that if credit default swaps and other failed instruments, like mortgage backed securities, added up to roughly $120 billion, it would only equal 60 days of turnover in the forex market.

“The carry trade was the major culprit. The subprime lending mess, the rising foreclosures and the failures of various financial institutions just added to make it the perfect storm.” To see the complete story click here.

TRADING TECHNIQUES

In Al Brooks' article, "Trading breakouts and micro trends," Al pointed out several examples of how to spot failed breakouts of micro trends. On Jan. 5 several potentially profitable trade set-ups based on failed breakouts occurred. On the below five-minute E-mini S&P chart from Jan. 5, there are several examples of the failed breakout. The green arrows indicate buy signals following a failed downside breakout and the red arrows indicate sell signals following failed upside breakouts. For a more detailed description of these set-ups, look at the complete article.

MARKET STRATEGY

James Cordier and Michael Gross suggested executing a short strangle in silver, pointing out that elevated volatility levels caused by the move from $20 to below $10 from July to October has created a situation where premiums of $500 or more can be collected in the May calls for strikes more than 100% out of the money. Similar premiums can be collected for short puts 35% out of the money.

They suggested selling calls at $19 or $20 and puts at $6. So far, silver has remained safely in that range.

TRENDLINES
CME, Liffe almost in the clear for CDSs

Since our January issue, two exchanges have come a few steps closer to finding a home for clearing credit default swaps (CDS). CME Group cleared two regulatory hurdles on Dec. 23, when The Commodity Futures Trading Commission and Federal Reserve Bank of New York granted regulatory approval for clearing CDSs through CMDX, CME Group’s joint clearing venture with Citadel Investment Group. CMDX is operationally ready to launch pending SEC approval.

NYSE Euronext’s Liffe-LCH.Clearnet centralized CDS clearing solution through Bclear, which was launched in Europe on Dec. 22, was granted permission by the SEC to provide CDS clearing in the United States on Dec. 23.

Another development on the clearing landscape was the International Derivatives Clearing Group’s launch of a clearinghouse for OTC interest rate swaps on Jan. 6.

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USFE shuttered

With his new position as CEO of MF Global, spotlighted in our Trading Places column for January, Bernard Dan also became chairman of the U.S. Futures Exchange (USFE). But the USFE chairmanship turned out to be short-lived, as the exchange closed at the end of the year when MF Global failed to find a buyer for it after putting it up for sale on Dec. 17.

Sentinel trustee files suit against KBW and Cohen

Citadel and Goldman Sachs have not yet answered the complaint filed by Frederick J. Grede, trustee for the Sentinel Management Group’s bankruptcy, but that doesn’t mean he hasn’t been busy. This week Grede filed suit against Keefe, Bruyette & Woods Inc. (“KBW”) and Cohen & Company Securities LLC to recover $130 million from KBW and $150 million from Cohen.

Grede says that Sentinel’s head trader Charles Mosley received “substantial favors,” including lap dances, travel, dining and sporting event tickets, for buying collateralized debt obligations from KBW and Cohen brokers, including Stephen M. Folan and Jacques de Saint Phalle, who were previously brokers at FTN Financial Securities, which was named in a separate prior suit.

With Sentinel now out of bankruptcy and into the liquidation trust, the remaining issue is how to spread the pain among Sentinel customers. And a recent decision stemming from the Bayou case, in which the judge required customers to return principal and profits paid out within two years of the crime coming to light, may provide a clue.

All of Sentinel’s customer funds were required by the CFTC or the Securities and Exchange Commission to be segregated funds, Grede explains. The central question among the customers is whether the distribution is fair, considering that some customers, the futures commission merchants, received 70% of their funds back through the sale of Sentinel holdings to Citadel. Some got none, and just a day after Sentinel put out a letter announcing that it would refuse to honor redemptions, four firms received 100% of their money back, Grede says. “The key question is: is it fair that some customers got 100% out, some got 70% and most got zero? My position is that should be equalized,” Grede says.

FOREX TRADER
Update on the U.S. Dollar Index

In the January issue, Abe Cofnas examined how a common indicator for the dollar, the Philadelphia Housing Index (HGX), had begun to show a divergence from the dollar and what that could mean. HGX has had an interesting change in behavior. Normally its price action is very much in synchronization with the U.S. Dollar Index (DXY). This makes sense fundamentally because housing is a leading indicator of interest rate expectations. As housing has declined, so has the dollar. This is reflected in the correlation between the HGX and the DXY until Sept. 30. Between Sept. 30 and about mid December, the housing index and DXY were going in opposite directions. The dollar was rising while the housing index continued to decline. This divergence was the signature of how market psychology for the dollar changed from being driven by interest rate expectations to risk appetite. The surge of the dollar, despite the decline in the housing index, was a result of a flight to safety and the deleveraging of other assets. The divergence has stopped and this can mean that several scenarios are now on the horizon.

The DXY’s rise could be over or decelerating as the market considers the continuing decline of housing. With zero interest rates upon us, expectations of a further and deeper recession will lead to a dollar decline as the deleveraging of assets becomes depleted and short covering of the dollar runs out of steam.

Another scenario examined is that the spread between the DXY and the HGX will narrow and eliminate the excessive moves that have driven the dollar faster and higher than it would otherwise have gone. Playing a narrowing of the spread between the DXY and the HGX can be accomplished in options on these indexes.

FUTURES 101

In Futures 101 “Trading the calendar” Christine Birkner wrote about the various economic reports and important exchange delivery notice days and how they can affect markets. One of the most important aspects of following the economic reports is knowing what the expectations are. A good example came last week when the unemployment situation report for December came out. Going into the report, consensus expectations for nonfarm payrolls were a drop of 500,000 and the unemployment rate was expected to go to 7.0%. However the evening before the release there were several Web-based rumors that the number of jobs lost could be as high as 700,000.

The new more-negative expectation changed perception and when the actual number came out, -524,000 with additional downward revisions of 184,000 in October and November and a 7.2% unemployment rate, the negative reaction by the market was muted. The Dow Jones Industrial Average dropped 143 points or about 1.6%, not what you would expect on such a bad number. Traders who were not aware of the downward shift in expectations were at a great disadvantage.

HOT COMMODITIES

Corn: March corn took flight in the second week of December, roaring to $4.30 in early January from $3.10, blasting through our experts projected highs. However, in the second week of January, it has retreated to trade in the range they anticipated, between $3.15 and $3.75 per bushel.

Crude: Despite a hot war in the Gaza Strip and intense cold across the Midwest, crude oil futures prices have so far defied expectations and continued their downward trajectory. Our analysts had support between $38 and $40 per barrel, which we breached on Monday, Jan. 12. Crude did trade briefly above $50 this month, which is well below their most conservative resistance level of $56. That said, anything can happen and there’s a lot of January left.

The Swiss franc peaked out against the U.S. dollar in early December at 1.23 before falling off the map. January has been a little kinder and the currency has steadily climbed from 1.0665 to the 1.11 – 1.12 area, just below the support our analysts projected.

MARKET WATCH

“The Fed goes into 2009 with a depleted, though not exhausted, monetary toolkit after a year of extraordinary policy exertion,” wrote Steven Beckner. Having lowered its target Fed Funds rate by 75-100 basis points to 0-0.25%, the Fed’s pantry, if not empty, is awfully sparse and Chairman Ben Bernanke is now banking on a stimulus package from the new administration to help spark the economy. While the funds rate is not the only tool, how many more special auction facilities can be created? It is looking like all that is left for Chairman Bernanke is his oft mentioned helicopter.

MARKETS

A floor of newly issued government, corporate and municipal debt has loosened supply and pushed bond prices lower, but from a historical basis and despite the recent correction, 30-year bond prices remain high, as does the number of failures to deliver those bonds. In the February issue, available online Jan. 26, Futures will look at how bonds trade, the ramifications of the increasing number of Treasury fails and recent steps taken to reduce their numbers and market impact.

U.S. Treasury bond futures have corrected roughly 25% from its huge run up in November and December and appears to have leveled off into a range.

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