The Weekly T Report: For Once the Focus Wasn’t on Europe

What a week.

Just over a week ago we had a disappointing non-farm payroll report (why don’t farmers count?) that sparked a sell-off that accelerated throughout the day as the market got nervous about the elections.

The market was right to be nervous about the elections.  The Greek elections resulted in some groups adamantly opposed to the Euro and the existing bailout plan with significant power.  That, coupled with a solid victory for Hollande in France gave the markets a real fright that left us staring at some bright red screens on Monday morning.

But in the end, the markets tolerated the results and the ongoing uncertainty about who will govern Greece remarkably well.  Spain was truly manic with the Spanish market swinging wildly all week as fear of bank problems switched to excitement over recapitalization plans back to questions about the future.

I continue to believe that the Axis of Weeble, will do just that for now.  They will wobble but not fall down – just yet.

Greece will get some concessions from the Troika.  It is in no one’s interest to rush their exit.  Depending on how big the concessions are this could buy Greece anywhere from a few months to a year or more of time to make a final decision on the Euro. The concessions can be big if the ECB plays nice with its portfolio of bonds and does something along the lines of what we recommended.  I think we will see enough progress in Greece early this week that it will be supportive of the market.  I continue to like the post PSI bonds, even though they were down last week, as I don’t think the problem comes to a head just yet, and at 21% of par a lot of bad outcomes are already priced in.

Spain is just starting to really deal with some of the issues.  The market seems to like to give them the benefit of the doubt even though we have probably just scratched the surface of how big and bad the problems really are.  There is more pain coming in Spain, but right now I think we can see some continued outperformance.  I like Spanish stocks versus German or U.S. stocks as the decoupling argument has been more than priced in.  I don’t like Spanish bonds (though I recommended covering the short last week) because I still don’t see any natural buyers.  I would be more likely to sell Spanish CDS as it is back to very wide levels and is far more likely to gap tighter on a short squeeze than the bonds are.

The latest elections in Germany are interesting.  Merkel’s party did poorly.  So far it is being framed as a vote against austerity.  If that is true and she embraces some “growth” rhetoric alongside her new best friend Hollande, we could see markets react positively.  The growth won’t do anything – especially since very little actual austerity was ever tried – but the markets do like it.  My one concern, that I just can’t shake, is that German’s were voting more against sending money to other countries than against austerity.  If that is true, look for some choppy markets as a truly hardline Germany would be bad for the markets.

All week we managed to largely ignore weak data out of China.  You know it is a strange week when Chinese weakness barely registers on the radar screen.

So I think the “relief” rally that I was looking for may have already occurred.  How is that possible in a week where the market didn’t do much?  Well, we had lots of bad data and negative headlines, yet the markets held in.  So much of what I felt was “oversold” has been corrected not by the market rising, but by the market not selling off more when it had plenty of excuses to sell off.  I continue to believe that we will get news out of Europe that will be construed as positive, but I think the strength of any rally will be minimal and not last for long.

So now let’s get to the real excitement – JP Morgan.

CDX and IG9 have become buzzwords.  Having helped create the IG and HY indices and been an original board member of CDS Indexco (before it was sold to Mark-it) I have to admit that I enjoy how it is suddenly front page news.  Not since ABX have so many people wanted to discuss CDS Indices and tranches.

I’m very torn on what this will do to the markets.  I am leaning towards saying that JPM is way overdone because I think people will understand the premise that for a hedge to provide meaningful gains to JPM, even in a stressed market, needs to be big.  That is the key.  They markets didn’t move massively against them, they only moved a bit, but the P&L is still big because the positions are so large.  $2 billion is a big number, but it’s not even 1 month of profits after taxes.  For a bank that seems to generate $5 to $6 billion a quarter, that number just isn’t that big.  With over $2.3 trillion in assets, it is 0.08% of assets.  Again, small for something the scale of JPM.  Also, let’s not forget that JPM is talking about buying back $10 billion to $15 billion of stock.  For a company of their size, they need buybacks that large to move the needle.  So $2 billion is bad, but it is mostly bad if you ignore how big JPM is.  That may be the story and we will come back to that, but for now the initial disclosure really doesn’t seem that bad.

There is some concern that the loss will grow.  That is possible, but since the announcement talked about changes to the model, I’m not sure the $2 billion didn’t already include a lot of wiggle room.  They didn’t disclose how much they made in the AFS (available for sale) book.  That may be offsetting more than the market is giving credit for.  It also didn’t mention what has happened to assets in their “banking books”.  While not able to take accounting gains on those assets, any real world price appreciation is actually useful to JPM. If this trade was in a non-mark to market book would we even be talking about it?

Probably not, and that is what concerns me for the market.  I’m not concerned that the loss will grow out of control at JPM.  I think it will be contained and net of other positions I doubt their quarterly profit will be hit by more than $1 billion net after all is said and done.  I don’t think other banks have similar positions.  In fact banks have the opposite because for every CDS trade of any type, there is a buyer and a seller.  I suspect that due to mark to model accounting, that the losses JPM is experiencing this quarter were already booked as gains last quarter by their counterparties, but that could just be me being cynical.

What could be negative for JPM and other banks is that once and for all people will realize just how big and opaque these banks are.  BAC had $3.3 billion of FVO adjustments in Q1.  FVO stood for fair value of obligations or something like that.  How do they get a pass on something that big?  Why was no one paying attention to it?  Ummm, because the CEO announced earnings with a headline that didn’t include that or the $1.5 billion of DVA.  Think about it for just a minute.  The joy of JPM bashing, which I have to admit is only slightly less pleasurable than GS bashing, has to take a back seat for a minute.  What do we really know about the earnings of any of these banks?

What the TF is $3.3 billion of FVO?  What are the real swings on the value of the banks’ positions?  Huge.  Plain and simple.  All the big banks, foreign and domestic, must have massive swings in value if everything was truly marked every day.  Banks rely on accrual accounting for huge swaths of their portfolio of prop bets (yes, loans are as much of a credit bet as selling IG9 mezz tranches, people are just more comfortable with loans) because they know their P&L would be extremely volatile if everything was held in available for sale.

So, I think this particular trade isn’t actually that bad, and JPM may already be trading too cheaply, I can’t help but wonder if there will be a flight from too big to understand banks (not that they even give any information that would help us understand what they do).  That is the risk here, that this trade will make the market aware of the dangers of being so big, how quickly big losses can occur on huge portfolios and just how little information we get from the banks.  If people stop focusing on just this one trade and start looking at some big but incomprehensible line items from BAC, MS, C, and GS earnings, the selling in big banks could continue.  The big banks won’t be helped by renewed regulatory scrutiny as the soundbites directed at them this week will be downright scary as what politician will be able to resist taking a shot at the industry?

So as much as I want to say this particular trade has almost played itself out, the reaction is overdone, and that it isn’t industry wide, I think it might be too early as this develops into a real backlash against big and opaque banks.  To the extent that you can ever have any strength in the overall market while banks are weak, we might get it this time.  This will not be so much about specific concerns about any bank, or anything to do with the economy, it will just be fear of owning something so big that you cannot possibly hope to understand given the current level of disclosure.

It should be another hectic week with so much going on.  In Asia, it is largely about the growth or lack thereof in China.  In Europe it is far more about politics and central banks as the economic problems are so well known and reliant on government programs and central bank liquidity.  We have now added the potential for lots of bank related headlines into the mix of just how slowly the U.S. economy is growing.  On that front, the data didn’t seem bad, though seeing one initial jobless claims number that doesn’t get revised upwards would be a big step for the credibility of that data and for the health of the market.

I remain reasonably constructive on anticipation that the week will start out with some announcements out of Europe that are construed positively and will be looking for opportunities based on that and from all the noise created by the JPM trade and banking headlines.