Greek For Moron Bankers

Professional option traders are, or should be, well-acquainted with their net *Greek* risks: delta, gamma, vega, and rho.

Today, we'll broach *rho* - the theoretical change in (total) option value given a change in interest rates.

For example, as substitutes or proxies for *owning stock*, call options have positive rho because they demand cheaper cash outlays. As interest rates rise, so do the prices of calls. Similarly, puts have negative rho. [short positions obviously have the opposite signed risk for each respective type of option].

But, for most traded options - those only 1-3 months from expiration - rho risk is fairly negligible. It's only when positions are taken in the out-months, 1-2 years out, that rho starts to even be a consideration.

And really, it's only a concern of large players or at the *firm-level*. I myself never much worried about interest rate ticks. After all, they usually only moved in quarter point increments, every several months.

But that's just in regards to stocks. Obviously, fixed-income products have a heck of a lot more *rho risk*.

Consider the TBTF (Too Big To Fail) banks:

Feb. 1 (Bloomberg) -- Wells Fargo & Co., unlike its three biggest competitors, is so convinced interest rates will rise that it sacrificed as much as $1 billion last year cutting back on fixed-income investments.

The nation’s fourth-largest bank, whose biggest shareholder is Warren Buffett’s Berkshire Hathaway Inc., reduced investments in mostly fixed-income securities by $34 billion in 2009’s second half, company filings show. JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc. boosted their holdings by an average of $35.5 billion.

By scaling back on the so-called carry trade, in which banks borrow in overnight lending markets at rates near zero and invest in higher-yielding securities, San Francisco-based Wells Fargo aims to protect against losses when rates rise. The three other lenders increased investments on the theory that profit will outpace any future losses.

So Wells Fargo is, supposedly, betting on higher rates. They are trying to increase the bank's *rho*. Nothing wrong with that, right? But how big is this bet?

Wells Isn’t ‘Speculating’

"I applaud Wells," said Chris Whalen, managing director of Institutional Risk Analytics in Torrance, California. "The other three are speculating, taking a position on risk, and Wells is not."

JPMorgan CEO Jamie Dimon told analysts on the fourth- quarter earnings call that the bank’s exposure to rising rates was "way down" after having been high.

"I wouldn’t worry about it that much," Dimon, 53, said on the call. JPMorgan spokesman Joseph Evangelisti declined to comment beyond Dimon’s remarks.

Wells Fargo had an investment portfolio of $172.7 billion at the end of 2009 after the reductions. Citigroup led increases at the three largest U.S. banks, adding $47.5 billion of investments in securities to bring it to $254.6 billion. Citigroup spokesman Jon Diat declined to comment.

Bank of America’s investment portfolio grew to $301.6 billion at the end of the year from $257.5 billion in June, according to company filings. In the company’s fourth-quarter earnings call, Chief Financial Officer Joe Price said the bank would benefit from rising rates because it would receive more income from loans and other interest-bearing assets. Spokesman Scott Silvestri declined to elaborate.

AND, how much overall interest rate risk does a behemoth bank have?

I'd wager that mostly the banks just park their scant cash in short term government instruments. And like near-month options, short term debt can't really bear that much rho risk. So what if rates pop and some of the banks are locked in at lower yields; probably in 6 months time, or less, they'll have their cash back and will redeploy at a higher rate.

So in that sense, JPM, BAC, and C are in fact correct - that positioning their tiny bond portfolios for higher rates in the future is not really that imperative - in the larger scheme of things.

And the larger scheme IS what's more important. In other words, what is the actual net rho of these banks?

The BAC CFO said:

...the bank would benefit from rising rates because it would receive more income from loans and other interest-bearing assets.

In other words, he's asserting that his bank has a POSITIVE RHO - that the net value of its assets would actually INCREASE should rates rise.

He's certainly correct in saying that the bank would *earn more* on its interest bearing assets.

BUT he failed to mention that its COLLATERAL, already distressed real estate, will get hammered even more (as mortgage rates jump). Okay, a little bit more interest on a couple hundrend billion dollar bond portfolio....versus....a massive depreciation in the value of multi-trillion dollars worth of outstanding loans. Hello, McFly???

I submit that banks, through their lending operations, inherently have MASSIVE NEGATIVE RHO. While Wells Fargo seems to acknowledge that in its actions, the guy from Bank of America sees the situation oppositely.

The idea that higher rates are good for banks is ludicrous on its face. If it was, you'd hear bankers clamoring for interest rate hikes - and the politicians beholden to them would actually be raising the cost of freshly printed fiat!

More Floridian Foolishness

I spoke with my real estate buddy down in Naples briefly the other day.

Apparently he's got 8 clients with *full offer* bids in on properties (foreclosed?) at the moment. And, get this, he says that he doubts even one of his clients' bids will be accepted because they aren't *high enough*.

Now, I don't care what's happening at the end of this *green shoots*, deranged-optimism rally down in one particular part of the country....This economy is heading to hell in a handbasket.

First of all, let's discuss what's transpired in the past 3 months.

INSANE, bankrupt banks were tripping over each other to offer fixed 30 year mortgage rates at levels never before seen. A friend of mine acquired one such loan on his house in Orlando - a brand new home, I assume he put 20% down,....he received a 4.5% fixed 30 year loan. Unbelievable.

Also, these bankrupt banks like Bank of America, Wells Fargo, and JP Morgan were offering refi's at levels below 4%!!! How brainless is that? They are taking assets off each other's books that are paying 6% and transforming them into ones that pay a whole lot less. And for what exactly?

Oh, so they can book fees today and burnish their current earnings? Real smart, Morons.

This all happened in the context of not only the *spring buying season* but also amidst a furious, all-aboard bear market stock rally. The S&P rallied some 45% off its early March lows based upon, well, nothing fundamental whatsoever.

So idiots down in Florida, mostly *speculators*, are going bonkers trying to knife-catch an endless stream of foreclosures, big freakin' deal. This is no cause for longer term optimism. Haven't we been in this same exact myopic place some 4-5 years ago?

I mean, rates can only rise from here. Stocks have PEs twice as high (20X earnings) as seen by most bear markets. State and local governments are on the cusp of bankruptcy. Commercial real estate is bidless, in total over-supply, and trading 50% lower than two years ago. And residential real estate, in the most high-priced, blue-chip neighborhoods like NYC, Boston, and Silicon Valley has just started to drop.

To think that the long run prices of condos in Florida, a state whose entire economy has always depended on *real estate*, won't be aggravated by the above catalog is short-sighted and Moronic.



Now, recently I received this *prospectus* from another friend, who's also in real estate. It's selling:

....170 contiguous developed & platted lots, 100% complete (performance bond put up for final coat of asphalt) recently acquired by the sponsor of this deal as part of a larger discounted bulk purchase of the unsold portions (including raw paper lots) of ****** ******* an operational 18 hole golf and country club gated master planned residential community in Fort Meyers FL. The in place facilities are magnificent and 1,300 new homes out of the original 2,700 home subdivision sold for as high as $1,000,000. The new homes currently being sold start at under $200,000 by national builder, ***** ******, which means lot values to builders are in $40,000 range. The gross pro forma sell out to builders over a conservative time period of 30 months is $7,000,000 for the 170 lots which the sponsor is putting into the partnership at $3,000,000 ($17,600/lot). There are $1.4 of primarily soft cost to run the sales and marketing so the gross profit would be about $2.6mm.

The $1.4mm in sales costs can be capitalized into a $4.4mm project cost or the initial capital can be the purchase cost of $3mm and the other cost taken out of unit sales. The sponsor is open as to capital structure and structuring the returns but suggests a mid teen pref to the investors money and then a 50% split. The investor return should be over 20% IRR on the $3mm capital investment and less with the fully capitalized $4.4mm (which dollar amount is a projected 58% of retail value so could be looked at as a high yield loan with a kicker)

The sponsor has not shown any lot value price growth as might materialize if the market has bottomed out. We are in the process of bringing in one or two other builders for the 170 lots.

Some of y'all unfluent in these matters may have to re-read that for comprehension - I certainly did.

Basically someone is firesale-ing a couple of hundred lots in an existing community in Fort Meyers. This is hardly a rare event down there today.

But notices like these should be the fair warning to all these *speculators* bidding up foreclosures that the supply of homes in Florida, both today and tomorrow, will be continue to be immense.

And that while some of them may catch a *near bottom* in one particular little condo....their money is still going into a dead asset class for the foreseeable future.

Big Government As "Victim"

With a reeling economy, it's hunting season for statists. They'll be ramping up the agitprop against sundry timely bogeymen: "volatile financial markets", Wall Street, predatory lending, the "credit crisis"...

So Boston's Turnpike Authority is facing rising debt payments. Was it Wall Street that forced it to borrow short for its long term infinite obligations?



Note this article from the Boston Globe used the subtitle - "Authority a victim of recent turmoil in finance markets"

That's right, while glibly mentioning a recent toll hike (January) and adding more tolls to "create a fairer toll system", Noah Bierman's article paints Big Government - not taxpayers and commuting wage slaves - as the victim.

"At the same meeting, the authority's board discussed a preliminary report on how to create a fairer toll system, which could mean adding tolls in some areas that are currently free, including the Interstate 90 extension. Cohen said the board remains in a "research phase" on the toll issue, which will take four to six months as the Patrick administration looks for cost savings elsewhere.

Cohen has been cautious on the issue, trying to steer clear of controversy since an aide public discussed adding tolls to Interstate 93.

But the report from Cohen's staff suggested Turnpike Authority officials might look at reinstating some Western Turnpike tolls for cars, as well as a Newton toll that ended in 1996. The report also said that the state could add an optional toll lane on I-93 that would let solo drivers use the carpool lane if they pay a fee. That idea, often called a HOT lane, has been raised in the past and has gained support nationally as US Secretary of Transportation Mary Peters has encouraged states to try it.

What would this discussion be without a mention of "carpooling" - as if that has anything to do with the incompetence of politicians whose solution to every problem of their own creation is a tax hike, a scapegoat, and these days, a rhetorical bone thrown to eco-pagans?



Y'all need to believe me when I tell you that Big Government is the biggest subprime borrower of them all.

Think about it. What exactly is the difference between your irresponsible neighbor with the adjustable or interest-only mortgage and the pols who build schools, roads, and tunnels with short term financing?

They both presume growing income and they both presume indefinite benign borrowing environments.

And "resets" and "recessions" are going to kill them both.

If only Big Government were going to die - instead us taxpayers will bear the agony - and it will morph into Bigger Government.

For example, my landlord is aboard the express train to bankruptcy. On the $600,000 (at best) house I rent from him, I just found out that his current $5,200 mortgage payment is scheduled to reset at over $7,500 per month. It's been tragic to hear him cheer every Federal Funds rate cut since September as they've been powerless to stave off his inevitable foreclosure. To his credit, he's refrained from blaming bogeymen for his plight - though he hasn't admitted to any personal culpability either.

Furthermore, just as homeowners are facing the double pain of a weaker job market and commodity inflation, municipalities are, and will continue to be, ravaged not only by sky-rocketing financing costs, but also withering tax revenues. Receipts of every stripe are spiraling down: property taxes, sales taxes, income taxes, corporate taxes, etc.

In fact, outside of commodity prices, it seems everything these days is dropping.

Note the very last thing to expect is an uptick in political competence.

Poor Big Government...just an innocent bystander caught in the crossfire of Wall Street greed.

Nobody Verifies Anything!!!

The Federal Reserve is "injecting liquidity" to ease the banking/credit/mortgage crisis, right?

Who among the lettered hasn't read that somewhere?

Well, it's all garbage. Realize that while on one hand, the government is making highly publicized little debt purchases, on the other hand, it is selling, er underwriting, make that CREATING OUT OF THIN AIR, a ton more new Treasury bonds. Remember, we need them to finance our deficit spending.

Read the following excerpts from this article A Little Acid Test for Fed "Liquidity"



So it's difficult to understand why investors would get all excited about the Fed temporarily buying up a few billion in government securities, when we've got a Federal government that's simultaneously and permanently issuing and then constantly rolling over many, many times that amount. It's an escape into dreamland to believe that Fed actions have any chance at all of providing more "liquidity" when the Federal government's deficits suck up in a matter of weeks every bit of liquidity that the Fed has provided in a year. These Fed actions are nothing but marginal tinkering around the edges of the global financial system, and investors are starting to catch on.

If investors think the Fed buying up a few billion of Treasury and agency debt means a hill of beans, they might do well to remember that the U.S. government is running up annual deficits in the hundreds of billions. In fact, the U.S. Treasury will float tens of billions of new debt in December alone (most of which will be sopped up by foreigners, who have increased their holdings of Treasuries by well over $200 billion in the past year). This will be mixed in with refinancings.

Last week, for example, the Treasury auctioned $21 billion in 3-month bills and $20 billion in 6-month bills. In doing so, the Treasury offset every bit of the Federal Reserve's actions this week, even if it turns out that the $40 billion "term auction facility" represents new liquidity and not just rollovers. Why aren't investors just as interested in that? When the Fed does open market operations, all it's doing is buying up (temporarily or permanently) a tiny fraction of U.S. Treasury debt and replacing it with currency and bank reserves. But every time the Federal government issues more debt to finance its deficits, the new issuance cancels out any beneficial increase in liquidity the Fed could possibly provide.

More interesting is to watch what happens on Thursday. That's when we get $34 billion of repos coming due. If the Fed does little more than $20 billion through its "term auction facility," that will put the total for the week at $40 billion, versus $39 billion expiring, and it will be clear that this whole maneuver is simply a way for the Fed to temporarily refinance its expiring repos using a slightly longer 28-day maturity, rather than any effort to actually increase the amount of reserves.

In any event, banking conditions aren't likely to change even if $40 billion in additional 28-day repos actually materialize. Indeed, a Bloomberg report noted "A Fed official told reporters that the U.S. central bank's efforts won't add net liquidity to the banking system. The plans are aimed at buttressing so-called term funding markets, such as for one-month loans, rather than overnight cash." Should be interesting.

Finally, it's worth repeating that the total amount of outstanding repos has increased by only $18 billion since March, nearly all of which has been drawn out as currency in circulation. Most likely, the Fed will enter a "permanent" open market operation on the order of $10-20 billion at some point in the coming weeks to formalize that increase in outstanding currency. That move will probably be met by ridiculously over-hyped reporting as well. But it's entirely predictable.

In short, Wall Street analysts aren't paying attention to the data if they believe that the Fed is "pumping" hundreds of billions into the economy to provide some kind of "safety net" for the banking system or the mortgage market. Is it really too much to ask that they make some attempt to understand the subject about which they opine incessantly?

As for the Fed itself, it's a great gift to offer people hope, but a great disservice to offer people false hope, and I think that's what the Fed is doing. What's going on in the mortgage market is not a crisis of confidence that we can talk ourselves out of - it's a problem of structural insolvency, where many borrowers literally don't have the means to service their debt over the long-term, because many of them were counting on rising home prices over the short-term. By acting as if a few billion in repos will substantially change this equation, the Fed is raising hopes, and setting the markets and the economy up for disappointment that will be far worse as a result. Bernanke would be better off admitting that the Fed has no chance of providing meaningful "liquidity" when the Federal government is issuing Treasuries at ten times the rate the Fed can absorb them. At that point, Americans would see better that the resources we need to invest, compete and become a financially sound nation are being hoarded by the Federal government and sent up in flames.



The guy also has another recent article titled Vanishing Act - Are the Fed and the ECB Misleading Investors about "Liquidity"?

I really do pity the Morons who not only read the news but actually believe it.

The Government can't do squat for you. Don't ever forget it.

Marginalizing Ben Bernanke

I am aware of the financial news scuttlebutt but twelve years of experience has conditioned me not to pay too much attention to it.

The other day, while idly watching my son at the park, I grabbed the only reading material I could find in my car - the April 2007 Futures magazine. (I DID NOT buy it. My buddy in Manhattan made me steal something from his contemptible roommate. This is just the type of service that I provide for my friends.)

Page 22 excerpts from Steven K. Beckner's Market Watch column:

Bernanke told the House Budget Committee there had been "no material change" in the Fed's economic forecast in the wake of the market slide and said he saw no "liquidity crunch" in the world or any breakdown in the workings of financial markets. He said he still expects moderate, if not improving, growth as the housing market stabilizes.

...Upside inflation risks, the Fed chief said, are the Fed's predominant concern.

Just to remind y'all the Dow dropped 416 points on Feb 27th, 2007. The media clowns attributed most of it to "subprime woes" but Wall Street roundly declared them "contained". Such was the backdrop to Bernanke's Congressional testimony two weeks later.

Let's fast forward to what we do know FOR A FACT today.

• Subprime mortgage problems have not been "contained"; they are actually proving contagious.
• August's market meltdown proves that the financial markets are prone to crunches of "liquidity". A liquidity crisis is not a singular landmine to avoid - it's an endless minefield. Or one can better think of it as a permanent gun pointed at the head of our financial system.
• Six months after his testimony, the "moderate growth" from a "stabilizing housing market" has not materialized. If fact we have been riding lower growth and a worsening housing market. What a sage!
• And back in April, with oil trading $64, soybeans trading $7.60, wheat trading $5.00, and gold trading $700 Bernanke was most concerned about "upside inflation risks". Yet today, on the eve of another Bernanke rate cut, gold is pushing $800, wheat is almost 70% higher, soybeans over $10, and oil is trading at $93 per barrel - I guess aside from the higher commodity prices, upside inflation risks can be brushed aside.

Remember when Bernanke dropped rates 50 basis points last month with the fierce intimation that it was "one and done"?

The guy is provably a walking monthly-contradiction of whatever he said last. Perhaps when oil is $100 a barrel he'll go back to worrying about "upside inflation risks"? In that case, you'll know to brace yourself for another "liquidity crunch"!

As I have said before, the hardest part about trading the financial markets is NOT UNDERESTIMATING the stupidity of all parties. For example, the Fed Chairman may well be a vacillating dolt, doing long term harm to our economy for short term feel-good, stock and bond upticks. Nevertheless, fund managers and sheepish investors (who should be farsighted) may go hog wild and bid up securities again after the inevitable rate cut tomorrow. I seemingly spend all my mental energy trying to figure out who the biggest Morons are, and how to bet against them.

It ain't so easy.