Liquidity Puts and Other Quant Gems

I remember wondering why some banks and especially Citibank, after things started to go very wrong during the summer of 2007, were so stupid as to take back on their books all sorts of toxic CDOs they had sold to other entities. Well, last week's Economist gave me the answer to that conundrum (emphasis mine):

"Citigroup came a cropper when it sold "liquidity puts" along with its CDOs. These gave the buyers the right to hand the CDO back at the original price if the market collapsed. They looked like a tweak that would enable the bank to extract a slightly higher return, and Citi's most senior managers knew nothing about them. The liquidity puts ended up costing the bank a king's ransom when $25 billion-worth of CDOs came back on the balance sheet."

Citibank didn't take back those CDOs out of a misplaced and almost suicidal attempt at safeguarding its reputation as I thought back then but simply because it was contractually obliged to do so. The stupidity had occurred a long time before, when some genius designed, mispriced and marketed those protective puts.

Speaking of genius quants, how about this modelling gem (emphasis mine):

"A BBB tranche in a CDO might pay out in full if the defaults remained below 6%, and not at all once they went above 6.5%. That is an all-or-nothing sort of return, quite different from a BBB corporate bond, say. And yet because both shared the same BBB rating, they would be modelled in the same way."

This is a comment I posted following this Great Depression-related entry on the Toro blog:

The problem with comparing our current predicament with the Great Depression is that such a comparison can, paradoxically, breed complacency as in: "We're not doing as bad as we were in 1931 or '32 or '38, therefore we're going to be OK". It's like the alcoholic saying: "I'm not a heroin addict therefore I'm OK".

What a difference one little trendline makes! All of a sudden, it is no longer a bullish potential head and shoulder bottom forming, it is a deadly bearish continuation symetrical triangle. Obviously, until and unless the formation is actually complete, all this is just speculation (the intellectual kind only and not the monetary one). To recap, the key levels for the SPY ETF are, as of today, 82 and 93.

Head and Shoulder Bottom, Follow-Up 2

Trader's Narrative has apparently bought into a revised head and shoulder bottom scenario. The way I and other bloggers saw it play out on 12/28/2008 had unraveled by 1/15/2009.

Is this recycled inverted H & S more likely than the original? Maybe so. It looks more conventional than the previous one and the volume picture fits pretty well with a spike in volume for the right shoulder that's smaller than the spike for the head. So we'll keep an eye on this. A decisive break above 92 would presumably complete the formation.

Abelson and the Aftermath Paper

In his latest Barron's piece Alan Abelson picked up and commented on, a little late but we'll cut him some slack (better late than never and all that), the fast-becoming classic Rogoff and Reinhart paper titled The Aftermath of Financial Crises.

So it's fair to assume the notion that we will have a long, protracted and painful recession is in the public now. Granted, Abelson has a well-deserved reputation as a congenital bear and his detractors are prompt to say about him that a broken clock is bound to be right at some point. However, he's been right on the money for the last couple of years and people are definitely paying attention to what he writes about.

From a contrarian point of view therefore, now that the possibility of real ugliness has seeped into the collective unconscious, we would deduce that any new data that even hints at a less than extremely ugly economic future should power some kind of rally. The question in my mind though is that I have the gnawing feeling that even those who have read and accepted the conclusions in the Aftermath paper still hope for something less painful unfolding. Others actually believe the coming stimulus package will thwart the bleak predictions in the Rogoff and Reinhart study. The spirit of hope that has engulfed the nation lately might thus, for better or for worse, foil any contrarian analysis.

Unconventional unconventionals

We had Donald Rumsfeld and his unknown unknowns. We now have Bank of England Governor Mervyn King's "unconventional unconventional [monetary] measures" (Dow Jones Newswire).

Unconventional monetary tools are used when the zero-bound has been reached and cutting interest rates is no longer possible, which is already the case for the Fed and just about for the BOE. They are also known as Quantitative Easing.

The "conventional unconventional" measures would be for the BOE to buy government securities.
The "unconventional unconventional" measures would be targeted purchases of any asset whose market has become dysfunctional. The BOE is considering paying above current prices for some assets, which it would presumably have to do since most of those "dysfunctional" assets are priced at, you guessed it, zero.

Global Liquidity Trap?

One thing ECB Czar Jean-Claude Trichet has just said during his press conference kind of surprised me: "A Liquidity Trap would not be appropriate for us".

This from a man who until today treated any talk of deflation in the Euro-zone as preposterous science-fiction and was very proud of the fact that his central bank, unlike his colleagues across the ponds, still had ample ammunition. Can non-traditional monetary tools and quantitative easing be very far?

Head and Shoulder Bottom, Follow-up

As a quick but urgent follow-up to a previous post, it is now obvious after yesterday's rout that the potential head and shoulder bottom scenario as I imagined it has unraveled. The breakout above 90 did happen but it turned out to be a head fake. The rationale behind being long having been smashed to smithereens, bailing out of that position would be the disciplined thing to do.

What is going to happen now? I have no idea. Some people think that a failed signal is often a very strong signal that the opposite of what was supposed to happen will happen, in this case SPY should go down hard, but it's mostly anecdotal evidence so I personally would wait and see what develops.