Sunday, September 14, 2008

Storm Watch

Will a major financial institution finally be allowed to go bankrupt? Sunday night headlines are suggesting that Lehman Brothers may have to be liquidated, despite weekend negotiations between the usual suspects to arrange for a rescue package. Given the recent string of bailouts and takeovers, a true bankruptcy of such a large firm may at long last spark some real panic.

In an earlier post I talked about keeping an eye out for unusual news that might herald a breakdown in the derivatives markets. In weekend articles about Lehman Brothers, I'm suddenly seeing words like "derivatives" and "swaps" that don't normally appear in every-day financial news. For instance, this appeared in Bloomberg.com:

Banks and brokers today held a session for netting derivatives transactions with Lehman, or canceling trades that offset each other, in case the New York-based firm files for bankruptcy before midnight.

"The purpose of this session is to reduce risk associated with a potential Lehman bankruptcy," the International Swaps and Derivatives Association [ISDA] said in a statement today.

Now, I have no idea what a "session for netting derivatives transactions" is, and this is the first time that I've ever heard of the ISDA, but it doesn't take a rocket scientist to see the big picture here. The bottom line is that a Lehman Brothers meltdown poses a risk to derivatives. Since leveraged ETFs like SDS and SSO use derivatives, their returns might be affected if a wave of defaults were to propagate across the market.

I don't think the full-blown emergency is here just yet, so I'm not dumping SDS. I would prefer to ride SDS to the end of the next decline, cash out, and then perhaps get into GRZZX at the end of the following rally, but that all depends on what the stock market does and on how quickly the derivative mess spreads.

Monday morning update:

Lehman Brothers, the 4th largest investment bank in the nation, has officially filed for bankruptcy. Its debt exceeds $600 billion. Wow.

European stocks are down between 3% and 5% today, and S&P 500 futures are down nearly 4%. The story was just the opposite last Monday after the Federalization of the mortgage industry. What a difference a week makes.

6 comments:

Tim said...

Jody

I think that the equity markets will fail before the derivative market does. That is I think all banks would have to lose all their equity first before people start going after the bonds and leveraged instruments attached to those. Exhibit A Lehman whose shares are probably worth zilch. Unless you expect BofA and GS to go to zero I think you SSD is safe..for now

Jody said...

Really? If bank A goes bankrupt and can no longer afford to cover its obligations on one side of a swap, someone on the other side has to lose. Sure, if solvent bank B is on the other side of the swap, then bank B eats the loss. But what if a leveraged ETF like SDS is on the other side? I think the SDS investor loses in that case.

Tim said...

The narrative of this whole credit crisis seems to be cover the obligations of the banks while letting the equity holders take a majority of the losses. That is dilute, sell or destroy the shares, anything to protect the counter parties and the debt holders. I feel that your SDS will become profitable before it becomes loss for you. We will have to see.

Jody said...

It sounds like we agree for the most part then. I'm in SDS right now precisely because I don't think derivatives are in danger yet.

Dave said...

Jody, just curious why you're still only 50% in SDS. Do you think there will be another bounce before the next leg down?

Jody said...

Except for the trend break last month, I simply haven't seen any strong bearish signals in my market indicators. In fact, it's entirely possible that I'll be going back to cash soon! If I cashed out right now the result would be a 4% profit in one month. Not huge, but not bad either.