Perceived and Actual Risk

This note was originally published at 8am on September 27, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.

“I am a contrarian in the sense of being willing to take on perceived risk as opposed to actual risk, because the market pays you for taking perceived risk. You may or may not get paid for taking actual risk.”
- Wilbur Ross


Wilbur Ross’s quote above gets to the heart of the question facing markets today. Is the risk in the market actual or only perceived? Well, consider some of the following data points.


Bank of America 5-year credit default swaps traded at 402 bps on Thursday of last week, a new all-time high (then dropped slightly to 382 bps yesterday).  Morgan Stanley’s credit default swaps closed Friday at 440 bps.  21 of the 40 largest European banks now have their swaps trading over 300 bps, 13 of which are trading over 400 bps and 10 of which are trading over 700 bps. A default swap at 300 bps implies approximately a 20% probability of default, 400 bps equates to a default probability around 25%, and 700 bps of annual premium works out to around a 40% default probability.


At the end of the second quarter 2011, Bank of America had $74.8 trillion of gross notional derivatives outstanding, second largest among US banks (JPMorgan leads the pack). Of that $74.8 trillion, $4.1 trillion represents OTC credit derivatives. Morgan Stanley has $56.4 trillion in notional derivatives outstanding, $5.7 trillion of which are OTC credit derivatives.  Of course, the vast majority of these notional derivatives are offset positions that should be effectively hedged (assuming no single large counterparty defaults). 


So what does all this mean? Notional derivatives show the size of a bank's counterparty risk, and cds shows the likelihood a bank will default (according to the market). Together, they give us an idea of the problem we have on our hands.  The market is currently saying that BAC – a bank with $76 trillion of gross derivatives exposure – has roughly a 25% chance of default.  Today, the majority of the systemic risk to the system is coming out of Europe and is likely to be addressed head-on on Thursday at the German Bundestag vote.  The market rallied yesterday amid speculation that the EFSF can lever the 440 billion Euro fund up to 2 trillion Euros.  However, the German courts may not allow the facility to use leverage without first getting additional approvals from the Bundestag.  Stay tuned.


Looking beyond the systemic risk posed by Europe and large bank counterparty exposure, fundamentally, the problems of the US Financials have been on three fronts thus far this year:


-  First, there’s been the ongoing issue of mortgage putbacks and great uncertainty on the part of investors around what the true liabilities are for companies with large mortgage exposures like Bank of America. This explains why tangible book value offers no support to the stock. BAC is currently trading at approximately 50% of tangible book value.


 - Second, systemically important financial institutions (SIFIs) were hit this summer with an aggressively punitive capital surcharge under Basel 3 of 2.5%. This is in addition to existing Tier 1 common requirements of 7.0%. The largest US banks (JPM, BAC, C, WFC) will all be hit by this. This is one of the factors calling into question whether Bank of America needs to raise common equity. For reference, BAC has approximately $115 billion in tier 1 common capital under Basel 3 but needs $171 billion to be fully compliant (a shortfall of roughly $56 billion), though, importantly, they are not required to reach this level of capital until January 1, 2019, which is obviously a long time from now.


 - Third, falling revenues and deteriorating fundamentals are putting the squeeze on the banks’ ability to navigate through these challenges. The newest problem facing the sector is that of declining margins (revenue) hitting simultaneously with rising credit and operating costs. Take Bank of America as an example. In 2Q, the company reported roughly $2 billion in non-cash pre-tax earnings from releasing credit card loan loss reserves through the income statement. For several quarters now, these non-cash pre-tax earnings have been used to offset cash expenses associated with higher mortgage servicing related costs and mortgage putback expenses. The catch is that those credit card reserve release non-cash earnings are about to come to an end for all six of the largest US card issuers (BAC, JPM, C, COF, DFS & AXP). This will occur at the same time that the Fed’s Operation Twist will really start putting the squeeze on bank net interest margins. Earth to the Fed: flattening the long end when banks have no more room to take down funding costs is not going to help bank margins.


None of these issues are going away – or are they?  On Friday there was an interesting story out of Bloomberg talking about the upcoming Basel meeting this week (Tuesday & Wednesday). The Basel Committee on Banking Supervision – the same folks who gave us the 250 bps SIFI surcharge this summer – is now considering the need for changes to those surcharges. Not surprisingly, large lenders in the crosshairs of these new rules feel they’re unfair and would like to see them changed. This is a matter of politics, and we have no real edge on the outcome, but we would point out that a substantial chunk of the 34% downside in the XLF since February 21 of this year can be traced back to SIFI surcharge pronouncements this summer. While it’s hard to precisely deconvolve how much of the selloff is attributable to each of the three factors we itemized earlier, an announcement of capital relief by Basel would trigger a material rally in the Financials. Keep your antennae tuned to this potentially important development.


Finally, on a completely unrelated note, take a look at NYSE margin debt. Margin debt hit its post-2007 peak in April of this year at $320.7 billion. Let’s put things in context. The chart below shows the S&P 500 overlaid against NYSE margin debt going back to 1997. In this chart both the S&P 500 and margin debt have been inflation adjusted (back to 1990 dollar levels), and we’re showing margin debt levels in standard deviations relative to the mean covering the period 1997-2011. While this may sound complicated, the message is really quite simple. There are two important takeaways. First, when margin debt gets to 1.5 standard deviations or greater, as it did this past April, that has historically been a signal of extreme risk in the equity market - the last two times it did this the equity market lost half its value in the ensuing period). We flagged this for the first time back in May of this year.


The second point is that margin debt trends tend to exhibit high degrees of autocorrelation. For those unfamiliar, autocorrelation is simply a statistical term that means that trends tend to continue. In other words, the last few month’s change in margin debt is the best predictor of the change we’ll see in the next few months. This is important because it means that margin debt, which has retraced back to +0.64 standard deviations as of August, still has a long way to go. We would need to see it approach -0.5 to -1.0 standard deviations before the trend reversed. We’ve dropped 230 S&P handles in getting from +1.5 standard deviations to +0.64 standard deviations. Bear in mind there’s plenty of room for short/intermediate term reversals within this broader secular move.  That said, this setup represents a material headwind for the market. 


Josh Steiner, CFA
Managing Director


Perceived and Actual Risk - margin debt


Perceived and Actual Risk - porto

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Month-End: SP500 Levels, Refreshed

POSITION: Short Consumer Staples (XLP)


Long-term investors: from a long-term TAIL perspective, much like Japan’s Nikkei, the SP500 remains in a bear market.


The reason why we make that analogy isn’t because Japan doesn’t have the New York Yankees. Japan simply has had the same Keynesian money printing policy of the Princeton/Keynesian school of economics. Every new centrally-planned policy to inflate has inflated asset prices to lower-long-term highs.


That’s the long-term.


In the immediate-term, we aren’t yet dead.


Tomorrow is the immediate-term. So are the first few weeks of October (potentially, the start of one of the worst earnings seasons we’ll have in the last 2 years). Tomorrow is also month-end.


We made this call when I moved the Hedgeye Portfolio to net short on August 30th and, since I moved back to net short on Tuesday, September 27th, I think it’s worth considering that same call again – the last 6 days of the month vs the first 6 days of the month (see table below):


Month-End: SP500 Levels, Refreshed - 3


It’s just price momentum data with a career risk management overlay.


Immediate-term TRADE support and resistance for the SP500 are now 1117 and 1182, respectively.



Keith R. McCullough
Chief Executive Officer


Month-End: SP500 Levels, Refreshed - SPX


Earlier this week Brad Blum, CEO of the Blum Growth Fund and 7% owner of COSI, announced that he is doing something unique in the public markets.  He is using the court of public opinion and shareholder (activism) democracy to resurrect the company.  This means he wants the CEO and the board to all step aside and let Mr. Blum run the show.


In his press release, Mr. Blum said “We call upon all shareholders to join us in our efforts to effect positive change at Cosi and participate in a non-legally binding expression of ‘no confidence’ for the current board. This is not a proxy fight or a hostile takeover, but an exercise in shareholder democracy.”


As things stand, I would bet that “shareholder democracy” is going to win.  On a couple different measures, so far, the court of public opinion is winning.  Since putting out the press release the stock is up 15.64% on extremely high volume.  In the six months prior to Mr. Blum’s press release the stock has declined 50%.   


We are also getting questions from shareholders, some of which are “is he for real?”  As an industry analyst for the past 20 years, I have been an eye witness to Brad’s success and also some of his failures.  That being said, the obvious answer to that is yes. Mr. Blum is for real and his track record as a leading industry executive is one of the best there is.  He has extensive restaurant experience and brings to the table a very specific skill set that has created a real economic value for a number of restaurant concepts.


Unfortunately for COSI, the previous chairman, Jim Hyatt resigned recently and has subsequently taken a position at Church’s Chicken in Atlanta.  Mr. Hyatt did an amazing job of getting COSI reorganized and set in the right direction, despite the most difficult macro environment in a generation.  His departure was driven by personal reasons and had nothing to do with Cosi, the company or the brand.  Having spoken to Mr. Hyatt, I know it was a very difficult decision for him to leave after putting in three very long years with the company.


The future for COSI is extremely bright.  There are not many small restaurant concepts today that that have the potential triple in size.  It is a concept that operates in the hottest segment of the industry: fast casual.  The fast casual segment continues to take market share from the more tradition categories of the industry.  Importantly, the heritage of the company is focused on the food (especially the bread), allowing for strong consumer appeal across three day-parts, which is rare in the indutsry and offers the company and shareholders tremendous opportunity.   


It looks like the chances of Mr. Blum succeeding are high.  Since the departure of Mr. Hyatt, the company has been silent about the future of the company besides a few cursory comments.  While I do not know the interim CEO and Chairman of the Board, Mark Demilio, I do not suspect he wants the job and none of the current board members are likely to take the job either, in my opinion. 


Even more telling is that the company is in a degree of turmoil and management has had over 48 hours to respond to Mr. Blum’s overtures yet there has been no press release defending their position.  To be honest, the company position is defenseless, but the lack of a response does not instill confidence to the current shareholder base that the lights are on and management is keeping the momentum that Jim Hyatt established.


Right now, time is critical and not on management’s side.  Management and the board need to act now on the where they are taking the company, the longer they put off the inevitable, the worse the business will get.  Shareholders and the employees deserve leadership from the board; whether it is via new leadership or not, the company’s potential needs to be achieved.  For what it’s worth, I believe Mr. Blum will be successful.



Howard Penney

Managing Director




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