What's good for Citadel may not be so great for E-trade

Let's take a sober look at the recent noise coming out of the Citadel/E-trade relationship. The questions of order routing, E-trade independence, and Citadel's high frequency trading keep coming up. From Citadel:

Citadel Investment Group ... announced today that its affiliate, Citadel Equity Fund, Ltd., has terminated the Rule 10b5-1 trading plan it entered into on August 11, 2009 in connection with its holdings of E*TRADE ... common stock. No sale of E*TRADE common stock had been made under the Plan, which was to commence on August 31, 2009.

The Plan provided for the sale of up to 120,000,000 shares of E*TRADE common stock, representing slightly over 10% of Citadel’s holdings of E*TRADE common stock on an “if and as converted” basis. Citadel owns in excess of 1.1 billion shares of E*TRADE Common Stock on such basis, in addition to its existing debt holdings.

Citadel was planning to sell some of it's E-trade holdings but ultimately decided not to. Why?

Citadel and E*Trade struck a deal in June in which E-trade would route nearly all of its retail customers' Nasdaq stock and options trades to Citadel's market-making operation in return for a nice chunk of cash for E-trade - $100 million. Citadel obviously really wanted this deal and was going to pay for some of this by selling E-trade shares.

Citadel also knew that as soon as the media gets a hold of that information, some E-trade retail investors will jump ship - giving Citadel more of an incentive to sell. That in fact happened, as E-trade lost 14,281 accounts on a net basis recently.

But the Office of Thrift Supervision, who is (strangely enough) the regulator in this case, has surprised everyone by (at least for now) not giving Citadel and E-trade's the go-ahead to route nearly all orders (they are currently routing 40%). Citadel no longer needed to sell the depressed e-Trade shares - ergo the announcement.

The transaction would be of great help to Citadel's market making operation because like any electronic exchange, it relies on order volume. But what concerns people is the link to the Citadel's proprietary high frequency trading that uses Citadel's market making platform (among others). The high frequency trading desk (part of Citadel's multi-startegy hedge fund) places it's algorithms on the platform to electronically hit bids or lift offers on the platform's order flow (see "simplified" org chart below).





The reality is that such an arrangement helps E-trade clients by providing additional liquidity and tightening bid/ask spreads. In terms of execution, it certainly beats what market makers do on NYSE. But even though none of this is improper, the potential for cozy relationships among the Citadel's entities makes people uncomfortable. And that is not so good for E-trade, particularly given the current anti-financial-services charged environment where conspiracy theories abound. They stand to lose many more retail accounts.

The best course of action for E-trade would be to get out from Citadel's control, possibly by being acquired by Ameritrade or Schwab. This way Citadel's market making operation becomes just another service provider and the potential for conflicts (or perceived conflicts) disappears. But that may take some time, given the state of E-trade's retail loan porfolio. From MarketWatch:

A combination of TD Ameritrade and E-Trade could generate $500 million to $600 million in cost synergies, making a deal attractive, the analyst noted.

A deal sometime in 2010 would make sense, but only if E-Trade's loan portfolio has significantly improved, or if TD Ameritrade can structure a deal that shields it from the bulk of the risks lurking on E-Trade's balance sheet, Vinciquerra said.

Disclosure: no holdings in ETFC

Time to take "procyclicality" out of bank capital requirements

In a recent post called The perverse impact of Value at Risk, we focused on the problem of banking institutions using market based models to set aside capital. For example the same dollar position in the S&P500 (or most other asset classes) during 2007 would have a third of the current (2009) capital requirements (because 2006-07 market volatility was so much lower).

This issue is actually not unique to trading positions. Loan loss reserves follow the same pattern. Banking institutions use historical default experience to assign loss reserves to loan portfolios, but this data tends to be cyclical. Therefore the reserves would drop during a prolonged economic expansion. Instead, however, banks should be doing the opposite - increasing reserves during good times to be able to draw on them during times of economic stress.

The US Treasury finally woke up to this problem and issued a statement yesterday with guidelines to reform bank capital requirements. They focused among other things on what they call "procyclicality of the regulatory capital and accounting regimes". During times of growth, capital requirements drop, promoting extension of more credit and increasing the ability to take larger risks. That in turn feeds growth of credit and liquidity in the system, creating what's called a "positive feedback loop". An example of that would be placing a speaker next to a microphone and connecting the two - creating the unbearable noise and potentially frying the speaker. This is how credit bubbles get built.

Of course this also works in the opposite direction. A "negative perturbation" in the system causes capital requirements to go up and liquidity and credit availability to get sucked out of the markets, forcing capital requirements to increase even more, and so on (violently deflating the bubble). Engineers would call this procyclicality an "unstable equilibrium".

From the US Treasury:

Certain aspects of accounting standards also have procyclical tendencies. For example, during good times, loan loss reserves tend to decline because recent historical losses are low.

... The capital rules should rely less on procyclical Value-at-Risk (VaR) models, point-in-time internal rating systems, and non-stressed risk parameters. A movement toward greater use of longer-horizon, through-the-cycle risk estimates should result in higher capital requirements in the early phases of the credit cycle and more uniform capital requirements throughout the cycle.

...in determining their loan loss reserves, banking firms also should be required to be more forward-looking and consider factors that would cause loan losses to differ from recent historical experience.

The Treasury proposes some creative solutions to even out bank capital requirements or even push them to become "anticyclical" (moving toward a "stable equilibrium"). Some examples include linking capital and loss reserves to economic indicators - the stronger the economy, the more incremental capital (above the minimums required) the banks should reserve. Banks can also issue debt that converts to equity in an economic downturn, effectively recapitalizing the bank.

It's a well thought out proposal - definitely worth a read.

Natural gas prices below zero?

How low can natural gas prices fall? The commodity is now down almost 60% from the beginning of this year.



This has to be the bottom, right? Maybe not so fast. From the FT: "A 2006 gas glut in the UK briefly pushed wholesale prices there below zero." How's that possible? It is possible when you have too much supply and not enough storage.

The chart below shows just how steep the natural gas futures curve has become.



If you own a storage facility with capacity, you can buy gas in the spot market, sell it in the futures market a couple months out, and generate over $1/MMBTU a month, or over 40% per month! Of course there are the financing and the storage costs. But it's still a great return. So why aren't people doing that?

In fact people are doing that, but most already got into this trade earlier. And as everyone was storing gas, the US storage capacity became increasingly limited. We are now significantly outside the historical levels for the amount of gas in storage (chart below from EIA) and the store-and-sell-forward trade doesn't work any more.



The demand for power has declined because of the slow economy as well as mild weather, which is limiting demand for gas. As market participants get deliveries of gas, some have no place to store it and are forced to sell at lower prices. That's how UK prices once dipped below zero.

The groundhog day of leveraged finance

High yield paper default rates seem to be on the decline, at least on a month to month basis. The slowdown in defaults has definitely been helped by the new demand for corporate bonds.

Number of monthly HY defaults



But let's take a step back to see the bigger picture of what has actually occurred in the high yield market based on some data recently published by JP Morgan. We've been here before in 2002, though maybe not to the such extremes. The movie is being replayed.

Default rates have so far not broken the 2002 record. However if one includes transactions in which creditors had to exchange their bonds for other (often worse) paper to prevent a default ("distressed exchanges"), we've definitely cracked the 02 default rate record.



In terms of absolute dollar amounts of defaulted paper, the current level is also a record, with nearly $70 billion of HY paper defaulting in 09. The chart below actually includes the first HY cycle (we are now in #3), from the days of Drexel Burnham.

HY bond default volume


In addition to these HY bond defaults, nearly the same amount of leveraged loans defaulted in 09, an unprecedented level for that market.

Leveraged loan default volume


Recoveries have reached record lows, wiping out junior tranches of structured credit transactions, such as HY CDX tranches.

Recovery rates for defaulted HY bonds


Not that ratings mean a whole lot in this space, but it's still interesting to see the ratio of upgrades to downgrades collapse to near zero.


One of the most striking aspects of the high yield debacle is that Wall Street never learns. Perhaps another way to put it is that people who do some of these deals know darn well that the transaction is over-leveraged, the company is stretched thin, and the movie will not end well. Yet they do the deals, get paid, and leave the mess behind for others to clean up. The chart below shows two cycles of new deal markets overheating, as increasingly higher volumes of more aggressive, lower quality transactions got done. Shortly after, we have a spike in default rates and the movie replays it's bad ending.

Fidelity sends a letter to the SEC on money fund regulation

Fidelity has sent a letter to the SEC (included below) to comment on the recent SEC proposal to regulate money market funds. Here are some highlights:

* Fidelity points out that the proposed SEC rules, if implemented without changes, will essentially force their money market funds to yield zero in the current environment.

...we estimate that the potential yield reduction could be as high as 25 to 43 basis points for an institutional non-rated fund, 19 to 32 basis points for a rated institutional fund and 14 to 31 basis points for a retail fund. In today's low-rate environment, the average taxable fund is yielding 0.18% and the average municipal fund is yielding 0.17%.

* Fidelity is pushing to keep the 90 days limit on the average asset maturity, which the SEC has proposed to shorten. Fidelity's point is that 60 vs. 90 day maturity is not the issue when it comes to the risk profile of a money fund.

* Fidelity is asking to include Government Securities as "Liquid Assets" to avoid being restricted on the amount of government paper they can hold in the "prime" money markets fund. With the dearth of eligible corporate assets, Fidelity needs this option.

* They are trying to keep the 10% bucket for assets that don't qualify as "liquid" securities. Their view is that the daily and weekly liquidity requirements the SEC is proposing should be enough.

* Fidelity wants the ability to buy some amount of paper from "second tier" issuers (smaller corporates). Again, their view is this was not what caused the problem in money market funds - the Reserve was destroyed because it had Lehman CP, which was a "first tier" issuer.

* One of the biggest problems for money funds has been a push by some, including the SEC, to mark the portfolio to market and have investors come in and out at NAV, like any other fund. That completely destroys the appeal of a money market funds, and Fidelity wants to keep money funds at one dollar NAV.

* Related to that, the SEC has proposed that money funds disclose the mark to market of their portfolio (Market Value Pricing). Fidelity doesn't like that at all. Their view is that if an investor sees the mark to market at $1.001, thew will jump in because they will be getting in at a dollar. But as soon as anyone sees a market value of $0.999, they will move out, pressuring the fund (potentially creating a run on the fund).

* Fidelity slammed traditional approaches to asset backed CP investing:

Fundamental to the analysis of whether an asset backed security represents minimal credit risk is an evaluation of the sources of liquidity available to repay the security when due. Examples of sources of liquidity that appropriately should be considered in making a minimal credit risk determination include third party committed liquidity facilities and the cash flows generated by the underlying assets. Taken alone, neither an issuer's sale of underlying assets at market value nor its continued access to the market to issue new securities is sufficient.

The Commission could consider requiring that, in order to be an Eligible Security, an issuer of an asset backed security cannot rely solely on the sale of assets at market value or continued market access.

This may cause a further hit to the ABCP market as money funds leave that space altogether.

Argentina on the brink

Capital continues to flow out of Argentina as the nation tries to defend the depreciating peso. Collapsing investor confidence is reducing deposits at banks as corporations and individuals convert cash into dollars. With interest rates now at 19% (to stem the peso decline), the potential for growth that Argentina's neighbors are experiencing is minimal. Being shut out of capital markets, Argentina has been working on restructuring it's debt again, (2005 was the last restructuring) with the goal to extend looming maturities. From Bloomberg:

Argentina will offer to swap $2.3 billion of short-term debt linked to inflation for bonds due in 2014 as it seeks to extend maturities after commodity export slumped revenue, Economy Minister Amado Boudou said.

“With this measure we are taking another step for Argentina to return to financial markets,” Boudou said during a news conference at the Economy Ministry. “The swap also aims to strengthen Argentina’s financial position next year with respect to the burden of the debt on the public accounts.”

The chart below shows the movements in currency values for Argentina's peso compared to some of it's neighboring nations' currencies.




Many believe that a key cause of such divergence between Argentina and other emerging nations has to do with it's government's policies. In particular people point to the nationalisation of the nation's pension fund in 2008. From Reuters:

Argentina's surprise plan to nationalize its private pension system caused chaos in local markets and spread gloom to other emerging markets on Wednesday as investors read it as a desperate government move to stave off default.

Argentina's government wanted to tap into the pension fund to obtain financing for it's own needs, so it decided to nationalize the fund. This action bought them some time, but created a larger problem down the road. From Dow Jones/Fitch:

"Argentina continues to stand apart due to the government's highly questionable response to the crisis, which, instead of injecting liquidity into the system, has reduced local capital markets' depth by nationalizing private pension funds in late 2008...

The disappearance of a major group of institutional investors is expected to reduce the depth of the local capital market, eliminating an important source of long-term financing for Argentine corporates..."

The nationalization of some $26 billion in assets, or 9.3% of gross domestic product, has "caused major concern within the international investment community," Fitch said.

What makes this situation so dire is that the corporate sector is now completely dependent on government funding. Argentina's private banks are too weak to provide support to corporations, with lending during this year coming entirely from state owned banks. But more importantly, the government now controls the pension fund's investment process, and when push comes to shove, the politicians will force the pension to buy government paper instead of corporate bonds.




Hat tip Ed!

Negative 30-year swap spread signals hidden risks

The 30-year swap spread is off it's lows but strangely continues to stay negative. Swap spread is the difference between the treasury yield and the interest rate swap rate (the fixed rate on a new swap) for a particular maturity.



Swap spreads went negative after Lehman default, supposedly for the following reason:

"Pension funds need to hedge long-term liabilities by receiving fixed on long-maturity swap rates," Liverance said. "When Lehman dissolved, pension funds found themselves with unmatched hedging needs and then needed to cover these positions in the market with other counterparties. This demand for receiving fixed in the long end drove swap spreads tighter." (Bloomberg)

With pension liabilities stretching out to 30-years and beyond, a 30-year swap was a good way to convert to floating. Speculations abound that some pensions, concerned about falling rates (which will make the NPV of their liabilities higher) put on new swaps. They could have also bought the 30-year bond to achieve their goal, but many were trying to preserve their liquidity, focusing instead on swaps. The demand to receive fixed on the 30-year swap became so strong that swap rates fell below the corresponding treasury yields.

It's a technical market dislocation, but what does it mean fundamentally? It says that somehow one gets paid more over 30 years taking US government risk vs. getting paid a fixed rate equivalent of LIBOR - which is essentially an average bank risk. This is clearly absurd, given that a default in treasury bonds will wipe out the banking system.

The question becomes then, given the fundamental mispricing, why hasn't the market taken this negative spread out? Conspiracy theories abound, but let's take a look at the way one would take advantage of such arbitrage opportunity.

The way to do it would be to buy the bond on repo (leverage by borrowing the bulk of the bond value using the bond as collateral), and simultaneously put on the corresponding interest rate swap. The buyer pays interest on the repo and fixed rate on the swap, while receiving coupon on the bond and LIBOR on the swap (and has to post some margin on the swap). Seems like this trade should work.

Obviously nobody wants to wait 30-years for this trade to work, so as maturities get shorter over time, the spread should turn positive. Below is a chart of the swap spread term structure, which shows that over time the spread should turn positive (at a current rate of about 3 bp per year):



The risk however is that the spread could become even more negative and a margin call could force the bond buyer to put up more capital or unwind. But what could cause another such spread move into the negative territory? Possibly another dealer default?

It's unlikely we will see another dealer go down in the near future (given all the government support), but this could be a fairly long-term trade. A rumor is enough to get the dreaded margin call. Which may force others who have this trade to unwind it, making the spread go more negative. The trade may just not have enough juice in to to make it worth while, given the risks. To make this work also requires doing it in size.

This mispricing shows that as much as we may think the markets are back to normal, the long-term view remains shaky. Risks that two years ago were thought to be ridiculous, may now seem real enough to prevent managers from taking out this arbitrage opportunity.

Larry's UNG dilemma

"CFTC is pushing small investors out of the commodities markets!" said Larry. Larry is a small investor who wanted to go long US natural gas and had in the past used "UNG" to do so. UNG is an ETF that is long US natural gas:

The investment [UNG] seeks to replicate the performance, net of expenses, of natural gas. The trust will invest in futures contracts on natural gas traded on the NYMEX that is the near month contract to expire. It is nondiversified.

UNG started trading at a premium to NAV recently, and Larry doesn't want to be the sucker who buys an ETF at a premium. But wait, ETFs (unlike closed-end funds) are not generally supposed to trade at a premium to NAV. From iShares:

With ETFs, Authorized Participants such as specialists on the exchange or institutional broker/dealers can create or redeem shares directly with the fund through an "in-kind" transfer mechanism. APs create ETF units by delivering a basket of securities to the fund equal to the current holdings of the ETF, plus a designated "cash component." In return, the APs receive a large block of ETF shares (typically 50,000 shares in the case of iShares Funds), which investors can then buy and sell in the secondary market.

This process also works in reverse, so if an investor wants to sell a large block of shares of an ETF and there seems to be limited liquidity in the secondary market, the APs can readily take them in and redeem them.

This constant exchange of the portfolio assets for shares of the ETF works to tighten any spread between where the fund trades and it's NAV. As demand increases, more shares are created, while if demand drops, shares are taken out of the market.

Now imagine a situation of increased demand (as is the case with UNG), but the fund can no longer accept "a basket of securities equal to the current holdings", because that basket is the NYMEX natural gas futures contract. UNG, worried about CFTC limiting it's ability to hold natural gas futures, stopped creating new shares (because as it grows it will need to buy more futures). With the supply and demand out of balance, UNG now trades at some 17% premium. UNG can eventually use TRS instead of futures, but it may take time to set that up (and the regulation around TRS remains unclear).

UNG and it's NAV


UNG is Larry's choice because it's quite liquid, but the premium he has to pay forces him to stay away. Larry of course could open a futures account, but futures commissions and minimums are significantly higher (value of a single nat gas futures contract is about $30K).

Of course the reason for this whole dilemma is that CFTC wants to stop Larry and his friends from "speculating" on natural gas markets. That's because speculation is bad and it drives up prices. Larry and his evil gang of speculators have driven prices up this year, but somehow the fundamentals of natural gas oversupply got in their way (with natural gas trading 50% down year-to-date). CFTC, we urge you, please stop Larry before it's too late.


Disclosure: no exposure to UNG