The Glide Path Option

7th Nov '09 by John Mauldin

1 comment 1553 reads

The Present Contains All Possible Futures
The Ugly Unemployment Numbers
Argentinian Disease
The Austrian Solution
The Eastern European Solution
Japanese Disease
The Glide Path Option
Philadelphia, Orlando, and Phoenix

The present contains all possible futures. But not all futures are good ones. Some can be quite cruel. The one we actually get is dictated by the choices we make. For the last few months I have been addressing the choices in front of us, economically speaking. Today I am going to summarize them, and maybe we can look for some signposts that will tell us which path we're headed down. For those who are new readers and who would like a more in-depth analysis, you can go to the archives at www.2000wave.com and search for terms I am writing about. And I will start out by briefly touching on today's ugly unemployment numbers, with data you did not get in the mainstream media.

The Ugly Unemployment Numbers

The headlines said unemployment, as measured by the "establishment survey," was down by 190,000; and even though that was slightly worse than forecast, market bulls were cheered by the fact that the number was not as bad as last month's. It is an improvement that we are not falling as fast.

Well, maybe. What I did not see in many of the stories I read was that the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey polls larger businesses; the household survey actually calls individual households.

Let's look at the real number in the establishment survey. If you don't seasonally adjust the number, the actual change in unemployment for October was 641,000, or about 450,000 more than the seasonally adjusted number. And the Bureau of Labor Statistics added 86,000 jobs that they simply guess were created through the so-called birth-death ratio. Interestingly, the birth-death ratio number is not seasonally adjusted, so it is just added to the unemployment number. http://www.bls.gov/web/cesbd.htm

The total (U-6) employment rate is at a record high of 17.5% (this includes those who are part-time for economic reasons). There are now over 10.5 million people who have lost their jobs since the beginning of the downturn.

My favorite slicer and dicer of data, Greg Weldon (www.weldononline.com), offers up an even more horrific number. As I have noted before, if you have not looked…

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doverbeach

9th Nov '09

I am picking up just one line from your post, because too often it goes unchallenged.

No mention of an exchange for credit default swaps?

Thank goodness for that!

First of all, I don't think you really want an exchange at all - you have just fallen for the Chicago markets' desires to expand their business here. Having CDSs traded on exchange will not help systemic risk one iota - I think what you think you want is a clearing mechanism, so that settlement risk can be reduced through offsetting and riask can be managed through margining. Clearing works perfectly well for suitable OTC markets, as the successfull close out of Lehman's extremely large repo and part of their swaps books showed.

But CDSs are not a suitable market to be centrally cleared.

There seems to be a common misaprehension that if a product is simple then it can obviously be cleared. I am not trying to claim that CDSs are Horribly Complicated Financial Engineering That Need A PHD To Understand Them. They are simple products, however, a clearing house needs much more than that.

It needs an assurance that there will always be a market in the contracts which it clears, providing continuous pricing. This doesn't have to be easy - clearing houses can cope with unusual contracts with weird pricing - Natural Gas prices can sometime go negative!

A clearing house collects margin in two forms - variation margin, which is a daily mark-to-market which would in the case of CDSs be easy in normal conditions, and initial margin, which is essentially the amount the contract may fall in value between the point where margin is not paid because of a default and the point where the clearing house closes out the contract.

Clearing houses are designed to cope with the failure of a member and the liquidation of its positions, the aim being to insulate other members who happen to have traded with the defaulter from any effects.

They are NOT designed to cope with the failure of cleared products. So after Lehmans defaulted, the CDSs on other banks which Lehmans had with a clearing house could have been dealt with in a straightforward manner. But the CDSs that other members had on Lehmans could not be closed in the market by the clearing house as the contract had effectively ceased to exist.

The only way to get a reasonable valuation on them would be to organise exactly the same sort of auction process that was done anyway. Clearing would not have made this any easier at all.

After the auction process there were concerns about domino defaults if counterparties were unable to meet the resulting obligations - in a cleared system these would have been larger as the clearing house would have been likely to:

(a) set the price for the variation margining of the Lehmans CDSs at below 10% the day Lehman's defaulted, requiring collateral against these immediately and giving less time for orderly liquidation of positions

(b) to immediately raise the initial margin levels on CDSs on any members which it knows are highly exposed to Lehmans contracts. This could provoke further panic in the markets - clearing houses usually manage to take extra margin from dodgy members on the quiet (nb this is VERY rare), but a CDS clearing house would effectively be forced to publish its views on the soundness of its members through initial margin setting that affects other members. Say (choosing a silly example) the clearing house knew that HSBC had huge positions in Lehamns contracts that it was going to have trouble covering - does the clearing house promptly increase the margin it charges on HSBC CDSs? So who wants to deal with a counterpaty the clearing house has obviously just added to its watch list?

And there are also significant complications in the netting. On a simplistic basis, there are two sorts of large participants in the CDS market. There are firms that tend to mostly write protection. These firms will get little netting gain from a clearing house and will find the costs of proving both variation and initial margin unpleasantly high. And there are firms that buy and sell CDSs, using them to hedge moving positions held by the firm. Here the CDSs may or may not net down considerably, but by removing one side of a hedge into a clearing house, the firm may find that its netting position actually gets worse, or (more likely) doesn't improve by enough to justify the higher margin costs.

And finally the idea of clearing a market where defaults are caused by the government deciding that one firm needs to go under as An Example to the others, is just horrible.

Clearing is not a good idea for these contracts. The clearing house will not be able to manage its risk. And a central counterparty which cannot effectively manage its risk is a far greater systemic problem than an uncleared CDS market.

The Glide Path Option

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John Mauldin

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