A Bronx Tail

By Todd Harrison  MAR 14, 2007 8:30 AM

A wise man once said that the saddest thing in life is wasted talent. For alotta market bulls, yesterday was such a day.

 


“The other night he threw away his baseball cards because he said Mickey Mantle wouldn't pay our rent.”
-Lorenzo Anello, A Bronx Tale


A wise man once said that the saddest thing in life is wasted talent. For alotta market bulls, yesterday was such a day.

The bovine had every excuse to run higher on the heels of buff earnings from Goldman Sachs. The biggest, baddest broker in the land blew away Street estimates, offering assurances that the sub-prime woes were “isolated” and recession was unlikely. Never mind that the company's quarter ended on February 23rd, days before the proverbial schvitz hit the fan. This was Goldman. And it wasn't blinking.

By the time the closing bell tolled, you could almost hear the bears lock the door behind us and wryly opine “Now you’s can’t leave.

One day does not a market make, we know, but reaction to news—rather than the news itself—has always been one of our chief market tells. Indeed, if the fundamental metric is best at the top and worst at the bottom (remember the duct tape low?), we’re left to wonder how much zest is left in this tape.

In the interest of forthright communication, I’ll share that I covered the meat of my trading shorts into yesterday’s close. My exposure was predicated in puts and focused on the financials, which bore the brunt of the supply. Given the 24% pop in the VXO (volatility) and the double digit drippage in the space, I took much of my trade and balanced my book. I’ve got residual downside exposure in that complex, including Fannie Mae (FNM), and will look to fade (read: sell) rallies against some “core” longs, including SunMicro (SUNW) and Goldenstar (GSS).

But that was then and this is now. And it’s the now that warrants our immediate attention.

As our path to profitability resides in the ride ahead, I wanna offer the “other side” of the containment trade that is being offered by mainstream media. I do this without vice or virtue with hopes that it allows you to make better and more informed financial decisions.

Many market pundits are offering that the sub-prime space is a pimple on the broader market complexion. That’s true, on a percentage basis, but it only scratches the surface of the structural risks in the system. We’ve long discussed the interwoven financial fabric that is threaded together by massive amounts of derivatives. Some estimates offer that there are as much as $370 trillion in outstanding derivative contracts but the scary truth is that nobody knows for sure.

Nobody knows.

Now, derivatives aren’t evil products. They’re fantastic risk management tools when managed correctly. Unfortunately, given the proliferation of hedge funds and the massive amounts of leverage in the system, the odds of a “tail event” (an outlier move that isn’t factored into financial models) increase in kind. I’m not smart enough to know if New Century (NEW) or Accredited Home (LEND) are the tails that’ll wag this dog but there is certainly the potential that they are.

And it is that possibility—the percentage probability—that is currently being priced into the system.

You see, in a finance based economy, such as the one we currently have, the dependence on financial operations has never been more acute. General Motors, General Electric, Ford - to name a few - all feed their bottom lines and buffer earnings through financing operations. We like to call these “financials in drag” because most folks don’t view them through the same lens as traditional banks. But let’s be honest, do you think GM makes money selling cars? No. They make money selling loans. And those loans are packaged and repackaged numerous times and passed amongst financial intermediaries.

That’s a good thing in a liquidity driven, stable market. And it’s rarely questioned when companies beat their bottom line earnings estimates. The other side to that trade will come to bear, however, if a pebble falls into this intricate global machination. The perception of that risk has diminished through the years as it failed to materialize. The unfortunate truth is that the risk, rather than dissipating, has actually increased on a cumulative basis.

John Succo, a risk manager that I hold in the highest regard, once wrote an article for Minyanville that recounted the lessons of 1998 (read article here). While the names have changed as a function of time, the moving parts very much remain in place. The only difference between a mistake and a lesson is the ability to learn from it. And while we all hope to avoid the missteps of periods passed, the onus is on us to proactively prepare ourselves.

For if history is to repeat itself, the sounds of silence will have an eerily familiar ring to it.
Position in fnm, gss, sunw

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

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