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Contagion Concerns From a 2007-08 CDS Trader


Charts don't matter, macro data doesn't really matter, and until the contagion stops, valuation doesn't really matter either.

The last time we were in a similar situation, I was fortunate enough to get to trade ideas with Bennet Sedacca. His views on how the credit cycle were unfolding were spot-on, and he was one of too few people who had the intellectual ability, institutional freedom, and access to data to explain to the world what was happening. At the time I was back at my old hedge fund, where I was responsible for risk management, equity derivatives, and had some legacy responsibility for CDS/credit research thanks to picking up credit trading/research duties before we hired a guy to handle that full-time. I have traded and analyzed subprime housing and corporate credit derivatives, had access to real-time CDS data from 2006-2009 and spoke with the traders at the big banks who handled the flow, and for this reason feel compelled to do what I can to share my thoughts with the Minyanville community about what I'm seeing based on this experience.

The "Greece is Lehman" analogy is lazy, and while there are similarities there are important differences as well. What made the Lehman Brothers episode so scary was the fact that it was an important counterparty for a lot of financial institutions, its collapse occurred when all balance sheets from households to corporations and governments were overleveraged, when housing was still collapsing, and when asset valuations were generally higher. Nobody but the most extreme bears was prepared for it.

Since Lehman Brothers fell housing starts have fallen by a third. Non-farm payrolls have decreased by 5.7 million. Corporate balance sheets have strengthened significantly. Since the end of 2007 Apple (AAPL) has added about $50 billion of cash to its balance sheet. General Electric (GE) has added around $90 billion. Overall, nonfinancial corporate balance sheets are stronger than they've been since before the dot-com bust, as this Barclays chart shows.

One of the reasons for this is corporations are responding to their sterling performance by sitting on their cash instead of hiring and investing, or even returning capital to investors, like they would be in a normal cycle. This chart, shown by the brilliant Matt Busigin (@mbusigin), shows that hiring is lagging badly behind retail sales as companies to date have not had confidence in the recovery. The blue line represents the one-year change in retail sales and the red line represents the one-year change in non-farm payrolls.

Additionally, as this Bloomberg article notes, stocks are effectively at their cheapest level in 25 years. I recently wrote about how Berkshire Hathaway (BRK A) looks like a compelling investment at these levels (see Berkshire Hathaway's Operating Businesses Have a P/E Less Than 5). Technological innovation is leading to a resurgence in Silicon Valley. LinkedIn (LNKD) is one of my favorite ideas for this decade, a decade which my friend Professor Pinch and I think will be remembered more for the emerging "data economy" than problems with the sovereign debt of certain Mediterranean countries.

That being said, there are important similarities to Lehman as well. We've been talking about this Greece situation seemingly forever. Here's a Bloomberg article dated November, 2009, which is when the extent of the problem with Greece's debt and deficits really got on the radar of investors. One of the first pieces I wrote for Minyanville last summer was about European officials underestimating the extent of their problem (see Jean-Claude Trichet's Folly). And yet since that August 30, 2010 piece the S&P 500 has risen 22%. So who cares, right?

Well, between the devaluation of the Thai baht in July, 1997 and the summer 1998 peak of the S&P 500 a little over a year later the market increased by 31%, even as the Asian Financial Crisis dominoes were falling one by one. And then the S&P 500 fell by 20% over the following six weeks as Russia defaulted on its debt and Long Term Capital Management had its problem.

Since last August the Greece 2-year yield (my preferred measure for liquidity concerns -- the 10-year yield rises first and once it spreads to the 2-year it's game-over) has increased from 11.5% to over 28%. The Ireland 2-year yield has increased from 3.5% to over 13%. The Portugal 2-year yield has increased from 3.5% to over 14%. These countries are officially broken as far as the market is concerned. Spain and Italy have always represented the "firewall." Contagion can't be allowed to spread there. Maybe the market could handle the collapse of Bear Stearns and Lehman Brothers, but Morgan Stanley (MS) and Goldman Sachs (GS) were to be protected. It's the same with Spain and Italy.
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