The Hunt For CDS Red October Is On

|
Includes: HYG
by: The Other Street
Starring Stanley Morgan, HSBC Gulliver, Vezinelos Papandrakis, Bragging Mario, “JC” Tricheur and Lanico Merkozy. The soundbite comes from Sean Connery’s famous line, “my name is Bond, Junk Bond," ticker HYG. It came out last Thursday.
Remember the original movie? There is this Russian submarine, undetectable, aiming for the U.S. for all we know. It’s there, nobody knows where. It then gets detected, disappears again, with big ups and downs and unexpected moves.
Sounds familiar? Doesn’t it feel like the markets over the past few weeks? The difference is that every Tom Clancy novel has an end. We are still writing this one. Where could it be now that we have hit the S&P coordinate 1101?
Conventional and highly trained technical pilots are calling for 1010 as the next sublevel. I have no problem with that, even though it is not my favorite. This was one of the Three Little PIIGS scenarios I laid out in this year’s re-edition of my 2009 book, “Anatomy of The Meltdown." I had hoped for 1190 as a base pivot point and it worked for a while. It would have worked if the Red October retake cast had been more cooperative. It turns out 1) they are self-centered; 2) they don’t get the script; 3) they think it is fiction.
Well, it turns out it is not fiction. For weeks now, I have been researching CDS data. None is available, to speak off. Blurbs, guesses, that’s all I could find. Here is my take. The buyers of CDS – insurance against credit default of any kind, corporate or sovereign – know who they bought the insurance from. What they do not know is to whom the issuers of the insurance resold it to. In case of a claim, the chain is becoming murky and certainly not liquid. The net result is obvious: owners of CDS increase their reserves until they figure out who is owed what.
The alert was sounded last Friday when HYG broke the $84 level, despite closing strong on Thursday on the back of some good news from Europe (votes) and the U.S. (economy). It did not rebound since then, as Morgan Stanley (NYSE:MS) made it to the rumor mill. Now we have Dexia – we’ve seen that movie before. We’re about to find out whether U.S. banks have the “net” zero exposure they claim, and whether the $1.7 trillion in excess reserves they hold at the Fed are sufficient to cover the losses that CDS are supposed to hedge. A bit like Red October – until the end, we won’t know whether Junk Bond Ramius will nuke the U.S. We are getting there. Once we find out, we'll get the rip-your-face rally. In the meantime, it's Halloween Night.

PS: This article was written on Monday 10/4 pm. It is now 10/5 pm. Today's late rally qualifies a a rip-your-face rally. AXP was down 4% intraday, it closes flat, and my median performance is 5.7%, with a number of peaks in the 10% range.
Disclosure: I am long SDS.

Additional disclosure: As of this writing, I was also long puts on MMM, AXP, MS and HYG, for a net zero exposure. I undid most of these hedges late today.