Does the Bailout Constitute a CDS Event?

Good day… And a Terrific Tuesday to you! Right out of the starter blocks this morning, I have to apologize for the tardiness of the Pfennig yesterday. We were experiencing some technical difficulties… In fact, if you sent me an email, I didn’t get it yesterday! Things look better this morning, so, maybe we’re back on track! I know it’s no one’s fault when this stuff happens, but it sure doesn’t make me feel good about getting up at X:XX AM (I won’t say because you will think I’m crazy!) to come in and write the Pfennig, only to see it not go out until late in the day!

Well… The stock market here in the United States sure liked the news about Fannie and Freddie! I guess that they, just like the dollar bulls, didn’t get the memo that this will put billions of dollars of burden on taxpayers, and most likely is going to cause a major disruption in the Credit Default Swaps (CDS) that are on the books. Oh, well, we have to learn to deal with mental giants all our lives; this is just another case of that!

So, first, I’ll get to the currencies, and then take you for a ride on the CDS liquidation wagon. It’s not a pretty/scenic ride, but one that has to be taken!

OK… So, the Fannie and Freddie news caused dollar bulls to shake the euro (EUR) to its foundation yesterday, with the single unit falling even further, and at one point looked as though it might fall below 1.40. The euro (and other currencies) selling came swift and harsh, right after the stock market opening bell. The good news though is that the euro has rebounded in the overnight markets of Asia and Europe to 1.4175.

There wasn’t any data prints or news from overseas yesterday morning to warrant that selling, just plain and simple stock market euphoria, and foreigners wanting in on the “action”. When foreigners are buying U.S. stocks, they have to exchange their currency for the dollar.

But, as I said, the currencies have rallied back overnight, so, as long as yesterday’s selling is water under the bridge, I’ll be OK with that!

Let’s get to this Credit Default Swaps stuff, because this is important stuff, folks. There will be a meeting today to discuss how all of this is going to fall out… But here’s some perspective on the situation… First and foremost, there’s a question as to whether the government’s conservatorship constitutes a “CDS event”, which would force the settlement of the CDS contracts that are outstanding. Fannie and Freddie have roughly $1.5 trillion in debt outstanding… But that’s chickenfeed compared to the notional amounts of CDS contracts that could be multiples of that $1.5 trillion!

If the government’s conservatorship does constitute a “CDS event” there won’t be enough debt to settle the contracts, which will lead to a need for cash… And that could lead to major problems, the least of which being that holders needing cash might have to sell other assets to raise the cash they need.

I know this is all confusing, it took me a time or two before I fully understood these Credit Default Swaps… But in essence they are simply an insurance policy, as they can be used by a debt holder to hedge, or insure against a default under the debt instrument. This would be under the heading of “derivatives” that you’ve heard all about. When the “credit event” or “default” occurs, then these contracts get unwound, and Peter pays Paul, and Paul pays Robert, and so on… In other words… It could get very ugly out there! The association that governs the Credit Default Swaps, ISDA, will meet today to discuss how this will all come down or fall out. So, more on this tomorrow…

I got a kick out of Bill Bonner’s thoughts yesterday regarding the bailout… He called it “Hurricane Hank sweeps through the nation’s capital.” That’s in reference to U.S. Treasury Secretary Hank Paulson, who is the “brains” behind this bailout. Bill’s actual comment was: “Hurricane Hank swept through the nation’s capital yesterday with gale-force regulatory winds and a tidal surge of federal cash, upending two of Washington’s biggest enterprises and permanently changing the landscape of housing finance in America.” Click here to read the whole piece.

OK, there’s got to be something else to talk about besides this bailout… And I’ve got just medicine!

Last night, I was doing a bit of reading while taking in the Monday Night Football game. (Of course I can only stay up for the first half, and not even that most Mondays). I came across some research by HSBC on the Brazilian real (BRL) that I think is important… And you know how I love to use a historical perspective to give direction on what’s going to happen. Here you go…

“During the great Brazilian real (BRL) run of the last 5 years, the Brazilian currency has corrected and closed at least 10% from the highs a total of 4 times, 5 if you include the current sell off.

“Since crossing the -10% threshold it took BRL as little as 6 weeks to resume its rally and post a new ‘highest close’ and as long as 44 weeks…average time before posting a new high is 22 weeks.

“As far as magnitude is concerned, the 4 individual corrections in this study have seen BRL close as much as -15.5% from the all-time high, with an average sell-off of 13.4%.

“Last Thursday we closed beyond the 10% correction threshold in dollar/BRL. History suggests two things: For one, we’ll be here a while…and two, the greater part of the correction (in magnitude) is behind us.”

Great stuff!

Aussie (AUD) and Kiwi (NZD) rallied throughout the night, which indicates to me that carry trades are getting put back on the books of investors. Japanese yen (JPY) moved to a touch below 108 this morning, but could not move further, again, indicating to me that carry trades are being put on the books. We’ll see how these carry trades react when the Reserve Bank of New Zealand (RBNZ) meets this week and cuts rates 25 BPS as they are expected to do.

This carry trade junk is being put on in the face of a HUGE geopolitical news story this morning… Here’s the skinny: Admiral Eduard Baltin, former commander of Russia’s Black Sea Fleet said yesterday that Russia was to conduct joint naval exercises with Venezuela in the Caribbean.

What? Just what is going on here? Is Russia really going to send one of its most powerful war ships as part of the exercise to take place in the Caribbean? YIKES! This would be the first such deployment so close to the United States since the end of the Cold War.

The admiral indicated that if the U.S. wants to interfere in the Black Sea, then Russia will play war games in the U.S.’s back yard.

OK… I don’t like the sound of this folks… Even if it’s just saber rattling, which it probably is, I don’t like it! And the geopolitical risk should weigh heavily on things like the carry trade, and make currencies like the Swiss franc (CHF), more valuable… But, we’ll have to wait-n-see, eh?

The data cupboard will yield July’s Pending Home Sales data this morning. This probably won’t be a market-moving piece of data, but you never know these days.

I think that with all this saber rattling, and GSE bailout, and CDS problems, that gold looks to be at a bargain basement price of $803. The Blue Light Special siren is going off, and the spotlights into the sky are sending a signal… But then that’s just my opinion, I could be wrong. Of course, I feel as though I’ll be right as rain! But again… It’s just my opinion! And with the dollar intervention and subsequent dollar admiration going on, my track record has been tarnished!

All is said to be fair in love and war… And while the dollar’s got cards it’s not showing… Former Fed Chairman, Paul Volcker says, “the U.S. financial system is broken.”

Currencies today 9/9/08: A$ .8120, kiwi .6740, C$ .9420, euro 1.4170, sterling 1.7620, Swiss .8855, ISK 89.40, rand 7.88, krone 5.6550, SEK 6.6780, forint 169, zloty 2.4375, koruna 17.4650, yen 108, baht 34.54, sing 1.43, HKD 7.80, INR 44.80, China 6.8380, pesos 10.46, BRL 1.7360, dollar index 79.23, Oil $105.15, Silver $12.06, and Gold…. $800

That’s it for today… Thanks to all who have been sending along good thoughts and wishes regarding my upcoming scans on Friday. A loooooonnnnnggggg day yesterday, and I was beat! But, ready to go this morning! As mentioned above, we couldn’t receive email yesterday… We could send it out, but not receive it… Funny, how dependent we have become to email… Pretty amazing. I forgot to mention last week that my colleague and long time friend, Chris Gaffney had completed a triathlon and bettered his previous best time! Good Show! Hey! I almost forgot again! I’ve wanted to tell you all this for the last week, but kept forgetting… My friend, Addison Wiggin’s movie I.O.U.S.A. is still in the theaters. You can find out if it’s playing near you by clicking here and entering your zip code.

I think I saw that Google celebrated their 10th anniversary yesterday… WOW! In 10 short years they have conquered the world! Or so it seems, eh? Who hasn’t said… “Hey, just Google it”? Happy anniversary Google. Hurricane Ike is headed toward the Gulf of Mexico… Again, let’s hope it fizzles out before it hits land… I hope you have a Terrific Tuesday!

Chuck Butler
September 9, 2008

The Daily Reckoning