David Einhorn: The Inevitable Ramifications Of Short-term Popularity Policies Over Solvency

A long, oldie but goodie analysis from David Einhorn.

http://prudentinvestornewsletters.blogspot.com/2009/10/david-einhorn-inevitable-ramifications.html

Unemployment insurance tracker

http://projects.propublica.org/unemployment/

Gold reaches all-time high in euros

http://jsmineset.com/2010/02/16/gold-hits-new-all-time-high-in-euro-terms/

The Euro is cratering due to concerns about Greece's debt crisis, and looming problems on the sovereign debt of Portugal, Italy, Ireland, Greece, and Spain, part of the (mostly) Club Med countries affectionately dubbed the PIIGS nations. Hence, nervous investors are fleeing the Euro and piling into gold, driving up gold prices to all-time highs when indexed against the Euro. Gold is still below it's all-time high when priced in USDollars, due to recent dollar strength, but that will prove to be a head fake as insolvency among states like California, Illinois, et. al will become more apparent. In fact, the US federal government's fiscal problems will soon become transparent once the media provides more illumination. In other words, the recent flight to safety in the USDollar and US Treasury bonds will prove to be a wrong-way bet. The Euro may be trash, but so is the USDollar.

The bond vigilantes (multi-national hedge funds) attacked the debt and securities of companies and banks in 2008, and now they will put on bear raids against sovereign countries with solvency concerns, betting on their decline. First it was Iceland, then Dubai, now Greece, and eventually the PIIG countries.

Like a pack of predators, they target the weakest countries first, moving up the food ladder as they take out each debtor nation. In my opinion, countries in their crosshairs down the road will include Japan, the UK, and the US.

Profitable bulemia

The scenario of banks downgrading each other's balance sheets due to opaque accounting of toxic assets is understandable--they are competitors after all. If misery loves company, one could argue perhaps they should be cheering each other on in their attempts to restore their balance sheets to solvency.

But there's an interesting twist in this game of mutual cannibalism: not only are they throwing stones at each other's glass houses, they are also betting on their own demise. Let me repeat: banks are profiting from bets against their own solvency.

Here's an excerpt from The Daily Reckoning:

But something magic happened in the fixed income trading group for Citi. This is pure gold if you like arcane financial statements packed with fictional earnings. If you dig into the quarterly report, you'll learn than fixed income trading revenues were boosted by a "net $2.5 billion positive CVA on derivative positions, excluding monoclines, mainly due to the widening of Citi's CDS spread.

That takes some sorting out. A CVA is a "credit value adjustment." As you can learn here, it's the credit risk premium of a derivative contract. Once you sort it out, you learn that Citi "made" $2.5 billion on a derivatives position designed to profit when the companies own credit default swaps spreads widen.

Or, in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up. The credit default swap market is the place where you can bet on the credit worthiness of a firm, or, essentially, the chance that a firm might default on its bonds. Citi appears to have reported a $2.5 billion trading gain in the fourth quarter precisely because the market thought the company stood a good chance of failing (hence the widening CDS spread).

As far as we can tell, if you use this kind of perverted logic, the closer Citi gets to bankruptcy, the more money it would "make" on its derivatives. That shows you how bogus the quarterly number was. The company reported declining revenues in its core banking and lending activities. But thanks to fixed income and this handy $2.5 billion CVA, the company was able to report $1.5 billion in net income.

The financial bazaar has truly turned bizarre.