☀️☕️ Credit Squished!

Happy Thursday!

Market Roundup 📊 16-Mar-23

US large-cap S&P 500 closed 0.7% DOWN 🔻
Tech-heavy Nasdaq Composite closed 0.05% UP ▲
Pan European STOXX Europe 600 closed 3.01% DOWN 🔻🔻🔻
HK’s Hang Seng Index closed 1.52% UP ▲
Japan’s Nikkei 225 closed 0.03% UP ▲

— The MoneyFitt Morning (@MoneyFitt)
Mar 16, 2023

📝 Focus

Credit Squished

📊 In the Markets

Now nobody believes in “higher-for-longer”!

📖 MoneyFitt Explains

🎓️ Short Selling and Short Squeezes

📝 Focus

Credit Squished

Somehow managing to accelerate its decades-long, scandal-ridden, risk-management-free, endless banana-skin-stepping slide (think Archegos, Greensill, Bulgarian cocaine trafficking, corporate espionage, Mozambique tuna bonds) the venerable Credit Suisse fell apart on Wednesday. Only very late in the day did the SNB and FINMA (the Swiss central bank and its main regulator) publicly state that Credit Suisse “meets the capital and liquidity requirements imposed on systemically important banks” and that “If necessary, the SNB will provide [Credit Suisse] with liquidity.”

Every Bank Everywhere All At Once – Image credit: Everything Everywhere All At Once / A24 via Tenor

► In Swiss trading, CS’s shares had taken yet another record-breaking dive (over 30% at one point!) and sparked a broader sell-off in already jittery European and US bank stocks when the chairman of its biggest shareholder, the Saudi National Bank, was asked in a live interview on TV whether it would provide additional money if CS needed it. “The answer is absolutely not, for many reasons outside the simplest reason, which is regulatory and statutory”, he said. But the markets stopped listening after hearing “absolutely not” and sold everything everywhere all at once. Saudi regulations prevent it from exceeding 10% control, and it already has 9.9%.

► This came shortly after CS revealed that PwC found a “material weakness” in its financial reporting over the past two years. The price of its bonds collapsed and their credit default swaps soared. (Buying a CDS is like getting insurance for your financial exposure to a counterparty just in case it goes bust, but can be used as a bet that the bond issuer –in this case Credit Suisse– will default, showing doubt about a bank’s survivability.)

► Fundamentally, interest rate risk in European banks is overseen by regulators through the Liquidity Coverage Ratio (LCR) where banks must hold high-quality liquid assets (HQLA) like short-term government debt that can be sold to fund at least 100% of banks’ projected cash outflows during a 30-day stress scenario. CS had an average LCR of 144%. This contrasts with the lax regulations and supervision of mid-sized and smaller banks in the US after the 2018 watering down of the post-GFC Dodd-Frank Act designed to ensure banks didn’t do exactly what Silvergate, SVB and Signature did.

► But to say what’s going on with CS is totally unrelated to the S-banks over in the US is probably not accurate… playing on not unjustified global jitters about the outlook for banks after last week’s bank failures, short sellers 🎓 have been laying on huge bets in the space. Reuters reports US$16 billion of shorts on European banks by hedge funds like Marshall Wace and Odey, with Handelsbanken, Mediobanca, BNP Paribas, Credit Suisse, Close Brothers and Deutsche Bank among the top targets, based on the proportion of the company’s shares loaned out to short sellers.

Like another S, the scorpion in Aesop’s Fables, short sellers can’t help themselves… it’s in their nature. – Image credit: Tenor

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📊 In the Markets

The huge market drops in Europe thanks to the price collapse of Credit Suisse amid persistent fears of contagion following the collapse of Silicon Valley and Signature Banks led to quite a wild ride in US markets. They did manage to end the day mixed, with the Swiss National Bank’s belated support coming in for the beleaguered Swiss lender, a drop in wholesale prices and falling retail sales raising hopes the US central bank, the Fed, might hold off on its inflation-busting interest rate hikes at next week’s round of rate-setting meetings.

Now nobody believes in “higher-for-longer”!

In frenzied trading that led to temporary halts in some interest rate futures contracts on the CME and much wider spreads, traders are increasingly betting on a rate cut this year, while nervous investors shifted money into so-called safe havens. The end result is that bond prices continued to rally with yields (the actual interest rate you get at the price, and which move in the opposite direction) tumbling. 2-year Treasuries now yield 3.98%, a huge drop from 5% just last week.

► Meanwhile, with the fastest drop in yields since the 1980s, all those very large short positions in bonds at the start of the year have been painfully squeezed into covering 🎓 their positions and exacerbating the move. (Remember that the consensus view of Wall Street’s Finest and the smartest strategists on the planet was for higher interest rates for most of 2023, i.e. bond prices were expected to fall. Beware of consensus views!) 

► A lot can happen in a week when collapsing banks are involved. There was a 70% chance (~90% at one point) of a 0.50% hike a week ago, and now it’s zero. Futures markets even imply a 50-50 chance of NO hike in March, then a 0.50% HIKE in May and then a 0.50% CUT in June. What?! (Reminder: these are not forecasts. And another reminder: Different markets often look warily at one another, suspecting the other knows something they don’t. Even within the same bank, communication can be more limited than you’d imagine.)

– Image credit: CME FedWatch Tool manually via The MFM

This is what Wednesday’s interest rate futures trading frenzy landed us with. According to the blue-box-path, interest rates could be 0.25% lower by the end of July than where they are today. And 1% lower than today by next January! (Not forecasts.)

📖 MoneyFitt Explains

🎓️ Short Selling and Short Squeezes

If you believe that a stock will go down for whatever reason (perhaps it is expensive relative to its prospects or perhaps if you suspect fraud), you can sell the shares you have. But if you don’t own any of its shares, you can still sell them by first borrowing shares for a fee from an existing shareholder via your broker and then selling them on the market.

If you’re right, then you can repurchase them (known as covering your shorts) at a lower price and pocket the difference, less the fee you paid to borrow the shares. Easy!

But if the shares go up a bit, you can just wait for the shares to come down, while calmly re-examining your investment thesis.

BUT if the shares start shooting up, you are in a bind and have to decide very quickly if you want to buy back the shares you sold and take the loss or watch the loss potentially widen dramatically.

If you have a lot of shares, your buying will push the share price even higher and the losses will be even bigger. But if you don’t repurchase them, your losses could be even bigger than that, potentially much bigger, especially if everyone knows you are short.

The nightmare scenario is if other traders force the shares higher and higher knowing that at some point you have no choice but to repurchase them. If your losses on paper are looking too huge, the broker you borrowed from can force you to buy back those shares.

Welcome to the wonderful and terrifying world of “squeezed shorts!”

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