Credit Default Swap (CDS) dealers have reduced outstanding contracts for the first time since 2001 (see Bloomberg article). The volume of trades globally fell to $54.6 trillion from $62 trillion, according to the International Swaps and Derivatives Association. Traders are unwinding trades and protecting against losses as the U.S. credit markets continue to struggle. Currently, 17 banks handle about 90 percent of trading in credit derivatives. At the request of the Federal Reserve Bank, these individual banks have begun tearing up trades that offset each other in an effort to help reduce the day-to-day payments, paperwork, and potential errors, further reducing the amount of capital that commercial banks are required to hold against the trades on their books. It is unclear how many offsetting trades are left, and what level of counterparty exposure that will remain once the tearing up of trades completes.

In an effort to help boost its struggling stock market, the Securities Regulatory Commission in China is scheduled to sign-off on a plan that will allow short selling and margin lending (see Bloomberg article). The government is hoping that the changes will add fresh capital to the equity markets. China has also recently eliminated its tax on stock purchases and has relaxed company buyback rules. The move is in stark comparison to orders in the U.S., Europe, and Australia that have recently placed limits on short-selling. It is ironic that China, often criticized for being less open, appears to be offering free market solutions for its declining markets at the very time other economic superpowers are increasing trading restrictions within their own markets. The next year should be interesting, and telling, as countries about the globe take different approaches towards bolstering their economies and strengthening their capital markets.

Hedge fund executives are telling CNBC that Wall Street is beginning to market a new hedging product that would allow them to short stocks on the banned short sale list (see CNBC article). No doubt that this will be a new derivative-based product given that puts and other derivatives are still allowed to be sold, and that market markers are still allowed to short securities in order to hedge their own writing of derivatives. Many opponents of the new products feel they are nothing more than a loophole to the SEC order. Of course, those introducing the products stress that they will only be used for hedging purposes. Yet, it is still not clear to me how you verify this, or whether this will be just another "wink-wink" arrangement where it is assumed that everything is for hedging purposes. If the shorting product is abused and impossible to verify for hedging, then the ban on shorting financial stocks will prove to be useless, unnecessary, and itself a loophole for creating stable markets and handcuffing those who are thought to be causing the problem. In fact, does anyone else find it strange that the very firms that are protected by the short selling ban are developing products to find a way around the restrictions? Are hedge funds biting the hand that feeds them, and are financial companies just facilitating their own destruction? It all seems a little odd to me. Then again, I am still trying to understand the logic of mark-to-market accounting for illiquid assets, or why rating agencies can be so wrong and so late, yet still have the power to start the financial dominoes falling. Not a lot makes much sense right now.

As the country and the financial markets struggle to both understand and swallow the need for a $700 billion bailout of the financial system, the impact of using taxpayer money to fund such a bailout could have repercussions beyond the credit markets. The money will have to come from somewhere, i.e., taxes and/or deficit spending. As such, the potential flooding of the economy with money, and a further possible lowering of interest rates, could create increases in inflation. While this will affect nearly all areas of the economy, it could once again provide a catalyst for raising energy and commodity prices. In fact, just recently Barclays predicted that commodities will in fact revive their sharp and historic correction over the summer, and are simply in a normal correction stage rather than a change in demand (see Bloomberg article). If it is true that demand will stay strong, or at least will not collapse due to a global slowdown, any increase in deficit spending, lowering of interest rates, and further devaluation of the dollar could certainly be bullish for commodity prices. But of course, this depends on the strength of the global economy, which will depend to some degree on the handling of the credit crisis - in yet another illustration of the myth of decoupling.

The Libor rate is once again signaling problems, but this time it is unclear who has the problem (see WSJ article). Just a few months ago there was some concern that Libor was understating the true borrowing cost (see previous posts here and here). Since the British Bankers' Association collects data from banks regarding their borrowing costs, it was speculated that banks were reporting costs that were actually lower than their true cost, mainly to keep from signaling to the market that others might be worried about potential problems with their company (ie., forcing higher lending cost). Now on Monday of this week, the rate for the 28-day Federal Reserve lending was 3.75 percent, higher than the one-month dollar Libor rate of 3.19 percent. This would normally not make sense given that the Federal Reserve requires collateral to secure the loans, whereas the short-term Libor lending between banks does not. Of course, within the last week Treasury yields have nearly disappeared as investors moved cash from money market funds to Treasuries after worries of some money market funds "breaking the buck." No doubt that as the government continues to debate possible bailout plans, and the Federal Reserve continues to find new ways to inject liquidity, anomalies such as what is being observed in credit markets will continue to keep investors scratching their heads and looking for safe places to park their money.

As the financial musical chairs continue to get shifted, we are now learning that Warren Buffett, who has been relatively silent (investment wise) until last week, is now beginning to see value in the markets (see WSJ article). Is Buffett investing only in small regional banks, as some others are doing. No. Berkshire Hathaway is taking a position in Goldman Sachs, investing $5 billion in return for receiving perpetual preferred shares in Goldman. At the same time, Goldman will also be looking to do a stock offering to raise over $2 billion in additional capital.

This turn of event is significant, in my opinion, in that it signals a couple of important points. For one, by taking a sizable position in Goldman, the richest man in the world is indicating that the financials are in value territory, and that it is time to step up and take a position. This will certainly give a boost of confidence to other investors. The move by Goldman also shows that companies themselves are willing to recapitalize, believing that the market is now stable enough to do so, or at least that there are government and Buffett-type backstops available if times get difficult. Given the recent restrictions on short sales, this also appears to be a good time to do a secondary given that the diluting affects of the offering are less likely to be punished by short sellers and the market. Is volatility behind us, and is this a bottom? No, and probably not. Nonetheless, we may be finally reaching a point where leading companies in leading industries (and even non-leading industries) will finally begin to see their value reflected in the market place. This may not be a bottom, and financials will certainly still see volatile times ahead, but looking through the cloud of bankruptcy does allows potential opportunities to start appearing.

While the recent bankruptcies and potential failures have generated concern for both Wall Street and Main Street, and the federal bailouts have offered some hope (as well as concern), the root cause of the problem - housing - is still a mess (see Reuters article). As mentioned by Wilbur Ross, the current federal plans do not really address the housing problem. In fact, while blame is being assigning to banks and the federal government, the blame should also be shared by the American consumer who for years has been living above their means. As mentioned by Ross: "In one sense, the American consumer is the victim; but on the other hand, the perpetrator of it." So the worry is that while the current bailouts may help to stabilize the market, the underlying housing problem will still keep the economy from growing anytime soon, with some analysts expecting the problem to carry into 2009 and possibly beyond, as excess housing inventory continues to be drained from the system.

New York is planning to bring parts of the credit derivative market under the control and regulation of insurance supervisors (see Financial Times article). One has to wonder whether this is in fact the proper regulator for credit derivatives, and whether adding another separate oversight agency is the best move. Such a move is being made at a time when plans for a central counterparty clearing house for the credit derivatives market are still being discussed (see Financial Times article). No doubt that such a clearing house would have its own regulator. The problem is that regulatory inconsistencies, which at times even produce regulatory arbitrage, may be contributing to the current problems as much as the lack of regulation. Hopefully a smart, comprehensive, non-complicated, and consistent agency and set of regulations will result. As recently stated by Robert Pickel, from the International Swaps and Derivatives Association: “The state ... should proceed very cautiously and in consultation with federal regulators before acting in a way that may ultimately cause more harm than good.” We can only hope. Unfortunately, time is not on our side for some of the current market problems.

In an attempt to profit from the recent increases in volatility, an ex-Merrill Lynch trader is planning to start a volatility hedge fund (see Bloomberg article). The fund will try to profit by buying and selling option contracts linked to currencies, commodities, and global equities. Year-to-date, volatility funds are up 7.3 percent (see previous post), allowing them to outperforming other hedge funds. The trend in offering such funds seems to be increasing given that earlier this month CQS launched a Global Volatility Fund (see previous post), and other new funds are also raising capital. The new proposed funds are also coming at a time when the VIX has recently rose to its highest value since 2002. Could this be a contrarian signal, indicating lower volatility going forward? Possibly, but given new regulations and changing market rules, it is likely that volatility levels will be elevated for the foreseeable future.

As reported at a Financial Times Alphaville blog post, hedge funds are looking for new ways to short securities, including everything from shorting index funds and then buying back every security in the index except one, to restructuring swaps to have the same exposure as a short position. Both techniques will no doubt have an affect on market volatility as more stocks become actively traded. Ironically, derivatives such as swaps, which had their own role in the current financial crisis, are now being used to help get around restrictions imposed as a result of the very same crisis. Where there is a will, there is a way. Innovation and financial engineering never sleeps.

The global federal-induced short-squeeze is now going global, as countries from Australia, Taiwan, and the Netherlands join the U.S. and U.K. in prohibiting some short selling (see WSJ article). Potential problems with the short-sell ban are already becoming evident as those needing to hedge positions, or those making a market in derivative products, are finding it difficult to comply. During the last order the SEC had already considered some restrictions on market makers who need to short stock when making a market in put options. Now, the SEC is also considering allowing short-selling to be used in some cases as a hedge - it is expected that they will allow such shorting.

Of course, where do you draw the line? What about hedge funds that actually hedge their positions? Will they be excluded? What about convertible bond and arbitrage positions? What about allowing investors to hedge their investments when companies raise money in a rights offerings? What if the sale is for risk management purposes? If risk management is considered a viable reason for shorting, couldn't everything be considered risk management to some degree? Isn't shorting an overvalued company a way to take the risk of the overvalued stock out of the marketplace? Yes, this argument is a little much, but the points is that once again it is difficult to know where to draw the line when making exceptions, which only becomes more difficult as the unintended consequences start becoming worst than what the order was hoping to accomplish in the first place.

While the order did seem to stem the selling tide last week, it ultimately makes the stock market more inefficient. If now less efficient, does this mean that the market is in fact now more risky, given that prices are more artificial than before, and that any snap-backs could be worse in the long-run (if the order is removed)? These are questions that will no doubt only be clear with 20-20 hindsight. Extraordinary times do often require extraordinary measures, but eventually we are going to come to regret interfering with a market structure and mechanism that was put in place to keep us all honest, and keep prices as efficient as possible. Finally, I do find it ironic that for the last year or so we have continued to complain about how the prices of all the various credit default swaps and CDOs were difficult to price, making it even more difficult to know their current value and a company's true level of exposure for holding such securities. One can argue that we are now starting to make transparency mistakes with our equities.

The latest SEC rule change that restricts the short selling of financial stocks is causing many hedge funds to reconsider some of the models they use (see WSJ article). As an added pressure, some pension funds that invest in hedge funds are asking fund managers if they have strategies that rely on shorting, causing some less diversified pension funds to consider withdrawing hedge fund investments. Many smaller hedge funds with less sophisticated back office operations are also now finding it more difficult to comply with the new SEC regulations and still respond to the market, continuing the recent trend of challenging times for small funds (see previous post). The new rules, if successful in reducing the selling pressure on stocks, may also affect hedge funds that have been profiting recently from volatility (see previous post), although the last short-squeeze and trend reversal was short-lived (yet the rule affected less than 20 companies). Are funds eager to get back to shorting? Of interest is the following:

"Now the market is popping big time, and it's going to frustrate people. Are the short sellers wishing today that they could be shorting at these levels? Yes, they are."

No doubt that some will take this quote as a further indication that the shorts simply want to drive the markets down at the expense of everyone else. Others will see this as further proof that the markets are still over-valued. Of course, such a quote could just be an admission that the new rules have in fact created an artificial SEC-induced short-squeeze. If the natural tendency is towards a reversion to market efficiency, the new rules certainly don't help us achieve this goal over the long-run, even if they do slam the brakes on what some believe might have been an over-reaction in the opposite direction.