Credit Default Swaps Useless as Hedge Against Default; CDS on Greece a Purposeful Sham; Derivatives King Always Wins

As a result of labeling 50% haircuts "voluntary", Credit Default Swap contracts have proven to be useless when it comes to protecting against sovereign default. The serious implication is investors will need to find another way to hedge.

Bloomberg reports Greece Default Swaps Failure to Trigger Casts Doubt on Contracts as Hedge

The European Union’s ability to write down 50 percent of banks’ Greek bond holdings without triggering $3.7 billion in debt-insurance contracts threatens to undermine confidence in credit-default swaps as a hedge and force up borrowing costs.

As part of today’s accord aimed at resolving the euro region’s sovereign debt crisis, politicians and central bankers said they “invite Greece, private investors and all parties concerned to develop a voluntary bond exchange” into new securities. If the International Swaps & Derivatives Association agrees the exchange isn’t compulsory, credit-default swaps tied to the nation’s debt shouldn’t pay out.

“It will raise some very serious question marks over the value of CDS contracts,” said Harpreet Parhar, a strategist at Credit Agricole SA in London. “For euro sovereigns in particular, the CDS market is likely to remain wary.”

This approach may undermine confidence in credit-default swaps as a hedge and force banks to look at other ways of laying off risk, according to Pilar Gomez-Bravo, the senior adviser at Negentropy Capital in London, which oversees about 200 million euros ($277 million).

“If they find a way to avoid a trigger event in the CDS, then people will doubt the value of credit-default swaps in general, leading to more dislocations in the market,” she said.

“It is symptomatic of the regulatory and legal goalposts being constantly shifted either randomly or to suit political interests,” said Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London. “For genuine long-term investors, either financial or non-financial, it’s a major liability.”

CDS on Greece a Purposeful Sham

Janet Tavakoli writes “Standard” Credit Default Swaps on Greece Are a Sham and It’s Not a Surprise

“Customers” that accepted ISDA documentation when buying credit default protection on Greece are now discovering that ISDA defends the position that a 50% discount on Greek debt is “voluntary” and therefore not a credit event for credit default swap payment purposes according to its documents.

First Step in a CDS: Protect Yourself from the ISDA Cartel

As previous sovereign problems have illustrated, the only way to buy protection is to rewrite the flawed ISDA “standard” document and agree to new more sensible terms, before concluding the initial trade. One has to first protect oneself from the ISDA cartel “standard” documentation before one can buy sovereign default protection, or any other protection for that matter.

This isn’t the first time investors have been burned in the sovereign credit default swap market. Hedge funds Eternity Global Master Fund Ltd. and HBK Master Fund LP thought they purchased protection against an Argentina default and sued when J.P. Morgan refused to pay off on Argentina credit protection contracts they had purchased.

At issue was the definition of restructuring. Did Argentina's "voluntary debt exchange" in November of 2001 meet the definition of a restructuring? The Republic of Argentina gave bondholders the option to turn in their bonds in exchange for secured loans backed by certain Argentine federal tax revenues. J.P. Morgan claimed this didn't meet the definition of restructuring, at least for the protection it sold to Eternity.

J.P. Morgan's story was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed its slightly different contract language met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.

In other words, J.P. Morgan made sure its contract language would allow it to get paid when it bought protection and would make it harder for its counterparty to get paid when it sold protection.

Language Arbitrage: You’re Not a Sucker, You’re a Customer

Banks that play this game call it “language arbitrage.” Anyone that bought sovereign credit protection on Greece after accepting ISDA “standard” documentation without modifying the language now finds that they are on the wrong side of an “arbitrage.” An arbitrage is a riskless money pump. In this case, it means that money has been pumped out of credit default protection buyers with no risk to their counterparties, the financial institutions that ostensibly sold them credit default protection on Greece.

Derivatives King Always Wins

Note how the "Derivatives King" JP Morgan wins on its contracts, even on both sides of essentially the same bet.

By the way, I have a couple of questions:

1. What the hell are banks doing in all these derivatives markets in the first place?


2. Isn't it time banks act like banks instead of arbitrage hedge funds?

Addendum:

Reader Scott writes ...

One look at the ISDA membership should disabuse anyone of the notion that this is some kind of neutral judge. The big banks that write most of the derivative contract also compose the group that defines a credit event. This is not much different than have a baseball pitcher call the balls and strikes. How this is legal is beyond me.

Five Stocks Underrepresented Among ETFs: RIG, GIS, BHP, CAT, KFT

Investors looking for ETFs to act as proxies for certain stocks have no shortage of options. Want a fund a with large weight to Apple (Nasdaq: AAPL) so you don't have to pay Apple's triple-digit price tag? There's an ETF for that. Want oil equities exposure with a bias to Exxon Mobil (NYSE: XOM) without an exclusive commitment to that stock? There's an ETF for that, too.

Those are just two examples. There are plenty more. However, there are also more than a few examples of large, well-known stocks that are underrepresented in the ETF arena. Here are five, that in our opinion, should be weighted a bit more heavily by ETFs. In no particular order...

Transocean (NYSE: RIG): Transocean is the world's largest provider of offshore drilling services and as the world's largest provider of anything related to the oil business, one might think RIG was easy to find in the ETF world. It's not. The Oil Services HOLDRS (AMEX: OIH) offers a weight of just under 10% to RIG, making it the only ETF to allocate a noteworthy portion of its weight to this stock. Transocean is based in Switzerland and it's nowhere to be found in the iShares MSCI Switzerland Index Fund (NYSE: EWL).

General Mills (NYSE: GIS): It's not hard to find General Mills rival Kraft (NYSE: KFT) in ETFs, probably because the latter is a Dow stock and bigger than Big G. That's too bad because General Mills has consistently outperformed Kraft in recent years. Plus, Big G is a reliable dividend stock and it's “just” the second-largest U.S. food company. Only the Global X Food ETF (NYSE: EATX) features General Mills a prominent holding.

BHP Billiton (NYSE: BHP): The only excuse here, and it's a weak one, is that BHP is not a U.S.-based company. This is the largest mining company in the world and has a market value of close to $208 billion. The fact that just two ETFs, the iShares MSCI Australia Index Fund (NYSE: EWA) and the PowerShares BLDRS Asia 50 Index (Nasdaq: ADRA), give double-digit allocations to BHP is stunning.

Caterpillar (NYSE: CAT): As Roger Nusbaum noted earlier this week, Caterpillar is a good example of a situation where it's best to own the stock directly instead of using an ETF as a proxy. A lot of ETFs hold CAT, but not a lot feature the world's largest maker of construction and mining equipment prominently. With CAT flirting with $100 again, that's disappointing.

An Easy-To-Understand Guide To Last Night's Euro "Resolution"

Let’s not sugarcoat tonight’s “resolution” – this is merely a temporary measure that will buy them more time to resolve the true cause of the currency crisis. Let’s take a brief look at some of the key points of tonight’s statement (read it in full here):

“All Member States of the euro area are fully determined to continue their policy of fiscal consolidation and structural reforms. A particular effort will be required of those Member States who are experiencing tensions in sovereign debt markets.”

Translation: Austerity will continue. This is more of the same. Trade deficit nations undergoing a balance sheet recession will be forced into further budget consolidation which will continue to put downward pressure on growth and ultimately worsen the fiscal picture.

“We commend Italy’s commitment to achieve a balanced budget by 2013 and a structural budget surplus in 2014, bringing about a reduction in gross government debt to 113% of GDP in 2014, as well as the foreseen introduction of a balanced budget rule in the constitution by mid 2012.”

Translation: they still believe Italy and the other periphery trade deficit nations can undergo austerity, external sector outflows and debt improvements. Greece has already proven this wrong.

“We reiterate our determination to continue providing support to all countries under programmes until they have regained market access, provided they fully implement those programmes.”

Translation: The ECB will temporarily enter markets in order to avoid catastrophe, but will not become the fiscal issuer required to resolve the crisis.

“To this end we invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors. The Euro zone Member States would contribute to the PSI package up to 30 bn euro. On that basis, the official sector stands ready to provide additional programme financing of up to 100 bn euro until 2014, including the required recapitalisation of Greek banks.”

Translation: Greece is the offering to the German austerity Gods. Bondholders will take a haircut on the $120B Greek debt they own, but will also be recapitalized. This is really nothing more than a peace offering to those who want to see the banks “take a loss”.

“Being part of a monetary union has far reaching implications and implies a much closer coordination and surveillance to ensure stability and sustainability of the whole area. The current crisis shows the need to address this much more effectively. Therefore, while strengthening our crisis tools within the euro area, we will make further progress in integrating economic and fiscal policies by reinforcing coordination, surveillance and discipline. We will develop the necessary policies to support the functioning of the single currency area.”

Translation: We know we need a fiscal union of some sort, but we can’t get everyone on board. This is a work in progress.

“The EFSF will have the flexibility to use these two options simultaneously, deploying them depending on the specific objective pursued and on market circumstances. The leverage effect of each option will vary, depending on their specific features and market conditions, but could be up to four or five.”

Translation: A larger EFSF will help to stem the bleeding and reduces the odds of a worst case scenario where we experience a Lehman type event. The leveraging of the EFSF ensures that Europe’s banks will not be allowed to fail and cause massive private sector contagion.

“Financing of capital increase: Banks should first use private sources of capital, including through restructuring and conversion of debt to equity instruments. Banks should be subject to constraints regarding the distribution of dividends and bonus payments until the target has been attained. If necessary, national governments should provide support , and if this support is not available, recapitalisation should be funded via a loan from the EFSF in the case of Eurozone countries.”

Translation: Substantial capital has been set aside in the case of widespread bank failures or recapitalization needs. Again, this fends off the worst case scenario where a massive banking crisis spreads into the private sector.

Conclusion: This is a step in the right direction. By recapitalizing banks and enlarging the EFSF they have set a nice sized rifle on the table. Unfortunately, this is just more of the same in greater size. Ultimately, none of these measures will resolve the true cause of the crisis which is rooted in the currency and the incomplete currency union. Until Europe resolves the imbalance caused by the single currency there is no reason to believe this crisis has ended. I still believe the ultimate resolution here will involve fiscal transfers of some sort directly to the sovereigns that resolves the lack of sovereignty issue. That likely means e-bonds or a central Treasury at some point. We are clearly not there though this statement buys them time.

For now, we can breathe a sigh of relief knowing that we aren’t on the verge of Lehman 2.0. Unfortunately, we can’t expect this to resolve the sovereign debt crisis as austerity will continue and the current measures do not attack the lack of sovereignty issue. All in all, this removes the worst case scenario, but virtually guarantees a muddle through scenario. If budgets worsen on the periphery we should expect to revisit this issue in the coming quarters and the crisis will once again ripple through the market forcing Euro leaders into greater action. Perhaps a true resolution is not far in the future. Unfortunately, it likely means more market volatility before leaders realize the true gravity of this situation.

A Fast-Food Dividend Stock for Hungry Income Investors : MCD

McDonald’s (NYSE:MCD) – This most-famous-of-all fast-food chains operates in more than 100 countries. Internationally, people love the quality and quick service McDonald’s provides, and shareholders have benefited from MCD’s huge cash flow and its history of returning cash to stockholders through buybacks and dividend hikes.

Following another tremendous quarter announced Friday, MCD stock gapped higher, which supports the current move. Analysts’ consensus target price has been raised to $109. Technically, MCD is breaking from a “deep V” with a target price of $110.

S&P 500 Extends Biggest Monthly Rally Since 1974 on Europe Deal

U.S. stocks rose, extending the biggest monthly rally since 1974 for the Standard & Poor’s 500 Index, as European leaders agreed to expand a bailout fund to $1.4 trillion and American economic growth accelerated.

Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM) advanced at least 8.3 percent, following gains in European lenders. The Dow Jones Transportation Average, a proxy for the economy, jumped 4.5 percent. The index extended its October rally to 20 percent and is poised for its best monthly gain since 1939. Alcoa Inc. (AA) and General Electric Co. climbed more than 6.2 percent to pace gains in companies most-dependent on economic growth.

The S&P 500 rose 3.4 percent to 1,284.59 at 4 p.m. New York time, erasing its 2011 loss and rising to the highest level since Aug. 1. The gauge has climbed 14 percent so far in October. The Dow Jones Industrial Average added 339.51 points, or 2.9 percent, to 12,208.55. The Russell 2000 Index of small companies rallied 5.3 percent and is up 19 percent in October. About 11.9 billion shares changed hands on U.S. exchanges at 4:30 p.m., or 29 percent above the three-month average.

“This sort of half-baked solution out of Europe comes at a good time,” Michael Shaoul, chairman of Marketfield Asset Management in New York, which oversees $1 billion, said in a telephone interview. “The market simply wanted to say -- OK, we’ll give them a chance to work things out. They can mess it up, but my best guess is we put this behind us.”

Concern over Europe’s debt crisis sent the S&P 500 to a one-year low earlier this month. The index came within 1 percent of extending its decline from its April peak to 20 percent, the common definition of a bear market. Since then, it has risen 17 percent on optimism Europe would contain its crisis. (more)

EU official: banks to take 50pct cut on Greek debt

A European Union official says the currency union's leaders have reached a deal with banks to take losses of 50 percent of their Greek bonds in a key move to solve the eurozone's debt crisis.

The official was speaking early Thursday morning on condition of anonymity pending an official statement.

A second official confirmed that there was a voluntary deal.

Also

We just may have a deal:

• EU OFFICIAL SAYS DEAL REACHED ON GREEK DEBT-CUTTING PLAN: AP
  
• 'PRIVATE CREDITORS TO TAKE 50% CUT ON GREEK BONDS, AP SAYS
• EU official, who wished to remain anonymous, tells Bloomberg that euro-area leaders are set to approve accord for 50% writedown on Greek bonds

If true, this means that Portugal, Ireland, Spain and Italy will promptly commence sabotaging their economies (just like Greece) simply to get the same debt Blue Light special as Greece. It also means that, at least according to Barclays, we have a CDS credit event, although we are certain that Europe would never announce this deal unless ISDA (complete determinations committee list here) was onboard, and corrupt as always. In addition, Greece was unable to generate a 90% acceptance for a 21% haircut tender offer. And we are somehow supposed to believe they can do it with 50%? Lastly, as a reminder, on September 14, Moody's put SocGen, BNP and Credit Agricole on downgrade review. This will be the trigger

These 3 Companies are Spending BILLIONS on Stock Buybacks : INTC, BLL, AIC

After stocks slumped badly this summer, many questioned the wisdom of big stock buyback programs. After all, companies were spending huge amounts of cash on repurchases at formerly higher prices and would have been able to buy a lot more shares if they waited until stock prices really slumped. Yet just as individual investors can't time the market, neither can corporations. And with cash balances rising higher and higher, buybacks, along with dividends, are the most logical use of a company's money right now.

The real takeaway of buybacks is the real leverage it can provide to earnings per share (EPS) growth. Take toy maker Hasbro (NYSE: HAS) as an example. Net income is likely to fall roughly $25 million to $375 million this year, as the toy maker derives fewer benefits from the Transformers movie franchise than it did in 2010. Yet earnings per share are likely to be around $2.80 this year, up around 7% from a year ago. Goldman Sachs figures that ongoing stock buybacks will actually boost the company's 2011 results by around $0.20. Were it not for the shrinking share count, Hasbro would be suffering from negative year-over-year EPS comparisons.

For many companies in the midst of big buybacks, a shrinking share count can help propel moderate net income gains into more robust EPS gains. Here are three stocks that are clearly benefiting from a rapidly shrinking share count.

1. Intel (Nasdaq: INTC)
The fact that this chip giant delivered 24% net income growth (on a non-GAAP basis) in its third quarter is surely impressive, when much of the investment community had seemingly written off the desktop and laptop computer markets in the face of the tablet computer onslaught. But the fact that earnings per share rose by 33% should be even more attention-grabbing.

Intel is doing its best to appeal to dividend-focused investors, spending $1.1 billion in the most recent quarter in support of a payout that currently yields 3.6%. Yet another $4 billion was spent re-acquiring company stock, eliminating 186 million shares from the share count. In fact, Intel is so focused on shrinking the share count that it just announced plans to borrow $5 billion to increase its current share repurchase plan by another $10 billion to bring it up to $14 billion. ($4 billion remained on the previous plan.) If completed, that would reduce the share count by an additional 11%, which means net income growth could slow to just 5%-10% in 2012, but EPS growth would still stay in the more impressive 15%-20% range. Despite a 4% jump in Wednesday trading, shares still trade for less than 10 times likely (upwardly revised) 2012 profit forecasts.

2. Ball Corp. (NYSE: BLL)
A fast-rising Chinese middle class is the reason this company is boosting sales at a double-digit clip this year. Ball is the largest supplier of soda cans in the United States, the second-largest in Europe, and the largest in China. (The company also has strong market share in food cans.) It's a healthy business: Ball is expected to generate $400 million in free cash flow this year, and $500 million in free cash flow next year, according to analysts at Merrill Lynch.

You would think aluminum cans is a fairly boring and quite mature business. Yet at a recent analyst meeting, Ball's management ran through a series of new types of cans and bottles (such as its Alumi-Tek re-sealable bottles) that are driving growth. But management's top-line growth plans aren't really the story here. Instead, it's what all that free cash flow is doing to the share count. The number of shares outstanding has fallen for seven straight years to around 183.5 million by the end of 2010, but that figure may fall to 150 million by 2013, according to Merrill Lynch. The EPS impact: Merrill assumes after-tax income will rise almost 20% from $430 million in 2010 to $511 million by 2013. But a radical cut in the share count should boost EPS 42% during that time frame, from $2.29 to $3.25.

3. Assurant (NYSE: AIZ)
This specialty insurer has managed to shrink its share count every year since going public back in 2004. And while shares remain at a tangible discount to book value, management intends to keep buying back stock. The insurer bought back $533 million worth of stock in 2010, and analysts at Sterne Agee think Assurant will spend $500 million on buybacks in 2011, another $600 million in 2012 and $500 million more in 2013. This would reduce the year-end share count from 2011 to 2013 by 26%.

So even though the analysts foresee operating income rising 14% during that time frame (from $426 million to $489 million), they think EPS will rise from $4.41 in 2011 to $6.50 in 2013, a 47% jump. By the end of 2013, tangible book value per share should approach $55. That's far above the current $38 share price.

Risks to Consider: The biggest risk for these companies is a newly-weakened economy bringing down stock prices across the board, which would make these big buybacks look like an ill-timed, injudicious use of a company's capital base.

Action to Take --> These companies are boosting per share profits at a fast clip, even as the economy remains in a funk. Shrinking share counts also set the stage for sharply higher profits when the next upswing in the economic cycle arrives. Any of these three stocks merit further research on your part, but from where I sit, they look pretty enticing.