August 12, 2010 -From a Western financial professional’s perspective, South Korea has traditionally been overlooked. The most familiar big three finance hubs in the East were forged in Singapore, Hong Kong, and Tokyo. However, Korea is redefining itself as a major marketplace for a specific breed of financial product, for better or worse, broadly labeled “derivatives”. For those having flash backs to calculus at the thought of the word, don’t fret… you’re actually on the right track. Here we’ll give a crash course on derivatives and their place in financial markets, inspect their recent appearance in emerging markets, and theorize as to the effect they will have on Korea’s global financial presence and the economy as a whole.

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Sure it’s easy to love a scandal when the home team (main street) is hurting, but smearing your rival’s leading guard (GS), because he continuously posts “tripple doubles”, doesn’t necessarily bring the trophy home. Goldman Sachs has been the source of an accelerating wave of controversy over the past few weeks, due to the SEC suit against the firm for fraud, and was most recently bent over the well worn U.S. Congressional hearing desk, compliments of U.S. Senator Carl Levin, of Michigan.

There’s a lot of chatter on the blogosphere about the actual construction of the ABACUS deal and just how it went down. Most of which requires time on an investment banking desk or a masters in quantitative finance to understand. We’re going to take a stab at making it one big step simpler…

What is a CDO?

If you don’t know this then you’re already lost. A CDO is a Collateralized Debt Obligation, which means that it is a security that is priced to a certain degree of risk based on a diversified pool of a particular type of debt assets. Generally CDO’s are set up by collecting a pool of cash flow producing assets, in the case of the recent crisis many CDO’s were actually Mortgage Backed Securities, thus the term MBS. The pool of cash flow producing assets is diversified across the nation and is then divided into levels of risk, known as “tranches”. The risk levels have nothing to do with the quality of any one mortgage or borrower. Instead the risk levels are simply a pecking order of who loses, from first to last, when payments from any asset in the pool stop coming in.  See this excellent explanation of mortgage based CDO’s for a crash course.

What is a Synthetic CDO?

Now let’s try to get a grasp on synthetic CDO’s. If a normal CDO is tied to cash flow producing assets, a synthetic CDO is priced based on a portfolio of cash flow producing assets in a far more indirect manner. Synthetic CDO’s are derived by selling Credit Default Swaps (CDS) on cash flow producing assets (bonds, mortgages, etc.) in order to receive periodic interest payments that theoretically mimic the cash flows of the pool of performing loans. If CDS’s are the insurance on a pool of assets going belly up, then synthetic CDO’s are priced by extrapolating the present value of future cash flows coming out of the CDS’s of that pool. The synthetic CDO’s are then tranched from first to last loss, just like a normal CDO, where the riskiest tranche is always the highest yielding. The most common tranche categories from first loss to last, are “first-loss (FL)”, “D”, “C”, “B”, “A-2″, “A-1″, and “Super Senior (SS)”.

For Synthetic CDO’s to exist there must be a “market maker”, which is comparable to the “bookie” in a high stakes gambling circuit. These contracts and securities are generally formed and exchanged between few specific parties and organized by an investment bank, rather than a central clearing house (e.g. NYMEX, CBOE, etc.), and in the case of ABACUS the bank “making the market” was Goldman Sachs.

(Review note: FL will always be the first investor group to lose their principle, while SS will be the last. For SS to go belly up, the entire pool of assets tied to the CDS must default. When all loans are performing, CDS insurance premiums continue to roll in and Sythetic CDS’s yield large profits, mainly due to the small amount of principle required to sell the CDS’s and thus open a synthetic CDO position.)

What is ABACUS?

Abacus is a whole new breed. The idea behind this “business entity”, as it was described by its founders at GS, was to create two tranches of a synthetic CDO, which weren’t actually tied to any real cash flow producing assets at all. If a CDO is a fish in the hand, and a Synthetic CDO is a fish on the line, this baby cut the line and instead imagined the fish on the other end, basing their assumption of the fish on a bunch of other fish that had recently been caught.

Before we go any further, take a look at this illustration to get a sense of the way the ABACUS deal was structured. It’s not perfect, but it clearly shows that there are only two tranches in this mechanism, A-1 and A-2. If you are comfortable with the definition of a Synthetic CDO above, you should be asking, “how can you only have AAA and AA rated tranches if the lower tranches don’t go belly up first?” Isn’t the point of the tranches to create a pecking order of defaults? In a Synthetic CDO “yes”, in ABACUS “no”.

This is where the lines begin to blur… ABACUS Ltd. is specifically a business entity, organized and formed by Goldman for the purpose of market making. According to the SEC Goldman formed ABACUS on a request from John Paulson’s hedge fund, in order to make a market for Paulson to buy a quantity of AAA and AA rated Synthetic CDO tranches. In this way Paulson could purchase securities, designed to mimic CDS’s on AAA and AA tranches of a residential mortgage pool without having to find a buyer of the CDS’s of lower tiered tranches as with a normal or synthetic CDO contract.

The two lucky souls who ended up responding to the market making were IKB Deutche Industriebank and ACA Capital. Involved in insurance, corporate bonds, and municipal debt, these firms were clearly more than able to perform the due diligence to realize the risks of their positions, and were interested in placing a long bet on the strength of the U.S. housing market. By entering into the contract these two firms sold Paulson the securities designed to mimic AAA and AA CDS tranches, thus making themselves liable to pay the full principle of a the theoretical value of the reference portfolio in exchange for a handsome cash flow premium.

As we all know, synthetic CDO’s and assuredly agreements such as ABACUS performed very poorly for the sellers of the CDS contracts (e.g. the side long the housing market), when the reference portfolios crashed towards zero and for months no market was successfully made. Many similar agreements had been made and the volume of bets surrounding the housing market far surpassed the actual amount of mortgage debt issued, further muddying the market’s perception of what these reference portfolios were even worth.

What you should know is that Goldman Sachs was not along in this levered gambling of mortgage debt. Many parties came to the table wanting to get a piece of these long housing market positions (synthetic CDO’s and ABACUS style CDO’s) which generated cash upon issuance, like a short sale, and offered the potential for profit if reference portfolios continued to appreciate.

The blame here rests solely on the greed and ignorance of a whole industry bent on better than possible returns at smaller theoretical risk. Anyone who was a part of this investment banking market making process and had access to the volume of transactions being done, could have seen the excesses in their purest forms. Goldman was hired to make a market where a new type of security could be sold. Granted, the security was bogus, but there were no lies being peddled in the process and the prospectus clearly stated the terms upon which ACA and IKB must agree in order to have this theoretical CDO exposure. Whether Paulson’s fund had a hand in developing ABACUS or not, Goldman simply offered a product to consumers ad hoc and these two banks felt that the terms were fair enough to engage. They ended up making a terrible long bet on the U.S. housing market near the end of the party. They lost. End of Story

Hat tip to Baseline Scenario, Alea Blog, and Interfluidity for their analysis of ABACUS, which helped us bring you some of the links and data that contribute to our analysis here today.

Where We’ve Been

1.) The iShares Dow Jones US Financial Sector Index (DJUSFI) ETF (IYF) has rallied 34% in the last 52 weeks, to 51.51 on February 4, 2010.

2.) The DJUSFI itself, which IYF is designed to mimic, presently totes a 61.07 trailing p/e when accounting for earnings losses.

3.) The DJUSFI’s forward p/e appears reasonable at 13.36 when accounting for positive and negative earnings, yet the expectations of future earnings, used to compute this number, are based on a full scale U.S. economic recovery.

4.) Higher p/e ratios are tolerated as upside earnings surprises have helped to keep multiples low throughout the latter half of 2009.

Consider the possibility that your view is now the byproduct of a positive feedback loop, fueled by a bias that is based on a string of positive surprises. Statistics reminds us to rely only on pertinent, non random, past data when forming hypotheses and to discard random events, disguised as oracles.

Signal Flares

Looking ahead, we see a trend forming in the very sector which plagued the economy into recession. New home sales have fallen to 342,000 units in December (just above the March 2009 low) after the initial housing stimulus expired and a new incentive package failed to pick up the slack. Simultaneously the Case-Shiller resold home price index stalled in October and November and existing home sales in December tanked to the lowest level since August. Most disconcerting was the jump in months supply of existing homes which jumped almost a full month to 7.2 months worth of housing inventory.

Where the Money Came From

Banks have profited from three factors in the latter three quarters of 2009 that could actually hurt them in 2010. (1) It’s no secret that the Federal Reserve propped up the nations largest banks through the largest liquidity campaign in the history. Mortgages are still being purchased by the Fed, but they have vowed to quit the purchases of MBS from Fannie and Freddie by the end of March. These purchases allowed potential buyers of similar assets on private balance sheets to find a market price and risk taking re-entered the market. (2) Once it was clear that banks weren’t going to fail or be nationalized the first leg of the rally carried prices from book values near .50 to levels nearer to fair value. At this point , it was still understood that the “infected” TARP banks would need some wiggle room to begin lending and get their capital requirements up to par. The answer was found in the repealing of “mark to market” accounting (FASB 157), where banks were suddenly able to keep Real Estate Owned (REO) properties, which had been foreclosed and seized by the bank, on their balance sheet at a price estimated by the bank itself. (3) The rally, which resulted from the new found faith in the financial system as a whole, carried confidence and thus risky investments into the market. This return to risk naturally benefited banks through increased fees and expenses from their brokerage arms and increased profits from proprietary trading of their own funds.

Holes in the Cheese

Just as these three factors contributed to the investment in banks in 2009, we see most bank shares at artificially high prices, supported by unsustainable multiples, and several reasons to doubt the foundations of U.S. banks. The 10-year Treasury rate and the 30 year fixed mortgage rate are at historic lows amidst a record U.S. fiscal deficit of 1.4 trillion USD in 2009, insisting that the end game will include higher rates on mortgages in the future. Taking it one step further, we see recent strength in the USD index, and an upward trend in the 10 year Treasury Note yield, forcing borrowing costs to rise in 2010 and decreasing the incentives for home owners to buy and traders to trade risky assets. This shift will be doubly negative for banks as rates chip away new found cash flows from mortgage refinances and profits from proprietary trading. Similarly, higher rates in 2010 will force 2009 refinanced payments higher, where ARM’s reset at rates above “teasers”, and fixed products will become less attractive to new buyers on the margin. The benchmark Treasury Yield (10 year note) illustrates the bottoming of the yield below.

How to Play It

If you look through our archives you’ll see that we held a position in the ProShares Double Short Financials ETF (SKF) earlier in 2009. SKF follows the 2x inverse of the DJUSFI and has been on a wild ride over the past two years. I will be the first to tell you that we did very poorly by holding this position, as our assumption that (a) market handicappers would overstep the obvious but short term increases in profits due to the revision of accounting rules (FASB 147) and (b) that trading fees and proprietary trading gains would be short lived for financial firms, as the market topped and returned to a decline in mid summer 2009. You should know that this did not occur and we ended up closing the position in August for a considerable loss.

While we did take a loss, we see SKF as a crucial element to our financial strategy in 2010. We are bearish on blue chip financial firms in 2010, due to the ramifications of rising interest rates, widespread exposure to mortgage defaults, and a tired equity market. However, it is prudent to hedge where value lies, and in financials we found our protection in the obvious favorite.

We are playing the financial volatility with expectations for weakness, by going long Goldman Sachs (GS) and 2x short the Dow Jones U.S. Financials Index, using an equally weighted long position in SKF. Review the charts below of both names. GS is actually included in the DJUSFI, as the fifth largest holding, yet it’s 7.1 p/e and 1.39 price/book make the firm an incredible value, compared to it’s DJUSFI peers.

-GS 6 month performance-

-SKF 6 month performance-

By opening positions in both GS and SKF, with an equal share of capital in each, we are playing a sort of bear biased saddle. While we expect financials to fare badly in 2010, GS has relatively little exposure to mortgage issues and has proved that it’s innovation will prevail in any environment. The firm has missed earnings estimates only three times since Q2 of 2001, and has exhibited solid dividend yield and earnings per share growth over a 10 year period. By trading this strategy on a weekly basis, we will sell shares and capture gains from the winning position and add this capital to the other vehicle. Should our thesis prove correct, we expect that losses from goldman sachs will be limited, and that their value relative to the financial sector will support share prices in most environments this year.

Remember this is an active trading strategy and unknown market factors can always drastically change prices over short periods of time. For added protection enable loss stops on both positions to protect yourself from extensive losses.

Disclosure: Long GS, Long SKF

The oil issue has been speculative to this point. It's hard to argue against 90 dollar oil when we saw 145 in July 2008, but the fundamentals aren't congruent with the price growth we've seen and this trader finds it easier to argue FOR $60/ barrel oil. Crude supply in the U.S. remains high, at 330 million barrels, while gasoline demand remains week and imports are rising. Crack spreads for refiners are reflected in their output averse management of facilities, where capacity utilization rates have stagnated at 81.3%. Refiners are the effective buyers of crude and the capacity numbers are sending signals of distress. The IEA's world demand predictions for 2010 were recently raised from the current 2009 level of 84.9 Million Barrels / Day (mb/d) to nearly 87 mb/d by 2010 Q4. (It should be noted that predictions for Q4 2009 global demand at 85.5 mb/d overshot the actual level of 84.9.) Rate hikes in China this week will calm the giant and should increase the likelihood of U.S. rate hikes in the first half of 2010.

Rate hikes will cool speculative trades and pull a significant amount of upward speculation out of Crude, as they increase capital holding costs and the risk of trading on margin. Softening Chinese growth will also cool global supply and demand speculation, with respect to crude, in an equally bearish development for the commodity.

The Consumer

Earnings season may present upside risk to short positions, which is why our stops have been tightened on our SDS and SCC positions. SPX might make it's way to 1200 where a lot of traders are calling the next Fibonacci resistance level, but momentum seems to be sputtering as earnings have begun.

The December Retail Sales report showed -0.3% growth combined with the revised higher 1.8% November rate, and makes it difficult to gauge buying sentiment moving into 2010. However the negative growth in the month of Christmas will leave many scratching their heads, and suggest that energy prices are playing a bigger role in retail sales than previously thought.

All in all, crude seems to be weakening, even on the backs of solid earnings from Intel, which should have been interpreted as positive to the overall economy. In after hours trading Intel traded up around 0.8% on a 0.55 EPS report vs. 0.34 EPS expected. Granted the day saw some sour economic fundamental data from the previous mentioned reports, but the market response was weak for a 62% profit beat.

Financials

Markets are becoming tougher to surprise at these levels and we could see more weakness from the banks. Soc Generale (SCGLY.PK) had an awful quarter in France and the U.S. regional First Midwest Bancorp (FMBI) missed the -0.07 EPS consensus by 76 cents, at -0.83 EPS. If regional financial problems due to MBS and the potential for more mortgage pain continue to show their fangs, financials could sell off through earnings.

Financials are the guts of the recession and will surprise many at how fast they can lower the tide for all. JP Morgan (JPM) will answer questions in this category on Friday, where weakness from the best in breed lending giant would create malignant concern in the banking sector at large. 

Disclosure: Long SDS, Long SCC, Long DTO (see: DS Portfolio)