Leveraged ETFs, particularly inverse ones, are highly risky and potentially dangerous trading vehicles not only because of the leverage employed, but because of the dynamics of the funds themselves. For example, the hedging flows of short ETFs are at times 2-3x greater than long ETFs because of differing incremental NAV changes between bull and bear ETFs (the same reason why shorting allows for a maximum return of 100%, whereas a long position’s maximum return is theoretically infinity). Timing is a necessary key for levered ETFs, particularly inverse ETFs, as time decay is increasingly prevalent and convexity issues, particularly from near-market close hedging demand, cause massive divergences between the ETFs and the underlying.
Nonetheless, our fourth trade idea is a long play on the epitome of leveraged trading vehicles– the 3x inverse financials ETF (ticker FAZ) from Direxion. It has experienced a massive 99.2% move from January 2008 highs to its recent low two years later in an unprecedented decline and imbalance from the underlying. However, we see a developing rally in the ETF that could offer some large profits to the upside.
American banks led global equity markets out of their troughs back in spring last year, as news of record earnings fueled a rally in valuations. The AIG CDS unwind counterparty payments at par value injected banks with billions of dollars that boosted their capital bases and earnings power with onetime gains, while the ultra-steep yield curve offered an easy carry trade for banks. Additionally, from the prop trading side, the USD carry trade provided huge revenues and the historically wide spreads in fixed-income issues offered unprecedented scalping potential. The Fed’s March 2009 announcement of the continuation of the MBS purchase program and issuance of the Treasury purchase program greatly helped banks, as well as markets, too.
However, spreads have tightened, QE liquidity has been deployed, and there are no more zero-haircut counterparty bailout payments to be funneled into bank balance sheets. Meanwhile, bank balance sheets have not delevered significantly, asset marks have continued to be significantly inflated relative to market values, and the double-dip catalysts on the asset book side (option-ARM/Alt-A, commercial real estate, eastern Europe) have began manifesting.
Banks have utilized the risk asset rally to issue massive amounts of debt and equity in attempts to recapitalize balance sheets, as well as pay back TARP funds in the case of the bailout beneficiaries. However, loan loss provisioning hasn’t substantively increased and capital buffers for future losses on asset books are weak at best. Charge-offs in commercial real estate and credit cards and nonperforming loans and loan-backed securitized assets continue to increase, but loss provisioning has not moved in lockstep. For example, Wells Fargo’s annual charge-off rate for its commercial real estate book increased over 5x YoY from Q4 2008, while its residential real estate book’s annual charge-off rate rose over 1.5x in the same period. Meanwhile, its loss buffers have gone nowhere fast, and Wells’ ratio of nonperforming assets + 90 days’ past due to loss provisions increased almost 140%, suffering an almost doubled Texas ratio.
Commercial real estate portfolios are going to witness large writedowns in the near future, as the crisis everyone had been warning about finally materializes. In December, Morgan Stanley relinquished five SanFran office buildings to lenders, while days ago Tishman Speyer and Blackrock Realty defaulted on a $4.4B loan that financed their $5.4B purchase of Stuyvesant Town/Peter Cooper Village in 2006, leading to imminent foreclosure.
Though subprime losses have been mostly written down, a new wave of defaults from Alt-A paper and hybrid- and option-ARM resets are quickly coming and not marked down. This spells trouble for bank balance sheets. Meanwhile, the Fed’s MBS purchase programs that drove down mortgage rates is ending and the Obama administration’s various mortgage modification programs have already run their course. Additionally, the ratio of 120+ past due mortgages that haven’t been foreclosed on has more than doubled YoY.
Already the writedowns are coming. Just days ago, Spanish bank BBVA announced a 94% decline in quarterly earnings YoY on writedowns. Contagion risk is particularly high in the financial sector and the resurgence of asset book writedowns depleting capital reserves should manifest in 2010.
Technically, FAZ broke out of its long falling wedge back on the 22nd and is currently bull flagging that move. A correction to about 18.75, near the support level of this bull flag, is our first target point of entry, with very tight stops. A breakout through $20.25 is the other buy trigger. The high convexity of this issue, combined with reversing markets and a rallying USD, should make this a potentially large trade, as well as more risky.
Shadow Capitalism
Trade 4: Long FAZ
Leveraged ETFs, particularly inverse ones, are highly risky and potentially dangerous trading vehicles not only because of the leverage employed, but because of the dynamics of the funds themselves. For example, the hedging flows of short ETFs are at times 2-3x greater than long ETFs because of differing incremental NAV changes between bull and bear ETFs (the same reason why shorting allows for a maximum return of 100%, whereas a long position’s maximum return is theoretically infinity). Timing is a necessary key for levered ETFs, particularly inverse ETFs, as time decay is increasingly prevalent and convexity issues, particularly from near-market close hedging demand, cause massive divergences between the ETFs and the underlying.
Nonetheless, our fourth trade idea is a long play on the epitome of leveraged trading vehicles– the 3x inverse financials ETF (ticker FAZ) from Direxion. It has experienced a massive 99.2% move from January 2008 highs to its recent low two years later in an unprecedented decline and imbalance from the underlying. However, we see a developing rally in the ETF that could offer some large profits to the upside.
American banks led global equity markets out of their troughs back in spring last year, as news of record earnings fueled a rally in valuations. The AIG CDS unwind counterparty payments at par value injected banks with billions of dollars that boosted their capital bases and earnings power with onetime gains, while the ultra-steep yield curve offered an easy carry trade for banks. Additionally, from the prop trading side, the USD carry trade provided huge revenues and the historically wide spreads in fixed-income issues offered unprecedented scalping potential. The Fed’s March 2009 announcement of the continuation of the MBS purchase program and issuance of the Treasury purchase program greatly helped banks, as well as markets, too.
However, spreads have tightened, QE liquidity has been deployed, and there are no more zero-haircut counterparty bailout payments to be funneled into bank balance sheets. Meanwhile, bank balance sheets have not delevered significantly, asset marks have continued to be significantly inflated relative to market values, and the double-dip catalysts on the asset book side (option-ARM/Alt-A, commercial real estate, eastern Europe) have began manifesting.
Banks have utilized the risk asset rally to issue massive amounts of debt and equity in attempts to recapitalize balance sheets, as well as pay back TARP funds in the case of the bailout beneficiaries. However, loan loss provisioning hasn’t substantively increased and capital buffers for future losses on asset books are weak at best. Charge-offs in commercial real estate and credit cards and nonperforming loans and loan-backed securitized assets continue to increase, but loss provisioning has not moved in lockstep. For example, Wells Fargo’s annual charge-off rate for its commercial real estate book increased over 5x YoY from Q4 2008, while its residential real estate book’s annual charge-off rate rose over 1.5x in the same period. Meanwhile, its loss buffers have gone nowhere fast, and Wells’ ratio of nonperforming assets + 90 days’ past due to loss provisions increased almost 140%, suffering an almost doubled Texas ratio.
Commercial real estate portfolios are going to witness large writedowns in the near future, as the crisis everyone had been warning about finally materializes. In December, Morgan Stanley relinquished five SanFran office buildings to lenders, while days ago Tishman Speyer and Blackrock Realty defaulted on a $4.4B loan that financed their $5.4B purchase of Stuyvesant Town/Peter Cooper Village in 2006, leading to imminent foreclosure.
Though subprime losses have been mostly written down, a new wave of defaults from Alt-A paper and hybrid- and option-ARM resets are quickly coming and not marked down. This spells trouble for bank balance sheets. Meanwhile, the Fed’s MBS purchase programs that drove down mortgage rates is ending and the Obama administration’s various mortgage modification programs have already run their course. Additionally, the ratio of 120+ past due mortgages that haven’t been foreclosed on has more than doubled YoY.
Already the writedowns are coming. Just days ago, Spanish bank BBVA announced a 94% decline in quarterly earnings YoY on writedowns. Contagion risk is particularly high in the financial sector and the resurgence of asset book writedowns depleting capital reserves should manifest in 2010.
Technically, FAZ broke out of its long falling wedge back on the 22nd and is currently bull flagging that move. A correction to about 18.75, near the support level of this bull flag, is our first target point of entry, with very tight stops. A breakout through $20.25 is the other buy trigger. The high convexity of this issue, combined with reversing markets and a rallying USD, should make this a potentially large trade, as well as more risky.
Share this:
Related