E. Jardine's  Instablog

We all know the marketing scheme.  A store advertises a “Going out of business” sale which subsequently creates such a boost in sales that the store decides to stay open.  After a few more months, the cycle repeats only this time there is a diminished effect on even bigger markdowns as wary customers smarten to the tricks of a business that has nothing to lose.   The business owners will continue to make irrational decisions on the hope and a prayer that things will get better.  They also actively pursue a suitor to acquire the assets of a business with revenue but a poor customer base.  

During the financial crisis, the same type of going out of business sale occurred, except it was the banks and financial institutions that saw their debt prices fall to a steep discounts.  In some cases, investors lined up to provide a lifeline like Buffet’s 9th inning deal with Goldman Sachs.  In other cases default was averted through direct support from the government.  Many of investors have already forgotten that Bear Stearns’ initial fire sale occurred in the summer of 2007 when they created a backstop of liquidity for a couple CDO hedge funds that rapidly declined in value.  This $3.6 billion bailout paved the way for a JP Morgan and the Fed to arrive as a suitor nearly 9 months later.  Wachovia, Merrill Lynch and WaMu were purchased and each transaction either made the bondholders whole or dramatically increased their liquidation payout. Each transaction unfortunately piled sandbags against a tidal wave of debt that should have seen default. Ultimately, institutions were recapitalized at the expense of the tax payer.

We are now in a system where there countries like Greece and Ireland are posting signs and investors can buy sovereign debt at huge discounts.  In some cases, investors have even been rewarded for these purchases at sale prices.  Look no further than a graph of ten year Greek bond yields to see each going out of business sale.  It is interesting to note that yields are peaking at progressively higher rates or deeper discounts. Those deep discounts met with more skepticism and investors are desensitized to the reality that default is just around the corner.

Just as JP Morgan moved in with the support of the Fed, Germany is being called to move with support of the European Central Bank.  This will immediately thrust the next weakest country into the picture with Ireland taking center stage followed by Spain and then potentially followed by these United States!  A default must occur to clean the system of the debt load which has reached its endpoint.  Most academics now agree that the bailout of Long Term Capital Management (LTCM) for a mere $3.6 billion in 1998 was not the systematic risk that everyone thought at the time.  If Bear did not bailout their hedge fund in 2007, they would have had a much better chance of survival.  I’d even be daring enough to suggest that if Bear Stearns had defaulted, it would have had drastic consequences on the system but Merrill, Wachovia, AIG and maybe even Lehman would have been spared.  By sparing the small from default, it endangers the large.  Let the irrational furniture store go bankrupt so we can return to a world of rational pricing.  Amputate the limb or euthanize the patient before disease spreads. Please allow the Greeks their inevitable default so we can avoid the CDS guns moving to their larger neighbors or even worse moving westward across the Atlantic.  Make no mistake a default will be painful and reveal the systematic risks currently hidden but it could avoid the even bigger default further down the road. 

How should one trade this?  Well, don’t believe the press when they say quote trillions of CDS exposure as there is a net number that is much smaller.  Counterparty risk is real but it is more a factor in overnight liquidity crisis’.  This event has been unraveling for over a year so losses will occur but are reflect in prices. The financial sector (XLF) is not nearly as toxic as it was in 2008.  Look at the (KRE) which is depressed with the entire sector but contains constituents with almost zero direct and indirect exposure to Greece.  The short opportunity is likely outside of the EU entirely as China(FXI) is starting to show signs of a long cold winter.

Eric Jardine is a portfolio manager at Baker Avenue Asset Management in San Francisco.  The opinions expressed are his own and do not necessarily represent those of Baker Avenue.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in KRE, XLF, FXI over the next 72 hours.

Additional disclosure: Eric Jardine is a portfolio manager at Baker Avenue Asset Management in San Francisco. The opinions expressed are his own and do not necessarily represent those of Baker Avenue.