From John Maudlin, what caused that market melt up last week:
The banks “voluntarily” took a 50% haircut. Voluntary in that Merkel, Sarkozy, et al. told them that the alternative was a 100% haircut. “That’s the offer, guys. Take it or leave it.” Cue the theme from The Godfather.
And because the write-off was voluntary, there would be no triggering of credit default swaps clauses. Because if it’s voluntary it’s not a default – capiche?
And that smooth move, dear reader, triggered a rather significant unintended consequence, which resulted in the market “melt-up.” Let me see if I can walk you through this rather bizarre world of derivative exposure without exposing too much of my own ignorance.
Let’s say you bought credit default swaps on a certain bank’s debt (let’s use JPMorgan, but it could be any bank) because you think that Morgan is exposed to too much credit default swap risk. Just in case. Now, if (say) Goldman sold you the CDS, they could and would in turn hedge their risk by shorting some quantity of Morgan stock, or perhaps if the risk was sizeable enough, the S&P as a whole. It would depend on what their risk models suggested.
But as of yesterday, the risk evaporated: there would be no CDS event. So why buy CDS? Time to cover. And then the shorts get covered.
Further, the risk to financials was cut by a large, somewhat murky amount. But it was definitely cut, so buy some risk assets. Which puts any long/short hedge fund in a squeeze, especially those with an anti-financial-sector bias. But because of the nature of the hedge, the whole market moves. It involves rather arcane concepts that traders call delta and gamma. (Remember that the recent rogue traders had been at delta trading desks?) Guys at those desks can calculate that risk in a nanosecond. You and I take a day just to wrap our head around the concepts.
And it just cascades. The high-frequency-trading algo computers notice the movement and jump in, followed quickly by momentum traders, and the market melts up. Because a significant risk was removed. But not without cost.
A great list by traderstewie, Things I’ve learned after 15 years of trading.
From trading for a living on Open Interest: