E-piphany

This is starting to get confusing.

The market on Friday sold off in part because investors were concerned that, despite another claim from the Continent that there would be a resolution to the Greek crisis this weekend, no one believed them. On Monday, stocks rallied hard (+1.3%) because the plan was trumpeted as being a done deal.

Except that it is anything but a done deal at this point. Already there are concerns because little Slovakia – who is contributing less than 1% of the rescue money – is insisting that they will not disburse any monies until Greece actually cuts spending as it has pledged to do. Slovak Prime Minister Robert Fico said “Personally, I don’t believe that the Greek parliament will be able to approve the restrictions passed by the government yesterday,” and further noted that the money would only be disbursed after parliamentary elections on June 12th. (See story on MSN here.) There are 25 other nations, each with their own issues, that need to act in the affirmative for this package to work, unless Germany (which is facing elections very soon as well) is willing to go it alone. I think this is still an odds-against bet, although finally the amount of money they are discussing is more than a drop in the bucket.

But there is a very deep well of hope which investors keep drawing from. They’re not going to believe that anything bad could happen until Greece actually defaults or withdraws from the EU, and then the market is going to have a sudden, wrenching adjustment. It shouldn’t; the trajectory here hasn’t been terribly hard to figure out. But investors will act like it is a surprise.

Markets also rallied because Warren Buffett said Goldman should not be held responsible for the money lost by one of their clients in the current scandal. Two remarks are appropriate: first, Warren Buffett might be the only man in the world who has such credibility that he can nakedly talk his book and people take his words entirely at face value. This is “dog bites man.” The man-bites-dog story line would be if Buffett thought that Goldman should be held responsible! The second remark worth making is that Goldman isn’t being held accountable for the losses. They’re being held accountable for the fraud.

While stocks rallied hard, it is worth noting that this happened with major European bourses either closed or very inactive due to holiday; NYSE volume was the lowest in a couple of weeks. Let’s see what happens tomorrow.

On the plus side, economic data continues to confound me by coming in better than expected – albeit only modestly. The ISM Manufacturing index for April was 60.4, marginally beating the 60.0 expectation, and the internals weren’t bad. Personal Income and Spending were right on target, but those are March numbers. Vehicle Sales were a little weak, but still: overall, the growth engine continues to sputter and cough, but it hasn’t quit yet. Of course, the main thing that does right now is to help push the dollar higher and to keep interest rates defensive. TYM0 fell 13.5/32nds, with the 10y yield still in the same dull range (last at 3.70%).

Tomorrow’s data slate consists of Factory Orders for March (Consensus: -0.1%) and Pending Home Sales for March (Consensus: +4.0%). What will be interesting though is to see how investors in Europe react to the “deal” announced over the weekend. All wiggles aside, however, I feel this is a pay-me-now-or-pay-me-later deal. If the market doesn’t begin to discount the serious possibility that no deal will get done in time to save Greece, then it risks a sharp discontinuity later. The VIX is still around 20, suggesting that the possibility of a meaningful gap in the market is being given no respect.

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I saw a pretty frightening article today that I don’t think has gotten a lot of play but should. I suppose that as people read through the mammoth finance bill, we’ll get the same sort of news from time to time as when people waded through the mammoth healthcare bill. There will be surprises about some of what it contains.

According to this story in Pensions and Investing (you may need a subscription to access it), defined benefit pension funds will be denied the use of swaps. Now, the unsophisticated voter – which is, of course, what this populist bill is mostly targeting – will say “good! Them dangerous derivatives could blow up my pension!” But in fact, this will exact large costs on pension funds. Many things that pension funds want and need to do cannot be done any way other than with derivatives. For example, pension funds have ultra-long liabilities, and so have an appetite for 40-year bonds. The problem is, there aren’t very many of those, and if a pension fund buys a super-long credit then it has super-long credit exposure. On the other hand, a pension fund that enters a 40-year interest rate swap that is fully collateralized will face no important credit risk, but gets the duration it needs. As another example, pension funds also have exposure to longevity risk: the risk that the retirees covered by the pension fund turn out to live lots longer than the actuary expects them to. This is great for the retiree, except when he or she discovers that the pension fund only has enough money to fund an 80-year average life instead of the 90-year average life that might happen if, say, we discovered a cure for cancer. This risk, when it is addressed, is addressed with longevity swaps in which entities with risk to longer lives (like pensions) lay off the risk to entities with risk to shorter lives (like life insurance companies).

To say nothing of the utility of inflation swaps to a post-retirement medical plan or a pension plan that has inflation-linked liabilities.

Moreover, according to the article this would also affect stable-value wrappers that allow defined contribution plans (IRAs, 401(k)s) to offer stable-value products. Technically, that involves a derivative.

Huge pieces of legislation like this are good for one thing: enacting enormous shifts in the way government interacts with its citizens before they can organize to prevent it. Congress should break up the legislation so that we can look at the pieces of it. Why not? Because then, crazy paternalistic rules like this would never pass muster.