Friday, November 21, 2008

If I could Ultra Ultra Short Financials, I would be RICH!!!

Let’s say you saw the credit crisis coming, and wanted to short the financials.

You see two different securities that you are interested, XLF and SKF. XLF is an index that covers many of the financial companies, and SKF is an index designed to give twice the inverse return of XLF. You think about shorting XLF, but you want more return for your future predicting powers, so you buy SKF instead expecting to get double the performance. Over three months, which return is better?

Shorting XLF.

The chart above shows XLF vs. SKF over a three month period ending Nov 14, 2008.

This is the problem with the new world of leveraged ETFs. The profile states “The investment seeks daily investment results, before fees and expenses, which correspond to twice the inverse of the daily performance of the Dow Jones U.S. Financials index.” But what it does not say is that it is only accurate at certain times. Looking at the chart, it seems that huge moves short for XLF were accurately captured by SKF (Oct 4 – Oct 10), but long moves by XLF proved to be overcompensated to the downside by SKF (i.e. Oct 10 – Oct 15 and Oct 23 – Nov 3).

Moreover, over time, for reasons not explicit to the end user, the SKF index does not continue to hold the NAV over time. Thus instead of getting the inverse result, the investor only gets the inverse result “for a short duration of time” before the index falls apart again on a bear (XLF bull move) move and waits for the next XLF short surge.

For a retail investor like myself, this is disheartening. I am not sure that I have ever seen the disclaimer for this poor correlation in the index. At least their should be some standard of correlation or grading system that should be applied to all indexes that use leveraging techniques.

On the other hand, better to just keep playing than crying about the rules of the game. In any case, I plan to use this information to my advantage. As of Nov 22, SKF is now trading at $280 after one of the biggest drops in NYSE history. Will it continue? Well, even if this is the onset of the Greater Depression, the XLF index can only go to zero folks. And the market NEVER goes straight down. Thus a purchase of SKF puts based on the observations mentioned here will most definitely yield a large return as the index swap agreements are rolled over and the bounce commenses.

Transparency: The author bought JAN 09 $80 SKF PUTS at $2.4 / contract and similar positions at similar strikes and prices and closed the JAN 09 $80 SKF puts at an average of $2.85 yielding a 19% gain.

Monday, November 10, 2008

Competing Shorts : Capital One or American Express?

Assume credit cards are the next crisis. Also, assume the crisis comes because the charge off rates go to historical levels that no wants to buy credit card bonds. Not a stretch of the imagination in any regard, considering the state of the US consumer. Where is the best place to be short?

Looking at options, both Capital One (COF) and American Express (AXP) charge close to the same amount on their JAN 10 $20 puts ($5.2 and $4.8 respectively).

But looking at their market situations, there is a clear advantages to both.

Capital One
• Pro: Lower average credit score to AXP customers
• Pro: Lower average income to AXP customers
• Pro: Large auto lending component to the business
• Con: Has substantial commercial lending deposits from it’s commercial bank

American Express
• Pro: Higher customer balances than COF customers
• Pro: Travel Services department (business credit cards) income is largely influenced by business capital spending in general, clearly in decline
• Con: No commercial bank to fund lending activities (used the Fed commercial lending facility early in November)


If you look at in terms of product, COF vs. AXP is like Ford vs. BMW, AXP has a more affluent, and privileged clientele. This may provide a more orderly deleveraging and is currently reflected in the lower charge off rates for AXP customers compared to COF customers.

But if you look at it in terms of capital position, COF vs. AXP is like C vs. LEH, COF has internal capital it can use as a cushion when no one wants to buy it’s short term financing facilities. Whereas AXP, like the now defaulted Lehman Brothers, had minimal internal capital and lots of leverage that relied on securitization and commercial paper markets for operation.

Both are solid short candidates, but despite it’s pedigree, AXP is more exposed to credit market freeze and thus appears in a more precarious position.

Supporting Research:

“Capital One said this month it's restricting credit card issuance after charge-off rates spiked to 6.34% in the third quarter from 3.96% in the same period last year.”

“Banks, in turn, are trying to wean themselves from the securitization markets. They're turning to other financing such as certificate of deposit programs, but those can be costly.The market shutdown is particularly bad news for non-bank finance companies. The ability to sell off car, education and auto loans is critical to companies such Ford Motor Co.'s Ford Motor Credit, American Express Co. and student lender SLM Corp., or Sallie Mae. Without securitization markets, they have less capital to make new loans to consumers.”

“… approximately 50% of [American Express] funding was unsecured and 50% was done through securitization.
Moving to slide eight, metric performance for international consumer, we continue to have strong metrics in international consumer although we did see some slowing in billed business in the third quarter. FX adjusted growth in the first and second quarter was 10% compared to the 8% in the third quarter.” American Express CFO, Daniel Henry – EVP & CFO

“In the US while the write-off rate in the quarter was 5.9% the write-off rate in September was 6.1%. We expect the fourth quarter to be higher then the third quarter and we expect the first quarter of 2009 to be higher then the fourth quarter of 2008.” American Express CFO, Daniel Henry – EVP & CFO as reported in the American Express 3Q conf call...

Transparency: The author owns both AXP Apr 09 puts at $3/contract and COF JUN 09 $25puts at $5.58/contract.