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A way to explain why this rebound was massive

I read this piece by John Mauldin this week. Always have for his weekly write ups. Of particular interest is this portion where he tries to explain perhaps why we see such a huge run up this month:

  1. The banks “voluntarily” took a 50% haircut. Because the write off was voluntary, there would be no triggering of credit default swaps clauses.
  2. If you bought credit default swaps on a certain bank’s debt (lets say JP Morgan , but it could be any bank) because you think that Morgan is exposed to too much credit default swap risk.
  3. If 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.
  4. When they took that voluntarily haircut, the risk evaporated. There would be no CDS event. So why buy CDS? Time to cover.
  5. The shorts get covered.
  6. The risk to financials was cut by a large, somewhat murky amount. But it was definitely cut, so buy some risk assets. This puts long/short hedge fund is in a short squeeze.
  7. 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.

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Monday 31st of October 2011

Hi Drizzt,

A newbie here. Been following your blog recently and have to say i did learn a bit more on stock trading. I looked thru your portfolio, but have this puzzling query which I hope u can enlighten me. Can ask why your fees when u sell stocks is not factored into the overall transaction cost?? Thanks!

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