Swaptions and Financial Turmoil

Before diving into a discussion on "Swaptions", let's explain the term. "Swaptions" are options on interest-rate swaps and a way to hedge (or out and out bet on) expected moves in treasuries.

UBS says Options on Two-Year Interest-Rate Swaps are `Expensive'.

Options on two-year interest rate swaps are "expensive" relative to those for longer maturities and will cheapen in the next year because turmoil in global credit markets will ease, according to UBS AG.

UBS strategists recommend selling so-called 1y2y swaptions and buying 1y10y swaptions. The strategy is a bet normalized volatility will fall on the 1y2y swaptions more quickly than it does on the 1y10y over the next year.

I have to wonder what's in this recommendation for UBS? Are they caught on the wrong end of swaptions just as Bear Stearns (BSC) was caught looking the wrong way on mortgages?

But more to the point, any person or hedge fund making huge trades predicated on the belief that "turmoil in global credit markets will ease" is likely to be barking up the wrong tree.

Risk Aversion at Citigroup

Bloomberg is reporting Citigroup Unit Won't Take New Mortgage Bank Clients

Citigroup Inc., the largest U.S. bank, stopped accepting new clients in a unit that offers credit lines to mortgage banks, according to two people familiar with the situation.

Citigroup's decision may make it harder for some home lenders to survive.

[Mish comment: If so, look for another leap forward in the mortgage lender implode-o-meter already sitting at 149]

Other warehouse lenders are refusing new clients, in part because they're finding it "too difficult to determine the financial condition" of the companies, WarehouseOne President Gary Hoyer said in an interview.

The interesting thing above is lenders are finding it "too difficult to determine the financial condition" of potential clients. What happens if it's worse than they think not only for new clients but existing ones?

Conduit Risks Are Hovering Over Citigroup

The Wall Street Journal is reporting Conduit Risks Are Hovering Over Citigroup

Though few investors realize it, banks such as Citigroup Inc. could find themselves burdened by affiliated investment vehicles that issue tens of billions of dollars in short-term debt known as commercial paper.

The investment vehicles, known as "conduits" and SIVs, are designed to operate separately from the banks and off their balance sheets.

Citigroup, for example, owns about 25% of the market for SIVs, representing nearly $100 billion of assets under management. The largest Citigroup SIV is Centauri Corp., which had $21 billion in outstanding debt as of February 2007, according to a Citigroup research report. There is no mention of Centauri in its 2006 annual filing with the Securities and Exchange Commission.

Let's put this in English. Citigroup has $100 billion in assets off the balance sheet that is 100% likely to not be marked to market. Thus those losses have not yet appeared on Citigroup's corporate filings. In addition Citigroup (C) as well as JPMorgan Chase (JPM), Lehman (LEH), and Bear Stearns (BSC) are all stuck with LBO commitments that the debt markets are now unwilling to fund. This is bound to start a new dance craze I call The Bernanke Shuffle.

In all of this is there any hint anywhere that remotely suggests "turmoil in global credit markets will ease". Is that UBS prediction based on yet another "credit model" destined for the scrap heap of history?

Here's my failsafe prediction: Before this mess finally ends, there are going to be scores more hedge funds, pension plans, mortgage lenders, and possibly even banks carted out in a wagon wishing they never heard the term "swap", "swaption", "conduit", "MBS", "CDO", "CDS" "SIV", "Mark to Market" and probably a dozen others terms as well.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/