HXD.TO (TSX hedge) bought @ $27.66

I haven't blogged for several months 'cause I've been busy. On the other hand, I haven't invested in anything since the last time I blogged except for HDX.TO, the Horizon Beta Pro S&P/TSX double inverse ETF. If the S&P/TSX goes down by x% on a given day, HXD.TO will go up about 2x%.

HXD.TO, like other inverse ETFs, works as a hedge, but only if the index really drops. If the index goes sideways, you lose money. That's because you need even bigger gains to get back to even after you've lost money. For example, if you invest 100$, and lose 10% on day 1, you're down to 90$. To get back to 100$, you need to make 10$, or 11.1% of your current 90$ balance. (Hence Warren Buffet's two first rules of investing.) So if the index goes sideways (up 10%, down 10%, up 5%, down 5%) you'll lose money.

I bought HXD.TO on October 31st, at $27.66/share. It's now at $24.60/share.

Buying a hedge like this is not very Benjamin Graham-esque (because I'm worrying too much about that nutty Mr. Market). However, I still see a lot of downside in the current market:

1- The firings are just getting going.

Remember that this crisis arose in the credit markets. The firings began about april or may 2008 and have kept going up since then. Until unemployment drops, spending will be anemic and corporate earnings will continue to slide.(http://data.bls.gov/PDQ/servlet/SurveyOutputServlet). Note however, that the stock market often recovers before earnings do! Makes things a bit tougher to predict.

2- Alt-A and Option mortgage rate resets.

Sub prime mortgage resets resulted in a big increase in mortgage defaults, which resulted in asset write-downs, thus impairing the credit markets. A big spike in Alt-A and option mortgage resets is due for the 2010 to 2012 period. (See here for the ubiquitous credit swisse graph (http://economist.mrwhipper.com/?p=603), and here to get the credit suisse report http://www.imf.org/external/pubs/ft/gfsr/2007/02/pdf/chap1.pdf). Alt-As are designed for people who can't provide sufficient documentation to get lower interest rates. Because mortgage originators didn't hold the Alt-As (they were securitized), the originators would not incur any of the credit (default) risk. This incentive structure encourages some creativity in Alt-A mortgage documentation. Consequently, rating Alt-A mortgages as AAA is a joke, but they did it anyway. We're going to see a high default rate in Alt-As (though perhaps not as bad as with the subprimes), and its going to cause more problems in the credit markets.

Option mortgages are not much better. These include interest only mortgages and negative amortization mortgages, in which you don;t ay down the principle. Think these people can handle higher interest rates?

Moreover, with dropping housing prices, a lot of these mortgages are going to be upside down, even more so with the rate reset. Consequently, the value of the collateral (the house) and therefore the value of the mortgage is a lot lower than it would have been pre-recession.

The rate reset will also have a domino effect on other consumer debt (car loans and credit card debt), increasing their default rates. Think about it: if you have to choose between paying your mortgage and your credit crd debt, which do you think you would choose?

Default rates will go up, the value of the assets used as collateral (houses, used cars, and the junk people put on their credit cards) will drop even more, so the value of holding this securitized debt is going to fall some more too. This is going to freeze up the credit markets again.

3-Delevering

Is it deleveraging or delevering? Whichever it is, it's happening big time and is likely to continue, especially given what I've said above.

Consumer debt securitization allowed non-banking investors (like investment banks, hedge funds, mutual funds, etc.), often refereed to as the shadow banking system (see bill gross' columns here (http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm)), to "invest" in consumer debt. This resulted in an expansion of available credit and lower rates. The problem is that the shadow banking system was also levered, maybe even 40 to 1 (http://articles.moneycentral.msn.com/Investing/JubaksJournal/fluke-credit-crisis-was-a-heist.aspx?page=2). So when the value of the shadow banks' consumer debt assets dropped, and they had to meet their margin requirements, and/or pay back some of their loans, they had to liquidate whatever they could liquidate: stocks and bonds.

Similarly, delevering might have resulted in an increase in the US dollar. Investors (shadow bankers and individuals) were borrowing US dollars and buying foreign stocks and other assets. When these investors had to pay back their loans or meet their margin requirements, or shore up their assets, they had to trade their foreign assets for US dollars, sending the US dollar up. (http://seekingalpha.com/article/108305-deleveraging-pushes-the-dollar-up)

One way to see delevering in action is to look at margin debt on the NYSE (http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=table&key=278&category=8). Margin debt peaked in July 2007, and has been falling ever since. When that stops falling, it'll be an indication that delevering is petering out. However, bill gross (http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2009/Investment+Outlook+April+2009+Evolution+or+Revolution+Bill+Gross.htm) (of pimco bond fame) thinks that delevering is a long term trend.

4- Junk

And then we have junk bonds. Defaults rates are going up for those as well, leading to a drop in junk bond values, and more delevering.

5- CDS

Because securitized debt and junk bonds are risky, investors decided to buy credit default swaps to decrease their credit default risk. The problem is that the CDS is only worth what's in the "insurer's" portfolio. If the "insurer" holds toxic debt too and a lot of defaults occur at the same time, the insurer becomes overwhelmed and can't pay. AIG is a case in point. In my opinion, once the default rates increase, CDSs won't end up being worth much, leading to even more write downs.

Jim Jubak recently stated that the net CDS obligations in case of default total 2.8 trillion. (You have to figure out the net because a lot of CDSs are offsetting.) That's a 50% drop from the peak, but it's still a lot.

In comparison, Geithner's most recent bailout plan is to buy up to $2 trillion in toxic debt ( http://www.nytimes.com/2009/03/24/business/economy/24bailout.html?_r=1). In the case of defaults, the CDSs would still have to pay out. They would just pay whoever is administering the Geithner money. This gives an indication of the size of the CDS problem.


Soooo, that's why I hedge.