We suggested traders get involved in some financial names when they were looking pretty torn up, and the street was negative on the sector.
These suggestions may have surprised a few people, but they are consistent with our big-picture view. Banks’ balance sheets have nearly $700 billion in unrealized losses. As a group, this is pretty grim. The banks that are in the most trouble would fail my Financial Institutions Risk Management class. Banks must run a matched book on an interest rate exposure basis. That means their assets’ average maturity should match their liabilities’ average maturity.
Inexperienced managers will try to cheat and expand their net interest margin by buying long-dated bonds and financing them with short-term deposits. A few banks, like Bank of New York Mellon, run a matchbook well. Furthermore, they have a robust business in securities safekeeping, which generates fee business and does not risk the bank’s balance sheet. We suggested selling a cash cover-up on the name. That trade has generated most of the gains possible, so we suggest closing it.
Discover Financial Services lends money to their customers through their credit card offering. Since the rates on credit cards float, they are not taking interest rate risk. They do have some liquidity risk as depositors might want their money back when credit card borrowers roll over their debt instead of paying it off or down. But they have an out. They can securitize their credit card receivables and sell them to institutional investors like pensions, insurance companies, and mutual funds. People were down on DFS because they were worried about the economy falling into recession and the resulting financial distress people feel during these episodes. We remain constructive on the economy. GDP grew over 5% last quarter, and we suspect it will grow at 1 to 2% in the current quarter. That is around economists’ expectations.
Finally, we suggest people buy long-term treasuries for a trade. The sell-off in the long-term bond market was brutal. 30-year treasuries were down over 50% from peak to trough. We think the rally in bonds may take a rest. Further, most of the money that could be made by selling a cash-covered put has been made, so we also suggest closing this trade.
In addition, it is expensive to finance long-term treasury bond purchases. SOFR stands for Secured Overnight Financing Rate. It’s a benchmark interest rate for dollar-denominated loans and derivatives. In simpler terms, it’s a measure of how much it costs to borrow money overnight, with the loan secured by Treasury securities. Since the yield to maturity on long-duration bonds is higher than the financing rate, it is expensive for dealers to finance their inventory on bonds. There is no reason for hedge funds to execute a carry trade (buy long bonds and finance at a short-term rate to capture a yield differential) as the carry is negative.
Those who participated in these trades at the prices indicated would pocket $1,046. Not a bad day’s work.
