Monday, March 17, 2008

The Chaos trade

In the end financial markets are nothing more than a massive confidence game fueled by information and smart young things in fine suits and expensive shoes. (Don't get me wrong - I loved every minute of it.)

When you trade, your word is your bond. And you are only as good as your last trade.

So when the whispers questioning Bear's solvency drowned out the word of their traders on the street, the jig was up.

And Wall Streeters all gossip like old ladies. You'd be surprised.

And that is what ultimately brought down Bear Stearns.

Interestingly enough, the source of all this chatter on the street, the mortgage desk, had turned a profitable first quarter - thanks to the chaos trade. (Basically the chaos trade is the Wall Street version of the Clinton campaign "kitchen sink" strategy. You crunch the numbers and throw everything but the kitchen sink at it. It's a massive crapshoot.)

Another oddity in this deal centers on Bear's mortgage trading desk. While much has been justifiably made of that desk's central role during the wide-ranging global credit collapse - it was perennially the first- or second-biggest underwriter on Wall Street - the embattled desk actually made money in the first quarter, Bear execs said.

Over the previous three months, Bear's mortgage and asset-backed trading desks shifted a portion of their capital into a series of proprietary trades designed to profit from the ongoing maelstrom. Notionally called hedges, in reality they were a series of free-standing bets that Bear executives dubbed The Chaos Trade, given the current climate.

The trades were bets pretty far afield from the standard trading of standard Freddie Mac and Fannie Mae guaranteed securities. The trades speculated on the decline of value in specific tranches of mortgage securities, futures on bond indexes, the shape of the yield curve and individual brokerage and bank bonds.

The payoff for Bear from the so-called chaos trade was impressive: $1.9 billion in one quarter, nearly off-setting the $2.5 billion write-down, Bear execs said. On top of that, one senior Bear executive told Fortune that in the quarter, the firm made $800 million on a series of other mortgage trades, giving its desk a profit for the quarter. The senior Bear executive declined to characterize the nature of the trades.

Read all about it here: JP Morgan and the Fed inherit the chaos trade.

Could they have pulled it out? Maybe. Maybe not. If I knew the answer to that I wouldn't be fighting the jihad in my pajamas, I'd be swilling champagne and flying in my G-5 to my private island in the Caribbean for a few days. I do know that this post subprime market is a boil that needs lanced. And that's what we're seeing. The good news. The markets are working. Confidence in the market held. For today. Stocks and treasurys rallied. The dollar held. Oil advanced and retreated. The bad news: It's not over yet: MF Global is causing a stir and will be closely watched. Lehman and Goldman are reporting tomorrow and they will be important. Citibank, Washington Mutual are also on the rumored list. No doubt there are more lurking out there. Another Fed action is expected Tuesday and the Captain still has the seatbelt sign illuminated, possums.