Friday Options Update: FRE, FNM, LEH, WB, AIG, SLM, MER, XLF

July 11, 2008

Freddie Mac (FRE), Fannie Mae (FNM)– The market tumbled out of bed this morning to speculation of a possible government “conservatorship” of mortgage financers Freddie Mac and Fannie Mae, which own or guarantee nearly half of all U.S. home loans, bringing to mind the worst possible images of not only the impotence of the two chartered companies in their present form, but also the auxiliary effects through the broader financial sector if the companies were declared unfit to carry on. Remarks from U.S. Treasury Secretary Henry Paulson (who indicated today that the Feds’ current mission was to support the financers as they are presently structured) seemed to rule out an imminent government takeover. This did little to assuage traders, who feel that a bailout would essentially value these shares at nothing and set in motion potentially very negative auxiliary effects in the larger financial space. Fannie Mae options are trading at nearly 4 times the normal level against a 22% drop in share price value to $10.39 – paring some of the pre-Paulson cataclysmic losses earlier in the session. Implied volatility has risen another 47% on the session to 267%, and comparing this shoulder-to-shoulder with the 123% degree of volatility shown by Fannie Mae shares historically tells us that the option market is pricing in about 117% more potential price risk to its shares over the next 30 days. In other words, the cost of insuring against price swings is rising appreciably as speculation over the future of the mortgage financers broadens. Puts at the July 5 strike have already traded at some 4 times the normal level, attracting buyers as well as sellers as the 45-cent premium on this contract reflects about an 11% probability of Fannie Mae shares halving in value again by next Friday.

VIX – Concern about the aftershocks of a possible forced socialization of Fannie Mae and Freddie Mac sent the S&P dramatically lower, leading the CBOE Volatility Index 10% higher by midday to 28.16. Intimations of “the other shoe to drop” in the broader market caused a rush among option traders to buy calls at the July 27.50 strike, where the $1.90 premium implies a move to at least 29.40 between now and next Tuesday. While the clear bias was to buyers at the 27.50 strike, calls at strikes 30 and 32.50 attracted buyers and sellers, and we wonder if selling pressure in August calls at strikes 27.50 and 30 may be evidence of traders cashing out of those positions to fund the purchase of front-month protection. The cost of protecting S&P-exposed portfolios against volatile price movement over the next 3 days is up more than 100% at most strikes in the July contract. In this environment, it would be no surprise to see traders resort to VIX call and calendar spreads, selling higher-strike positions to keep trade costs under control.

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