I haven’t said much about what I’ve been doing personally here of late. In sum, the general theme is that I’ve been scaling out of positions the entire summer, and am now 100% cash. Had I not sold anything, I would be up more on the year than I am at present – but that’s pretty much par for the course in a rally that has been as sharp and persistent as this one.

There’s still a strong undercurrent of disbelief at this rally, so in that sense not much has changed since March, when the world was bearish and nothing but pain existed for equity holders. The difference now (besides much higher prices) is that there’s a growing contingent with a belief that the recovery is at hand, or their more speculative counterparts who don’t believe in a recovery but are afraid of missing a higher move.

A growing number of financial stocks that are essentially worthless have seen their option values multiply several-fold; the well-documented list includes Fannie Mae (FNM), Freddie Mac (FRE), AIG, Citigroup (C), and Lehman (LEHMQ.PK), and August trading volume has been heavily concentrated in those names. I’m not discounting the option value of a stock; real-world outcomes are probabilistic and stock prices should reflect that. But it does speak to speculation returning to the market, and that’s a sign of caution in a time of great uncertainty – and make no mistake, the short-term bandages are only hiding long-term problems.

Good investing is not about having a myopic focus on maximizing returns, it’s also about managing risk. Winning is important, but so is not losing. With the feedback loop of the last six months, market conditions are such that it’s very easy to forget that losing is a distinct possibility in an era of debt deflation. Although inflation has been the headline worry of Fed watchers, I’m not convinced; the intermediate concern (2-5 years) that seems underestimated is deflation. Central banks are small in comparison to global capital flows, and although we might try to stimulate like crazy, it will be difficult to offset trillions of dollars in irresponsible lending being rationalized.

In light of this, I’m looking at convertible securities that offer yields of 6% or more (about 500 bps over 2-year Treasuries) in industries that will have above-average profitability in the case of an economic recovery. My assumption is that the yield alone will offer an attractive return, and with most at a discount to par, the total return potential approaches double-digits over a two-year time frame. If I’m wrong about the immediacy of a market recovery, the convertible option offers a hedge on rising stock prices – in sum, a better balance of risk and reward than either a straight stock or bond allocation.

A final closing note: I’m going to change up my policy about writing, since I often spend dozens of hours studying something only to determine it is a dead end. So, in the future, I’ll comment on those, instead of just the scarce opportunities I end up acting on.

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Primus Guaranty (PRS) announced yesterday that it entered into a significant credit mitigation deal with one of its counterparties, reworking $1.2 billion in notional value of credit default swaps. According to the press release, $40 million in notional exposure written on a monoline insurer was terminated for $15 million, or 37.5 cents on the dollar. The other billion-plus is being moved to a subsidiary of Primus Financial capitalized with $36 million, which is the maximum exposure (plus future premiums on those swaps) that can be lost.

Working backwards, ring-fencing certain swaps clips the tail risk existing in the portfolio at about 3.1% – a fairly high level that’s about 50% above what I’ve modeled previously. From the press release, my assumption is that the counterparty is willing to do this to minimize credit/counterparty risk related to Primus; it’s not collateral per se, but it functions in the same way.

As for the monoline settlement, well, it speaks volumes about what happens if you aren’t a systemic risk – privately negotiated solutions actually come about, and it means that companies that took risks take losses (or at least agree to accept more uncertainty/variability). One possibly safe extrapolation: if counterparties to a company that doesn’t warrant liquidity concerns like Primus are willing to take substantial haircuts on their CDS transactions, you better believe that Santa Claus came down the chimney for everyone with claims against AIG that were repaid in full. It’s simply a perverse trait of the financial system, and our government, that smaller players are left to deal amongst themselves, whereas larger players are assisted and handed a different set of rules to play by.

More to come after earnings next week…

Lastly, a non-related note. I’ve learned a lot from David Merkel, and he asked those who read them to link to this about the SEC. It’s the least I can do, and I encourage you to read it.

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Disclosure: I own both Primus stock (PRS) and debt (PRD).

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