24 June 2007

Black(stone) Friday! Oh Oh, Credit Markets Come Home To Roost!

Let's dispense with the silly first - BX (Blackstone) looks to be opening up in the $37 range. That's not awful, but its hardly the huge pop that people were talking about with the oversubscription ratio.

The Dow, S&P and Nasdaq all opened up moderately down. The 10 is up again, opening up 0.7%, which puts us back in the groove on interest rates - going higher. The markets are doing the "inverse of the 10" deal again this morning; the charts on my 9-pane are interesting; near perfect inverses for the first few minutes, but then they appear to have decoupled a bit. It will be interesting to see how this plays out over the remainder of the day - my guess is that the "Blackstone fever" has infested traders - at least for a while. Certainly, its all CNBS was talking about for the first half-hour!

As I noted last night, we got the Hindenburg Omen confirmation. Asian markets were down last night; I wonder how much of that was people paying attention and how much was just plain old-fashioned exhaustion.

It looks like the market is starting to consider risk once again:

"June 22 (Bloomberg) -- U.S. stocks fell on concern hedge- fund losses at Bear Stearns Cos. may signal wider problems in credit markets.

Bear Stearns, the second-biggest U.S. underwriter of mortgage bonds, dropped after people with knowledge of the company's proposal said it plans to take on $3.2 billion of loans to stave off the collapse of a hedge fund. Citigroup Inc., JPMorgan Chase & Co. and Moody's Corp. also declined. "

No, you think?

$3.2 billion? For guys that had $6b in leverage out against $600m in collateral?

So what's the truth here guys? The claim was that they lost "20%"? Really? Or was it 50%? Or was the leverage ratio more like 25:1, not 10:1?

And better - why do you flush $3.2 billion down the toilet if you're Bear Stearns? There is only one reason to do that - you're afraid of the explosion that will result if you don't do it - that is, the blast will be even bigger in its impact on your bottom line.

CNBC is also reporting that Cantor Fitzgerald is getting bids as low as ten cents on the dollar for some of the CDOs they're trying to sell! That's a ninety percent haircut!

There are a lot of liars out here on the street right now, and sooner or later, they're going to have to fess up. If the real loss was 50%, that's horrendous. It also tells you a lot about the exposure on the street to this issue and points out the fact that there is absolutely no way that this will be, or can be, contained. It simply doesn't matter whether people want it to be or not - there is some $2-3 trillion in losses out there that are being hidden under the carpet at the present time!

This can and WILL come out, and if I'm right about the magnitude of this "crash" isn't the right word for what's coming. More like catastrophe. This pile of paper is what supports the consumer credit markets! If it implodes, and it looks like that's exactly what's happening, the damage, given the leverage being employed, will be tremendous.

We haven't seen a day with the futures limit down in the AM in five or six years. We may well be headed for a few of them in the coming months.

Let me be clear - what I'm implying here is that this cycle of fraud and avarice in the markets may be worse than the '00 Tech Wreck. In fact, it may be much worse.

You heard it here first guys and gals. I may be wrong about this - but the evidence appears to be mounting that indeed, I'm right - and the pump monkeys out there are doing their damndest to keep you, the retail bagholder, from finding out, because they know what happens once the cat is out of the bag.

Unfortunately, Bear's Hedge Fund blowup has let the cinch loosen up a bit on the sack that has been kept tightly closed since February, and it appears that at least one rabid cat got loose.

Now they've got a problem - as I noted last night there's at least one small broker/dealer that has been shut down due to repricing of assets. This is likely to continue, but the "big guys" on Wall Street are almost certain to lie about their exposure until they are forced - by someone -to fess up.

And lookie what that rabid cat dragged back home and dropped in front of the door!

"June 22 (Bloomberg) -- Losses in the U.S. mortgage market may be the ``tip of the iceberg'' as borrowers fail to keep up with rising payments on billions worth of adjustable-rate loans in coming months, Bank of America Corp. analysts said. "

Oops. And who do they target? One of my favorite whipping boys - Countrywide Financial and another good one for the post, Indymac Bank. Are 'ya short (or, if you prefer, "Got PUTs"), perhaps?

Then there's this from Bloomberg:

"June 22 (Bloomberg) -- U.S. high-yield debt investors, after snapping up a record $600 billion in new loans and bonds this year, are starting to push back."

No, you think?

And finally we see a ratings agency waking up.

"NEW YORK, June 22 (Reuters) - Fitch Ratings on Friday said it may cut its collateralized debt obligation (CDO) manager rating on Bear Stearns Asset Management, part of Bear Stearns Cos.' due to troubles arising from bad bets on subprime mortgages."

Hmmmm.... do you think that perhaps - just perhaps - the credit markets might be freaking out a bit? Uh huh....... The ratings agencies - late to the party, but they can't ignore it forever - unless they want to get sued out past Pluto. Not for being wrong - for willful or even collusive overrating of debt instruments in the face of hard evidence that the ratings are vastly too high.

And let's be perfectly clear on this - this is not confined to subprime mortgages or even residential housing. Today was horrible in the CMBX as well - not only is the BB up (again) and now in the stratosphere zone, nearly straight up since the 6th of June (a total of over 60 bps!) but the BBBs, As and even the "gold standard" AAA spreads are moving the wrong way. Someone (or perhaps, given the BROAD impact now, lots of someones) is/are in trouble in the commercial R/E space, but I still don't know who.

Contained? I don't think so!

Now add this - I have reason to believe (from perusing the public statements out of the OCC) that before the year is out stated income loans will be toast. This is going to be lots of fun for the homebuilders and the housing industry in general. It needs to happen, but it is not going to be pretty. If you want to know why I am quite sure this is going to happen, read this document. The salient part of it is:

"Let’s not sugar-coat what’s going on here. The practice of inflating income is at best misleading, and at worst, fraudulent. Yet if the studies are to be believed, it’s a practice that has become widespread in the riskier loans in the mortgage market."

Any questions?

The speaker? John Dugan, Comptroller of the Currency on May 23rd of this year. You know, the guy who can make that happen? Yep.

To add to this, we got another Hindenburg Omen today and the S&P closed under the 50 (not by a lot, but under is under!) There goes your first-level support. 1490 is now the critical number; if we close under that decisively, odds are very high that a major top is in and the trend to the upside has been broken, although I want to see the Dow Jones and Nasdaq also break the 50 - which they have approached but not yet done.

In addition, if there was a McClellan on the Nasdaq, we'd have a Hindenburg there too. Some people have said that the NYSE isn't "really" the right thing to use for this because of all the "bonds that trade like stocks." Well, that doesn't apply to the Nasdaq, and it too had New Highs and New Lows both over 2.2%.

Finally, Goldman broke the 50 decisively to the downside.

If you remember my list from here, we now have:

* The S&P closes under the 1490 level. NOT YET.
* China blows up (stocks). NOT YET.
* Goldman, Bear and Merrill close under their 50s. NEW SIGNAL TODAY; Goldman. All three now below. CHECK.
* HGX breaks trendline support. CHECK (from the other day).
* The Nasdaq (and Dow) break their 50s. NOT YET.

So we've got two of five, with two of the remaining three one more solid selloff away. The Nasdaq will breach the 50 at 2564, while the DOW does at 13,321 (about 40 points more down.) Monday, depending on China's action Sunday night, could reach all three targets, making five of five.
So what do we have to look forward to here?

This is my thesis, which you might note hasn't changed much over the last three months......

We have ~$300 trillion in notional value of derivatives flying around. If even 1% of those go boom, that's a $3 trillion dollar explosion - to put this in perspective, the US GDP last year was $13 trillion dollars, give or take one. That is an absolutely huge amount of money and no amount of "pumping" by the Fed or anyone else will stave off what is going to happen when it detonates and the Fed knows it.

Worse, foreigners have gotten a whiff of the stink and they're bailing on both the dollar and treasuries. This is ominous because as treasuries mature they are effectively "bought back" and a new sucker, er, investor is required to take their place. If this fails to continue at any point real interest rates will rise precipitously - they could shoot as high as 10% in a month's time, as the government will be forced to raise the offered coupon in order to finance its debt! There is really no other option, and the fear of this event - if that dynamic gets going and cascades there is no way to stop it as it is totally beyond US borders - will keep the Fed from attempting to keep the party going for much longer. As evidence of this, the TOMO activity (liquidity flush) from the Fed this week has been enormous, yet it has had almost no net positive effect. The taps are now being slowly closed, as despite the rise in bond prices the Dollar has resumed its slide, especially against the Euro and Pound. This is very likely to continue.

Next, Japan's government is getting very concerned about the effects of a forced "fast unwind" of the carry trade on their economy. They're wising up, and as a consequence they're starting to jawbone about doing something to slow it down. The market is responding by unwinding some of these trades to avoid being caught "offsides" if Japan decides to get truly aggressive. FX moves that go against you will BURY you in short order - the FX markets are amazingly liquid but margin capabilities are crazy in those markets. What this means, however, is that adverse moves have a habit of wiping people out even when the move as a percentage is quite small. This is certain to continue.

The government (ours) is very unhappy about the idea of people risking someone else's money yet treating the gain as a capital gain when they're right - and someone else's loss when they're wrong. This inequity is almost certain to be corrected, if not now (assuming Bush vetos it) down the road after the '08 elections. This change, by the way, needs to happen - carried interest is really more like a bonus than a capital gain, and while I know the hedgies and such will scream, they better get used to the idea because down the road I think it is a near certainty that the treatment will be revised. This will put a damper on private equity and LBO activity.

Real inflation is running close to 10% annually in the US. Eventually, the politicians and bankers will be forced to deal with this by raising the Fed Funds rate to defend the dollar, because most of this inflation is occurring via FX disadvantages in imports. Why forced? Because if they don't more and more nations will break their dollar pegs, a trend that is already starting in the Middle East - not a good place for it, given that we buy OIL from there. This is certain to play out over the next couple of years and will further drain the liquidity pool.

The OCC (regulators of banks) has said (if you read the right sorts of places) that stated income loans are likely to be restricted severely or banned outright this year. Guess what that will do to what's left of the bubble? Yep. Bye-bye. Return to rational valuations or you cannot sell the house. Period! By the way, this is probably the fairest way to solve that particular problem - and its a problem that needs to be solved. This process is very likely to move forward, with a formal comment period after the proposal is put out sometime this summer.

Companies that levered themselves up by buying back stock with debt and other cute financial tricks will find the cost of financing that debt has grown precipitously. When you have a D/E ratio on your balance sheet of 8:1, even small changes have ruinous impacts on your profits. This is nearly certain to hose entire sectors, especially mortgage lenders and home builders, who are in the worst possible position to be able to afford it. This trend is very likely to continue.

That's it for now - may update it later this evening or over the weekend.

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