General Electric ~ Bearish Chart

Technical Breakdown in US markets

This week's trading saw the resumption of the technical breakdown in the market.

Monday and Tuesday were important from a technical standpoint as we again saw the appearance of another confirmed Hindenburg Omen meaning the market is displaying very unhealthy tendencies

The fundamental picture of the economy is clearly sagging into recession due primarily to high oil prices and weak consumers and we should see some major fireworks as a result.

Royal Bank of Scotland warned its clients about a very bleak picture and the likelihood of a major stock market collapse that would be felt around the world.

Major financial institutions are now publicly confessing what we have known for quite some time about the problems that have been caused by stupidity, greed and negligence.

From a technical perspective the Dow – as of Wednesday - was below 12,100, which is an important level.

On Friday we continued to get some heavy technical driven selling. The Dow broke through the 12,100 level referred to previously and then breeched a very important level at 11,900. If the market closes below that lower level a couple of times next week it will signal a very serious breech of a long-term technical trend.

We've now had a cluster of 5 Hindenburg Omens in a short period of time probably meaning the odds of a very negative outcome has increased significantly.

There's a lot of important data and events next week including the FOMC meeting on Wednesday; final GDP for the quarter on Thursday; and new and existing homes sales.

Today Moody's downgraded both the major bond insurers, AMBAC and MBIA. This actually means that all the paper these insurers wrap must also be marked down which is very significant. These downgrades were the reason why there was so much selling in the financials today.

The heart of the global systemic crisis

On the occasion of this 26th – Summer 2008 Special – edition of the Global Europe Anticipation Bulletin, the LEAP/E2020 team has decided to launch an alert on the July-December 2008 period. Indeed, our team is now convinced that this period will consist for the whole world in a major plunge into the heart of the phase of impact of the global systemic crisis. The upcoming six months are in fact the core of the unfolding crisis. The troubles met in the past six months were mere harbingers.


US consumer confidence index (1978-05/2008) – Source: Briefing.com / Conference Board

In the next semester indeed, all the components of the crisis (financial, monetary, economic, strategic, social, political… ones) will converge at the height of their intensity (1). Avoiding to repeat a description of the various sequences already anticipated in the previous editions of the GEAB, our researchers have decided to describe the trends that will be at work in the world's main regions in the next six months. Therefore they analyse eight fundamental processes that will mark the next semester and affect decisively the years 2009-2010, i.e.:

1. A Dollar in distress (EUR 1 = USD 1.75 at the end of 2008): Panic-fear of a US currency and economy collapse eats into the American collective psyche

2. Global financial system: An impossible requirement – placing Washington under international trusteeship – provokes the system's break

3. European Union: The periphery sinks into the recession, the Eurozone only slows down

4. Asia: The « double whammy » inflation/export-collapse

5. Latin America: Difficulties increase but growth remains steady in most parts of the region, Mexico and Argentina in crisis

6. Arab world: Pro-Western regimes go adrift / 60 percent risk of socio-political explosion on Egypt-Morocco axis

7. Iran: 70 percent probability of an attack by October 2008 confirmed

8. Banks/Speculative bubbles: When bubbles collide

In parallel, LEAP/E2020 presents five strategic advices for the intention of central banks, governments and regulatory authorities, aimed at reducing and channelling the very bad consequences of the phase of impact of the crisis.

As to private investors, LEAP/E2020 develops in this 26th issue of the GEAB, a series of 8 operational advices for them to avoid committing fatal mistakes in the course of the next semester.

For this public announcement, LEAP/E2020 chose to present its anticipation on the upcoming break of the global financial system.

Global financial system: An impossible requirement – placing Washington under international trusteeship – provokes the system's break

Who owns the US debt? – Source: Fincher
Washington's decision to raise the bids for the return to a « strong Dollar », by compelling Ben Bernanke to intervene, bears the seeds of an acceleration of the global financial system's breaking process (2).

Ben Bernanke is indeed the last wall before the largest US currency and asset owners become fully aware of the fact that Washington no longer has the means of its monetary policy. What used to be a deliberate policy of currency drop (when it was decided to stop publishing M3 in March 2006, as announced by LEAP/E2020) in order to reduce the country's trade deficits and the real value (for themselves) of the their debt (labelled in Dollar), turned against its perpetrators entailing a major outflow (capital outflow, steadiness of trade deficits, soaring inflation...). The « Bernanke » card is the last « psychological » card Washington can play. The fact of using it proves that US leaders have reached the last limits of what they can do to hold back their partners into the system founded after 1945 and based on the US economy and currency (3).

In a few weeks time (after the next G8- and other organisations-meetings have taken place), when it will be confirmed that there is no way to stabilise the US currency (not to mention the eccentric idea of pushing it up) because the US economy is sinking always deeper into the recession and because the world is already filled with US Dollars no one knows what to do with, then the global financial system will burst out in various sub-systems trying to survive as much as they can before a new global financial equilibrium is found (4). As he is embarking on this road to nowhere, consciously or not, voluntarily or not, Ben Bernanke is signing the end of the current financial system. The return to a “strong Dollar” is a bit like the « liberation of Iraq » : wishful thinking turning into a nightmare.


The inverted pyramid of global liquidity - Sources: Bank of International Settlements / Independent Strategy
As a matter of fact, if Washington really intended to stabilise the Dollar or, more ambitiously, to push it up against the other currencies, there would only be one way (5), in two parts: raising significantly the Fed's interest rates, and lowering drastically the pace of money printing. But if the government decided to implement this type of policy, the US economy (both real and financial) stops dead a few weeks after : the real estate market falls to zero by lack of affordable credit and as a result of soaring interests on Adjustable Rate Mortgage loans, consumption becomes negative (i.e. shrinks back each month), corporate failures multiply exponentially, Wall Street collapses under the burden of innumerable debts and succumbs to the instantaneous implosion of the CDS market due to counterparties default...

Such a series of events, sure to happen if Washington implements a voluntary policy of dollar-rescue, is probably unacceptable by the US authorities. Therefore, apart from talking – and further self-discrediting – they cannot do anything. The method used in the past decades is no longer available: no one will accept to buy large amounts of Dollars in order to rescue the US currency if some voluntary policy (like the one described previously) is not implemented by Washington. As they will not do it, the rest of the world will draw its own conclusions: everyman for himself, knowing that from mid-August onward, as Beijing is relieved from the constraint of the Olympic Games, a large number of “tough” options (6), put on the back burner until the Games, will resurface (7).

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Notes:

(1) For a more detailed calendar of these trends, see GEAB N°18.

(2) The Bank of International Settlements is beginning to worry about a risk of global Great Depression. Source: Banking Times, 06/09/2008

(3) Source: Euro Pacific Capital, 05/23/2008

(4) On this subject, read in GEAB N°26 our advice to central banks, governments and regulatory authorities.

(5) We will disregard the other option consisting in bombing the ECB, the Bank of China and the Bank of Japan.

(6) Source: ContreInfo, 04/21/2008

(7) As Russia is becoming the largest oil-producer - before Saudi Arabia - in the world, the balance of power on the oil market is also changing a lot. Source: Times of India, 06/12/2008

The global slump has begun as poison spreads

Ambrose Evans-Pritchard: The global slump has begun as poison spreads

Submitted by cpowell on 07:53PM ET Sunday, May 11, 2008. Section: Daily Dispatches
By Ambrose Evans-Pritchard
The Telegraph, London
Monday, May 12, 2008

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/05/12/ccambr...

The avalanche of bankruptcies has begun. Six US companies of substance have defaulted on bonds over the past fortnight, against 17 for the whole of last year.

As a "non-believer" in the instant rebound story, I am not easily shocked by gloomy reports. But the latest note by Standard & Poor's -- "The Bust After The Boom" -- gave me a fright.

The sick list is varied, though most for now are victims of the housing crash: Linens 'n Things, ($650 million), Kimball Hill ($703 million), Home Interiors ($310 million), French Lick Resorts ($142 million), Recycled Paper Greetings ($187 million), and Tropicana Entertainment ($2.49 billion).

As the Fed's latest loan survey makes clear, lenders have dropped the guillotine. With the usual delay, the poison is spreading from banks to the real world.

Diane Vazza, S&P's credit chief, says defaults are rising at almost twice the rate of past downturns. "Companies are heading into this recession with a much more toxic mix. Their margin for error is razor-thin," she said.

Two-thirds have a "speculative" rating, compared to 50 percent before the dotcom bust, and 40 percent in the early 1990s. The culprit is debt. "They ramped it up in the last 18 months of the credit boom. A lot of deals were funded that should not have been funded," she said.

Some 174 US companies are trading at "distress levels." Spreads on their bonds have rocketed above 1,000 basis points. This does not cover the carnage among smaller firms outside the rating universe.

The California city of Vallejo (117,000 inhabitants) has just made history by opting for Chapter 9 bankruptcy, the result of tax erosion from a 26 percent fall in local house prices. Half Moon Bay may be next.

"This is the tip of the iceberg. Everybody is going to line up for Chapter 9 in California," said John Moorlach, Orange County board chief.

US consumers are juggling plastic to put off their day of reckoning. The Fed survey said credit card debt had jumped 6.7 percent in the first quarter to $957 billion, or $6,000 per working American, despite usury rates near 20 percent.

"My guess is that many Americans continue to run up massive credit card debt because they have little intention of paying it off," said Peter Schiff at Euro Pacific Capital. Quite.

Thankfully, the Fed's monetary blitz has averted a depression. Emergency lending under the "unusual and exigent circumstances" clause of the Fed Act -- the nuclear Article 13 (3), unused since the 1930s -- has put a floor under the banking system.

There will be no "reset Armaggedon" as rates vault on honey-trap mortgages. Drastic Fed cuts -- to 2 percent from 5.25 percent in September -- have conjured away that disaster, at least.

One dreads to think what would have happened if Fed liquidationists (Plosser, Hoenig, Fisher) had prevailed, as they did in 1930 -- and still do in Euroland, where Germany's Axel Weber holds sway, and nobody of sense dares lead a mutiny.

Despite the rescue, US house prices are likely to fall 25 percent from peak to trough (Lehman Brothers, Goldman Sachs). We are barely half done, yet 10 to 12 million households are in negative equity already.

The bears at Societe Generale are going into Siberian hibernation, issuing an "Ice Age" alert. They have slashed exposure to global equities to a minimum 30 percent for the first time ever.

Their weighting of super-safe "AAA" government bonds has been raised to a maximum 50 percent. This is a bet on gruelling "Japanese" deflation. The bank expects equities to fall by 50 to 75 percent.

"Nowhere and nothing will be immune. We are on the cusp of an equity meltdown that will slash and shred portfolios," said Albert Edward, SG's global strategist.

"We see a global recession unfolding. Liquidity will drain away and crush the twin emerging market and commodity bubbles. The recent hope that 'the worst might be over' is truly staggering. Profits are disintegrating," he said.

Today's "bear rally" may live on into June. Don't count on it. Global bourses are no longer rising hand-in-hand with oil in exuberant celebration of liquidity relief (US, UK, and Canadian rate cuts).

Crude ceased to be a friend of equities when it reached around $110 a barrel. At last week's close of $126, it became an outright threat. The Bush rescue package -- $800 in rebate cheques per household -- has been rendered null and void by the latest spike. The average US home is now spending over 8 percent of income on energy or fuel.

OPEC is playing with fire by refusing to pump more oil to offset rebel attacks in Nigeria. The cartel's output drop of 350,000 barrels a day in April is a hostile act at this point.

But there again, why should Middle Eastern states help America as long as the White House keeps filling the US petroleum reserve to prepare for war with Iran? Bush is playing with fire too.

The oil spike will burn itself out. China has hit the buffers. With inflation at 8.5 percent, it risks political turmoil. Moreover, it has repeated Japan's mistakes in the 1980s, building too many factories shipping too many goods at slender margins into a crumbling export market.

Lehman Brothers' Sun Mingchun says China will tip over in the second half of this year. "With so much latent overcapacity, an export-led slowdown could trigger a chain reaction which, in the worst case, could threaten the stability of financial and economic system," he said.

Britain, Europe, Japan, and China will go down before America comes back up. This is turning into a synchronised bust, after all. The Global Slump of 2008-09 is under way.

Prepare for the credit crisis to spread

By Wolfgang Munchau

Published: September 2 2007 18:57 | Last updated: September 2 2007 18:57

“Financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design . . . The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”

A Short History of Financial Euphoria, John Kenneth Galbraith

The late John Kenneth Galbraith would have enjoyed this summer. He was no expert on modern credit markets but his analysis of historic bubbles fits our most recent boom and bust episode with uncanny precision.

All historic bubbles were accompanied by a sharp rise in leverage. A salient feature of modern bubbles is the emergence of innovative financial products. No matter whether we are talking about junk bonds or modern collateralised debt obligations (CDOs), as Galbraith has pointed out, such products boil down to variants of debt secured on a real asset.

By historic standards, our credit bubble is probably one of the largest ever, given the sheer size of the market itself and the degree of euphoria that was characteristic in the final stages of the boom. While the fallout was initially concentrated in the financial sector itself, it would be surprising if the ongoing problems did not trickle down into the real economy. The availability of credit affects house prices and numerous studies have demonstrated the interlinkages between US house prices and US economic growth.

So what should central banks do? I suspect that central banks are not going to be the main actors in any rescue operation, but rather governments. Central banks’ room for manoeuvre to cut interest rates is more constrained this time than during the most recent recession. But more important, this is not the kind of crisis that can easily be stopped by a few hasty rate cuts or bank bail-outs. If your subprime mortgage exceeds the value of your house by 10 per cent, and if the monthly payments exceed your income, no positive interest rate could bail you out. Your only hope is some serious debt relief.

The economists Dimitri Papadimitriou, Greg Hannsgen and Gennaro Zezza last week published a study* in which they demonstrated the danger to US economic growth posed by the present real estate crisis. Their policy recommendations go significantly beyond the usual bail-out calls. They argue that it is almost impossible for policymakers to stop the decline in real estate prices, but “if the Fed and Congress can work to stop any incipient recession, they will prevent job losses, which are one of the main contributors to foreclosures. An effective job-creation method could be some form of employer-of-last-resort programme that offers government jobs to all workers who ask for them”.

We should remember that the subprime market is not the only unstable subsection of the credit market. Once US consumption slows, we should prepare for a crisis in credit card and car finance CDOs. And once corporate bankruptcies start to rise again as the cycle turns down, both in the US and in Europe, we will probably hear about problems with collateralised loan obligations. The credit market is very deep and offers significant potential for contagion.

In this sense, the debate about whether this is a liquidity or a solvency crisis is beside the point. Banks may look at their CDO investments as a source of temporary illiquidity, but may sooner or later realise that they are sitting on a pile of junk. The fiscal and monetary authorities should therefore assume that they are confronted with a solvency crisis. Bailing out the odd bank, as the Germans did last month, is not going to be sufficient and perhaps not even necessary.

Instead, the monetary and fiscal authorities should stand ready to support the economy if and when needed. Lower interest rates will probably be part of any such deal, but a large part of the help will invariably come from fiscal policy. The US Federal Reserve will probably cut interest rates soon and the European Central Bank will almost certainly postpone the rate rise it unwisely preannounced only a few weeks ago. I am convinced the next interest rate movement both in the US and the eurozone will be downwards.

One of the problems the monetary authorities have to deal with is moral hazard. This is not a theoretical issue, as some suggest, but a far more immediate concern. Moral hazard is the result of asymmetric expectations, as markets expect the central bank to bail out the financial sector during a time of crisis. The problem of moral hazard is to some extent related to the monetary policy strategy of central banks, with their mechanistic focus on a single consumer price index. Such strategies often have no space for asset prices, but markets know fully well that central banks must invariably take account of asset prices during sharp downturns. One way out of this asymmetry is for central banks to include asset prices into their policy frameworks in some form or other.

This said, a bail-out of the financial system will probably become unavoidable, but it should be accompanied with structural policy changes. Tighter financial regulation is probable. The role of the ratings agencies is bound to change too. And central banks should reconsider their monetary policy frameworks. They are part of the problem.

Roubini on the problem

Here are two examples of how uncertainty and opacity has vastly increased in financial markets.

First, you take a bunch of shaky and risky subprime mortgages and repackage them into residential mortgage backed securities (RMBS); then you repackage these RMBS in different (equity, mezzanine, senior) tranches of cash CDOs that receive a misleading investment grade rating by the credit rating agencies; then you create synthetic CDOs out of the same underlying RMBS; then you create CDOs of CDOs (or squared CDOs) out of these CDOs; and then you create CDOs of CDOs of CDOs (or cubed CDOs) out of the same murky securities; then you stuff some of these RMBS and CDO tranches into SIV (structured investment vehicles) or into ABCP (Asset Backed Commercial Paper) or into money market funds. Then no wonder that eventually people panic and run - as they did yesterday – on an apparently “safe” money market fund such as Sentinel. That “toxic waste” of unpriceable and uncertain junk and zombie corpses is now emerging in the most unlikely places in the financial markets.


Second example: today any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.


So combine an opaque and unregulated global financial system where moderate levels of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, misrated, mispriced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price; then you have created a financial monster that eventually leads to uncertainty, panic, market seizure, liquidity crunch, credit crunch, systemic risk and economic hard landing. The last two asset and credit bubbles in the US – the S&L real estate bubble and bust of the late 1980s and the tech stock bubble of the late 1990s – ended up in painful recessions. The latest credit and asset bubble was much bigger: housing, mortgages, credit, private equity and LBOs, credit derivatives, corporate re-leveraging. So, the current bust and de-leveraging of the financial system is likely to lead to another painful economic hard landing.

The liquidity crisis and the stagnating US trade deficit

The liquidity crisis and the stagnating US trade deficit (Aug. 12, 2007)
The global liquidity squeeze has turned into a global financial panic. It has started with the subprime mortgage woes in the US. Many of those subprime mortgage loans require no down-payment at all, and carry a very low introductory interest rates for the first few years, call the “teaser rate”. After the period of the teaser rate expires, the interest rates on those subprime mortgage loans will move in tandem with the prevailing short-term market interest rates. As the short-term interest rates have risen substantially, those subprime borrowers suddenly face an unbearable monthly interest payments after the expiration of the teaser rate period. Thus many subprime mortgage loans end up in delinquency and then in default. Since most of those subprime mortgage loans are packaged into mortgage backed securities, the defaults of subprime mortgage loans have thus damaged the values of those mortgage backed bonds. Due to the invention of complicated financial derivatives, the damage on the price of those mortgage backed bonds is further amplified. Those subprime mortgage backed bonds are held widely by financial institutions and hedge funds around the globe so many entities have run into trouble by holding related bonds and derivative instruments. However, this kind of woes are not limited to subprime mortgages. In the non-subprime category a substantial fraction of newly granted mortgage loans also are adjustable rate mortgages that carry very low teaser rates and with scant down-payments. At a very low interest environment financially sound people will borrow 30 year fixed rate mortgages to lock in very low interest rates. In the non-subprime category, only those with good income but financially stretched will borrow adjustable rate loans with a teaser rate even substantially lower than the already low rates of the fixed rate mortgages, apparently in the hope that future interest rate will stay low or the rising housing prices will bail them out. As those scenarios failed to develop, the default rate in the non-subprime sector is also rising. Then there are home equity loans that are also adjustable rate loans. The default rate of home equity loans is rising, too. Those non-subprime adjustable rate mortgages and home equity loans are also widely packaged into mortgage backed or real estate equity backed bonds. Thus the pains of mortgage woes are quickly spreading beyond the subprime region. At the same time of mortgage woes the liquidity in the markets of junk bonds that are issued mainly to finance the frenzy of takeover booms in the hands of private equity firms is also drying up. Though some are trying to play the word game and called the spread of the financial pain and the drying up of liquidity as “the reassessment of financial risks”, the reality of diminishing liquidity finally hit and the financial pains has turned into a global financial panic in the last two days, on Aug. 9 and 10 of 2007. In order to understand the true nature of this liquidity crisis we will discuss in this comment the origin of the liquidity squeeze, the future course that this crisis will likely to take, and how this crisis will affect the global economy.

The global liquidity is pumped up by the global trade imbalance, not by the total amount of global trades. The majority of the global trade imbalance is due to the runaway US trade deficits. Let us consider first the situation of USA. As the US runs trade deficits, US dollars are handed over to foreigners. Since US dollars are not legal tenders in foreign countries, those dollars related to the trade deficit (we will call them trade-deficit-dollars from here on) must flow back to the US markets, mainly via the Wall Street. A portion of those returned trade-deficit-dollars will purchase US based assets like stocks and real estates, but the majority of the trade-deficit-dollars will be lent out in the form of purchasing dollar denominated debt instruments, ranging from US treasury issues, mortgage backed instruments, corporate bonds and so on. As lending generates more lending, the trade-deficit-dollars balloons to a large amount of liquidity. In 2005, the US current account deficit, the broadest measure to gauge the trade situation, has topped 600 billion dollars. Thus we may expect that the total liquidity originated from trade-deficit-dollars has already reached tens of trillions of dollars. It is this liquidity glut that is supporting the US government spending, the local government spending, the consumer spending, the mortgage lending, the borrowing by private equity firms to finance their buyout frenzy, and the borrowing by hedge funds to engage in speculative activities. However, the US trade deficit has stagnated for more than a year, and thus the liquidity squeeze. We will look into the actual data to give supports to this argument in the following paragraphs.

The current account deficits are not adjusted for inflation, so we always consider the ratio of the current account deficit over the nominal GDP, expressed in percentages, as a proper measure to gauge the trade situation. This ratio is called trade-deficit-to-GDP ratio in short. The four quarter moving averages of this ratio are plotted as the blue curve in the graph at the right. Four quarter moving averages of the growth rate of real GDP are plotted as the green curve, and four quarter moving averages of the growth rate of real (means inflation adjusted) debt are plotted as the red curve in the graph respectively. Since the onset of the globalization process in the early part of 1980's, there have been three bursts of US trade deficits as can be seen as three sharp rises of the blue curve. The first burst of the trade deficit occurred in the period from 1983 to 1986, and the growth rate of real debt (the red curve) far exceeded the growth rate of real GDP (the green curve) in this period, creating the debt bubble of 1980's. It was this debt bubble that generated the real estate bubble of 1980's and induced frenzied merger and acquisitions by issuing junk bonds to finance such activities. The US trade deficit at that era were mainly due to the trade deficits with Japan. Thus in early 1985 major powers agreed to let Japanese Yen appreciate against US Dollar; Japanese Yen rose almost 100% in the succeeding years. This great devaluation of US Dollar took about 2 years to be translated into the stagnation of US trade deficit and then the decline. As can be seen from the blue curve of the trade-deficit-to-GDP ratio, it started to stagnate in 1986 and had turned to an explicit decline near the end of 1987. With this retreat of the US trade deficit, the red curve, the growth rate of the real debt, had turned down sharply from 1986, indicating the steep drop of the rate that liquidity was created. As the liquidity squeeze due to the slowing trade deficit advanced, the merger and acquisition activities came to an abrupt end, withdrawing an import support for the stock markets. As the ratio of trade-deficit-to-GDP started to turned down at the end of 1987, stock prices crashed and the growth rate of real GDP slowed substantially. The three curves tumbled together toward the nadir of 1991, until the growth rate of real GDP became negative and an official economic recession was declared. This series of events shows how the flows and ebbs of trade deficits induced the rise and the bust of the debt bubble, and how the fate of the debt bubble pushed around the growth of the real GDP.

As the ratio of trade-deficit-to-GDP fell to its nadir, US Dollar regain the power to rise against Japanese Yen. Thus the US trade deficit started to expand again from its nadir of 1991. However, the second burst of the US trade deficit needed to wait Japan's near zero interest rate policy that unleashed yen carry trades to push US Dollar sharply higher against Japanese Yen. During this second burst of US trade deficit, a debt bubble did not emerge. Instead the trade-deficit-dollars flew into stock markets and created a stock price bubble. The debacle of US Dollar in 1998 and 1999 caused US trade deficit to decline in 2000 as can be seen from the peak of the blue curve in 2000. As the ratio of trade-deficit-to-GDP came down, so was the growth rate of real GDP. The third burst of US trade deficit has started in 2002, though temporarily disrupted in 2003 by the SARS scare. By the time of this third, or the current burst of trade deficit, China has replaced Japan as the major contributor to the US trade deficit. The movement of Dollar vs. Yen becomes less a factor in dictating the movements of the US trade deficit. Chinese Yuan has been pegged to US Dollar until the middle of 2005, and is allowed to float up slowly since the middle of 2005. Thus the drop of dollar against other currencies except Chinese Yuan from 2002 has a much less effect on the US trade deficit than used to be. Only from the beginning of 2005 US trade deficit less energy has started to stagnate, but the overall trade deficit was kept rising through 2005 due to the rapid rise of the price of crude oil. Only when the oil price stagnated, the US trade deficit has ceased to rise, and the blue curve has peaked and started to fall in 2006. During this current burst of the trade deficit, a debt bubble developed as the substantially higher debt curve (the red one) than the growth rate of real GDP (the green curve) indicates. As the trade deficit starts to fall, the growth rate of debt, the red curve, is falling in tandem, indicating the rapid disappearance of the liquidity glut.

In order to guage the future course of the liquidity squeeze, we must first understand the direction of the US trade deficit. Considering the dominance of foreign made, especially Chinese made, consumer goods in the US market, the trade deficit of the consumer goods sector is probably near saturation. The trend in automobile sector is for Japanese brands to manufacture cars within USA and gradually replace American brands. This transition of power will not cause the trade deficit of the automobile sector to increase sharply. As liquidity bubble bursts, the Wall Street people that have profited mightily from the bubble will be poorer, and will buy less imported luxury cars, and thus the trend of deficit in the automobile sector is a stagnation at best. The capital goods sector is sensitive to the value of dollar. At the dawn of the globalization era, the US enjoyed a substantial trade surplus in this sector. After experiencing waves of runaway trade deficits, this surplus in the capital goods sector had turned into a deficit of 17 billion dollars a year by 2005. The falling dollar from 2002 is narrowing the deficit in this sector fast. As a whole the US trade deficit less energy will continue to stagnate unless unexpectedly US dollar strengthens against the currencies of its trading partners, including Chinese Yuan, by a substantial amount. Barring such an unlikely currency exchange rate movement, only hope for a rising US trade deficit is for the price of crude oil to jump sharply from here. If that happens, the blue curve will turn up again, the red curve will bottom out, the liquidity squeeze will ease, stock prices will rise, but the growth rate of real GDP will fall further due to heightened inflation rate. If the oil price does not come in to rescue, the ratio of trade-deficit-to-GDP will continue to fall, and the growth rate of debt (the red curve) and the growth rate of real GDP (the green curve) will follow the blue curve down in a measured pace. Thus the liquidity squeeze will continue for quite a while.

Some claim that if only FED lowers interest rates and replenish the lost liquidity, everything will be fine. Let us look into this theme in details. Greenspan FED took the radical action of lowering interest rates to the 1% level in 2003, and ignited the housing bubble that is now deflating painfully. US Dollar tumbled from the level of 115 Yen/Dollar toward the level of 100 Yen/Dollar. Japanese government stepped in and bought up more than 400 billion dollars to prevent US dollar to collapse below 100 Yen/Dollar. As Japanese Government's dollar buying spree ends, FED was forced to raise interest rate rapidly and steadily until the Federal Fund's rate reached 5.25% to prevent the demise of dollar. This steady rise of the short-term interest rate is now boomerang back to intensify the pain of the mortgage woes. If FED lowers short-term interest rates substantially to replenish the lost liquidity and to prevent the deflation of the debt bubble, Japanese Government probably needs to buy up nearly one trillion dollars this time to prevent a whole sale collapse of US dollar. Even if Japanese Government is able to perform such a feast again, FED will be forced to raise interest rate again after Japan's dollar buying spree ends in order to defend the dollar and to fight off the inevitable inflation in such a scenario, and thus the financial crisis will reemerge in a few years.

There are people who naively claim that a whole sale collapse of US Dollar will only inconvenience some American tourists in overseas, but will achieve the desirable effect of shrinking the US trade deficit in a few years without any pain. Such a shrinkage of the US trade deficit will apparently force the further shrinkage of the global liquidity and makes the situation worse, rather than ease the crisis. Then there is an immediate and enormous danger overlooked by those claims. The danger is due to the existence of “derivatives”. The derivatives we are talking about here are not those exchange traded put and call options nor the exchange traded futures contracts. They are off the market financial contracts granted among large financial institutions, life insurance companies, hedge funds and so on. Those derivatives carry fancy names like interest rate swap, currency swap, credit risk swap, barrier options, lookback options, chooser options, knock-in and knock-out options, forward or delayed start swap options, index-amortizing swaps and so on and so on in addition to the familiar names similar to the exchange traded options. Those derivatives make the hedging of long financial positions possible, and thus encourage various entities to hold financial positions far beyond their reasonable means; such positions are called leveraged holdings. The leveraged and vastly expanded holdings of various long positions then in turn further escalates the trading of derivatives. It is reported that the total amount of the exiting derivatives already exceeds 50 trillion dollars globally. The values of a substantial portion of those derivatives depend on the value of US dollar. When US dollar collapses, a sizable loss, like 10 trillion dollars will be incurred in a sector of the participants of the game of derivatives. Many losers in the game naturally have no means to sustain such an outsize loss and will inevitably go under. Derivatives are a zero sum game. If there are losers, there will always be the matching winners. However, as losers go bankrupt, the paper wins of the winners also disappear. Most of those winners are probably using the derivatives to hedge their highly leveraged holdings that will lose value as dollar plunges. Thus those so called winners must realize the full amount of loss in their over-extended holdings once their insurance derivatives evaporates, and will go under along side with the losers. The bankrupted losers and winners of the derivatives tied to the value of dollar probably are also playing the game of derivatives tied to interest rates. As they go down, interest rate related derivatives will also evaporate, and expose the holders of outsize interest rate instruments directly to the rapidly gyrating market force. In a very short time span the shock wave of collapsing dollar will spread and will bring down the whole derivative house of cards, along with the whole global financial system. If that kind of scenario unfolds, due to the sheer size of losses involved, the whole world's central banks, IMF and the world bank combined will be utterly powerless to combat such a whole sale disaster. The best we can hope is that FED will not succumb to the temptation of lowering interest rates in a haste, and not to test the jinni of Dollar and derivatives.

The best way to understand why the problem of liquidity is globally connected is to look at the case of China. Chinese economic growth is based on the rapidly growing influx of dollars. The major source of the influx is from its rapidly expanding trade surplus. In order to slow down the pace of the rise of Chinese Yuan vs. US Dollar Chinese Government must buy up those influx of dollars. In the process of dollar buying a matching amount of Chinese Yuan must be sold into the market. It is this huge amount of Yuan flooding the domestic market that powers the growth of China's economy. Currently China's trade surplus is expanding by taking away the share of export markets of other countries. However, as the US trade deficit continue to stagnate as discussed before, the growth of China's trade surplus will gradually come to a hold, and China's economic expansion will also slow down unless Europe will expand its trade deficit sharply to shoulder a portion of the role that the US trade deficit used to play.

Europe's economy has benefited from the dynamic rise of new EU members. The low labor costs of those developing EU member states boosted the manufacturing in EU as a whole. However, if EU let its trade deficit to expand rapidly and shoulder a portion of the burden to let China continue to expand, then their newly industrializing members will suffer. EU is also benefiting from the influx of oil money. Many oil producing countries do not want to deposit their oil money into USA due to political reasons, and choose Europe as the target to pour their money into. Thus European financial institutions become the conduit of oil money to be reinvested into USA. Those European financial institutions and hedge funds are exposed to the same financial risks as their US counter parts. Actually the financial panic of Aug. 9 has originated from Europe. If the derivative market collapse, European financial system that is tightly integrated into global system will also be destroyed just like their American cousins. It is difficult to envision that Europe can really serve as the economic locomotive to pull up the whole global economy if the US economy stumbles.

Japan's economy is in a peculiar shape. In the middle of 1990's when Japan has embarked for the policy of very low interest rate, their central bank, The Bank of Japan, was still tightly controlled by the bureaucrats of MOF (the Ministry of Finance). It was the idea of the mercantilistic MOF bureaucrats to use the very low interest rate to suppress the value of Yen so that Japan can sustain a sizable trade surplus. This policy has wiped out the interest income of Japanese consumers that are known to be heavy savors. With this blow, the consumer spending has withered and the deflation has set in. This more than a decade long hardship of Japanese consumers is still continuing today. As Japan's job situation worsens, Japan's economy can only grow by increasing exports, utilizing the idled labor resources. That is what is happening today in Japan. As the US trade deficit stagnates and the ratio of trade-deficit-to-GDP comes down further, Japanese economic growth will also vanish.

The claim of soothsayers that the US has nothing to fear since the global economy is strong is simply dubious at best. The safest course for FED to take is to adhere to its current interest rate target, and steadfastly defend this target. If needs arise, FED can continuously inject sufficient amount of liquidity into the financial market to prevent the Federal Funds rate to go above 5.25%. After a while the financial market will get used to the gradually shrinking liquidity bubble, and the panic stage will be over. As the liquidity bubble withers away, the US economic growth rate will come down further and the job market will become worse, but the ratio of trade-deficit-to-GDP will keep declining. As the ratio drops to a certain level, US Dollar will regain the power to bounce up without the artificial stimulus like yen carry trades. It is at that juncture FED will be able to lower interest rate gradually and jump start the economic growth again. Only after such a soft landing is accomplished, policy makers should seriously consider ways to address the means to prevent the reemergence of global trade imbalance and to rein in the run away leverage and the explosion of derivatives even at the cost of scaling back the irresponsible and ill-thought-of globalization process. Otherwise the financial crises will reoccur again and again until the big bang that destroys the global financial system as well as the global economy.

11 reasons to freak out

"Total world stock market capitalization was about $37 trillion in 1990; it grew to about $51.225 trillion in March 2007. According to Morgan Stanley, the total world nominal value of derivatives stood at around $5.7 trillion in 1990; it grew to $415 trillion at the end of 2006.

Doing the math, it means the $ value of derivatives are about 8 times larger than stocks now, whereas in 1990 stocks were 6.5 times larger than derivatives. Hmmm!
Implications/guesses/comments:
1) There are too many derivatives in the world
2) The parceling out of those derivatives into smaller bundles for all to play the game doesn't seem to be reducing risks as “experts” expected.
3) They have never faced a serious test in this cycle
4) They have become increasingly complicated to price
5) Ratings agencies (S&P and Moody's) preferred fees to due diligence
6) Private equity is more interlinked to derivatives than most realize
7) Stress testing a derivatives portfolio can be tricky if you don't know whether or not the
counterparty (maybe one of the 3,000 hedge funds) will be in business
8) One wonders why stock prices aren't a lot higher given that massive amount of leverage
i.e. liquidity manufactured across the globe
9) Tied to point #7: It sets the stage for a massive global deflation, though everyone seems
to think inflation is the problem. (If we accept that inflation is too much money chasing
too few goods, then why isn't it higher with so much money generated since 1990?
Maybe the massive deflationary pump of billions of new labor market entrants and
overcapacity is stronger than experts realize.) A debt default is deflationary. And it
leads to forced savings, which adds deflationary pressures in a world driven by “drunken
sailor spending.”
10) There could be much, much further to go “on the downside” as funds rush for the rapidly
narrowing exits.
11) We want to pull the cover over our heads and go back to bed when we contemplate the
potential for a real market cleansing. We use the words “real market cleansing” because
we think the relative stimulus from central banks through rate cutting, in a world where
$415 trillion in credit craters, ain't going to have much impact.
So, if your friend turns to you today, or anytime in the near future, and says this: “You know
something, there are going to be some real bargains in the market soon!”—we suggest its time
to find a new friend."
BLACK SWAN TRADING
From http://www.blackswantrading.com

Absolute Capital Hedge Fund Suspends Withdrawals

By Laura Cochrane and Stuart Kelly

July 26 (Bloomberg) -- Absolute Capital Group Ltd., an Australian hedge fund that invests in collateralized debt obligations, suspended withdrawals from two of its funds after forecasting losses amid a rout in U.S. subprime mortgages.

The firm froze its Yield Strategies Fund and Yield Strategies Fund NZD, which together have about A$200 million ($177 million) under management, Chief Investment Officer Bill Entwistle said in an interview today. The Sydney-based company is 50 percent owned by ABN Amro Holding NV's Australian unit

Absolute Capital, which says it doesn't invest in the riskiest portion of CDOs, is suffering from the widening impact of delinquencies on U.S. home loans to people with poor credit. Basis Capital Fund Management Ltd., another Australian hedge fund battered in the North American market, has hired Blackstone Group LP to negotiate with bankers to help it limit losses.

``Because of the contagion from subprime, all of the credit sectors are re-pricing,'' Sydney-based Entwistle said. ``There are lots of sellers and no buyers, the market has to settle down before we can get some clarity.''

The Yield Strategies Fund returned 6.4 percent the past year while the Yield Strategies Fund NZD, which started in May, gained 0.2 percent to June 30.

Australia's hedge fund industry has been rocked by losses at Basis Capital, which has said the value of its Yield Alpha Fund may plunge more than 50 percent if its assets are sold at distressed prices. Sydney-based Mariner Bridge Investments Ltd. on July 20 wrote down the value of its U.S. residential mortgage-backed securities.

Biggest Investors

The nation's 20 million people are the world's biggest investors per capita and Australia has the fourth-largest managed funds industry. Unlike in the U.S., where only qualified investors can place money in hedge funds, Australia allows individuals to invest in the vehicles.

Australian hedge fund managers directly controlled A$41 billion in assets as of July last year, the most in Asia, according to AsiaHedge. Assets almost tripled in the two years to June 2006 as money from compulsory pension savings, tax breaks, a new state-owned investment fund and takeovers boosted fund inflows, according to government data.

Absolute Capital said it won't process any requests for withdrawals until Oct. 25, estimating it may take three months for enough buyers to return to the CDO market.

Repackaged Debt

CDOs pool assets ranging from investment-grade debt to high-yield loans, and repackage them into bonds. Different portions of a single CDO have their own rating, ranging from as high as AAA to nothing at all.

Entwistle said 50 percent of Absolute Capital's two funds is invested in the so-called ``mezzanine'' portions of CDOs, which are typically assigned the second-highest non-investment grade rating of BB by ratings companies.

Basis Capital's investments included the unrated portions of CDOs, the first in line for losses when borrowers fall behind on mortgage payments.

``There's probably more pain to come,'' said Michael Birch, who helps manage $133 million at Wallace Funds Management, a Sydney-based hedge fund. ``We need more clarity as to the scale of the writedowns at Basis and Absolute. It might take six months for the full impact to come out.''

The sting from U.S. subprime mortgage delinquencies that hit a decade-high this year is being felt across businesses, regions and asset classes.

Buyers Vanish

Almost 40 companies have reworked or abandoned debt offerings in the past three weeks as after struggling to find buyers. Federal Reserve Chairman Ben S. Bernanke said July 19 there will be ``significant financial losses'' from risky mortgages, pointing to estimates as high as $100 billion.

Bear Stearns Cos., the fifth-largest U.S. securities firm, on July 18 told investors in its two failed hedge funds they'll get little if any money back after ``unprecedented declines'' in the value of subprime mortgage securities.

Investors earlier this month were demanding an extra 10.5 percentage points in yield over benchmark rates to own some of the lower investment-grade rated parts of CDOs, up from about 3.1 percentage points in July 2006, according to data compiled by Morgan Stanley.

Sales of CDOs surged to $503 billion last year, compared with 2003. Investor appetite for the securities is now waning. Analysts at New York-based JPMorgan Chase & Co. said CDO sales in the U.S. this month reached just $9.1 billion at July 20, compared with $42 billion for all of June.

Ratings Criticized

Ratings companies have been criticized by investors for not acting quickly enough to the subprime mortgage crisis. Leah Rhodes, a Melbourne-based director of structured finance at Standard & Poor's, today said losses from U.S. subprime loans ``did exceed our expectation.''

A spokeswoman for the Australian Securities and Investments Commission, the corporate regulator, didn't immediately return telephone calls seeking comment on Absolute Capital.

Kim Ivey, chairman of the Australian Alternative Investment Management Association, which represents 80 of the nation's hedge fund managers, said there will be more hedge funds hurt by the subprime market.

``I expect that it will be contained to just a handful,'' he said. ``More of a concern is what will happen once the fallout moves from the subprime sector to more senior debt, when many more managers have exposure.''

Trouble in Hedgefundistan

Two columns of black smoke can be seen rising over Wall Street and disappearing into the ice-blue New York sky.

Terrorism?

Not quite. The plumes of smoke are all that's left of two major hedge funds which blew up just weeks ago leaving nothing behind but a few smoldering embers and a mound of black soot.


The compiled assets of the Bear Sterns High-Grade Structured Credit Strategies Fund—nearly $20 billion—have vanished into the miasma of cyber-space where they will soon be joined by $1.4 trillion of other, equally worthless, Collateralized Debt Obligations (CDO).

If you look carefully, you can almost see the mangled and bloodied bodies of the CDOs, the CSDs, the RMBS and the other shaky debt-instruments being pulled from the wreckage and tossed unceremoniously on the bonfire.

Is this how it all ends? The first whiff of trouble in the housing market and then—in a flash--all the funds in “Hedgistan” begin teetering towards earth?

“No Value”-“No Bids”

According to Bloomberg News, Bear Sterns announced last week that there's “little value left” in one of its funds and “no value left” in the other.

Nothing, nada, zippo.

The news was like a bucket of cold water dumped on the stock market leaving slack-jawed traders shuddering in trepidation.

What does it all mean?

Does that mean that the entire hedge fund empire—which is built on a foundation of dodgy loans and quicksand---may be headed for the crapper?

No one really knows. But a pall has settled-in over downtown Manhattan where gloomy-looking men in pinstriped suits are waiting for the other shoe to drop.

Y'see, the hedge fund industry is based on the bizarre notion that one does not have to produce anything of value to make boatloads of money. You don't even need assets any more---just a risky loan that can be transformed into an investment grade security through the magic of “securitization” a sprinkling of Wall Street snake oil.

Abrah Kadabra---presto-chango!

It's like taking shards of bottle-glass and selling it as the Hope Diamond. Who's gonna notice?

The only catch is that--now that these toxic CDOs are going to auction--there are no bids. That's a bad thing.

“No bids” means that $1.4 trillion of shaky investments have no discernable market-value. The CDOs were graded “mark to model” which translates into “mark to fantasy”. It means that the investment bankers and hedge fund managers got together over Martinis one night and pulled a number out of a hat.

Now no one wants to buy them. They're worthless.

The skydiving hedge funds just pulled the CDO rip-chord and nothing came out but confetti.

Aaaaaaaahhhh!

And that's just half the story. There's trillions of dollars in derivatives riding on these shaky CDOs. That's enough to bring down the whole market in a heap once interest rates rise or liquidity dries up. Now it's just a matter of “when” now, not “if”.

This illustrates an important point, though. It shows what it takes to be a good hedge fund manager:

Take a shabby sub-prime mortgage; chop it into “investment”, “mezzanine” and “equity” tranches. Bundle it with other equally suspect mortgage backed securities (MBS). Decide (arbitrarily) what the CDOs are worth Tell your banker. Leverage at a ratio of 10 o 1. Take 2% “off the top” plus salary for your efforts. Buy a summer home in the Hampton's and a Lexus for the wife. Wait for the crash. Then repeat.

Congratulations; you are now a successful hedge fund manager!

Oh yeah; and don't forget to prepare a few soothing words for the investors who just lost their entire life savings and will now be spending their evenings squatting beneath a nearby freeway off-ramp.

“We're so very sorry, Mrs. Jones. Can we get you some cardboard-bedding to keep off the rain?”

The problems that are appearing in the stock and bond markets all started at the Federal Reserve when Fed-Chief Alan Greenspan opened the sluice-gates in 2003 and lowered interest rates to 1%. (Way below the rate of inflation) Since then, trillions of dollars have flooded into the markets creating multiple equity bubbles in real estate, stocks and credit.

Serial bubble-maker Greenspan is to finance-capitalism what Wrigley is to chewing gum. The greatest flim-flam man of all time.

The Fed has tried to conceal the massive increase to the money supply, but the evidence is everywhere. (Many analysts now calculate that inflation is running at roughly 13%) Food and energy have skyrocketed. Housing prices have soared. Everything has gone up except the cheapo imports which the Fed uses to manipulate the inflation stats.

The gigantic housing bubble is mostly Greenspan's doing. After printing-up mountains of cash and creating artificial demand through low interest rates; he promoted his product-line with the typical huckster sales-pitch. “Maestro” advised us that the extension of credit to all-God's creatures, worthy or not, is a good thing.

Here's a clip of Alan praising subprime lending in a speech on April 8, 2005:

"With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. . . . As we reflect on the evolution of consumer credit in the United States, we must conclude that innovation and structural change in the financial services industry have been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means. . . . This fact underscores the importance of our roles as policymakers, researchers, bankers and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers."

Yes, of course, with all these “advances in technology” and new-fangled “credit-scoring models” why would we need to verify a loan-applicant's income or require that he scrape together a measly $5,000 for a $450,000 mortgage?

That's all so 20th Century!

Now that foreclosures are mushrooming at an unprecedented pace, the Fed is trying to distance itself from the problem by blaming the banks for their shoddy underwriting practices. But the guilt lies with the Central Bank. Its all part of their whacko plan to crush the dollar and create a police state.

It may sound trite, but “inflation is theft”. Unfortunately, inflation is also part of the ruling class' strategy to rob the poor, fuel the stock market with cheap credit, and move jobs overseas. It is the autocrat's method of “social engineering”---shifting wealth from one class to another by simply printing more money and pumping it through the system via low interest rates. Remember, bankers know that people will ALWAYS borrow money if lending standards are relaxed and the money is cheap enough. At 1%, the Fed was basically losing money on every transaction, but persisted with their plan anyway.

Anyone who cares to go back and trace interest rates moves for the last 7 years will see that the Fed is really a political organization that decides monetary policy entirely on the basis an elite agenda that supports endless war, outsourcing of American jobs, and domestic repression.

Are you surprised?

Now, a bad situation is about to get a whole lot worse. Consumer credit rose last month by a whopping 12.9%---credit card debt by 9.8%! Since housing prices have flattened out, homeowners can no longer borrow on their dwindling equity (Mortgage Equity Withdrawal; MEWs) which is forcing the maxed-out American consumer to use plastic even though rates are averaging from 18% to 27% monthly.

Automobile repos have also hit historic highs. But the real damage is showing up in the subprime market where the percentage of defaults continues to rise unabated.

In itself, a correction in real estate is not enough to bring down the whole economy. Unfortunately, the contagion from the subprime meltdown has spread to the stock market, the insurance industry, banking and pensions. Not even Secretary of the Treasury, Henry Paulson or Fed-master Ben Bernanke are claiming that the subprime problems are “contained” anymore. Just this week, the scholarly looking Bernanke said to Senators on the Hill that the housing market has “deteriorated significantly”.

It's about time. If anyone still has any doubts about the magnitude of fiasco, I recommend they look over these eye-popping charts which tell the whole story. The housing blowdown will spread the carnage from “sea to shining sea”. http://www.itulip.com/forums/showthread.php?p=12232#post12232

The faltering housing market has drawn attention to an even more colossal credit bubble that is limping towards earth as loan requirements tighten and liquidity dries up.

The prevailing fear on Wall Street is that we may be seeing the beginning of a global credit crunch.

The danger is not just the subprime loans or even the mortgage companies that made the loans, but the overall risk to the secondary market where these loans have been sold as CDOs to the tune of $1.8 trillion.

In this new deregulated environment, the banks don't have to rely on savings anymore to make the loans. They simply originate the loans, take their commission, and sell the debt as CDOs. They're even allowed to sell the risk of default through credit default swaps (CDS) which are a form of insurance that minimizes the banks exposure. These weird innovations have spawned riskier and riskier loans and increased the likelihood of damage to the broader market.

The Toxic Cycle of Debt?

Economics correspondent, Stephen Long, explains it like this:

“The problem that arises from the subprime mortgage collapse is that it creates a toxic cycle of debt. Banks originate loans or bundle up loans that mortgage companies have made and sell the risk on to the hedge funds. Then the hedge funds say, ‘Hey, we've got this product that has an investment grade rating so we'll borrow against it from the banks.' (oftentimes leveraged at a ratio of 10 to 1) Now the hedge funds are trying to buy the original loans to stop them from going into default.”(The hedge funds are forced to slow the rate of foreclosures so they won't go bankrupt.)

So, what happens when these shaky bonds (CDOs) are “down-graded”?

Will the hedge funds fall like dominos just like the subprime mortgage-lenders? Will we see liquidity evaporate in the broader market triggering a plunge in the stocks and a massive sell-off in the bond market?

CDOs were conjured up with the idea that vast amounts of money could be made on very meager assets through a complex expansion of leverage. They were promoted as “limiting risk” by spreading it to a greater number of investors and providing extra protection through derivatives. Mortgage Backed Securities were sliced and diced into “more risky” and “less risky” tranches depending on investor appetite. Only now—to everyone's surprise---“collateralized debt obligations with stellar Triple-A ratings have been getting hit by the subprime market's woes.” (Wall Street Journal, “Bernanke revises subprime outlook”) On top of that, the ABX derivative index “has started showing pronounced weakness at the top of its ratings structure.” (ibid WSJ, 7-19-07)

Get it? In other words, even the VERY BEST of these multi-trillion dollar investments are beginning to falter. The contagion is spreading through the entire market. The CDOs are worthless. No one wants them. In fact, the whole new regime of exotic debt-instruments which emerged from 2000-on, is barely hanging on by a thread. One minor downturn in the stock market and the hedge funds will go freefalling through open space.

A speech by Robert Rodriguez of First Pacific Advisors (CFA) gives us a good idea of the enormity of the money involved. In his “Absence of Fear” address in Chicago on June 28, 2007 he states:

“Since 2000 hedge funds have more than doubled in number, while their assets have tripled. They too are using elevated levels of leverage, as are PE (Private Equity) firms and investors in highly leveraged fixed income securities. These funds are heavy users of derivatives. The Global derivatives market grew nearly 40% in 2006--the fastest pace in the last nine years--to $415 trillion, per the Bank of International Settlements. The amount of contracts based on bonds more than doubled to $29 trillion. The actual money at risk through credit derivatives increased 93% to $470 billion, while that amount for the entire derivatives market was $9.7 trillion. The International Monetary Fund, in its April 2006 Global Financial Stability Report, estimated that credit-oriented hedge fund assets grew to more than $300 billion in 2005, a six-fold increase in five years. When levered at 5-6x, this represents $1.5 to $1.8 trillion deployed into the credit markets. Fitch, in their June 5, 2007 special report, “Hedge Funds: The Credit Market's New Paradigm,” says that despite the upward trend in maximum allowable leverage, “notably, no prime broker reported raising margin requirements in response to historically tight credit spreads and growing concerns about the general level of risk-complacency in the credit markets.”

If Rodriguez's “eye-popping” numbers are accurate and the market slumps a mere 5%, “the value of a hedge fund's assets could lead to a forced sale of as much as 25% of its assets”. If the market falls just 10%, the fund would get a 50% haircut!

Yikes! That just shows how over-exposed the industry really is.

As the requirements on mortgages gets tougher and the subprime market continues to languish; bankers will naturally become more hesitant to loan zillions of dollars to hedge funds and private equity firms. When credit gets tighter, the hedge funds will begin to nosedive which will send the stock market in a long-term swoon. That's what happens when a market is this over-leveraged. It's unavoidable.

The markets are now perfectly poised for a full-system breakdown. FDIC Chairman Sheila Bair expects a CDO time bomb. She summed it up like this:

"Its going to get worse before it gets better. How much worse, I don't know."

Presentation to CFA association, New York

A recent example of the flawed nature of this market came to my attention when my associate, Julian Mann, showed me a very garden variety LIBOR sub-prime floating rate security. A major pricing service valued this bond at par, while on March 19, 2007, one of the major rating agencies rated this bond A3. To affirm the accuracy of this bond's pricing, we went to two brokerage firms that traffic in this type of security and requested what their bid might be, if we owned this security. One responded with a $7 bid. In other words, a 7% of par bid, a difference of 93% to the pricing service. The other firm declined to bid, but they did indicate that, if they were to, their bid would have probably been around this level. Julian has found several other similar examples, so this one does not represent the proverbial “needle in the haystack.”

We believe that many of these models are flawed and give a spurious representation of accuracy. Given the deterioration in underwriting standards, models predicated on prior experience have little value when compared to the data of the last two or three years. In essence, one is assuming a normal distribution curve of data for modeling purposes, while in reality you have data that comes from a highly skewed distribution. We are beginning to see the negative effects of flawed modeling by the growing number of downgrades in the sub-prime sector. This trend is also starting to develop in the Alt-A sector as well. We believe these trends will continue to unfold over the next two or three years and should lead to a retrenchment in the securitization/origination industry. If our assessment is reasonably correct, mortgage credit availability will likely contract and, therefore, exacerbate the housing contraction and its effects upon the general economy. We disagree with the opinion expressed by our esteemed Federal Reserve Chairman Bernanke, when he said in his speech of May 17, 2007 at Chicago's 43rd annual conference on Bank Structures and Competition, “We believe the effect of the troubles in the sub-prime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the sub-prime market to the rest of the economy or to the financial system.” We will see if this optimistic assessment proves to be the correct one.

We are of the opinion that the distancing of the borrower from the lender has contributed to the development of lax underwriting standards. Each participant, in the securitization/origination process, takes their ounce of payment, but no one truly worries about the underlying credit quality since the loan will be sold. Furthermore, most participants are compensated on volume and not quality of loan originated. In our opinion, “a rolling loan gathers no loss.” Possibly, with so many sub-prime originators failing because of loan put-backs to them, some degree of underwriting discipline will return to the market; however, with so many types of loan originators operating outside of the regulatory system with minimal capital, it is far better to originate a loan, capture the fee, and then get out of Dodge, should the business go bad. One can always return another day.

Finally, the securitization market and the multiplicity of products that have been created have never been truly tested in a major credit contraction like that of 1990-94. This is because most of today's securitization products did not exist back then. Another risk is how have they been used in various types of leveraged investment strategies? Have the creators of these products structured their operations to be able to handle a contracting market? It remains to be seen how this all works together. One may gain some insight to the potential risk by reviewing the collapse of the manufactured-housing securitization market. After seven years, it is still a fraction of its former size with all the former major originators gone.

Another example of risk knowing no boundaries, on June 1, the Government of Pakistan issued a $750 million 6.875% of 6/1/2017 dollar denominated bond priced at par and rated B1/B+ at barely 200 basis points above the ten-year Treasury bond yield. The following week in the Los Angeles Times, the headline read, “Musharraf's grip falters in Pakistan.” The second headline, “Dismay over U.S. support of general.” I guess the market believes the extra 200 basis points of yield spread is sufficient compensation for risk. I think not.

This weakening in credit quality trend also applies to the corporate bond market. High-yield bond spreads are at record lows, with the CCC component of the Merrill Lynch high-yield index at 18%, more than double the proportion ten years ago. 7 High-yield spreads have declined from nearly 1100 basis points over the Treasury yield in 2002, to barely 240 basis points recently. We believe this narrowing of credit spread is being driven by the near-record low default rates. For this trend to continue, a near “perfect” credit environment must continue. We see virtually no margin of safety for this sector. This narrow credit spread environment is the key driver that is propelling Private Equity and their bids for companies. As Dan Fuss, manager of the top-performing $10.7 billion Loomis Sayles Bond Fund, recently said, “I haven't felt this nervous about a market ever.” 8

PRIVATE EQUITY
The Private Equity (PE) industry is flourishing. PE has seen its capital raising rise more than ten-fold between 1990 and 2000, only to witness a temporary pullback in 2002, and then more than double between 2000 and 2006. PE is no different than any other hot investment trend, in that its peak capital raising and capital deployment occurred in 2000, the stock market peak, only to see this process collapse in 2002, the stock market trough. Capital deployment fell from $270 billion in 2000 to $49 billion in 2002, per the Leuthold Group. I call this process “buy higher” and then “don't buy lower.” Now we've seen PE fundraising rise to new all-time highs and along with that, acquisitions as well. Leuthold estimates that in 2006 $469 billion in cash acquisitions were announced and/or completed. While this was occurring, valuations have skyrocketed, according to JP Morgan's data. 9 Between 2001 and 2006, the average EV/EBITDA multiple paid rose 41%, from 6.1x to 8.6x. Leverage increased 54%, with the Average Total Debt/EBITDA multiple rising from 4.6x to 7.1x.

We are of the opinion that PE is pushing the boundaries of prudence and that this trend is elevating valuations in the equity market. It would not surprise us that there will be many other Chrysler situations in three to five years. By that I mean, Daimler-Benz A.G. paid approximately $36 billion for the Chrysler Corporation in 1998, only to sell 80.1% of its ownership for $7.4 billion in 2006. Given that this is other people's money, why worry.

HEDGE FUNDS
Since 2000 hedge funds have more than doubled in number, while their assets have tripled. They too are using elevated levels of leverage, as are PE firms and investors in highly leveraged fixed income securities. These funds are heavy users of derivatives. The Global derivatives market grew nearly 40% in 2006--the fastest pace in the last nine years--to $415 trillion, per the Bank of International Settlements. The amount of contracts based on bonds more than doubled to $29 trillion. The actual money at risk through credit derivatives increased 93% to $470 billion, while that amount for the entire derivatives market was $9.7 trillion. 10The International Monetary Fund, in its April 2006 Global Financial Stability Report, estimated that credit-oriented hedge fund assets grew to more than $300 billion in 2005, a six-fold increase in five years. When levered at 5-6x, this represents $1.5 to $1.8 trillion deployed into the credit markets. Fitch, in their June 5, 2007 special report, “Hedge Funds: The Credit Market's New Paradigm,” says that despite the upward trend in maximum allowable leverage, “notably, no prime broker reported raising margin requirements in response to historically tight credit spreads and growing concerns about the general level of risk-complacency in the credit markets.” The report provides a forced unwind example where an initial 5% price decline in the value of a hedge fund's assets could lead to a forced sale of as much as 25% of its assets, assuming leverage of 4.0x (20% margin). They conclude that liquidity risk is among the more important issues facing credit investors. In an era of constrained returns and narrow yield spreads, increased leverage is the solution since volatility is low; therefore, a higher level of leverage may be utilized. We question this logic.

EQUITY MARKET
Enhanced risk taking is widespread here as well. Equity mutual funds are now at or near their all-time record low cash percentage holding of 3.6%. According to the Leuthold Group's data, investors are directing their cash flows to among the riskiest areas of the equity universe—foreign focus equity funds. $80 billion has flowed into these funds through May compared to $11.8 billion for large-cap domestic equity funds and a net outflow of $4.2 billion for small-cap equity funds. This is the second year in a row that the foreign sector has overwhelmed the flows into domestic equity funds. We are of the opinion that investors are chasing the enhanced returns in the foreign sector but do not realize the extent of the risks they may be taking. We see little value in the domestic equity market since we view valuations as being elevated because, in our opinion, consensus profit expectations are assuming unsustainably high operating margins. There appears to be minimal valuation differentiation across most market cap sectors. For example, my value screen just hit a new low in terms of the number of qualifiers. Prior to the recent equity market decline, only 33 companies, with market caps between $150 million and $3 billion, were identified out of nearly 10,000 in the Compustat universe. The previous low was 46 this past February, and before that, it was 47 for both January 2004 and March 1998. When the market cap upper limit was expanded to $150 billion, only ten additional companies qualified. In times past, I would generally get 250 to 400 companies in just the smaller market cap range alone.

Wall Street Chasing Performance through Chemistry

“It’s like they’re chasing a dream. Even when they make tremendous profits, they’re still worried,” he said.

Alden Cass, a clinical psychologist who counsels Wall Streeters with drug addictions, said drug abuse and high anxiety are undercurrents to the current boom.

“When things are really good, they feel invulnerable,” Cass said. “That can lead to adultery, substance abuse, problems with the law.”

When it comes to profits, things are really good.

Six of the largest U.S. investment banks — Goldman Sachs, Lehman Brothers, Citigroup, JPMorgan & Chase Co., Morgan Stanley and Bear Stearns — combined for $17.6 billion in first-quarter profit this year. That’s after shelling out $28.8 billion for pay and benefits, financial statements show.

Those profit and pay figures are more than double those seen in the first quarter of 2000, the last days before the dot-com bubble burst. New York’s comptroller estimates Wall Street’s 2006 bonuses will generate $1.6 billion in state tax revenue.

Cocaine and hillbilly heroin
“To my knowledge, we have not seen an uptick in drug use,” Morgan Stanley spokeswoman Jean Marie McFadden said.

The other five firms declined comment or did not return telephone calls.

But Cass said opiate abuse among his clients is rising and they openly talk about being hooked on prescription drugs like OxyContin, known as hillbilly heroin.

“That’s what has changed from previous booms on Wall Street,” he said.

Cass and Stratyner said their clients sometimes conceal their habits by taking prescription drugs they get for back surgery or sports-related injuries. The Internet has also expanded the black market for drugs.

Wall Street professionals in their 20s use Ritalin and Adderall, prescription drugs used to treat attention-deficit disorder and hyperactivity, to enhance their performance as they grind out 100-hour weeks, Cass said.

Big bonuses and the need to blow off steam have helped invigorate demand for cocaine in Manhattan, according to two junior bankers who did not want to be named.

Juan Rodriguez, convicted of selling drugs to investment bankers and other professionals, said his clients never complained about the price of cocaine, even as it escalated.

“My customers were all business individuals,” Rodriguez said, citing Morgan Stanley bankers as among his clients.

Morgan Stanley said the company has a strong policy against substance abuse and uses random drug testing.

Passing the test
One hiring manager at a major New York bank said new staff must take a urine test, which is typical for the industry. But he said new hires can choose when to schedule the test during a 45-day period before their start date.

“Our drug test is not so much a test of whether you actually take drugs as it is an intelligence test to see if you can figure out how long it takes to get traces of the drug out of your system,” said the manager, who asked not to be named.

The hiring manager said his employer also had a policy of random drug tests for employees but that in several years he had never encountered anyone subjected to such a test.

Drugs are not the only reason for executive meltdowns.

Overwhelming pressure and anxiety to meet profit goals undid star trader David Becker as he rose the Citigroup ladder.


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Nine months after becoming global commodities chief, Becker found himself on the fast track to prison. The largest U.S. bank discovered in 2004 that Becker and others conspired to overstate profits by $20 million.

Becker, 41, pleaded guilty and is serving a 15-month sentence in federal prison. He declined to comment.

Before he committed his crime, he sought psychiatric help to deal with the pressure of balancing family and career, court papers show.

A metaphor for his life was a painting he owned depicting a man being pulled by all four limbs, Becker’s psychiatrist, Dr. Barbara Deutsch, wrote to the judge in the case.

“He felt enormous pressure to make the group’s budget at all costs,” Deutsch wrote. “He felt identified with this tortured man.”

Amid Financial Excess, a Revival of Austrian Economics

Does the U.S. risk repeating the mistakes that led to the Great Depression? The Bank for International Settlements’ annual report, released Sunday, suggests that it does, and offers a remedy steeped in the doctrine of Austrian economics.

In the 1930s adherents of the “Austrian school,” named for its Austrian-born proponents Ludwig von Mises, Joseph Schumpeter and Friedrich Hayek, argued the Great Depression represented the unavoidable remediation of misallocated credit and overinvestment in the 1920s. The Austrian school largely failed to become orthodoxy as first Keynesian demand management appeared to end the Depression and later monetarism blamed the Depression on inadequate attention to the money supply.

Austrian economics, however, has enjoyed a minor revival in the last decade, most prominently at the Basel, Switzerland-based BIS, which has few formal banking duties but is an important talking shop (it is sometimes called the “central bankers’ central bank.”) The BIS’s leading “Austrian” is a Canadian, William White, the head of the bank’s monetary and economic department and sometimes-rumored successor to retiring Bank of Canada governor David Dodge. In a 2006 paper Mr. White wrote that under Austrian theory, “credit creation need not lead to overt inflation. Rather…. the financial system … create[s] credit which encourages investments that, in the end, fail to prove profitable.” This leads to an “an eventual crisis whose magnitude would reflect the size of the real imbalances that preceded it [because] the capital goods produced in the upswing are not fungible, but they are durable. Mistakes then take a long time to work off.” He argued that in recent decades, “financial liberalisation has increased the likelihood of boom-bust cycles of the Austrian sort.”

Although the concluding chapter of the BIS’s latest annual report, released Sunday, never mentions the Austrian school, it is suffused with its influence. “Virtually no one foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s, respectively,” it begins. “In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a ‘new era’ had arrived.”

It notes that “the prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003.” While fundamental economic improvements are at the root, “the market reaction to good news might have become irrationally exuberant. There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking… [S]uch endogenous market processes … can, indeed must, eventually go into reverse if the fundamentals have been overpriced.”

Apart from financial imbalances, the report argues the world economy also displays dangerous misallocations of capital. In its “recent rates of credit expansion, asset price increases and massive investments in heavy industry, the Chinese economy also seems to be demonstrating very similar, disquieting symptoms” to Japan in the 1980s. “In the United States, it is the recent massive investment in housing that has been unwelcome from an external adjustment perspective. Housing is the ultimate non-tradable, non-fungible and long-lived good.” In other words, the U.S. could be stuck with a lot of houses that are hard to sell to each other and impossible to sell to foreigners, and won’t need replacement for a long time.

What does the BIS say central bankers should do? Essentially, relax their single-minded focus on price stability, and tighten monetary policy when “a number of indicators — not just asset prices but also credit growth and spending patterns — are simultaneously behaving in a manner that indicates increasing exposures.” In other words, when easy credit is fueling excesses, raise interest rates to end the party, even if inflation is quiescent.

In practical terms, few central banks are ready yet to heed the Austrian prescription. Federal Reserve Chairman Ben Bernanke spent a lot of his life arguing just those sorts of prescriptions helped bring about, and deepen, the Great Depression. (See, for example, his 2002 speech, “Asset-Price ‘Bubbles’ and Monetary Policy.” Under him, the Fed remains focused on inflation. The European Central Bank has recently reasserted the importance of money and credit growth in its deliberations, but its policy for practical purposes also remains focused on inflation. The Bank of Japan comes closest to sharing the BIS view and has routinely cited the risk overinvestment as a reason to raise rates, but it has recently stopped tightening as inflation remains near zero.

As Mr. White has acknowledged, the Fed can rightly argue its practice of leaving bubbles alone and cutting rates to mitigate their bursting appears to have worked well. The post-stock bubble rate cuts may have in turn created a housing bubble whose consequences haven’t fully played out. But the strength of economic growth since 2002 appears to have placed the burden of proof on advocates of an alternative policy.

This isn’t to say Fed officials are unsympathetic to some of the BIS’s diagnoses. Some, in particular New York Fed president Tim Geithner, regularly warn that risk-taking is at an extreme and a reversal could trigger a self-reinforcing spiral of price declines and asset sales. Yet, having thought it over, they’ve concluded anything the Fed does with interest rates to address this risk would likely make matters worse. –Greg Ip

Has the global bubble Popped

Is this the 'Big One'? Is the Bear Stearns blow-up the moment when America’s subprime debacle spills over into the global credit markets and pops the greatest bubble of all time?

Or have China, India, and Russia changed the game? Has their inclusion in the traded world economy - the “great doubling” of the global consumer base, in the words of Professor Richard Freeman – stretched the economic cycle by an extra couple of years?

Well, the coal-face analysts I talk to at Morgan Stanley, Goldman Sachs, Deutsche Bank, Barclays Capital, et al, all think there is enough liquidity to keep the global boom going well into 2008 - with Europe, Japan, and the emerging BRICs doing the heavy lifting as America takes a breather.

Most expect a nasty squall now, or soon, one that will knock another 7-8pc off stock markets, perhaps pushing America’s S&P500 down a hundred points to its 200-day moving average - currently at around 1432.

Every bull market needs mini-purges on the way. Technically, Wall Street and the Euro-bourses look wicked, with double tops and momentum indicators tipping into the graveyard (RSI, ROC, Stochastics, and MACD).

So no, the 'pros' are not yet calling the big one. But then they never do, until it happens. Such is the curse of consensus, and slavery to linear economic models. Crashes are famously non-linear.

We have clues. Alchemy’s boss Jon Moulton told the House of Commons this week that the private equity boom was “somewhere near its top.” Anthony Bolton, Britain’s Warren Buffet, told a forum in Monaco that the vast CDO and CLO debt boom was based on false models and could “collapse”.

We learn that investors in the Bear Stearns Enhanced Leveraged Fund are getting offers of just 5 cent on the dollar for their stakes. A wipe-out, in other words.

The Bear Stearns rot goes much deeper of course. When Merrill Lynch forced a fire-sale of assets, it revealed that even A-grade tranches of these CDO mortgage debt securities were worth just 85pc of face value, and the B-grades nearer zilch.

The creditors orchestrated a quick cover up, but the CDO cat is already out of bag. We now know that some $2 trillion of subprime and 'Alt A' mortgage debt is falsely priced on the books of banks and funds worldwide. Worse is surely to come. Bank of America warns that $500bn of adjustable mortgage debt in the US will be reset upwards in the second half of this year by an average 2 percentage points, and a further $700bn next year.

For now, bears are all watching the yield on that 10-year US Treasury bond – the benchmark price of world money, the Christmas Tree upon which all the other baubles hang: property booms, the emerging market bubbles, leveraged buy-outs, hedge funds and private equity, those $410 trillion in derivatives contracts (seven times global GDP) and that $2.5 trillion of debt packaged as “structured finance”.

The yield surged 65 basis points from early May to mid June to nearly 5.25pc on inflation scares, the fastest rise since 1994. Interestingly, the 94 bond shock did not in itself cause a US recession. But then the US was a very different country. There was no housing bubble, for starters.

However, it did set off the chain of events that led to Mexico’s Tequila crisis and the China bust a year later. Notice the time delay. My guess is that the latest credit crunch will set off a slow-fuse crisis in Eastern Europe, now the epicentre of speculative excess. Watch Hungary and Latvia, both current account disaster cases.

For now, the 10-year yield has since slipped back to 5.04pc. Don’t be fooled. Part of that is a fear reaction as spreads widened between quality and junk. There most certainly is a credit crunch at the low end – or a “gale force wind” in the words of SocGen’s debt guru, Suki Mann.

Just $3bn of the $20bn junk bonds planned for issue last week were actually sold. A long list of leverage buy-outs and dodgy floats have been pulled, or cancelled. Alliance Boots will have to pay 35 basis points more for the £9bn of debt required for its own jumbo buy-out by KKR.

(Strange, is it not, that victims of these bandit raids should have to pay for their own funeral pyres. Why is KKR not be raising its own debt, on its own books, or have we all lost sight of the greater morality here?.. But I digress.)

Roughly $300bn of leveraged buy-outs waiting in the pipeline will face a frosty reception, and perhaps a volley of rotten eggs. Without the takeover spree to juice the stock markets, the indexes will falter and then fall back.

Never take my rotten advice on the markets, but it might be good time to cash in a few stock gains, and rotate a little wealth into banal interest-bearing accounts. The cycle is already one year beyond its normal life. The balance of risk and reward it turning ever less friendly. Ambrose Evans-Pritchard in The Telegraph

WARY INVESTORS PEEK OVER THE HEDGE

By RODDY BOYD
July 2, 2007 -- Shell-shocked mortgage bond traders who just closed the books on a surpassingly ugly June are eyeing the calendar warily, waiting for the next two weeks to bring the first word of just how much damage hedge funds sustained as a result of the subprime mortgage mess.

With a series of bad bets on subprime bonds and arcane structured securities triggering the near-collapse of two Bear Stearns hedge funds, wide swaths of the $6 trillion mortgage-backed bond market have sold off sharply. In turn, it is believed that many investors - especially hedge funds, which can borrow over a dozen times their capital base - have seen their already lackluster performance shellacked.

If the performance of subprime investors is as bad as expected, institutional hedge fund investors and the investment banks that loan funds money and clear their trades will be faced with investors' concerns over capital withdrawal, matched by the banks' need for better collateral and reduced exposure.

With a fear of lawsuits for breach of duty and a lack of faith in the quality of the loans backing the subprime mortgages, there could be little incentive to ride out the storm.

In 1994 and again in 1998, this cycle of fund redemptions and reduced leverage resulted in something akin to a panic in the mortgage market, triggering the closing of hedge funds and brutal losses for Wall Street firms.

Already there are some unsettling indications that the global retreat from risk is spreading and Cheyne Capital's Queen Walk fund, both were hit with significant losses as a result of exposure to the mortgage bond market. Late last week, two British mortgage funds, Cambridge Place's $900 million Caliber Global Investment fund and Cheyne Capital's Queen's Walk fund, announced plans to close.

The trading on Friday gave little indication that things will get any better in the near-term. The widely watched ABX index, a key gauge of the health of the asset-backed and subprime mortgage markets, began what one market player called "a collapse." One index, called the ABX 06-2 Single-A, saw its value drop four points Friday; as recently as two weeks ago, a move of one or two points was considered unusual.

Another looming crisis is the potential for widespread downgrades by rating agencies of arcane, illiquid securities called collateralized debt obligations - essentially bonds created from pieces of other bonds. With about $200 billion worth of CDOs backed by the bonds and loans of mortgage issuers - many of which have suffered bankruptcy or near-collapse - the market has avoided disaster only because of a loophole in valuation.

However, if the rating agencies begin downgrading CDOs, these securities could be re-valued, potentially sending their market prices down as much as 50 percent.