The Rude Awakening
Laguna Beach, California
Wednesday, July 11, 2007 ------------------------- - Bear Stearns, the leading indicator in a catastrophic, top-down collapse?
- Wall Street's whiz kids feel the heat - but who's left carrying the bomb?
- A few possible answers, a Rude Awakening column derivative and plenty more…
------------------------- Eric Fry, offering a derivative of Rude Awakening column, reports… At 2:30 Eastern Time yesterday, the top five news stories on your editor's Bloomberg machine were as follows: 1) S&P May Reduce Ratings on $12 Billion of Subprime Bonds Amid Loss Outlook
2) Sears, Home Depot Say Profit Will Fall as U.S. Housing Slump Reduces Sales
3) Stocks in U.S. Decline; Shares of D.R. Horton, Sears Retreat on Earnings
4) Bernanke Says Inflation Expectations Still Remain 'Imperfectly Anchored'
5) D.R. Horton to Report Net Loss as Orders Plunge, Sees No Housing Recovery The Dow Jones Industrial Average fell 148 points. We wonder why it did not fall even more. In fact, to disclose our biases, the stock market's buoyancy has been perplexing us for several weeks. We realise, of course, that financial markets can behave irrationally for far longer than the average short-seller can remain solvent. Nevertheless, the robust stock market performances of 2007 - both here at home and abroad - would seem to rank among the all-time victories of hope over substance. On the numbers, the U.S. economy is slowing, the U.S. dollar is faltering, the housing market is limping, the mortgage market is withering and the leveraged world of credit-derivative exotica is imploding. The last of these worrisome items fascinates - and worries - us the most. As noted above, S&P is, belatedly, threatening to downgrade $12 billion worth of subprime bonds. "We expect the U.S. housing market, especially the subprime sector, will continue to decline before it improves, and home prices will continue to come under stress" S&P remarked, in defence of its negative outlook. "Weakness in the property markets continues to exacerbate losses," the ratings agency continued, "with little prospect for improvement in the near-term…Loss rates, which are being fuelled by shifting patterns in loss behaviour and further evidence of lower underwriting standards and misrepresentations in the mortgage market, remain in excess of historical precedents and our initial assumptions." S&P could have reacted a little sooner to the most obvious credit debacle in history, but at least it is finally reacting. And so is Moody's. Moments before the closing bell on Wall Street yesterday, the venerable ratings agency announced it would be trimming the credit ratings on $5.2 billion of bonds backed by subprime mortgages. These billion-dollar downgrades by Moody's and S&P are big numbers, but not nearly as big as the numbers these downgrades might influence. The knock-on effects of these downgrades could be far-reaching and substantial. As our guest columnist, Paul Tustain, has been explaining in recent editions of the Rude Awakening, Wall Street's whiz-kid investment bankers have been leveraging almost every single dollar of mortgage debt into multiple varieties of credit derivatives. Therefore, as credit conditions worsen, investors in CDOs alone, stand to lose as much as $250 billion, according to Institutional Risk Analytics. CDO investors may or may not lose such gargantuan sums overnight. No one really knows. In fact, no one really knows it they've lost the money already, but just don't know it yet. That's why a modest "little" downgrade on $12 billion of mortgages inspires such angst. "When a ratings agency puts a whole [asset] class on watch, it will force all the credit officers to get off their butts and reevaluate everything," says Christopher Whalen, an analyst at Institutional Risk Analytics. In other words, a downgrade could beget panic selling - from both willing and unwilling parties. The willing sellers would include those investors who simply wish to cut their losses. But the vast swarms of unwilling sellers would include those pension funds whose charters forbid owning lowly rated securities. "Insurers and pension funds may be among the investors required to sell their bonds if they are downgraded," Bloomberg notes, potentially driving down prices of $800 billion in subprime mortgages and $1 trillion of collateralized debt obligations." The markets cannot distinguish between a willing seller and an unwilling seller, the markets only know that panic selling tends to produce lower prices. Who stands to get hurt by lower prices for subprime mortgages and/or their related credit derivatives? Our guest columnist, Paul Tustain, offers a few guesses… --- Outstanding Gold Investments --- Enjoy A Hidden Way To Buy Gold At Less Than A Penny Per Ounce… Even if $600 Gold hits $2,000 by the end of 2008… here's a hidden way you can get in for less than one cent per ounce… Avoid the Financial Maelstrom and Ensure Your Wealth With Gold. Learn How Right Here: Outstanding Invsetment Gold Report ------------------------------------ Investment Landfill…The Last Word
By Paul Tustain We have hit upon a very rough - albeit questionable - method of identifying the next big failure in the CDO/CDS market. It may be coincidence, but if we had used this method a few months ago, it would have shown us to look first at Bear Stearns. Why? Our sources indicate that Bear Stearns only has problems with those CDOs issued in respect of Mortgage Backed Securities created in 2005 and 2006. This is logical. Those CDOs were issued nearest to the peak of the US housing market, so they have the least cushion. Older CDO issues should have more headroom before defaults become a problem. This would suggest that it is those firms who were late to the CDO party who should be in the deepest water. The following data was published by Standard & Poor's in a 2005 report entitled "CDO Spotlight: Update To Sizing Collateral Manager Participation In The US Cash Flow CDO Market." This table shows the ranking - by size of liabilities - of CDO managers at the end of 2004 and in the autumn of 2005. 
Bear Stearns jumped from nowhere at the end of 2004 to 13th place. It was late to the party, in other words. But it got very busy very fast.
We do not pretend to understand these statistics fully, and we would strongly advise all interested parties to examine the original report for themselves. But what is of interest is that the data seem to illustrate how Bear Stearns aggressively sought market share starting in 2005, which could be why it found itself one of the first to be in some trouble, as subprime loans began to default. If our crude theory holds true, then the data might point to imminent distress for a few hedge funds or other institutional investment portfolios. It would be a remarkably prescient analysis by Standard & Poor's if that were to be the case. But of course it might be complete coincidence, too. Maybe Bear Stearns has better risk management, and so it is first to see where things are going wrong. Maybe other providers adopted different measures to protect their exposed funds. Who can tell? By the way, the data only concerns cash-flow CDOs. The synthetic part of the CDO market is not included. The synthetic market is bigger. Long Term Capital Management failed in 1998. It was the last truly serious financial collapse which threatened the U.S. financial system. When LTCM went under, the bail-out fund required was $3.65 billion. The fund itself was leveraged to about $125 billion of assets using a similar style of wheel-financing to the one described above for Bear Stearns' hedge funds. There was also the presence of off-balance sheet devices called interest rate swaps - not so different in principle from the CDS described above. The recent rescue package announced for Bear Stearns smaller fund has been announced at $3.2 billion. We believe the overall liabilities of both funds are in the $20-$25 billion range. Back in 1998 LTCM was ploughing a lonely furrow. Its investment view was something to do with Russian bonds and the Japanese Yen. It was off the main investment spectrum, and there were few copy-cats putting the same market view into action in the same way. That is where things are very different this time. The data produced by Standard & Poor's above show just how conventional a strategy Bear Stearns has been following - all of it trailing the worldwide boom in housing markets. Many banks and funds are involved. Perhaps they are not quite so exposed as Bear Stearns, but it is only a matter of degree. This makes the size of the problem potentially much larger, and of much greater risk to the whole financial system. How large? Well, there are about 6,000,000 subprime mortgages in the USA. They typically result from re-financing deals - topping up to utilise whatever equity has accumulated in a house, usually to pay off credit card debt; so they stay near 100% debt-to-equity. The average house price in the USA is about $190,000, but we can reduce that to $150,000 on the assumption that we're at the lower end of the market. That gives us a principal sum of $900 billion. Every 1% drop in home values, therefore, would reduce the theoretical value of the underlying mortgages by about $9 billion. Obviously, most of these mortgages will avoid default. But the mortgages, themselves, are just the beginning of the credit derivative daisy chain that threatens to unravel. We cannot forget that Wall Street has constructed multiple layers of credit derivatives atop these mortgages. Depending upon who's counting, the world's investors now hold somewhere around $1 trillion worth of credit derivatives, at market value. But since the notional value of these arcane financial instruments exceeds $25 trillion, no one really knows how large the potential losses could become during a panic. Now you can see the difference in scale between LTCM and the subprime bust. This may be 20 times worse than LTCM. And it's getting worse - daily. At a time like this, we should not underestimate the skill of people like Ben Bernanke at the US Federal Reserve in underpinning the financial system. They have been remarkably effective at organising the lifeboats over many years and many crises. On the other hand the Bear Stearns episode could be the beginning of wider systemic difficulties. Here at BullionVault we think the Bernankes of this world will one day fail. The result will be a credit squeeze. Bond issues will be pulled, bank loans recalled, and business activity will sharply decline for lack of funding. The first two of these have certainly started - with a rash of failed issues at the end of June. Will these risks be contained? We don't know. We don't seriously expect that by some fluke we will identify the tipping point as it happens; that would be too lucky. Yet we feel compelled to share our views on the current situation with you. Clearly we're biased against excessive leverage, and against too much financial ingenuity, too. That's why we're in the physical gold bullion business. We believe that real physical gold is a sensible insurance against today's increasingly weird financial system. It has been astonishingly reliable in that role in the past. But this time, who knows? Joel's Note: Paul Tustain is founder and director of BullionVault.com - the low-cost gold ownership service for private individuals wanting to access the same low fees and tight spreads as professional gold traders enjoy. Starting with a free gram of gold - vaulted offshore on your behalf in Zurich, Switzerland today - you can learn more about BullionVault, now the world's fastest-growing gold ownership service, here: http://www.BullionVault.com ----- Resource Trader Silver Alert ---- High-Ho, SILVER! Those who heeded his call banked 400% in just 34 days on this "sterling" options play - one of the 10 Triple Digit winners he picked in 2006… Join the Maniac's rampage and YOU could rake in even more than this - and faster - as the global commodities crunch escalates. Get Started Today: The Resource Trader Alert --------------------------------------- Joel's Endnote: As always, we invite your comments. Please send any CDO, CDS or other acronym-related musings to us at aussiejoel@the-rude-awakening.com . Addison and Ian are rounding up today's headlines and will have their take on them in your inbox shortly. Look out for their 5-Minute Forecast in a couple of hours. Cheers, Joel Bowman
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