At These Levels

This is definitely funny from Alphaville:

Dresdner Kleinwort’s global strategist gives his spin on the official Canadian Moutain Guide for when the bears are coming.

How to avoid an encounter in the first place

1. Larger size groups are less likely to encounter bears - (so have a diversified portfolio)
2. Make noise, to let the bears know you’re coming and give them time to get away - (don’t be complacent; assume a bear market might be just around the corner.)
3. Watch for fresh signs, such as paw prints and droppings - (check the technicals)
4. Keep your dogs on the leash at all times - (risk managers should keep a close watch on traders.)
5. Use extra caution during berry season - (seasonality matters; the market is more vulnerable during the third quarter.)

An this is on the money and relevant to Friday's post and much much more.

I keep posting these things here as this is what the stock market cares about at the moment.

Bloomberg:

Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

The highest default rates on home loans in a decade have reduced prices of some bonds backed by mortgages to people with poor or limited credit by more than 50 cents on the dollar and forced New York-based Bear Stearns Cos. to offer $3.2 billion to bail out a money-losing hedge fund. Almost 65 percent of the bonds in indexes that track subprime mortgage debt don't meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.

That may just be the beginning. Downgrades by S&P, Moody's and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets.

``You'll see massive losses from banks, insurance companies and pension managers,'' said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York and co-author of a study last month that said S&P, Moody's and Fitch understate the risks of subprime mortgage bonds. ``The longer they wait, the worse it's going to be.'' [my bolds]

The paper quoted above. Two charts from his paper that show the size of the problem.

The bond market has already downgraded many of the bonds (first chart) and there are a lot of such bonds out there (second chart), but because they are not marked to market, many institutions are holding bonds that are worth 50c on the dollar, yet they are accounted at par. This will result in a lot of forced selling when the actual downgrades hit; this is what Bear Stearns is trying to avoid.

The financial sector is showing notable underperformance of late to the rest of the stock market and it so happens that it is the biggest sector in the stock market and general economy. This was a dead cat bounce on Wednesday and this is how I am playing it on my working vacation. And the Fed yesterday did not help…

Yes, gold and silver have sold off along with stocks. We have seen that decline in all assets -- commodities, stocks, bonds -- at the same, several times already. This is just a function of unwinding leverage. You borrow money to buy anything that is going up or yields more, and you keep making the same trade until kingdom come.

The borrowing is generally done in yen or Swiss francs (the lowest yielding major currencies) and the party continues until the music stops. All we need now is for the yen to start rallying big time (it did yesterday), to add some fuel to the fire. In February it looked like the music had stopped, but someone tipped the orchestra well and the party went on. Now, I don’t know…

Bill Gross is on the wires with his new investment outlook and the worry du jour – subprime blowups:

Whew, that was a close one! Ugly for a few days I guess, but it could have been much worse! No, I refer not to Paris Hilton upon her initial release from the LA County pokey after serving three days of hard time, but to the Bear Stearns/subprime crisis. Shame on you Mr. Stearns, or whoever you were, for scaring us investors like that and moving the Blackstone IPO to the second page of the WSJ. We should have had a week of revelry and celebration of levered risk taking. Instead you forced us to remember Long Term Capital Management and acknowledge once again (although infrequently) that genius, when combined with borrowed money, can fail. But (as the Street would have you believe), this was just a close one. Sure Bear itself had to come up with a $3 billion bailout, but folks, most of these assets are worth 100 cents on the dollar. At least that’s how they have ‘em marked! Didn’t wanna sell any so that someone would think otherwise…no need to yell “fire” in a crowded theater ‘ya know. After all, hasn’t Ben Bernanke repeated in endless drones that financial derivatives are a healthy influence on the financial markets and the economy? And aren’t these assets well…financial derivatives? Besides, I direct you to the investment grade, nay, in many cases AAA ratings of these RMBS (Residential Mortgage-Backed Securities) and CDOs (Collateralized Debt Obligations) and defy you to tell me that these architects were not prudent men. (Sorry ladies, they are still mostly men!)
 
Well prudence and rating agency standards change with the times, I suppose. What was chaste and AAA years ago may no longer be the case today. Our prim remembrance of Gidget going to Hawaii and hanging out with the beach boys seems to have been replaced in this case with an image of Heidi Fleiss setting up a floating brothel in Beverly Hills. AAA? You were wooed Mr. Moody’s and Mr. Poor’s by the makeup, those six-inch hooker heels, and a “tramp stamp.” Many of these good looking girls are not high-class assets worth 100 cents on the dollar. And sorry Ben, but derivatives are a two-edged sword. Yes, they diversify risk and direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets. Houses anyone?

The video of the interview is here (7 min). Ain’t over till it’s over? Not even close. Those VIX volatility bands say there is more.

 www.stockcharts.com

I almost missed the good doctor in the FT, but this is a slightly less acidic version of his well-estabilished views.

I thought the VIX was itching to go up back here (more than once, scroll down). I can’t explain the delay in beginning of that spike, but it looks to have started. The catalysts: Bear’s failing hedge funds due to the subprime meltdown. And it is not only Bear.

www.stockcharts.com

This may be the tip if the iceberg, but this is only understood by the institutional crowd. That raises the odds of a fast move, as the majority is clueless as to the depth of the issues.

Bear Stearns sweeps the problem under the carpet:

Largest Since LTCM

``The problem is not what we see happening, but what we don't see,'' said Joseph Mason, associate professor of finance at Drexel University in Philadelphia and co-author of an 84-page study this year on the CDO market. ``We don't know the price of these assets. We don't know which banks are exposed to this sector. These conditions are the classic conditions for financial crises across history.''

The bailout of the [Bear Stearns] fund would be the largest since Long-Term Capital Management LP, which received $3.625 billion from 14 lenders in 1998. After Long-Term Capital, run by John Meriwether, lost $4.6 billion, lenders including Merrill and Bear Stearns agreed to take a stake in the Greenwich, Connecticut-based fund.

They sold the assets over time to limit the impact of its collapse.

This is Mason’s paper referenced above. I have only skimmed it so I don’t know how good it is. The charts may be very interesting for those that have not seen them before.

If the problem is "solved", why are the futures down so much that early in the morning (NDX -10.00)?

Regarding a comment made yesterday:

Bear Stearns Fund Collapse Sends Shockwave Through CDO Market

By Mark Pittman

June 21 (Bloomberg) -- Merrill Lynch & Co.'s threat to sell $800 million of mortgage securities seized from Bear Stearns Cos. hedge funds is sending shudders across Wall Street.

A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark. The securities are known as collateralized debt obligations, which exceed $1 trillion and comprise the fastest-growing part of the bond market.

Because there is little trading in the securities, prices may not reflect the highest rate of mortgage delinquencies in 13 years. An auction that confirms concerns that CDOs are overvalued may spark a chain reaction of writedowns that causes billions of dollars in losses for everyone from hedge funds to pension funds to foreign banks. Bear Stearns, the second-biggest mortgage bond underwriter, also is the biggest broker to hedge funds.

The rest. It used to be great to be a prime broker...

I am on vacation. Therefore, my posts here will be few. Not that I don’t have the time under normal circumstances, but wireless data cards for laptops here are not as reliable as advertised, which makes the process not worth the multiple headaches.

I had missed that violin hedge fund the good doctor has found while traveling:

Old violins are playing the last waltz!

If, as I believe, the US economy has already reached the stagflation phase (weak economy but accelerating inflation), rising interest rates come at a very inopportune time for the economy and also for asset markets.

I concede that some bubbles outside the US seem to be even more blown up than the US economic (notably excessive consumption) and financial market bubble (in particular excessive debt).

But, as I explained before, when one bubble after the other is gradually deflating, to play the last few asset classes that increase in value (London properties, Chinese equities and other emerging markets and their currencies) becomes increasingly dangerous.

Playing violins

As a sign of how far the global asset bubble has already matured is the recent launch of a hedge fund that invests in old violins. And according to Florian Leonhard, a London based violin dealer and restorer, it is 'financially a dead-secure long term investment' with a target of returning 8% to 12% per year!

Therefore, as indicated in recent reports, I would lighten up on positions in asset markets, which are extremely extended and where the risks seem to outweigh the returns. The number of assets, which are still rising, is narrowing and it appears that one inflated asset class after another is gradually no longer appreciating.

The rest, which has relevance to Monday's post, is highly recommended.

No matter if you talk about yields,

www.stockcharts.com

or bond prices,

www.stockcharts.com

we have a “lordee mercy” situation in the bond market.

The bond bull market that begun in 1982 probably ended in 2003 at the time of the lowest tick in yields/highest tick in bond prices. No one knew it at the time, but this bond selloff here sure looks like the game is over for the bonds.

I am sure the bonds will rally at some point. They won’t go down in a straight line. And those that are telling you to buy them now will say that they were right. But if you go back and think just a little, you will see that every bond rally since 2003 has been a selling opportunity. Every high in prices has been lower and every low has been lower too (inverse for yields). So, the bond buyers have been wrong since 2003 and have been fighting the tape, and I don’t expect to see them stop doing that anytime soon. Until the market teaches them an expensive lesson that is.

Bill Gross is a great man. But here is what he has done with his forecast in the past three years. First, the 10-year yield was about to trade between 3-4.50 percent, then it was 4-5.50 percent, now:

Wider Range

Gross, who is raising his holdings of cash and cash equivalent securities while awaiting the Fed's next move, widened his forecast range for 10-year yields on concern inflation may accelerate in countries with weakening currencies such as the U.S. Ten-year yields will probably fluctuate between 4 percent and 6.5 percent until 2011, he said. Previously, Gross said the yield would say between 4 percent and 5.5 percent.

Those are moving targets. It’s difficult to get out of a bond bull market that has lasted for so long where every bond selloff has proven to be a buying opportunity. There is still time to get that fixed-rate mortgage, if you don’t have one already.

Some quality insights from trusted sources. I have to make one note, given this infamous 2002 statement that was made by the man who now runs the Fed. How will the deflation scenario pan out if the cost of money is zero according to Ben?

How likely is this to stop getting more extreme with the bonds doing what they are doing? Most of that data does not capture the latest spike.

The LBO boom that has been keeping the stock market up despite the collapse in housing:

Morgan Stanley, Bain LBO Costs Jump; KKR May Pay More on Bonds

By Edward Evans

June 11 (Bloomberg) -- The cost of financing leveraged buyouts is rising after last week's tumble in U.S. Treasuries pushed yields on 10-year notes above 5 percent.

Hub International Ltd., a Chicago-based insurance broker being purchased by Morgan Stanley and Apax Partners Worldwide LLP, cut the size of a planned $790 million bond sale and boosted the interest rate by a quarter percentage point on June 8. South African retailer Edgars Consolidated Stores Ltd. increased the yield on 1.18 billion euros ($1.58 billion) of notes used to finance its acquisition by Bain Capital LLC the same day.

Bain, based in Boston, Kohlberg Kravis Roberts & Co. in New York and dozens more private equity firms have relied on low-cost debt to finance $1.4 trillion of takeovers since mid-2004. Now, yields are rising just as they sell bonds and loans for some of the biggest deals, including the $32 billion takeover of Dallas- based utility TXU Corp. and the $26 billion purchase of First Data Corp., a Greenwood Village, Colorado-based credit-card payment processor.

More here.

But those interest rates are rising fast, aren't they?

Tony Crescenzi of Miller Tabak on the bond move (7 min video). No Fed rate cut soon equals lower bond prices and higher yields.The higher dollar resulting from the perception that there will be no Fed rate cuts soon clocked precious metals, even though there is an inflationary problem at present. I would view this as a precious metals' correction -- not the start of a rout -- unless the dollar rallies below 1.30 against the euro.

It sure takes a long time for these things to get going but the message of the VIX has been clear. They are betting (scroll down a couple of posts) big time. That's it for this week.

 www.bloomberg.com

I am about to fly to Eastern Europe on Thursday after a 9-year hiatus. I have a lot of office work I need tot get out of the way so don’t look for much in this forum this week. There will be more weeks like that depending on my traveling schedule in the next three months.