just more stuff

Two trades:

short GS @ 220.14 - any ABX index mortgage backed security now costs more to insure against default than it's worth... meaning that losses cannot be hedged against. BBB and BB rated mbs's have lost an average of 30%. Time for the creditors to call in their debts. GS has the most hedge fund exposure or the big five, but they all fell 10% in tandem in February.

long NFI July $2.50 puts for $0.05. - No, I don't think they'll be out of business by then. However, no one will buy them out now, and they might lose more money on their next sale of mortgages.

I still have some ammo on the sidelines, but now I have a 1.5:1 short ratio (60:2 if you count potential for options)

They're Done!

Last time I had that thought, it was February 15th, one week before subprime completely imploded. Crap. I thought it was about a month. I don't have much time.

The hedge funds are done.

Here's how I know: I got confirmation that my earlier (today) speculation that banks could make a run on the funds is both likely and imminent.

The first bit of info came courtesy of theroxylandr. Here are his charts:

In this chart, we see the 20% jump in corporate bond spreads over Treasury bonds. This explains announcements of $3 billion in corporate bond issues that have been postponed or canceled. Why? Because very much of the debt that's being issued makes no sense anymore. Any more? Obviously, credit has gotten much more expensive. Deflation is coming.

This chart is of the residential mortgage index. As theroxylandr points out, "We are well below February panic levels." (Should've bought NFI Jan '09 2.50 puts for 0.20 three days ago. Now they're 0.55.)

This chart is for commercial real estate backed mortgages.

This first bit of info clearly shows that the banks will have to raise margin whether there's anything for them to gain or not. We have four fund implosions and counting so far. These charts make it manifestly obvious that subprime defaults are not contained.

Here's the second bit of info, courtesy of this comment by PEAK DEBT on Russ's Winterwatch.

PEAK DEBT wrote:
CDO^2 “Super Senior” AAA ColorHedge Fund attempted to buy protection on 5 different deals @ 10am today. Hearing best offer for protection from the entire dealer community was 90-95 points upfront and 5.0% running premium. This would mean that the dealer community that created these CDO^2 structures and sold them at 100 cents on the Dollar w/in the last 6 months actually beleives that these deals are worth less than 5 cents on the Dollar. Another Hedge Fund is trying to buy protection on 24 different CDO^2 line items totaling 280mm at 3pm today. Look out below!
Posted on 28-Jun-07 at 11:29 am

Panic! The rats are fleeing the ship! When protection costs more than what you're protecting, then if it breaks, it's worthless. Losses will be terrifying! Time to set up a tollbooth on the ratlines.

They're Done!

bad and getting worse

Here's another article on the subprime rot spreading up the credit chain. Credit is still tightening. Bloomberg reports that "Cambridge Place Investment Management LLP said today it will close the $908 million Caliber Global Investment Ltd. fund after losses on U.S. subprime debt," and "At least eight companies abandoned bond sales this week."

We're entering a period where these funds could fold on a daily basis, as any loss at all will cause a margin call. Remember, the beauty of CDO's is that you can put almost any price on them. However, when someone else lends you money, THEY get to put any price they want on them.

In other words, institutional lenders to hedge funds can pretty much help themselves to any hedge fund assets they want to, simply by raising margin on subprime-backed CDO's.

I think this is a possibility that could prove too much temptation for someone to pass up. Merrill Lynch bears watching closely, since they have inside knowledge of the Bear Stearns assets and what they're worth. They are also one of the largest institutional lenders to hedge funds.

In the meantime, until credit tightening catches us with foreign central banks, fewer choices for them should create greater demand for Treasuries, probably the ones with higher yields. We could see the yield curve flatten out again in the next few months. We will almost certainly see credit spreads widen.

I think cash is the best place to be right now. Any market rallies will be self defeating; the higher they go, the greater are the chances of killing the private equity buyouts.

As far as the Fed goes, Bernanke will announce, "Given our expectations for GDP growth to rebound in the second quarter, our stance on interest rates remains unchanged. The housing market is slightly weaker than expected, but that weakness remains contained. Housing weakness and rebounding growth should continue to temper inflation expectations caused by full employment and capacity utilization."

The market will take off for a couple of days until Bernanke decides to throw some cold water on it.

not over yet

I would not have been surprised if there had been a market crash today. Unfortunately, I still don't have options funding yet, but that should be rectified tomorrow.

Sold FRO, OPX, and RIO at the open. Account was even, instead of taking a 0.5% loss.

It seems that the market is confident of Wall Street's ability to hide the problems within the Bear Stearns hedge funds scare. I'm pretty sure they will. However, what they cannot control is the fact that the banks no longer trust the ratings systems on the CDO's. They are demanding more collateral from hedge funds before specific CDO's are downgraded by S&P, Moody's, etc.

As the defaults roll in, this problem can only get worse. Credit will get tighter. Spiking rates will alternate with flight to quality.

playing catch up...

because I didn't have my option account funded until today. I could have been all over this Bear Stearns (BSC) subprime hedge fund liquidation scare since last Thursday. Oh, well. I've got to be patient and not hurt myself trying to jump onto a moving train. This weekend will be pivotal.

Jim Cramer says that this scare is overblown because it's different from the subprime scare in February. This is a "liquidity" crisis, not a "credit" crisis. New Century went bankrupt because their loans went bad, and subsequently their funding was cut off. The other firms are purposely trying to squeeze BSC. In this case, Cramer says the margin call came as a result of too many redemptions, not defaults on CDO assets. Fair enough. I have one question for Cramer, though. "Do you think redemptions from other funds will increase this week?" While he is right that a bailout is more easily worked out in this situation, there are oodles of boodle to be made by shaking the tree for many funds that are short. The big firms might lose their grip and scare everyone too much. This weekend is pivotal.

options

bought:

IEF Dec 2007 78.00 put (IEFXZ.X) for $0.40. - I see 10-yr. treasuries falling as defaults rise

WM Jan 2009 20.00 put (VWIMD.X) for $0.30 - can you say $58 billion in option ARM's?

looking for options

Here are some options I looked at over the weekend, with comments:

CFC Jan. $30.00 put @ $1.20 (3%)
XHB Dec. $30.00 put @ $1.55 (5%) - expensive
GS Jan. $175.00 put @ $2.42 (1%)
TOL Dec. $22.50 put @ $0.85 (3%)
IEF Dec. $78.00 put @ $0.45 (0.6%) - #1, very cheap
MS Jul. $80.00 put @ $0.40 (0.4%) - cheap
SPY Dec. $122.00 put @ $0.60 (0.3%) - very cheap
FXY Dec. $87.00 call @ $0.80 (1%)
AGG Dec. $99.00 put @ $1.50 (1.5%) - ask is $4.50 (4.5%) - too expensive
BSC Jan. $120.00 put @ $2.30 (2%)
AMZN Jan. $57.50 put @ $3.10 (4%)

Uh, Oh!

Remember how the subprime collapse was "contained?" Well, not according to this story. It seems that even after selling $4 billion of mortgage CDO's on Thursday to meet a margin call. There's been no word on what they lost on the sale. However, it appears that they weren't able to meet the call. Nice of them to hide the news over the weekend. I wonder how deep this runs. It's probably really bad. The fund is a $6 billion fund. They lost 23% Jan. through April. That's about $1.5 billion. They had $300 billion in redemptions before they prohibited them. Who knows how much they lost on the margin call. 10%? Now Merrill seizes $400 million. The fund will close, but how badly will it hurt Bear Stearns? Merrill? The industry?

Just another reason to short the market beginning with bonds, financials, and homebuilders.

It seems to me that there's a distinct risk of a scenario that I haven't heard from anyone. It plays out like this. The U.S. slides into recession, and defaults go up. The Fed cuts. Instead of going down, the 10-yr. rates climbs higher and higher, causing defaults which in turn cause a higher rate. Remember, the Fed only controls one end of the yield curve.

market news

May retail numbers came in at double analyst expectations. The market responded positively; bonds and stocks were up. I would have expected a further decline in bonds as any good economic news raises the prospect of higher rates. Maybe they're already priced in. Or maybe the market is more worried about inflation than higher rates and is willing to accept higher rates if it won't hurt the economy.

In the meantime, I will sit on my hedge and limit my upside for downside protection.

In currencies, I am long NZD/USD. I went to full leverage today, after the dollar jumped against everything else and the NZD kept up. It's recent strength against the dollar should attract more inflows, especially since it's absolutely killing the Yen. The carry traders should be emboldened considerably.

Hedged

I hedged the portfolio 50/50 long short today. I sold Adobe because it doesn't fit into my portfolio no matter which way rates go. Adobe needs an economy expanding faster than inflation and interest rates. If rates go up, the economy will not expand enough to encourage tech spending, and if rates go down, it will be because the economy is in the crapper.

Which it might be soon, as Realtytrac announced that May foreclosures were up 90% year over year and 19% month over month. Ouch. If this is our spring selling season, then the rest of the year will only get worse.

The second and bigger move in my hedge was to buy Ultrashort S&P 500. I was tempted to buy OPX on the chance of a bounceback, but I've gotten to the point where I think it's wiser to stop the bleeding than to go on the offensive. The more carnage the bears wreak, the greater the chance that the bulls will panic and leave the field. I haven't left the field, but I did sue for peace. That will give me a chance to safely watch for a sign of which way the market will go.

getting killed hanging in here.....

Fortunately, tomorrow the May retail numbers come out. They should give me an indication about whether the economy has continued weakening from the first quarter. If so, I'll stick to my guns, if not, I'll have to cut back a couple of positions and add a short.

I will try to add some options. The iShares Lehman 7-10 Year Treasury (IEF) December $83 calls are only at $0.20. That's dirt cheap. The 10-yr would only have to swing back to about 4.7% to make that profitable. However, volume is pitifully thin on it and I'm not sure I can get it.

In the meantime, while I'm deciding to stick out the market's rising rate jitters, I should look for an option to hedge. Maybe I'll buy a short-term IEF call and a longer-term put. Don't know yet, but I'll put it up here when I make a decision.

rates

The question of where rates are going and why is of paramount importance for me to determine any other strategy. This is because where rates are going will determine whether we have a bear or bull stock market.

Unfortunately, my thoughts have kept flip-flopping, with varying degrees of certainty as I consider different aspects of this incredibly complicated question.

In formulating the following analysis, I tried to take a step back from some of my recent considerations to simplify the question as much as possible.

I can see two reflexive processes at work in global economics today. The first, causing credit expansion, has continued while at the same time feeding its enemy, contraction. Eventually the contractive forces will overcome expansionary ones, at which point, the expansionary forces will disappear. Credit will contract, collateral values will shrink, and the authorities will be forced to step in to keep things from getting out of control.

Let me flesh this out a more specifically. The first self-reinforcing process is that of credit expansion. This consists mainly of China and OPEC lending money to the US to promote more demand for their goods. It is self-reinforcing, especially with China, because the system requires the creation of ever more credit to sustain the same level of trade deficit. This creates the political will to tolerate a negative rate of return in order to promote economic growth. At the same time, the system is also self-defeating. There are three main reasons for this. First, there is inflation caused by pegging currencies to the dollar. Second, asset bubbles are caused by overheating economies. Both of these cause global bank rates to go up. Third, the trade deficit is a drag on economic growth. Slower growth, together with lower currency yields than the rest of the world leads to a weaker currency.

As the dollar weakens, that in turn puts more pressure on foreign inflation, foreign asset bubbles, and makes the trade deficit worse. We can see that the contractionary forces are self-reinforcing as well.

fog lifting a bit

The market recovered 150 points today. However, there were more signs that the clock is ticking on liquidity. For one thing, the trade deficit was down 6.8%. Imports of cars, and clothing led a 1.9% monthly decline. Deficit with OPEC was down, but China's was up. Another sign of a weakening economy is that consumer confidence came in at a 10 month low.

A bad economy is good for stocks. Inflation is good for stocks. A falling dollar is good for stocks. We have all three right now. For the time being, the market will continue to do well.

The reason that the market is so confused is the size of the conflict in the global picture. Will rates go up or down? On the up side, we have global growth. Growth is feeding global inflation. Inflation is causing foreign central banks (FCB's) to raise rates and break dollar pegs. This causes a declining dollar and causes inflation here in the US.

On the other hand, the US is the focal point of the world economy, and our economy is a stone's throw from recession. Housing has not gotten better, despite a dozen predictions of a recovery. Instead it's gotten worse. For the past three months now, we've had weakening consumer sentiment and poor retail numbers. Rates will fall, but the question is when.

In the meantime, the market should be ecstatic when sentiment swings back in favor of rate cuts. That is, until they realize that the rate cuts are coming too late (they usually are). This last part is pretty much pure conjecture. I'm just assuming that market sentiment will stay the same. "Rates are coming down! Let's buy!" instead of "Uh, oh. Things must be really bad if they're going to lower rates."

There are many perils along the way as we approach the turning point from credit expansion to the coming credit contraction.

trying to get my thoughts straight

I sold FXY today because bonds have dropped the most in three years. The dramatic fall of bonds has propped up the dollar.

The yield curve is now no longer inverted after the 10-yr yield rose to 5.13% from 4.97% yesterday, and for the third straight day. This comes together with news this week of Syria breaking it's dollar peg and speculation that the U. A. E. will be next. In addition, Australia's economy is stronger than expected, and the bank of New Zealand roiled the markets with a surprise rate hike to 8%.

I must admit that the decline in bonds (and corresponding rise in yields) caught me by surprise. I think that bonds fell for a combination of reasons. First, there is the Bernanke's assault on the idea that the Fed may lower rates. Second is the trend of countries (first Kuwait, now Syria) breaking their peg to the dollar. In addition, we have strong economic growth in Australia, and an upward bias to rates in Europe. Finally, there was yesterday's surprise rate increase in New Zealand.

The market has finally realized that global growth is forcing rates higher. The question is, how much more do bonds have to go? My stocks have gotten killed the past couple of days. Clearly, the attempt of FCB's to keep rates in the US low is not working. Is this the turning point from credit expansion to credit contraction? If it is, I would not want to be long the stock market.

Well, I don't see much to do tomorrow except to see whether rates keep rising. If so, it could quickly reach the point where buyout deals don't make sense. On the other hand, if rates subside, and FCB's step in to provide liquidity, the market will take off again.

For me, it's impossible to tell whether the speculative rush to sell bonds will trump nonspeculative bond buying. Hindsight is 20/20. Because we have processes working against each other, it is impossible which is more likely to prevail because there's no way of knowing the quantities each side is working with.

I think that today's steepening of the yield curve actually might make it more likely that rates will be dropped. Higher rates could make the housing market much worse, hurt consumer spending, and whack the stock market.

Well, time to look over my portfolio and see what I want to keep. Getting my thoughts into words has helped a little, but I'll have to come back to reread this after some more thought later today.

New Target

for the Homebuilder's index. With rates more and more likely to go up, and the Fed's aggressive (lately) stance on inflation, the target needs to be lowered. In the 1990 housing recession, homebuilders traded down to 30% of book value. My new target is moved from 20% under book ($25) to 50% of book, or $17.50.

the current global macro view

I'm rereading The Alchemy of Finance by George Soros in order to better understand the situation that the world economy is in right now. The analysis that I came up with follows below.



Since 2001, when the dollar weakened (-e), we've had a strengthening economy (+v). and low interest rates (-i) kept the dollar weak, leading to a huge trade deficit (-T).



+v & -i & -e = -T

We must make a observation about the dollar before continuing. The dollar is strong compared with countries that we have a trade deficit with. This includes Japan, China, most emerging markets, Saudi Arabia, Russia, the UAE, etc. On the other hand, the dollar is weak against most of the developed world: Europe, Great Britain, Australia, and Canada.

In order to sustain the deficit, foreign countries pegged their currencies against the dollar by buying dollar denominated bonds with nonspeculative currency inflows (+N). Nonspeculative money has continued to be greater than (>) any speculative outflows (for example, US purchases of foreign stocks).


-T = +N & -i = +v


This inflow enabled low rates which further stimulated the economy. So we can see that combined with our first observation, that this is a reflexive process.

+v & -i & -e = -T = +N & -i & +v

This is what we had up until pretty recently, and it still pretty much holds. However, there are a couple of reflexive processes working against it, mostly because it is internally unstable.

-T = -v (in the normal course of events, a trade deficit depresses the economy)

-e & -i = -S (low exchange rate plus low interest rate causes speculative outflow)

Adding this in, we currently have:

+N > -S = -i & +e & -T

As -S grows, the situation could reverse itself, giving us:

+N < -S = +i & -e & -T = -v & -e

However, we should not understimate the will of foreign central banks to keep their currency pegged below the dollar, despite inflation, losses on their reserves, political pressure, etc.

Monthly Foreclosure Update

from Ventura County, courtesy of Realtytrac.

Total delinquent, going to auction, and REO: 2,691 + 14% over May 7th.

Only REO: 927, + 9% over May 7th.