Wednesday, June 20, 2007

Subprime Problems Return

Market Action:
Here we are, with the Dow down almost 150 on Wednesday. This follows a couple of days that could have been substituted by a hibernating bear; sorry for the confusing metaphor but…the market has been very dull until Wednesday’s afternoon trading. After last week Friday’s CPI news, the market did jump out of the blocks and traded a bunch of shares, partly due to options expiration (quad witch again).

Bear Stearns Auction:
Probably the biggest news of the week, in our opinion, is the blow up of two of Bear Stearns’ real estate hedge funds. Not that we are surprised that a real estate fund might be having trouble, it’s just the Way it’s trouble is being handled. We feel the need to spend some time on this topic this evening due to the significance both to the economy and to our position on the subject.

Apparently, Merrill Lynch has seized some of the funds’ assets and is trying to sell them to get themselves off the risk. According to a WSJ article, Merrill Lynch circulated “a list of about $850 million of the mostly highly-rated complex securities used as collateral for the” funds.

In Wednesday’s WSJ, a front page article on the subject (highly recommended reading) noted that the funds had $9 billion in loans which the funds’ managers were trying to get others (Goldman Sachs and Bank of America) to take over those loans. The article says that a few weeks ago, these two funds had assets of $20 billion, “most in complex securities made up of bonds backed by subprime mortgages”.

According to the article, “In recent weeks, however, the firm’s [funds] have been besieged by investors and lenders trying to recover their money as the value of the funds’ underlying bonds fell sharply.” This was after one of the funds “reported that its value fell 6.75% in April after the fund’s bets on the mortgage market went wrong. Two weeks later, it put the loss at 18%, spooking already-nervous investors and creditors and sending many of them running for the exits.”

Now, here is where the story gets interesting, and scary we might add.

The article continues, “Unlike stocks and Treasury bonds, whose prices are continually quoted and easily obtained, many of these derivative instruments trade infrequently and don’t have clear market prices. To come up with market values for these investments—a process known as ‘marking’ to market—investment funds often rely on their own valuation models.”

And, “As of March 31, the Enhanced Leverage fund had $638 million in investor capital and at least $6 billion in borrowings. It used the money to make $11.5 billion in bullish bets and $4.5 billion in bearish bets…Its sister fund had $925 million in investor money, and made $9.7 billion in bullish bets and $4 billion in bearish bets.”

Did you read that right? So, the two funds had roughly $1.5 billion in capital and nearly $30 billion in assets. That’s a 5% capital ratio, borrowing $20 for every $1 it had. These assets are valued based on their own valuation models, not what the market might have considered the value of the assets.

Near the end of the article is a quote from Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm in Chicago, “No one in the subprime business wants to ask the question of whether they need to re-mark all the assets. That would open the floodgates.”

Enter Merrill Lynch, trying to sell $850 million of their assets. Merrill said that anyone could bid on these assets at an auction that was to take place after the close on Wednesday.

We don’t need to go into the types of assets that were on the block, like CDO’s squareds, but suffice it to say that these securities are fairly complicated. A quote from Mark Adelson, who is a managing director of fixed income research at Nomura Securities, in the online WSJ this evening says that, “ CDO squareds are complicated things, and even the smartest guys can’t figure out what to bid on them in one day.”

These are clear problems in the finance world but the reason for their problems goes back to the original mortgages granted to people who Should Not have been loaned this money. Real people are getting hurt because of these exotic mortgages and underwriting practices.

Wednesday’s decline in the stock market seemed like enough to declare a small victory for the bears but we certainly don’t see it that way. There continues to be the smallest possibility that the June 4th Dow highs can hold but we don’t have much confidence in that at the moment, especially since the NASDAQ indexes have made new highs since then. The several indexes we follow are not tracking with each other at the moment and for the time being we think it would be best to stand aside.

If we notice something that contradicts this position over the coming weeks we will immediately identify it here but, in the mean time, we plan to post only on Wednesday evenings and at other times of interest.

You may want to check out the True Contrarian at the link to the left. He seems to be posting once a week again.

As always, your comments are welcome. We know that the market is close to turning over but until it does, we need to stay to this weekly format.

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