Thursday, June 21, 2007

The Black Hole

Here we stand in the middle of another US/Euro equity sell off, this one triggered by bond concerns related to the housing market, just like the last wobble. So, by now everyone knows that Bear Stearns has two hedge funds that speculate in CDO's, and both funds have made bad bets. One fund was leveraged as much as 20 to 1. The amazing thing is, in all the papers, blogs and research reports, no one can actually describe the trades made or the status of the funds.

Based on the Markit Index for CDO's, the perceived risk of owning low-rated subprime-mortgage bonds created in the second half of 2006 rose to a record as loan delinquencies and mortgage rates climbed. But this index depends on sales data to price risk; if certain paper isn't trading, then how can you price risk? It sounds like the entire bond market is hoping no one will actually transact any of the crap CDO's so no manager actually has to see the size of their losses. A nice big black hole.

How much do leveraged funds have of this crap paper and what is its real price? No one knows, and no one seems to want to know. What does seem to be clear is that the housing market is not improving, the recent surge in the 10 year is making the problem bigger and it's still early in the cockroach game. There seems to an inept old man waving a flashlight around this black hole of a room, so we only see a few of the critters. Wait until he finds the light switch.

Of course, we may not have found the final sucker in this game. As stated in the WSJ," "There's an opportunity out there to buy these loans at a discount," says Lou Morrell, vice president for investments and treasurer at Wake Forest University in Winston-Salem, N.C. The university's $1.2 billion endowment is in the process of placing about $25 million with a hedge fund to invest in subprime mortgages. Because these loans could sell for steep discounts, he says, "they will be popular with a lot of endowments out there." " Well gee golly gosh, Andy.

Meanwhile the equity markets, after a huge run since the Feb/Mar correction, are susceptable to any bad news. But is there a connection? What if a lot of hedge funds are carrying a leveraged CDO position that is falling apart? Redemptions start with treasuries and other liquid fixed income assets, but do we have enough contagion that the equity assets get hit?

Must be frustrating holding a bunch of oil service, E and C, mining, equipment and ag stocks, knowing the numbers in July are going to be fabulous, while the mooks reaching for yield in their leveraged, greed saturated funds look at you like a four year old pretending he didnt just take a crap on the living room rug. And then smear it on the wall. Thank you Eric Theodore Cartman.


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