Thursday, August 09, 2007

Collateral Damage

After a three day world wide rally in all markets, Bank Paribas comes out with the classic French capitulation manoeuvre: we are too scared to price our assets in this market, so we will avoid creating liquidity for our investors and suspend redemptions. See no evil, hear no evil, speak no evil. Bouf. Who is willing to start the tsunami of repricing? Are we gonna just let Citadel come in and buy all of the crappy paper at sick discounts or are we going to try to create a liquid market and fair pricing?

It seems clear that over the coming weeks we will continue to have dribs and drabs of asset managers reporting losses, shutting down funds and retiring to the hamptons. The silly euro buyers who seem to be the major suckers at this poker table will report major losses and will suffer an even worse liquidity situation.

If this were the downside, then no worries. Some investors get hammered, the weak funds get eliminated, the remaining players have a better understanding of what derivatives mean and we all move on. Maybe this takes until October, waiting for the third quarter reports and tax year ends to clear the books. Or maybe it even takes until next spring, taking some extra time to push fund managers into a mark to market. When the ratings agencies have downgraded the investment's credit rating, the fund managers will be forced to reprice the paper.

But what about those leveraged funds and their funding partners, the banks. Funds borrow and lever up 5:1 or maybe 10:1 and buy a bunch of fixed income assets. Some of those assets are illiquid CDOs - they don't trade and therefore have no market pricing. The funds use their own internal model to decide on the price of these assets, creating an opportunity for very subjective pricing. And an opportunity for severe collateral damage for the banks' loans.

The banks are likely to decide that they need to look a bit deeper into the funds' holdings and the result is a growing uncertainty by the banks about their own risk as lender. If they can't price the assets, then they can't figure out if some of the collateral backing the bank loans is any good. The banks then ask the funds to liquidate the marketable assets and repay some or all of the loans.

Then there are the CDO ratings and the ongoing collapse of the housing market. As the default rates on mortgages, which are quite low at the major banks, start to go up, the mortgage paper gets downgraded. I suppose then the funds have to change their pricing models and then the mark downs come. The ARM resets peak in Jan/Feb of 2008, so the default rates peak maybe about June. The markets usually price in events six months ahead of time, making the bottom in this whole mess around Nov/Dec of this year.

Back in Feb, we started the process of preparing for this repricing in the credit markets. We are now getting a bit more visibility on the players involved - IBanks, commercial banks, insurance companies, ratings agencies, mortgage insurers and originators, fixed income funds, etc. I can't imagine owning any of these names until late in 2007. In general, August 15 is the cut off for capital redemptions for September 30, so it looks as of today like the hedge funds are selling off their most liquid equity positions to prepare for redemptions. So the solid names like BA and GE are getting hammered 5%.

The US housing market collapse will impact the US economy, and Q3/Q4 will be slow growth quarters, maybe even recession quarters. This will impact Asia and its exporting/dollar buying machine, but by how much? One thing that hasn't changed is the liquidity glut is still with us. Rates are going up worldwide and some of the carry trade is coming off, but there are still vast pools of capital ready to play. Oil is still over $70, the Asian trade surpluses are still strong and the private equity guys are still raising $20b funds. Any ideas?


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