One thing I have read over the years that I truly believe is once everyone starts talking about a subject ad nauseum, well it is most likely priced into the market. Subprime? I think it's priced into the market. Bond insurer bailout? Probably 90% priced in but I am sure we will get a knee jerk rally for no good reason once it is official. All the other credit issues from student loans, auto loans, credit card degradation, corporate spreads, commercial real estate issues, mortgage issues spreading up to prime borrowers? I hear drips and drabs of it from a few sources - but the mainstream press either ignores it or says its "doomsday" types who think these are real issues. So I don't think any of it (if it all comes to pass, which I think it will) is priced in. Hence why I continue to hold specialized Ultrashorts such as Financial (SKF) and Real Estate (SRS) <--- commercial real estate. In between the oversold rallies where "buy buy buy early cycle" mantra is screamed from pundits on CNBC, I still think we have a lot of issues to work through. Just like a 7 year bubble in housing does not get worked through in 18 months, I don't think a 20+ year bubble in credit gets worked through in 6 months. But as always, I could be wrong, and in times like we experienced at end of January when the "worst of breed" sectors rallied hard on the upteemth "time to buy the financials!" rally, it is hard to stand by your convictions when an army of computers say "Fed cuts 125 basis point, we need to buy early cycle plays". I do think by end of 2008 you will be hearing about credit card defaults, auto loan defaults, mortgages among the "well off" (prime) defaulting - much like 2007 was the year of "subprime". But for now, it's all generally dismissed... so it will be interesting what exactly comes to fruition and more importantly for investors, when "denial" turns into "acceptance" of these issues. As I stated a few weeks ago in 'Is it Time to Adjust Strategy', I'll be interested to see how the market reacts to the NEXT round of writeoffs, and foreign capital infusions which I assume should be coming by late March. We've had >$100 B in writeoffs and conventional wisdom (most of which never assumed we'd ever get anywhere near $100B) now says we are 80% of the way through... maybe $20-40B more and we're done. We'll see; if things really degrade $250B+ would be very easy to do in my book.
Last, if banks at these "fire sale" prices were such a great value - where are all the mergers and acquisitions? (and no I don't count government pushed acquisition of Countrwide Financial (CFC)) If things are so cheap, and things are so rosy and banks are SO undervalued - why are the stronger banks not eating up the "undervalued" ones? Where is all the massive insider buying? I just don't see it. So I don't buy this "great value" thesis. Remember it's all a big interconnected web based on Kool Aid and confidence. Once Kool Air or confidence leaves, then things contract. And it is all very leveraged - so contraction begets 10:1 contraction elsewhere. Think of it as your stock on margin - this is what all these "smart guys" have done - leveraged themselves to the hilt, so they are getting the equivalent of massive margin calls, which forces them to sell at bad prices, which causes another leveraged "smart guy" somewhere else in the world into a margin call, which forces him to sell, and so it goes. So I still believe we have a lot of interesting times ahead of us, despite what CNBC screaming heads say. And once again, nothing straight down (or up) - certainly we will have pockets of irrational exuberance like we saw 2-3 weeks ago, when these companies at the heart of all the issues rally and people are giddy that the "Fed fixes everything". So timing is key... trying to catch the meat of the downdrafts but being less levered against these parts of the market during "Kool Aid" phases.
- A widening array of financial-market problems threatens to trigger a new phase in the global credit crunch, extending it beyond the risky mortgages that have cost banks and investors more than $100 billion in losses and helped push the U.S. economy toward recession.
- In the past few days, low-rated corporate loans -- the kind that fueled the buyout boom of recent years -- have plummeted in value. As a result, banks are expected to try to unload some of those loans this week at fire-sale prices.
- Nervous buyers also have retreated in recent days from the market for securities backed by student loans and municipal bonds, roiling some corners of the short-term money markets. Similarly, investors have recoiled from debt backed by commercial real estate, such as office buildings.
- Behind the latest problems are some common themes: Investors bought some of these debt securities with borrowed money, or leverage. As prices have declined, lenders have forced the sale of some of these securities. The cash being pulled out of the market by these sales has magnified the losses from rising defaults.
- After years in which banks and investors have lent money on especially easy terms, "You've had the biggest credit bubble -- probably the biggest credit bubble we have ever had," says Jim Reid, credit strategist at Deutsche Bank AG in London. Part of the bubble has already been unwound, he says. The problem is, "nobody quite knows where that ends."
- Especially hard hit: the market for loans to big U.S. companies with low credit ratings. Problems in this market have been percolating for months. These loans, known as leveraged loans, were a popular way to finance the multibillion-dollar private-equity buyouts of recent years that have wound down amid the credit crunch. During the past two weeks, prices on many of these loans have fallen to levels that in a normal environment would indicate that the market expected the corporate borrower to restructure or seek bankruptcy protection.
- Investors are also fleeing leveraged loans because the payments they make to investors are tied to short-term interest rates. With short-term rates falling, thanks to the Fed's rate cuts, those payments are shrinking. "The yields are just not all that attractive especially if you fear that [interest rates are] going to fall further," says Christian Stracke of debt-research firm CreditSights in London. "That just means that the yield you are going to be receiving is going to fall further."
- This week, UBS Securities and Wachovia Securities will be trying to sell portfolios of loans that may be held by a class of collateralized loan obligations called market-value CLOs. Both investment firms were lenders to these CLOs, which depend heavily on borrowed money. Now, with the market value of the loans behind these securities falling, the firms are liquidating a total face value of more than $700 million of them.
- Fitch Ratings last week cut the credit rating on pieces of 24 CLOs, putting several of them deeply into junk territory, with ratings in the triple-C or double-C range. Fitch also says it is reviewing its methodologies for rating market-value CLOs. These investments have triggers in place that force banks to liquidate loans being used as collateral when their prices fall by a certain amount.
- Having to liquidate portfolios of collateral is an added burden for banks, which already had $152 billion of loans they were trying to sell from buyouts of recent years. As the values of the loans they are holding decline, they could need to take additional write-offs. Market-value CLOs account for about 10% of the estimated $300 billion market for CLOs, according to research by J.P. Morgan Chase & Co.
- Related investments called total return swaps have also been hurt. These instruments are set up by banks for hedge-fund clients or other investors to buy loans with borrowed money. The loans serve as collateral, and when the values of the loans decline, the banks' clients can be driven into forced sales.
- Problems are cropping up elsewhere in credit markets. Money-market investors in the past have been large buyers of short-term instruments backed by tax-free municipal bonds and student loans. But they have been shunning these instruments -- known by such names as auction-rate securities and tender-option bonds -- because they fear the debt used to back the instruments will default or get downgraded by rating services.
- More than half of the nation's $2.6 trillion of municipal debt, meanwhile, is guaranteed by bond insurers like Ambac Financial Group Inc., MBIA Inc., and Financial Guaranty Insurance Co. Because these insurers are also on the hook for billions of dollars in troubled subprime-mortgage-related bonds, their guarantees are no longer worth as much. Concerns about the credit ratings of the bond insurers are filtering into muni markets.
- Commercial real estate is another segment of the market that is showing cracks. There were no new offerings of commercial mortgage-backed securities in January, and the cost of protection against default on such securities issued in 2005 and early 2006 has more than tripled, according to Market Group's CMBX index. Goldman Sachs estimates banks could write down $23 billion from CMBS losses this year.
But aside from that, things are peachy...., homebuilders are bottoming since we will have a housing boom by end of year (or a shortage if you listen to Cramer), malls will be packed by summer, and banks will be saved by Fed cuts.... buy buy buy.
Long Ultrashort Financial, Ultrashort Real Estate in fund and in personal account
