Market Observations On A Difficult Day

This is the sort of day that scares the daylights out of most investors. If they read news or tuned into CNBC, it was even worse.

The News versus Real Information

Much of the bearish commentary involves long causal chains of events -- one domino after another. It sounds erudite. It seems persuasive, since dominoes were falling today.

What is lacking in most analyses is an effort at quantification. Frequently, those who try to provide such information are shouted down. Ultimately, the refinancing of mortgages, the unwinding of hedge fund positions, the response of homeowners and government agencies, and the actions of corporations are all marginal actions. It is not like a light switch.

There is a stereotype in the market that everyone who took a sub-prime loan cannot pay. That all Alt-A borrowers are liars. That none of the teaser-rate borrowers have acted to refinance during the last few years.

What is needed is some sense of magnitude, and the numbers are so easily misconstrued. A mortgage executive was interviewed on CNBC last week and admitted that defaults were up 100%! They had 30,000+ mortgages and defaults and gone from 25 t0 50, well within their loss reserves.

Most of the stories about "subslime" spreading to prime mortgages are completely lacking in quantification--the aggregate impact. Added to this is the assumption that these borrowers are not qualified to refinance.

The problems are obvious, but the effects are difficult to predict. When the market lacks information, sellers act on each piece of information and potential buyers back off.

The Hedge Fund Effect

Some of the best commentary today came from James Altucher, who manages a fund of funds and sees hundreds of hedge fund pitches. He explained on RealMoney, TheStreet.com's paid site, that many hedge funds borrowed at 5.5% and bought mortgage obligations yielding 6.5%. To get the "holy grail" of hedge fund performance, they leveraged this 12-1 or so and seemed to show consistent strong yields with little volatility. We know this to be true, since this is the environment in which hedge funds like ours have been competing for assets. The leverage method looked good until the fund's longs went down and the shorts went up. With 12-1 leverage, it takes little to blow out the entire fund.

It was the quest for yield....

On CNBC's "On the Money" Altucher cited another strategy -- put selling. This strategy has worked for years -- until today. These funds are also blowing out.

Implications for the Average Investor

For the average investor, it means that quality stocks are on sale. The hedge funds must sell to cover marginal calls and redemptions. Many observers noted that today's trading had plenty of selling in good stocks and buying in (widely shorted) marginal stocks. To the savvy observers this looked like hedge fund liquidation.

The Time Frame

The process did not necessarily end today. The psychology of Fridays has now changed. A few weeks ago, everyone was worried that big mergers would be announced on the weekend. No one wanted to be caught short. Now everyone fears that more bank and hedge fund news will come out. How much anticipation was built into today's trading? Who knows?

At "A Dash," we are less concerned about follow-on economic effects, although the economically sensitive stocks got hit today. Everyone's forecasts build in some effect on GDP from the housing situation. The extreme views forecast recession, while others see a haircut of 0.5% or so. It was interesting that even Nouriel Roubini, interviewed by Maria Bartiromo tonight on CNBC, was looking only for a slowdown in growth, not a recession.

Conclusion

Those with bullets to fire are getting a chance, but most are waiting for evidence of a bottom. This is notoriously difficult to predict

We have some modeling on this process -- more later.

Comments

[Al Capital:]

Well Jeff, you have the numbers to make an order-of-magnitude estimate of the potential total loss scenario: about $30-50 billion in loans converted to CDOs and then leveraged 10-1, for or about $300-500 billion. Most likely losses? That is dependent on how liquidity is raised so its not exactly determinable but I am guessing roughly the equivalent of a Hurricane Katrina (or maybe two of them). If the Fed keeps the credit market liquid, that will keep the losses at a lower level, and as amazing as it seems, the critical action by the ECB (followed by the Fed) may actually work (to stabilize the markets) if they keep sufficient funds in place long enough. The nice aspect of this solution is that there is no debate needed about monetary policy.

mnrtrading.blogpsot.co.../

2007 Aug 11 02:56 AM

[Andrew:]

Very insightful re-cap.
I believe hedge funds aren't the only ones selling. I'm noticing sell off in widely held, dividend paying stocks as well (i.e. big pharma, energy). I believe income funds and insurance companies are getting ready to buy debt on the cheap.

Anyway, this can be a good opportunity for invstors with strong cash position.

Financial institions and hedge funds that want to qualify for liquidity bail outs by the Fed should make all mgmt (director level on up) give back bonuses from the past 3 years. The thought that "professionals" have made their money and left investors to hold the bag is revolting.

2007 Aug 11 12:23 PM

[wixeywaxy:]

The best comment I've seen on this problem. What I would ad for the sake of those who are unaware is the fact that the problem is not so much the number of non performing mortgages as it is the falling value of these mortgage assets based not on facts but perceptions. Given time the hysteria will subside and the value of these protfolios will rise to something more realistic to the actual failure rates. The Fed will supply the funds necessary for the funds to ride out the storm, but it won't save those who are the most extremely leveraged or those who have used their leverage to make bad investments. All this is unlikely to have dangerous consequences for the economy nor is the irrational response apt to last more than a few months. Vic

2007 Aug 12 10:27 AM

[omooc:]

I read that, in 1998, Long Term Capital Management leveraged at 80:1. So, 12:1 is nothing. The fact that ECB and CBs in Australia and Asia acted swiftly is reassuring. It is interesting that the Fed acted three times Friday. So, it seems to me that the worst is over. omooc (8/12/07, 8:42 pm)

2007 Aug 12 08:37 PM