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“Of all the newfangled financial creations that have caused problems this past year, arguably the most nerve-wracking are derivatives traded over-the-counter…” - Economist, August 8, 2008

And the beat goes on.

On several occasions over the past year, hopes rose that the credit crisis was about to abate only to be dashed by yet another set of surprisingly large bank write-downs. Surprising to some but not on these pages. The risks from the credit crisis are far broader than originally thought and only now becoming grudgingly clear. And there is truly no end in sight.

UP and OUT is my way of characterizing what Nouriel Roubini has accurately described as the full scope of the financial Frankensteins created over the past decade. UP in the form of write-downs moving up the quality spectrum within an asset group. And OUT to other financial instruments created by the wizards of Wall Street.

Exacerbating the situation is the (efficient market hypothesis inspired) accounting rule change instituted last November, FAS 157, in which assets impacted by diminished demand produce lower values requiring mark-to-market write-downs thereby requiring new capital to meet banking related capital requirements leading to further pressure across the entire banking system. A vicious circle.

The equity markets are beset with multiple layers of issues – some, such as inflation, likely to not be an issue for much longer. However, fears of a global economic slowdown are now more real than ever, particularly when we get to 2009 and corporate default rates begin to rise as noted in the following chart* from last week’s NYSSA Market Forecast event (courtesy high yield expert Marty Fridson):

Moreover, according to Marty, the peak isn’t projected until 2010 at an 11% rate. This is the origin/catalyst of the $250 billion (net) credit default swap pain noted by PIMCO’s Bill Gross back in January of this year. So, if you want to see how banking losses get into the $1 to 2 trillion range, this is one contributing component.

Investment Strategy Implications

Last week’s so-called “Olympian rally” in equities must be taken with a huge grain of salt. As noted in several areas of this report*, the contradictory nature of the recent market rally is hardly the stuff of sustainability. Highly fragmented market action with little to no sustained and coordinated leadership provides no real investment comfort beyond riding the bear rally from its undervalued levels.

Until there is more market structure, an overall market neutral approach is advisable to take. Scalping “lunch money” trades is also a good short-term course of action for a modest amount of money. However, given the looming danger of a no-end-in-sight credit crisis and a 2009 that may stress test more than the banking system, the deleveraging process on multiple levels (banking, US consumer) warrants an above average level of caution.

 

Source: Why To Take the Rally With a Grain of Salt