Does Stability Breed Instability?

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Includes: DIA, QQQ, SPY
by: Michael Shedlock

Reuters is reporting US corporate bond spreads approach widest on record.

Spreads on U.S. corporate bonds on Thursday approached their widest levels since the bankruptcy wave of 2002 on worries about hedge fund selling of a wide range of corporate, mortgage and municipal bonds.

Spreads, the extra yields that corporate bonds pay over US Treasuries, gapped out across the board, though banks and brokers were especially hard hit on fears of more writedowns as mortgage problems spread...

Average investment-grade spreads had closed on Wednesday at 264 basis points over Treasuries, just 8 basis points shy of a record set on Oct. 10, 2002, a year of massive bankruptcies, according to Merrill Lynch data going back to December 1996. Thursday's widening was likely to put the index at or close to a new record, analysts said.
Zero Hour 9:00 AM - I'm a rocket Man - Elton John

Zero Hour Liquidity Discussions
Tip of the hat to Elton John and Professor Bennet Sedacca for the "Zero Hour" concept.

Zero Hour Stability

Inquiring minds may be asking "Does Stability Breed Instability?" That's a good question. Sticking with the corporate bonds theme, please consider the following chart.

SWYSX (Schwab Yield Plus Select) Weekly Chart (SWYSX)



click on chart for sharper image.

Just what does Schwab propose SWYSX to be?
Let's take a look at the fund summary. Emphasis is mine.
The investment seeks high current income with minimal changes in share price. The fund primarily invests in investment-grade bonds. It may invest in bonds from diverse market sectors based on changing economic, market, industry and issuer conditions. The fund may invest to 25% of assets in below investment-grade bonds that are rated, at the time of investment, at least B by at least one nationally recognized statistical rating organization (NRSRO) or are the unrated equivalent as determined by the investment adviser. It maintains an average portfolio duration of one year or less.
Carlyle Capital Misses More Margin Calls

Bloomberg is reporting Carlyle Fund Gets Default Notice After Margin Calls.
Carlyle Capital Corp. missed four of seven margin calls yesterday totaling more than $37 million, the Amsterdam-listed fund said today in a statement. The company expects to get at least one more notice of default related to the margin calls.

Started by David Rubenstein in 1987, Carlyle expanded its mortgage investments last year, selling $300 million of shares in Carlyle Capital. The fund used loans to buy about $22 billion of AAA rated mortgage debt issued by Fannie Mae and Freddie Mac, securities that Carlyle says have the "implied guarantee" of the U.S. government. Even those bonds have slumped, leading to the failure of hedge funds led by Peloton Partners LLP...

The Carlyle fund eliminated its dividend and waived an incentive fee on Feb. 28 when it reported quarterly financial results, seeking to build liquidity as mortgage defaults in the U.S. rise.
Cockroach Theory

There never is just one. And when Carlyle eliminated its dividend and incentive fee (the latter normally 20% of profits), it is clearly sending out an SOS. Don't answer it. There are likely more cockroaches hiding.

Any fund so arrogant as to leverage illiquid investments like mortgages 32:1 deserves neither sympathy or cash.

Furthermore, Carlyle knows full well there is not a government guarantee on Fannie Mae or Freddie Mac. The statement is either a blatant lie or complete ignorance by Carlyle. Fed governor William Poole has stressed that point twice now. Please see Poole, Paulson, Bernanke on Bailouts and Bank Failures for proof.

Besides, what kind of manager leverages 32:1 on implicit, let alone explicit guarantees? Ambac (ABK) and MBIA (NYSE:MBI) prove that even explicit guarantees may be worthless.

Does Stability Breed Instability?

Eventually it does. Stability Breeds Herding, Complacency, Leverage, and Risk Taking.

Seeking ever higher returns, companies like Carlyle leverage at 32:1. Funds like SWYSX resort to buying riskier and riskier bonds to maintain yield. Excessive risk taking leads to excessive complacency and ever compressing risk premiums.


Eventually it snaps. And a snap at 32:1 leverage can wreak a lot of havoc.

That is the process in which stability, given enough time, lays the groundwork for its own demise. We saw it first in housing, then corporate real estate, and now hedge funds. Leverage is going to continue to unwind and until that process completes, now is not the time to be taking excessive risks.