| TSG Weekly Market Watch July 6, 2007 |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||
| Sunday, 08 July 2007 | |||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending July 6, 2007TradeSystemGuru.com Topics This Week
In our last TSG newsletter we sliced and diced through various types of housing data and concluded that if we had to pick just one, the Case-Shiller home price index was the best. As we saw, the index peaked in July 2006 and home prices have been falling since. According to a number of analysts, this is the first time in history that home prices have fallen in the absence of a recession and few economists believe that one is imminent. Is this an example of another ‘this time is different’ situation or is the property crash giving us advanced warning of recession ahead? Fund FoiblesTo date, more than 50 sub-prime lenders have either disappeared or been bailed out with major injections of capital. According to Bloomberg roughly 65% of mortgage-backed bonds in an index to track subprime mortgage debt no longer meet the ratings criteria in place when they were sold. And this may just be the beginning. Last week, a brokerage firm became the first securities industry casualty of the subprime fiasco. After failing to meet margin calls on mortgage-backed security Collateralized Mortgage Obligations (CMOs), Brookstreet Securities collapsed and its offices were closed under the watchful eye of the SEC. The failure was due to a “notional pricing disparity” which means that the original value placed on the investments plummeted as the subprime market collapsed requiring cash the company didn’t have. Wall Street firm Bear Stearns avoided a similar fate by injecting $3.2 billion to bail out a money-losing mortgage-backed securities hedge fund. As of the third week in June, S&P had downgraded 45 bonds backed by subprime mortgages and said it may have to reduce ratings on 88 more following similar action by Moody’s. In May, rating agency Fitch singled out another 35 CDOs in the U.S. “experiencing the greatest stress,” according to Bloomberg. The news agency also reports that downgrades by rating agencies will force hundreds of investors to sell holdings which will send shock waves through the $800 billion market for subprime mortgage backed securities and the $1 trillion collateralized debt obligation (CDO) market. One mortgage debt specialist quoted estimated that CDOs will lose $125 billion. Another estimate by Institutional Risk Analytics, a company that writes accounting programs to track these assets, estimated that 25% of CDOs are in jeopardy to the tune of $250 billion. We got a taste of the panic such a move can cause with the market reaction to the Bear Stearns hedge fund fiasco recently. The reason for the tension is simple. A rating reduction below investment grade results in the mandatory liquidation of downgraded funds or bonds by registered brokerage houses as required by law. As I understand it, Bear Stearns avoided this requirement by purchasing these instruments themselves using their own money (instead of client funds). How bad could it get? The market of asset backed securities that use consumer, commercial and other loans as collateral has doubled to $10 trillion since 2000 according to the Securities Industry Financial Markets Association. As a point of comparison, the savings and loans crisis that crushed markets in the 1980s and 1990s required the sale of $452 billion of assets, costing taxpayers $140 billion to resolve the debacle. Brookstreet Securities was a small firm and the overriding question now is how many larger broker firms and hedge funds await similar fates? Waiting for the Other Shoes to DropAn interesting article entitled Investment Landfill: How Professionals Dump Their Toxic Waste on You may shed more light on this question. (A link to the article is provided below). According to author Paul Tustain Director of BuillionVault.com, approximately six million subprime borrowers in the United States took out 100% mortgages on homes at the top of the housing market. Everything was fine as long as home prices were rising but now with prices falling, defaults are rising. According the Ohio Attorney General Marc Dann in an interview a couple of weeks ago, 49% of those taking out subprime loans in Ohio in 2006 failed to make their first payments! In 2006, the state ranked number eight in the top 10 states with the highest mortgage foreclosure rates according to a July 6 Reuters report. The problem for institutional investors who have purchased CDOs containing these subprime loans (including hedge funds, banks and brokerage houses) is something any savvy investor well understands – leverage. For example, if an investor uses 50% margin, it means that he has $1 of cash invested in every $2 of stocks in his portfolio. Great while the market is rising since the value of his holdings increases twice as fast. But leverage is a double edged sword. He loses $2 for every $1 invested on the way down. Hedge funds use anywhere from 5 to 15-times leverage which means for every dollar of cash invested, they were able to purchase $5 to $15 worth of CDOs according to Tustain. As the value of these mortgage-backed securities falls, hedge funds and brokers need to come up with many times more money than they originally invested to meet margin calls. All but the very biggest can’t without a serious cash injection so bankruptcy is the only other option left. But the larger the fund, the greater its ability to leverage (thanks to the generosity of banks to big clients), hence the losses mount more quickly when investments like CDOs fail.
Table 1 – Ranking of the largest CDO collateral managers showing increases in market share from 2004 to 2005. As of September 30, 2005 28 collateral managers represented approximately 50% of the U.S. CDO market on the basis of outstanding liabilities rated by S&P. In 2005 Bear Stearns ranked in the middle of the pack for CDO liabilities and its hedge fund $3.2 billion bailout was relatively small (see Table 1). The top CDO collateral manager ranked by Standard & Poor’s in 2005 had CDO liabilities totalling $22 billion or nearly 4-times total liabilities for Bear Stearns. The top 25 firms represented less than 50% of the total CDO market in 2005 which means that another 50% or more in CDOs are held by small firms with greater total liabilities than listed in Table 1. As we see above, Bear Stearns moved to 13th place from out of the top 25 places in 2005. Duke Funding Management LLC registered fastest liability growth rate as the firm moved from 17th to 3rd in 2005 with liabilities more than double those of Bear Stearns. However, 2006 experienced the greatest issue of CDOs with more than $500 billion being issued in that year alone according to a study by Professor Joseph Mason of Drexel’s Business School and Joshua Rosner of research firm Graham Fisher and Company. Given the dynamics of the housing correction curve (in the S&P Case-Shiller Home Price Index), companies that took on the greatest CDO liabilities at the top of the housing market in 2006 are at greatest risk. Crash ComparisonWe have already mentioned the losses involved in the savings and loan crisis that hit the markets more than 20 years ago. Remember the collapse of Long Term Capital Management in 1998? As we learned later, it threatened the stability of financial markets and only thanks to intervention by the Federal Reserve was a meltdown avoided. According to Paul Tustain, it required a bailout of $3.65 billion and the fund was leveraged to around $125 billion. How big a meltdown could central bankers handle today? No one really knows since it largely depends on how much further home prices fall and the strength of the economy throughout this correction. Derivative Detail DevilAccording to Tustain, the credit default swap derivative market represents an even larger risk than the subprime market. According to data from the Bank of International Settlements, global over-the-counter derivatives totalled $465 trillion as of June 2007 (estimate based on growth rate over previous six months). But credit default swaps (CDSs) which are in effect insurance policies against default of bonds (including CDOs) are the fastest growing segment of the derivative market. From 2005 to 2006, total dollar volume of CDSs doubled to nearly $35 trillion. Credit default swaps are in effect insurance policies against default. One party (buyer) pays a fee to another party (seller) in return for compensation in the event of default of a bond or other instrument. Over the last few years investors have lined up to back these insurance policies to insure instruments (like CDOs) against failures in return for a premium. But due to competition for these investments, premiums have shrunken to nearly zero compared to more established instruments like Treasury bonds. In other words, investors have been willing to accept premiums of as little as 1-2% more than that offered by a T-bond to assume large and in many cases unknown risks – unknown because the instruments they backed are new and have not collapsed before and because due to the complexity of the instruments no one really knows what they are insuring.
Figure 1 – The total value of over-the-counter derivatives sloshing around the global has more than doubled over the last three years and is on schedule to hit $500 trillion in 2008. When the insured bonds default, the policy backer must ante up for the full value of the loss. As investors who backed UK insurer Lloyds of London in the early 1990s learned, it was penny wise and dollar foolish to risk everything on policies about which you had little understanding. Many investors who had put up homes, stock portfolios and other assets as collateral lost everything when loses began to mount – all because they wanted to earn an extra 2-3% on their investments. Stay tuned next time when we will take an in-depth look the derivatives market and what a collapse in any one sector could mean to global financial stability. We will also look at why current house price data, including the highly respected Case-Shiller home price index, may be misleading and what it means for buyers, sellers, lenders, mortgage securities investors but most importantly Wall Street in the months ahead. Articles of Interest Investment Landfill: How Professionals Dump Their Toxic Waste on You Growing Fallout in the Subprime Market article links S&P, Moody's Mask $200 Billion of Subprime Bond Risk
SummaryIt was another week of Dow déjà vu as the blue-chip index gained a healthy 1.5%. But take a step back and look at the bigger picture. The blue chip index closed higher (13,639.48) two weeks ago and higher still (13, 668) on June 1 before losing ground each time. It was a good week for the other indexes as well, the best performing of which was the Dow Transports – an interesting development given that oil hit an 11-month high on Friday. Technically SpeakingIt is interesting that the moves in the Dow Jones Industrial Average resemble past summers. It is definitely in consolidation phase putting in what looks to be a bullish flag pattern over the last month. The test will come with the neckline at 13,270. If it holds it will mean higher prices, if not the confirmation of a bearish triple top chart pattern. At this point the index is above both its 50-day and 200-day moving averages. A similar situation exists for the S&P500 with neckline at 1490. However, the Nasdaq Composite seems downright unstoppable at this point. It is well above its 50 and 200-day moving averages in a strong uptrend. Tech leaders like Google, Apple and Research in Motion have been powering it higher. Commodities also rallied this week pushing the NYFE CRB Index up to 416.07 this week from 410.36 last week and 408.41 two weeks ago. Even with long-term interest rates rising this week, gold managed a stronger performance to close at $654.70 from $651.60 last week but its still off its close two weeks ago of $657.10. Gold broke down below its lower uptrend channel line in mid-May and appears to be in a correction mode since mid-April. Good news for inflation hawks but bad news for gold bugs. It was another lackluster week for the dollar as the U.S. Dollar Index closed the week at 81.26 down from 81.69 and 81.92 two weeks ago. This weakness is due to a trend toward higher rates by a number of central banks in the last few weeks, and most recently the Bank of England. This has been motivating Forex traders to buy higher-yield currencies and dump the dollar. It was another strong week for oil as the NYMEX crude oil (continuous) surged to close at $73.15 up from $70.68 last week and $69.14 two weeks ago. One contributing factor is increasing oil demand from troops in Iraq. Each troop uses an average 16 barrels of oil per day and there are another 100,000 plus soldiers in Iraq now. On the international front, the MSCI Emerging Market Index ETF (EEM) continued to rock and roll this week as it to close at 138.30 from 131.65 last week and 131.44 two weeks ago. EarningsWith a total of 4232 companies (up from 4222 last week) having reported earnings for Q1-2007, the improvement versus the same quarter last year held steady at 8%. Q2 earnings reporting season should commence next week. Economic ReportsHere’s what the charts had to say this week.  Chart 1 – Despite the continued bad news in housing, the manufacturing and service sectors appear to be humming along. Manufacturing ISM came it at 56 in June while non-manufacturing ISM (the service sector) hit 60.7. Good news for the economy and more evidence that things aren’t slowing down in a number of sectors just yet.
Chart 2 – According to the National Association of Realtors best leading indicator on housing markets pending homes, the situation continues to deteriorate. Pending home sales, a measure of contracts written but not yet closed, dropped 3.5% in May from a month earlier but 13.5% from May 2006. The index now sits at 97.7 signalling that housing activity is now worse than in 2001 when the indicator value was set at 100. Meanwhile, evidence is growing that published home prices have been inflated by incentives offered by both builders and existing home sellers which are being included in the reported sales price. This combined with the widespread practice of buyers pressuring sellers to pay under-the-table cash bonuses which are added to the price which buyers use to make downpayments. How widespread has it become and how much lower would selling prices be had this often illegal practice not occurred? Chart 3 – Employers added 132,000 jobs in June and revised the May number from 157,000 to 190,000 and the April number up to 122,000 from 80,000 for an additional 75,000 over the last two months. Jobs growth averaged 145,000 for the first half of the year. While strong, many view this level of growth as a goldilocks scenario meaning that the economy is growing but no so fast as to necessitate a higher Fed funds rate. Next WeekHere are the economic reports we’ll be watching. - Monday, May consumer credit (previous $2.6 billion).- Tuesday, May wholesale trade (previous 0.3%).- Thursday, May trade deficit (previous $58.5 billion).- Friday, June import prices (previous 0.9%), June retail & food sales (previous 1.4%), June retail & food sales ex-autos (previous 1.3%), May business inventories (previous 0.4%).SynopsisLast week we talked about the unexpected drop in bond prices thanks to rising interest rates in a number of countries. This week the Bank of England followed a number of central banks in raising its overnight rate to 5.75%. As we saw last week, after breaching their long-term trend line, 30-year Treasury bonds rallied but this week they breached support again as 30-year yields climbed. However, as we see in Chart 5, bonds remain very near long-term support.
Chart 4 – Twenty year chart comparing the stock-bond relationship before the 1997 disconnect when they moved in the same direction and the relationship post Asian flu (1997). Chart by Metastock.com The change in the relationship between stocks and bonds is clearly visible in Chart 4. Since the stock-bond decoupling in the wake of the Asian flu in which a number of Asian currencies dropped significantly, the deflationary pressure at the root of the decoupling is still very much in force if the present trends in stocks and bonds are any indication. This means that when stocks rally, bonds fall and vice versa.
Chart 5 – Ten year chart of 30-year Treasury bonds showing long-term support line and previous breach in late 1999, early 2000 just three months before the S&P500 and Nasdaq Composite Indexes fell out of bed. Chart by Genesisft.com Given that bonds are in a downtrend and are sitting on their lower channel support line (not shown) and that the S&P500 is at its upper trend channel line, technicals are telling us that the most likely (but not guaranteed) outcome is for bonds to rally and stocks to correct. This of course assumes that 1) they don’t break outside their current trend channel lines and 2) the decoupled relationship between stocks and bonds continues. However, it is never a good idea to take any forecast for granted. Close scrutiny of the situation is warranted from here for either confirmation clues showing stocks are correcting and bonds rallying or an indication that this scenario is breaking down. Stay tuned for our next update on July 22! ------------------------------------------------------------------------------------------------------ If you find this newsletter insightful, please feel free to forward this newsletter and share it with a friend (or simply have them opt-in free from our home page http://www.tradesystemguru.com to be added). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable;
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