By Alan M. Newman, Editor, Crosscurrents | 26 December 2007
These excerpts from the December 17th issue have been posted to coincide with receipt by snail-mail subscribers.
Derivative Uncertainties
To further solidify our analysis of a derivative crisis in progress, Bloomberg's David Evans recently reported (see http://tinyurl.com/2f4ypm) that Florida local governments and school districts had pulled $8 billion out of a state run investment pool, representing 30% of the pool's assets, after realizing one of their money market investments contained more than $700 million of defaulted debt. Of the $42 billion in short term assets managed by the State Board of Administration, almost 6%, or $2.4 billion consists of defaulted commercial paper. The State Board also manages the state's $137 billion pension fund. We are concerned that if speculation about pensions threatened by deteriorating derivative contracts does not abate quickly, there is a distinct possibility of a run on assets of every kind and description, not just in Florida but in many other locales. The Bloomberg article goes on to quote John Coffee, a securities law professor at Columbia Law School in New York, predicting investment pools will likely file lawsuits to recover losses.
Most of the now defaulted asset-backed commercial paper was sold to Florida by Lehman Bros. The company declined to comment on the matter but Coffee is on record saying that since the risks were hidden, "I'd expect the pool is going to sue the people who sold them the commercial paper." We would expect that the Florida situation has the potential to be played out literally thousands of times over across the nation as school, fire, water and other local districts find that supposedly safe short term investments were in reality, tainted derivatives. Clearly, as we have shown in these pages since late summer, the chart patterns of many major banks and brokers were (and still are) evidence of a rapidly deteriorating environment for structured finance. In the process, those who have been first in line to liquidate holdings of the pools have gotten out intact. The others behind them have been and still are at risk. Joseph Mason, a professor of finance at Drexel University who has studied the history of bank failures, says, "Since nobody wants to be at the end, you get a run on the pool."
While we would love to shove these ugly developments under a rug or find a way to stress only positive aspects (there are none), we cannot ignore the growing refrain of concern, uncertainty and even fear voiced by observers. In a span measuring only a few minutes on Tuesday, December 4th, we found stories claiming a "Dire Credit Market" (see http://tinyurl.com/2xjbba), "Could Citadel's valuation of E*Trade's CDOs wipe out capital at three big banks?" (see http://tinyurl.com/25glbu), and "Dangerously Close to a Money Panic" (see http://tinyurl.com/3cvb2q). The pattern of waning confidence is already having an extremely negative impact.
As startling a development as any may turn out to be the refusal of auditors to verify the results of the major banks when they are due to report results in January. As related by the NY Post's John Crudele (see http://tinyurl.com/2zf5qj) more than a month ago, under a rule enacted in early 2006, banks can no longer indemnify auditors for mistakes. Given the recent mess and uncertainty over derivatives, auditors may simply step back, which would only serve to heighten apprehensions further.
Add to the mix potential problems with structured finance covering consumer credit card loans and auto loans and you have the potential for a mess unlike any seen since the Roaring Twenties ended with a whimper. Since the market for derivatives is so opaque, there is no completely accurate method to gauge counter-party risks or even to judge precisely who may be on hook to whom for how much if defaults and writedowns continue at their now frenetic pace.
Now, toss in the administration's plan that hopes to freeze mortgage rates for five years and you have the makings of an even uglier mess. The "plan" really changes nothing at all, but ironically, will likely make it even more difficult to structure or value mortgage derivatives. Therein lies the crux of the issue. Last week, our colleague Jim Bianco, one of the savviest minds on Wall Street, commented, "The real problem is investors in structured securities have lost confidence in the securities they own. They are too complicated to understand and they have stopped buying new ones. Consequently, existing structured securities are losing value as bids and offers are non-existent." Bianco goes on to cite the 20,000 ratings downgrades of ‘structures’ and in our view, correctly states that "Delinquencies and defaults are not a problem if you understand what you own. Defaults and delinquencies create a panic when operating in the dark— which is what has been happening in the credit markets this year."
The most gut-wrenching uncertainty that has surfaced may be that quite a few participants are rooting for a worsening environment by shorting the ABX indexes, which were recently pricing in a replay of the Great Depression. If Goldman Sachs did not game the index (see http://tinyurl.com/yq9eo3), they clearly gave the impression of a horrific conflict of interest. Financial engineering has created a brave new world, one that was tested quite severely in 1987 and 1998. And now in 2007, structured finance has again laid out a very uncertain future.
Rationales & Targets
In the last issue, although we were confident the risk/reward ratio favored the downside, the "Current Forecast" assumed a "brief rally" was probable over the "short term." It would have been unrealistic to expect to forecast the extremes exactly as they played out but we believe our take was accurate and timely. The Dow actually bottomed the following day and then rallied strongly into December 10th before finally turning down again last week. Sentiment presents a very mixed bag. Option indicators could support additional brief rally attempts but longer term sentiments imply the bears are giving up and walking away from any possibility that a protracted downside might be in store. To wit: total assets in Rydex Bear Index funds has plunged to its lowest level since the October 2002 bottom! While we must grant that assets in Rydex Bull and Sector funds has gone mostly sideways for four years, the contraction in pessimism is one of the most surprising developments, given the Dow Theory bear market signal and the ongoing corrective mode. We interpret this as an extremely negative long term development and remain in bear mode.
Market Indicators
The perspective below has correctly called all meaningful tops over the last few years. We ran the chart and placed it on the front page of the November 6th issue, only four days after Nasdaq’s high. Propitious, to say the least. In theory, when Nasdaq volume picks up substantially relative to everything non-Nasdaq, we have entered a speculative phase and risk looms large. What now? We note the prior four circled reversals resulted in worse corrections than now. The first instance from the end of January to mid-August ’04 encompassed 18.6% on the downside. The second correction was 12.6% from the end of December ’04 to the end of April ’05. The third was 14.8% from mid-April to late July ’06. The 11.1% recent drawdown seems way too tame given the run in "Speculative Intensity." Our long held 15% downside target is still quite viable and equates to 7.7% below Friday’s close.
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Normxxx
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