Reply #1: Market WrapUp: The Expanding Menu of Horrors [View All]

[ozymandius]

BY FRANK BARBERA, CMT

Over the last 20 years, municipal issuers and other investors have utilized auction rate securities (ARS) to meet their financing needs. During that period of time, seldom have these auction rate securities met with insufficient demand. That is, until the last few weeks when concerns about monoline insurer solvency have caused the market to place a huge premium on liquidity, in turn, causing many of the bidders at these auctions to pull out. The result: thousands of auctions have failed, or been priced at huge 20% reset type premiums. Since late January, the ‘cap’ rates for a wide variety of ARS paper have expanded from 4% to as high as 20%, with most notes now at least 15%. The reason, with the monolines under a serious threat of being downgraded, a number of the large brokers who in the past offered a liquidity backstop, have now simply stopped bidding. Under the terms of the arrangements, the auction arrangers are not obligated to repurchase the securities much to the horror of investors who thought these securities were absolutely liquid instruments.

Chalk this up as one more instance of the unwinding of derivatives markets which, week in and week out, has continued unabated in 2008. In fact, last week, according to Bloomberg.com, UBS concluded that “mathematical models that traders use to calculate prices in the 2 trillion dollar market for collateralized debt obligations simply don’t work anymore. In its commentary, UBS admitted that integral ‘correlation’ models which represent the odds of one default potentially infecting another, and the very fabric of pricing for many of these derivative securities, now show a nearly 100% chance of contagion. As a result, any number of quant funds are already in deep trouble in 2008, some down as much as 15 to 20%.

Across Wall Street and the Financial community, hedge funds are starting to crumble like DB Zwirn & Co., where investors have pulled out 2 billion in the last few weeks, and which on Thursday night sent out a letter to investors outlining plans to liquidate remaining assets, 60% of which were not easily tradable. Of concern here is not the fate of one particular fund, but the downside risk to all markets should the hedge fund industry begin to delever. In our view, aside from the bursting of the bond market bubble, 2008 has an excellent chance of witnessing the bursting of the hedge fund bubble, which in the last decade has seen the industry grown from a small sub-section of speculative capital to perhaps THE dominant force in global finance. While many believe that hedge fund forced liquidations will be orderly as last year's saw several punctuated declines followed by quick recoveries, the odds of that pattern repeating in the weeks ahead seem very distant at this juncture with the kind of damage which has been sustained throughout the credit system. It would seem likely that 2008 will ring down the curtain on leveraged finance for some time to come, perhaps decades.
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So what does this all mean for the market? In our view, it translates into a highly unpredictable investment climate, where things can seem OK on one day, and turn out to be ‘pitch black’ the next. As we have done with great success in the recent past, our mantra of the moment is keep an eye on the ball, in this case, the ball being the financial sector. We strongly suspect that within the broad stock market, whether it starts in the near term or later on this year, there is still another ‘leg’ down ahead for the global equity markets. The proverbial Elliot A-B-C decline has probably already seen Wave A down, with Wave B, the counter-trend phase now in force. What could signal the end of the Counter-Trend Bear Market rally phase and the beginning of Wave C to the downside? In our view, we still say the financials are the hot spot to watch and maintain a sharp eye.

http://www.financialsense.com/Market/wrapup.htm