Sunday, July 1, 2007

The Week Ahead - ABX, LCDX, CDX

Financial markets close early on Tuesday (1 pm ET for the stock market) and will be closed on Wednesday for Independence Day. Perhaps it's just as well to have a breather. I could ramble on about the calendar and coming earnings, but I think the biggest issues for the street over the next couple of weeks are how problems in subprime, corporates and hedge funds play out. Anything else that pops out on the geopolitical side (terrorism, Middle East), or from the Chinese market will only likely enhance market volatility, unless we get some great news.
The above is one scary picture. The ABX bbb- 07-1 (tied to 2H '06 subprime loans) shows that what was described as a "meltdown" in $1.8 trillion subprime mortgage market earlier in the year was really only the appetizer. The real meltdown is now underway. S&P noted earlier in the week that some of the most toxic chunks of 07-1 came from collateral related to deals from Freemont and Washington Mutual's (WM) Long Beach Mortgage.

Incidentally, a few weeks back there was a rumor that WM was a takeover over candidate. Ha! I found it doubtful both because of Long Beach and WM's involvement in all strata of Alt-A products.

The real story with the ABX slide is the issue of contagion. Surely, no can be surprised at another leg down in subprime as hundreds of thousands of mortgages reset each month (in some cases, rates going up by as much as 600 basis points) - but along with the subprime debacle, there has been the sudden rise in bond yields over the past month and a growing aversion to riskier debt by investors. Growing risk aversion because of converging problems with higher yields, subprime woes, hedge fund liquidation rumblings and the suddenly diminished LBO activity could mean BIG problems are stewing in the credit markets by way of demand for corporates and in whether funding mechanisms sieze up for some of the dozens of leveraged buyouts that have yet to be completed. The evidence is already there.

Friday's 200 point trading range in the Dow had way more to do with tension in the credit markets and ongoing hedge fund woes ala Bear Stearns then with oil at $70+, or with failed (thank God) London car bombings.

On Friday,'s leveraged loan derivatives index, LCDX, fell to a low of 97.73, from a high of just above 100 when the index was launched at par in mid-May. The LCDX slide naturally coincides with a drop in the Markit's high yield CDX index as well, but the spread between LCDX and CDX narrowed in ominous fashion to only about 26 basis points.

Here's a look at the fun and games going on recently in the high yield corporates world - just as scary as the ABX.... The way I read this pie in the sky LCDX, CDX stuff - a great deal of hedging is going on against future loan issuance related to LBOs. The narrowing spread in LCDX vs CDX also indicates concern about the value of such loans relative to cash loans. There is over $200 bln worth of loans on the forward loan issurance calendar - all related to the flurry of springtime merger Monday announcements.

The 4th of July week is supposed to a quiet one for the markets. Let's hope so. But as I consider the depth and breadth of developing problems with credit and leverage, I am only surprised at how the stock market has not been pummeled but has managed to stay range bound between S&P 1490 and 1540. That's got to be an object lesson in liquidity boosting by way of Fed Discount Window and Treasury TIO activity. It's tempting to think that q2 earnings season will save the day for the bulls, but I have become wary of that scenario given the deterioration in credit markets.

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