Tuesday, July 31, 2007

Dow Down 146, or Lesson Number 316 That Structured Credit REALLY Matters

Talk about a trading range today - about 300 points for the Dow and we nearly nearly tested upward resistance at S&P 1490 only to hit at brick wall at the 50 day moving average in the 1484 area and then see the index close down at 1455. C'mon did you really expect that all would be forgotten and that Friday's low was a buying opportunity? There were a lot of 'sparkies' out there thinking that, apparently. This is not last February and a brief Shanghai stock market plunge. The market is dealing with some pretty complicated stuff that will make it hard for the short-attention-span people to keep from buying on every dip.

Last night I briefly ruminated that bad news in structured credit (eg. subprime), or corporate high yield credit would spur carry trade unwinding. It happened again today.

Let me be clear: Carry trade unwinding is driven in large part by the perception that risk taking ability is dropping here in the U.S. due to recent structured credit troubles.

There's a lack of understanding concerning the above emboldened line. Why? Because there are too many folks blaming things like subprime, or LCDX exclusively for stock market declines and ignoring the carry trade, or citing the carry trade as the sole culprit for market declines. Rising risk aversion due to the mortgage meltdown and contagion into corporate high yield debt are intertwined with the carry trade.

It's really a vicious and dangerous cycle because as more yen carry trade unwinding occurs there will come a trigger point when the Japanese yen rises enough for carry trade unwinding to go from orderly and voluntary to forced and disorderly. When carry trade unwinding takes on a disorderly life of its own it will then beget liquidation of whatever speculation it previously funded which would bring on further pressure to stocks and any other paper tied to speculative bets. It's a financial super highway with lots of traffic, no speed limit and no center barrier. It's this vicious cycle that one of these days bring us a 1,000 point down day for the Dow.

The risk game has always relied on the ability to take risks. Duh. How so many still fail to grasp that a meltdown in one risky area of the market can simply be "contained" (eg. subprime) and not impact risk in other areas, I'll never know.

The Dow was on the plus side until American Home Mortgage fessed up that it's insolvent, finally reopened for trading and went from a 10-handle down a $1-handle. Gosh is it oversold now and a buying opportunity? LOL. How cheap is cheap? Well, $1.04 for AHM may still be too expensive once they try to liquidate in "orderly fashion" of whatever will be left of it.

So we go from the west coast blow ups of subprime names like New Century to a big fish on the east coast which specialize in near prime (Alt-A) and prime lending. AHM was not a fly by night company, it was a top-10 mortgage company with a Q1 book value of over $20 bln. It is based in Melville, NY (Long Island) where a variety of money center banks have back office operations. It had over 7,000 employees, nearly 1,500 in Melville.

Of course, on Wall Street, the people at AHM who will lose their jobs hardly matters at this point (though ongoing loss of high paying jobs will eventually matter in a great way). It's the issue of exposure that got under the skin of investors today. Who's exposed and by how much to the AHM collpase? We know the numbers are in the billions and we'll be certain to find out more as the process unwinds - yep, just what the market needs more uncertainty about who's exposed to what and by how much.

RAIT Financial Trust (RAS) came out of the woodwork quickly to acknowledge its exposure to AHM through CDOs tied to AHM. RAS slumped 20%.

By coincidence, this evening, Bear Stearns (BSC) said that it was halting redemptions in a third hedge fund - just a few weeks after confessing that two subprime funds were vaporized by wrong way bets. This time around it's an $850 million fund with bets in ABS tied to the Alt-A tier of mortgages. Do I even bother to mention that Bear thinks the assets in this fund are priced at least at mark-to-market this time? That's what a Reuters story stated. We'll soon know.

As I mentioned in my CNBC options column recently, speculators have been loving the puts of Bear Stearns and it looks like they'll make some money Wednesday.

After starting the day lower, the Yen snapped back to the 118.55 level as carry traders did their unwinding into the damage caused by the AHM news.

Tonight Yen futures are up 22 points.... should be an interesting day on Wall Street tomorrow.

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