naked capitalism

Credit default swaps prices have risen sharply all over the globe. Nevertheless, the CDS related to the debt of major Wall Street players have been particularly hard hit, which isn’t surprising, given their LBO financing commitments, exposure to hedge funds via their prime brokerage operations, and falling profitability. Some experts, however, think the CDS are oversold and represent a buying opportunity.

From Bloomberg:

On Wall Street, Bear Stearns Cos., Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Goldman Sachs Group Inc., are as good as junk.

Bonds of U.S. investment banks lost about $1.5 billion of their face value this month as the risk of owning the securities increased the most since at least October 2004, according to Merrill indexes. Prices of credit-default swaps based on the debt imply that their credit ratings are below investment grade, data compiled by Moody’s Investors Service show.

The highest level of defaults in 10 years on subprime mortgages and a $33 billion pileup of unsold bonds and loans for funding acquisitions are driving investors away from debt of the New York-based securities firms. Concerns about credit quality may get worse because banks promised to provide $300 billion in debt for leveraged buyouts announced this year.

“The market is being driven by fear,” said Mark Kiesel, who oversees $80 billion of corporate debt at Newport Beach, California-based Pacific Investment Management Co., manager of the world’s biggest bond fund.

Credit-default swaps tied to $10 million of bonds sold by Bear Stearns, the second-largest underwriter of mortgage bonds, rose to about $110,000 on July 27, from $30,000 at the start of June, indicating growing investor concerns.

The contracts, financial instruments based on bonds and used to speculate on the chances of default, imply a rating of Ba1, one level below investment grade and six lower than Bear Stearns’ A1 ranking, according to New York-based Moody’s.

`Wall of Worry’

Prices of credit-default swaps for Goldman, the biggest investment bank by market value, Merrill, the third largest, and Lehman, the No. 1 mortgage bond underwriter, also equate to a Ba1 rating, data from Moody’s credit strategy group show. Bonds of New York-based Goldman and Merrill are rated Aa3, seven levels higher than swaps suggest. Lehman is rated A1, the same as Bear Stearns.

About 1 percent of the thousands of companies followed by Moody’s have a gap of more than five levels between their actual and implied rankings, analyst Tony Smith said in a July 19 report titled “Broker Securities Climb a Wall of Worry.”

Spokesmen for the firms declined to comment or didn’t return phone calls. High-yield, or junk, bonds are rated below Baa3 by Moody’s and BBB- by Standard & Poor’s.

Credit-default swaps are the fastest-growing part of the derivatives market. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

Losing Value

Investment-grade bonds of brokerage firms lost 0.47 percent on average since June, while securities with similar ratings returned 0.19 percent, according to Merrill indexes. Finance companies are the biggest part of the corporate bond market, accounting for 40 percent of the $2 trillion of debt outstanding, according to New York-based Morgan Stanley, the second-biggest investment bank by market value.

Investors demand an extra 1.25 percentage points in yield to own the bonds of brokers instead of Treasuries, up from a low of 0.64 percentage point on Jan. 29. The wider spread represents an extra $6 million in annual interest for every $1 billion they borrow.

Lehman sold $1.5 billion of 6 percent notes due in 2012 earlier this month at a price to yield 1 percentage point more than Treasuries with a similar maturity. The company sold five- year debt with a 0.62-percentage-point spread on Jan. 9.

The difference adds up to $5.7 million a year in extra interest. The price of the new securities fell to 99.8 cents on the dollar to yield 1.38 percentage points more than Treasuries yesterday, according to Trace, the bond-price reporting system of the NASD.

Skittish Investors

Investors grew more skittish about the credit markets this month as mortgage defaults increased and at least 40 bond and loan sales faltered. U.S. foreclosures rose 58 percent in the first half of 2007 from a year earlier, as more homeowners fell behind on payments, according to a report yesterday by RealtyTrac Inc., an Irvine, California-based seller of foreclosure data.

Concerns escalated last week after banks including Goldman, Bear Stearns and New York-based JPMorgan Chase & Co., the No. 3 U.S. bank, were left holding $10 billion of loans they provided for the buyout of Chrysler, a unit of Stuttgart, Germany-based DaimlerChrysler AG, by Cerberus Capital Management LP in New York.

JPMorgan was among at least eight banks holding about $10 billion of loans for Nottingham-based Alliance Boots Plc, the U.K.’s biggest pharmacy chain being purchased by Kohlberg Kravis Roberts & Co.

Fewer Cylinders

Financing leveraged buyouts and bundling subprime mortgages and bonds into other securities called collateralized debt obligations generated about $21 billion in fees last year, data compiled by Freeman & Co., Thomson Financial and JPMorgan Chase show.

“The brokers were hitting on all cylinders,” said Chuck Moon, who manages $30 billion as head of investment grade credit at Hartford, Connecticut-based Hartford Investment Management Co. “Now there are a couple of cylinders in question.”

Bond and credit-default swap prices suggest Wall Street firms are no safer for debt investors than companies teetering on the edge of investment grade, including mining company Freeport-McMoRan Copper & Gold Inc. in Phoenix and Stamford, Connecticut-based copy machine maker Xerox Corp.

Credit-default swaps tied to $10 million of Freeport’s bonds cost about $115,000 and those linked to Xerox’s debt trade at $96,000, according to CMA Datavision. Xerox bonds are rated Baa3 by Moody’s and BBB- by S&P. Freeport’s are ranked Ba3 by Moody’s and BB+ by S&P.

Pimco Buys

That may be a signal to buy, said Moon. Bonds of brokers are “attractive” because yields have widened so much compared with Treasuries, he said, declining to comment on whether he’s adding them.

The growth in credit-default swaps allows finance companies to hedge more of their risks than a decade ago, Moon said. “I don’t think it’s a disaster because, quite frankly, the institutions have become more sophisticated about their risk management practices.”

Pimco bought bonds of banks and brokers in the past two weeks, expecting them to sustain earnings growth and benefit from global mergers and acquisitions, Kiesel said. Profits at Bear Stearns will rise to $14.53 a share this year and $15.66 in 2008 from $14.27 in 2006, according to the average estimate in a Bloomberg survey of 16 analysts.

Reasons to Buy

Merrill’s MOVE Index, a measure of expectations for Treasury volatility, reached 92.6 on July 26, up from a low this year of 51.2 on May 15. Merrill reported a 31 percent rise in second-quarter profit on July 17, while Lehman’s earnings rose 27 percent to a record.

“We have been adding, I wouldn’t say we’ve been power- lifting,” Kiesel said. “You want to leave some powder dry as you’ve got an unprecedented amount of high-yield supply that’s hitting the market. That’s a train coming down the tracks. So stepping in front of that takes some guts.”

Banks have agreed to provide bonds and loans for buyouts including the $25.6 billion takeover of Greenwood Village, Colorado-based credit-card processor First Data Corp. and the $45 billion acquisition of energy company TXU Corp. of Dallas. If they can’t find investors for the debt, the banks may have to provide it themselves.

Pimco is still “underweight” in corporate debt, meaning it owns a smaller percentage than is contained in their benchmark index. The firm is a unit of Frankfurt-based insurer Allianz SE.

Marking Down

Bear Stearns analyst Ian Jaffe raised his recommendation on broker debt to “overweight” from “underweight” on July 13 because risk premiums increased and the economy is growing. Jaffe, who is based in New York, declined to comment.

CreditSights Inc., an independent bond-research firm in New York, also says investors should buy broker bonds.

“We’ve been probably the earliest and biggest critics of the brokers for the proprietary trading risks they’re taking and the private-equity lending,” said David Hendler, the head financial services analyst at CreditSights. “We’re saying the fear and spreads don’t make sense.”

Banks face losses from acquisition-related debt because they typically sell the bonds and loans later at a discount. Treasury Secretary Henry Paulson, a former Goldman chairman and chief executive officer, described the credit markets decline as a “wakeup call” for banks in a July 26 interview.

`Got a Problem’

“They’ve got a problem,” said Daniel Fuss, vice chairman of Loomis Sayles & Co. in Boston, which manages $22 billion in bonds. “It’s pretty bad. They’re going to have to go back to the private-equity people” to renegotiate their lending commitments, he said.

The perception of the risk on Bear Stearns bonds has risen more than its competitors on concerns that a decline in new securities backed by home loans will reduce earnings. Sales of mortgage bonds may tumble by a third to $556 billion in the second half of this year compared with the first six months, Lehman debt strategists said in a July 30 report.

Bear Stearns last month was forced to extend $1.6 billion in credit to one of two hedge funds that collapsed from bad bets on securities backed by mortgages to people with poor or limited credit.

“You’re getting paid for their concentrated exposure to mortgage risk,” CreditSight’s Hendler said. “A lot of investors are trying to gauge subprime risk and how it affects their direct exposures. There is a lot of negative, fearful behavior.”

Credit-default swaps tied to $10 million in bonds of Goldman Sachs, the world’s most profitable securities firm, rose as much as $26,000 to a record $105,000 on July 27, according to broker Phoenix Partners Group in New York. The default swaps traded at $81,000 yesterday.

“Fundamental credit research does not mean anything at all in this environment,” said Scott MacDonald, director of research at Aladdin Capital Management in Stamford, Connecticut. “People are just trying to get out of the way.”

European and Asian equity markets performed well overnight, and according to the futures market, US stocks are set to have a good day as well. Yet the credit markets are in a state of near-panic. Some illustrative factoids and comments from the Financial Times:

“It is nothing short of ugly in credit land,” said Alan Ruskin, global strategist at RBS Greenwich Capital.

The turmoil has forced bankers to delay or cancel several billion dollars of new high-yield bond and loan deals, as investors demand better terms in the face of a $300bn pipeline of pending debt deals to fund leveraged buyouts.

However, it has caused dramatic spasms in credit derivative markets as investors have rushed to hedge against plummeting prices on less-easily traded portfolios of debt.

Credit derivative indices on both sides of the Atlantic on Monday pushed through new boundaries, beyond levels reached in the May 2005 credit “correlation crisis” that followed Ford and General Motors’ downgrades to non-investment grade. Credit derivatives provide buyers with protection against corporate default in return for an annual premium.

The cost of insuring the US investment-grade credit derivative index, or CDX, jumped 20 basis points to trade above 100bp on Monday morning. On June 18, the index was trading just above 30bp for five years of protection, and it has more than doubled over just the past week. Indices tracking the US high-yield and leveraged loan markets suffered similarly.

In Europe, the cost of insuring high-yield European corporate bonds against default leapt 60bp to more than 500bp yesterday, the biggest ever one-day move in the index. The iTraxx crossover index, which tracks 50 mostly junk-rated European corporate names and is a key barometer of credit market sentiment, has widened more than 250bp since June.

Jochen Felsenheimer, analyst at UniCredit, said that with intraday moves on the scale of fifty basis points or more, “betting on the next couple of basis points is credit roulette rather than serious investment”.

He added: “[This correction has been] triggered by a concern that goes right at the heart of the matter: the fear that liquidity might finally and suddenly be drained out of the system.”

Over the last few years, investors have had periodic bouts of anxiety that they might be living in a bubble. This was in part because asset prices benefited from the fact that liquidity was abundant, growth was strengthening across the globe and corporate and emerging market fundamentals were improving.

But now, as asset prices have swung violently lower, investors have difficulty gauging where the bottom will be.

Thus problems in the credit markets have led a severe and broad-based sell-off in other asset classes in recent days as investors have dramatically reassessed their risk appetite. According to an index of risk indicators across asset classes compiled by UBS, risk aversion is at its highest level since the terrorist attacks on New York in September 2001.

Indeed Ashish Shah, credit strategist at Lehman Brothers, likens the sell-off to the liquidity crisis that followed the collapse of Long Term Capital Management and the Russian debt default. “In 1998, as in the current market, we saw a broad-based ‘flight to quality’ and mass risk reduction,” he said. “In addition, leveraged players were forced to sell down positions in order to manage their risk exposures and meet margin requirements, much as we are seeing currently.”

Worse still, as Jim Sarni, portfolio manager at Payden & Rygel notes, the lack of demand for credit risk has come at a time of the year when activity usually ebbs. “We think this is more seasonal than systemic at this stage,” Mr Sarni said, noting that the basic fundamentals for corporate credit remained sound.

However, Mr Shah thinks the best recent historical comparison is the so-called “correlation crisis” of May 2005, which caused huge swings in the relative value of complex structured credit products backed by derivatives.

Back then large investment banks and some hedge funds were forced to take huge mark-to-market losses on their holdings of the riskiest portions of these products. This led to a sudden withdrawal of liquidity from the still young derivative indices as investors rushed to buy protection, but found few who would sell it.

The current movements in the credit markets echo this pattern. “Cash bonds and loans are next to impossible to move right now, or only with outrageous bid offers,” said one hedge fund trader.

Or as Jack Ablin, chief investment officer at Harris Private Bank said: “Derivatives are much more flexible [than cash bonds] and are used by hedge funds as a good way to get in and out of the market quickly.”

“Prices for credit are lower and it is both a valid correction, but also an over reaction on the part of some investors. The liquidity spigot is starting to run dry.”

The obvious question is “What gives?” How can investors in credit products have such a different perspective from their stock market counterparts?

The comparison to the LTCM era is the key. As nasty as the 1997-1998 credit crisis was, it had relatively little impact on the equity markets. The two main reasons why were first, there was no widespread asset price inflation, so a seize-up in the credit markets would not have immediate implications for asset prices. The only investment that was arguably a bubble at that time was emerging market equities, and they took a beating along with emerging market debt. Second, while the LTCM crisis could have produced a systemic failure, there was no resulting large scale institutional damage.

So it would seem that the equity markets are seeing the current credit contraction as a re-run of 1997-1998. But the underlying fact set is different. Not only do we now have bubbles or near bubbles in many markets, but it is not clear that Bernanke is as willing as Greenspan to increase liquidity to stem a crisis (although the bond futures markets are already betting on a rate cut by December). This Fed has a more pressing inflation problem than in the 1990s, and Bernanke is likely to capitulate at a later point than Grennspan would have.

Ah, this is one of those days where there way too many good points for departure for commentary and here I am with a pricey and pokey Internet connection, and competing holiday activities.

Finally, the reassessment of Greenspan’s tenure has begun. Not surprisingly, the Brits are more pointed in their critique. From “Greenspan has left more than a wall of worry to overcome” by Tim Price in the Financial Times:

Whenever investors are unable to rationalise market trends, they resort to cliché. The latest hoary old chestnut to be trotted out to justify extraordinarily robust equity valuations (until last week, at any rate) is that all bull markets climb “a wall of worry” – a platform of problems that perversely boosts stock prices to fresh highs.

There is doubtless something to the “wall of worry” conceit. There are certain successful investors (one thinks of the likes of George Soros, John Templeton and Marc Faber) who have spun widespread disenchantment about market returns into gold. It is easier said than done, for example, to buy when there is blood on the streets. But heuristics, those rules of thumb that traders use as shorthand to parse the financial runes, can only take us so far. And there are times when widespread conventional fears about the market’s prospects will turn out to be wholly justified. Now feels like one of those times.

We can trace the market’s current tremors back to the previous Federal Reserve chairman, Alan Greenspan. It was Mr Greenspan who, in the aftermath of the dotcom bust, practically drowned asset markets with a tidal wave of liquidity and easy money. It was Mr Greenspan who drove the Federal funds rate – the rate charged by US banks for lending to their peers – down to 1 per cent in 2003-2004, a four-decade low. And it was Mr Greenspan who opened the floodgates of liquidity that might have saved the US equity market, for a time, but that also triggered an unsustainable boom in government and corporate debt, residential property, and a carnival of mortgage lending unimpaired by anything approaching prudence. It is now left to his successor, Ben Bernanke, to reap the whirlwind.

The post-millennial stock market rescue was not the only time Mr Greenspan stepped in to “save” Wall Street. He has form as a serial inflationist, willing to slash interest rates to bail out investors who should not need rescuing from themselves: one thinks of the stock market crash of October 1987; the Savings and Loan crisis; the Asian crisis; the collapse of hedge fund Long-Term Capital Management; the feared Y2K crisis. No central banker has done more for the concept of moral hazard – the risk that the perceived support of the monetary authorities will cause financial institutions to play fast and loose with other people’s money.

It is abundantly clear that, having gorged on overly easy money for years, Anglo-Saxon financial markets are suffering from indigestion.

As in previous financial debacles, the regulators will be found to have been asleep at the wheel. How else to explain the lax standards implicit in the lending activities of US subprime financiers – or the conflicts of interest at the heart of the ratings agencies tasked with appraising structured debt vehicles that now resemble pyramid schemes? Or the “price-to-model” evaluations of illiquid debt securities that allowed investment banks and hedge funds to price their portfolios pretty much wherever they wanted to?

The problem for financial markets now is that a functioning financial system ultimately comes down to trust. When trust is in short supply, there is no obvious price base for securities and credits that during the good times seemed to offer unimpeachable quality. Nor is this crisis of trust restricted to the corporate sector – national Treasuries have been busily debauching their own currencies with the help of the printing press. As Mr Greenspan himself admitted in 1999: “Gold still represents the ultimate form of payment in the world. Fiat money, in extremis, is accepted by nobody. Gold is always accepted.”

So the US now nurses concerns about credit quality and a possible credit crunch, a housing crisis, the sustainability of corporate profit margins and the logical response of consumer spending to deteriorating fundamentals. US lenders, mortgage brokers, investment banks and ratings firms will all, one suspects, enjoy their day in court.

But when the central bank itself was complicit in the funny money boom of the new millennium, one is left to wonder just how sizeable the “correction” and cross-market contagion could ultimately become.

Those of you who are long in tooth might remember the days when Dr. Doom, aka Henry Kaufman, chief economist of Salomon Brothers, could move the market. Kaufman was intellectual, articulate, and insightful. I remember as a summer associate listening to his section of the Monday morning meeting at Salomon. You could hear a pin drop when he spoke.

Although Kaufman’s sobriety has gone out of fashion, he has a hard-to-match perspective on the bond markets. In an opinion piece in the Financial Times, “The Dangers of the Liquidity Boom,” he discusses how the distinction between credit and liquidity has been blurred, and how it has led market participants to have exaggerated confidence in ready access to credit.

One illustration of the sort of sloppy thinking that worries Kaufman is the way that various pundits have argued that there is noting wrong with America’s declining and recently negative savings rate, since individual net worths are increasing. The appreciation in asset values means that consumers need to save less.

But when a crisis hits and a household needs funds suddenly, a rise in the value of one’s home or IRA is not as easily monetized as liquid assets. A strategy of selling or borrowing against assets presupposes that asset values are stable and that credit is available and reasonably priced.

From Kaufman:

In an interview with the Financial Times, Chuck Prince, chief executive of Citigroup, made this insightful remark: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you got to get up and dance. We’re still dancing.” Mr Prince was hinting at a conundrum investors and policymakers face as we float in a sea of liquidity.

Why do our financial institutions hear music in expanding liquidity? One reason is that the concept itself has been liberalised since the second world war. In the postwar years, liquidity was by and large an asset-based concept. For companies, it referred to the size of cash and very liquid assets; the maturity of receivables; the turnover of inventory; and the relationship of these assets to total liabilities. For households, liquidity chiefly meant the maturity of financial assets being held for contingencies along with funds that reliably would be available later in life. Today, companies and households alike often blur the distinction between liquidity and credit availability. It is now commonplace, when envisaging assets present and future, to think in terms of access to liabilities. Money matters but credit counts.

This new mindset has been abetted by at least three important structural changes. One is the tidal wave of securitisation that engulfed financial markets in recent decades. Conversion of non-marketable assets into marketable ones on a massive scale has changed the nature of financial assets as well as financial behaviour. Through securitisation, a vast array of assets once locked up in the portfolios of investors and lenders has been packaged, sold and resold alongside more traditional assets. Long-standing credit instruments have been joined by a long and diverse list of new ones, many extra ordinarily complicated, even arcane. The sharp increase in tradable assets has stimulated risk appetites, eroded traditional concepts of liquidity and fostered the expectation that credit is always available at reasonable prices.

Technological change also has bolstered the easy-credit outlook now common among investors. As markets have been linked globally by information technology networks, financial information flows nearly instantaneously, computerised trading is spreading and transactions are executed almost without delay. Investors can access financial data and participate in markets around the world and around the clock. This encourages a notion that markets for credit are always available and with near-perfect information.

These two developments – securitisation and the seamless interconnectivity of markets – have brought intricate quantitative risk-modelling to the forefront of financial practices. Securitisation generates market prices while information technology appears to hold out the promise of quantifying pricing and risk relationships. The potency of this combination – its effect on risk taking – cannot be overstated. Armed with complicated modelling techniques, powerful computers and reams of historical market data, growing numbers of investors have become entranced with the dream of scientific rectitude. Few recognise, however, that such modelling assumes a constancy in market fundamentals that is illusory.

No big financial institution wants to step off the dance floor while the music of liquidity is still playing. Doing so prematurely would risk the loss of enormous profits to competitors, declining earnings, eroding market share, employee dissatisfaction with bonuses and disgruntled shareholders. Executives are therefore loath to rely on judgment and reason in risk management. Rather, they are driven towards risk quantification and modelling, with their clear-cut timelines, aura of scientific certitude and lure of near-term profits.

The common practice of marking to market poses hidden risks amid the vast array of securities flooding the market. Marking to market overstates values and gives investors a false sense of comfort. When liquidity seizes up, no one can truly claim that the last quoted price in organised markets or quoted by dealers in the over-the-counter market is the real market value without considering other factors.

Today’s abundance of liquidity offers many short-term profit opportunities. But if the quality of debt continues to deteriorate, pressure will mount to expand the concept of liquidity even further, perhaps to absurd dimensions, and markets could turn the liquidity polka into a sombre march.

Grim news for the high-tech, health-minded set: office printers can emit micro particles that damage the lungs. From the BBC:

The humble office laser printer can damage lungs in much the same way as smoke particles from cigarettes, a team of Australian scientists has found.

An investigation of a range of printer models showed that almost a third emit potentially dangerous levels of toner into the air.

The Queensland University of Technology scientists have called on ministers to regulate these kinds of emissions.

They say some printers should come with a health warning.

The researchers carried out tests on more than 60 machines.

Almost one-third were found to emit ultra-tiny particles of toner-like material, so small that they can infiltrate the lungs and cause a range of health problems from respiratory irritation to more chronic illnesses.

Conducted in an open-plan office, the test revealed that particle levels increased five-fold during working hours, a rise blamed on printer use.

The problem was worse when new cartridges were used and when graphics and images required higher quantities of toner.

The researchers have called on governments to regulate air quality in offices.

They also want companies to ensure that printers are based in well-ventilated areas so that particles disperse.

A draft of a paper, “Innovations in Credit Risk Transfer: Implications for Financial Stability,” by Stanford’s Darrell Duffie, investigates ” the design, prevalence, and effectiveness of credit risk transfer,” with an eye to implications for the financial system.

The paper is worth reading for those seriously interested in the CDO/CLO markets, and sets forth a “summary of opinions” some of which were speculative. One was particularly interesting:

While the gross level of credit derivative and CLO activity by banks is large, the available data do not yet provide a clear picture of whether the banking system as a whole is using these forms of CRT to shed a major fraction of the total expected default losses of loans originated by banks. The recent dramatic growth of CRT markets is driven mainly by various other business activities by banks and non-bank financial entities.

Duffie appears to have been diligent in mining available information, including regulatory data. The fact that he could not determine how much credit derivative activity of banks is on their own behalf, as opposed to clients, points to a large gap in knowledge. One would think regulators would have required banks to report on their use of derivatives to transfer risk as a part of their research and oversight.

Another finding is that “toxic waste” is aptly named:

Incidentally, the latest available data regarding returns on the equity pieces of CDOs is rather discouraging. Of all 59 CLO deals that had terminated in time for Moodys’ January 2007 report on CDO equity returns, the mean across deals of the internal rate of return on the equity pieces of CLOs was estimated by Moodys to be 2.35% with a standard deviation of 21.14%. For collateralized bond obligations, the mean IRR of the equity tranches across 36 terminated deals was −14.2% with a standard deviation of 43.5%.

Duffie also finds flaws in model construction, namely the assumptions on default correlation. In lay terms, this means how diversified the portfolio is from a default risk perspective. He says in pretty unvarnished terns that there is no empirical foundation for current practice:

Currently, the weakest link in the risk measurement and pricing of CDOs is the modeling of default correlation. There is relatively little emphasis in practice on data or analysis bearing on default correlation. When valuing CDOs, somewhat arbitrary “copula” default correlation models are typically calibrated to the observed prices of CDS-index tranches, a class of derivatives that behave much like CDOs, as explained in the Appendix. Some of the industry-standard calibrated correlation models are internally inconsistent, as we shall see by example, in that the correlation model that matches the price of one tranche of a CDO structure is typically much different than that of another tranche of the same structure. Although these differences are sometimes eliminated in practice with proprietary copula models that have a richer set of parameters, the additional parametric details are usually not based on information that bears realistically on default correlation. A model with enough flexibility can be made to match market prices, without necessarily capturing reality in any significant way. Risk managing the mark-to-market valuation of CDOs, moreover, is not treated directly by the current copula approach to valuation, which has no place in its modeling framework for uncertain changes in credit spreads.

The dependence of the market on CDO valuation methodology is particularly weak in the case of bespoke CDOs, those based on a customized portfolio of names. Bespoke CDO correlation assumptions tend to be based on extremely slender analysis, largely extrapolation of CDS-index-tranche-implied correlation parameters, with little evidence or analysis of the degree to which common risk factors are present in the actual bespoke portfolio.

Institutional investors tend to rely on the ratings of structured credit products, including CDOs, when making investment decisions. Methodologies for rating CDOs, however, are still at a relatively crude stage of development. Correlation parameters used in ratings models tend to be based on rudimentary assumptions, for example treating all pairs of names within a given industrial sector as though they have the same default correlation, and treating all pairs of names not within the same industrial sector as though they have the same default correlation. As opposed to valuation models often used for dealing, investment and hedging decisions, ratings decisions place at least some emphasis on data bearing directly on correlation.

The Appendix delves further into the default correlation issue. Duffie posits it may explain why hedges of CDOs have not worked correctly:

The predominant industry approach to pricing and hedging CDOs and tranched index products is known as the “copula.” A key parameter for the Gaussian copula model, the version of the copula model most commonly used for quotation purposes, is known as the “base correlation.”…..The copula correlation parameter is in theory a property of the underlying pool of debt, not a property of the tranches. ….

Because hedging depends on accurate pricing, the lack of reliable industry models for CDO pricing is especially problematic for dealers in tranche products, or levered hedge funds, who tend to hedge their mark-to-market exposures to certain tranche products with positions in other products…..The current lack of reliable default correlation models also leaves significant doubt about the quality of pricing of “bespoke” tranches, those based on a pool of collateralizing debt that is tailored to the specifications of investors.….

A notorious example of the ineffectiveness of delta hedging of tranches occurred with the rating downgrade of General Motors (GM) debt in May, 2005. Theoretically, the loss that occurred to a seller of protection on the equity CDX tranche should have been largely offset by buying protection with a mezzanine tranche position, sized to offset the delta exposure of one tranche with the delta exposure of the other. For example, the deltas shown in Table 4 would have implied buying mezzanine protection for 71.4/18.4 = 3.9 times the total CDX debt principal underlying the equity tranche position. Some market participants who took this Delta-based approach to hedging equity tranche positions with mezzanine tranche positions suffered significant losses when the mezzanine tranche price did not respond to the GM downgrade as suggested by the delta estimates that were used at the time of the downgrade. Indeed, the mezzanine tranche prices responded much less vigorously than predicted by the copula-based Delta models available at the time, and in fact responded in the opposite direction to that suggested by standard models. Rather then reducing their losses, hedgers following this approach slightly increased their losses! In mid-2007, a hedge fund managed by Bear Sterns suffered significant losses on CDOs backed in part by
sub-prime mortgages.

Even when theoretically correct, delta hedging need not be especially effective in the face of large sudden price changes. In the case of the GM downgrade, standard copula-based delta models were inadequate to the task. Reporters also questioned whether efficient market pricing was a reliable approach during the GM downgrade, given the limited amount of capital available to take advantage of tranche price distortions caused by a rush by some market participants to exit their losing positions. The situation was further exacerbated by the fact that the rating downgrade moved GM debt from investment grade to speculative grade. Investors specializing in investment grade debt (by design or by contractual limitation) would have needed to sell an exceptionally large amount of GM debt relative to the entire size of the speculative grade bond market. The associated price impact, or at least anticipation by traders of the potential price impact, could have further pushed market prices away from their efficient-market levels.

The more I learn about CDOs, the more I am convinced that this form of financial alchemy will come to be recognized as junk science. While the basic structure and objectives of CDOs and other tranched products, namely, assigning priority in payments of principal and cash flow in order to create new securities with particular characteristics (in this case, triple A credit ratings) to satisfy market demand, is valid, many of the analytical and pricing approaches are either flawed or based on insufficient data.

And the notion that Bear Stearns hedge fund problem of hedges failing to work, and that possibly being a result of shortcomings in default correlation, is disturbing, for it suggests it isn’t the last time we will see this sort of mishap. Portfolio insurance, a technique of automated selling that was supposed to improve the safety of institutional equity holdings, instead acted as an accelerant in the 1987 crash. Will failed CDO delta hedges play the same role in this credit contraction?

It turns out that those who blame the recent increase in the number of Atlantic hurricanes on global warming aren’t nuts. A study just published in the Philosophical Transactions of the Royal Society analyzed storms over the last century. It found that the increase since 1980 was due to climate change, and attributed 50% to 70% of the change in ocean warming to human activity.

From the BBC:

A new analysis of Atlantic hurricanes says their numbers have doubled over the last century.
The study says that warmer sea surface temperatures and changes in wind patterns caused by climate change are fuelling much of the increase.

Some researchers say hurricanes are cyclical and the increase is just a reflection of a natural pattern.

But the authors of this study say it is not just nature – they say the frequency has risen across the century.

Two-decade rise

Hurricanes are a spinning vortex of winds that swirl around an eye of low pressure.

Thunder clouds surround the edges of these storms and they can wreak devastation on people and property when they hit land – most famously in the case of Hurricane Katrina in New Orleans in 2005.

Scientific analyses in recent years suggest hurricane numbers have increased since the mid-1980s.

This new study, published in Philosophical Transactions of the Royal Society in London, looks at the frequency of these storms from 1900 to the present and it says about twice as many form each year now compared to 100 years ago.

The authors say that man-made climate change, which has increased the temperature of the sea surface, is the major factor behind the increase in numbers.

“Over the period we’ve had natural variability in the frequency of storms, which has contributed less than 50% of the actual increase in our view,” said Dr Greg Holland from the United States National Centre for Atmospheric Research in Colorado, who authored the report.

“Approximately 60%, and possibly even 70% of what we are seeing in the last decade can be attributed directly to greenhouse warming,” he said.

Experts say that 2007 will be a very active season with nine hurricanes forecast, of which five are expected to be intense.

According to Bloomberg, in “Bulls Load Up on Stocks in Worst Rout Since 2002 ,” optimistic investors are undeterred. In general, bond markets downturns precede stock market declines, since equity market investors need to be convinced that the signals from the credit markets are valid. In my youth, the lag was usually four months. And the “Greenspan put” conditioned investors to buy on dips, so we have nearly a generation of investors that have yet to see a credit-driven contraction.

The Journal, by contrast, in “Analysts Debate If Bull Market Has Peaked,” suggested that professionals are deeply divided on the prospects for equities.

The prospects for the stock market hinge on the bond markets. If liquidity returns to the fixed income world, the bulls will be proven correct. But if conditions continue to be uncertain or deteriorating, expect equities to take a toll.

From Bloomberg:

The biggest losses in equity and credit markets in five years are making the U.S. stock bulls more bullish.

The Dow Jones Industrial Average posted its steepest gain since 2003 on July 12, two days after tumbling on Standard & Poor’s plan to cut credit ratings for bonds backed by subprime mortgages. The benchmark for America’s biggest companies climbed to a record the next week, following a decline sparked by losses in Bear Stearns Cos. hedge funds. Some of the world’s largest investors say the S&P 500′s biggest slump since September 2002 last week now offers them even more opportunities to profit.

“You look at earnings, you look at ongoing takeovers, and I’m happy to increase holdings as valuations improve,” said Andy Brough, who helps oversee $7.6 billion at London-based Schroder Investment Management Ltd. “You make money buying shares when markets are falling, and that is what I’ve been doing.”

Money managers say the 4 1/2-year bull market remains intact, even after stocks around the world lost about $2.1 trillion of market value last week, according to data compiled by Bloomberg. Equities are even more of a buy because profits are growing, shares remain cheap compared with earnings and the Federal Reserve isn’t restricting credit, according to fund managers at Schroder, ABN Amro Asset Management, BlackRock Inc. and JPMorgan Private Bank.

Junk Bonds

Stocks tumbled around the world last week on concern higher borrowing costs will slow takeovers, spur defaults and curb earnings. The Dow average fell 4.2 percent to close at 13,265.47. The S&P 500 dropped 4.9 percent to 1458.95. The Dow Jones Stoxx 600 Index in Europe lost 5.1 percent to 372.69, the largest decline since March.

The Stoxx 600 rose 0.3 percent as of 9:18 a.m. in London today. September futures on both the Dow average and S&P 500 added 0.6 percent.

The extra yield investors demand to own U.S. high-yield corporate bonds rather than Treasuries is rising at the fastest pace in five years, according to Merrill Lynch & Co. data. Spreads on bonds rated below Baa3 by Moody’s Investors Service and BBB- at S&P widened 91 basis points last week, or 0.91 percentage point, the most since June 2002, when they surged 109 basis points.

`Extreme Volatility’

The risk of owning corporate debt in the U.S. and Europe has also risen amid concern the slump in securities backed by mortgages to people with poor or limited credit will spread across bond and equity markets. Credit-default swaps based on $10 million of debt in the CDX North America Investment Grade Index rose last week to $81,250, the highest since the index was created in 2004, according to prices compiled by Frankfurt-based Deutsche Bank AG.

Investors are shunning bonds and loans needed to fund leveraged buyouts. About $690 billion of the debt-fuelled takeovers supported this year’s stock rally. Cadbury Schweppes Plc, the world’s largest candy maker, on July 27 became the first company to delay an acquisition because of “extreme volatility” in debt markets.

“This whole subprime issue is of course not positive,” said Astrid Smit, head of investment strategy at ABN Amro, which oversees $260 billion. “But the fundamentals still look good. If you sell equities, what are you going to buy? In the current environment, it is still the preferred asset class to own.”

Smit said some of ABN Amro’s funds were using the pullback to reduce cash holdings and buy stocks. The company is a unit of Amsterdam-based ABN Amro Holding NV, the biggest Dutch bank.

`Heads Taken Off’

Jim Paulsen, who helps oversee $175 billion at Wells Capital Management, is buying shares of financial companies, the worst performing industry in the S&P 500 this year. The S&P 500 Financials Index has plunged 7.4 percent this month, poised for its biggest monthly decline since September 2002.

“The market has chronically wanted to produce a crisis,” said Paulsen, the chief investment strategist at Minneapolis- based Wells. “When you’re seeing financial stocks getting their heads taken off, it’s hard to step in. But there’s a possibility of a good return over the six- to nine-month horizon.”

Bear Stearns, down 24 percent this year, and Lehman Brothers Holdings Inc., which fell 18 percent, helped pace the decline in U.S. stocks on July 10 after S&P said it was preparing to lower ratings on billions of dollars in bonds backed by subprime home loans. The New York-based investment banks are the biggest underwriters of mortgage-backed bonds.

Economic Growth

The S&P 500 and Dow average rebounded the next day as Fed officials said the economy will weather the worst housing slump since 1991. The Dow posted its biggest gain since 2003 on July 12, rising 283.86 points, or 2.1 percent, as economists increased forecasts for second-quarter growth after a government report showed exports climbed to a record in May. Europe’s Stoxx 600 Index also rallied.

“People have taken their eyes off the good news, the fact that the economy seems to be poised to reaccelerate, that earnings have been much better than expected,” said Jack Caffrey, the New York-based equity strategist at JPMorgan Private Bank, which has more than $300 billion in client assets. “This has been something of a gift. You have the chance to buy at particularly low valuations.”

The Commerce Department said on July 27 that the U.S. economy grew at a 3.4 percent annual rate last quarter, the fastest pace in more than a year.

Booming Growth

Better-than-expected profits from Armonk, New York-based International Business Machines Corp., the world’s largest computer-services company, helped propel the Dow average above 14,000 for the first time on July 19, a day after losses at two Bear Stearns hedge funds sent the 30-stock gauge down as much as 1.1 percent. European stocks also advanced after earnings from Walldorf, Germany-based SAP AG, the world’s biggest maker of business management software, beat analysts’ estimates.

Robert Doll, who oversees $1.2 trillion as chief investment officer of global equities at BlackRock in Plainsboro, New Jersey, said some of his funds bought shares of energy producers as the market declined last week.

“Global growth continues to boom,” said Doll, who predicts the S&P 500 will rise another 6.2 percent this year. “The building blocks for this bull market are still there.”

The S&P 500, the benchmark for American equity, is up 2.9 percent this year and the Dow industrials gained 6.4 percent. The Stoxx 600 index advanced 2 percent.

Stocks recovered even more quickly on July 25 from declines sparked by the credit markets. A rally in energy shares and earnings that beat analysts’ estimates from Seattle-based Amazon.com Inc., the world’s biggest online retailer, helped the S&P 500 and Dow average rebound and close higher.

Deal Troubles

Benchmark indexes fell earlier that day after banks hired by New York-based Kohlberg Kravis Roberts & Co. failed to sell loans they provided to finance the $22 billion buyout of Nottingham-based Alliance Boots Plc, the U.K.’s biggest pharmacy chain.

More than 40 companies worldwide have reworked or abandoned debt offerings in the past month. Banks are holding at least $32 billion of loans from buyouts they haven’t been able to sell to investors, restricting funds for new deals.

“As some of these sectors get beaten up it gives you an opportunity,” said Robert Schumacher, who helps manage $135 billion as chief investment strategist at Van Kampen Investments in Oakbrook Terrace, Illinois. He expects the S&P 500 to climb as much as 20 percent in the next 12 months. “This isn’t a systemic problem that the economy can’t overcome.”

`Selling Opportunity’

Investors will face a more volatile market as the sell-off has accentuated price swings. The Chicago Board Options Exchange Volatility Index, derived from the prices paid for options on the S&P 500, climbed July 27 to the highest since April 2003.

Turmoil in credit markets foreshadowed stock declines in the past 20 years. Spreads widened on average six months before European shares reached highs in 1987, 1991, 1998 and 2000, according to Morgan Stanley. Stock market peaks were followed by declines of at least 10 percent in the Morgan Stanley Capital International Europe Index, according to a July 16 report by the New York-based company, the world’s second-largest securities firm by market value.

“We take no comfort from the fact that equity markets have been resilient in the face of deteriorating fundamentals,” Morgan Stanley strategists in London wrote. When the market “does not react to bad news it is a selling opportunity,” the analysts said in the report.

`Warning Sign’

U.S. stocks have also declined following “spikes” in high-yield corporate bond spreads, according to Bespoke Investment Group LLC, a research firm in Harrison, New York. A rise of more than 20 percent in spreads over an average of 103 trading days preceded drops of at least 2.8 percent in the S&P 500 six times since January 1997.

“It’s a warning sign,” said Quincy Krosby, who helps oversee about $330 billion as chief investment strategist at The Hartford in Hartford, Connecticut. “The very initial worry that says, `Take cover’ will show up in the spreads.”

Shares fell the most when price-earnings multiples were high, according to Bespoke’s calculations. The S&P 500 had a multiple of 48.8 when it plunged 23 percent in the seven months ending October 2002 as spreads on bonds with ratings below investment grade widened by 367 basis points. The S&P 500 traded for 27.8 times historical earnings when it slipped 2.9 percent in the almost seven months ended October 1998 as yield premiums widened 407 basis points.

Low Valuations

The S&P 500 is now valued at 15.4 times estimated profit, the lowest since January 1991 when compared with actual earnings, according to Bloomberg data. That’s one reason why any slide in U.S. stocks may be limited, Bespoke wrote in a note on July 24.

Those valuations, coupled with steady Fed interest rates since June 2006, are enough to make stocks a buy, said Walter “Bucky” Hellwig of Morgan Asset Management. The turmoil in the credit market is allowing him to add to holdings in technology, energy, and raw-material shares at cheaper prices.

“In a perverse sense, the widening of these spreads in conjunction with rising earnings makes the stock market more attractive,” said Hellwig, who helps oversee $30 billion in Birmingham, Alabama. “Interest rates are still low, inflation is still low, and there still is global growth and equities are becoming more attractive.”

At junctures like this, when markets have come a bit unglued and may be undergoing a sea change, making forecasts is as scientific a process as reading tea leaves. And since I am (literally) at sea with pricey satellite access, I’m limiting myself to checking the usual suspect media sources rather than being as comprehensive in surveying the landscape as I’d like to be.

Nevertheless, at this greater-than-usual remove, we’ll hazard a few observations:

1. It is striking how much the press (which presumable reflects their sources) is trying to sound a reassuring tone. For example, the Wall Street Journal, in “Investors Surf Choppier Markets,” asserted that things aren’t as bad as they seem:

Rising volatility, along with heavy trading volume, isn’t necessarily troubling. There have been similar recent periods when volatility, or sharp moves in the prices of securities, soared to these levels, and each time markets rebounded sharply. And a surge in volume doesn’t indicate which way stocks are headed next.

It feels worse this time around to some, though, because it has been so long since they had to deal with these kinds of jumpy markets.

Even the usually cold-blooded Financial Times offered some solace in its Lex column, “The end of LBOs.” It argued that, despite the seeming unending stream of ever bigger transactions, private equity was not playing a large role in equity price formation, hence its exit would not be a death knell for the stock market:

Private Equity Intelligence provides an estimate for “dry powder” – committed equity as yet unspent – for buy-out funds. To this can be added the likely capital raised by private equity outfits on the road now to produce a total of $548bn. It is reasonable to assume that this money is spent on takeovers that are three-quarters debt-financed and occur at a one-third premium to the stock market price.

On this basis the total LBO takeover premium due to be paid to stock market investors is $506bn. This is only 2 per cent of North American and European market capitalisation. Of course, this might be concentrated in specific areas – smaller capitalisation stocks for example – and in certain countries such as the UK. But if investors are accurately discounting the immediate pipeline of activity, anticipated LBO takeover premiums are not heavily distorting equity prices in aggregate.

Might stock markets instead be discounting a much longer golden era of near indiscriminate buy-outs? This is what fans of private equity predict: the underwriters’ research on Fortress Group, for example, is comically bullish, in one case forecasting assets under management of $23bn top $260bn by 2016.

Yet it is doubtful that public equity investors accept this kind of “new paradigm” argument. If they believed the conditions were ripe for a sustained, massive rise in leverage, big quoted companies would not have prudent balance sheets and be valued on earnings multiples that imply profits may be near a cyclical peak. Public equities most likely reflect the view that the LBO boom is a cyclical phenomenon of finite duration and questionable wisdom.

Michael Panzner characterized this sort of commentary as a sign of complacency; it reads to me instead as participants trying to talk down collective, and perhaps their own, fear.

Bloomberg is calling a rally in “Cheapest Stocks in 16 Years Draw Investors Amid Rout,” pointing to demand for health care, tech, and telco stocks.

2. The market’s slide continued despite the release of a strong GDP data. Not only did GDP rise at an annualized rate of 3.4%, but the GDP deflator, the Fed’s preferred measure of inflation, rose at an annualized rate of only 1.4%, versus 2.4% last quarter. This is just about as good as it gets once you are past the initial phase of a business cycle, yet the markets shrugged it off. A decline in the face of good data indicates entrenched bearish sentiment. However, it’s possible that investors will take this information to heart by Monday.

3. The underlying cause of this mini-panic, the suddenness and severity of this credit contraction, does not yet appear to be relenting and credit market participants are worried it could extend its reach. As the Financial Times, in “‘Wake-up call’ for investors,” tells us:

A flight to safety saw US government bonds rally, the yen strengthen and emerging market debt and equities stumble. An index of the main indicators of risk across asset classes compiled by UBS showed that risk-aversion had hit its highest level since the terrorist attacks in September 2001.

From Bloomberg’s “Treasuries Rise Most Since September Amid Credit Market Rout”:

“If we get a couple days without any big blowups, a good amount of the risk that’s been priced in will start to reverse,” said Michael Pond, an interest-rate strategist in New York at Barclays Capital Inc., one of 21 primary dealers required to bid on Treasury auctions. “The market will focus more on fundamentals, which will bring a rise in yields.”…..

Credit-default swaps based on $10 million of debt in the CDX North America Investment Grade Index soared as much as $13,500 yesterday to $81,000, according to Deutsche Bank prices, the highest since the CDX indexes were created in 2004. The iTraxx Europe Series 7 Index of 125 companies with investment- grade credit ratings jumped 16,000 euros ($21,800) to as much as 60,000 euros, the biggest increase since the index was created three years ago….

The difference in yields between two- and 10-year notes rose to 25 basis points from 19 points a week ago, the highest since September 2005, suggesting investors are seeking the safety of shorter maturities.

The much anticipated and dreaded unwinding of the carry trade is playing into the credit contraction. If it reverts to its old pattern, the debt markets would benefit from the increased liquidity, but if the yen continues to rally, a rocky situation could worsen. From the Financial Times:

The strengthening of the Japanese currency indicates an unwinding of the carry trade, in which investors borrow in cheaper currencies to buy higher-yielding assets elsewhere, which has been a significant source of liquidity in global markets.

Bottom line: equity markets are being driven by bonds. If conditions in credit markets remain uncertain, expect more volatility and erosion in stock prices. If the credit markets regain their footing, and risky borrowers can again obtain funding (presumably at richer prices), the stock markets will shrug off this week as it did the traumatic two weeks that started February 27.

The New York Times’ Floyd Norris, in “In This Mess, Finger Pointing Is in Style,” discussed who might be responsible for the subprime woes and included this tidbit:

Who’s to blame for the subprime mortgage mess?

It’s the lenders, says William Poole, the president of the Federal Reserve Bank of St. Louis. As he sees it, bankers and mortgage brokers persuaded innocent borrowers to take out ARMs — adjustable rate mortgages — when rates were all but sure to rise. He also blames investors who bought the mortgage securities that are now in trouble.

Bankers should take their share of scorn, but they were not the only ones who encouraged borrowers to take out adjustable rate mortgages at precisely the wrong time. So did Alan Greenspan, the longtime chairman of the Federal Reserve.

In Mr. Poole’s view, it was obvious from 2002 to 2004 that short-term interest rates were all but certain to rise, thus driving up the cost of ARMs. But the bankers did not point that out to their customers.

“Apparently driven by the prospects of high fee income,” said Mr. Poole in a speech a week ago, “mortgage originators persuaded many relatively unsophisticated borrowers to take out these mortgages; then, investors willingly purchased them when they were securitized. Many of these mortgages are now in default, some of the lenders are bankrupt, and the mortgage-backed securities are trading at deep discounts to face value.”

In 2004, however, the Fed sent a different signal. Mr. Greenspan, speaking to Credit Union executives on Feb. 23, said “recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable rate mortgages rather than fixed rate mortgages during the past decade.

”
Norris focused on the implicit criticism of Greenspan and the barb is well deserved. Security, particularly where most American’s biggest financial asset is concerned, might be worth the tens of thousands of dollars worth of insurance embodied in a fixed rate mortgage.

However, what is at least as interesting is Poole’s criticism of the banking industry. I can’t recall a time when a financial regulatory official has blamed mainstream institutions (as opposed to a few outliers) of taking advantage of customers. Is the Fed finally getting on board with the idea of borrower protection? Or is this simply lip service in the face of recent Congressional pressure?

Today’s Financial Times has a good piece on the turmoil in the markets yesterday, which has continued into Asian markets today (although Europe appears to be staging a recovery). There were two noteworthy elements in this article, namely the divergence between the equity and credit market perspectives, the second on Bernanke’s posture.

On the first issue, the disparity between the fixed income and equity market viewpoints, fixed income types speak of truly grim conditions, of the markets for riskier credits having shut down completely, and concerns that the market seize-up could extend its reach to better quality credits. By contrast, many of the equity market participants sounded relatively sanguine, believing that the credit markets are working through a repricing of risk, but that earning yields are sufficiently high so as to be able to withstand an increase in yields.

It seems that there is limited personal and institutional memory of the days when credit was less freely available and the fixed income markets ruled the earth. Political strategist James Carville once joked he wanted to come back as the bond markets because then he could intimidate everybody. If the credit contraction continues, it will affect the real economy, not just the financial markets. The optimistic sorts forget that corporate earnings will suffer at higher interest rate levels (which may come via increased risk spreads rather than a change in Treasury yields). And corporate cost cutting has already been widespread and deep, There isn’t much if any fat to cut to improve margins to offset reduced sales.

Second, the article notes that Bernanke has said that he believes that the subprime problem will lead to only $50-$100 billoin of losses. This is lower than most private sector estimates. The consensus is in the $100-$200 billion range, with the highest estimate I have seen to date at $250 billion. Keep in mind that even $250 billion of losses is not large enough to do much damage to either the economy or financial institutions in and of itself. However, the greater the damage from subprimes, the greater the chill on the rest of the housing market.

It’s also puzzling that Bernanke has not made any reassuring remarks. He offered some soothing words after the February market plunge (although at a previously scheduled Congressional hearing) and both a Fed and a Treasury offered some calming statements the day Bear announced its losses on its hedge funds and the markets went into a bit of a panic. While the equity markets tend to get greater press coverage, it’s the credit markets that have a much greater impact on the economy, and they have been in turmoil for the last two weeks. Perhaps Bernanke wants to save his firepower for what he perceives to be a real crisis, but the current conditions in the credit markets are turbulent. How much worse do they have to get before he deigns to take notice?

From the FT:

There are two starkly opposing explanations for stocks’ belated reaction {to deteriorating conditions in the credit markets]. Bears say that cheap credit has provided the stock market with crucial support and that valuations can no longer be sustained. Jeremy Grantham, the respected founder of GMO, a large fund manager, goes so far as to liken the stock market to a dinosaur. “As yet the equity market seems totally unaffected, with volatile and risky stocks still making the running. Although the brontosaurus has been bitten on the tail, the message has not yet reached its tiny brain, but is proceeding up the long backbone, one vertebra at a time.”

A more positive view is that the credit market is undergoing a healthy correction and that it is natural for the credit and equity markets to diverge. Private equity investors, and companies themselves, are raising credit cheaply and using it to buy back shares. This directly favours equity investors at the expense of credit investors, who are left lending to companies with more debt on their balance sheet and hence a higher risk of default.

Larry Hatheway and Jeffrey Palma of UBS make this point forcefully in a recent note. “Shareholder-friendly behaviour in the form of mergers and acquisitions, leveraged buy-outs and buybacks should benefit equity investors relative to bondholders,” they say. They describe recent moves as fundamentally consistent and “rational”.

On this reading, there is no reason for equities to fall until returns for shareholders and lenders have been brought into balance.

Jonathan Morton of Credit Suisse said in a note that 28 per cent of S&P 1500 non-financial companies have free cash flow yields higher than their cost of capital – classic conditions for a private equity buyout. He added that it would take a five percentage point rise in corporate bond yields, which still looks highly unlikely, before this fell to less than 10 per cent of companies. Thus he expected private equity to remain a feature of the market, but not the principal driver.

Marc Chandler, currency strategist at Brown Brothers Harriman in New York, says: “While tighter credit is a concern, we posit that conditions are simply returning to a more ‘normal’ level after ‘abnormally’ loose conditions over the past few years.”

Practitioners on the ground in the credit market find it hard to be so sanguine. Rather than an orderly correction, they confront a situation where the market for riskier forms of credit seems to have come to a complete halt. US issuance of high-yield, or low-quality, debt stayed below $1bn for the third successive week, according to Thomson Financial. The last week of June brought $9.7bn of high-yield issuance; by last week that had fallen to $322m. This financing is crucial for private equity deals.

“The cancellation of high-yield deals and the inability of the large banks to syndicate their leveraged loans is causing the credit markets to shut down,” says T. J. Marta, strategist at RBC Capital Markets. “Something has to give here: either equities have to give it up or credit is going to implode.

“We knew this was coming,” he adds, “and the question is whether we reach a critical mass that causes a financial seizure or an economic event.” He says the next six to eight weeks, usually a quiet time for markets as many traders take their vacations, will be critical.

Problems for the credit market have also translated into further weakness for the dollar, which was already at its lowest level for more than a decade against various currencies before the credit market’s woes began in earnest.

One big support for the dollar is the inflow of foreign money used to buy US debt securities. If demand for these securities continues to collapse, the dollar will lose another support. Another perverse effect is that government bonds, subject to a dramatic sell-off last month as traders reacted to stronger economic data, are recovering. This is because investors are seeking a low-risk “safe haven”.

David Ader, rates strategist at RBS Greenwich Capital, says: “If it were only a story of the economic data, yields would be higher for sure. But it’s not a case of the data but this grinding unwind of risk and decrease in risk tolerance. It’s a process, it’s a theme, and it won’t end tomorrow.” Admitting he does not know the answer, he says traders are betting either that this return of risk aversion hits stocks and hurts the economy or that it merely hurts Wall Street, leaving Main Street unscathed.

Regulators, however, still appear to believe that the problem will not cause a systemic crisis for the  market and will require no external intervention. Ben Bernanke, Fed chairman, in publicly estimating subprime losses at $50bn-$100bn, declined to reassure investors that the problem would not spread to other markets. But the central bank still seems confident that the process at work is a healthy one that will remove excesses.

“The punishment has been meted out to those who have done misdeeds and made bad judgments,” said William Poole, governor of the St Louis Fed, last week. “We are getting good evidence that the companies and hedge funds that are being hit are the ones who deserve it.”

This may justify the confidence of investors. Yet equity markets were sending some warning signals before Thursday’s plunge. Financial stocks have sharply underperformed, while the largest stocks are outperforming smaller companies. This “narrowing” of the market to the biggest names typically happens at the end of a long bull market.

But equities can also point to separate means of support. US corporate earnings appear to be on course to grow at an annual rate of more than 5 per cent in the second quarter – impressive after four years of uninterrupted strong growth. Companies are not heavily geared, so costlier credit will not much dent their profits.

Until Thursday, emerging market equities were still within 1.5 per cent of their record highs, while the price of emerging market debt has fallen much less than that of US corporate debt over the past few weeks. This suggests that confidence in the secular growth of the big emerging markets remains intact, despite the current wave of risk aversion.

Nor is the credit market the only source of liquidity. The large sovereign wealth funds of oil-rich states and successful Asian economies have a surfeit of cash and a need to place it somewhere. China’s purchase of a stake in Blackstone, the giant private equity house, and its role in Barclays’ bid for ABN Amro suggest that this cash will continue to support the market.

Hence even some of the most aggressive bears suggest stocks could avoid a decisive turn downward for another year. As Mr Grantham puts it: “A few more bolts in the bridge may fail, but in the end you have to bet that the bridge will hold, supported by amazing animal spirits. The odds of failure rise but they probably don’t become high until October 2008.”

For the time being, there is less optimism in the credit market. Jim Reid, credit strategist at Deutsche Bank in London, Thursday recommended buying back into credit, having for months advocated betting on spreads to increase. But he said he expected the credit cycle to end “very messily” thanks to the “indiscriminate leverage” seen during the bullish period.

He added: “As a minimum the thing we are in little doubt about now is that having a huge derivative credit market does not give us a new paradigm of permanently tighter spreads, but instead a potentially violent and volatile credit market.”

An article in Nature magazine, as reported by the BBC, has found that ozone is a more significant greenhouse gas than previously recognized. Ozone interferes with plant photosynthesis, which reduces their effectiveness as a carbon sink. The study estimated that it reduced plant productivity by 14% to 22%, which is a large enough level to impair agricultural productivity.

From the BBC:

Ozone could be a much more important driver of climate change than scientists had previously predicted, according to a study in Nature journal.

The authors say the effects of this greenhouse gas – known by the formula O3 – have been largely overlooked.

Ozone near the ground damages plants, reducing their ability to mop up carbon dioxide (CO2) from the atmosphere.

As a consequence, more CO2 will build up in the atmosphere instead of being taken up by plants.

This in turn will speed up climate change, say the Nature authors.

“Ozone could be twice as important as we previously thought as a driver of climate change,” co-author Peter Cox, from the University of Exeter, UK, told the BBC News website.

Scientists already knew that ozone higher up in the atmosphere acted as a “direct” greenhouse gas, trapping infrared heat energy that would otherwise escape into space.

Ozone closer to the ground is formed in a reaction between sunlight and other greenhouse gases such as nitrogen oxides, methane and carbon monoxide.

Greenhouse emissions stemming from human activities have led to elevated ozone levels across large tracts of the Earth’s surface.

This study is described as significant because it shows that O3 also has a large, indirect effect in the lower part of the atmosphere.

Research into ground-level ozone has tended to concentrate on its harmful effects on human lungs.

But the gas also damages plants, reducing their effectiveness as a “carbon sink” to soak up excess CO2 from the atmosphere.

Co-author Stephen Sitch, from the Met Office’s Hadley Centre, said: “Calculations of the efficiency of land ecosystems to take up carbon would be less efficient than we thought previously.”

Furthermore, Peter Cox said: “The indirect effect is of a similar magnitude, or even larger, than the direct effect.”

There are uncertainties, Professor Cox admits; but he added: “Arguably, we have been looking in the wrong place for the key impacts of ozone.”

Ozone enters plants through pores, called stomata, in the leaves. Interfering with the reactions involved in photosynthesis, it leaves the plants weakened and undersized.

However, efforts to determine how rising levels of ozone will affect global plant growth are complicated by other factors.

High levels of both CO2 and O3 cause stomata to close. This means they take up less of the carbon dioxide they need for photosynthesis, but also absorb less of the harmful ozone.

The researchers built a computer model to estimate the impact of predicted changes in ozone levels on the land carbon sink over a period running from 1900 to 2100.

This model was designed to take into account the effect of ozone on plant photosynthesis and the interactions between O3 and CO2 through the closure of pores.

They used two scenarios, depending on whether plants were deemed to have high or low sensitivity to ozone.

Under the high scenario, ozone reduced plant productivity by 23%; under the low scenario, productivity was reduced by 14%.

“It’s an interesting effect, and I don’t think it has been introduced into a coupled [computer] model before so that the overall effect can be seen,” said Dr Nathan Gillett, from the Climatic Research Unit at the University of East Anglia, UK, who was not involved in the study.

The results may have implications for global food production, particularly in vulnerable areas.

We warned earlier that if conditions deteriorated in the financial markets, investment banks were particularly exposed by virtue of their taking on multiple exposures to the same underlying risk. For example, they lend to hedge funds via their prime brokerage operations, and also may be exposed to them by providing credit default swaps on assets they hold or providing customized derivatives.

Investors have awakened and realized that the unwinding of leverage represents not merely reduced profit opportunities for Wall Street, but is leading to significant losses on credit market positions which could reach a level that damages their equity bases. Prices of securities firm stocks and bonds have fallen sharply, and credit default swaps have spiked up to record levels.

If the credit contraction were to accelerate, the investment banks are the weak links in the financial system. In previous recessions, banks were still bigger players in aggregate in financial intermediation. When they engaged in profligate lending, such as doggy LBOs and lousy real estate deals in the late 1980s and took significant losses, the damage to their capital bases forced them to curtail lending, which produced a nasty recession.

This time around, investment banks are the dominant players in financial intermediation. In particular, a Bank of England report on financial stability singled out 13 “large complex financial institutions” such as Barclays, Goldman, Merrill, and UBS, as key players in global financial intermediation and that their concentrated risk exposure represented a source of systemic risk.

From Bloomberg:

The risk of owning bonds of Wall Street firms soared and their stocks plunged as concerns escalated that investment banks will be hurt by losses from subprime mortgages and corporate debt.

Credit-default swaps on $10 million of Goldman Sachs Group Inc. bonds jumped as much as $18,000 to a record $85,000, according to broker Phoenix Partners Group in New York. Bear Stearns Cos. credit swaps surged as much as $29,000 to $110,000, also a new high. Lehman Brothers Holdings Inc. climbed as much as $24,000 to $104,000. Goldman shares declined as much as 4.7 percent, Bear Stearns fell 5.9 percent and Lehman dropped 5 percent.

“You have a stampede of the animals away from the watering hole,” said Scott MacDonald, director of research at Aladdin Capital Management in Stamford, Connecticut, which manages about $20 billion in assets. “Right now, everything that smacks of financial risk is backing out through the door.”

Risk premiums surged and stocks dropped after Absolute Capital Group Ltd., an Australian hedge fund, suspended withdrawals from two funds after forecasting losses on U.S. subprime mortgages. The credit swaps extended increases from yesterday when banks including Goldman were stuck with $20 billion in loans they couldn’t sell to finance buyouts of Auburn Hills, Michigan-based automaker Chrysler and Europe’s Alliance Boots Plc.

An increase in the credit-default swaps, which are five-year contracts used to bet on the companies’ creditworthiness, signals deterioration in investor confidence.

Confidence Sapped

That confidence has been sapped after slumping demand for high-yield, high-risk debt forced almost 40 companies to rework or abandon bond offerings in the past three weeks, leaving banks holding at least $32 billion of risky debt on their own books. The decline threatens to bring an end to a record run for leveraged buyouts, which surged to a total $690.4 billion of deals this year, spelling a slide in advisory and underwriting fees.

The rising risk perceptions of brokers extended to stock indexes as well as those gauging the risk of owning everything from bank loans to subprime mortgages.

The AMEX Securities Broker/Dealer Index of 12 brokers dropped 4.5 percent, the biggest one-day decline since March, while an index allowing investors to bet on the U.S. leveraged loan market fell to its lowest since it began trading two months ago. Benchmarks gauging the risk of owning investment-grade corporate bonds in the U.S. and Europe had their worst day on record. An ABX index tracking default risk on the safest subprime bonds fell to its lowest ever.

`Less Tolerant’

“Investors are less risk tolerant,” said Camilla Petersen, an analyst at Atlantic Equities LLP in London who covers U.S. banks and securities firms. For the brokers, that means underwriting of leveraged loans and high-yield bonds may slow, she said. “It’s not a credit issue right now, because corporations aren’t defaulting on their debt. It’s more of a volume issue.”

Goldman Sachs analysts today took Merrill’s stock off their “conviction buy list,” saying in a note that “concerns about LBO activity and subprime/CDO exposure have pressured the stocks.” Future risks include “a prolonged slowdown in global equity markets, further widening of credit spreads or a decline in global GDP growth.”

Shares of New York-based Merrill tumbled $3.92 to a 10-month low of $74.18 as of 12:42 p.m. in New York Stock Exchange composite trading. Credit swaps on Merrill bonds rose as much as $28,000 to $90,000, the highest since October 2002, Phoenix prices show.

“Investors are jittery,” Petersen said. “So as soon as you get any prominent broker or analyst lowering their price target or downgrading the stock or pulling it off the conviction buy list, it’s just going to be sold down exponentially more than it would under normal market conditions.”

Deutsche, WestLB

Credit swaps on New York-based JPMorgan Chase & Co., which is helping finance both the Chrysler and Boots deals, rose as much as $25,000 to $75,000, Phoenix prices show. JPMorgan shares dropped $1.52, or 3.4 percent, to $43.75.

The CDX North America Investment Grade Index, tracking the credit risk of 125 U.S. investment-grade companies, rose as much as $10,250 to $67,000 in New York, according to Deutsche Bank AG.

In Europe, the benchmark iTraxx Crossover Index of 50 European companies rose 40,000 euros to 404,000 euros, according to JPMorgan. The iTraxx Investment Grade index, comprised of 125 companies, rose 8,250 euros to 44,250 euros.

Deutsche Bank

Default swaps on Deutsche Bank, Germany’s biggest bank, rose as much as 12,000 euros to 38,000 euros, according to Royal Bank of Scotland, from about 15,000 euros at the beginning of the month.

Deutsche Bank was one of eight banks stuck with 5 billion pounds ($10 billion) of loans for Kohlberg Kravis Roberts & Co.’s purchase of pharmacy chain Alliance Boots.

The LCDX index, tied to the speculative-grade loans of 100 companies, dropped to its lowest since it started trading May 22, signaling an erosion of confidence in that market. It fell 0.9 to 93.7, according to Goldman prices.

The CDX North America High-Yield Index, a gauge of U.S. junk-bond risk that falls as confidence erodes, dropped 0.94 to 91.94, according to Phoenix. The price implies it costs about $498,000 to protect $10 million in junk bonds, up from $471,000 yesterday and approaching a record $517,000 in May 2005, according to a JPMorgan pricing model and Credit Suisse Group data.

Delinquencies on subprime mortgages underlying benchmark derivatives indexes accelerated in June, increasing the chances that the bonds will default, reports yesterday showed.

Subprime Losses

Hedge funds run by at least seven firms reported or forecast losses after the rout in securities backed by subprime mortgages, some of which have lost at least half their value as defaults among the riskiest borrowers rise.

The ABX index tied to 20 subprime mortgage bonds rated AAA and created in the second half of last year dropped about 0.4 percent to about 94.13, according to a Goldman Sachs note to clients. The index has dropped 5 percent this month, suggesting a similar decline in the value of top-rated subprime mortgage bonds. Those bonds hadn’t lost much value until this month.

The 10-year interest-rate swap spread, a gauge of what companies pay over benchmark lending rates, rose to 74.2 basis points, the highest since February 2002.

Regular readers know I have limited internet access now by virtue of being (literally) at sea. I checked in and saw the dramatic decline of the equity markets and figured a distraction might be welcome.

From the BBC:

A US cat that is reportedly able to sense when a nursing home’s residents are about to die is baffling doctors.
Oscar has a habit of curling up next to patients at the home in Providence, Rhode Island, in their final hours.

According to the author of a study in the New England Journal of Medicine, the two-year-old cat has been observed to be correct in 25 cases so far.

Staff now alert the families of residents when he sits down next to their ailing loved one.

“He doesn’t make many mistakes. He seems to understand when patients are about to die,” David Dosa, a professor at Brown University who carried out the research, told the Associated Press news agency.

Oscar was adopted as a kitten at Steere House Nursing and Rehabilitation Centre.

The cat is said to do his own rounds, just like the doctors and nurses at the home, but is not generally friendly to patients.

Although most families are grateful for the warning Oscar seems to provide, some relatives ask that the pet be taken away while they say their last goodbyes to their loved ones.

When put outside the room, Oscar is said to pace up and down meowing in protest.

Thomas Graves, a feline expert from the University of Illinois, told the BBC: “Cats often can sense when their owners are sick or when another animal is sick.

“They can sense when the weather will change, they’re famous for being sensitive to premonitions of earthquakes.”

A doctor who treats patients at the home said she believed there was probably a biochemical explanation, rather than the cat being psychic.

The drumbeat of grim news on the housing front continues apace. From the Financial Times:

Peter Kretzmer, an economist at Bank of America, said: “We are in the second wave of declining home sales. The first wave was the breaking of the upward momentum and flattened out late last year. But now we are seeing the initial stages of a second wave of decline, hastened by lenders becoming more cautious.”

The Wall Street Journal, in “The State of the Slump,” pointed to a few upscale markets where residential real estate is appreciating. However, the macro picture is not pretty, and I found these factoids noteworthy:

Jeffrey Mezger, chief executive of KB Home, one of the nation’s largest mass-market builders, says its average home price has fallen about 12% from a year ago. In some markets, such as Southern California, he says, “there are two markets emerging.” While the high-end housing market has remained strong, prices are down in the entry-level and first-time move-up market.

As measured by the S&P/Case-Shiller national index, house prices in this year’s fourth quarter are likely to be down about 7% from a year earlier, says Thomas Lawler, a housing economist in Vienna, Va. He expects a further fall of about 3.5% in 2008.

First, to the 12% price fall at KB Homes. As we noted earlier, sellers, particularly homebuilders, have been offering incentives to close deals, so the effective price decline is almost certainly greater than the nominal level. Second, Case-Shiller has been more bearish than other forecasters for some time (and has been proven correct), to our knowledge, this is the first time we’ve seen a projection of price decline of over 10% from a housing market expert. As we’ve stressed before, this is a massive level for the US as a whole (a national slump is a completely different beast than a local market bust).

Although the Journal finds a bit of cheer in the relatively good performance of higher-priced homes, if credit tightening continues, they too will be affected.