On Bear and Credit Woes

Currently docked in Marseille (managed to get a Financial Times yesterday in Monaco, so I feel slightly less cut off from the symbol world) and catching up on the grim market news of yesterday.

It seems that the equity markets are getting the message that things are bad enough in the credit markets so as to affect the real economy, as opposed to merely a few isolated funds and certain types of investments. Even though the Bear downgrade by S&P was the proximate cause, there has been a barrage of bad news this week: subprime-related casualties, a worsening outlook for housing due to banks restricting credit even to reasonably solid borrowers, weakening employment stats.

The odd thing is that all these outcomes were predictable provided one acknowledged that the housing market was as inflated as it is being proven to have been. The other credit excesses, namely LBOs and CDOs, have yet to work themselves through, but their main impact is likely to be indirect. They have the potential to impair the capital bases (or merely the risk appetite) of the major investment banks, which would prolong the credit contraction and in a downside scenario, might produce a systemic seize-up.

Finally, there are rumors that Bear will be acquired. I can't imagine someone will want to catch that falling safe, but DeutscheBank, in a similar value-destroying exercise, acquired Bankers Trust roughly a decade ago. Note my negative view isn't based primarily on the worth of Bear's franchise. If that were the only consideration, it might be a very good time to snap up the firm. Investment bank acquisitions have a terrible track record, and Bear has a particularly entrepreneurial, sharp-elbowed culture. I can't see it as a fit with any other financial services firm.

The high (or, more accurately, low) points from the yesterday's market action Bloomberg. The one item this Bloomberg story misses is a similarly predictable weakening in consumer spending, and we feature a Financial Times story on that topic after the Bloomberg story.

First, from Bloomberg:

Stocks tumbled on evidence losses in the mortgage market may slow the economy and reduce bank profits, sending the Standard & Poor's 500 Index to its worst three-week retreat since 2003.

Bear Stearns Cos., the manager of two hedge funds that collapsed last month, helped carry financial shares to their biggest decline in five years after S&P cut the company's credit outlook. Energy shares fell to the lowest since May, led by Exxon Mobil Corp. and Chevron Corp., on speculation weaker job growth and falling oil prices will hurt earnings.

The S&P 500 erased its gain for the week, falling 39.14, or 2.7 percent, to 1433.06 in its worst day since Feb. 27. The Dow Jones Industrial Average slumped 281.42, or 2.1 percent, to 13,181.91. The Nasdaq Composite Index sank 64.73, or 2.5 percent, to 2511.25.

The sell-off exacerbated a rout last week that wiped $2.1 trillion in value from global equity markets. Shares declined in Europe, with benchmark indexes dropping in all 18 western European markets except Luxembourg. An index of market volatility in the U.S. rose to a four-year high.

``We're just seeing more and more credit problems,'' said Michael Strauss, who helps manage $40 billion at Commonfund in Wilton, Connecticut. ``It's going to be difficult for the market to trade with any confidence.''

Almost 12 stocks fell for every one that rose on the New York Stock Exchange as all 24 industry groups in the S&P 500 and all 30 members of the Dow fell.

The yield on the benchmark 10-year Treasury note fell 9 basis points, or 0.09 percentage point, to 4.68 percent. The dollar fell the most in almost a month against the euro, trading within a cent of its record low. Some 2.1 billion shares changed hands on the NYSE, 29 percent more than the three-month average.

Stocks opened the day lower after the Labor Department said employers added fewer jobs than economists forecast in July and a private report showed growth in U.S. service industries slowed.

Bear Stearns

Bear Stearns had its credit-rating outlook cut to negative by S&P on concern declining prices for mortgage-backed securities will decrease earnings. The perceived risk of owning the New York-based company's bonds rose to the highest in at least six years.

Stocks fell to their lows of the day after the firm said its return on equity in July may be close to the lowest ever and borrowing costs may slow mergers and acquisitions.

'As Bad as I've Seen It'

``I've been out here for 22 years, and this is as bad as I've seen it in the fixed-income markets,'' Chief Financial Officer Samuel Molinaro said on a conference call with analysts. He compared the crisis to 1998, when hedge fund Long-Term Capital Management collapsed and Russia defaulted on its debt. Bear Stearns fell $7.28, or 6.3 percent, to $108.35, the lowest since 2005.

The S&P 500 Financials Index fell 3.8 percent, its steepest loss since 2002, and contributed the most to the drop in the overall S&P 500. An index of brokerages and money managers in the S&P 500 has fallen 15 percent since reaching a record on May 30.....

Credit-market losses stemming from subprime lending are leading to a tightening of funds available for investment, and helping to drive up the cost of borrowing for consumers and companies...

'Big Logjam of Credit'

``You've got a big logjam of credit that can't clear,'' said Brian Barish, who helps oversee about $10 billion at Cambiar Investors in Denver. ``Add a lot of fear and rumor, and it makes for a tough situation.''...

Volatility Surge

The Chicago Board Options Exchange Volatility Index rose to 25.16, the highest since April 2003. Higher readings in the so- called VIX, derived from prices paid for S&P 500 options, indicate more risk in stocks.

In economic reports, the Labor Department said 92,000 jobs were added to payrolls in July compared with a forecast for an increase of 127,000 in a Bloomberg survey of economists. The jobless rate rose to 4.6 percent in July from 4.5 percent in June. Economists in a Bloomberg survey had expected it to remain at 4.5 percent.

The report said homebuilders cut payrolls by 12,000 after a 3,000 increase the previous month as the housing slump continues.

Homebuilders Slump

A gauge of homebuilders in S&P indexes dropped 5.3 percent as a group as all 16 of its members declined. D.R. Horton Inc., the second-largest U.S. builder, slipped 69 cents to $16.46. Pulte Homes, the third biggest, lost $1.40 to $18.59.

After the employment report, JPMorgan pushed back its forecast for when the Federal Reserve will change interest rates. The firm expects an increase in the middle of next year, compared with its prior prediction of around the end of this year.

The Institute for Supply Management said its non- manufacturing index dropped to 55.8 last month, from 60.7 in June. Economists in a survey had expected a reading of 59 for July. The index, which shows service industries still expanding, has averaged 56.8 in the past 12 months.

The Russell 2000 Index, a benchmark for companies with a median market value of $647 million, dropped 3.6 percent to 755.42. The Dow Jones Wilshire 5000 Index, the broadest measure of U.S. shares, fell 2.7 percent to 14,432.34. Based on its decline, the value of stocks decreased by $497 billion.

Today's sell-off left the S&P 500 with a 1.8 percent drop for the week and a 1 percent advance for the year. The Dow lost 0.6 percent this week and is up 5.8 percent in 2007.

Now, the Financial Times, in "US consumer spending slows":

US consumer spending rose at the slowest pace in nine months in June in a sign of cooling household demand.

Spending rose 0.1 per cent after a gain of 0.6 per cent the previous month, according to the Commerce Department.

The slowdown is likely to be a source of concern for policymakers, although many economists expect consumer spending to hold up amid strong hiring and rising incomes.

Incomes rose 0.4 percent in June for the second month, according to the report, slightly less than economists were expecting.

Consumer spending accounts for more than two-thirds of the economy but has been replaced as the main driver of growth in recent months as business activity picks up.

The Federal Reserve’s preferred gauge of inflation rose less than forecast, increasing 0.1 per cent for the fourth straight month.

The core personal consumption expenditure index - excluding volatile food and energy prices - was up 1.9 per cent from a year ago, the smallest increase in three years.

On the Power of Japan's Retail Currency Speculators

The UK's Times, in "The Kimono Traders," gives a detailed portrayal of the activities of Japan's army of retail currency traders, who are overwhelmingly female. They also happen to be aggressive and confident speculators, and control enough in the way of financial assets so as to dominate the activities of foreign institutional investors who are also playing the carry trade.

This female cadre has consistently sold yen into every rally, and their actions alone have kept the currency undervalued, which is creating a dilemma for the central bank. This brave new world of powerful retail traders sounds very much like the heyday of day traders in the dotcom era, and is likely to come to a similar sorry close.

The claim is that Japan's central bank has effectively lost the ability to influence the currency's direction because these retail trades in aggregate are large and uncontrollable.

That statement of course is nonsense, and the reality is more complicated (as an aside, while central banks' control over currency levels is limited, but they can send powerful signals that markets respect). If push came to shove, it would be easy to cut the air supply of these retail traders by restricting their access to margin credit (say by setting net worth requirements, or a certain level of capital commitment that would exclude a large proportion of current players from the market. Or similarly, it could impose a transaction tax that would make small trades uneconomic. (Admittedly, this sort of change may not fall within the central bank's purview. It may instead come under the jurisdiction of the FSA, or might even require legislation).

Similarly, the notion that the retail speculators will keep the yen low on an ongoing basis doesn't hold water either. It's essentially a weight of money argument. The first time I heard it was in Japan in 1985 (even then Japanese equities were overvalued by international standards). I was assured that Japanese stocks would never go down because Japanese financial institutions controlled so much capital and they would always invest the bulk of it at home. You know how that movie turned out. The analogy does suggest, however, that the domination of the fearful females could continue far longer than any sensible observer would anticipate.

The reason the authorities aren't yet taking action is fear of a political backlash. So far, despite the possibility of large-scale disruption of foreign economies and of large investor losses if the yen were to appreciate, this speculation is profitable and popular. And the powers that be believe that retail investment in higher-yielding foreign markets is a good thing. So intervening to correct this situation would be seen as wealth destruction, rather than prudent dampening of speculation. Regulators are likely to wait for the train to start to go off the rails before they act.

What might lead to an unwind? One scenario comes from an article earlier this year in the Financial Times, which argued that continued currency imbalances would lead to a deflationary crisis. The entire piece is worth reading, and here is the meat of its argument:

Central banks are likely to attempt to ratify current inflated asset values by inflating prices and incomes to avoid a deflationary economic collapse. Unfortunately, sharp reductions in interest rates in the US, UK and the euro area will lead to a rapid unwinding of the global carry trade, perversely threatening to worsen problems in the credit markets.

The solution would have to involve massive unsterilised intervention by the Japanese authorities, which would have the effect of inflating Japanese prices to a level consistent with the current yen exchange rate, thereby alleviating huge upward pressure on the yen as the carry trade unwinds.

Combined with a similar inflation in the US this "solution" would require roughly a doubling of the Japanese price level, destroying the real value of Japanese savings.

From the Times:

In an elegant café overlooking Shiba Park in Tokyo, Ritsuko Shiono looks up from her book to check the foreign-exchange spot rates on her pink, sequin-dashed mobile phone. She is particularly interested in the Turkish lira. Meanwhile, 5,400 miles away in Ankara, the Turkish central bank is in panic mode because of Ritsuko – and the thousands of Japanese women like her who have quietly seized control of global currency markets.

Ritsuko, 34, is, as she puts it, “waist deep” in a fiendishly complex currency swap involving the Japanese yen, the US dollar and the Omani riyal. The trade has lost her more than 100,000 yen (£417) this morning alone. She is beginning to think she might get more joy from borrowing another 200,000 yen from her online broker and selling her yen for Turkish lira, but is irritated because the prices she’s after have not yet flickered on to her little screen.

To the growing horror of male Japan, when Ritsuko’s mind is not on the foreign exchange markets it is on stocks, bonds, property and other investment opportunities that might make her rich. She, and others like her, are blowing to smithereens one of Japan’s oldest taboos: in the emerging investment sisterhood, money is no longer a dirty word. In the past year eight new investment magazines have been launched to cater for them, and even their traditional fare of fashion and lifestyle titles have begun to incorporate sections on making money.

In the space of just a couple of years, Japanese online currency speculators – many of them housewives, elderly matriarchs or young working women – have taken the markets by storm. Economists, major corporations and investors, awed by the sheer market influence of the Japanese speculators, have been forced to rethink their analysis of global currency markets. James Gow, the British chief executive and co-founder of one of Japan’s big three internet currency brokerages, FXOnline Japan, says: “We are looking at Japanese women taking a very different attitude to risk and markets than they used to, and a lot of people have been taken by surprise by that.”

Borrowing their native yen more cheaply than any other major currency, multiplying their initial stake by as much as 200 times through margin trading and then dipping into dozens of higher-yield foreign exchange markets, the online traders of Japan now account for around $15 billion (£7 billion) of deals each day. Some have made the equivalent of hundreds of thousands of pounds in just six months’ trading, others trade with a fraction of that. They are, say currency analysts, “obsessive” sellers of the yen – relentlessly ditching the Japanese currency and its wafer-thin interest rates for the more lucrative currencies of New Zealand, Brazil, South Africa and Iceland. About a fifth of all trades that hit the screens at the Nomura brokerage are generated by “housewives” – the catch-all term the professionals use to describe Ritsuko and her powerful cohorts.

“Everyone seems so surprised that Japanese women are such energetic currency investors,” Ritsuko says, “but they really should have paid more attention to us. In an information economy, women are more powerful than men. We are the people who pay minute attention to tiny shifts in fashion and spend our lives online checking for gossip on the best restaurants and hotels.”

Ai, an investor from Nagoya in her late twenties, also argues that it is Japanese women’s ability to mine information that has now been transferred to the currency and stock markets. There are other advantages of their sex. While male online traders tend to close up their positions at 7pm and head out for a beer, she sneers, women just keep on trading. Some trade “spot forex”, dipping in and out of currencies around the world and playing directly on the volatility of markets to reap small gains. Others, by pumping up their initial stake via borrowings, take advantage of the differentials between overnight lending rates of various currencies: there is a lucrative difference between the 0.5 per cent rate for the yen and, say, the 8.25 per cent of the New Zealand dollar or the 17.5 per cent of the Turkish lira.

Turkey’s nightmare is that the Japanese housewives will lose interest and pull out of the lira, causing it to plunge. And it is not just the Turkish Government that is petrified by the Japanese housewives’ spectacular assault on its currency. Two months ago, when the New Zealand Government tried to intervene in currency markets by selling the dollar, its efforts were immediately and completely consumed by Japanese investors with virtually no effect on the exchange rate.

And as well as wrestling with the subversive, utterly unexpected cultural phenomenon of “greed is good” women, Japan itself has started to panic that this new breed of profit-hungry housewives threatens its economic revival and global standing. Because the housewives are endless sellers of the yen, any upward pressure on the Japanese currency is almost entirely absorbed by the online traders. For months now, the yen has fallen against most global currencies at every turn.

James Gow of FXOnline says: “Where the Government of Japan used to spend billions of dollars intervening in currency markets and fighting the prevailing tide to deflate the yen and help exporters, it now has thousands of Mrs Tanakas doing the same thing out of choice.” Although government intervention remains an option, things may be beyond immediate central bank control: individual Japanese have opened 600,000 margin trading accounts in the past year, with the deposits on those accounts amounting to around $5 billion.

One of FXOnline’s customers is Yoshie Akai, a 70-year-old grandmother from Kobe who has been an avid trader of forex for three years. She woke last Friday morning to find that she had lost about 8 million yen (£33,000) overnight. With more sangfroid than the most ruthless Wall Street dealing-room shark, she was trading again by mid-morning. “I was depressed in the morning. But if I leave this as it is, I will just be a loser. I’ll recover from this disaster,” she says. “I used to know when to buy. Now I’ve learnt the hard way when you should sell. You get a different sense of reality and risk when it is just numbers on a computer, not a bundle of notes sitting in front of me.”

Akai is one of two types of women traders emerging in Japan. One is the traditional holder of the family purse-strings. The once cautious housewife who routinely and unquestioningly used to deposit the family salary into postoffice savings (or might occasionally be tempted into a conservatively managed mutual fund) has decisively lost her faith in the strategy that she was told would ensure financial security. Ten years of near zero interest rates have shattered her trust that “Japan will provide”. She feels let down by Japan and she is looking for ways to make enough cash for a big holiday, or perhaps a new car.

The other is a totally new breed of investor: young women in their twenties and thirties using their own salaries to gamble on currencies or stocks and driven by the desire to make money fast. Their ambitions go far beyond a new handbag or a foreign trip. They want houses, fast cars and a lifestyle that has little in common with the thriftiness and self-denial preached by their mothers.

Both types fill the teaching room of the advanced investment class at the Nagoya financial school – a course designed for, and taught by, women. Yuko Kuriki, the instructor, says women want to use the markets to assert their independence as thinkers and create their own financial security. “Japan certainly has a sense of embarrassment about individuals getting rich but people have come to realise that without risk, you can’t get anywhere so there is a shift from savings to investment. Some women are now risking the family savings on stocks and forex: some are worried about their future, others are unashamedly greedy,” she says. “We are a culture that is traditionally most concerned with not losing money, rather than making lots of it. But the country has offered no yields for a decade so we have had to become investors.”

One of her students, 58-year old Etsuko, took to the markets after her husband killed himself during Japan’s financial crisis of 2003. “Japan has let us down, and I have to invest to make a living,” she says.

Sitting on the desk in front of Etsuko, 27-year old Ai represents the more aggressive face of Japanese women investors: “I want to challenge my lack of capital. I want to buy my own house and I’m a better investor than my husband. The markets offer me a sort of empowerment,” she says.

Proud of her class, Ms Kuriki stresses that her students, by the time she has finished with them, are not simply haphazard stock-pickers. “They are not like a lot of men. Women sell quickly when shares start falling, but they are much quicker than men to get back into the market and start buying again on the dips. Men decide on the basis of theory or past experience. Women look at the fundamentals.”

A yen for trade: Ritsuko’s day

7am: Ritsuko decides on two currency bets. She has 100,000 yen (£417) in her online trading account and the brokerage will lend her ten times that.

8am: She studies the Nikkei and Bloomberg and reckons the euro will rise

8.15am: She borrows 500,000 yen. (cheaply: the overnight interest rate is just 0.5 per cent), goes on to the spot foreign exchange market and buys euros at one euro per 160 yen.

8.30am: A medium-term bet: she borrows another 500,000 yen and buys New Zealand dollars, which will earn 8.25 per cent interest.

12 noon: Lunch and shopping (there are sales at Furla and Max Mara).

5.31pm: She was right: the euro is up 1 per cent. She buys back her yen, this time getting 176 yen per euro. After brokerage fees, her profit is around 5,000 yen – which about pays for her lunch.

2 months later: Ritsuko believes the Icelandic krone will be more lucrative than her New Zealand dollars. She exits her position with one sixth (two months out of 12) of the 8.25 per cent annual interest on the NZ dollars, pocketing around 6,100 yen – which she immediately churns into her next trade.

Private Equity Firms Requiring Investment Banks to Honor Funding Commitments

The era of lax lending is inflicting damage on one of its biggest perps, namely, investment banks. Wall Street firms, overeager to win funding mandates from private equity firms, agreed to terms that were very much in favor of the private equity firms. And now the LBO firms are holding them to their financing commitments, which in this market with no appetite for risky LBO paper, means the Wall Street firms are certain to take losses.

While I have no sympathy for the investment banks, this is a more serious matter than might appear. If market conditions do not improve, their losses are likely to be substantial (they are big enough that some firms have offered to pay the LBO firms' breakup fees rather than make good on the financing) and in a falling profit environment, might even generate quarterly losses, which means a reduction of capital.

Whatever damage investment banks sustain from their stupidity is not enough to impair them by itself. But it means they will be ill equipped to sustain a second hit. And since investment banks have now become the central agents in financial intermediation, LBO-related damage could be the first blow of a one-two punch that creates systemic risk.

On a more mundane level, I anticipate that the bloodymindedness of the LBO firms will come to haunt them.

From the Financial Times:

Private equity groups believe they can force Wall Street banks to fund billions of dollars of pending takeovers in spite of the credit market turmoil by exploiting legal concessions extracted from the banks during the recent takeover boom.

Investment bankers and lawyers say some Wall Street firms are lobbying buy-out funds to cancel recently announced takeovers in the hope of avoiding big losses on the sale of the high-yield debt used to fund leveraged buy-outs.

Some banks are even considering picking up the break-up fees paid by private equity groups to companies when a takeover collapses.

But buy-out executives believe changes in the legal wording of deals provide them with guarantees that will enable them to close deals such as the $45bn purchase of the Texas utility TXU or the $27bn takeover of Alltel, the US wireless operator.

One private equity lawyer said: "The banks are coming to us appealing for help, saying that this is the time when relationships will be forged for the next 10 to 15 years. Private equity is responding by saying the same and reminding the banks they have a commitment to fund these deals."

Wall Street's likely failure to persuade buy-out groups to pull out of deals underlines the shift in the balance of power from investment banks to private equity firms during the record-breaking merger activity of the past few years.

Before the onset of the latest takeover wave four years ago, private equity firms and banks had "financing outs" in their agreements that enabled them to pull out without paying a penalty if capital market conditions deteriorated markedly.

But, as takeover activity intensified, buy-out firms, under pressure from corporate boards, gave up those escape clauses and forced banks to do the same.

Banks accepted the new conditions because they were eager to secure the lucrative financing associated with leveraged buy-outs.

Legal experts say the absence of those provisions makes it extremely tough for banks to pull out of deals unilaterally. "As a legal matter, it is very difficult for the banks to get out of these deals," said a senior lawyer who has worked with banks and buyout firms

Other experts predict the tough conditions banks face will prompt them to re-impose conditions such as the "financing out" on future deals, restricting buyout funds' debt-raising ability.

Buy-out executives argued that scrapping a takeover would be a huge blow to private equity groups that pride themselves on their deal-making ability, and would hurt their standing with future target companies.

"No one wants to be first to pull a deal," one executive said. "If you do, it could be hanging over you for years. And other buy-out groups would use it against you."

Jim Rogers Still Negative on Housing and Investment Banks

Jim Rogers, who is by no means a card carrying bear, thinks the US housing market, and therefore homebuilder and investment bank stocks, still have further to fall. And the news of the last few days provides confirming data points.

First, this morning's Wall Street Journal has as a page one story a news item that should be no news to anyone with an operating brain cell, namely that mortgage lenders have started restricting credit even to borrowers well above the subprime level:

Jittery home-mortgage lenders are cutting off credit or raising interest rates for a growing portion of Americans, extending well beyond the market for subprime loans for people with the weakest credit records....

Lenders say they are being forced to raise interest rates and stop offering certain loans because mortgage-bond investors have lost their appetite for a broad range of mortgages considered risky. That includes those dubbed Alt-A, a category between prime and subprime that often involves borrowers who don't fully document their income or assets, or those buying investment properties....

Lenders are tightening standards and "raising rates like crazy," said Melissa Cohn, chief executive of Manhattan Mortgage, a New York mortgage broker. She said Wells Fargo & Co. is charging 8% for a prime jumbo 30-year fixed-rate loan that carried a 6 7/8% rate late last week. (Jumbo loans are those too large to be sold to government-sponsored mortgage investors Fannie Mae and Freddie Mac.) A Wells spokesman said rates are lower on loans made directly by the bank than on those through brokers.

The market for mortgage-backed securities is "very panicked," Michael Perry, chief executive of IndyMac Bancorp Inc., another big lender, said in a message on the lender's Web site yesterday.

Earlier in the week, Barry Ritholtz pointed out, at Seeking Alpha, that the Case-Shlller Housing Composite showed the worst results since 1991:

Pretty amazing: This data release (May 2007) marks the 18th consecutive decline in growth, dating back to December 2005. As the chart below shows, annual returns of the Case Shiller Composite now show continued negative annual returns -- an annual decline rate of 3.4%.....

Excerpt:

“At a national level, declines in annual home price returns are showing no signs of a slowdown or turnaround,” says Robert J. Shiller, Chief Economist at MacroMarkets LLC. “Year-over-year price returns are continuing to either move deeper into negative territory or experience persistent diminishing returns. If there is any positive news in these numbers, it may be that in both May and April eight of the 20 markets showed positive monthly growth rates. This compares to only one or two of the 20 in the late winter and early spring. We need a few more months of data, however, to determine if this is the beginning of a national turnaround, since the national trend is still at a sharp deceleration.”

With Chicago now reporting negative annual returns, 15 of the 20 metro areas are now reporting negative annual price returns. In addition, 16 of the metro areas saw a decline in their annual growth rate compared to April’s data. Detroit continues to lead the metro areas in growth rate declines, down 11.1% from a year ago and has been in annual decline since May 2006 . . .

So Roger's grim views should come as no surprise. From Bloomberg:

The U.S. subprime-market rout that wiped out $2.1 trillion from global share values last week has ``got a long way to go,'' said Jim Rogers, who predicted the start of the commodities rally in 1999.

This week's rebound in equity markets hasn't persuaded Rogers, 64, to pull out of bets that U.S. investment banks and homebuilders are heading for further declines.

``This was one of the biggest bubbles we've ever had in credit,'' Rogers, chairman of New York-based Beeland Interests Inc., said in an interview from Hong Kong. ``I have been and am still short the investment bankers in America. I'm also short homebuilders.''

The Morgan Stanley Capital International World Index plunged 5.3 percent last week, its worst weekly drop in five years, on concern defaults among subprime mortgages may be spilling over to other credit markets and hurting earnings and takeovers. Further losses may be in store even after the index, which tracks $32.6 trillion of stocks, advanced 0.7 percent this week.

``Given the stage of the credit cycle that we're in now, we would have to expect more negative news popping up,'' Beat Lenherr, who oversees $7 billion as chief investment officer for Asia at LGT Bank in Liechtenstein AG, said late yesterday in an interview in Singapore. ``The market sentiment is a bit nervous to the degree that every bad news is answered with selling.''

No Big Disaster

Some investors say sustained consumer spending and jobs growth may help offset the impact of mortgage defaults.

A report due later today may show that payrolls rose 127,000 after a 132,000 gain in June, according to the median estimate of economists surveyed by Bloomberg. The jobless rate is forecast to hold at 4.5 percent for a fourth month, near a six-year low.

``Subprime will not derail the economy and we're not calling for a big disaster,'' said Hans Goetti, Singapore-based managing director at Citi Private Bank, which has assets of $100 billion in Asia. ``Consumer spending will not fall off the cliff as a result.''

The MSCI World Index today climbed 0.1 percent, its fourth gain this week, as investors speculated that better-than- forecast earnings will help offset the impact of mortgage losses.

Financial Stocks Down

A measure of financial companies such as Countrywide Financial Corp. has dropped 3.7 percent so far this year, the only group to decline within the MSCI World Index. Countrywide Financial, the biggest U.S. mortgage lender, said yesterday it has ``significant'' sources of short-term funding after the slump in demand for loans pushed some rivals toward bankruptcy.

Shares of Bear Stearns Cos. fell 13 percent last week after two of its hedge funds failed because of the subprime crisis. Merrill Lynch & Co. is down 3.6 percent this week, heading for its third weekly decline, while stock in Lehman Brothers Holdings Inc. is 5.9 percent lower.

The housing slump may extend into 2008 because of stricter mortgage standards and a glut of properties. IndyMac Bancorp Inc. yesterday said it is joining rival lenders in making ``very major changes'' to home-loan standards and charging higher rates because of a slump in mortgage securities.

U.S. homebuilders rose yesterday, pushing a Standard & Poor's index of 16 such companies to a 4.1 percent gain, the measure's biggest advance in six months. The index has dropped 35 percent this year after the worst housing slump in 16 years left eight homebuilders nursing quarterly losses of $1.97 billion.

Beazer Homes

Beazer Homes USA Inc.'s stock jumped 14 percent yesterday, the most ever, after hedge fund Citadel Investment Group LLC almost doubled its stake in the homebuilder. The company has lost almost three-quarters of its market value this year.

``This is the only time in world history when people were able to buy houses with no money down and in fact, in some cases, the builders gave them money for a down payment,'' Rogers said. ``So this bubble is the worst we've had in housing and it's going to be the worst before its over cleaning it out.''

China is a market that Rogers isn't selling even as the fallout from subprime drag on share prices worldwide, he said. He's sold his other emerging market holdings as stock gains outstripped the prospect for earnings, Rogers added.

``China's the next great country in the world and we must learn about investing in China, because that's where fantastic fortunes are going to be made in the next century,'' Rogers said. ``I would be looking at China very carefully.''

The CSI 300 Index last week jumped 8.4 percent. The index had gained 2.7 percent to a record as of 2 p.m. in Beijing, heading for its fourth weekly gain in a row. The benchmark has more than doubled this year and is the best performer among 89 stock indexes tracked by Bloomberg.

``I'm not of a mood to pronounce the end of the world just yet,'' said Hans Kunnen, who helps manage $117 billion at Colonial First State Global Asset Management in Sydney. ``You only have to go back three years to see how debt was being priced as if there was no risk at all. Well, there is risk, and it's simply being priced back in.''

Some Semblance of Calm Returning to Credit Markets

If credit default swaps prices are a valid indicator, the fixed income markets are regrouping. Prices, which spiked up earlier this week on panic buying of risk protection, have eased off. However, while this decline is a good sign, note that it does not equate (yet) to an improvement of liquidity in the riskier sectors of the market, which have largely seized up.

Later in this post, we also excerpt the astute but usually worried Gillian Tett of the Financial Times, takes comfort from the blow up of German lender IKB, arguing that it is sign of how far subprime risks are spread (although as she observes, it is also proof of how weak German financial institutions are at assessing and managing complex securities.

First, from Bloomberg:

Prices to protect corporate bonds against default fell for the first week since June as global financial markets stabilized.

Credit-default swaps on 10 million euros ($13.7 million) of debt included in the iTraxx Crossover Series 7 Index of 50 European companies dropped 5,000 euros to 390,000 euros at 11:40 a.m. in London and are down 52,000 euros for the week, according to JPMorgan Chase & Co. The contracts used to speculate on credit quality rose to the highest in at least three years at the start of the week.

The declining prices signal that traders have already accounted for the risks of the U.S. real-estate recession spreading to other parts of the global economy. Stocks in Europe are heading for gains this week and U.S. indexes rose three of the past four days. General Electric Capital Corp. raised $2 billion yesterday in its first U.S. sale of 30-year fixed-rate bonds since 2002.

``There was panic buying of credit protection earlier this week,'' said Suki Mann, a strategist at Societe Generale SA in London. ``Perhaps some sense of proportion is starting to prevail,'' said Mann, who recommends investors increase holdings of corporate debt.

Credit-default swaps gyrated during the week, with the iTraxx Crossover, Europe's benchmark indicator of corporate creditworthiness, peaking at 507,000 euros on July 30, the highest since the index began trading in 2004. The weekly decline reduced the cost to protect bonds for the first time since June 15.

Swap Gyrations

Less volatility may mean companies will have an easier time raising money after more than 50 borrowers from Tyco Electronics Ltd. in Berwyn, Pennsylvania, to Moscow-based OAO Gazprom postponed or reworked debt offerings in the past six weeks. Bond sales dropped to $193 billion in July, the slowest month in two years, from $483 billion in June, according to data compiled by Bloomberg.

Traders says they're still concerned about credit quality deteriorating after American Home Mortgage Investment Corp. said yesterday that it will close and Accredited Home Lenders Holding Co. said it may need to seek bankruptcy protection. IKB Deutsche Industriebank AG required a bailout in Germany as its investments in U.S. subprime mortgage securities soured.

``Even though we have seen a calmer day in credit, we are not necessarily out of the woods yet,'' said Jim Reid, head of fundamental credit research at Deutsche Bank AG in London.

Losses on AAA

Losses from U.S. mortgage defaults are spreading to higher rated securities. U.S. subprime-mortgage securities with the top AAA credit ratings from Standard & Poor's are becoming riskier, based on the rising cost to protect the notes using credit- default swaps. An index of credit-default swaps linked to 20 securities rated AAA and created in the second half of 2006 fell 2.6 percent to a new low of 89.69 yesterday, according to London-based administrator Markit Group Ltd.

``Once the higher rated tranches start to be affected, a whole different investor group is exposed to the sub-prime fallout,'' Reid said.

Credit-default swaps were designed to protect creditors against losses. Prices fall as the perception of credit quality improves and rise as creditworthiness deteriorates. The contracts pay the buyer the face value of the debt protected in return for the defaulted notes or the equivalent in cash.

The CDX North American Investment-Grade Index closed yesterday at $74,000 per $10 million of debt, down from $89,000 at the start of the week and a highpoint of $103,000 on July 30, according to Deutsche Bank AG.

And from Tett at the Financial Times:

How do you say "yikes" in German? That is a question many investors might ask right now when they look at IKB, the specialised German lender.

At the start of the week, IKB startled markets by admitting it had racked up vast losses on its credit portfolio - a move that prompted KfW, the German state bank, to underwrite around €8bn ($11bn) of IKB-owned securities. But, yesterday, it emerged that IKB's exposure to the subprime sector had somehow ballooned to €17bn - many times the total market capitalisation of the group.

And that is not the worst of it. These staggering problems emerged a mere 10 days after IKB issued an upbeat trading statement in which it hailed "a successful start to the financial year" - and denied that it faced subprime problems. Perhaps this information oversight simply emerged because IKB's own management did not know the scale of their own losses. After all, as we have written extensively on these pages, the value of complex credit instruments has fluctuated so wildly in recent weeks that even experienced hedge fund managers find it hard to measure their losses.

However, woes of this scale certainly do not crop up in a matter of just 10 days, even in turbulent times.... No doubt politicians would also be demanding a public inquiry given that public money is now being used to clean up this mess, via KfW.

Perhaps this will occur. If so, IKB could yet end up being truly good news for Deutschland AG. For it is a peculiar irony of Germany's business world that while the country produces hordes of sophisticated, ultra-smart engineers, it is notably poor at churning out the type of sophisticated bankers it also needs.

As a result, many German financial institutions are woefully ill-equipped to handle complex derivatives risk (or indeed, capital market risks at all). That is troubling, given that many of these have been quietly shuffling into complex finance in recent years to boost returns.

But the lessons of IKB go further than German banking. In some respects, investors should consider it reassuring that US subprime losses are now cropping up all around the world. For this shows that financial innovation is enabling bankers to distribute risk more widely than ever before.

And that could potentially be a thoroughly good thing for financial stability right now, since if risk is spread around, it is less likely to cause a devastating shock to any single part of the financial world. The silver lining to the IKB cloud, in other words, is that it shows that American institutions are not the only ones reeling under subprime pain. The risk of large-scale American bank collapses is thus reduced. But one downside of spreading risk around in this manner is that it is fiendishly difficult for regulators to actually see where it is going, or to anticipate where problems are building up. After all, how many global investors - or policymakers - had even heard of IKB a week ago?

Worse still, what the subprime saga shows is that as risk has been passed around in recent years, it has not just ended up in the hands of people well-suited to manage this (such as hedge funds) - but those who are not. IKB was one of those lacking appropriate risk management skills. But I doubt it was alone. The shocks from this subprime saga probably have further to run.

* Meanwhile, if investors needed any more reason to feel uneasy, look at the extraordinary saga unfolding around AXA's two troubled mutual funds (see opposite). Two months ago, it was widely presumed that anything carrying the tag of "money market fund" was a stodgy, safe-ish bet. But AXA's two "dynamic money market" funds have apparently lost over 20 per cent of their value in a month, while being invested in securities with an average credit rating of A.

AXA is now fighting to restore its reputation with an unprecedented bailout. But the bigger question now is how many other surprises now lurk in other, supposedly dull "dynamic money market funds"?

Cosmic Rays May Have Caused Past Falls in Biodiversity

Periodically, the Earth has experienced significant species die-offs. While the so-called K-T extinction, which marked the end of the dinosaur age, has been attributed to an asteroid crash, other declines remain something of a mystery.

An article in Science magazine, summarized on its website, recounts a study by researchers from the University of Kansas in Lawrence who argue that cosmic rays may be responsible. The Sun has an erratic orbit relative to the plane of our galaxy, and mass extinctions occur when the Sun moves furthest from that plane.

From ScienceNOW:

Researchers may have uncovered the reason why Earth's biodiversity mysteriously plummets periodically. They have found that a rollercoaster-like wobble in the sun's orbit around the center of the Milky Way galaxy regularly moves Earth closer to a source of dangerous intergalactic cosmic rays.
Over the last 500 million years or so, the number of species on Earth has tended to dip regularly about every 62 million years. The last time this happened, about 55 million years ago--or about 10 million years after the great K-T extinction event that wiped out the dinosaurs--biodiversity sank by about 10%; around 115 million years ago, it dropped by a similar amount. So far, evolutionary biologists have only been able to establish that the phenomenon seems cyclical, but they haven't isolated a cause.

Now, researchers from the University of Kansas in Lawrence think they have found a possible answer. Physicist and co-author Adrian Melott says that he began suspecting a galactic cause after noticing a 2005 paper that calculated that the drop in species diversity occurs regularly on a time scale of tens of millions of years, which—for a cyclical event--is too long for something happening within the solar system. So he and Kansas colleague Mikhail Medvedev began examining the possibilities. At about the same time as the drops in biodiversity, the researchers determined, the sun reaches the highest point in its orbit relative to the galactic plane, where most Milky Way stars reside. At that point, the scientists report in the 1 August Astrophysical Journal, the solar system is closest to an incoming source of potentially lethal cosmic rays created by interactions between the Milky Way's magnetic field and radiation generated by a cluster of nearby galaxies.

These galaxies are located in the direction of the constellation Virgo, and the radiation consists of particles called muons, which are so powerful they can penetrate about 2.5 kilometers of sea water or 900 meters of rock--enough to reach just about every living thing on Earth and damage its DNA. Because the zenith of the Sun's oscillations match almost exactly with the times of the dips in the fossil record, the researchers found, "we've noticed an incredible coincidence," Melott says.

Physicist Richard Muller of Lawrence Berkeley Laboratory in California calls the paper's hypothesis "intriguing" and something that should be "of great interest" to both the astrophysics and evolutionary biology communities. The problem, says Muller, who co-wrote the 2005 paper in Nature that piqued Melott's interest, is that killer cosmic rays may not have been the direct cause of the drops in biodiversity. There could be other candidates, such as significant climate change. "We've got to try to understand the mechanism better," he says.

New Flavor of Credit Market Fallout?

Many observers had expected quite a few hedge funds that had subprime exposures to report significant losses for June, and there have been rumors of funds that had begun the liquidation process because it was apparent they were too badly damaged to survive. But the specter of investors clamoring to pull funds out of a fund that is merely mortgage-related, as opposed to exposed to subprimes, is a new development. Admittedly, the fund in the headlines is a Bear Stearns fund, so the tsuris may merely be a negative branding issue. But it is unprecedented for investors to seek large scale redemptions from a hedge fund that is still (allegedly) profitable. This raises two new concerns:

1. Hedge funds by nature are not liquid, and if investors begin to become nervous about hedge funds in general (as opposed to very selected names), repeated occurances of hedge funds refusing to allow investor withdrawals would further impair market psychology.

2. Hedge funds may raise their cash levels on an anticipatory basis to allow for a modest level of investor withdrawals (no one wants the bad press of reneging on contractual agreements). But any selling to raise cash would increase pressure on the markets.

From Bloomberg:

Bear Stearns Cos., manager of two hedge funds that collapsed last month, blocked investors from pulling money out of a third fund as losses in the credit markets expand beyond securities related to subprime mortgages.

The Bear Stearns Asset-Backed Securities Fund had less than 0.5 percent of its $900 million of assets in securities linked to subprime loans, spokesman Russell Sherman said in an interview yesterday. Even so, investors concerned about losses sought to withdraw their money, he said.

New York-based Bear Stearns triggered a decline in credit markets in June when funds it managed faltered as defaults on home-loans to people with poor credit rose to a 10-year high. Federal Reserve Chairman Ben S. Bernanke said in July that losses on subprime-related credit products may reach $100 billion.

``There will be more pain,'' said Felix Stephen, a strategist who helps oversee the equivalent of $7.5 billion at Advance Asset Management Ltd. in Sydney. ``I'm giving it a couple of months at least. It's not the subprime issue that really matters, it is the first card to fall in the tower of cards in this situation.''

Macquarie Bank Ltd., Australia's largest securities firm, said yesterday that investors in two hedge funds may lose 25 percent of their money and Boston-based hedge fund manager Sowood Capital Management LP said this week that it lost $1.5 billion in July after declines in the corporate debt markets.

`Having Problems'

The latest developments may signal that the slump in the subprime mortgage market may not be ``contained,'' as officials including Treasury Secretary Henry Paulson have said.

``You don't necessarily have to be a subprime fund now to be having problems,'' said Bryan Whalen, a money manager in Los Angeles at Metropolitan West Asset Management, which oversees more than $21 billion in fixed-income assets.

Banks and insurers ranging from UBS AG in Zurich to CNA Financial Corp. in Chicago have reported losses related to subprime mortgage debt. UBS, the world's biggest money manager, replaced Peter Wuffli as chief executive officer in July after three quarters of declining earnings and losses at one of its hedge funds that invested in securities linked to subprime mortgages.

The latest developments at Bear Stearns and Macquarie sent stocks tumbling in Asia and Europe. The Morgan Stanley Capital International Asia Pacific Index fell 2.75 percent and the Dow Jones Stoxx 600 Index lost 1.6 percent to 373.97 12:07 p.m. in London. Shares of Bear Stearns are down 25 percent this year.

Bond Risks

The risk of owning European corporate bonds soared. Credit- default swaps based on 10 million euros ($13.8 million) of debt included in the iTraxx Crossover Series 7 Index of 50 companies jumped as much as 80,000 euros to 480,000 euros, according to JPMorgan Chase & Co. An increase indicates a decline in the perception of credit quality.

Bear Stearns doesn't plan to close the fund, which has $50 million in cash and gets about $13 million in principal and interest monthly, Sherman said. The fund, which probably lost money in July, can afford to wait until the slump in the mortgage market is over because it doesn't have any debt, he said.

``We don't believe it's prudent or in the interests of our investors to sell assets in this current environment,'' Sherman said. ``The fund portfolio is well positioned to wait out the market uncertainty.''

Funds Collapse

Even though investors demand an extra 4.19 percentage points in yield to own high-yield, high-risk company debt, the most since May 2005, defaults on corporate debt are near record lows. Merrill Lynch & Co. index data show the spread narrowed to 2.41 percentage points on June 5, the lowest since at least 1997, when the index was created, and is below the peak of more than 10 percentage points in 2002.

Debt rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's is considered high-yield, or junk.

The collapse in July of Bear Stearns' High-Grade Structured Credit Strategies Fund and its High-Grade Structured Credit Strategies Enhanced Leverage Fund fueled concerns about subprime securities. As investors retreated from risky credit, more than 45 companies were forced to cancel or rework bond and loan sales, according to data compiled by Bloomberg.

The two funds, managed by 22-year Bear Stearns veteran Ralph Cioffi, 51, invested almost all of their assets in subprime mortgage-related securities. They failed when creditors demanded more collateral after the value of those securities dropped. Bear Stearns extended $1.6 billion in credit to one of the funds before seizing its assets last week.

`Uncertain' Impact

Both funds filed for bankruptcy protection yesterday, two weeks after Bear Stearns told investors they would get little if any money back. Bear Stearns in June assigned its top mortgage trader, 45-year-old Tom Marano, to get the best prices for the funds' remaining assets.

``It's uncertain when we will see the full impact'' from the subprime fallout, Craig Overlander, co-head of global fixed- income at Bear Stearns, said in an interview today in Hong Kong. ``We can stress test, we can come up with possible scenarios but really we won't know until we see what's coming in the mortgage pipeline, the forms they are coming and the environment in which they will reset.''

Investors became more skittish last month as delinquencies on subprime mortgages grew. Blackstone Group LP stepped in to help Sydney-based Basis Capital Fund Management Ltd. avoid a fire sale of assets. Absolute Capital Group Ltd., partly owned by ABN Amro Holding NV, froze investor accounts.

``These are all continuing issues that don't go away in one day or in one week,'' said Ira Jersey, strategist at Credit Suisse Group in New York. The Bear Stearns announcement ``won't be good'' for credit markets, he said. ``It will take a number of weeks to resolve.''

Late Payments

Late payments on subprime home loans, those made to the riskiest borrowers with lower credit scores, rose in the first quarter to the highest level since 2002, the Mortgage Bankers Association has reported. At least 60 mortgage companies have halted operations, gone bankrupt or sought buyers since the start of 2006, according to Bloomberg data.

American Home Mortgage Investment Corp., which lends to homeowners with higher credit scores than subprime borrowers, said yesterday that it doesn't have cash to fund new loans, stranding thousands of home buyers and putting the company on the brink of failure.

Shares of MGIC Investment Corp. had their biggest one-day loss and Radian Group Inc. tumbled the most in eight years yesterday after the home-loan insurers said their stakes in a subprime mortgage company once valued $1 billion may now be worthless because of ``unprecedented'' disruptions in mortgage markets.

Financial Times on the Alchemy of Finance

John Kay, in an interesting but somewhat discursive opinion piece in the Financial Times, compares the structuring of complex securities to alchemy, with all its negative connotations. He points out that the elaborateness of the models has the effect of obscuring risks that would be more apparent otherwise, namely, that if you believe markets are efficient, there are no free lunches, and if you believe they are inefficient, that means that someone is the chump, and it may well be you.

From the FT:

What is the link between a visit to Russia by an 18th century Swiss mathematician, collateralised debt obligations, and the philosopher’s stone?

The Swiss mathematician, Daniel Bernoulli, first propounded the St Petersburg Paradox. A version for today’s markets envisages a casino with a coin-tossing game at fair odds. You hope to win at the first toss with a £100 stake. But if you lose, you will stake £200 on the next throw. If you lose again, you raise your stake to £400, and so on. You keep doubling your bet until you win. Simple mathematics shows that when you do win, you recoup all your previous losses and make £100 profit. Since you are bound to win eventually, the scheme is a sure means of winning £100.

Still, I don’t recommend it. One problem is that you can only be certain that you can last out until you win if you are infinitely rich, and if you are infinitely rich, why would you risk so much to gain £100? As the philosopher Russell Hardin observed, the St Petersburg Paradox does not survive the injection of any dose of realism.

Does today’s structured debt market survive any dose of realism? Perhaps we shall learn in the next few weeks. Like the gamblers in Bernoulli’s fable, today’s sophisticated investors hope to make risky prospects into sure things. Their prospective winnings come from turning mortgages and corporate credits into triple A securities.

But does this philosopher’s stone they seek exist? The risk characteristics of a bet can never be eliminated, but can be changed by division and aggregation. In every B-rated bond, there is A- and C-rated paper waiting to get out. Discard the C and your B has become an A.

This scheme works, but at a cost: in an efficient market, the value of the risk reduction will be precisely offset by a reduction in return.

Perhaps someone will take the lowly rated paper from you at a good price. You might be lucky. But bear in mind the gambler’s advice: if you don’t know who is the patsy in the room, it’s you.

Another means of turning risk into certainty is “payment in kind”. Any deterioration in credit leads to the provision of sufficient additional security to maintain the initial value of the issued paper. This pledge guarantees the purchaser against volatility and if the pledge can be believed, every instrument that benefits from it is as safe as the US Treasury.

You don’t need the insight of Bernoulli to spot the flaw. But the insight of the vendors of these products is to bury that issue in complex mathematics of which Bernoulli had not imagined.

But the best way to get something for nothing in financial markets is to profit from mispricing: identify pairs of securities whose relative value differs from its historic levels. If history repeats itself, these arbitrage opportunities can be leveraged to both reduce risk and enhance returns. Of course, history might not repeat itself.

But history often does, as supplicants find when they search for the philosopher’s stone.

Yet medieval science did not know the atomic structure of gold, but only the superficial characteristics of the precious metal. Gold glistens and alchemists brought shiny objects to the gods.

They were sent away: it was not enough that gold was lustrous, true gold was malleable and heavy. The alchemists trudged back and forth, adding components to the mixture until their confection met these specifications.

Eventually, the blocks they produced were shiny, dense and soft. The gods agreed that since the metal had the characteristics of gold, it must indeed be gold.

The alchemists made generous donations to the temple. And so it came to pass that the amount of gold in the world far exceeded the quantity that had ever been mined.

Many centuries later, the computer replaced the philosopher’s stone, the gods were replaced by the rating agencies but financial supplicants were as importunate as alchemists. And so it came to pass that the volume of investment grade securities far exceeded the value of investment grade credits.

Credit Default Swaps Put Goldman, Merrill, Lehman and Bear at Junk Levels

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.''

The Credit-Equity Market Disconnect

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.

The Shellacking of Greenspan Begins

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.

Dr. Doom on the Dangers of the Liquidity Boom

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.

Office Printers as Bad as Cigarette Smoke?

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.

Paper Points to Problems with CDO Models

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?

Study Finds Human Activity Producing More Atlantic Hurricaines

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.

Bulls Keeping the Faith (At Least So Far)

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.''

Reading the Tea Leaves (Financial Markets Edition)

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.

Man Bites Dog (Federal Reserve Edition)

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.

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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?