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Friday, March 07, 2008


it is either The End or close to a turnaround

i concentrate on equity markets for my activities, and thank goodness at the moment because the Apocalypse or something very like it has taken hold in the credit markets. global deleveraging has hit a new gear, notes brad setser, and credit contagion has now started to move viciously into some of the bastions of safety, including agency-backed instruments.

Macroman doesn't watch his Bloomberg screen quite as closely as he used to, but on Thursday morning he reported that a two year Treasury yielded 1.6%. By late Thursday in the US (early Friday in Asia), the two year was only yielding 1.45%.

The corporate credit market by contrast isn't doing well. Nor is the housing credit market -- including the Agency MBS market. (Agency MBS spreads are now significantly wider than in this chart) Agency MBS are mortgage backed securities guaranteed by one of the Federal Agencies. Thank Carlyle Capital, and perhaps others.

Talk of deleveraging has replaced talk of decoupling. And if Carlyle Capital is really geared up 32 times (it borrowed $32 for every dollar raised from investors), there may be more to come.

agency spreads have skyrocketed, indicating that large players (like carlyle) are being forced to unwind their only liquid securities in quantity to meet margin calls. gillian tett pulls it apart.

Now, in theory, there are plenty of reasons to expect investors to start rushing into the credit markets soon, in a manner that could stabilise sentiment. After all, many credit prices have slumped dramatically. And while banks may be capital constrained, plenty of investors are sitting on pots of free cash, such as sovereign wealth funds and even mainstream asset managers and pension groups.

But these groups are notably not buying credit yet, either because they are still paralysed with shock or, more realistically, because they have a nasty feeling that while a leveraged loan, say, looks cheap, it could be cheaper in the future.

How can you combat this? Fifteen years ago, the US government devised a clever trick in the aftermath of the savings and loans crisis, by conducting firesale auctions of S&L assets. This was brilliantly effective in establishing clearing prices and turning sentiment around, because as soon as investors saw some assets being sold at knockdown prices they starting jumping in, meaning that within a few months, prices were rising again.

But these days the US government faces a crucial impediment to repeating this trick. Back in the days of the S&L crisis, US banks were not forced to mark their books to the firesale prices. But now the mark-to-market creed has taken hold. And it is a fair bet that if US banks were forced to mark their books to the initial clearance price for a CDO squared, say, some would run out of capital. Hence the trap: in the modern financial system, you can have mark-to-market accounting systems, or quick action to establish clearing prices, but probably not both, without blowing up some banks.

Of course one way to exit this trap would be to abandon the mark-to-market rules for a while, or loosen capital adequacy standards. Some furtive discussions between policymakers along these lines are already occurring.

But I would be surprised if any action occurs soon. So the risk now is that we will remain trapped in this climate of grinding fear for months – at best. Few institutions have much incentive to voluntarily create clearing prices. However, hedge funds are now being forced to make asset sales in an ad hoc, opaque manner that is adding to the sense of fear. This is forcing the banks to mark books lower and pull in their horns, sparking even more hedge fund sales and fuelling concern about banks. It is a viciously unpleasant spiral.

john jansen of across the curve:

The rolling crisis has turned the markets dysfunctional and malfunctioning. Liquidity has dried up and small chunks of bonds can drive spreads quickly tighter or wider. The direction of the outright market and the spread market is truly dependent on the last large trade as the dealer who executed the trade will often repair to the screens to unwind the trade. Volatility is intense and there is little incentive to hold anything but a small position which in and of itself exacerbates the liquidity problems.

I do not know how or when but it certainly feels as though a climax is approaching and some gentle denoument will follow which should lead to a restoration of normal trading. The market gathers and collects information and transmits the signals to the eclectic group of masochists who engage in this activity for fun and profit. At the current time the cacophonous sounds emmanating from the fixed income trading rooms of the world can be deciphered into a warning that something is terribly wrong with the system. The system will give us a painful catharsis which shall signal that the problem has passed.


I posted a comment yesterday about the illiquidity in the market for off the run Treasury securities. That problem has deepened overnight. One trader at a very large shop described the off the run market as being in lockdown. The same trader suggested that the historical relationships between cash markets and futures markets had broken down. I spoke with another trader who has made relative value trading of off the run Treasury debt his life’s work and he noted that there has been practically no trading today. The market has dried up.

the off-the-run convergence trade was famously one of the traps that felled john meriweather's erstwhile quant giant long-term capital management in 1998. looks like it's claiming more victims.

what jansen's catharsis might look like is anyone's guess. but the complete panic in the municipal bond market -- closely linked with the fate of the monoline bond insurers and auction rate securities as levered players are forcibly unwound -- has lifted.

i will note this much: crashing markets need blood -- the chase is pursued to a bitter end and someone ends up a carcass to be picked over. that carcass might be carlyle.

meanwhile, quant find liquidation in equities may have turned a corner, per bespoke.

While there has recently been a pick up in news flow regarding hedge funds failing to meet margin calls, it is interesting to note that even though the S&P 500 is back down near the lows of January (on a closing basis), our index of stocks most widely held by hedge funds has actually been outperforming the S&P 500.

this can be anecdotally confirmed by an improvement in the relative strength in the four horsemen of the nasdaq to the s&p -- aapl, for example, and rimm. but it goes beyond mere anecdotes -- there appears to be an alleviation of the pressure on the nasdaq 100 (see chart) between at least the january 22/23 bottom at (2) and both points (3) and (4). each subsequent upthrust has brought a higher percentage of issues out of their volatility envelopes as well.

the picture of 65-day lows is improving on each test as well. these are points which did not escape the attention of dr. steenbarger as well.

anything is possible here. but i find it hard to reconcile what looks like some improving breadth measures in combination with virulent bearish sentiment with a prolonged market collapse.

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