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Subprime Meltdown Blows Up

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This was a tough week for stocks with news from the subprime sector hogging the headlines. The blowup of two Bear Stearns mortgage backed securities hedge funds rocked the financial market and the damage is far from over. With the market already unsteady lawmakers slipped in a couple of sucker punches that nobody saw coming. Add in the Russell rebalance and Blackstone IPO and volatility was very high.

Dow Chart - Daily

Nasdaq Chart - Daily

Friday's economics were completely ignored due to the breaking news headlines hitting about every 15 min all day long. The only report of note was the Mass Layoffs for May, which fell to 1,190 events from 1,218 in April. Overall 119,089 workers lost their jobs in May compared to 126,047 in April. Manufacturing continued to be the biggest sector loser with 26,521 layoffs. The continued drain in jobs will pressure the housing sector and cause even more problems in the subprime sector. However, the rate of jobs decay is not serious compared to the number of new jobs created each month.

This was a very light week for economics but next week is a veritable minefield of critical reports and the FOMC meeting. There are four Fed surveys, two home sales reports and two consumer confidence/sentiment reports. The Chicago PMI on Friday is officially expected to see a small decline from last month's activity spike but the whisper numbers are for another strong gain. Since the Fed will have this data ahead of its two-day meeting they will take any continued strength into account in their rate decision. As of today nobody expects the Fed to change rates but it is entirely possible the Fed could change its bias stance and put comments in the statement signaling a coming rate hike at the August meeting. There will always be a liberal dose of caution around a Fed meeting and this week will be no different.

Economic Calendar

The biggest market mover on Friday continued to be the mortgage blowup at Bear Stearns. You probably already know they had two hedge funds that specialized in collateralizing mortgage loans and leveraging the debt to obscene levels. These collateral debt obligations (CDO) and collateral mortgage obligations (CMO) were a major source of funding for the hundreds of mortgage companies that sprang up during the housing boom. You could get almost anybody financed because the debt was sold off in so many pieces that no single entity had all of it. By spreading the risk and knowing that the vast majority of loans would pay satisfactorily it was a no brainer for hedge funds, pension funds, mutual funds, etc, to invest some of their cash assets into these income-producing securities. Unfortunately these CDO/CMO debt placements were designed to unwind if the defaults exceeded certain levels or the value of the securities fell below a threshold price. These fair-weather investments promised large returns and low risk to the end purchaser. The risk fell back on the packager and in this case the CDO/CMO hedge funds created by Bear Stearns. They had repurchase agreements and collateral agreements with their buyers that required a repurchase when default conditions appeared. The financial backers like Merrill, Barclay's and Goldman Sachs also had agreements that protected them from defaults and put the liability back onto the Bear Stearns hedge funds.

Bear Stearns raised $600 million in their fund offerings when these funds were launched. They immediately leveraged it to more than $11.5 billion using the $600 million for collateral. They then shorted various instruments to raise additional cash and increase that leverage another $5.5B. With $17 billion in cash/debt backing them they proceeded to package up to $30 billion in loans for resale. Remember, they only started with $600 million in real money. As things started to crumble around them they continued to add money but the snowball was already gaining speed. With CDOs and CMOs being put back to them and with no new buyers the funds began to self-destruct. Backers began demanding repurchase of their securities or they would exercise their right to sell them on the open market and bill the hedge funds for the shortfall.

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With tens of billions in defaulting CDO/CMO securities suddenly flooding the market nobody wanted to be a buyer. Bids evaporated and it became a fire sale. Nobody really knows what they are buying and if the mortgages behind the debts will ever be repaid. Barclay's is said to have $500 million at risk with Merrill, Goldman, Lehman, etc already underwater for that much or more. Cantor Fitzgerald offered $400 million in CDOs at auction on Friday and said they were getting bids as low as 10 cents on the dollar. Even assuming they could double that and get 20 cents on the dollar it would be a huge loss for hundreds if not thousands of debt holders and all of those holders are going to go after whoever sold them the debt.

To get a perspective of how much of this debt exists one noted analyst claims $140 billion in subprime and Alt-A CDOs were sold in 2005 and over $500 billion in 2006. As the debt is collateralized and the various strips are sold off it produces further billions in derivatives, swaps, etc. To protect themselves further the companies buying/dealing in this debt will buy or short various other derivative instruments to maintain or enhance their yield. According to another analyst trading in these derivatives increased +24% in Q1 alone to more than $533 TRILLION. Yes, trillion not billion. Of course much of that is the same debt jumping from firm to firm but it is still a big number. It is also a number that even if overstated by a factor of 10 it would mean $50 trillion in outstanding obligations from tend of thousands of investors. Since firms writing these derivative instruments never expect them to be used they can vastly over leverage themselves while producing a trivial amount of real cash in the process. They never expect to be called or have the instruments put back to them. If they used the same 10:1 or 20:1 leverage that Bear Stearns used it would mean a monumental house of cards that could collapse at any moment.

Brookstreet Securities, a California securities dealer, announced it had terminated the staff of more than 100 and closed its doors on Friday. It could not meet its margin calls on its CMO debt and its clearing firm National Financial Services, sold the securities at a substantial loss to cover the margin calls. The NASD ordered the company to liquidate any remaining customer accounts and shutdown. Brookstreet said many of their customers lost their entire investment when NFS seized the Brookstreet assets. That would be bad enough if the story stopped there. Unfortunately NFS and securities regulators are going to pursue Brookstreet for realized losses that will be huge. Brookstreet claims it had reduced exposure by $400 million as the subprime meltdown continued but that left nearly $85 million in exposure at the beginning of the week with mark to market margin calls occurring daily. This is the tip of the iceberg.

Across America there are tens of thousands of investors and firms with positions in these CDO/CMO securities and much of it bought on margin. As the value of these securities falls they are faced with margin calls to avoid having the positions liquidated and the investor charged with the loss. When Cantor Fitzgerald said on Friday they were receiving bids as low as 10 cents on the dollar that public admission will require another round of mark to market margin calls on those thousands of investors. Regardless of whether you are an individual investor or institutional investor you are facing a very real threat of having to cough more money on Monday just to avoid having your investments sold to cover margin calls. Since there are no buyers they will be sold for pennies on the dollar and you will be liable for the shortfall. These securities and the dozens of derivatives they secure are held by hedge funds, banks, insurance companies, investment firms, hedge funds, pension funds and individual investors. They serve as a base of an inverted pyramid of leveraged loans including much of the consumer finance sector including credit card loans, auto loans, etc. If a company has a lot of these CDOs in their portfolio and face a margin call what are they likely to sell to raise money? The answer is equities and potentially a lot of them to cover repeated margin calls.

This is a very real short-term risk to the financial system and as many commentators were saying last week, this story is far from over and just took a major turn for the worse. With no buyers and the value of the CDO/CMO market dropping every day there could be as much as $500 billion in CDO/CMOs that will be hitting a market where the bid is only pennies on the dollar. Even for major institutions this will cause major pain in the current earnings cycle. Those markdowns, real or imagined, will have to be reported with a charge to earnings for Q2. Even if you are a long-term holder and you are perfectly happy with your securities you will still have to mark their value down to whatever the current value supports even if it is pennies on the dollar. Since these obligations for major players tend to be in the billions it will be a major charge to earnings.

To put this in perspective I am going to use a housing analogy. If there were 10 similar homes all for sale on the same block and the asking price for each was $500,000 the market equilibrium would be balanced. If a couple sellers were unable to make the payments and the houses were foreclosed and then quick sold by the banks for $300,000, what would happen to the value of the rest of the houses? Right, the new valuation is $300,000 for all of them. If a couple more sellers realizing they would never get out whole decided to bail the next bank sale could be $200,000 because we had already established the new value level at $300,000. The remaining home owners may be perfectly happy taking down their for sale signs and just waiting out the storm but the value of their homes is still half of what it was before the selling began. Their loan value is probably well below their current loan and the idea of refinancing is now out of the question. If they have an adjustable loan that will reset soon to nearly double the initial rate as many homeowners do in the coming Q4/Q1 period then they will be faced with paying twice the house payments for a house that is worth half. They can't refinance because the home value is underwater. If they were initially trying to sell because of financial problems then their problems and their future just got a lot bleaker. Odds are good they will end up losing their home because they can't sell it for what they owe on it and the next round of foreclosures will lower the prices even further. There are stories making the rounds now about $200,000 condos in Florida going for $40,000 in foreclosure auctions. When there are no buyers there is no value.

This is what is happening in the CDO/CMO market today. The weekly fire sales have been occurring for months but there was always a buyer for 70%, 60% or even 50% of the original value so the news never made it to the street in such stark terms as the Bear Stearns news this week. Now everyone holding these CDO/CMO securities are like the homeowners above. Their value is currently less than junk but their obligations are still 100%. The vast majority of CDO owners will just hold the debt knowing the long-term payout of the principal will continue in most cases and the market will eventually improve. It may take many years but if they are patient they may get most of their money back. In the short term they will take a paper hit and possibly be forced to put up some more money if the value of the security falls below certain levels. While the news value to the market of $500 billion in defaulting CDOs is tremendous the real impact to the major players will be minimal. The headlines will be scary and there will likely be many more firms like Brookstreet that close their doors. In the long run the market will survive. Bear Stearns said it was investing $3.2 billion in the better of the two hedge funds to provide "an orderly de-leveraging." What that means in english is Bear Stearns will wait patiently until CDO buyers begin to return to the market and then repackage the securities to sell to them. In the end everyone knows Bear Stearns is going to be a seller so it could take quite a while before any meaningful bids appear. All the major investment banks took a tumble on the Bear Stearns news with GS -4.50, LEH -2.60 and -$5 since Wednesday, MER -2.80, -6 from Wednesday and BSC -2.06 and -$8 from the prior Friday high.

IIn the short term the real damage is to prospective homebuyers. With the CDO/CMO market in complete disarray the options available to anyone with less than perfect credit are dropping fast. The number of people who can afford to buy a home with the new underwriting standards is a fraction of those buying homes just two years ago. The homebuilders are probably due for another leg down and another year before some semblance of normal returns. This will continue to depress the economy and probably keep the Fed on the sidelines for a long time. On the bright side the reemergence of this subprime blowup has put an end to the selling in bonds. They are being bought once again and that forces real interest rates to fall.

Amidst the firestorm of subprime news Blackstone (BX) finally made it into the public arena. After setting the price at $31 on Thursday night BX opened as high as $38 before selling off to close just over $35 for a +13% opening day gain. For weeks we have heard that the offering was oversubscribed by a factor of 10. If that were true you would have expected a lot higher price by days end. The deals underwriters did NOT exercise their options for extra shares. 113 million of the 133 million shares offered traded hands on Friday. That kind of turnover suggests investors were in it just for the opening pop and in light of the "tax'em to the maximum" news coming from lawmakers this week and they wanted out in a hurry before the rules changed. It was announced on Friday that lawmakers are considering raising the taxes on "carried interest" earned by funds to the corporate rate on cash held for future investment. This was the second tax hike proposal for the week and it appears lawmakers are on a hunt for easy money ahead of the elections. Tax those fat cats and win votes. This was another reason Blackstone did relatively poorly in its debut. If lawmakers are on the warpath for hedge fund scalps it might be a good idea to hide on the sidelines until the smoke clears.

Despite the -185 Dow loss there were some stocks moving higher. Bernstein initiated coverage on Google and Ebay with an outperform rating and said the sector should continue to grow for another decade or longer. Google gained +11 on the news and Ebay +63 cents after trading up as much as $1.30 on a very down day. Bernstein has a $635 price target on Google.

Jabil Circuit (JBL) gained +1.93 after reporting earnings that beat the street. Jabil had warned earlier in the quarter that earnings would be weaker than expected. Jabil reported 23 cents compared to 21 cents analysts were expecting. Macy's (M) spiked +2.50 on five times normal volume on rumors a buyout may appear. RIMM was up at the open after Goldman Sachs said shipments for the quarter should be at the high end of prior estimates. PALM was cut by Jeffries on iPhone concerns. They believe Palm will suffer the most from the iPhone release. It was announced on Friday that iTunes is now the 3rd largest music retailer just behind leader Wal-Mart and Best Buy. The iPhone is expected to add to that volume.

PMCS and SANM both lost ground after S&P said they would be kicked out of the S&P-500 and replaced by the companies Tyco is spinning off, COV and TEL. Discover Financial Services (DFS) will replace ADCT.

Oil prices continue to hover just under $70 as traders become more comfortable over the $69 level. Fears this weekend come from Nigeria where the strike continues and shows potential signs of heating up next week. Nigeria is the 3rd largest crude exporter to the United States. Tensions over Iran are still making news but have little real impact on prices. The Iran premium has been priced in for months. The International Energy Agency (IEA) is almost begging OPEC to raise output quickly because of rapidly rising demand. The IEA said global inventory levels are down to only a 23-day supply. The IEA claims China's growth spurt boosted oil imports by +4.5% in May and China's demand is doubling every decade. They global claim demand is rising twice as fast as supply and without a rise in production now by OPEC we will see shortages this winter. They are expecting demand to rise to 88 mpbd in Q4 and that will be an all time record by nearly 2 mbpd. There is a lot of confusion about whether we can actually produce that much oil per day and the IEA wants to build up supplies well ahead of this winter demand spike. On the gasoline demand table below you will notice a jump in demand of 104,000 bpd over last week and +162,000 bpd over the same week in 2006 and we are not even into the highest demand period of the year over the July 4th weekend. The Senate passed a bill this week that would increase mileage standards for autos and light trucks to 35 mpg by 2020. That is nearly twice the average of those vehicles on the road today. They also would require 50% of vehicles on the road by 2015 to run on alternative fuels. That prompted a boost in ethanol stocks on Friday.

Gasoline Demand Table

August Crude Oil Chart - Daily

A lot of Friday's market volatility was attributed to the Russell rebalance. A change in the rules for who could be added to the Russell indexes allowed a lot of large companies to be added to the indexes for the first time. Companies like Tyco (TYC) and Schlumberger (SLB), which are incorporated outside the U.S. were not previously eligible for Russell index inclusion. With this year's change to the rules they are now being added. Their addition to the Russell 1000 index meant an influx of an additional $15 billion in investment capital from funds indexed to the Russell-1000. That capital had to come out of other Russell indexes. There were 277 stocks added to the Russell including 128 new Q1/Q2 IPOs and 184 stocks were removed. Volume on the Russell hit 1.159 billion shares and well over the average volume of 700,000 shares.

Russell-2000 Chart - Daily

With the Russell rebalance and the news driven market flush, volume across all the exchanges hit 7.54 billion shares. That puts Friday as the second highest volume day of all time. The top four days are all this year with Feb-27th 8.347B, Friday 7.54B, Mar-1st 7.4B and Feb-28th 7.17B. Unfortunately Friday's volume was significantly negative at nearly 3:1 down volume over up volume. Across the broader market declining stocks beat advancing stocks by 5:2. On the S&P-500 that ratio was extremely imbalanced at 9:1 in favor in decliners. (435 decliners to 49 advancers) This tells us what index saw the biggest withdrawal of funds to add to the Russell or what futures were being sold to cover margin calls.

The Dow has been up for the last 13 Fridays but evidently 14 was the unlucky number this time with that string broken this week. Only one Dow stock was positive and that was DD by a nickel. Volume was so heavy at the close that the Dow was still settling out nearly 10 min after the close. The Dow declined nearly -20 points well after the closing bell.

I have mixed emotions about the market direction for next week. I said on Tuesday that a break below 13600 on the Dow could produce a failed double top and that is exactly what it looks like this weekend. However, I am probably more bullish today than I was on Tuesday. We had several outside attacks on equities by lawmakers and the subprime blowup. Add in the selling on the Russell rebalance as another artificial event. Those outside influences knocked a lot off the indexes but they failed to penetrate major support.

Next week is going to very volatile because of the flurry of economic reports and the FOMC meeting. However, it is also quarter end and a prime setup for window dressing. Funds can buy the dip and especially focus on the winners like Mastercard, Schlumberger, etc, and look like heroes when they mail their quarterly statements. There is little risk in buying winners in a down market and those losers from last week will start to look even more attractive for new money. With the markets at or near their highs early last week it is tough to convince fund managers to invest new money one week ahead of the quarter. Now they have a chance to buy the dip one more time.

Despite the crash in the financials I believe it is a liquidity crisis not a credit crisis. CDOs are extremely illiquid and that exacerbates the problem. The major companies are going to pull through it. Bear Stearns has a market cap of $150 billion. A temporary $3 billion headache is not going to sink them. Goldman (GS) has pulled back nearly $15 from their 6/13 high and right to strong support at $220. That is a prime entry point for those looking for a long-term position. With a market cap of $225 billion any subprime hangover is only a few cents to earnings. Goldman reported on its house of subprime pain with its earnings on 6/15 and quarterly earnings of $4.79 per share still beat estimates.

Goldman said it did $1.7 billion in investment banking revenue and their backlog of deals is higher now than the record levels set back in the dot.com era. Goldman is the world's largest investment bank. Thomson Financial reported on Friday that worldwide M&A rose +53% in the first half of 2007 to $2.5 trillion. Goldman retained its slot as the largest global underwriter of mergers and acquisitions and rose to 1st in Europe for the period from its prior position at 4th. Thomson saw no letup in M&A activity ahead. Subprime problems are only a minor headache for Goldman and the other majors including Bear Stearns. It is not going to crash the financial system even if thousands of little guys have to bite the bullet.

Earnings are only two weeks away and earnings warnings have been nearly nonexistent. Technically there have been more warnings than positive pre-announcements but both have been very scarce. We are expected to see S&P earnings growth in excess of 6% and the whisper numbers are over 10%. The subprime problem is likely to keep the Fed on hold for the rest of the year even though the economy is rapidly accelerating. Global economic conditions are also accelerating and global markets are mostly at their recent highs. There is little to be gloomy about and a lot to be thankful for.

Obviously the markets don't need a reason to go down but the way I look at it there are far more reasons for them to rise. Because of the many economic events next week we could see some additional volatility and some caution ahead of the Fed announcement. After the Fed meeting passes, assuming they don't do something unexpected, I think the bulls will return and we will see a return to the highs. Getting over those highs could be another story but we will cross that bridge when we get there. In every market forecast there is always the potential for an economic landmine in next week's reports but we have seen no evidence of economic problems in recent weeks. Everything has been improving fine and a couple of weak reports in our near future could help with the Fed picture. I could be wrong but I think this is another dip to buy. A break below 13250 on the Dow, Nasdaq 2550 and S&P 1490 would change that view back to bearish. Owning the Russell-2000 futures or the IWM ETF on Monday would not be a bad idea either. Stocks being removed have no further impact and those funds late to the rebalance party will only push it higher.
 

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