The Market Ticker

Let's lead with Bloomberg's top-page story on risk being hidden in CDOs.....

"Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans. "

No kidding!

Personal income came in up 0.4%, last month revised down a tenth, spending up 0.5%. Of course headline inflation has absorbed all of the spending growth, which is not a good thing at all; this means that we're seeing no real GDP growth.

Both numbers were also below expectations by 0.2%.

Yields were whacked immediately and futures popped up a bit. The dollar, however, is getting shellacked. The Pound, by the way, is now well north of 2.00, which is up even more from yesterday. That's not so good - at all.

(Can someone please explain to me how numbers that are worse than expectations constitute "good news"? Why do I think we've got more "the market is open" crap going on here? You guys over on the Street didn't read Bloomberg this morning on the CDO mess, did you? Nor did you pay attention to Redbook and ICSC. Why do I keep thinking that this sort of "wheee!" mentality is very much like the 16 year old kid who's tooling down the highway getting a hummer from his girlfriend, totally oblivious to the cliff he's fixing to drive straight off?)

Url is back over $70 and looks to be adding to that advance. That 7 handle is likely to be noticed again today..... and I bet not in a way people like. That's not so good either.

RIMM hit the cover off the ball on earnings last night and announced a 3:1 stock split. They continue their strong followthrough with the Crackberry. Yes, they have a great business. So what? You want to talk about "overvalued"? P/E of 50 eh - and that was before the huge pop they're going to get today (20%?) You have to be nuts to short them (plenty of people have and it has led to tears - repeatedly) - but if this doesn't signal a blow-off top, I don't know what does. Shades of March 2000..... anyone remember how that ride ended? The Street seems to have amnesia...... but no, I'm not going to short it. I keep having to pull my fingers back with my teeth from the keyboard on doing it though. Why do I think I'm going to be writing about how f#&king stupid I was not to short the hell out of RIMM six months from now?

Countrywide had a blowup of their CDO ratings last night, and AHM dropped a big steaming turd as well. AHM is getting their just desserts, but CFC, so far, isn't getting hurt. Wonders never cease in this market. Or is the bottom line here that investors simply are stupid - they don't understand that big markdowns on those bond ratings mean that the company is now forced to take a huge writedown on the residuals that are cluttering their balance sheet, and oh, by the way, they got his news BEFORE the end of the quarter - which means it should show up in this quarter's results!

There will be those who say "oh this is no big deal; its just one that went bad." Uh huh. Ok. Go back to the top and read that Bloomberg article again. And again. Let it sink in. One trillion dollars. There is NEVER, NEVER only one cockroach!

I continue to hold my SDS position that I picked up the other day. I'm not sold on this "rally". Why not? The debt markets.

Its the credit markets stupid! Always!

Right now we have end-of-quarter, and guess what - hedge funds are doing their mark-to-markets right now for the end of quarter reports. When they do, I suspect there's going to be more than a couple really ugly surprises that bubble to the top.

Here's how it works - you take $100m (for example) in cash and then lever that up 10, 20 even 50 times. The prime brokers all let you do this one way or another. That's Merrill, Lehman, Bear, Goldman, et.al.

Ok, so now you go buy up all those nice high-yielding CDOs that have been so profitable for the last few years. Life is good!

Until there are downgrades. When you're levered up 20:1 a 5% hit on those values wipes you out and you get a margin call. Now what? You try to sell some assets only to find that they're not worth 75 cents on the dollar like you thought - they're worth ten! Oh that sucks. Now what are you going to do?

You're dead, but more important, your prime brokers have huge smoking holes in their balance sheets too. This is why the brokerages are trying to avoid those "fire sales" - they know that they're sitting on ticking nuclear weapons and they can't get rid of them!

This is what happened with the Bear funds and I bet its happening right now with a bunch of other hedge funds. You won't hear about this during the day, but over the weekend you're going to see a lot of sweaty palms; the blast will start to hit early next week.

We are looking at a $1t (optimistic) to $3t (pessimistic) problem here - far bigger than the S&L crisis (by five times at least and maybe by as much as twenty times.) This will not be contained and I also believe it cannot be avoided at this point in time.

The broker/dealers will try mightily to avoid telling the truth, as well the hedge funds and everyone else who is "invested" in this crap as they have a very strong vested interest in NOT recognizing these losses.

But delinquencies are delinquencies, homeowners who can't pay still can't pay, mortgage resets are less than 20% of the way through the system and the pressure will continue to build in the coming months.

The honest rating agency would look at the reset schedule over the next two years and extrapolate out the CERTAIN, say much less probable impact, then use THAT projection to re-rate these securities. That should have begun last year and by now this nonsense would be over. They aren't doing it and this, when the book is finally written on this mess two or three years from now, will be identified as the reason that a major market dislocation occurred.

The recession that will inevitably follow, however, must be laid at Greenspan's feet and his insane belief that he could not only stave off the impact of the 9/11 attacks and tech blowup, but that he could avoid it entirely through huge liquidity injections.

Wrong.

Reality as we wind down the week - and first half - is that:

• Deals in the LBO/PE world are starting to run into trouble and credit markets are tightening significantly, even though this is NOT getting much press - yet. Dollar General had a near-blow-up that left hundreds of millions with the bridge banks - something they didn't expect and do not want. Nor is this the only deal that has had "material problems"; rumblings of others are certainly out there, and two IPOs in the leveraged space (Evergreen and one other) have been pulled. Heeleys pulled a secondary stock offering yesterday. You can't fuel a bull that is running on LBOs without a loose credit market. The market is not running on fundamentals and hasn't been for more than a year. This leg is getting kicked out from under the stool!
• The turds keep coming sloppy and fast after-hours, and threaten to become an explosive flood of diarrhea, all in the credit markets. AHM and CFC's are just the latest two to add to the Bear fund blowup. The odd S&P futures action midweek after the close smelled like a big margin call, and I bet we get more of those, perhaps tonight after the close, as a consequence of some of the other downgrades.
• The credit rating agencies are coming under increasing pressure to get off their ass and honestly re-rate these debt instruments (CDOs/CLOs) prospectively. God knows if it will happen, but in my opinion it must and eventually will. When it does, it will be like Katrina coming ashore. In my view you've got the warning posted; if you play "La la la la la" like so many did in New Orleans you're going to be hiding in the Superdome quite soon. To that I say: No thank you, I'll run now!
• We reversed a trend that has held for a year, where Fed Afternoons are punctuated with monster rallies. That didn't happen yesterday and instead after 2:00 was met with big selling pressure on heavy volume. Trend shift? Maybe.
• The pattern for the last six months has been to do whatever in the morning but then close with strong volume on upward price movement. For the last week, it has been the opposite - the volume has shown up in the afternoon all right, but it has been SELLING volume, not buying. This is a tectonic shift and its not a one-day phenomena. After a week straight of this I have to take notice of it and view it as something important. This price action is common as a "distribution" mechanism near major market tops.
• The Street has both record margin debt and record bullishness. This is also a marker for market tops. Reliable? Not necessarily. But you have to look at it in the context of everything else. When the big street pundits all think the world is great and are margined to the hilt, welllllll.... Margin calls are ugly things, as they tend to beget more margin calls when they start going off.
• The dollar is getting its ass kicked once again. Watch the FX markets as they do matter, especially for inflation pressures on the import side! Yes, they help exporters, but with 70% of GDP being consumer spending, inflationary pressures outweigh help for exporters.
• China broke the 50 to the downside. Again. I'm not sold until I see it happen convincingly, but if you remember, this is one of my five markers of "big trouble in your face." That's one more of my five; assuming this holds we are now up to three.

My signals again from this article are:

• The S&P closes under the 1490 level. That's second-level support, and has been approached several times recently - but it has held. We pinned it early in the week but have yet to close below. NOT YET.
• China blows up (stocks). CHINA HAS CLOSED BELOW THE 50. Awaiting confirmation, could get it Sunday night.
• Goldman, Merrill, and Bear Stearns all close under their 50s. CHECK.
• HGX has broken trendline support. CHECK.
• The Nasdaq Composite (and DOW) break the 50. NOT YET, although we took a hell of a run at it during the last hour in the Dow.

Call it two and a half out of five.

So far.

In one of the most obnoxious cases of barring the door after the horse has left we have this from US Banking Regulators today:

"Lenders, in most cases, should verify income levels instead of relying on borrowers' statements, the Federal Reserve and other banking regulators said in guidelines issued today. They also said banks should account for potential interest-rate increases in scrutinizing whether homebuyers can pay off loans. "

Told 'ya that one was coming - the OCC telegraphed that a few months ago. Not hard to figure out. But this is certain to put an even bigger fork in the US housing market. And, IMHO, this is not only overdue it is far from strong enough. But there you have it - regulators BSing their way along while refusing to address this head on.

No matter - the credit markets will take care of it - and soon.

You know its bad when Steve Liesman starts doing pictorial "on the white board" pages on CNBC explaining how it all blows up - and at 12:45 ET today, he did just that, complete with a picture that was eerily similar to this:

Unfortunately, he kinda glossed over what happens when the low-rated tranches blow up and why it matters. Since you really need to understand this to realize why it matters, I'll go through it.

Generally-speaking, the way this works is that the lower-rated tranches ("equity" and "mezzanine") provide what amounts to insurance for the rest! That is, when losses are taken due to defaults all of that gets allocated to the equity tranche, until it is wiped out. Then it moves up to the next.

The problem is that damage to that equity tranche is not contained there. It inexorably moves up the chain because the remaining insurance value available drops as each loss is taken.

Think of it like an insurance company in Florida. No hurricanes, they make lots of money.

Ok, now we get one small hurricane. They take some losses, but still have plenty of money left. However, that does not mean all is ok, because the amount of capital that they have left to pay off subsequent losses has gone down. This means that your risk that they won't pay your claim goes up - even if you were undamaged at that point.

This is (and should be) reflected in the risk premium - the odds that you'll get hosed if you have a loss. The same thing happens here; the equity tranches have, in many cases, been wiped out, as the losses anticipated on these loans as a percentage of the total pool (e.g. percent that go into default) was only expected to be 5-6% - but now its fifteen percent, or three times the expected rate.

Likewise, in the ALT-A space, historical default rates have been right around 1%. But now they are running close to five percent.

So in effect the insurance company has folded - they paid all the previous losses and now are broke. Now your "credit enhancement" is gone on the higher-rated tranches and as a result they should be marked down - in most cases SEVERELY marked down, as there is no more insurance!

This is what's going on now..... and it is just getting started.

Remember folks - it takes six months or more from the time that someone stops paying their mortgage until it shows up as an actual foreclosure and the loss is recognized in the CDOs! We are at the start of the reset/default/foreclosure process, not the end!

You'd think that people would be repricing risk and backing off. You'd be wrong. Lookie what I found around on the net at http://www.stencorpnotes.com/:

"STEN's primary business is funding purchases of used cars and trucks by credit challenged retail buyers from independent “buy here/pay here” sales lots in Arizona. This business and the company's other businesses are described in more detail on the Company page and in the prospectus."

And what's the "headline"? Earn annual yields up to 13.31%.

13.31%?! This is all "relatively safe", right? Yeahhhhhhhhh.... ooooookkkkkk.... now you know how the hedgies and pension funds got sucked in. Lever that sort of return up 20:1 and... wow!

Looks like its not working out all that well for STEN's stock price now though....

Then look at the ABX today, which looks like a cliff today - especially the "A" tranche. Not good. While you're over there, look at CMBX - after what looked like a bit of settling down, it went parabolic - again - today. Who's in trouble that we don't know about yet, including in the commercial real estate space?

Add it all up and this is why I am holding my SDS and shorts, and just shorted CTX. Like a Cat 5 hurricane storm surge, this is likely to come ashore with very little - if any - warning.

Hang on to your hats - the wind is picking up and I see black clouds on the horizon.....