The Debt Calamity - Part 1

We noted on the front page sidebar in this month’s Journal that the major markets have to be considered to be in full correction mode. The activity this week has done nothing to dispel that feeling, bi-polar though the market has been. After rising 4.5% in the first three trading sessions this week the S&P got clobbered today to the tune of 3%, along with everything else that moved. The cause was news overnight by PNB Paribas, one of France’s largest banks, that it has frozen three funds that have large exposure to US CDOs (Collateralized Debt Obligations – mortgage backed securities). The issue is not that Paribas is short on funds; these three funds are small potatoes for them. The part of the announcement that shocked the market was the refreshingly coherent (if not reassuring) statement that "The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating”. In short, the sub-prime/near prime market has gone no bid. The panic was real enough to have banks gobbling up overnight credit, driving up short rates and forcing the ECB, US Fed and Bank of Japan to inject over $160 billion into the overnight loan market to ease the strain. As this note is completed European markets are again down a couple of percent so it’s up to Wall St to salvage the week. Rest assured they will try but we’re none too sure they will succeed. Tout TV happy talk can only go so far. We’d like to tell you the worst is over but it’s likely that its not. There are hundreds of hedge funds that have followed the same script recently. Take in investor cash, leverage up ten to one with other people’s money borrowed at prime rates from friends on the Street then invest the money in CDOs that yield a couple of percent more then you pay on the loans. At 10:1 leverage you get a 20% return on equity on what is basic bond arbitrage disguised as financial alchemy. One little problem though. If your unit holders get nervous and start redeeming you have to unwind the trade. Remember that “complete lack of liquidity” quote in the first paragraph? Little problem becomes Big Problem. If you have to repay those Treasuries at par with mortgage securities that are bid at 60, if at all, your 10% equity component just vaporized and your fund is history. Most hedge funds are secretive and have covenants that only allow quarterly redemption requests by unit holders that commonly have to be filed 45 days before quarter end. That would be August 15th. Wall Street will be sure to try and bar the fire exits over the next week and you will be hearing hourly screams for interest rate cuts by the Fed to ease the pain. We expect a lot of hedge funds will go under in the next few weeks and months. We can’t summon a lot of sympathy for people who get nine figure paycheques based on, in effect, unimaginative use of other people’s money. Our main concern is how widely the contagion spreads and whether the credit markets lock up long enough to stall...

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