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Sub-prime CDO’s Take Down Hedge Fund Cracks in the housing sector became a little more visible. The blame game over who is responsible is getting more pointed. Some think the 2002-2005 period of easy money from the Greenspan Fed pumped up a home price bubble that fostered speculative overbuilding, which is now being corrected. Others accuse regulators for not doing enough (until now when it is too late) to protect consumers from the predatory practices of many sub-prime mortgage originators. Excess liquidity, new technologies in structured finance and good old human greed also played a factor. These all contributed to the excessive creation of sub-prime mortgage ABS securities and their placement into CDO’s at fat spreads to those who structured the deals but at less than optimum risk-adjusted spreads to those who invested in them. Whatever the reason, all the above will be sighted as contributing to the virtual collapse of two Bear Stearns Asset Management (BSAM) hedge funds that leveraged heavily in CDO’s that contained sub-prime ABS. These two hedge funds are not unique and although they might have been among the more aggressively managed, there is little doubt that others have similar positions. Concern grew over the potential negative effect this might have on the major international banks and financial institutions that provide the loans that allow the hedge funds to leverage their strategies. Several of these lenders sent shivers through the market when they seized and threatened to liquidate some/all of the securities that the BSAM hedge funds had put up as collateral. Because much of this collateral consists of CDO’s that do not frequently trade in the secondary market, the fear amongst CDO managers and investors is that a forced liquidation will lead to price discovery. Should the collateral be sold at significant discounts to par, this would force billions upon billions of other CDO’s to be marked down in value. Such a markdown would be a concern to insurance companies, pension funds, banks, and other investors in CDO’s. Fed Stands Pat Federal Reserve policy makers met yesterday and, as fully expected, left interest rates unchanged at 5.25%. It has now been one full year since the Fed last tightened on June 29 2006. In the statement that accompanied the latest rate decision, the Fed acknowledged “ongoing adjustment in the housing sector” but noted that the “economy seems likely to continue to expand at a moderate pace” in coming quarters. It acknowledged modest improvement in core inflation but stressed that “a sustained moderation in inflation has yet to be convincingly demonstrated.” It went on to say: “the high level of resource utilization” (a low unemployment rate) “has the potential to sustain those pressures.” As such, “the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.” Market rates were a little higher following the announcement. Fed fund futures are signaling a small 15% probability of one rate cut by year-end. This is down sharply from March when there were widespread expectations of two cuts by year-end. Despite the current low probability of a rate cut, things could change quickly if problems similar to those at BSAM begin to spread. We do not want to be alarmists and we do not think that the problems at BSAM will lead to systemic problems. Still, it would be ironic if the Fed needed to ease in the future because of CDO’s and hedge fund problems after resisting such a move in the face of the pure problems in the housing sector itself. A Fed ease would also be ironic because it would be throwing more liquidity at a problem that is itself the result of abundant liquidity and leverage. They say that the growth and use of derivatives is a benefit to the financial system because it distributes risk instead of having it concentrated in a few hands. This means, however, that the pain from the sub-prime sector will affect a broad range of investors. As such, in the future, leveraged transactions will be reduced, lending standards will be tightened, and the negative effects from housing will be a drag on the economy into 2008. Market Developments Two-year treasury yields touched 5.13% on June 13 and the 10-year reached 5.32%, the highest since March 2002. Factors pushing rates higher include a rebound in 2nd Qtr U.S. GDP estimates to 3.5% (up from 0.7% in 1st Qtr) and multiple Central Bank rate hikes designed to cool accelerating economies and reign in modestly growing inflation concerns. Those high yield levels did not last very long however, as buyers stepped in to take advantage of the highest rates in a year. Bond markets also received support from better core inflation readings for May. The year-over-year rise in core CPI now stands at 2.2% (versus 2.3% in April) while core PCE dipped to 1.9%, down from 2.4% in February and the first print below 2.0% since April 2004. Disappointing housing data and the hedge fund scare also combined to push rates lower. By month end, 2 and 10-year yields had fallen back towards 4.90% and 5.05% leaving the yield curve at a positive 15 bps versus 2 and 10-year rates of 4.90% and no spread at the end of May. Looking ahead, I think 2-year rates will range trade between 4.85 - 5.15% and 10-years between 4.90 - 5.25%, with rates headed first towards the top of the range. Equities moved to new cyclical highs in early June with the DOW30 rising to 13,692 and the S&P500 hitting 1,540. These levels could not hold and prices subsequently fell about 3.5% in three days during early June. From there, prices moved sideways, rallying at mid-month only to fall back once again. I think equities should continue to be range-bound in the period ahead. The range I am watching on the DOW is 13,250 to 13,700. A break above would target 14,000 while a break below would target 13,000. For the S&P I am watching the range of 1,475 to 1,540. A break above targets 1,575 while a break below targets 1,440. In late April, when sentiment was very bearish against the U.S. dollar, we thought the currency could post a 2-3% rally. Over the next 6 weeks, EUR fell 3.0% against USD from 1.368 to 1.327. Against JPY, the USD rose 3.75% from 119.5 to 124. In the latter half of June, the dollar gave up a portion of those gains as concern over hedge funds made EUR a more attractive play while a reduction in risk appetite led to some unwinding of the yen carry trade. Currently at EUR 1.354 and JPY 123.15, I look for the dollar to weaken. Against the dollar, I think EUR can climb back up to the top of the range at 1.36-1.365. Looking at USD/JPY, I think there is a risk for a larger selloff, especially if global investors take risk trades out of the market and repay yen loans in the process. If USD/JPY falls below 122.2 I see risk to 121 and, if broken, 118.5. Stock image bank. Images from Corbis, Getty images, Zefa ... Stock image bank by Epictura images. We offer royalty free stock images, stock photography and illustration. 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