Agora Financial’s Rude Awakening

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Laguna Beach, CA

$285.7 trillion worth of derivatives – who’s holding the bag?

The CDS time bomb ticking under Wall Street…and what you can do to avoid the fallout,

When financial woes surpass celebrity gossip and more…

Eric Fry, reporting from Laguna Beach, California…

“When CDOs trump Paris Hilton,” observes financial journalist Caroline Baum, “there’s a problem.”

Guess what, dear investors? There’s a problem.

News stories about CDOs (collateralized debt obligations) and other credit derivatives have finally bumped Paris Hilton off the front page of the Wall Street Journal. Of course, the travails of the millionaire heiress still hold sway on the covers of People and Daily Variety. But America’s credit crisis has become almost as big a story as Lindsay Lohan’s DUI.

This crisis is just beginning.

Financial stocks tumbled anew yesterday – a belated recognition that the Fed’s interest rate elixir might NOT be good for whatever ails the American financial system…or at least not good enough. The Dow’s 280-point tumble suggests that bad news might actually be bad news.

Just yesterday, Standard and Poors’ announced that a Cheyne Capital commercial paper program with about $6 billion in assets may be forced to liquidate. How many more forced liquidations and hedge fund implosions are waiting offstage?

We shudder to guess.

The excesses of the preceding credit boom gurantee the traumas of the ensuing credit bust.

A major credit crisis is already “baked in the cake,” predicts Mish Shedlock, editor of the Survival Report. “Who’s holding the bag on all these credit derivatives?” Shedlock muses. “The pension funds and hedge funds are obvious bag holders. These are the folks who have been buying the ‘toxic tranches’ of CDOs. But even the ‘prudent’ investors who think they have protection via credit default swaps may find that they too are bag-holders. What if the hedge fund who sold them a credit default swap (CDSs) goes out of business?…Oops!

“With $34.4 trillion worth of swaps floating around,” Shedlock concludes, “we are talking about the possibility of a major waterfall in CDSs. And that is just the CDS market. The total derivatives market as of year-end 2006 was $285.7 trillion, according to the International Swaps and Derivatives Association (ISDA). That’s a lot of potential bag holders, is it not?”

Indeed.

Dan Amoss, editor of Strategic Investment, provides the grisly details.

Mike “Mish” Shedlock’s Survival Report:

THE “SUBPRIME” TIME BOMB TICKING UNDER WALL STREET

Thought you were “done” with the property bust?

Think again — then get ready as a deadly subprime lending time bomb ticking under Wall Street sparks the worst property-led recession of the last 76 years!

This triple-edged “housing hedge” strategy could shelter both you and your money against the fallout IF you let me rush it to you FREE, as soon as possible…Get It Here.

Indigestion on Wall Street
By Dan Amoss

Credit used to be as free as love in the 1960s. But the days of free credit ended about three weeks ago…and the days of expensive credit arrived. As credit becomes more expensive, asset prices will deflate. And that will not be very much fun for investors.

During this particular credit cycle, investors might suffer even more pain than usual. That’s because there was nothing “usual” about this particular credit cycle. In fact, the world has never known anything like it.

In the modern financial system, the ability to create credit extends far beyond the reach of the traditional banking system. A labyrinth of credit contracts and derivatives provides sources of financing that never pass through the door of a traditional bank.

This labyrinth is known as “Securitization.”

Every imaginable stream of future cash flow – from car and mortgage payments to the loans that fund private equity deals – can be “securitized” and sold to the highest bidder. Securitization is simply the process whereby a stream of future cash flow becomes pledged to a separate legal entity, which then divvies up the cash flow among different “tranches,” or classes, of creditors.

Like everything in life, the securitization revolution has its positives and negatives. One negative consequence is that securitization creates a vast expanse between borrowers and lenders. The two sides never know each other…or care to know each other. But obviously, the further a lender is separated from a borrower, the more potential there is for fraud on the part of the borrower and underestimation of risk on the part of the lender. Very bad loans tend to be made when this is the case, as those who’ve dabbled in subprime mortgages are discovering. On one end of the lending chain are plenty of fraudulent “liars’ loans” yet to default, and on the other are plenty of lenders who don’t fully understand the risks they were taking.

Bill Gross, the most accomplished bond fund manager in the world, recently published his views on the subprime debacle. In his July Investment Outlook, Gross acknowledges that securitization and derivatives diversify risk and “direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets…

“The flaw, dear readers, lies in the homes that were financed with cheap and, in some cases, gratuitous money in 2004, 2005, and 2006,” Gross concludes. “Because while the Bear [Stearns] hedge funds are now primarily history, those millions and millions of homes are not. They’re not going anywhere…except for their mortgages, that is. Mortgage payments are going up, up, and up…and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable-rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises, with nearly $700 billion ARMS subject to reset, nearly three-quarters of which are subprimes…”

The housing market will remain sluggish far longer than most expect. $800 billion of ARM resets can only add to the supply of distressed sellers in 2008. This will further depress an already sluggish housing market that’s having enough trouble working through a huge supply overhang. To say the least, this scenario will weaken demand for securities backed by residential housing.

Until now, hedge funds have been creating a great deal of the miraculous “liquidity” sloshing around the globe. By buying the highly leveraged equity and mezzanine tranches of collateralized debt obligations (CDOs), the buyers provided the cash to make new loans and create new CDOs. Liquidity surged; share prices soared; everyone was happy…until homeowners began defaulting on their loans in record numbers. Suddenly, CDOs were not providing the returns the buyers expected. Instead, they were providing the large losses the buyers did not expect. Indigestion resulted.

Indigestion tends to suppress an appetite. That’s where we are today – in the indigestion phase. Institutional investors’ appetite for mortgage-backed securities is spoiling just as Wall Street tries to serve them heaps of new portions.

Get ready for the days of expensive credit.

Joel’s Note: “The is a time-bomb ticking under Wall Street,” says Mish Shedlock. Want to know the best way to protect your investments? Simple. Read the Survival Report.

Rude Endnote: You didn’t need to rummage through the pages of your dusty old Econ. 101 textbook to realize that a glut of housing inventory and a tightening of credit would result in a drop in prices. But just how serious is the situation?

“U.S. homeowners, buyers and sellers have officially endured an entire year of falling home prices.” Wrote Addison, about 21 seconds in to yesterday’s 5. “The median American home cost $228,900 in July, down 0.6% from the month before… the 12th consecutive month of tumbling home prices.

“All told, home prices fell 3.2% across the country in second quarter – the steepest rate since the S&P started its Home Price Index in 1987.”

I think, in light of today’s column, it’s worth nicking the chart they used to illustrate just how drastic this drop has been…

So, about that ticking time-bomb under Wall Street? Yeah…here’s the link again: Mike Shedlock’s Survival Report.

Grab the rest of your Executive Series news when the chaps from Baltimore chime in again in a couple of hours.

Cheers,
Joel Bowman
Rude Awakening