The Cockroaches vs. Chicken Little

Containment seems to be the operating word on Wall Street today.
Sub Prime Loan Delinquencies
MBA: Delinquency rates for subprime ARMS increased to 15.8% in Q1. Delinquency rates for subprime fixed loans increased to 10.3% in Q1.
Ben Stein’s article in the New York Times was widely circulated before the open:

Chicken Little’s Brethren, on the Trading Floor
The total mortgage market in the United States is roughly $10.4 trillion. Of that, a little over 13 percent, or about $1.35 trillion, is subprime – certainly a large sum. Of this, nearly 14 percent is delinquent, meaning late in payment or in foreclosure. Of this amount, about 5 percent is actually in foreclosure, or about $67 billion. Of this amount, according to my friends in real estate, at least about half will be recovered in foreclosure. So now we are down to losses of about $33 billion to $34 billion.
. . . But by the metrics of a large economy, it is nothing. The total wealth of the United States is about $70 trillion. The value of the stocks listed in the United States is very roughly $15 trillion to $20 trillion. The bond market is even larger.
Much more to the point, the fears and terrors about subprime mortgages have helped knock off 6.7 percent of the stock market’s value in recent weeks. This amounts to about $1.1 trillion, or more than 30 times the losses so far in the subprime market. In other words, these subprime losses are wildly out of all proportion to the likely damage to the economy from the subprime problems.
. . . MY point is this: I don’t know where the bottom is on subprime. I don’t know how bad the problems are at Bear. Yet I do know that the market reactions are wildly out of proportion to the real problems that have been revealed. Maybe there is some giant thing hiding in the closet that might rationalize the market’s fears. But if it’s hidden, how can the market be reacting to it in the first place?

Goldman Sachs injected $3 billion into their Global Equity Opportunities (GEO) fund, slashed the fee and made an unprecedented conference call to discuss the state of its troubled hedge funds:

Goldman, Investors to Inject $3 Billion Into Troubled Fund
This is not a rescue. This is two things. First, given the dislocation in the markets, we believe that this is a good investment opportunity for us and the other investors that we have brought in. We also think at the same time this will be very helpful to the current fund investors because it will give the fund the wherewithal to also take advantage of these market opportunities. And so we think it is both of those things but not a rescue. — David Viniar, CFO, Goldman Sachs

The Rebuttal

Mr. Stein, traders shoot first, ask questions later, and a large part of the logic is encapsulated in Dennis Gartman’s #13 Rule of Trading: There is Never Just One Cockroach [PDF].
Mr. Viniar, shoring up GEO goes against Gartman’s #1 Rule of Trading: Never, Ever, Ever, Under Any Circumstance, Add to A Losing Position.

Stein’s Chickens vs. Gartman’s Roaches

This is a classic dilemma. Yes, we know there is good economic news all around the world. But the world looked so perfect coming out of Y2K as well, didn’t it? In fact, one of the key sentiment strategies is to look for “glowing good news” because when the market has priced in perfection, the risk is tilted mainly to the downside.
What worries me is not the hedge funds or even the problems in the subprime market per se. What we have here seems to be a fixed income market that is completely seized up to the point where normal course of business has been totally interrupted. And what will this do for earnings?
For some real perspective, I asked one of my friends who works the front line as a risk manager for a global brokerage firm:

Rank speculation only but here’s some thoughts…
It’s an interesting situation looking at it from a fixed income perspective rather than equity. Most retail investors think Wall St = stocks but if you look at the source of earnings, FI is huge. And from the FI perspective there seems to be lots of cockroaches (a Dennis Gartman statement – there is never truly one cockroach, there are others hiding).
Many funds are leveraged long some form of credit risk and it only takes a small movement to snowball kind of like portfolio insurance, plus much of the structured products have gone no bid since they are all model based pricing and everyone is questioning the assumptions in the models.
I think the situation could be worse than 1998 in that corporate america was still able to borrow in ’98 since it was Asia/Russia that had the credit problems. Now the PE firms have borrowed to finance the takeovers using, this late in the cycle, using very optimistic projections. We should see some defaults in 2008 of PE buyouts.
Also the info on ARM subprime is that the big season for resets has not happened yet – it will be in Q1 2008 (there are timetables floating around on the internet showing the number of billions of resets in mortgages, by month). So the housing situation has not bottomed unless the US economy goes on a tear and bails out people at the bottom of the totem pole.
If you are interested in following credit you can look at The main index to watch is the CDX IG (Dow Jones CDS Investment Grade). The index level for CDX.IG you can think of as the average credit spread (the interest rate above USD LIBOR) on 125 of the most liquid US investment grade corps. The CDX actually tracks with VIX quite closely.
Click on “CDX.NA.IG”. In June/July, the spread went from the 30s to 80. That is a massive move in a short amount of time and represents a sudden unwind. But the level ~80 is actually where things were only about 2 years ago, which felt tight then. It just tightened even more because people were writing credit left right and center from 2005 to mid-2007.
What is frustrating about Ben Stein’s article is he says: “This economy is extremely strong. Profits are superb. The world economy is exploding with growth.” – but don’t stock markets top out when the economy is strong, not weak – it doesn’t wait until GDP goes down, it goes down beforehand? I would like to go back and find the top of cycles in GDP. What is the 6m, 1y and 2y returns on S&P from those dates, compared to the average?
Also, he says several times that “X” is only “a small portion of the economy” so therefore, X doesn’t matter. But real economic growth is probably around 2-3%. So you don’t have to reduce GDP very much to get a recession.

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