Monday, February 26, 2007

Caution is warranted

At the beginning of February, I noted that the stock market had been able to rally when and where it most counted, thus frustrating the bears. Three weeks, a couple of new highs, and over 50 Nasdaq points later, many indices are declining from overbought levels, so it would seem that we’ll have another juncture soon.

Among the leading sub-indices, the broker and dealer index ($XBD) has been one of the weakest. It broke the 50 dma today with volumes in Bear Stearns (BSC), Lehman (LEH), Merrill (MER) and Morgan Stanley (MS) around twice the daily average. Normally this would be a prelude to malaise in the general market; this time however, the carnage in the subprime sector may have something to do with it.

The mortgage lender imploe-o-meter maintains a list of top 25 subprime lenders. The relevant entries are listed below:

11. First Franklin [acquired by Merrill Lynch from National City for $1.3bln]
14. BNC [Lehman bros. subsidiary]
17. OwnIt, 2006-12-07 [partially-owned by Merrill and BofA]
19. MLN, 2006-12-29 [Much of the sales force has gone to Lehman]
24. ECC/Encore [fire-sale bought out by Bear-Stearns]

So it’s obvious some of the big Wall St. investment banks were in on the subprime gravy train – the operative word being “were”. The greater unknown is their involvement in the credit default swap (CDS) market. Conor Sen wrote a nice CDS primer for Technically Speaking, Market Analysis and Theory. Here’s the section that I want to highlight:

Since CDS doesn't exist on an exchange, much of the volume transfers through few hands -- namely the big banks like Goldman Sachs, JP Morgan, Morgan Stanley, and the like. Nobody on the outside knows how much CDS these banks hold and what kind of directional exposure they have. If hedge funds hold $100 billion of CDS protection and Morgan Stanley took the other side of the trade, if that $100 billion of debt defaulted with no recovery, Morgan Stanley has to pay $100 billion to those hedge funds. I highly doubt Morgan Stanley has $100 billion in loss reserves set aside. Should Morgan Stanley be unable to pay its debts, holders of Morgan Stanley CDS would then come into play -- and suppose Lehman Brothers is on the short end of $50 billion of Morgan Stanley CDS. You can see where this is going. It sounds absurd to say, but it's not inconceivable that a CDS domino effect could destroy the debt and credit markets as we know them.

No wonder Warren Buffet called them “financial weapons of mass destruction”! While all this is still speculation and the major indices are not yet testing near term trend lines, I felt comfortable enough to initiate a short position in IAI (iShares DJ broker-dealer ETF) today. IAI has a big overlap and a near perfect correlation with $XBD.

In addition to IAI today, I also re-shorted a couple of home builders last week. I have always felt that the weakness in the housing sector would spread to the rest of the economy but so far the market has brushed that concern aside most nonchalantly. Will it be “surprised” just as investors in New Century and Nova Star were “surprised”? We’ll soon find out. Tomorrow is another day, or maybe not.