Sunday, June 24, 2007

Subprime woes at Bear Stearns

All was not well on Wall St. last week. The week started off on a wrong footing as Best Buy, Circuit City, and FedEx all reported disappointing earnings. Since middle of the week the woes of two two small hedge funds at Bear Stearns that invests in subprime mortgages has grabbed headlines. In its wake, the news that Home Depot was buying back a staggering $22.5bn worth of its stock was relegated to the side line. The saga at Bear Stearns is still ongoing. This commentary based on a WSJ article was worth a read. The central issue, as WSJ pointed out, was that hedge funds are marking the value of their MBS (mortgage backed security) portfolios to “model” rather than to “market”. Consequently, these hedge funds have not reported losses despite the large drop in the subprime ABX indexes. However, now that Meryl Lynch is threatening to sell off the assets in those Bear Stearns hedge funds, there may be a whole-sale re-pricing waiting to happen.

The one other thing can trigger the hedge funds to “mark to market” a ratings change one of the agencies. That is precisely what’s coming. On Friday, both S&P and Fitch announced they may issue downgrades to certain CDOs (collateralized debt obligations).

So Monday will probably bring a fire storm, especially in the financials. After the 1.3% decline on Friday, the S&P 500 is sitting right below its (still rising) 50 DMA. However, a drop below the recent low of 1487 would establish a short term down trend that suggest a test of 1460, the February peak. We’re still a ways above the uptrend in the weekly chart so there is no reason to panic. From strictly an earnings point of view, there is obviously a slow-down as noted in the opening paragraph. But I believe the spinmeisters will succeed for at least one more quarter yet in convincing everyone a turn-around is right at the corner.

There has been a very significant pick-up in volume in the Powershares inverse ETFs (such as SDS, the double short S&P ETF) since March and the trend has only accelerated. Some of it must be traders wanting more juice from the intraday moves, but I’ll also hazard a guess that there is a positive correlation to retail holdings (institutions are more likely to short directly or use futures to hedge). Whether that is enough support for this market I cannot tell. For now I’m still expecting some upside but with greater volatility. I’m not going to short this market until there is an established intermediate down trend over the intermediate term.