Tuesday, July 17, 2007

Shaky start ahead, but what's the news

From this evening's vantage point tomorrow morning's market may be under pressure. Two reasons---First, Intel reported strong earnings and higher than expected revenues but margins declined as pricing pressure was greater than expected and second, the two Bear Stearns sponsored hedge funds that have been under pressure are reported to be almost total write-offs. The Intel news speaks for itself. The Bear Stearns hedge fund news may be a big deal as it's just the kind of news that will scare the market and cause traders to shoot first and ask questions later. Should it really be news at all?

The two hedge funds in question invested in CDO's composed of subprime mortgage loans on a leveraged basis. One fund was leveraged at approximately 18 to 1 and the other at 11 to 1. So it takes about 6th grade math to calculate that if these formerly investment grade rated subprime mortgage loan CDO's are now priced at, for example, 92 cents on the dollar, the higher leveraged fund is wiped out and the other is worth just pennies on a dollar of investment. It really should not be news that these securities are priced at this level or even lower at this point, if in fact a price can be had. The message is that the degree of leverage employed by the funds was extreme and left no margin for error.

Hedge fund investors are definitely grown-ups in an investment sense. They are required to be wealthy funds or individuals, they know what they are investing in, and should be well aware of the risk profile of their investments and the reason for the high returns that they had been earning. Their lawyers will of course be looking at going after Bear Stearns, but in a rational world they should have no case.

The biggest question remains the same question that has been around for the last month. Are there other funds out there with the same risk profile that the market does not yet know about. If so will that stress the fixed income market further and impact the financial institutions that have funded the leverage? To date, having no answer to this question has been good news.

So at the moment, the cosmetics for the morning look bad and cosmetics drive trading. Under the make-up, it's hard to see how anything has really changed but it may take some time for that thought to be sorted out.

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