Pete Kendall's Socio Times: A Socionomic Commentary

July 18, 2007
Benchmark ABX Indexes Fall to Record Lows
The benchmark ABX index sank to record intraday lows in nervous trading on Wednesday on concerns over mounting deterioration in assets backed by subprime mortgage securities, traders said.

The ABX "BBB-" 07-1 index, which is tied to loans made in last year's second half, fell to 43 on Wednesday after closing at a record low of 45.02 bid on Tuesday. The ABX 06-2, which references loans made in last year's first half, slid to 47.75 following its record low close of 49.09 in the prior session, traders said.

"The Bear Stearns situation is definitely contributing to the already negative sentiment in the subprime market," said one portfolio manager.

On Tuesday, Bear Stearns Cos. Inc. said in a letter to investors its two troubled hedge funds that bet heavily on risky subprime loans now have "very little value."

"The preliminary estimates show there is effectively no value left for the investors in the Enhanced Leverage Fund and very little value left for the investors in the High-Grade Fund as of June 30, 2007," according to the letter.

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Big Break in the ABX Index Is a Picture Confidence Crashing
Category: NEWS
By: Pete Kendall, July 19, 2007
Since the subprime industry’s unfolding debacle is leading the decline in stocks, as well as the bursting debt bubble, there is much to learn from it. First and foremost is how important it is to ignore those who continue to suggest that the trouble is over or contained. Since late last year, when the lowest grade ABX Index started angling down and away from the 100% line, analysts have been positioning for an imminent rebound. Somehow the slow, relentless nature of the subprime reversal convinces many that it will stop and reverse, but its durability actually relates to the size of the implosion and its eventual extension across the depth and breadth of the credit universe.
The Elliott Wave Financial Forecast, March 2007
credit indexAs we noted yesterday, the highs for the latest, and we strongly suspect the last, rally leg may not be in yet, but it was nonetheless interesting to see the ABX indexes plunge to a new lows as stocks turned down. Notice also that the high and mid-grade mortgage instruments, shown as the top and middle line on the chart, bounced slightly yesterday. Stocks also bounced off their lows. So, the wrestling match between denial and acceptance of the unfolding credit crisis appears very salient to the stock market right now. As we have noted many times in recent months, confidence is the glue that binds the financial world. As it wanes, the debt and stock markets will, too. As Socio Times suggested here yesterday with our discussion of the news environment, a tight relationship between price declines and debt deflation will be readily apparent in the week’s ahead. 

The ABX indexes have fallen a long way since the March issue offered the comments at the top of this entry. The extension “across the depth and breadth of the credit universe” is still mostly to come, but there’s nothing slow about subprime’s reversal. The chart shows the meltdowns clear spread to higher grade mortgage securities (the middle and upper lines in the chart). As the economy turns, its move into all types of credit will be unstoppable.  Amazingly, however, the “positioning for an imminent rebound” goes on.

As for the now near total decimation of Bear Stearn’s “Enhanced Leverage Fund,” it offers a perfect example of how fast things are changing on Wall Street. It was only a little more than a month ago that the fund still retained most of its top value and the June 12 Socio Times entry had this to say:
The first return to earth is now very clear in deals like Bear Stearns’s High-Grade Structured Credit Strategies Enhanced Leverage Fund. The fund, which has a big exposure to low grade subprime mortgages, fell 23% from the start of the year through late April. According to an account in the Wall Street Journal, observers are convinced “the paper losses will have a limited impact on Bear” because it moved the funds into a separate corporate entity, Everquest Financial Ltd. But the Journal also reported, “Some market participants predict the fund's downturn could have a chilling effect on Bear's planned initial public offering of Everquest.” The paper adds, “Recently, the fund prevented some investors from pulling their cash [from the High Grade Structured Credit Fund].” The harder Wall Street asserts “everything is fine,” the quicker the conversion from liquidity boom to bust is likely to unfold.

The Everquest Financial offering has since been cancelled and one lasting effect of the High Grade Structured Credit Fund is that it illuminated how completely mispriced many “marked to model” debt instruments are in many hedge funds and elsewhere.  The latest fund to get hit by the fallout is Basis Capital, an $2 billion fund that was Australia’s “hedge fund of the year in 2006.” Basis is unable “to meet margin calls” and has been “declared in default” by its lenders. Basis warns that if its lenders seize assets and sell at "distressed sale prices," the net asset value of the fund could be halved since May 31. In a letter to shareholders, Basis offers an explanation that sounds very much like the bursting of the liquidity bubble envisioned in recent issues of The Elliott Wave Financial Forecast and The Elliott Wave Theorist:  "This indiscriminate pricing is largely the result of a market-wide lack of liquidity, which has resulted in very little collateral actually being traded." In other words, illiquidity breeds illiquidity and the one thing that still prevents asset holders from recognizing its full effect is the lack of liquidity. Another important aspect of the Basis meltdown is that it’s not just a subprime fund. Subscriber Deron Kawamoto points out Basis’ Pacific Rim Fund was down 9% in June and also received margin calls according to a Financial Times article.  “That fund has small exposure to the US so most of the losses there had to be coming from Asian and corporate debt.  So much for being ‘contained’ to subprime.” The spread to all but the safest credits instruments should happen fast.

ED. NOTE: Socio Times will be on somewhat of a hiatus through mid-August as vacation, the August issue of EWFF and a stint in the Short Term Update chair conspire to limit entries. Enjoy the summer and lets meet back here in the middle of August for what promises to be exciting times. 

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Holy Illiquidity, Batman!
Posted by: J. Colin Vaughan
July 19, 2007 02:26 PM

sub-prime will take the market in general to sub-zero
Posted by: Rene
July 19, 2007 02:26 PM

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