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Welcome to the Hotel California


So do you wanna party with Hoofy? Hey, I don't blame you!


Most by now are familiar with the following dynamic:

  • Bears buy Credit Default Swaps on the debt of various companies – mainly financials – with reckless abandon using hyper-leveraged instruments.

  • The corporate bond market underwrites the CDS purchases.

  • The CDS get crushed by ever tightening corporate spreads forcing the bears to cover their leveraged bets.

  • The underwriters have just collected free money to lend at very tight spreads (no need to worry about risk spreads since the lenders are playing with house money) which in turn fuels LBOs, M&A and buybacks. Stock prices go up, bears must cover their equity bets, and Hoofy throws a big party.

While I have been forced to respect this scenario for the last many months (or else I'd be doing something else by now), there are a couple of articles in this morning's Wall Street Journal which explain why I have refused to defer to it.

First is the piece discussing that the losses at a Bear Stearns mortgage-related structured product were in fact much bigger than initially disclosed, because the initial loss estimate relied on mispriced mark-to-market holdings.

Second, is the commentary on how companies that have no business still being in business have been rescued by cheap, risk-seeking money.

The two stories are one and the same in mind. That is, risk spreads in corporate bonds have collapsed not because the lenders see an ever ending plateau of prosperity in corporate America, but because, IMHO, bears' bets on the demise of many companies have been crushed by squeezes triggered by the mispricing of the derivatives tied to the debt. In essence, the underwriters of the CDS bearish bets have come to see the premiums collected from the CDS buyers, much as option sellers these days view the premiums they collect: free, and risk-free money, with the critical difference being that the option markets price their instrument in a relatively market driven environment, while the CDS market – not being an open, tradable market – mostly relies on the very same underwriters to "arbitrarily" mark-to-market the value of their own assets. One does not have to be a genius to guess who is going to be the winner in that trade.

Of course in the end, no amount of mark-to-market "pricing flexibility" can prop up the real value of those instruments if they have to be liquidated; and in turn, the velocity (volatility) with which the mark-to-market pricing catches down to actual liquidation prices, together with the leverage the instruments carry, can create its own death spiral as borrowers and lenders are hit by "sticker" shock, the former default, and the latter tighten credit. That's basically the movie we saw unfold in the sub-prime market and the reason why that market unraveled so quickly, and seemingly out of the blue.

So do you wanna party with Hoofy? Hey, I don't blame you!

Mirrors on the ceiling,
The pink champagne on ice
And she said 'we are all just prisoners here, of our own device'
And in the master's chambers,
They gathered for the feast
The stab it with their steely knives,
But they just can't kill the beast

Last thing I remember, I was
Running for the door
I had to find the passage back
To the place I was before
'relax,' said the night man,
We are programmed to receive.
You can checkout any time you like,
But you can never leave!

Just ask the Bear Stearns fund investors.

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No positions in stocks mentioned.
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