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The Return of Absolute Return


Buy-and-hold is officially dead and gone.

Beware of the blob, it creeps
And leaps and glides and slides
Across the floor
Right through the door
And all around the wall
A splotch, a blotch
Be careful of the blob
Burt Bacharach, The Blob

The Blob on Wall Street

A morass of government intervention has eaten every company, every deal pronounced "too big to fail." It's the Blob, and to understand it, we must first understand how and why it was formed in the first place.

The evolution of the credit crisis began in the mid 1990s, when the money supply began to grow at unprecedented rates. At the same time, stock prices began their ascent to the bubble highs of 2000.

Once the stock market bubble was popped in 2000 and stocks began to plummet, it seems that the Greenspan-led Federal Reserve became a serial bubble-blower. The Fed lowered rates dramatically into the 2003 low of 1%, a rate not only too low given the actual economic statistics, but one that was also allowed to stand for entirely too long.

Because of this, another bubble formed at Greenspan's urging. With 30-year mortgage rates near all-time lows, homeowners were encouraged to bypass fixed-rate mortgages and take on adjustable-rate mortgages. Thus the housing bubble was born.

Lending standards fell as money flooded the system, courtesy of a too-easy Fed. Individuals and institutions burned by a busted bubble in stocks became infatuated with the real-estate market - and prices -- not only in residential space but in commercial, hotels, and raw land -- were bid up to ridiculous levels.

The combination of easy money and rising prices enticed even the most conservative investors to embrace real estate; unlike stocks, it was something tangible, something you could touch.

Enter the world of Wall Street alchemy. One of the old phrases on Wall Street is "if the lady wants green shoes, sell her green shoes." Let's say that real estate is the base asset. With money so cheap and easy, and credit spread so thin, the alchemists concocted first, second, third, fourth and fifth derivatives of the asset itself (i.e. real estate). Since it was assumed that real estate was so tangible, so steady, the loans were also assumed to be "money good" - and the derivatives of these loans were taken to be "money good," as well.

It seemed like such a cinch: You could take a bunch of loans, lever them up, and break them into equity, mezzanine, subordinated and senior tranches offering dramatically higher yields than stodgy agency mortgage-backed securities and Treasuries.

This worked wonderfully, until something horrible happened: Many loans based on little or no credit history and little or no documentation began to perform poorly. Delinquency and default rates began to rise - and they continue to rise to this very day.

Click Here to Purchase "Bond Basics: A Q&A with Bennet Sedacca"
No positions in stocks mentioned.

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