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The Street Was Wrong

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'The Street' said don't worry, the meltdown in the sub-prime 'space' would not extend into mainstream investment banks, and that the impact of the meltdown in sub-prime would not cause a domino effect, within the financial markets.

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Merrill Lynch (MER) failed to 'sell' all of the $850 million in 'collateral-assets' (securities) placed on the auction block yesterday, as the latest manifestation of the subprime mortgage meltdown began to take on a more serious tone.

The securities are linked to the pair of embattled Bear Stearns (BSC) hedge-funds that specialize in mortgage related 'CDOs,' or Collateralized Debt Obligations, the ironically and appropriately named "High Grade Structured Credit Strategies Enhanced Leverage Fund" and the "High Grade Structured Credit Strategies Fund.

Indeed, enhanced leverage is all that need be said as the $1.6 billion in underlying capital invested within the pair of funds, once controlled as much as $25 billion in CDOs, 'enhancing' their 'leverage' by more than fifteen-to-one.

'The Street' said don't worry, the meltdown in the sub-prime 'space' would not extend into mainstream investment banks.

'The Street' said don't worry, the impact of the meltdown in sub-prime would not cause a domino effect, within the financial markets.

Gee, what a surprise… not.

'The Street' was wrong.

Note the comments from Bear Stearns Chief Financial Officer Sam Molinaro:

"We are very focused on trying to maximize the value of our client's assets and we are taking every action to ensure that we get a successful outcome."


Indeed, it looks more like Merrill Lynch is the one trying to ensure the most successful outcome, or, the least painful one. Unless of course, the move backfires and creates a panic fire sale in the broader CDO market.

Yesterday's equity market sell-off was a loud backfiring sound.

Gee, what a surprise… not.

Indeed, last Thursday Bear Stearns attempted to 'bail' itself out by dumping $4 billion in securities held by the two funds. But, the assets sold at that time were the most 'desirable' and 'least risky' held by the funds.

Note the comments from the management of the funds, which includes long-time Wall Street veteran trader Ralph R. Cioffi:

"The securities for sale are among the least likely to suffer losses from the meltdown in risky mortgage assets caused by years of loosened underwriting standards and a slump in the US housing market. This will ensure that money is raised expeditiously."


Reading between the lines I sense major anxiety.

Moreover, according to Hedge World, the pair of funds have already 'passed' the riskiest of the assets to Everquest Financial, a new specialty finance company that Bear plans to - gasp - take public in the wake of a tidal wave of requests for 'redemptions,' estimated to total 20% of the fund's collective underlying investment capital.

Indeed, when we slice and dice the numbers, the sale of $4 billion in the 'best' securities held by the funds, it fails to meet the $4.5 billion (leveraged equivalent) in redemptions.

And this after the "Enhanced Leverage Fund" was already down (-)23% in just the first four months of the year, through the end of April.

Gee, no wonder Bear Stearns halted 'redemptions.'

Ironically, Enhanced Leverage Fund manager Cioffi had himself warned of turbulence on the horizon, during a speech at an investment conference way back in February, when he stated:

"Up until now, any CDO manager, primarily new CDO managers with light staffing, very little technology, and unbalanced capability was able to get a CDO done. I do not see that going forward. We are looking at somewhat immature markets. There is a catharsis and cleaning-out process coming."


In that case, even heavy staffing, lots of technology, and unlimited capacity do not translate into success.

Maybe there is just a fundamental screw loose on 'The Street.'

Not only are Merrill Lynch and Bear Stearns involved, but the entire 'lineup' of top-shelf investment banks and brokers are coming to the party, and now that the 'punch-bowl' has been pulled, and 'last call' is long past due, the entire Street is at risk of a hangover.

According to Reuters, the list includes Goldman Sachs (GS), JP Morgan Chase (JPM), Bank of America (BAC), Citigroup (C), Lehman (LEH), and Barclays (BCS).

Indeed, as the classic seventies song goes, this ain't no party, this ain't no disco, this ain't no fooling around!!!

Note the comments carried on the newswire from Josh Rosner, managing director of Graham Fisher & Company:

"The implications extend well outside the market, and into the real economy, as it would reduce liquidity for mortgages. It could create a broader sell-off."


As far as extending into the "real economy," the last thing the macro-economic scene needs right now is more tightening in credit conditions, which threatens to impose a significant hangover on the US consumer-homeowner. Note the latest weekly statistics from the Mortgage Banker's Association, released on Tuesday:

MBA Refinance Index: 1,776.8, down (-)78 points, or (-)4.2% in the last week, and hitting its second lowest level since last November. This index is now down by a sizable (-)377.9 points, or (-)17.6% in just the last four weeks.


It is no coincidence that this index has hit its lowest level since last November, against an interest rate backdrop defined by a whopping +62 basis point spike in the 30-Year Fixed-Mortgage Rate, from 5.98% in the last week of November, to the current rate of 6.60%.

In my opinion, given the push in the energy market, and food price inflation, combined with the complete lack of capacity for continued mortgage equity withdrawal, it is no coincidence that retail sales figures are revealing eroding final demand. Note the latest evidence as defined by the weekly UBS Chain Store Sales numbers:

Chain Store Sales: down (-)0.1%, making it two of the last three weeks that sales have fallen, amid an accelerating disinflation in the year-over-year calculation, pegged at up just +1.9%, sliding from +2.9% in just the last three weeks.


In other words, 'real' chain store sales are negative.

Thus, is would be of great interest at this point if we were to witness a downturn in the already stagnant US labor situation. Indeed, evidence the story that hit the wires last week, whereby Lehman Brothers announced that they would 'merge' two of their residential mortgage units, resulting in - gasp - layoffs.

As per the prospects for a "broader sell-off" in equity markets, I shine the spotlight on the investment banks, which have led the upside charge during the most recent bull market. And what better place to start than with Bear Stearns, which broke down yesterday? As evidenced in the chart below:



Within the chart above I focus on the downside violation of the uptrend line, the directional downside reversal in the longer-term 200-Day EXP-MA and the negative reading in the med-term Rate-of-Change indicator.

Then I turn to the weekly chart on display below plotting the price of Bear Stearns relative to the S&P 500 Index, as this Ratio Spread led the way higher, and is now threatening to lead the way lower.

Indeed, the last time that the Ratio was below a declining secular 2-Year EXP-MA, at the same time the 52-Week ROC was negative (following hard on the heels of extreme bearish divergence), was seven years ago.



Also at risk is former Money Monitor 'fave' Merrill Lynch, shown in the chart below, amid intensified downside technical action as defined by the threat to the long-term 200-Day EXP-MA, the negative med-term ROC reading, and the breakdown in the On-Balance-Volume indicator.



Next note the broader US Financial sector, as defined by the Dow Jones "iShare" index IYF on display in the daily chart below. I shine the spotlight on extreme bearish momentum divergence ala the 100-Day ROC (not a 52-Week ROC as is mistakenly marked in the chart), possibly a precursor to a major double-top formation unfolding.

I also note the heightened risk of a downside violation as relates to the med-term trend defining 100-Day EXP-MA, which held as support two weeks ago. Thus, a downside penetration of the $117 level would constitute a technical breakdown, and imply at least a test of the March low, if not an overt trend reversal and bear phase.



Most disturbing of all... For more, continue on to the next page...

CLICK HERE FOR PAGE 2

No positions in stocks mentioned.
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