Investment Flash: Derivatives Say
Bernanke Will Be Wrong
By
Paul Lamont
May
23, 2007
U.S.
mortgages in foreclosure rose in April 62% from a year ago according to
RealtyTrac Inc. Folks are increasingly losing their homes as we warned last
October. Attempting to allay fears, Federal Reserve Chairman Ben Bernanke
spoke last Thursday: "We believe the effect of the troubles in the
subprime sector on the broader housing market will be limited and we do not
expect significant spillovers from the subprime market to the rest of the
economy or to the financial system." We clearly disagree. Credit Suisse’s
ARM Reset Schedule, included in our last report, shows that over
$1 Trillion dollars worth of adjustable rate mortgages will reset over the next
5 years. Bloomberg is just now reporting on the extent
of the subprime meltdown. Even more telling is what credit derivative
market charts are showing.
Credit Derivatives
The credit
derivative index, ABX.HE, prices the cost of default insurance on U.S.
mortgages. For instance, the ABX.HE falls in value if the risk increases that a
pool of mortgages will default. During the February subprime panic, BBB and
BBB- (or subprime credit) derivatives collapsed. This is evident in the chart
below from Markit.
According to the Federal Reserve Bank of Cleveland’s
economists, “That’s a 29 percent drop in only one month. Since then, there’s
been a rebound, up over 10 percent, but the
market seems to be anticipating continuing large losses in the subprime market.”
According to their analysis, subprime troubles won’t be limited to the February
panic. After looking at the chart below, ‘spillover effects’ are also evident.
It shows the A-rated credit derivative index which has not recovered either. In
fact, this index has displayed the same pattern as subprime, especially that
slow corrective (a-b-c) rise, which implies the market here too is
‘anticipating continuing large losses.’ Perhaps Chairman Bernanke does not
expect it, but reports in the field, credit derivative indexes, and the Federal
Reserve Bank’s own research economists are warning of further U.S. mortgage
woes.
So Where Are The Losses?
Derivatives are something of a financial accounting anomaly. Since they
are traded between parties (Over-The-Counter), holders do not have to use
mark-to-market accounting (assigning value based on current market price). To
quote Warren Buffet on derivatives:
“…there is no real market and “mark-to-model” is
utilized. This substitution can bring on large-scale mischief. As a general
rule, contracts involving multiple reference items and distant settlement dates
increase the opportunities for counter-parties to use fanciful assumptions. The
two parties to the contract might well use differing models allowing both to
show substantial profits for many years. In extreme cases, mark-to-model degenerates
into what I would call mark-to-myth.”
A hedge fund manager
that I have been discussing this with said: “None of these guys mark to market
even though there are no question big losses. The CDO's (Ed Note: Collateralized
debt obligations based on credit derivatives) are held by hedge funds, insurance companies and
foreign banks etc. Once these CDO's
start getting downgraded or hedge funds that own this paper get redemptions and
are forced to sell, then things will start to get ugly.”
We are preparing
clients for when things do get “ugly.” For more details, visit our website. Starting in July, our
monthly Investment Analysis
Report will require a subscription fee of $40 a month. Current readers may
‘reserve their seat’ via FeedBlitz for half price ($20 a month).
Copyright ©2007 Lamont
Trading Advisors, Inc. Paul J. Lamont is President of Lamont Trading
Advisors, Inc., a registered investment advisor in the State of Alabama.
Persons in states outside of Alabama should be aware that we are relying on de
minimis contact rules within their respective home state. For more information
about our firm, or to receive a copy of our disclosure form ADV, please email
us at advrequest@ltadvisors.net, or call (256) 850-4161.