June 2007

Volatile Markets

The housing market and, in particular, the derivatives of the housing market continue to be of growing concern for bond and stock markets. Reminiscent of the Long Term Capital Management days, collateralized loan obligations, or CLOs, are rapidly being sold off to unwary investors. CLOs are large pools of bank loans that are bundled by Wall Street and sold off in pieces. As The Wall Street Journal put it, “They aim to spread [loan] default risk an inch deep and a mile wide.”

The potential problems within the financial sector and the housing market are underscored by Bear Stearns hedge fund problems of late. Bear Stearns’s illiquid investment funds, the High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leveraged Fund (uses borrowed money in order to leverage) admits that a downturn in some areas of the housing market hurt the fund’s bets on complex securities backed by subprime mortgages. Many experts believe that Bear Stearns’s $3 billion bailout represents only the beginning of things to come. The “house of cards” is not falling as yet however there are many fissures in the foundation, so to speak. If other major investment firms begin to show similar “cards” the markets will take note.

A recent article from the Bank of America estimates that approximately $500 billion of adjustable rate mortgages are scheduled to reset higher in 2007 by an average of over 200 basis points, or 2.0%. In 2008, nearly $700 billion in ARMs are subject to reset – of which three-fourths represent subprime loans. If interest rates continue to rise, as they have been worldwide, home loan delinquencies and ultimately defaults will skyrocket as housing prices come back down to earth. Currently, approximately 7% of subprime loans are in default and the trend is definitely higher.

Market volatility is likely to increase in lockstep with economic uncertainty over the second half of the year. During the first half of 2007, the market’s performance has been surprisingly strong and we would not be surprised to see some profit-taking in coming months, given the market’s relatively long, uninterrupted run. Also, the increasing volatility in the market may, in part, be the result of “stock distribution” by Wall Street. The months ahead will tell the tale.