Sobriety Can Be Hard

I just returned from a trip to Cabo San Lucas, and I have to say after not a drop – the City looks different when not seen through tequila-laden eyes…

And so do the rating agencies when seen through the reality of the underlying credit rather than the “mark-to-model” numbers that seemed all-so-convincing as recently as May. It turns out that the “ratings” given to the senior tranches of certain CDO securities were more of a mirage than a reality, as the underlying mortgage credit has continued to weaken across the country.

Moody’s, S&P Lose Credibility on CDOs They Rated

The last few days have continued the downward spiral that started with these CDO’s early in the summer and now is spreading to global equities, as the reality of a deepening world-wide credit crunch is becoming more clear. As I feared in my post last Monday the rebound before the Fed did not move apparently was nothing more than a brief pause on a continuing downward trend.

One of the most surprising data points that continues to be discussed surrounds the massive negative moves in so-called “quant-based” hedge funds over the last couple of weeks.

Goldman, who’s funds have perhaps been the most visible of the sufferers, with clear eyes and looking into the midst of the storm, agreed to re-up its commitment to the strategies by committing “$2 billion of its own money” and into one of its losing funds according to Bloomberg:

Goldman Fund Cuts Fees to Woo Investors After Loss

The fact that Goldman is being joined by Perry, Greenberg, and Broad – some of the savviest investors of our time – suggests that perhaps there is opportunity to be had in keeping a level and clear mind in the midst of the recent volatility.

I continue to remain cautious and selective – but I also continue to dive in where clear opportunities present themselves…like enjoying a mexican sunset with open eyes.

The Limits of Expectations

When I first read this doomsday article yesterday, I thought the guy was frankly a bit extreme to say the least:

MBS Monetization and US Dollar

It wasn’t only that the graphics atop the page made me hesitate, but I thought that the idea underlying his argument – that “Fannie Mae will eventually become a funnel for monetization, after functioning as a centralized efficient clearing house…” was far fetched, especially when Bush yesterday kept a lid on Fannie and Freddie Mac’s capacity.

However, overnight the Fed made such a doomsday picture for the dollar more believable, as it made the writer of this complimentary article eat his words:
Fed Joins Banks Adding Cash to Stem Credit Collapse and Fed Adds $35 Bln in Funds, Most Since September 2001

Some of the figures tossed around in these articles make me begin to wonder whether such an extreme scenario is not that far fetched – particularly when I read that the intent is to provide “reserves to “facilitate the orderly functioning” of markets”…in other words to provide an artificial buffer to inaccurate underwriting.

I personally think that the system will not spiral out of control for a number of reasons, maybe the most important of which is that we don’t want it to – in other words, investor psychology and American optimism should provide a “floor” of some kind.

However, the second consecutive brutal day in the market highlights that things are not looking pretty right now.

And those who have made heretofore money hand over fist using predictable trends are continuing to struggle as the underlying credit continues to unwind: Market Turmoil Is `Perfect Storm’ for Quant Funds

As the article states and I mentioned yesterday, today is a different day: ““Previously uncorrelated factors have recently been falling with the same pace, leaving investors with very few places to hide.”

Correlation, Causation, and Change

Reality reared its ugly head overnight last night as the Europeans realized that they have some trouble on their hands in the form of U.S. denominated mortgage backed securities.

The equity markets took a pummelling as the beneficiaries of global liquidity (i.e. broker-dealers) faced tougher prospects for an easy out: U.S. Stocks Tumble on Credit Concerns; Banks, Brokers Retreat

Interestingly, at the same time that more bad news emerges around CDO’s and other asset-backed pools of securities, many quantitative hedge funds are apparently taking large hits as their statistical models face a changing marketplace: Highbridge, Goldman `Quant’ Hedge Funds Lose Money

To me this is unsurprising and driven by the same trend causing the implosion in the CDO markets. Most of these “quantitative” hedge funds are driven by modeling techniques that utilize a high degree of statistical analysis. Statistics is great for telling a story about what has happened and also powerful for picking up potentially unnoticed correlations (and therefore – in theory – causation). However, this power is harnessed and utilized in the context of looking at historical data.

The challenge facing the credit markets and statisticians generally is that things seem to have changed. For whatever reason (I have speculated about many possible theories below), the underlying credit dynamics of the housing market and the surrounding financing markets have had a dramatic impact on the mispricing of risk generally, and now reality is coming home to roost. It is not surprising that as these underlying changes play out, models based on data collected in a different historical context sometimes fail.

Maybe part of the reason why these models don’t work as planned is because the system is built on the backs of sometimes not entirely rational creatures – american homeowners.

This article offers an interesting take on why home owners are lured into loans they may not be able to afford: The Psychology of Subprime Mortgages

As the author states: “I think a big part of the reason sub-prime loans remain so seductive, even when the financial terms are so atrocious, is that they take advantage of a dangerous flaw built into our brain. This flaw is rooted in our emotional brain, which tends to overvalue immediate gains (like a new house) at the expense of future costs (high interest rates). Our feelings are thrilled by the prospect of a new home, but can’t really grapple with the long-term fiscal consequences of the decision. Our impulsivity encounters little resistance, and so we sign on the bottom line. We want the house. We’ll figure out how to pay for it later.”

Such a statement sure sounds like it makes sense and is predictable to a human being like you or me. But unfortunately, statistics speaks a different language than common sense…and as it turns out that linguistic gap may have dramatic consequences.

Web 3.0 is Real

Whether it will evolve as some combination of a Wii and Secondlife, with Nuance voice recognition technology allowing us to get past the interface hurdle…or simply through next-generation I-phone like devices tapping into social networks like Pownce or Facebook – the next “big” thing seems to be unfolding on the horizon in the internet space.

Check out this video where Google’s CEO takes a stab at anticipating where “3.0” is headed.

Bouncing With Beta

Since everyone else is enjoying the ride over the last few days, I figured maybe there is some space for good news.

On globalization front, it looks like DFJ is continuing to expand its global VC horizons by entering into another partnership: DFJ’s Global Offensive

This is a great for the idea that collaboration between entrepreneurs will continue to be enhanced on a global scale which should escalate the pace of innovation.

…and (not) unrelatedly, peaks tend to bring signs of the next movement in global risk premiums. Not sure whether this would ever materialize, but the fact that China is now openly recognizing that they are the 1,000 lb gorilla in the U.S. Treasury market makes one gulp just a tad…then look back to that booming ticker:

China threatens ‘nuclear option’ of dollar sales

Positive Signs?

Maybe Cramer’s cage-rattling was like BX’s IPO, in that it indicated the “top” of a market. Hopefully in this case it marked the peak of the hysteria and angst which has driven up the VIX index dramatically over the last couple of weeks as people grappled with the credit markets’ unwind.

As a friend mentioned in his comment below, NFI, one of the subprime mortgage lenders to take a plummet last winter and spring, has announced that they are going to resume issuance of subprime loans after the market has been literally frozen over the last few weeks: NovaStar Will Resume Making Subprime Loans

Apparently Novastar disagrees with Indymac, who only last week stated that the secondary markets for mortgage backed securities are illiquid

The market rallied significantly today, led by the same Financial stocks who have been hammered over the last weeks, so apparently some people agree that conditions are changing.

It will be interesting to see if this is sustainable or simply a dead cat bounce before the next round of carnage.

As I have mentioned before, I am selectively diving in on both the long and short side, but cash looks pretty good right about now.

I Hate to Quote Cramer But…

This is just an example of the angst that people feel when reality smacks them in the face. It is almost funny to see someone who as little as two weeks ago was “bullish” freaking out like this…but a little scary:

At least he recognizes that the engine driving this train is the pain being felt by homeowners who are being hammered by the ongoing mortgage-resets.

Unfortunately, I am not sure 50 bps will do much to change anything at this point.

Transparency is Sometimes Scary

IndyMac (IMB) prides itself on providing transparency to its investors, a beacon in the complex and sometimes confusing financial services sector. (For a primer on the mortgage securities industry visit their webpage’s investor relations section and read their investor presentations.)

Following this tradition and a disappointing earnings release yesterday (was anyone surprised?), their CEO went so far as to publicly release the e-mail he sent to his employees explaining the current situation:

Email from Mike Perry, Chairman and CEO: Conditions in the Private Secondary Markets and Their Implications for our Industry and Indymac

I would take a few seconds and read the e-mail if you are interested in trying to understand what is happening in the housing sector, but to quote an important piece:

“Unfortunately, the private secondary markets (excluding the GSEs and Ginnie Mae) continue to remain very panicked and illiquid. By way of example, it is currently difficult, at present, to trade even the AAA bond on any private MBS transaction. In addition, to give you an idea as to how unprecedented this market has become…I received a call from U.S. Senator Dodd this morning who seeking an understanding of “what is really going on and how can I and Congress help?””

Basically the markets are frozen and no one knows what to do. I also heard from a confidential source that there are issues in the pricing of certain non-real estate related securities in the distressed debt market that people are struggling to figure out.

As major hedge funds hit hiccups, and the market reacts, it is not surprising that illiquid markets become unpredictable. The implications of this could be dire, especially for the real estate market as challenges in securitizations mean harder home mortgage refinancings.

Remember – look at the chart in the upper right hand side of this page – ARM resets are still rising and not at the peak. In other words, at the asset level, the worst is probably still yet to come.

Now, this may not necessarily translate into drops in all markets across the board, especially now that everyone is acknowledging the elephant that has been trouncing around the room. The key question is whether Greenspan is right in that the hedge funds and other sophisticates will find a way to arbitrage away the illiquidity or whether the irrational fear that is creeping into the markets will create an ever growing snowball.

Cue the Orchestra

As if on cue, an article hit the screen today foretelling the bubble bursting…and as if responding to my post from yesterday, the author called for a pop of the Web 2.0 bubble.

Bubble 2.0 Coming Soon

I am sticking by my optimistic guns and hoping that he is just a hater and that the frenzy going on at the cross ways of media and technology will continue to boom and generate innovation and valuable new ideas. But the idea that cycles exist is surely coming back into the zeitgeist as the credit and real estate markets wake up from the greatest fiesta in history with the beginnings of an equally epic hangover.

That the party is over for many who were riding short boards along the wave of liquidity is becoming more apparent daily as banks are starting to openly claim that they are pulling back their previously generous open arms: Bank warns hedge funds of liquidity crunch

And other blue chip hedge funds are now publicly taking huge hits Tudor Raptor Fell 9% in July; Caxton’s Global Lost 3%

Although this is likely only the cresendo of the coming climax, sometimes people mistake the hillside for a mountain top, and maybe if we concentrate hard enough we can make it true.

Metaphors Mix Vision

I am not sure what to think about the fact that a money manager and I have been having the same feeling of “watching a train wreck in slow motion” as the current credit cycle unwinds.

Although I can safely say that he is more bearish than I am, I do agree with the overall sentiment that things will worsen significantly before we are out of this thunderstorm:

Jeremy Grantham: We’re Watching A Slow-Motion Train Wreck

But in the mean time, thankfully the creative side of our economy continues to elicit, if not lightning bolts, at least enough camera flashes to distract one from the clouds.

Although the GUI leaves something to be desired, this collection of start-ups confirms that ingenuity and creativity are booming:

KillerStartups.com

The website attempts to use the “digg/filter” model to allow users to sort through the various new startups popping up out there.

I hope the name isn’t too ironic or foreboding of another turn of events in the web 2.0 space…I think the credit markets will be dark enough without another bubble bursting alongside it.