CDO’s and the Market: An Investor Guide

A quick downdraft Friday afternoon was linked by some to a rumor that CDO’s were being repriced to the market for the quarter end.  This would be negative not only for Bear Stearns hedge funds, but also other funds holding these assets.

The selling begat more selling, tripping some technical models, including ours.  As we noted, our intermediate term outlook moved to neutral.

The Containment Perspective

A New York Times article quoted various high-placed sources have spoken out to assure the markets that the subprime problems were "contained."

Jim Cramer, writing for RealMoney has repeatedly said the same thing.

James Hamilton at Econobrowser asks "CDOs:  what’s the big deal?"

Raising Key Questions

Barry Ritholtz responds to Hamilton by raising a number of key questions.  (Barry says that he is employing a Socratic method, but we note that Socrates, like a good cross-examiner, knew the right answer in advance.  We think that Sophocles is a better analogy!)  We look forward to some answers from Professor Hamilton.

A Helpful Expert Analysis

David Merkel, an authority with plenty of experience in these markets, offers a long and thoughtful analysis which is worth reading carefully.

David concludes as follows:

In summary, this will not be a “piece of cake,” but the losses will be
concentrated among a small set of investors.  As for the CLO market, it
will have its troubles, but not yet.  Prudent investors will avoid it,
but there may be some rallies there in the short run, away from
subprime and Alt-A.

Our Take

No one knows for sure the extent of the problem.  Markets hate uncertainty, so the reaction is immediate and dramatic.  Will asset problems spread to banks making loans to hedge funds?  If investors are reassured that this is not another event on the scale of Long-Term Capital Management, attention will turn back to earnings and interest rates — perhaps quite soon.

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  • Bill a.k.a. NO DooDahs July 2, 2007  

    You might enjoy my comment at Mike’s place.
    “…aside from a few companies and funds, and spillover into the sector’s stock prices, this is a non-event. Quote me on it, and see if the market doesn’t recover quite nicely everywhere else (and in aggregate indices as well).”

  • Jeff Miller July 2, 2007  

    thanks for stopping and pointing us to this discussion. You seem to have a good sense of what is happening — as you often do.

  • Bill aka NO DooDahs! July 2, 2007  

    On another thread, someone remarked that equity markets seemed unfazed by the subprime situation, and that reality would soon set in. My response was that equity markets HAVE reacted to it. Response is localized.
    From 6/1 to 6/29:
    Cons. Cyclicals – Homebuilders, XHB, -13.8%
    Financials – Real Estate, IYR, -9.7%
    Financials – Banking, KBE, -5.6%
    Financials – Brokers, IAI, -4.8%
    Financials – Capital Markets, KCE, -4.6%
    SPY in that timeframe, -2.5%.
    Others in the same timeframe had gains:
    Industrials – Aerospace and Defence, PPA, 0.5%
    Industrials – Environmental Services, EVX, 0.8%
    Telecom – Wireless, WMH, 1.2%
    Technology – Electronics, PHW, 2.1%
    Technology – Networking, IGN, 2.4%
    Technology – Semiconductors, SMH, 2.9%
    Energy – Oil Services, OIH, 3.0%
    Energy – Clean, PBW, 3.1%
    Energy – Oil Equipment and Services, IEZ, 3.4%
    The index is not monolithic.

  • Jeff Miller July 2, 2007  

    Bill –
    Thanks for this helpful analysis, showing the diverse effects in the market.
    Regular readers know that we think there is plenty of fear reflected in current market prices.