Price Discovery May Yield More Unpleasant Surprises for Market
*WELL, SO MUCH FOR THAT*.
Stocks turned tail Tuesday, turning a triple-digit morning gain in the Dow Industrials into another triple-digit loss as the deterioration in the credit markets resumed.
Monday's rebounds in the credit and equity markets appear to have been mere interludes in the ongoing drip, drip, drip of bad news resulting from the unwinding of risk and leverage.
The villain for Tuesday's piece was American Home Mortgage Investment <http://online.barrons.com/quotes/main.html?type=djn&symbol=ahm>, whose shares lost nearly 90% of its market value after the mortgage real-estate investment trust said it might have to liquidate after failing to meet margin calls.
But American Home's debacle hardly was a bolt from the blue (trading in its stock had been suspended since Friday) and follows the bust of other mortgage lenders from New Century Financial earlier this year on down. Nor after the sharp slide in Countrywide Financial <http://online.barrons.com/quotes/main.html?type=djn&symbol=cfc> last week. Meanwhile, Credit-Based Asset Servicing, or C-BASS, a joint venture of MGIC Investment <http://online.barrons.com/quotes/main.html?type=djn&symbol=mtg> and Radian Group <http://online.barrons.com/quotes/main.html?type=djn&symbol=rdn>, also said it was getting "unprecedented" margin calls.
Nor were the losses in U.S. mortgage-related securities confined to these shores. Oddo & Cie, a French securities firm, said it would shut down three funds totaling 1 billion euros owing to the plunge in collateralized debt obligations. Two Macquarie Bank-run high-yield funds face losses of up to 25%, according to a report in The Australian. Late Tuesday, the bank said the funds have been hit by volatility in the U.S. credit markets but said they had no exposure to the subprime market.
And so it goes. But, according to a note from one prominent investment firm (which probably doesn't want its name attached to the valuable insights it shares with its clients and friends), the credit markets are heading into an even tougher period for a variety of reasons:
"Fixed-income hedge funds do the most rigorous pricing of their portfolios at month-end. Most of their portfolios are [over-the-counter]-traded.
"The funds will send out pricing sheets [Tuesday] after the US close, and dealers will submit pricing. As the credit problems have spread up to the higher-rated credits (and the most leveraged), the 'pricing discovery' [Tuesday] night may get ugly. It already has by reading the news headlines.
"What is different in the market this time is scale of derivatives in use.
"So as prices fall, the dealers are calling in more collateral. With some of these structures there is little equity underlying the investment. As the collateral is called, equity on some of these securities can go negative, quickly."
With regard to the Sowood (whose two hedge funds, which were shut down after losses of upwards of 50% but were absorbed by Citadel, much to the market's relief), the episode shows that when things come apart, they can do so quickly, this market pro notes. "Unfortunately, 'pricing discovery' at the end of June [when the subprime market already was in full retreat] may seem like a breeze when compared with what might come next," he adds.
So, we may soon discover just how deep the rot is in these hedge funds and mortgage REITs that traffic in these murky investments. It isn't apt to be pretty.
------------------------------------------------------------------------