Archives

                 BEST OF DOUG NOLAND

This should be an easy Bulletin to write: The apparent collapse of two hedge funds -highly leveraged (at least 10 to 1) in illiquid collateralized debt obligations (CDOs) and other "structured" instruments. Escalating losses induce the fund’s ("repo") lenders to hit The Street with bid lists of CDO collateral apparently loaded with subprime exposure. The dearth of buyers willing to pay anything close to "market" ("marked") prices then forces the specter of revaluation and downgrades of similar securities and a possible contagion de-leveraging of CDO exposures throughout. Smelling blood, scores of enterprising speculators of various stripes move to place assorted bets seeking profits from the expected forced liquidations, generally widening Credit spreads, and the potential snowball unwind of leveraged speculations. The Wall Street firm that sponsored the funds is forced to step up and loan the funds $3.2 billion, increasing its risk profile in an increasingly Uncertain marketplace. And with the CDO market having evolved into a critical source of system Credit and liquidity creation, the potentially dire Credit ramifications certainly could have rocked U.S. and global markets….

On several fronts, the Credit Bubble and U.S. Current Account Deficit-induced ballooning pool of global finance was inevitably going to lead to major market Uncertainties. That day has arrived – the comforting and dependable flow (deluge) of finance into U.S. debt securities can’t now be so mindlessly taken for granted. Will the global speculator community generally remain cohesive in pursuit of risk assets, or will we look back on the subprime implosion as marking the onset of dog-eat-dog opportunism, forced liquidations, hedging, and de-leveraging? Does the recent rise of the powerful sovereign wealth funds create, as the bulls believe, an inexhaustible pool of finance for stocks and risk assets? Or, perhaps, as it seems our government officials fear, does their advent mark an inflection point where a meaningful portion of the global pool of speculative finance abandons automatic Treasury/agency purchases in pursuit of better returns however they may be attained (including shorting, hedging, and bear trading).

Not uncharacteristically, over-zealous financiers and speculators have greatly exacerbated late-stage Bubble risk and Uncertainty. The M&A boom got too hot. Global stock, real estate and assets markets turned too hot. The Chinese, Asian and general global economy became too hot. Billions were made too effortlessly; the CDO game was too easy. And robust economies and myriad spectacular asset and debt Bubbles are by their nature gluttons for additional Credit and marketplace liquidity. Inevitably, things turn tenuous, and the line between runaway boom and unwinding Bubble turns troublingly thin. For the semblance of order is maintained only as long as speculation and leverage-induced demand for risky debt instruments meets the ever escalating supply.

Most of the ingredients for Credit crisis are within reach, yet heightened volatility is likely still the best short-term bet. I would expect the gigantic pool of speculative finance to be increasingly keen to short securities and bet on/hedge against systemic stress. This is a notably unbullish dynamic, one that likely alters that nature of speculative flows - and that could at any point initiate a rush for the exits, market dislocation and panic. Big down days seem inevitable, the kind that really shake confidence and instill fears that the "wheels are coming off." But there will almost surely also be days of panicked short covering and euphoric buying. And those days will reinvigorate notions of goldilocks, New Eras and unlimited finance. There will be days when the hedge funds and sovereign wealth funds are perceived as bull market friendly and days when their supporting role is seriously questioned. Uncertainty Reigns Supreme.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.