BEING STREET SMART
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Sy Harding
STOCK MARKET JITTERS! July 27 2007.
The potential problems in debtland I’ve been writing about the last couple of months came to roost on the markets with a vengeance this week.
I mean four triple-digit down days in the last six trading days. Almost ten times as many stocks down as up in Thursday’s plunge. Very heavy trading volume on the down-days, compared to the light volume as the market rallied to new highs a few weeks ago.
Investors seemed to finally catch on to what has been happening in recent weeks.
It’s no secret the stock market had been able to withstand an uncommon number of negatives over the preceding six months or so. Most obvious were high and rising oil and gasoline prices, a slowing economy, slowing earnings, inflation fears, record consumer debt, a worsening real estate slump, and a collapse in the sub-prime mortgage sector.
It was also no secret that the support holding up the market, in spite of those historical negatives, was the liquidity created by the huge multi-billion dollar corporate buyouts, and corporate stock buybacks, that were in the news every day.
It was also no secret that those deals were being financed not by conventional business loans held by banks, but by ‘less than investment grade’ corporate bonds and debt obligations (CDOs), originated by banks and then sold to investors. It was very similar to the way the frothy part of the real estate boom was financed not by conventional mortgages held by banks, but by low-quality mortgages originated by lenders, then packaged into collateralized-mortgage-obligations (CMOs) that were sold to investors.
Rising mortgage defaults in the housing sector decimated the sub-prime mortgage sector months ago, forcing more than 80 sub-prime lenders to close up. Four weeks ago two Bear Stearns hedge funds raised the initial concern that the problem was spreading to investors in those CMOs, when the funds revealed losses that last week resulted in them being declared worthless. That was the first warning that the debt/credit bubble was bursting across a larger universe than just the housing industry. Investors in all types of packaged debt began to take notice. Wall Street said no problem, it’s a ‘Goldilock’s’ economy.
But in last weekend’s column I noted the problems encountered the previous week by a couple of high profile LBOs (leveraged buyouts) that indicated the virus was spreading to corporate debt. Banks had committed to financing the $40 billion buyout of Chrysler by hedge-fund Cerberus Capital Management, and the $18 billion buyout of U.K. drug store chain Alliance Boots, by Kohlberg Kravis Roberts. But the banks were unexpectedly running into problems finding investors willing to buy the debt, even by sweetening the terms with higher interest rates.
I noted that it “put the banks in a precarious position, since banks are sitting on roughly $220 billion in LBO deals in the U.S. and $50 billion in Europe that they’ve already committed to. And if they have trouble selling the debt to investors prior to the closings they get stuck with it themselves, a risk exposure not intended when they committed to the deals.”
Well that is just what did happen this week. JP Morgan Chase, the lead banker on the Chrysler buyout deal revealed they had not been able to sell all the debt needed for the deal to investors, and would take on $10 billion of it themselves, and try to sell it later in the year. And the eight banks committed to financing the Alliance Boots buyout had to withdraw their offering of $10.3 billion in bonds, saying they will keep the debt on their own books for now.
Those problems were at the core of the market’s problems this week. They were exacerbated by news of several other debt deals being in trouble, as institutions, hedge funds, and other investors reassess the risk in such deals. And then the troubles piled on. Kohlberg Kravis Roberts will probably have to postpone the large initial public offering (IPO) it had announced. It wanted the investor capital from the IPO to complete the financing on 11 deals it struck last year.
The picture was not helped by more bad news from the housing industry, in the form of another plunge in home sales in June. And on Friday came a warning from mortgage-giant Fannie Mae that it could have $4.7 billion in unrealized losses on its books from the further deterioration of sub-prime mortgages it holds.
It’s not a good situation. It looks like Goldilocks may have met the three bears, the ending to the Goldilocks story that investors don’t always remember.
The stock market has been supported primarily by liquidity created by corporate buyouts and share buybacks, and the lending windows at banks and brokerage firms for those kind of deals were hammered closed this week.
It looks like the market correction that seemed likely in this year’s unfavorable seasonal period has begun, and that as I expected, its catalyst is the bursting of the one remaining bubble, the debt/credit bubble.
It will not be in a straight line down. There will be rally attempts as Wall Street brings all its guns to bear on containing the damage. But the bottom is not likely to be seen until toward the end of the market’s unfavorable season in the October/November time frame.
Sy Harding is president of Asset Management Research Corp., publishes www.StreetSmartReport.com, the free daily www.SyHardingblog.com, and authored 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.
