Visions of Rollercoasters and "Dead Cats"

By Ron Ojeda, Blue Moon Capital

Debt and equity markets from Chicago to New York to overseas continued to react to the uncertainty created by an illiquid debt market. Last week started with three days of gains that were the best we’ve seen since March of 2003. But the lion’s share of those gains were experienced in a relatively narrow band of the S&P 500; financials, materials and energy markets were the sectors hardest hit since mid July.

With that lack of breadth, most savvy traders had one eye on the door. On Thursday when BNP Paribas, the largest bank in France, barred withdrawals from three of its’ asset backed securities funds, the broad selling started. Nine out of ten sectors in the S&P 500 were down more than 2.5%. By the way…that’s why it’s illegal to yell “Fire!” in a crowded theater. If it were not for the “dead cat bounce” on Friday with the market recovering late in the day from a 213 point drop to finish at down just 31 points, the market would have suffered its’ fastest 1000 point drop since the five days following September 11^th, 2001.

Given these events it is important to remember that the equity markets are simply the tail of a very big dog. That dog being the global debt markets. Friday finished the week off with a manic trading day driven by global central bank activity. The European Central Bank infused more than $130 billion into the markets on August 9^th, the highest amount since September 11^th, 2001, and an additional $84 billion on Friday with The Bank of Japan. The Bank of Canada and The Bank of Australia followed suit.

The Fed added reserves of $38 billion accepting mortgage-backed securities as collateral for overnight loans or repurchase agreements (Repos). The Fed will normally buy a combination of Treasury, Agency and mortgage-backed debt.

Bond investors, home mortgage buyers and jobless mortgage banking industry employees alike, who have been negatively affected by these events of the last month, have been anxiously looking for someone to blame. Unfortunately, this may be a time for them to look inward to see some of the culprits. Home buyers who stretched too far and borrowed against too much of their equity, mortgage brokers who sold inappropriate products to their customers and most importantly, the bond investors who enabled this activity by buying what Wall Street had to sell.

In the early 1990’s Wall Street was faced with a compelling problem. With a large wave of the population moving toward retirement, they needed an even larger amount of investment-grade income producing investments. With several money managers restricted on the quality of debt they could buy by their written investment policy statements, where were they going to find that investment?

Someone had a brilliant idea that would transform speculative paper into investment grade paper, "What if we bundle all these loans together into a pool? We can reduce the risk to the investor by diversifying his risk amongst all these loans.” Collateralized Debt Obligations were born and Large to small investors with mutual funds have been inadvertently feeding the beast ever since.

With the luxury of the big picture and hindsight as its’ benefactor, it appears the herd has had its’ way…again.

By: Ron Ojeda, Capital Development, Blue Moon Capital, LLC