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Wednesday June 20, 2007 - 10:42:30 GMT
Black Swan Capital - www.blackswantrading.com

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CDO Containment? Watch the yen!

Key News
• Sterling markets have been put on notice for another interest rate hike next month on the news that the Bank of England's governor Mervyn King only just failed to garner a majority for higher borrowing costs in June. (Thompson)
• China reacted coolly on Wednesday to a change in the International Monetary Fund's currency monitoring policies that has been widely interpreted as increasing pressure on Beijing to let the yuan rise faster. (Reuters)
• Two big hedge funds at Bear Stearns Cos. were close to being shut down last night as a rescue plan developed over several days fell apart in a drama that could have wide-ranging consequences for Wall Street and investors. (As of a few weeks ago, the two Bear Stearns hedge funds held more than $20 billion of investments, mostly in complex securities made up of bonds backed by subprime mortgages.) (WSJ)
• Key Reports (WSJ):
7:00a.m. MBA Refinancing Index. Previous: +5.6%.

Quotable

“The currency and financial policies in Asia today risk planting the seeds of a new and different financial crisis.”

Nuouriel Roubini

FX Trading - CDO containment? Watch the yen!

Do Treasuries catch a bid on a CDO problem or are they sold as a hedge? We can never get that right. But we could find out soon as two big Bear Stearns Hedge Funds holding CDOs might be going belly up.

From the Journal today [our emphasis]:

“Since 2000, Wall Street has created more than $1.8 trillion of securities backed by subprime mortgages, according to industry newsletter Inside Mortgage Finance.”

“’No one in the subprime business wants to ask the question of whether they need to re-mark all the assets. That would open the floodgates,’ said Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm in Chicago. "Everyone is trying to stop the problem, but they should face up to it. The assets may all be mispriced.'

“The problems can be exacerbated because many hedge funds invest in CDOs with the help of borrowed money. To buy a triple-A rated CDO note for $1,000, it is common for a hedge fund to put down only $100 of its own money and borrow the other $900 from a bank to finance the purchase.”

Hmmm…$1.8 trillion of securities manufactured from the raw material of subprime. And the so-called Triple-A tranches of the stuff, held at some very hefty leverage levels, looks more radioactive each day as it becomes increasingly clear ratings agencies made some very bold “bull market assumptions,” to steal a phrase from Jim Grant, who has continued to warn about CDOs. Just maybe there is more danger here than meets the ear. For we’ve been told again and again by those who know better, the subprime problem is contained.

There is no doubt the system has weathered the subprime problem very well so far. But this may be another test. It could generate some urgency on the part of other hedge funds to reduce some of their overall market leverage. And in the currency market, much of that has been created thought the ubiquitous carry trade (Japanese yen and Swiss franc being the key funding currencies).

So we continue to watch the Japanese yen. It seems now to be playing the role as the risk-gauge for the global economy. We know there is a massive one-way bet in the yen, as you can see in the huge open interest level in the currency futures market highlighted in the chart below:

Yen Futures Chart 437K open interest

And we know there are good reasons to continue to sell the yen. But it is not a slam-dunk that it will continue to be that way just because a major global central bank entices borrowers at 0.5%. If the CDO problem is systemic, the yen will likely catch a bid no matter what Treasuries do.

Jack Crooks

 

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