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8:30 AM EST, Monday, August 6, 2007:
The party is well and truly over, at least for now. We are moving into a recession. Share prices will tumble further. Friday's 281 point drop in the Dow was just the beginning.

I am not normally a panic merchant. But this "call" is bleeding obvious. The only thing that can stop the red ink is immediate action by Bernanke to pump liquidity into the banking sector and drop the prime rate. I can't call that one. He's getting a lot of phone calls and feeling a lot of pressure.

Here's the simple story: Huge losses are appearing in housing loans. A big percentage of those loans are now worthless. No one knows how many. But the losses have thrown Wall Street into turmoil. Suddenly no one knows whether the loans they're making are good or bad. No one knows if the loans they might make are saleable, and at what price. Since loans are now bundled and sold, no one knows if there'll be a buyer and at what price. The fear is that loans made today might be sold tomorrow at a loss.

In this uncertainty, the human brain makes one "decision." It shuts down, awaiting clarity and stability. Hence, the banking and investment banking community has essentially shut down making loans. This has three effects:

1. It kills the housing business, and hurts all those companies supplying that huge industry.

2. It puts less money into consumer hands. Remember all those refinancing mortgage loans? Consumers are 70% of the economy. They have been the mainstay of the economic boom of the past few years.

3. It puts less money into companies' hands for plant expansion, etc. This is sad because this area was just beginning to take off.

Now, switch gears. What would you do if you were a mutual fund, a hedge fund or Warren Buffett? Buy equities? No way! The outlook for them looks suddenly bleak. They're already fully priced (or were until late last week). With money drying up, there won't be anyone around to buy them. Much, much better are bonds and other debt instruments.

Debt instruments are on fire sale. Corporate bonds are way down in price. Some are now yielding 10%+. (Read the cover story in this week's Barron's).

Think earning 10%+ plus the capital appreciation you get when this crisis passes (a year or two) and the bonds go back to par. Many debt instruments are presently in limbo. Investment bankers have promised money to corporations, to private equity funds for buyouts... But no one will buy these instruments -- or at least not the people who bought them last week. Step in mutual funds. Step in hedge funds (those surviving). Step in Warren Buffett.

The desperation investment bankers are presently feeling will turn into great bargains for mutual funds, hedge funds and Warren Buffett. While they troll for "bargains" in bonds, they won't be buying equities. In fact, they'll be selling equities for two reasons: to finance their bond purchases and to finance their investor withdrawals. I'm not the only hedge fund investor feeling squeamish about equities. Thousands of investors are scrambling to get their money out. As they rush for the door, this can only produce panic selling.

Today's words are strong stuff. To check, I sent my comments to my favorite guru. His reply:

The only thing I would say is that this is a credit crunch, which can, and likely will, be solved by people stepping in and making markets the way you outline. They will not completely stop buying equities while they do this. If we can stop the credit crunch, we can stop the depression. I think the odds actually favor that outcome dramatically. The markets will be very volatile in the coming days and weeks, but I would still place my bets against depression and crashes.

My equally favorite other guru replied:

Why would a Fed cut help? Subprime borrowers are dead regardless, and corporate borrowers are being repriced from 200 to 500 bp or more above libor, so a 25 or 50 bp cut ain’t going to do much for them either.

But I agree the party is over, I just don’t think the Fed can (or should) try to keep the party going.

Today is already tomorrow in Asia. Monday was grim -- in some cases grimmer than Friday 2.2% drop in the Dow.

You can from this chart on Australia how small stocks are getting hit hardest. Small stocks are big trouble. When bad things happen, people dump their small stocks.

OK. The rest of today's column consists of articles I read on the weekend, which deal with capital markets. Sorry there' so much of it. But this is engrossing. And to get a full picture (not just my biases), you need to read all this stuff:

Havoc in America, August 6, 2007: from the Sydney Morning Herald.

THE head of National Australia Bank, John Stewart, said problems in the US subprime housing mortgage sector would continue to play havoc with the US financial system but Australia should be largely immune.

Mr Stewart told ABC television the magnitude of the problem in the US was wide.

"It's very serious and it's got a lot further to go, it's about 15 per cent of the mortgage market in the US," Mr Stewart said.

"To give you an idea, that is about $US1.3 trillion [$1.5 billion]. Right now about 20 per cent of it is in arrears."

US hedge funds associated with subprime mortgages would feel further pain, he said, possibly for another two years.

The Loan Comes Due by Floyd Norris of the New York Times, August 5:

SUDDENLY it’s not so easy to borrow.

That is true for homeowners, and it is true for companies.

Only two months ago, it seemed as if almost any company could borrow money at low interest rates. Now loans seem to be drying up everywhere.

What had seemed like a contained problem, involving home loans to people with poor credit, has suddenly mushroomed into a rout that threatens to make life difficult for everyone who needs to borrow money.

Home buyers are likely to pay more for mortgages, and some with less-than-pristine credit or an inability to come up with a down payment may find they no longer can borrow at all.

A German bank had to be rescued by other banks last week, because it had speculated in securities backed by American mortgages. One of the biggest mortgage lenders in the United States collapsed, and another said it would drastically scale back its lending because it cannot find investors willing to finance the loans it makes.

The volume of new high-yield bonds — also known as junk bonds — fell by 89 percent in July. The market for loans to highly leveraged companies has almost dried up. Standard & Poor’s counts $35 billion in corporate loans that have been delayed or canceled, including loans to finance the leveraged buyout of Chrysler.

The Chrysler deal will go through, because banks had promised to lend the money if others would not take the loans. But from now on there are likely to be fewer corporate takeovers, and those that do take place are likely to be at lower prices. “This is a classic credit correction,” said Jack Malvey, the chief global fixed income strategist for Lehman Brothers. “The magnitude of risk was significantly underappreciated.”

Mutual fund investors have been pulling back rapidly, with more than $1.3 billion coming out of funds that invest in leveraged loans during recent weeks, and $2.7 billion leaving funds that buy high-yield bonds, according to AMG Data Services.

Hedge funds, which had been major buyers of complicated securities that financed leveraged loans and mortgages, have also pulled back. Some investors have tried to pull money out of such hedge funds, leading Bear Stearns to stop investors from making withdrawals from three of its funds.

“That is the core of a financial crisis, when too many people head to the exits simultaneously,” said Robert Bruner, the dean of the business school at the University of Virginia.

Mr. Bruner is the co-author of a book on the Panic of 1907, to be published next month, and he sees similarities between then and now. “It was a time marked by the rise of new financial institutions and new financial instruments,” he said. “It marked the end of a period of extraordinary growth, from 1895 to 1907.”

The credit market has changed drastically in recent years, as banks grew far less important and credit rating agencies like Standard & Poor’s and Moody’s became the essential players in the new financial architecture.

Many loans, whether mortgages or loans to corporations, were financed by selling securities. It was the credit agency ratings that determined if those securities could be sold, and deals were structured to meet the criteria set by the agencies.

Those criteria turned out to be very generous. The agencies figured that even very risky loans were unlikely to cause big losses, and so most of the securities backed by loans to poor credit risks could get AAA ratings — the highest available — as long as those securities had first claim on loan payments. Investors bought the securities thinking they were completely safe, and some did so with borrowed money.

Now, however, there is fear even about those securities. The rating agencies are changing their criteria for the loans, and many investors no longer trust the ratings.

The markets are “very panicked and illiquid,” said Mike Perry, the chief executive of IndyMac Bank, the ninth largest mortgage lender in the first half of this year, as he announced plans last week to curtail lending sharply. It is very difficult, he said, to find buyers even for the AAA securities.

All this has happened with few defaults. Mortgage delinquencies are up, particularly on loans made in 2006 when credit standards were very low, but the real problem is that lenders and investors fear things will get much worse.“This is what we would characterize as the first correction of the modern neo-credit market,” said Mr. Malvey of Lehman Brothers. “We’ve never had a correction with these types of institutions and these types of instruments.”

It now seems likely that the rating agencies, and investors, were lured into a false sense of security by the lack of defaults. With the value of homes, and companies, rising, it was usually possible for a borrower in trouble to refinance the debt or, at worst, sell the home or business. Either way, lenders got paid.

Now, there is less confidence that rising prices will bail out lenders, and there is doubt not only about the quality of old loans but also about important parts of the new financial system.

“The markets seem to be expressing concern about the performance and the stability of hedge funds and, to a lesser extent, private equity funds,” said Mr. Bruner.

The credit squeeze is coming at a time when the American economy seems to be growing, despite problems in the housing market, and the world economy is strong. “The underlying economy is very healthy,” said Henry Paulson, the Treasury secretary, as he visited China last week. But a good economy in no way precludes credit problems. In fact, it is during good economic times that credit standards are most likely to be so lax that bad loans are made.

“Financial panics don’t happen during depressions,” said James Grant, the editor of Grant’s Interest Rate Observer. “They happen on the brink of depressions. The claim the world is prosperous is beside the point.”

Not all panics lead to economic downturns, of course, and if this one continues pressure will grow on the Fed and other central banks to lower the short-term interest rates they control and thus stimulate the economy.

But central banks do not always determine what happens in credit markets.

“The Fed tightened in 2005 and 2006, but creative financing on Wall Street blunted the impact,” said Robert Barbera, the chief economist of ITG, a research firm. “The collapse of that option in the last 90 days means the entirety of that tightening is arriving now, and there is a violent tightening going on.”

Of course, this phase will pass. The insurance companies and pension funds that are the traditional buyers of bonds always have money coming in, from interest payments and bond maturities, as well as from new business, and they will have to put it to work.

“The history is that lenders move in great caravans between two extreme points, which we can call stringency and accommodation,” said Mr. Grant, recalling how hard it was for companies to get loans as recently as 2002.

Lenders will move back to accommodation one day, he said, but for now it appears that risky borrowers,whether of the corporate or individual variety, will discover that it’s much more difficult to find someone to lend money to them.

A good time for a squeeze: From The Economist print edition of August 2:

Tighter credit conditions are just what the markets need

BANKERS and investors might not agree, but the recent sell-off in financial markets is good news. It may, at last, have brought people to their senses. For the past few years, too much money has been lent too cheaply and too easily to too many people, whether it was speculators trying to make a fast buck in Miami condominiums or private-equity groups financing their latest multi-billion-dollar takeover. This wake-up call came too late to save the American housing market from frenzy and subsequent bust. But it may have arrived in time to stop the takeover boom getting out of control—and when the world economy is strong enough to cope with the consequences.

Watch out for the American consumer

The big question now is how serious those consequences are likely to be. The impact on debt markets themselves will be big (see article below). As standards are tightened, many of the reckless practices that have become the norm in corporate lending will be abandoned. We will now hear a lot less about firms getting “covenant lite” loans, under which lenders give up their rights to monitor the behaviour of borrowers; or “payment-in-kind notes”, which allow borrowers to substitute more IOUs for interest payments. As investors steer clear of riskier debt, the takeover bids that have pumped this year's stockmarket froth will be curtailed and the most debt-laden borrowers may find it impossible to raise funds.

But most companies will be able to shrug off the credit squeeze. That is partly because creditworthy borrowers still have access to debt (albeit at a higher price), and partly because many firms don't have to borrow. Across the rich world, firms are flush with cash. Their profits have been fat for the past five years and, on average, companies have been funding their capital spending from their own resources. Credit wobbles by themselves, therefore, need not prompt an investment slump.

Other potential victims also seem well-prepared. Emerging-market bonds and shares, for instance, may jitter further. That could spell trouble for a few countries, such as Turkey, which have large current-account deficits (see article). But most emerging markets are in far better shape than they were during the financial crises of the late 1990s. They have restructured their borrowing and often built up vast coffers of foreign-exchange reserves.

The biggest risk to the global economy probably lies with debt-laden American consumers. They have been battered by falling house prices and expensive petrol, and their spending growth has already slowed sharply. A credit squeeze will aggravate the housing bust and falling house prices could drag spending down further. But the rest of the world is growing strongly and unemployment in America remains low, so a recession there is by no means inevitable. What's more, if the economy were to head downhill fast, the Fed, despite its public worries about inflation, has plenty of scope for cutting interest rates.

All told, the credit wobbles so far are likely to have only modest economic consequences. But what if they prompt a broader market meltdown? After all, many of the newfangled instruments that dominate today's debt markets have never been tested in a serious panic. Credit derivatives have probably improved the stability of the global economy by dispersing risk, but it is no longer clear where that risk is being held. And many of the new risk-dispersing instruments are so illiquid that trouble may not emerge for some time. It was several months after the subprime mortgage market turned sour before the scale of the losses at two Bear Stearns hedge funds became clear.

Investors are right to worry about more hedge-fund failures. Yet although these highly leveraged creatures seem to have made credit tremors more sudden and more frequent, these episodes have not been more calamitous. The past 18 months have seen two other credit wobbles, albeit on a smaller scale: one in May 2006 when investors worried about inflation; another in February this year, when fears about subprime mortgages first surfaced. In each case, the most exposed hedge funds had to cut their positions quickly. But thanks to the size and diversity of the hedge-fund industry, others moved in to buy the assets cheaply. The same dynamic seems to be playing out this time too (see article).

For all the hand-wringing about hedge funds and complicated derivatives, the real worry comes from a well-known source—the banks. They will face trouble on several fronts and it is they who could turn a healthy credit squeeze into a nasty crunch. Many banks have already agreed to underwrite deals and are finding that they cannot sell the debt on to investors. One estimate suggests that more than $300 billion of debt is already in the pipeline. Big losses could follow.

Banks will also suffer from their exposure to failed hedge funds, just as some have already been hit by their exposure to the subprime mortgage market. Some banks may have as-yet-undisclosed losses on their own accounts: trading in financial markets has become an increasingly important source of their profits in recent years. If banks' profits collapsed, they would become more reluctant to lend. A bank failure (or the fear thereof) could create a systemic panic.

Yet although banks are the biggest worry, their balance sheets look fairly solid. America's commercial banks bought back $58 billion-worth of their shares in the year to March, suggesting they have capital to spare. And although banks' shares have tumbled over the past few weeks, analysts are still forecasting higher profits for the year ahead. If the solidity of bank finances is to be tested, the markets have chosen a good time to do so.

Credit cycles are unpredictable creatures. Things could still go badly wrong. So far, though, the financial wobbles, however unnerving, look like a healthy repricing of risk. Markets, much like people, sometimes need a good squeeze.

Holiday horrors. The effect on financial firms. From the print edition of the Economist, August 2:

There are losers, but some winners too

“I KEEP thinking how nice it would be to turn off my computer and not come back until September,” says the head of leveraged-lending at a large bank. As the spasms in the credit markets claim more casualties, and unsold bonds and loans for funding leveraged buyouts pile up, wails of pain are echoing across Wall Street and beyond. But they are interrupted by the occasional hoot of pleasure.

Start with the victims. For private-equity firms new deals are suddenly harder to do and existing ones costlier to refinance. Their mega-funds may struggle to deploy their estimated $300 billion-500 billion of financial muscle. This could scupper Kohlberg Kravis Roberts's hopes of following Blackstone to the stockmarket. KKR looks particularly vulnerable because it is less diversified than its arch-rival in the leveraged-buyout business.

As credit for buyouts dries up, the biggest losers are the banks left holding “hung bridges”. These are loans to buyers that were supposed to be temporary and for which the banks charged fees. As the price of the loans falls in the secondary market—to below 85% of their value in some cases—a number of banks could face big losses. To add to their woes, private-equity clients are also more likely to tap undrawn loan facilities which were negotiated some time ago on more favourable terms.

Some of these risks can be hedged in the derivatives markets. But with a backlog of more than $300 billion, banks may end up selling loans at a discount to make room on their books for new commitments. According to the head of a hedge fund that does a lot of business with large banks, their lending desks are now being stripped of risk-management responsibilities by livid chief executives.

One boss who is probably more embarrassed than angry is Citigroup's Chuck Prince. His recent comment that the bank was “still dancing” in the loan markets has quickly returned to haunt him. Citi is the most exposed of all banks, having “tried to buy the market at the worst of times”, as one competitor puts it. It was the lead arranger on $25 billion of the roughly $40 billion of bonds and loans withdrawn in recent weeks. Things may get worse: Citi is involved in financing some giant buyouts still to come to the market, such as TXU, a Texas energy-utility, and First Data, which processes credit cards.

Citi should be able to take the losses in its stride, given its enormous balance sheet and low cost of funds (thanks to cheap deposit funding). But most investment banks do not have the luxury of also being a big universal bank. No longer happy to act mainly as middlemen, many have wanted a slice of the action themselves. Wall Street's five big investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns—have piled into potentially illiquid (and thus risky) assets, from bridge loans to collateralised-debt obligations (pools of tranched debt), over the past three years. Their lending commitments rose from around $50 billion in 2002 to over $180 billion in 2006, according to Moody's, a credit-rating agency. In Merrill Lynch's case, these commitments far exceed the bank's capital base—although they also include safe loans to blue-chip companies.

Buying shares of an investment bank today is “more of a religious experience—one based on faith—than an investment”, says Dick Bove, of Punk Ziegel, an investment bank. Bear Stearns's shareholders have had their faith severely tested. Two of the bank's hedge funds have imploded and a third has stopped investors from withdrawing funds. Even more vulnerable are stand-alone hedge funds that borrow heavily to dabble in debt. As easy financing evaporates, investors want their money back and the prime-brokerage units of banks that lend to them want more collateral, or “margin”. Credit funds were up by a mere 0.2% in June, according to Credit Suisse. Returns in July are expected to be negative.

Highly leveraged funds sink quickly in such choppy markets. Witness the demise of Sowood Capital, a $3 billion fund that lost half its value in short order and this week sold its credit holdings at a discount to Citadel, another hedge fund. Sowood was caught out in two ways: it over-borrowed and its hedges failed to neutralise its risks as expected. The debacle suggests that even the canniest of investors can slip up: the managers of Harvard's successful endowment have lost $350m investing in Sowood, according to reports.

The intervention of Citadel—which last year snapped up bits of Amaranth, another troubled hedge fund—is seen by some as encouraging. It suggests that large, diversified funds will not only survive, but could prosper by swooping on assets they consider cheap. The top 20 or so funds, including Citadel, have the reputation (and pay big enough fees) to negotiate hard for more flexible financing arrangements. So they are less likely to get caught out.

Smaller funds can prosper too. Paulson & Co, a fund based in New York, has done well from betting early that securities backed by subprime mortgages would fall in value. The good times may continue for other funds that are “short” on subprime.

But there are signs that the pain is spreading to other countries. Several European banks and insurers are rumoured to be sitting on “mortgage bombs”—troubled assets linked to America's subprime mess. IKB Deutsche Industriebank, which lends money to Germany's middle-sized companies, is being bailed out by a group of banks including the state-owned bank that partly owns it, thanks to ill-judged punts on American mortgages. And Australia's Macquarie Bank, which has been growing rapidly and buying up big infrastructure projects, has said two of its funds may post losses because of subprime woes.

One German bank, however, is doing well out of the subprime mess. After one of its analysts predicted two years ago that a slump was coming, Deutsche Bank piled into derivatives contracts that gain in value as the housing market sinks. These bets are thought to have netted the bank at least $250m, perhaps much more.

But it is traders of distressed corporate debt who are wearing the broadest smiles. After four years of infuriatingly strong markets, they finally have wads of discounted bonds and loans to feed on. Goldman Sachs, for one, has upped the size of a junk debt-fund it is raising, from $12.5 billion to $20 billion.

Though the mood has clearly darkened, no one really knows if this is the crunch that the markets have been anticipating. As Stephen Green, boss of HSBC, a global bank with copious subprime troubles, put it this week: “It is too early to tell if this is a temporary bout of indigestion or whether a whole new pricing structure will have established itself when people get back from their holidays.” Turn off the computer, head to the beach, and hope.

Half of All Hedge Funds Gone? by John Mauldin:

Long time readers know that I am a huge fan of Jeremy Grantham. He is one of the smartest and most successful investors in the world. In his recent letter, he stated that "within 5 years I expect that at least one major 'bank' (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist."

I have to make a comment on that. He may be right that 50% of the hedge funds that exist today will be gone, although I doubt it will be that high. But the demise of that many hedge funds is entirely predictable and something that we should expect. Except for the largest funds, the vast majority of hedge funds are small businesses. Michael Gerber estimates that 80% of all new small businesses fail with five years of starting up, and 80% of the remainder no longer exist in the next five years.

When you think about it, the odds on being a successful hedge fund manager are not all that high. To charge the fees that they do, they have to deliver the goods consistently. In these markets, that is tough.

So, while a lot of hedge funds in the market today will no longer be here in five years, the real reason is that they simply did not generate enough cash flow for themselves and their investors to survive. You can actually have a profitable year and see your assets under management leave. 7% a year for three years is not all that exciting.

And let me make a few predictions. There will be thousands more hedge funds in five years than there are today. And the industry will be twice as large. And that is a very good thing.

Most everything is cratering. So this chart has less relevance than it did when I first published it on Friday. Maybe it will be useful when things return to normal.


Solar energy
Emerging markets*
Australian miners and explorers
Shoes (?)


Financial Services, Banks, mortgage companies,
Investment bankers
Oil Services and oil explorers
Home builders
Automobile makers
Real estate syndications**
Consumer retail/discretionary***

* Vanguard's top performing fund this year is its Emerging Markets Index (VEMAX), which is up 20.9% so far this year and which I've recommended repeatedly. Sadly on Friday it fell 2.47%.
** Commercial buildings are now too pricey.

*** Consumers pulled money out of their homes by refinancing mortgages. That is over. Hence, consumer spending will drop.

Everyone loves Pfizer. 4.93% dividend yield and getting its act together, albeit slowly. To replace Lipitor, which is going generic, I humbly offer some suggestions for replacement drugs for women:

Take 2 and the rest of the world can go to hell for 8 full hours.

Suppository that eliminates melancholy and loneliness by reminding you of how awful they were as teenagers and how you couldn't wait till they moved out.

Plant extract that treats mom's depression by rendering preschoolers unconscious for up to two days.

Liquid silicone drink for single women. Two full cups swallowed before an evening out increases breast size, decreases intelligence, and prevents conception.

When taken with Peptobimbo, can cause dangerously low IQ, resulting in enjoyment of country music and pickup trucks.

Potent anti-boy-otic for older women. Increases resistance to such lethal lines as, "You make me want to be a better person. "

Injectable stimulant taken prior to shopping. Increases potency, duration, and credit limit of spending spree.

Relieves headache caused by a man who can't remember your birthday, anniversary, phone number, or to lift the toilet seat.

A spray carried in a purse or wallet to be used on anyone eager to share their life stories with total strangers in elevators.

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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