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July 16, 2007

Signs Of The Times
by Bob Hoye

Signs Of The Times:

"They are priced by convenient goony models dependent upon collusion by rating agencies. Failed auctions expose the shenanigans and might disable these very models. Vast write offs are certain on the mortgage bonds. The size of the write offs depends upon the level of corruption permitted by the authorities."

- Jim Willie, July 6

"Moody's Faces the Storm - Bearish investors are betting that the lucrative business in providing ratings, such as collateralized debt obligations, or CDOs, could dry up due to rising defaults in those mortgages extended to borrowers with poor credit histories."

In looking at the precarious condition of the credit markets as well as the sudden loss of complacency, it looks like Mother Nature is going into her dominatrix mode.

"UK Lenders Get Tighter with Credit, Tougher in Collection"

- Wall Street Journal, July 9

The old transition from banks handing out umbrellas on sunny days to calling them in when it begins to rain is global and eternal.

Or as von Mises explained it, at the peak of a boom bankers don't have to call loans in order to prompt the contraction - they just have to get a little concerned and stop making them.

But China's form of Tokyo's Zaitech of 1989 is still on:

"Many Chinese corporations are putting piles of cash into local stocks, fueling the bull market and their own profits."

- Wall Street Journal, July 11

In the 2000 tech-bubble, this was also described as the "virtuous circle" - whereby investment gains prompt higher profits, which drives stock prices even higher.

The opposite - the vicious circle - has been underway in the subprime mess and risk aversion is spreading out to traditional corporate bonds. There will be other spin offs.

Stock Market: We will stay with our "Rational Exuberance" theme. This based upon the observation that the financial forces that built the peak to a financial bubble have been remarkably similar.

These forces, and they are worth repeating, include the run of 12 - 16 months of yield curve inversion. Within this window usually the boom tops and as the curve reverses to steepening some of the most speculative items begin to fail.

For the end of this boom we've been looking to the Shanghai exchange much as when London was the senior exchange and New York was the big adolescent exchange - as in 1929 or 1873, or moving ahead in financial history, to Tokyo's eruption in 1989.

The collapse of recklessness in the adolescent exchange eventually dislocates the equanimity of the senior exchange. As Cicero observed when Rome was the senior market:

"If some lose their whole fortunes, they will drag many more down with them . . . believe me that the whole system of credit and finance which is carried on here at Rome in the Forum, is inextricably bound up with the revenues of the Asiatic province. If Those revenues are destroyed, our whole system of credit will come down with a crash."

- Cicero, 66 B.C.
(Translation by W.W. Fowler, 1909)

Generations of analysts have found it difficult to "quantify effervescence". Our "Upside Exhaustion" model comes close to this and registered that condition on the monthly reading on Shanghai.

That action has stalled out with series of declining highs not accompanied by a series of lows. The chart is boxed in by lows at 3404 in June and 3563 recently.

This will likely churn around through the summer, with diminishing global liquidity limiting the moves to the upside and liquidity concerns forcing the declines.

The subprime mess still only registers as a crisis - in order to have a panic there has to be the ability to sell. In so many words, a financial panic has been deferred. In the meantime there is no way to liquidate suddenly unwanted positions.

As we've noted, where is all that liquidity that was so widely touted?

It should be understood that the subprime mortgage mess is only a small sub set of the derivatives construct.

Amsterdam was the world's financial centre in the early 1600's and had an orderly means of making and honoring contracts. There was little reason to stray outside of normal financial settlements. That was until the Tulip bulb became the object of intense speculation. Transactions took place in taverns using chalk boards to list the markets for a variety of bulbs, with some deemed more precious than others.

As "Tulipmania" was on its way to a blow off city authorities frequently warned that these transactions were unenforceable. And they were not. Nevertheless, the speculative collapse took down the normal course of business that had, hitherto, been aloof from the mania.

The problem with today's unenforceable contracts - derivatives - is that they won't go away quietly, and as with tulips, soaring asset prices have funded an unsupportable level of consumption. And as with the South Sea, or any other bubble, governments have also elevated their consumption and will do nothing to end the boom and the prosperity.

However, credit markets have been changing in a manner typically seen near the culmination of great financial manias.

Reinforcing the reversal in the yield curve, junk spreads have been widening.

Every outstanding bull market has eventually succumbed - not to policy makers - but to changes in the credit markets.

Has the "Upside Exhaustion" model been able to quantify effervescence? Shanghai and the senior exchanges have been likely to be choppy through the summer and the retrospective decision on effervescence will be made in October.

Bob Hoye
Institutional Advisors

The opinions in this report are solely those of the author. The information herein was obtained from various sources; however we do not guarantee its accuracy or completeness. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each securitys price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance.

Neither the information nor any opinion expressed constitutes an offer to buy or sell any securities or options or futures contracts. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in securities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk.

Moreover, from time to time, members of the Institutional Advisors team may be long or short positions discussed in our publications.

Copyright © 2003-2008 Bob Hoye

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