Small Cap Network Blog

For several weeks now we’ve been using the so-called ‘TED Spread’ as a measure of how healthy (or unhealthy) the credit market has been. Since the TED Spread indicates the perceived difference between the safety of lending to other banks versus the safety of lending to the government (which is basically considered risk-free), the TED spread is a decent indication of how likely or unlikely a bank is to make a loan to another bank…. which is how most banks get the money they lend out. [Lending out your own money is so passé. Putting someone else’s money on the table is the wiser choice in the new economy.]

That’s a rough, thumbnail sketch of the TED Spread. If you want the full-blown explanation, click here to revisit the October 8th edition.

Well, not that we’re putting the TED Spread on the shelf for good, but we now want to shift our attention to another measure of credit liquidity… how much cash is actually available for borrowing? Lower risk is great, but if the money’s not available to lend out, then it’s just not available. Thus, lending can’t fully thaw out.

To figure out just how much cash liquidity there is out there (i.e. cash available for lending), we can use the 3-month LIBOR-OIS Spread.

The what? The ‘LIBOR’ definition is still the same… the London InterBank Offered Rate, which is the interest rate charged for short-term interbank loans all banks need from time to time to meet short-term liquidity requirements. The ‘OIS’ is the Overnight Index Swap rate.

The difference between those two rates is the perceived (though generally accurate) availability of funds available for short-term loans. In this case, the spread would indicate the availability of funds for three-month loans, though that kind of available cash for lending would benefit all sorts of loan time frames.

Anyway, the higher the LIBOR-OIS Spread, the less money there is for lending.

Almost needless to say, the spread went sky high in September, peaking at 3.64 in early October. That was the highest reading I could find since the spread’s been tracked. (Let me know if you can find verifiable instances of a higher LIBOR-OIS Spread.) Of course, you don’t need me to tell you that there was just no lending money available to pretty much anyone in October - a problem that persisted through the better part of December as the spread was coming down.

Anyway, here’s the good news… it looks like TARP’s intended liquidity injection may finally be making a dent. Or, maybe it wasn’t TARP but just time that helped. Either way, the LIBOR-OIS Spread is now back to 1.24, which is the lowest (healthiest) reading since September.

That’s still not as strong as the sub-1.0 readings that were the norm prior to September, but I don’t think we’ll see those levels again, ever. Lending policies, as we know now, were just way too loose then. I suspect the LIBOR-OIS Spread will still sink a little from here, but 1.24 isn’t bad at all.

Here’s a chart… a pretty stunning visual.

Like I said above, the TED Spread still has a role going forward… it’s just not a complete picture. I think we’ll start looking at both in tandem as we study the credit market’s in the future. In the meantime, this is great ‘bigger picture’ news for the economy. It’s not a fix-all, but it’s a start.

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The first batch of feedback from yesterday’s ‘Top Ten Market Predictions for 2009′ has arrived. Since everything in it, and all the responses to it, are going to be broad, I’m going to post them here in the blog. As more roll in, I’ll add them in other blog entries.

Here’s the first one.

Interesting predictions but I am not fully persuaded. First, I am much more bearish. I do agree that the Glass-Steagall Act separating investment banking and commercial banking will not be restored in 2009. More likely investment banking will go the way of the Dodo bird. But I don’t see the Titans taking the Superbowl this time.

Editor’s response: Interesting. Who do you think might be doing investment banking going forward? I ask because someone has to do it….maybe. You make an interesting point though - how much investment banking do we need, and what will it look like in the future? They (all the IBs) seem to be disintegrating. I don’t think it will go away though. If not the Titans, who do you like?

Next up…

If you think Linux is worthy, look at Leopard. a fantastic OS!

Editor’s response: Thanks. I’ve never heard of Leopard, but I’ll check it out.

And finally, we got this e-mail, which touched on several topics.

Thanks for all the neat predictions. I had put off going from XP Pro SP2 as long as could. Probably still be with XP Pro if I’d guessed how bad Vista was to be. In the end tho with the Vista SP2 beta release things have been more stable. Any probs that do arise are generally from the occasional rogue program I try like an old chess game I might find from some years back. Running Vista’s disk check during the reboot required for that does return things to normal. Things that usually go wrong on a rogue s/w are loss of sounds and presence of DVD. But as mentioned that clears up. Someone else also mentioned Windows 7.0 is just more bloar for now as with IE 8 beta. Oh, also heard some others on TV liking Slumdog Millionaire. Couple clips I’ve seen were so so. Prob have to be there. Ben Button tho got some glowing recos. But then it took me forever to finally see In Bruges and Casino Royale. All the best for a better New Year. Doubt can be more shaky since now we know what can really go bad.

Editor’s response: Thanks for the note. In order….

1. I understood about half of what you said regarding Vista’s functionality. I’ll get my computer-guru friend to translate the rest. I’d really like to get away from Vista, but can’t find all the drivers I need.
2. Yeah, if the chatter is correct, Buttons gets the nod, but Slumdog will be a contender. It seems like the Oscars are always a surprise though.
3. Agreed; it may not be any better in 2009, but it sure can’t get any worse than 2008.

If you’ve got any feedback, you can add it below.

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Not that they’ve done anything right before this, but the Fed’s decision to lower interest rates last week - to unprecedented low levels - has indeed fostered a little more willingness to lend. It’s still not great, but it’s better than it was.

My basis for the assessment lies in the TED spread… the measure of risk banks perceive they’re taking on by lending to other banks. The TED spread is as low as it’s been in months, after peaking at record-breaking levels in October when the credit market was frozen solid.

(What exactly is the TED spread, and why does it matter? We explained it on full detail in early October. Click here to review that explanation.)

As of right now, the TED spread’s reading is 1.44. For perspective, that’s almost back to the 1.1 level we saw before the lending market fell apart, and it’s well under the October peak of 4.63. In other words, the credit market is almost on its feet again, as banks aren’t terrified to lend to other banks. (Nobody actually lends their own money… they borrow money form other banks to lend to their own customers.)

Just for the record, I think when/if the TED spread gets back to 1.1 - though it wouldn’t surprise me if it didn’t though - I don’t think the lending market will actually be the same “no holds barred/no questions asked” kind of industry.

Even people with great credit are struggling to get loans now, so the standards will be much healthier going forward. That’s a good thing though - the interest rates will now actually reflect the true risk, whereas they didn’t before. We all have to jump through a few more hoops to get the rates we deserve, but it’s better than going back to the way things were (which caused the mess in the first place).

I digress though…. my point was just to let you know that the lending market is getting healthy again. Here’s the chart.

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As George Castanza would say about the Bernie Madoff fiasco, “This thing is like an onion - the more layers you peel, the more it stinks!” We got another round of news regarding the scandal this past week, and it stinks even more than it did.
I’m not going to rehash that here though… I’m more interested in some of the remarks about the latest batch of investigations. Some of them are funny, even if they don’t mean to be.

Here are a couple of my favorites….

Felix Salmon of Conde Nast’s Portfolio.com stated about the resulting confidence crisis…

“if you’re an investor, yes, you should be worried about losing your money to fraud — but you should also be even more worried about losing it the old-fashioned way, by investing it with a hedge fund manager who blows up spectacularly.”

Comparing the SEC’s complete failure to a Keystone Cops shtick, Greg Newton rebutted:

“characterizing the SEC as The Keystone Cops does defamatory disservice to The Keystone Cops’ investigative skills.”

Those were the only two I found that were appropriately bitter but also funny. As more of these jaded quips arise though, I’ll be sure to post them here.

Anybody else have one I missed? Leave ‘em below.

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Do you wanna’ know where the market is going to close today? I‘ve got a pretty good guess….either it will be spot on, or way off (how’s that for non-definitive). Frankly, I hope the guess is way off, because reaching the ’spot on’ target would be a sharp move lower. More on that in a second. What I wanted to do first was update my chart of, and thoughts on, yesterday morning’s look at the S&P 500 and the VIX.

Below is the exact same chart I gave you before, only updated with yesterday’s closing prices. Two problems immediately come to mind. The first is, the S&P 500 slid back under its 50 day moving average line. The second is, the VIX appears to have found support at its lower Bollinger band line. Both suggest the rally is winding down. All hope is not lost quite yet though.

It could take a few days for the market to get comfortable with the idea of a recovery. As such, we might see several ‘retests’ of the recent upward thrust. That’s a good thing. As long as we can hold our ground, and the down days come on lower volume than the good days, we’ve still got a better-than-average shot at emerging on the bullish side of the fence. Take a look at the chart, but then keep reading for the less-optimistic reality.

Ever heard of the ‘max pain’ theory? As far as the market is concerned, it’s the somewhat-cynical (though not entirely untrue) idea that the market has a way of providing the maximum amount of pain - losses - for the majority of investors.

The options market has a way of showing you a potential ‘max pain’ effect by indicating at which particular strike price most calls and puts are owned. Wherever the market can close and cause most options to expire worthless, well, that’s likely where the market will close on expiration day… which is today.

There’s something of a quirk with the idea though…..it’s either dead-on, or waaayyy off. There’s no in-between. That ‘way off’ result still provides some pretty decisive pain, but only for most of the call owners, or most of the put owners. Point being, this isn’t the kind of thing you want to bet on too early… sometimes the outcome we’re headed towards doesn’t become clear until the last day of expiration week.

Anyway, right now most of the owned calls are at 850, while most of the puts are owned at the 825 and 875 strike…right between 850. The most pain would be created by a close somewhere below 850 (where all those calls would be worthless) and above 825 (where at least the 825 puts would be worthless). A close under 875 would still be profitable for owners of the 875 puts though.

Here’s the SPX option open interest grid from CBOE.com. Take a look, but then keep reading for the alternative possibility.

The second scenario is a close above 875. That would make all the puts - both the 825 and the 875 strike - worthless, though it would reward all those folks who own the 850 calls. Normally the odds of this outcome would be a distant second. However, there’s obviously a lot more open interest with the puts than with the calls here… so the ‘max pain’ could actually come with a bullish close. I prefer that scenario, but I’m not getting married to any guess.

The good news is, the futures are well up this morning, and we sold off sharply yesterday. That sets up a strong possibility for the second (bullish) outcome today. As always though, be diligent and keep an eye on this erratic market.

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Government bonds were never the sexiest of investments, designed more to provide safety and assurance than to offer growth. Now, they don’t even accomplish their primary goal. Indeed, they may not even accomplish their goal of reliable returns. One has to wonder if lending to the government is riskier than investing in publicly-traded stocks.

As it stands right now, the yield on 10-year Treasuries is a whopping 2.4% (annualized). What’s so stunning is that folks are still buying them – there’s a moderately active market. Why? Great question. The only possible answers I can come up with are habit, a lack of understanding, or insanity.

A couple of different times I’ve heard the argument “Well, at the very least they’ll fight inflation.”

No they won’t – that’s the point.

If you buy $100,000 worth of 10-year bonds, your annual interest payment will be $2400. You’ll get $100,000 back a decade from now, and you’ll have collected $24K of tax-free income in the meantime. Unless we enter a period of deflation, and stay in it for 10 years, odds are you’re going to lose ground to inflation.

My sensitivity to the ridiculous reality is heightened by the knowledge that the Fed is allegedly going to cut rates again tomorrow. All well and good, but this could conceivably make the low-yield problem even worse (though how much worse could it get?).

On that note, no matter how much of a rate cut we get, know that the effective overnight rate (not the stated rate we hear so much about) is already rock-bottom. So, a rate cut won’t make borrowing noticeably cheaper… it’s more for show at this juncture.

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By now you’re all well aware of Bernie Madoff’s $50 billion heist - you know the party’s over when the FBI comes a-knockin’. What I’m still not clear about is what actually triggered the investigation and arrest. I think one of his employees got suspicious and reported the oddities. However, I’d love to know the exact details of the red flag that got the ball rolling. I suspect somewhere in the ponzi scheme, someone was supposed to get “paid”, and didn’t. People don’t like it when they’re on the wrong side of the table. (And when I say ‘paid’, I don’t mean employees - the word was that his employees always got paid. I mean there was supposed to be money or stocks for someone, somewhere, but it wasn’t actually there when they tried to claim it.)

Anyway, I’m not here to rehash what’s been all over the news…. you can do that on your own. All I wanted to do was point out an article about Madoff that appeared in a 2001 edition of MAR/Hedge….. a hedge-fund-related publication that’s a little obscure even within the hedge fund world. Here’s a link to the PDF. I can’t find a web page with the article, so you’ll have to use/get Adobe’s Reader if you don’t have it already.

The article is something of a contradiction…. suspicious of the consistent returns and minimal volatility boasted by his hedge fund, yet also impressed by those same returns and minimal volatility. Nobody ever questioned whether it was too good to be true as long as everyone was happy with the results. There’s a lesson in the realization of the truth…. now.

Read today’s news, then read the 2001 article, then compare the two side-by-side. The red flags were actually there, between the lines. I suspect there are more Madoff’s out there, even with all the oversight we now have.

On the other hand, I want to be clear about something else - most hedge funds are completely legitimate. In the same vein, most financial advisors are honest and honorable. They’re not always right, but I’ll take that over something ‘too good to be true’ any day of the week. Keep the 2001 article and today’s news in your mental ‘back pocket’. The next time you hear about red-hot performance and next-to-no risk, pull it out to remind yourself that the best of crooks can fool even the best of journalists.

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So let me get this straight…. the Senate shot down the automaker’s bailout, and three hours later the Treasury steps up to the plate and says they’ll keep the industry afloat since Congress didn’t? I have about a thousand questions; I’ll only ask a few of them…

1. If the Treasury is authorized to do this, why didn’t they do it two weeks ago?
2. Is the Treasury actually authorized to do this?
3. Has our government - and rules of limits and procedure - just turned into one big free-for-all?

The answers are…

1. Don’t know
2. Technically yes, philosophically no
3. Yep - there was never a clear plan for the $700 billion, and any department can do whatever they want now

Frankly, I’m not sure why automakers weren’t lumped in with the first bailout package… the $15 to $50 billion they need is nothing compared to the $700 billion ear-marked in the original bill. And, considering some money from the first bailout was used to assist fisherman, a rum company, and a company that makes wooden bows and arrows, you’d think throwing some cash at Detroit would be palatable. Guess not.

My beef isn’t the money - it’s the complete pointlessness of the process. If the Treasury can do what the Senate won’t, why bother with a bill at all? Just go to the Treasury. On that note though, another question is raised…..who oversees the Treasury? It’s technically the Executive branch (i.e. the President), which as of this morning is apparently how that branch to get around the Legislative (Congress/Senate) branch’s decisions in certain cases.

I’m not here to pass judgment, nor am I going to start accusing anyone of jump-starting communism or working towards a monarchy…. two arguments that have been made quite a bit lately. However, I have no problem saying this mess has become more than a little worrisome for reasons beyond the amount of money and lack of control. The apparent ineptness in Washington isn’t just an opinion anymore - it’s the Wild West… where anything goes.

OK, I’m done venting. Thanks. You can vent too if you like - the form is below.

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I blogged the idea a little bit yesterday and some more today, but Yahoo! Finance made my point for me far better than I ever could have made it myself. For whatever reason, I opened a browser Window this morning and went to Yahoo! Finance to see what crap they were spouting off today. However, I didn’t ‘refresh’ the page all day long. As it turns out, the index tickers refresh automatically on the page, while the text/story feeds require a new view (or a refresh). So, the only thing that changed on the page all day was the market’s numerical/percentage change.

Take a look at the 4:00 PM EST ’snapshot’ below. What Yahoo was telling us this morning ended up being completely wrong by the end of the day.

I’m not blaming or bashing Yahoo - they’re just regurgitating what the AP and Motley Fool delivers to them. I’m just saying - once again - you’ve got to get past taking these daily opinions and cause/effect relationships as being the gospel. I’m not saying I knew the market was going to rally 2% today, but I sure wasn’t betting that it would sink simply because some search engine site said it would.

The best newspaper or website you can use is the one between your ears - trust it before you trust some journalist’s (expect me, of course).

Just to be fair, one day does not make or break a trend. On the flipside though, none of these AP or Reuters stories ever adds any context or timeframe to their data. They all tend to correlate the latest economic data with what stocks are doing over the following hour. So, they’re fair game.

I know I tend to make this “don’t let the media steer you wrong” point over and over again. However, I think I’m going to keep preaching it until we all truly embrace the idea.

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I’m sure many of you have already seen this video of Peter Schiff taking on the rest of the world, and ultimately winning. For those of you who haven’t it seen it, you might want to check it out - it’s kind of fun as well as funny (funny in a “ha-ha” and in a “are you kidding me?” kind of way). If the name Peter Schiff rings a bell, it’s because he’s one of the economists/forecasters the media puts on TV every now and then, mostly because he’ll be the victim of a severe bashing from other pundits. As it turns out, Schiff was also spot-on when it came to the ripple effect that sloppy sub-prime standards and over-leveraged financial institutions would have on the market.

What’s scary is (1) how many other so-called gurus laughed in his face and told him he was wrong because they were oblivious, and (2) how perfectly he described what was going to happen. It’ll definitely make you rethink whether or not you want to continue getting advice or guidance from anyone on television… it’s obviously not a guarantee of accuracy or forecasting skills for most of these dopes.

In the interest of fair play, this video montage was assembled by Schiff, or a huge fan of Schiff, as it obviously puts him in a very positive light without mentioning any mistakes he may have made along the way (and I’m sure he made some). So, take it with a grain of salt. Still, it’s funny to think that any of these conversations happened at all, even if Schiff is occasionally wrong. These guys just crucified him, and he ended up being exactly right while so many others were completely wrong.

Anyway, here’s a link to the clip … good stuff.

http://econvideo.blogspot.com/2008/11/peter-schiff-retrospective-on-fox-news.html

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Looks like the last hour of trading is also going to be the most interesting hour again. I can’t confirm or cite the resource, but I think I heard that 90% of the market’s ‘recent’ (which was undefined) intra-day net movement has occurred in the last hour of trading …. for better or worse. Personally, I believe it.

The implication for you is that you really may not have to check in until 3:00 PM EST. In fact, you may not want to check in - on anything - until late in the trading day. The media is having a field day telling us this-caused-that, or how the latest round of morning data is what’s causing the current selloff or rally. Much of that garbage lately has become irrelevant by the time the closing bell has rung.

Anyway, as of 3:11 PM EST on Tuesday, the market had been well up, back to break-even, then pushed off the lows again in what looked like will be an attempt to cut some of yesterday’s losses, then tapered off a tad. I’ll let you know how it turned out for the bulls … at 4 o’clock.

The bigger implication that I’ll add is just to warn you not to take any intra-day action at face value.

On the intra-day chart (below) of the S&P 500’s 10 minute bars I’ve highlighted the last hour of the trading day. Not that it’s where all the movement was, but it sure looks like that’s where most of it occurred. More stark is the number of times the market reversed course in the last hour of trading. Many traders who were getting bearish prior to 3:00 PM ended up getting hit with a bullish reversal late in the day. The same goes for the bulls - they’ve been hit hard with a few bearish reversals.

In a few instances, the market’s intra-day trend followed through - and even accelerated - in the last hour of the day. However, there was never any clear hint about which move was brewing. Point being, if you’re jumping in an out trying to time the optimal entry based on what’s happening in the middle of the day, you may be attempting the impossible.

Just something to think about.

I’ve got some interesting stuff on the way later this week.

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(And yes, I would have said the same thing if McCain had won.) I know a lot of you were jockeying for one Presidential candidate over the other, since there’s a widely-held belief that one political party - or the other - is more accommodative to the stock market. In fact, I’ve seen members from each party come up with data suggesting their party is better for investors. My thoughts on this exercise? It’s amazing what you can find when (1) there’s enough data to choose from, and (2) you look hard enough to find the data that supports your case.

Folks, it’s an argument that will never be settled. It may even be a question that doesn’t have an answer.

In my experience, the controlling party has little to nothing to do with how well the market or economy does. Investors are just ‘votes’, and are scared or encouraged by candidates in an effort win an election. The truth of the matter as I see it is (after years of working in the equity market, and years of being an amateur political analyst) each party has caused good times and bad…and it has nothing to do with political philosophy.

Some stocks will do well under Obama. Others will not. The economy will eventually flourish under Obama. If he stays in for a second term, odds are the economy will eventually suffer under Obama.

You can’t get bogged down by something you can’t control, and something you can’t time. Obama can’t do it either. The best we can hope for is to delay and minimize the downside (which is something George Bush admittedly didn’t do well). 

The reason I bring it up…..even just a few hours removed from the election outcome, we’re already hearing the pros and cons for investors.

Here’s the bottom line - nothing has changed for investors. Stick to your strategies, find good companies, pay attention to charts, and monitor the underlying trends overlooked by everyone else. That’s all we can do under any party’s regime. It’s always been enough though.

For what it’s worth, I have no more and no less faith in the market than I did a day ago, a year ago, or a decade ago. I know eventually it will move upward, but I know there will be a lot of ups and downs in the meantime. A donkey or an elephant can’t change that.

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You don’t need me to tell you most everyone is expecting a rate cut of some sort tomorrow. The economy is in shambles, and lending has screeched to a halt. The Fed needs to inject a shot of adrenaline into the mix, and hope like crazy it works. According to the Fed Funds futures, there’s a 1 in 3 chance the rate cut will be ¾ of a point, and there’s a 2 in 3 chance of a 50 basis point rate cut. The latter I can see, but I think the former is a little but overboard.At the same time, half of the economists polled are looking for a ½ point cut, a fourth of those economists expect a ¼ point cut, and about a fourth of them are not looking for any change at all.

Normally the Fed Funds futures have been pretty reliable predictors – more so than economist’s predictions – but this time around is different. This time around, the Fed’s overnight lending rate is actually well under its target rate. That’s the first time we’ve seen that disparity in a long time…as in years.

The overnight rate is what banks charge each other for very short-term loans, but that’s the rate traders look at when trying to figure out just how far the Fed needs to go to get them to the same level. Now, however, the effective overnight rate is 0.9%, while the target rate is 1.5%.

Normally that would indicate a 50 basis point cut was in store. These are hardly normal times though. There’s a realistic chance a 50 point basis cut could send the overnight rate to 0.4%. The disparity would be maintained, even though the intent was to get the two rates aligned.

Why the problem now? When the Fed/Treasury starts to inject $700 billion into the whole system, it can skew those rates. It’s not a bad thing or a good thing – it’s just an indication of money flowing in.

This may be one of those times where the Fed doesn’t really need to do anything – the sheer possibility of a target rate cut has caused the effective rate to make its way there already. Point being, don’t be completely shocked of all those economists and Fed Funds futures are wrong. The Fed may need to do nothing except just accept the situation for what it is now.

Now, all of us understand that. However, let’s face it – the market’s not going to like not getting a rate cut. (Of course, the market won’t be happy until rates are 0.0% either.) So, I suspect we’ll see at least a pittance…nothing less than a ¼ point cut, but nothing more than a ½ point cut. But, I think it will be irrelevant.

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You know, it dawned on me today (ok, it hit me like a ton of bricks) that most financial journalists don’t really know enough about their ‘beat’ to do their job adequately. Case in point…the so-called credit crisis and financial meltdown we’ve seen over the last two months. Not too many reporters have really explained the events leading up to the implosion, though they all seem to have fluttered around it on occasion. I suspect the reason is just that their understanding of the whole thing is fairly limited. That’s a problem for serious investors who rely on these guys to get meaningful and factual information.

I’m not going to beat up the authors of the two articles I read today that drove me to this conclusion. Let’s just say I’d never heard of either one of them. However, both of the outfits they worked for were very reputable… which apparently doesn’t mean much these days.

So, since nobody else seems willing or able to, I’m going to devote some time to describe what really caused the mess we’re in now. Here’s the deal though – there are actually three distinct problems we’re dealing with. Yeah, one fuels the other two, but each has their own unique cause and solution.

Since each problem requires a somewhat-lengthy explanation though, I’m going to break this down into three bog entries. I’ll attack each problem one at a time, starting today with what happened to AIG and other insurance companies.

By now you’ve probably heard the acronym ‘CDS’ batted around. That’s short for what’s called a Credit Default Swap, which is just a fancy way of describing insurance against the default of a debt obligation.

Have you ever had mortgage insurance? Most lenders require you to purchase mortgage insurance if the equity in your home is worth less than 25% of your home’s value. Ultimately you pay for it, but it’s actually designed to protect the lender if you should happen to go into default – the insurer makes those mortgage payments to the lender if you can’t. Needless to say, it’s the mortgage insurance company assuming the bulk of the risk in the relationship.

Well, credit default swaps are basically the same thing. However, it’s called a credit default swap when done to protect the issuer of what’s called a collateralized mortgage obligation (CMO) or a mortgage-backed security (MBS).

You know who issues CMOs and MBSs? Mortgage lenders like Fannie and Freddie, but there are dozens of non-government entities doing the same. They’re essentially packaging up mortgage loans, and selling them to buyers looking for income, and decent returns. For all practical purposes, CMOs and MBSs act like fixed income, and trade as such.

However, to make a CMO or an MBS more attractive and less risky, those issuers will attach CDS insurance to them. If the underlying mortgage borrowers don’t pay (in part or in full), then the insurer will step up and make those payments to the owners of the CMOs or MBSs.

You know who’s one of the biggest CDS insurers around? AIG. However, that in itself still doesn’t explain why the mortgage-backed security market came unraveled. The problem largely lies in the way insurers like AIG are required to have liquid assets to cover their obligation if and when those CMOs or MBSs go into default.

See, a mortgage-backed security may hold pieces of (literally) hundreds of different mortgage loans. It’s no secret that some loans are going into default. By and large though, most borrowers are still making payments on time. That doesn’t matter right now. The current requirements are such that if the ‘quality’ of a CMO or MBS slips by just a little, then insurers like AIG are required to come up with enough cash to cover the entire face value of the CMO or MBS.

Or to say it another way, CDS insurers are being forced to act as if all the borrowers within a CMO are in default, even if only a small fraction of them are.

Well, between ARM loans, negative equity in real estate, a recession, and over-extended consumers, pretty much all CMOs and MBSs have ‘triggered’ the cash requirement for complete coverage.

The problem is, these insurance companies don’t have this kind of cash. On the other hand, they really don’t need it.

The fact of the matter is, no insurance company of any kind would be able to pay all the claims if 100% of their customer base all filed claims simultaneously. The actuaries have figured out what the ‘optimal’ insurance premiums are that controls their likely payout risk, yet keeps the insurance affordable. They’re not going to assume the worst could happen all at the same time, because it just wouldn’t.

However, CDS insurers are essentially being forced to act as if 100% of all their insured packaged mortgage debts are in default. Of course that’s not the case…most mortgage debt is still being paid.

It’s a ridiculous rule, and probably one companies like AIG never figured would be a problem. When the defaults started to pile up though, a little bad debt went a long way – in the wrong way.

It’s dumb for one reason…it assumes the worst, even though the worst is not the way things really are.

Here’s an analogy. Suppose you owe $200K on your mortgage, but can only sell your house for $150K. Your actual net liability (and potential loss) really is only the $50K difference between the two. According to the government though, you don’t get any credit for the real estate’s value. All they’re seeing is the loan liability, and they want you to put up $200K in cash as collateral.

CDS insurers are essentially going through the same thing… they’re being required to put up the cash for the entire face value of their CMOs or MBSs, but they’re getting no credit at all for the value – even if depressed - of those securities. The process is called marking-to-market, which really doesn’t fairly value the CMOs in question.

That’s why the insurance industry has been so desperate and strained lately. They need cash, and they just don’t have it handy.

A simplified explanation? Yeah, but at its core it’s a simple matter that’s been made overly-complicated by the media….or not been explained at all.

So, that’s phase one. I still want to look at the real estate implosion, and the unwillingness of banks to lend. These are separate issues though, and I’ll be covering them in a different entry.

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Earlier in the week I posted a blog entry about how I interpret the VIX in my quest to spot market reversals. Ultimately, I apply candlestick analysis to find points in time when it’s become pretty clear the VIX has hit a bottom or top, and then confirmed that reversal by following through…. at least a little. I also suggested wrapping the VIX up in Bollinger bands to help you spot those scenarios where the VIX’s trend was changing direction. I hope you were able to embrace the idea of the strategy. If you did, then you also know there’s still some interpretation that needs to be done to actually trade it.

However, for those of you who are not into interpretation (if you’re more system-based and less discretionary), there’s another methodology you can use. It’s not as quick to give you a signal, so you may be late to the party in some cases. However, since it’s not as quick to give you a reversal sign, it’s also less apt to give you an errant buy or sell pattern.

The strategy is simple - use crosses of two of the VIX’s moving averages as buy or sell (bull or bear) signals. A cross above is a bearish pattern for stocks, and a cross below is a bullish signal for stocks. (Remember, the VIX usually moves in the opposite direction as the market.)

As always, a picture is worth a thousand words, so I’ve plotted two different moving averages for the VIX on the chart below. The ‘market’ proxy is the S&P 500. The faster moving average is the red line, and the slower one is the blue line. If you had bought or sold at their crosses over the last several years, you’d be up fairly nicely. (The buys and sells are marked with green and red arrows, respectively.) Obviously in a bull market the bear signals are less effective, and in a bear market the bull signals are less effective. Regardless, it’s a powerful tool.

What moving averages do I use? Sorry, can’t tell you that - this is something I look at for me, personally, and it loses its effectiveness if everyone else starts to use the same. The reason I’m telling you about it at all is to give you a tool that works, and is simple to interpret. I encourage you to experiment with your own moving average lengths anyway, to find something that works for you and your style.

On that note, I’ve found that this strategy works for any and all time frames, from 15 minute charts to weekly charts. So, anybody should be able to benefit from this methodology. I hope you can use it too.

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Dear Small Cap Network Editor,

I have read over the past couple of weeks, the derivatives created in the past several years, are going to bury our economy. One article I read stated there are approximately sixty-six trillion dollars $66,000,000,000 of these instruments that are now practically worthless, and another article stated over eighty-eight trillion. My question is, how will the effects of these worthless derivatives effect the companies that hold them, and how will these companies survive after they write them off as worthless. Additionally, if these companies write these off, many of them will show substantial decreases in their net profit for the year, while some companies will show losses. If that happens, many companies will be paying much lower income taxes or have tax loss carry-backs or carry-forward losses, which will then have an effect on the taxes they pay to our Federal government, state governments and local governments. Won’t this have an enormous impact on the tax revenues for which the various governments operate? I look forward to your response and explanation.

Editor’s Response

Thanks for the question. The answer is yes, write-downs will impact tax revenues adversely. However, as to the extent it will negatively impact tax revenue - and the ripple effect it could have - it’s immeasurable. It may be catastrophic. Or, it may be imperceptible. I don’t know, and I’m not entirely sure anybody knows.

However, even at its worst I don’t think it will kick-start a depression….the government never seems to have enough anyway, so what’s a little more shortfall going to mean?

Also bear in mind that as nasty as those write-downs could be, it’s just the financial industry taking them. While other sectors suffer to some degree from the fallout, most of the headache is reserved for the financial sector. It’s the biggest sector, but it’s not like the well will run completely dry.

Anyway, youre thinking is right, but I can’t put a number or degree on the result. So, I can’t fully respond. I’ll put your question (and my answer) out here in the open though. Maybe an economist will stumble onto the site and be able chime in below.

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We’ve been trying to answer as many questions from our readers as we can in the midst of this market meltdown. There’s a lot of opportunity in it, but also lots of danger. So, if we can provide some much needed perspective about how to handle it, I think we’ll all come out better for out. That said, we’re surprised we only got this question once, since we’ve been deliberately ambiguous on the matter. The paraphrased question was….

When you’re talking about a bottom, do you foresee one bottom, or several strong bottoms as part of the bigger bottoming process?

Our answer is….we’re just dealing with one bottom at a time, so we assume any bottom is ‘the’ bottom until we have a reason not to. But, we’re certainly prepared for more than one.

The truth of the matter is there is no standard pattern that plays out at a bottom. The people who think we’re going to see several retests of recent lows are looking back to late 2002 and early 2003 as a clue, when the market made three drastic lows before starting a recovery. Something similar played out in 1994, when it took a series of lows to complete the flushout and begin the next bull market (though that bear was nowhere near as nasty as this one’s been).

However, there’s just as much support for a one-bottom theory….a ‘V’ shaped chart like the one we saw in 1990.

The 1987 crash was technically a double-bottom, but effectively a one-bottom move. It was just so volatile after the October tumble that it was difficult to distinguish between bearishness and bullishness. By December of that year though, the ultimate lows were made and the recovery was underway.

We also saw distinct one-bottom lows in 1984, and in the middle of 1982. (In 1982 we saw a couple of sharp selloffs leading to lower lows and minor rebounds into the bigger downtrend, but nothing that would qualify as a triple-bottom.) The bottoms in 1978 and 1974 were also one-bottom ends to their respective bear markets.

The point is, nobody knows how many times the market will have to get smacked to make a permanent bottom. Maybe one, or maybe three. Maybe five - nobody knows. Therefore, I strongly suggest assuming nothing. To try and make a prediction would be quite impossible.

Instead, if you really think we’re at ‘the’ bottom, I feel the best thing to do is phase into bullish trades on the way up. There’s a catch to the strategy though - you absolutely have to be willing to bail out of those very same trades when it’s clear that there’s another low on the way. If your ego can deal with doing that, then it’s time to go fishing.

Does that mean you may take small losses if you have to sell out if another selloff is made? Yep, but I don’t mind losing 5% to 10% a couple of times if it means I’m in the market at the very beginning of what will be the next bull market. Even Babe Ruth struck out more often than he hit a home run….but those precious home runs were worth it.

The alternative is to wait for certainty. That’s the higher-odds, lower-payoff strategy, since you miss the early chunk of the rebound. But, you won’t get burned by being wrong about where the market bottom was.

My ‘phase in’ strategy is sort of a hybrid of both, designed for the skeptic and the speculator.

In the meantime, don’t get bogged down by trying to figure out how many bottoms we’re going to make….nobody can possibly know.

By the way, if you want to see a long-term history of all the major bottoms for the S&P 500, click here for 1990 through 2008, and click here for 1970 through 1989. You can see how no two bottoms are alike. You’ll also see how the one-bottom move is more common, but recent history has dished out more multi-bottom ends to bear markets. Like I said, nobody really knows what we’ll get this time around.

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Poor guys…

(Yes, this was a joke. If it really had been a reunion of all the people Lehman laid off, the reunion would have been somewhere in southern Italy.)

Thanks for all of the great feedback with this weekend’s edition of the newsletter. Seems like everybody liked it, even if they didn’t agree with my optimistic assessment. (A healthy debate is always good.) However, there was one issue that I’m especially glad came up, as it told me I may have not adequately described something I thought I had. What was the issue? How I interpret and use the VIX (CBOE Volatility Index) to trade.

In the newsletter I joked how the current VIX reading above 70 made the previous record high for the VIX – of slightly under 50 – just look sad. Still, I felt the unusual spike in the VIX would ultimately be bullish. We received dissenting responses to the idea that essentially said since the VIX was at all-time highs, then using the VIX was pointless….how would you ever know when it was ‘too high?

Here’s my answer. That’s correct - as high as the VIX goes, it can always go higher. So the readers were right in saying that just because the VIX spikes to all-time highs doesn’t automatically mean a bounce is on the way….because the VIX can go even higher while stocks move lower. On the other hand, I never said the VIX was bullish the very moment it hit new highs (and I hope I never even implied that a high VIX is absolutely bullish for stocks).

What I’ve been saying (since the beginning of time) is that a spike in the VIX is bullish for stocks….once it happens. This is in reference to the shape of the VIX chart – I need to see a pointy top to get bullish, no matter where that pointy top occurs. Sometimes they occur around the 50 level. Sometimes it’s 30. This time around there may be a spike at 70….or maybe it will be 90 by the time it’s all said and done.

Bottom line – I never buy into a rising VIX. Once the VIX starts to reverse and head lower, then I start to buy.

The trick is knowing when the VIX has actually reversed. A lower close and lower trading range is a good sign. However, I like to see two or three lower closes or lower ranges before getting comfortable with any bullish posture.

That’s why I’ve been very adamant about not getting into bullish trades yet. The rising VIX has great bullish potential, but until the VIX starts to move lower that potential is nothing more than just that – potential.

One of the tools I find very helpful to spot a true VIX reversal is Bollinger bands, which I’ve plotted in blue on the chart below. Basically, the Bollinger bands show a standard deviation from the mean….the mean, or moving average line (red), is in the middle. As long as the VIX is pressing into those Bollinger bands – or tracing them – the uptrend is still in place. Once the VIX starts to diverge from those bands, then the market’s overall momentum is starting to change.

Between early September and now we saw a few instances where it looked like the VIX was going to start heading lower again, but none of them followed through. It will be pretty darn clear when the VIX starts to break the upward move and points lower again.

Just for the record, as drastic as the VIX’s pullback is today, its uptrend still hasn’t been broken. This might be the beginning of the end, but the VIX is still technically above the upper Bollinger band. So, as much as I want to jump in here, the VIX isn’t quite giving us the green light yet (though everything else is).

Won’t that mean we’re behind the eight ball if this is a recovery? Yeah, a little, but I’d rather have an 80% chance of making 20% than a 20% chance of making 80%.

Anyway, here’s the VIX’s chart. If the VIX can close lower again tomorrow – and under the upper Bollinger band – then I think we should all start thinking seriously about bigger-picture bullishness. In the meantime, I’ll also let you know I’m wading into shallow bullish waters today…a little speculation.