Look Out the Window, Moo!

My Dearest Moo Moo Cow,

In today's FSO market wrap, market commentator, Brian Pretti, has made an excellent post called Looking Out the Window

Listen to what he's trying to say..

• Many moons ago in what seems a lifetime far, far away, Barton Biggs was not running a hedge fund, but rather found himself penning weekly strategy commentaries at Morgan Stanley. I was pretty much a religious devotee in terms of checking in on what Barton had to say about life at the time. I can distinctly remember a particular piece written before the equity peak early this decade he titled, “Looking Out The Window.” The gist of the article was that Barton felt investment professionals of the era spent far too little time simply looking out the window and thinking. From my perspective, he was conceptually right on the money. But little did Barton know at the time, the world of instantaneous 24/7 information flow was about to accelerate in a very big way. In today’s world, who has time to look out the window when their eyes are glued to the screen?
  
  In the spirit of the “Looking Out The Window” commentary written by Barton, and in light of the events we’ve lived through in the financial markets over the last few weeks, I thought I’d spend some of my own time simply looking out the window and reflecting on what financial market messages of the moment may be suggesting to us. Personally, I’m as guilty as anyone in terms of following the day-to-day information overload flashing on the screen in colors my mind now reacts to virtually unconsciously. Filtering out white noise in this information miasma world of the moment has become one of my most important daily activities. And as crazy, or overly simplistic as this may sound, in looking out the window I try to force myself to distill recent market events into one or two macro ideas. What’s the big message here? How are recent market events interconnected? Do I have enough individual pieces of the puzzle to allow me to step back and see a larger picture perhaps unseen by those following every price tick in red and green?

Think my dearest Moo Moo Cow. What's the big message here? The subprime mortagage has taken centerstage in light of the decline (some would call it the burst of US housing bubble, my Moo Moo Cow) of the US housing market.

And what about the impact of this subprime woes?

Now that's an issue that needs consideration, yes?

First Mr. Pretti asks the assumption that global liquidity will be plentiful. Would this last?

• At least in my mind, two key points of financial market consensus thinking for some time have been that global liquidity/credit is and will continue to be plentiful. Additionally, I believe the thought that the Fed and their global central banking friends stand ready and willing to put out any and all financial market forest fires at a moment’s notice has driven the pricing of financial risk, or really lack thereof, in many an asset class (conceptually toward zero in many cases). First, it’s been such a good while now since we’ve run into any macro financial market speed bumps, if you will, that credit spreads in the world of fixed income a number of weeks back stood at levels most investment professionals probably thought they would never see in their careers. Of course these wildly tight intermarket spreads have been explained away in the headlines by the force of the carry trade, the magnitude of the global savings glut, the layering of risk and leverage in the hedge world, etc. As you know, Wall Street always has a rationale for what has already happened, but they often come up a bit short in seeing what’s to come. The following is simply an example of tightness in credit spreads up to this point. And without showing you decades of this relationship, you’re going to have to trust me that reversion to the mean and cycles of spread widening and contracting are virtual guarantees in the credit markets.

  
  

  

  
  

  At least for now, the events in the world of sub prime paper have turned a bit of this complacent consensus thinking on its proverbial head. Credit spreads in sub prime have blown out, and many a sub prime lender has simply been blown away in the winds of credit market repricing. This has happened fast. Moreover, as I see it, when looking at the pyramid that is mortgage financing in this country, we’ve just stripped away the entire bottom layer of the credit pyramid. So what happens to the real world of nominal dollar housing sales when your marginal buyer has now been shut out of the game? Can pricing really hold up in thin air above the now non-existent bottom level of the mortgage credit structure? The mortgage credit food chain of recent years just lost its most important marginal driver. And as always, change at the margin can be incredibly powerful in terms of ultimate trend change.

  That’s in the real world of housing prices. What about the world of trading paper promises backed by these very same real world houses called collateral? As you most likely know, intermarket credit spread widening has not been contained to sub prime residential mortgage paper at all. Alt-A mortgage paper and high yield bond spreads have also widened. We are seeing actual repricing of risk, but looking ahead the most important question is ultimate magnitude of this repricing as it directly bears on the character of the credit market. A credit market that has underpinned the economy. I think it’s very important to realize that many of the holders of this now deteriorating in credit spread paper are levered investment players. So the question isn’t solely how mortgage backed, asset backed, high yield, etc. paper will act as “investments” in the marketplace ahead, but rather how the levered holders of this paper will react in terms of human decision-making. My own observation is that levered holders of a deteriorating asset spend very little time looking out the window and thinking. Know what I mean? What’s the upshot of all of this? Quite simply we find ourselves in a credit contraction driven by the repricing of risk in credit markets by levered holders of sub prime and other high yielding paper. And quite importantly, we are now in the process of testing how leverage will respond to changing market conditions and financial asset prices. Isn’t this exactly what has started? It sure looks this way to me when I’m looking out the window.

How? And what equities?

• As you know, I’ve really been focusing on the credit markets up to this point. And it’s really no wonder as they are ground zero for the current credit cycle that has been so supportive to both our financial markets and real economy, especially this decade. So what about equities? Are they weighing in on what may be this very important change in macro financial asset risk based repricing? Again, in looking out the window and taking the time to think about longer-term views of life, I believe the answer is definitively yes. Although the coincidental drop in equity markets a few weeks back was blamed on Chinese officials, Greenspan mentioning the word recession, and the BOJ raising short term interest rates a wildly monumental quarter point, these short term rationales may all be noise. I firmly believe what the equity markets may also be seeing is this forward potential for a repricing of risk in many financial asset classes of the moment. A few pictures that, at least to me, paint a story.

Are they weighing in on what may be this very important change in macro financial asset risk based repricing?

How my dearest Moo Moo Cow? Do read the entire article...

Cheers!