Why the stock market keeps plunging

The mortgage debt crash continues with abandon

This is a brief update to what i wrote on the week-end about the growing dislocation in mortgage backed securities - in the meantime, the situation has gone critical, so to speak.

Below are charts of the CMBX indexes, referencing AAA, A, and below investment grade (BB) rated commercial mortgage debt pools. By means of explanation, these indexes track credit default swaps on said debt, and can be used to hedge. They broadly reflect what is actually happening with the underlying debt spread-wise. When the CMBX rises, the underlying debt falls in price - in this case, free-falls.







3 different CMBX indexes, referencing CDS on AAA, A and BB rated commercial mortgage debt pools. charts via Markit - click on charts for larger images.

The following points must be considered: as this article on Marketwatch mentions, life insurers are among the biggest holders of the commercial mortgage backed securities (CMBS) that are now going sour at, well, warp speed.
Furhtermore, AIG's ill-starred portfolio of CDS (recall that AIG was a writer of these swaps, so it is located at the losing end of these trades) reportedly has a lot of MBS exposure in one way or another (partly one more step removed, via having insured CMO tranches for instance, i.e. CDO's containing MBS), and the government can hardly stop with its bail-out of AIG now, even in the event of it growing even larger.

Since we don't know what steps AIG might have taken to e.g. hedge its remaining exposure, the bail-out loan may or may not grow immediately, but i suppose we shall find out soon.
However, even if AIG has hedged in the meantime, it means that whoever wrote that insurance is now commensurately underwater.

CDS on corporate debt follow suit

As the Wall Steet Journal's Marketbeat column notes here, as an extension of the trouble at the mortgage end of the credit markets, indexes tracking CDS spreads on corporate debt are also blowing out once again as well, back to levels that have last been seen in the wake of Lehman's demise.

I distinctly remember having read that someone with the Bank of England - unfortunately i don't recall who it was - described the October episode thusly: "We were 24 hours away from a complete systemic meltdown".
Not exactly a comforting thought.

Car maker debt crashes too

As is often the case with such situations, the panic-inducing events suddenly proliferate. Today the market also had to grapple with Congress playing hard-to-get with the 'big three' car makers, whose CEO's had flown in (in their private jets, no less) hat in hand to somehow unlock $25 billion in aid. In order to do so, they painted a suitably scary horror-scenario (see this post for what it consists of), but found a surprisingly unsympathetic Congress grilling them rather unmercifully with regards to their lack of qualifications to see the industry through this patch of crisis.

This promptly added to uncertainty in the junk bond markets, where the debt of the car makers makes up the vast bulk of all junk debt issued. Marketwatch notes today that
"Bonds issued by Ford Motor Co. (F: 1.26, -0.42, -25.0%) and General Motors Corp. (GM 2.79, -0.30, -9.7%) have been trading well below par value, at about 25 cents for every dollar invested, down from about 75 cents to 80 cents a year ago.".

again, not exactly comforting.
On Monday, CDS spreads on GM's debt had already risen to about 7,200 basis points (!), with Ford's not far behind at 6,300 bp's.

My guess: while Congress seems none too happy about the car maker bail-out request, the 'tough talk' could easily be just for show, similar to what we have seen on occasion of the TARP 'no we won't!' -'yes, we will!' farce. Recall that resistance to TARP largely was about adding as much pork as possible to the bill before passing it, while making it seem as if Congress worried about the backlash from bail-out-weary citizens.

As i have pointed out before, the elephant in the room is the outstanding notional amount of CDS on the car makers' huge debt. While i don't know the current amount with precision, it is a great deal larger than the underlying debt - and even though there is a lot of netting, we'd be looking at unusually large sums having to change hands at once and at relatively short notice.


An interventionist curveball smashing the windows

So we once again have a perfect storm bearing down on the financial markets - and ironically, one of the chief architects of the financial bail-out, treasury secretary Hank Paulson, got the ball rolling with his recent announcement that the treasury would after all refrain from using TARP funds to buy distressed mortgage assets. Instead, direct capital infustions into banks would be the preferred method of deploying the funds.

This initially sowed enough confusion to send the stock market sharply lower, but the market reversed one day later in what seemed to be a 'key reversal' day.
Leaving aside whether this new use of the bail-out funds is 'better' or not than the original purpose (many seem to agree that it is, but i will refrain from discussing the relative merits of interventions - they are all bad, for reasons explained previously), the market initially appeared to have changed its mind from voting 'nay' to voting 'aye'.

As so often happens, the change in course immediately set off a chain reaction of unintended consequences - which can be gleaned from the CMBX charts above.
The authorities are now akin to a single fireman running around in a burning house with a bucket of water - while he's busy dousing a pile of burning paper in one corner of the house, the fire immediately becomes more intense in another.
Given the ominous statement rumored to have come from inside the BoE regarding the October dislocations, we must now hope that the whole house doesn't inadvertently come crashing down.

The stock market once again proceeds to do the 'unprecedented'

This weekend, i presented the chart of the BKX index as one of the things that bothered me greatly (once again) about the stock market. Here is an updated version:



The Philadelphia Bank Index - the neckline of the h&s formation has broken - this looks ugly. It may rally back to the broken neckline, but a break back above it would be needed to invalidate the bearish message - click on chart for larger image

This has also led to wave 5 of 3 in the S&P index (the labeling may not be precise, but this seems to be the most obvious rough count right now) breaking below the 3 of 3 low, instead of being somehow truncated as it often - but not always - is after a crash like moves. I'm unhappy to report that one time when the 5th wave of a crash wave did clearly streak to a lower low was in 1929 (a year many people are now unexpectedly learning more about in view of recent events).



The S&P 500 says 'adios' to support - presumably this support level was just too obvious to hold. click on chart for larger image

Let me add that if this is indeed wave 5 of 3, that would mean that the crash wave will soon find its low, after which a larger (multi-week or multi-month) rebound could conceivably be expected - a large wave 4.
However, consider the potential measured move target of the BKX chart above - this 5th wave could still become rather scary - not that it isn't scary already.

Counterparty risks climb again

In view of the renewed stresses in the credit markets, we can probably conclude that counteparty risk - a problem which had been thought of as momentarily defused in view of the large decline in LIBOR that the Fed helped engineer by expanding its balance sheet into the blue yonder - is coming back into focus.

This is no small matter, as there is always a remote possibility that a large player is felled (see Lehman) and can not or will not find a bureaucrat willing to bail him out in time. This risk is now particularly acute, as the political backlash against the car maker bail-out shows.

Lastly, i leave you with a chart that should give the Bernanke-Paulson tag team at the very least a sleepless night or two:



Citigroup (C) - this is one of the world's largest banks - and its stock price is crashing, down 23% in today's trading alone. We know it had and still has vast exposure to the collapsing real estate credit bubble. This stock's recent performance gives reason for grave concern. If we are lucky it's just an overshoot tied to the general asset liquidation theme. - click on chart for larger image

charts by stockcharts.com and Markit

addendum: I should add that it is in the nature of final down waves in a crash scenario to be accompanied by a horrible news backdrop. We can be fairly certain that this is the final wave down in this paricular move - and although its extent can not be predicted with certainty, the low is probably close in time - in addtion the support level from the 2002 market lows is nearby. The move in credit spreads increasingly looks like a blow-off, which likely means it will soon pause. Having said all that, risk still appears extraordinarily high.
A slightly positive development is that some commmodity prices, including the precious metals, appear to be 'digging in' a bit of late. This is probably an early indicator of the impending market low. The dollar and the Yen - especially the Euro - Yen cross - have moved persistently in the opposite direction of the stock market. These currencies should be watched for possible divergences.