Is Wall Street Playing Hide The Pea?

by AvidTrader

Last week saw the head of Merrill Lynch relieved of his position for apparently taking major hits in the mortgage paper market. The company wrote off nearly $8 billion in bad loans just prior to the CEO’s release. For his lackluster performance his severance pay was reduced to $160 million. And then over the weekend the head of CitiGroup was the next casualty to succumb to the opaque world of sub-prime paper, also known as Structured Investment Vehicles (SIV).

There is a long known tenet that declares cheap money finds poor investments. The last decade has been accentuated by a desire to inflate either the economy or assets by our central bank. In 1999 a concern about a Y2K freeze up forced the liquidity spigot open and aided the NASDAQ to rise to dizzying heights. 9-11 created another infusion, rightfully so, and a real estate boom resulted. We saw what happened to the NASDAQ and are possibly watching an encore performance in home building stocks and real estate in general.

What appears to be an even uglier scenario is the paper that was created in supporting the real estate boom. Not only was their phantom documentation, but the ivory towers on Wall St. thought leveraging their positions in this paper was a good idea. So you have home buyers stretching the bounds to get into the hot real estate market, lenders needing to create paper for yield starved investors, rating agencies possibly rolling over for their clients so the paper appears palpable, and a Federal Reserve saying they will bail everybody out when it appears they need bailing out.. Looks like potentially the longest stretch of dominoes…maybe ever?

Often the indicators and even the market itself precede the news flow that appears to move it up or down. The news this week might reveal why these indicators have been flashing caution lights for the last few weeks. I have to imagine that the new leaders of these large financial institutions are going to confess their predecessors’ sins pretty quickly. That might lead to a mass confession among those who hold these toxic vehicles, making the market nervous.

What could exacerbate the situation is more resets that are coming on adjustable rate mortgages, probably creating more bad paper. Combine that with now stricter (realistic) lending standards and you could have a further correction in home prices and possibly more defaults on the investments these institutions hold.

The Fed appears committed to coming to the rescue and I wonder what asset class will benefit from another round of cheap money? Gold appears to be a beneficiary of late, topping $800 last week for the first time since 1980’s. Emerging markets and commodities are near all time highs so maybe a continued parabolic move in those markets. With most asset classes near their all time highs it could be a leap of faith going long here. Global economy has been very strong and if the numbers continue the way they have of recent, maybe foreigners can lift the economic tide the way the US has for the last few decades? Very interesting times we live in, huh?