Toomre Capital Markets LLC

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Telegraph: New Credit Crunch Looms

On Tuesday October 23rd 2007, The Telegraph newspaper out of the United Kingdom states in an article written by Ambrose Evans-Pritchard that a New Credit Crunch Looms. The article suggests that fresh turmoil in the global debt markets has set off sharp falls in commodity prices and higher-risk assets as investors scrambled for the safety of relative safer investments.

In one of the most dramatic currency moves of the year, the dollar soared as US investors liquidated foreign holdings, ending at $1.4129 against the euro and £2.0276 against the pound. Libor spreads in Europe's interbank market jumped to 64 basis points, roughly the level that set off the credit crisis last summer and prompted a liquidity rescue by the European Central Bank. The iTraxx Crossover index that measures spreads on corporate bonds has jumped 100 basis points since last week to 364 bp yesterday.

"It's the summer that won't end," said Peter Berezin, a strategist at Goldman Sachs. He said investors were shaken by last week's drop in US home-builder sentiment to an all-time low and by fresh falls in the ABX index for sub-prime debt. "We continue to learn that it pays to respect the sell-offs in ABX and housing-related credit. This has elements of the February and August sell-offs, where credit markets signaled problems," he said. The lowest tier of ABX debt has fallen to a record low of 20.72 – from par of 100 – pointing to huge losses that have yet to surface.

Toomre Capital Markets LLC ("TCM") has been very concerned about the evolution of this credit crunch and has privately argued that it is very much like a slow motion train wreck. Unlike some of the market sectors like United States equities where the markets seemingly quickly react to market moving news, the credit markets, and particularly the primary mortgage market which is composed of many, many local markets, react much more slowly. It takes considerable time for the delinquencies to first appear and then the stress of missed payments to turn into actual foreclosure actions. It also takes some time for individual homeowners to realize that the prices of their homes may not longer be appreciating, and seemingly often most recently, the value of the homes has in fact declined. It is psychologically hard to sell an asset at a loss and TCM suspects that many homeowners will hold off on selling homes in which they have a loss. Hence, the true state of both the magnitudes of the delinquencies/foreclosures as well as the losses given default are not likely to be known for some weeks and even months to come.

In the meantime, many financial firms, particularly the large commercial banks and international investment banks, still have considerable tainted structured finance debt inventory. The markets for much of this paper remains effectively closed as buyers demand considerable transparency about what exactly is behind the various CDO, CMO, RMBS, ABS and/or derivative bond classes that the dealers and financial intermediaries are so desperately pedaling to institutional investors world-wide. Earlier in October 2007, Merrill Lynch preannounced their absolutely horrendous, horrible and quite frankly asinine losses from structured finance, mortgage securities and other structured products. At that time, Merrill Lynch indicated that it might be losing as much as $5 Billion on tainted portfolio holdings of as much as $25 Billion. Why Merrill Lynch thought it was necessary to own so much subprime paper is a testament to their absolutely horrendous risk management controls and a complete lack of reasonable management oversight (like that provided by Jeff Kronthal up to the summer of 2006). How is Merrill Lynch going to explain another $5 Billion loss in the fourth quarter as whatever portion of that $25 billion remaining needs to be marked down at least another 20%. Surely Merrill Lynch is not like Goldman Sachs and does not have such a large oversized portfolio hedged.

The stresses from the next leg down in this credit crunch are likely to be ugly. If Merrill Lynch or one of the other mortgage players were to lose another $5 Billion in equity, does anyone think that this would not have a significant impact on their long-term credit ratings? Oh and if that were to happen, what might be the repercussions on their large book of derivative contracts, their collateral requirements and how the assets sitting in various Special Investment Vehicles ("SIVs") might be liquidated if investors were to continue to not roll-over Asset-Backed Commercial Paper ("ABCP") short-term debt holdings?

The global debt markets are likely to remain ugly for some months to come and liquidity truly will be king. The risk premiums for going from liquid to highly-illiquid investments are close to all-time highs. The key question for many institutional investors is when to take on more illiquidity? TCM first wrote of liquidity risk back in February 2007. One would have done very well at that point to have gone to Treasuries and cash equivalents. TCM suspects one would do well to repeat that portfolio approach through the balance of the first quarter of 2008. Reader comments are most welcome.