COLLATERALIZED DEBT OBLIGATIONS

Collateralized Debt Obligations, or CDOs for short can be created from many types of collateral, but the most popular lately are CDOs from MBS (Mortgage Backed Securities). The idea is to create some higher risk assets and some much safer ones, slicing up the MBS into what are called equity, mezzanine and investment-grade bonds. The equity takes the higher risk, and so it earns the higher return if things go well. But if things start to go wrong, the equity is lost first…and then the mezzanine. However, even if there’s quite a high rate of failure in the higher risk end, the investment-grade bonds still get fully paid out. In this way the bankers might, for example, convert a large package of MBS into perhaps 70% investment grade bonds, 15% mezzanine, and 15% equity. It is relatively easy to sell the high-grade investment bonds. Stamped with an investment-grade rating, these bonds are sold off to mostly respectable investment institutions. But the mezzanine, and particularly the equity, are harder to sell. In effect the 30% of the mortgages in the original MBS which were deemed on a statistical basis to be likely to fail, are concentrated into what investment insiders call “Toxic Waste”.  Enter the case of the Bear Stearns hedge funds:

Last week, increasing losses and redemptions induced the lenders of two highly leveraged (at least 10 to 1) hedge funds in “structured” instruments (Toxic Waste) to hit The Street with bid lists of CDO collateral loaded with subprime exposure.  The dearth of buyers willing to pay anything close to their “marked” prices forced the sponsor, Bear Stearns to step up and loan the hedge funds $3.2 billion. However, the specter of downgrades of similar securities and a possible contagion de-leveraging of CDO exposures throughout the market initiated a stock market plunges that is continuing today.

On the other hand, we keep telling you that 10-year US Treasuries is the only investment we believe in, no matter how much of them the Chinese may be selling. Last Friday, for the first time since the 10-year treasury yield started rising from a low of 4.602% on May 11th to a high of 5.316% on June 15th, it rose as equities dropped. This is quite significant in that it confirms a new top from which 10-year treasury yields will probably drop as they have over the past 20 years. You can check this behavior in Chart1 below. Notice that the RSI Readings over 70 (se dotted line) have marked peaks in interest rates and the current reading near 90 hints at either a pause or a pullback in rates.

CHART 1. Source: StockCharts.com
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In the meantime, the slowdown in retail sales is quite visible after peaking in early 2006, and has turned south sharply following the bursting of the housing bubble. This trend will likely continue heading if retail sales follow its historical relation to the yield curve as it has in the past, as the yield curve leads the trend in retail sales by roughly two years (advanced in chart 2 below).

CHART 2. Source: Moody’s Economy.comimage002

With such a negative housing backdrop, it’s understandable why retail sales are falling and consumers are putting off their plans to purchase big ticket items. Business equipment industrial production has clearly peaked on a year-over-year (YOY) basis and lags the shape of the yield curve by one year, indicating continued weakness for the rest of 2007.

CHART 3. Source: Moody’s Economy.com
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Finally, if you are going to keep some Treasury securities in your portfolio, you can either buy them from us or consider buying them yourself. It is quite easy to buy Treasury securities without a broker. Just go to the Treasury Direct web site (www.treasurydirect.gov) and follow directions. The purchases are paid for by direct debit to your current bank account.