HEDGE FUND NEWS
@ Mon 30 July 2007 : GMT

FINTAG COMMENT

Hedge Fund returns have been good this year. With market volatility kicking in, the current market wobbles are going to sort out the men from the boys. Many "closed" funds are opening up again and Prime Brokers are asking questions before lending. Beer Bellies are out of fashion and the Bulls dismiss the Bears for being bearish and Hedgies brush up their skills on the practice of shorting.

We also revisit our jobs@risk barometer as employment in the financial sector reaches an all time high.

Blackstone - as we predicted
"Is Blackstone the next lastminute.com?" we asked on 14th June 2007. According to Bloomberg it is down 22% since it IPO'd ...

DOG HOUSE NEWS

Bomb found at Canary Wharf (bbc)

Merrill: Hedge Fund Replication the “Solution” for Hedge Fund Newbies (allaboutalpha)

Fears of fresh stock market falls (bbc)

Yen Trades Near Three-Month High Against Euro as Stocks Decline (bloomberg)

Should you prepare for a market slump? (times)

Wall Street banks may be left holding the baby (times)

Investment banks raising margin requirements on lending to hedge funds (forbes)

F11TAG - that's the number plate on my Aston Martin
Foreign investors, hedge funds may get FII tag (economictimes)

How a fat tail comes home to roost (ft)

Man Global Strategies launches Founders Incubation Platform (hedgeweek)

Ever seen a poor CFO?

SHORT AND CURLY

HMV at the eye of the storm as hedge funds bet on a share dive (independent)
HMV holds the unenviable record of being the most shorted stock ever, with a staggering 30 per cent of the struggling music retailer's shares in the hands of hedge funds betting on its share price falling even more, according to market analysis firm Data Explorers.

The findings come as hedge funds predict a further battering for the FTSE, after the turmoil of the last week. Other companies singled out for more pain include Trinity Mirror, which reports interim results this week and had just over 16 per cent of its shares shorted on Friday.

Also this week, HSBC is expected to report bad debt provisions of $5.2bn (£2.5bn) in the first half of the year, up from $3.9bn the previous year. Stockbroker Oriel Securities estimates that the bank's mortgage and credit card loans to US consumers will make up $3bn of these bad loans, almost 50 per cent more than last year.

HSBC's figures will provide further confirmation of the deepening crisis in the US sub-prime mortgage market, which threatens to engulf the wider capital markets and spook already nervy equity investors.

According to Index Explorer, a subsidiary of Data Explorers, hedge funds have now taken the biggest bet for two years that the FTSE 250 will continue to fall. At the same time, the amount of short positions taken by investors on the main FTSE 100 index has fallen to a six-month low.

The last time these positions diverged to this extent, in April last year, it preceded a near-10 per cent fall in the FTSE 100, said Will Duff Gordon, director of Data Explorers.

"The markets remained soggy for two months," he said.

Hedge funds are switching out of FTSE 250 companies, seen as riskier growth investments, as well as out of retail and technology sectors and into more defensive FTSE 100 companies like oil and gas firms. The biggest increase in shorting over the last week was in the healthcare, insurance and banking sectors.

David Buik from financial spread-betting firm Cantor Index said: "We don't know to what extent the sub-prime mortgage problem is the tip of the iceberg.

"We are expecting a very bumpy road for the next three months. It will take that long to work out who owes what and who has lost what."

CRYSTAL BALL GAZING

The DisCredited Files (nakedshorts)
A prediction two weeks ago that the crowds watching for multiple among strategy hedge fund fiascos would probably leave disappointed is, so far, on the on the money. NakedShorts—and numerous much-better-informed-than-he sources to which he has spoken in recent days—believe that it's too quiet, way too quiet, out there.

It is possible that more bodies will begin floating to the surface in the next 48 hours or so, as funds with Jun. 30 redemption checks due on the wires by tomorrow issue sorry-about-thats. But counting against that possibility is a timing issue: the fact that pricing models had stumbled, again, did not emerge until early June, well after the typical 45-day notice period for Jun. 30 redemptions expired.

No evidence has emerged to suggest that the market for complex leveraged mostly-mortgage-backed derivatives has loosened at all in the last two weeks. Indeed, the decision by leading investment banks to postpone junk issues for several major buyouts—Chrysler's extraction from Daimler Benz, and the Alliance-Boots transaction in the UK are just kids-on-the-milk-carton for that phenomenon—suggests something of a rolling buyer's strike in a market that, as late as mid-May, was buying any old yield at any old price, no questions asked.

If the mortgage market clears this week's low stile, the next pressure point is around Aug. 15, when most redemption notices for Sep. 30 redemptions will be due. And unless something extraordinary happens—say, a Chinese bid for Fannie Mae at a 30 percent premium over Friday's close, for example—the redemption notices, especially from hot-money investors—Hello Geneva!—will be flying out of the fax machines.

After the jump, ketchup on some recent material, mostly (but not all) adverse, circumstances:

Saturday,July 28 2007

It took 750 words of margin call mayhem, in a roughly 800-word piece by The New York Times' Jenny Anderson, to get to what is, in today's context, the man-bites-dog bit:

MKP Capital, an investment company that has hedge funds focused on mortgage-backed and asset-backed securities, bet the market would fall apart and its investors have profited handsomely. MKP Credit, one fund, is up 7.3 percent for July and 22.3 percent for the year, while a distressed fund, MKP Credit II, is up 5.5 percent for July and 13.1 percent for the year, according to a person briefed on the fund's results.

FIT, FUN AND FACEBOOKED

Male Bankers - Are You Fat And Fed Up ? (hereisthecity)
The most apt definition of middle age is 'when your age starts to show around your middle'. But many bankers, of course, don't have to wait for the onset of middle age to reveal a paunch - all that junk food, those business dinners and booze often takes a toll on the waist-line before Old Father Time catches up with you.

And for many, once you hit 30, you can stare into the mirror as much as you want, holding in your belly for dear life, but you're only kidding yourself - you're fat and probably fed up too.

Being nearer 50 than 30, and short and bald too, I finally came to terms with the fact that I needed to do something about the only thing I did have control over - my weight. And I was packing way too much. Not that it was easy getting that fat - I've worked at it for years. Greasy fry-ups, chocolate, cakes, crisps and the like. I'd just have to walk passed a biscuit tin and I'd put on 3lbs!

Anyway, in February I was flicking through the cable channels and I came across an for Weight Watchers. I called the number on the screen, found out where my local group was being held and rocked up the following Thursday.

I remember wondering what the Hell I was doing as I peered into the Hall to see dozens of old fat women busy rehearsing their excuses for why they weren't going to record a weight loss that week. And not a bloke in sight. Receiving a warm welcome, though, I joined on the spot and was told that, in total, I'd be looking at dropping around 50lbs.

After being weighed, we had the meeting proper. Me, 30-odd fat birds and a couple of young women all chewing the fat - or not, as the case may be. One, a woman of 30 had lost 50lbs in around a year, and the other was a stick insect, who assured me that she, too, was once a fattie. I initially thought that she might have been a Weight Watcher plant, but she wasn't.

I attended the meetings religiously for about 5 weeks, lost 12lbs and then fell off the fat wagon. Returning like the Prodigal Son 6 weeks or so ago, after a couple of months of stuffing myself silly, I'm back in the WW Zone - and have now dropped 26.5lbs and lost a good 2 inches around the waist. I feel better, look better and am now that smug bloke who takes the p.ss out of the rest of those in the fat universe (although I'm still far from slim).

Anyway, I just wanted to shares my experience with you. Weight Watchers might not be 'in vogue' or hip, but it is effective. If you're fat and fed-up, you should give it a go. Then you can take the p.ss out of the fatties too.

WORRIES

Hedge Funds Feeling the Heat (financialarmegeddon)

As risk-takers of last resort, hedge funds have played a starring role in improving liquidity throughout the global financial system (however fleeting that state of affairs may eventually turn out to be).

Their aggressive interest in acquiring toxic slugs of myriad derivatives deals, buying illiquid interests in dodgy companies, and selling protection against the possibility of corporate default -- even for the shakiest borrowers -- enabled all sorts of deals to happen and exotic markets to develop that might not otherwise have seen the light of day (Hmmm....).

Their role as facilitators of modern-day financial alchemy has, in large part, depended on their ability to obtain cheap financing from prime brokers -- bulge-bracket broker-dealers. However, with losses mounting and balance sheets ballooning at many Wall Street firms on the heels of a sudden and dramatic change in sentiment in credit markets, some new age investors are discovering, as FT.com notes in "Tougher Terms for Hedge Funds," that the credit spigot is starting to run dry.

Investmet banks are responding to rising credit concerns by imposing tougher lending terms on hedge funds, in a move that threatens to exacerbate investor unease in the financial markets.

Prime brokerage departments at several investment banks have raised their margin requirements for certain hedge fund clients as they seek to insure themselves against the possibility of new hedge fund collapses as a result of the recent market turmoil.

"Financing terms for hedge funds are being tightened and this is forcing a further deleveraging of risk across global markets," said Gerald Lucas, senior investment adviser at Deutsche Bank.

One prime broker said his bank had started examining its lending criteria in the wake of the much publicised problems at two hedge funds run by Bear Stearns.

"Recently we have broadened our stricter standards to funds beyond those with exposure to US mortgage market. I'd say this is now a pretty broad-based retreat from leverage."

The move could raise the pressure on parts of the hedge fund sector, since it comes at a time when performance at some groups has slumped as a result of recent market swings.

The average hedge fund, across all strategies, returned just 0.8 per cent in June, down from 2.3 per cent in May, according to Credit Suisse Tremont. Fixed income-focused hedge funds were the worst affected, returning just 0.2 per cent in June.

If a hedge fund's performance deteriorates sufficiently, its prime broker's bank can demand that it sells assets to repay loans.

Ciaran O'Hagan, strategist at Société Générale, said: "Borrowers [now] find it harder to finance their leverage and that is proving a millstone for all risk-based strategies."

The stricter approach to lending to hedge funds by investment banks comes as markets continue to suffer as a result of concerns about the state of the US credit markets.

Doesn't sound anything like "containment" to me.

FREEBIES

Executives find favours bring better ratings (ft)
US executives have been able to secure more favourable research ratings for their companies from investment banks by bestowing professional favours on Wall Street analysts, according to new academic research to be published on Friday.

The study found that by offering analysts favours, ranging from recommending them for a job to agreeing to speak to their clients, executives sharply reduced the chances of a downgrade in the aftermath of poor results or a controversial deal.

The unprecedented research, carried out on some 1,800 equity analysts and hundreds of executives, suggests that the radical regulatory reforms of the past few years have failed fully to eradicate conflicts of interests on Wall Street.

“Favour-rendering to analysts is evidently widespread and . . . it seems to be compromising the value of the guidance these experts provide to investors,” said Michael Clement of University of Texas, who co-authored the study with James Westphal of University of Michigan.

Analysts' representatives said that accepting favours such as those described in the study - which also include putting analysts in touch with executives at other companies and advising on personal matters - was unethical.

“Activities such as these are in clear breach of our code of conducts and standards. Analysts should guard against both actual conflicts and the perception of conflicts,” said Kurt Schacht, director of the Center for Financial Market Integrity at the CFA Institute, which represents more than 80,000 analysts and fund managers.

But, according to the study, conducted between 2001 and 2003 and to be presented to next month's annual meeting of the US Academy of Management, nearly four out of six Wall Street analysts admitted receiving favours from company executives.

The frequency of favours increased in line with the shortfall between the company's earnings and market expectations - a crucial determinant of analysts' stock ratings.

The favours were instrumental in securing better treatment from analysts. Analysts who received two favours were 50 per cent less likely than colleagues to downgrade the company after poor results, the academics say.

The most popular favour, mentioned by nearly a third of respondents, was putting an analyst in touch with an executive at a rival firm, followed by the offer of career advice, and agreeing to meet with the analysts' clients.

SWF

Barclays Deal Spurs Drive to Limit Government-Fund Investments (blomberg)
he U.S., France and Germany are racing to draw up rules to govern developing nations' secretive state-controlled investment funds, spurred in part by Barclays Plc's use of Chinese and Singaporean money in its takeover bid for ABN Amro Holding NV.

With no international body such as the World Trade Organization to oversee such investment, officials in the U.S. are pushing the International Monetary Fund and World Bank to set guidelines. Germany and France, meanwhile, are urging a joint European response.

So-called sovereign wealth funds, which invest currency reserves in foreign assets, control an estimated $2.5 trillion, more than all the world's hedge funds combined. Those favoring rules or guidelines on their conduct say they might avoid a spiral of tit-for-tat curbs on investment that could hurt the world economy.

``All it takes is one fund to do something nutty and the risk of a backlash of protectionism will increase,'' says Edwin Truman, a former U.S. Treasury economist who is now a senior fellow at the Peterson Institute for International Economics in Washington.

China, for its part, says western governments have nothing to fear from its participation as an investor in their economies. ``The U.S. and other developed nations are over-reacting,'' says Fang Ning, deputy director of the Beijing-based Institute of Sociology and Politics, which advises China's State Council.

Don't Worry

If anything, Fang says, ``it's China that should strengthen its national-security guidelines when it comes to foreign direct investment,'' not the other way around. ``The western nations shouldn't be so worried.''

Developed nations also need to be careful they don't kill off a source of capital that may provide just the juice their markets need as stocks worldwide tumble on concern about higher borrowing costs. ``We would do ourselves very serious damage if we put up barriers to these funds,'' says Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts.

While state-controlled investment funds have been around for more than a decade in countries such as Kuwait and Norway, they have proliferated and expanded in recent years as emerging economies amass record foreign currency reserves earned on exports of commodities or consumer goods. Morgan Stanley projects such funds will have $12 trillion in holdings by 2015.

Seeking Higher Returns

Countries such as China and Russia, previously content to keep their reserves in low-risk, low-yielding securities such as U.S. Treasuries, are now seeking higher returns.

China, which said in March it would shift an estimated $200 billion of its $1.2 trillion currency reserves into riskier assets, followed that up by taking a $3 billion stake in New York private-equity firm Blackstone Group LP. Blackstone advised China Development Bank on last week's deal to invest as much as $13.5 billion in Barclays.

Russia, which last year took a stake in European Aeronautic Defence & Space Co., owner of Airbus, plans to carve out part of its $117 billion stabilization fund to finance a ``National Wellbeing Fund.'' Dubai's government last week agreed to buy a controlling interest in New Zealand's Auckland International Airport Ltd.

Size and Secrecy

What unnerves governments whose companies may be targeted isn't only the sheer size of the funds, but also the lack of information on their plans or limits on their reach.

``This is a new phenomenon that we must tackle with some urgency,'' German Chancellor Angela Merkel said at a July 18 press conference in Berlin.

Some, such as U.S. Senator Jim Webb, a Democrat from Virginia, cite national-security concerns; others say such investments raise the risks of financial-market disruption.

France and Germany want to avoid a patchwork of regulations and are pushing for the 27-member European Union to introduce a united approach. ``There is a need to have regulation at the European level which is more structured and stronger,'' Jean- Pierre Jouyet, France's European affairs minister, said in an interview.

Otherwise, companies in countries that don't participate ``will get picked off one at a time,'' says Willem Buiter, a professor at the London School of Economics.

One proposal pitched by EU trade chief Peter Mandelson is for the region to take a so-called golden-share option in strategic industries to keep control of them out of foreign hands.

The Norwegian Model

Advocates for international investment guidelines cite Norway's global pension fund, which has $324 billion of oil wealth invested across a range of assets, as a possible model. ``They've been involved in this for quite a while,'' says Kathleen Stephansen, chief economist at Credit Suisse in New York. The Norwegian government publishes the fund's holdings each year and follows a strategy that limits its acquisitions to small stakes in individual companies.

Clay Lowery, the U.S. Treasury's top international official, praised Norway's example in a speech last month in which he proposed that the IMF and World Bank draw up best-practice guidelines for other funds to follow.

An important element of any guidelines would be disclosure policies, so investors don't have to guess what the funds are up to, he said. Funds should disclose checks and balances to guard against corruption, and managers should describe their objectives, Lowery said.

The U.S. call is likely to draw questions at the August 2-3 Asia-Pacific Economic Cooperation finance-ministers' meeting in Coolum, Australia, Deputy Treasury Secretary Robert Kimmitt said July 27.

Shedding Light

Any rules should shed light on how sovereign wealth funds will be managed, what goals they will have and how they will inform other governments of their plans, the Peterson Institute's Truman recommends. Buiter proposes that state-controlled funds that don't subscribe to international guidelines should be barred from buying assets outside their borders.

Even in developed countries, some warn that the drive to develop rules or guidelines could do more harm than good. Italy's European Affairs Minister Emma Bonino said last week that giving EU members the ability to derail foreign takeover bids was ``not useful and also very difficult to implement.''

In the U.K., where Russia's state-owned gas company OAO Gazprom is buying up domestic gas suppliers, Chancellor of the Exchequer Alistair Darling rejects calls for protecting British companies from takeovers by state-sponsored funds. ``Free trade should be just that,'' he said in a speech last week.

Pressures for Protectionism

John Gieve, the Bank of England's deputy governor, last week warned that ``the switch of reserve-rich countries from lenders to owners of financial or real assets is likely to lead to political tensions and pressures for protectionism.''

Kimmitt says the key to avoiding that may be whether countries looking to buy assets also show they're also willing to allow more investment in their own economies.

``We're going to work hard to keep investment barriers low,'' says Kimmitt, who recently visited Beijing and Moscow to stress that point. ``We hope that the same will be the case in Russia and other trading partners of the United States.''

BLUE CHIPS ARE CHEAP

Schroder, ABN, Wells Load Up on Stocks in Worst Rout Since 2002 (bloomberg)
The biggest losses in stock and credit markets in five years are making the U.S. stock bulls more bullish.

The Dow Jones Industrial Average posted its steepest gain since 2003 on July 12, two days after tumbling on Standard & Poor's plan to cut credit ratings for bonds backed by subprime mortgages. The benchmark for America's biggest companies climbed to a record the next week, following a decline sparked by losses in Bear Stearns Cos. hedge funds. Some of the world's largest investors say the S&P 500's biggest slump since September 2002 last week now offers them even more opportunities to profit.

``You look at earnings, you look at ongoing takeovers, and I'm happy to increase holdings as valuations improve,'' said Andy Brough, who helps oversee $7.6 billion at London-based Schroder Investment Management Ltd. ``You make money buying shares when markets are falling, and that is what I've been doing.''

Money managers say the 4 1/2-year bull market remains intact, even after stocks around the world lost about $2.1 trillion of market value last week, according to data compiled by Bloomberg. Equities are even more of a buy because profits are growing, shares remain cheap compared with earnings and the Federal Reserve isn't restricting credit, according to fund managers at Schroder, ABN Amro Asset Management, BlackRock Inc. and JPMorgan Private Bank.

Junk Bonds

Stocks tumbled around the world last week on concern higher borrowing costs will slow takeovers, spur defaults and curb earnings. The Dow average fell 4.2 percent to close at 13,265.47. The S&P 500 dropped 4.9 percent to 1458.95. The Dow Jones Stoxx 600 Index in Europe lost 5.1 percent to 372.69, the largest decline since March.

The extra yield investors demand to own U.S. high-yield corporate bonds rather than Treasuries is rising at the fastest pace in five years, according to Merrill Lynch & Co. data. Spreads on bonds rated below Baa3 by Moody's Investors Service and BBB- at S&P widened 91 basis points last week, or 0.91 percentage point, the most since June 2002, when they surged 109 basis points.

The risk of owning corporate debt in the U.S. and Europe has also risen amid concern the slump in securities backed by mortgages to people with poor or limited credit will spread across bond and equity markets. Credit-default swaps based on $10 million of debt in the CDX North America Investment Grade Index rose last week to $81,250, the highest since the index was created in 2004, according to prices compiled by Frankfurt-based Deutsche Bank AG.

`Extreme Volatility'

Investors are shunning bonds and loans needed to fund leverage buyouts. About $690 billion of the debt-fuelled takeovers supported this year's stock rally. Cadbury Schweppes Plc, the world's largest candy maker, on July 27 became the first company to delay an acquisition because of ``extreme volatility'' in debt markets.

``This whole subprime issue is of course not positive,'' said Astrid Smit, head of investment strategy at ABN Amro, which oversees $260 billion. ``But the fundamentals still look good. If you sell equities, what are you going to buy? In the current environment, it is still the preferred asset class to own.''

Smit said some of ABN Amro's funds were using the pullback to reduce cash holdings and buy stocks. The company is a unit of Amsterdam-based ABN Amro Holding NV, the biggest Dutch bank.

Jim Paulsen, who helps oversee $175 billion at Wells Capital Management, is buying shares of financial companies, the worst performing industry in the S&P 500 this year. The S&P 500 Financials Index has plunged 7.4 percent this month, poised for its biggest monthly decline since September 2002.

`Heads Taken Off'

``The market has chronically wanted to produce a crisis,'' said Paulsen, the chief investment strategist at Minneapolis- based Wells. ``When you're seeing financial stocks getting their heads taken off, it's hard to step in. But there's a possibility of a good return over the six- to nine-month horizon.''

Bear Stearns, down 24 percent this year, and Lehman Brothers Holdings Inc., which fell 18 percent, helped pace the decline in U.S. stocks on July 10 after S&P said it was preparing to lower ratings on billions of dollars in bonds backed by subprime home loans. The New York-based investment banks are the biggest underwriters of mortgage-backed bonds.

The S&P 500 and Dow average rebounded the next day as Fed officials said the economy will weather the worst housing slump since 1991. The Dow posted its biggest gain since 2003 on July 12, rising 283.86 points, or 2.1 percent, as economists increased forecasts for second-quarter growth after a government report showed exports climbed to a record in May. Europe's Stoxx 600 Index also rallied.

`Chance to Buy'

``People have taken their eyes off the good news, the fact that the economy seems to be poised to reaccelerate, that earnings have been much better than expected,'' said Jack Caffrey, the New York-based equity strategist at JPMorgan Private Bank, which has more than $300 billion in client assets. ``This has been something of a gift. You have the chance to buy at particularly low valuations.''

The Commerce Department said on July 27 that the U.S. economy grew at a 3.4 percent annual rate last quarter, the fastest pace in more than a year.

Better-than-expected profits from Armonk, New York-based International Business Machines Corp., the world's largest computer-services company, helped propel the Dow average above 14,000 for the first time on July 19, a day after losses at two Bear Stearns hedge funds sent the 30-stock gauge down as much as 1.1 percent. European stocks also advanced after earnings from Walldorf, Germany-based SAP AG, the world's biggest maker of business management software, beat analysts' estimates.

`Building Blocks'

Robert Doll, who oversees $1.2 trillion as chief investment officer of global equities at BlackRock in Plainsboro, New Jersey, said some of his funds bought shares of energy producers as the market declined last week.

``Global growth continues to boom,'' said Doll, who predicts the S&P 500 will rise another 6.2 percent this year. ``The building blocks for this bull market are still there.''

The S&P 500, the benchmark for American equity, is up 2.9 percent this year and the Dow industrials gained 6.4 percent. The Stoxx 600 index advanced 2 percent.

Stocks recovered even more quickly on July 25 from declines sparked by the credit markets. A rally in energy shares and earnings that beat analysts' estimates from Seattle-based Amazon.com Inc., the world's biggest online retailer, helped the S&P 500 and Dow average rebound and close higher.

Deal Troubles

Benchmark indexes fell earlier that day after banks hired by New York-based Kohlberg Kravis Roberts & Co. failed to sell loans they provided to finance the $22 billion buyout of Nottingham-based Alliance Boots Plc, the U.K.'s biggest pharmacy chain.

More than 40 companies worldwide have reworked or abandoned debt offerings in the past month. Banks are holding at least $32 billion of loans from buyouts they haven't been able to sell to investors, restricting funds for new deals.

``As some of these sectors get beaten up it gives you an opportunity,'' said Robert Schumacher, who helps manage $135 billion as chief investment strategist at Van Kampen Investments in Oakbrook Terrace, Illinois. He expects the S&P 500 to climb as much as 20 percent in the next 12 months. ``This isn't a systemic problem that the economy can't overcome.''

Turmoil in credit markets foreshadowed stock declines in the past 20 years. Spreads widened on average six months before European shares reached highs in 1987, 1991, 1998 and 2000, according to Morgan Stanley. Stock market peaks were followed by declines of at least 10 percent in the Morgan Stanley Capital International Europe Index, according to a July 16 report by the New York-based company, the world's second-largest securities firm by market value.

`Selling Opportunity'

``We take no comfort from the fact that equity markets have been resilient in the face of deteriorating fundamentals,'' Morgan Stanley strategists in London wrote. When the market ``does not react to bad news it is a selling opportunity,'' the analysts said in the report.

U.S. stocks have also declined following ``spikes'' in high-yield corporate bond spreads, according to Bespoke Investment Group LLC, a research firm in Harrison, New York. A rise of more than 20 percent in spreads over an average of 103 trading days preceded drops of at least 2.8 percent in the S&P 500 six times since January 1997.

``It's a warning sign,'' said Quincy Krosby, who helps oversee about $330 billion as chief investment strategist at The Hartford in Hartford, Connecticut. ``The very initial worry that says, `Take cover' will show up in the spreads.''

Past Declines

Shares fell the most when price-earnings multiples were high, according to Bespoke's calculations. The S&P 500 had a multiple of 48.8 when it plunged 23 percent in the seven months ending October 2002 as spreads on bonds with ratings below investment grade widened by 367 basis points. The S&P 500 traded for 27.8 times historical earnings when it slipped 2.9 percent in the almost seven months ended October 1998 as yield premiums widened 407 basis points.

The S&P 500 is now valued at 15.4 times estimated profit, the lowest since January 1991 when compared to actual earnings, according to Bloomberg data. That's one reason why any slide in U.S. stocks may be limited, Bespoke wrote in a note on July 24.

Those valuations, coupled with steady Fed interest rates since June 2006, are enough to make stocks a buy, said Walter ``Bucky'' Hellwig of Morgan Asset Management. The turmoil in the credit market is allowing him to add to holdings in technology, energy, and raw-material shares at cheaper prices.

``In a perverse sense, the widening of these spreads in conjunction with rising earnings makes the stock market more attractive,'' said Hellwig, who helps oversee $30 billion in Birmingham, Alabama. ``Interest rates are still low, inflation is still low, and there still is global growth and equities are becoming more attractive.''

LESSONS

Hidden U.S. subprime losses may mirror Japan bank crisis (reuters)
nvestors and banks holding on to U.S. subprime mortgage bonds in hopes of a recovery in value may make losses worse, mirroring the Japanese banking crisis in the 1990s, according to authors of a new report.

The Japanese banking crisis, triggered in the early 1990s by a slumping property market and brokerage collapses, led to a decade-long credit crunch. The government subsequently had to step in to stabilize the banking system by injecting public money into top banks.

"The Japanese experience of holding large losses as opposed to taking a hit and moving on was a direct cause of the Japanese malaise," said Josh Rosner, co-author of the report and a managing director at Graham Fisher, an investment research firm in New York.

The new report, "Financial Services Exposures to Subprime," said "there are many institutions with significant levels of embedded losses that have not yet been recognized as a result of questionable valuations."

Today, only a few banks and brokerages have recognized losses on U.S. subprime mortgage bets, as the housing market has weakened. Bear Stearns Cos (BSC.N: Quote, Profile, Research) has publicly recorded losses from its hedge fund bets on subprime mortgage bonds held in collaterized debt obligations. Outside the U.S., four hedge funds, two in Britain and two in Australia, have said they suffered losses.

More investors are hiding losses that may only get worse, the report said. Growing concern about the deteriorating U.S. housing market may hurt corporate buyouts, debt financing and stock markets. The Standard & Poor's 500 Index lost $300 billion in value this week on concern about credit markets.

Today's investors and financial institutions are now "playing a dangerous game," Rosner said on Friday. "The losses will almost certainly be larger than they are today."

As more rating downgrades come, values will continue to fall and margin calls will increase, the report said.

Standard & Poor's cut ratings on $6.4 billion in debt this month and Moody's Investors Service slashed $5.2 billion worth. S&P on Thursday cut various residential mortgage-backed securities to junk, including one class of bonds whose ratings were out of synch by 12 levels.

S&P lowered its grade from "AA," S&P's third best rating, to "B," or five levels into junk status.

Bear Stearns also on Thursday seized control of most assets in a troubled hedge fund, after declines in the value of riskier, subprime home loans caused the fund's value to plummet to almost nothing.

Bear Stearns said it "assumed possession of the assets" securing a $1.3 billion credit facility provided to its High-Grade Structured Credit Strategies Fund after the fund was unable to meet a margin call.

Joseph Mason, co-author of the report, said the drying up of capital for investors and banks that rely on that financing to fund leveraged buyouts may begin to weigh on growth.

"I'm not saying it will cause a recession, but we could have a low economic growth environment," Mason said.

Rosner and Mason also compared the current subprime crisis to the U.S. savings and loans crisis in the 1980s, when waves of S&L failures led to a federal bailout.

In the Japanese case, the bursting of the asset bubble in the real estate and stock markets led to a deteriorating economy. Japanese banks were saddled with massive non-performing loans, raising concerns about a systemic meltdown.

AGREE TO DISAGREE

Economists can't agree but all are correct (times)
Do I contradict myself? Very well then I contradict myself.

Can this description, used by the poet Walt Whitman in his classic Leaves of Grass, be fairly applied to economists trying to explain what is going on? I think not, although the information pouring out of the City and Wall Street is quite capable of creating confusion.

Let's start with the recent plunge of the dollar. One set of economists warns that this will drive up the cost of imports, and reduce the competitive pressure on American producers. Result: inflation, higher interest rates, and a slowing economy.

Really? If you find that analysis disturbing just tune into another set of experts. They point out that the falling dollar is making American goods cheaper overseas, spurring sales of made-in-America goods, and encouraging a wave of tourists to come to America and fill our hotels and restaurants. Result: lots of new jobs, investment by export-led industries in new plants, and rapid economic growth.

Believe both. The falling dollar is quite capable of producing all the consequences - the good, the bad and the ugly - predicted for it. But that's where Ben Bernanke and the Federal Reserve Board's monetary policy committee come in. They can cool the economy by raising interest rates if the weak dollar threatens to trigger inflation or overheating.

Then there are the problems in the sub-prime mortgage market. One set of experts warns that the higher interest rates demanded by lenders will: exacerbate problems in the ailing housing market; kill many private-equity deals; drag down share prices; cause billions in losses for investors who piled into hedge funds; and scare consumers out of the malls.

Really? Other experts will tell you that the wake-up call for lenders is a healthy development. It will put a stop to improvident lending before the banks become so overextended that they create a credit crunch that curtails lending to sound borrowers. We are coming to the end of an era of excess liquidity - so much money sloshing around the world that borrowers who couldn't possibly repay were showered with loans, and companies were encouraged to borrow too much money (overleveraging, in the jargon of the trade). Prudence has made her reappearance in the nick of time. Banks might be forced to hold on to loans they previously off-loaded to investors, but that doesn't mean that the paper they are holding is worthless.

Believe both. As the collapse of the Bear Stearns hedge funds shows, many investors will find that they underestimated the risk they took on. Some private-equity operators now have to pay more for the capital they want to borrow, as Cere-bus Capital Management is finding as it tries to complete the takeover of Chrysler Group, and Kohlberg Kravis Roberts is finding at Alliance Boots. But there is still plenty of money around to fund sensible deals on sensible terms.

Consider, now, oil and petrol prices. One set of analysts says $80 crude oil and $3-per-gallon petrol will force consumers to divert spending from clothes, furniture and holidays to the more crucial role of keeping their 4x4s rolling. Meanwhile, airlines, trucking companies, and chemical companies that rely on petroleum-based materials will be forced to raise prices. The Fed will respond by raising interest rates to contain the resulting inflation. Result: recession.

Really? Other economists chortle that higher petrol prices will force consumers to cancel some of those long holiday drives, car makers to accelerate the introduction of more fuel-efficient vehicles, and increase the attractiveness of investments in alternative fuels. The results will be a reduction in America's reliance on crude oil imported from unstable regions, and a lower trade deficit.

Believe both. In the near term, high petrol prices will force consumers to spend less on other things and put pressure on lots of firms to raise prices. But the vigour of global competition will make it difficult for manufacturers to pass on higher costs, and the nation's security interests are served by the cuts in oil imports resulting from higher prices: short-term pain for long-term gain.

Finally, consider the airline industry. Heathrow is not the only airport so overloaded with passengers, and so burdened with inefficient management that getting from kerb to plane is a nightmare. Add that airlines have reduced staff levels, can't seem to arrange for the coincident arrival of passengers and baggage, and are recording more delays and cancellations than ever, and you have a picture of a transport system on the verge of collapse.

Really? The crush of passengers can be looked at another way. For one thing, it shows that air travel has become more affordable, enabling more people to take short vacations or visit grandma in her sun-speckled retirement home. For another, overcrowding at leading airports is encouraging better use of less-crowded facilities such as Stan-sted in Britain and TF Green in Rhode Island in America. Finally, more bums competing for the fewer seats available since capacity has been cut means that airlines are making money and can afford a new generation of quieter, more fuel-efficient, more comfortable aircraft.

Believe both. This summer is a nightmare for travellers. Flights are being delayed and cancelled, baggage is being lost, overworked staff are moving from surly to mutinous. But the boss of Heathrow has already resigned under pressure, governments are reexamining the balance between security and convenience, and there may be flat-bed seats in all of our futures.

Do we economists contradict ourselves? Not really. We are dealing with the massive, diverse American economy, to which Whitman's self-description applies: “I am large, I contain multitudes.” Irwin Stelzer is a business adviser and director of economic policy studies at the Hudson Institute.