Traders came back from the weekend happy to believe that the woes of two
hedge funds were
last week's news, spurring early gains on Wall Street.
But concerns about the credit markets bled into Monday's afternoon trading session, putting stocks on a wicked roller-coaster ride driven by rumors and shrinking LBO financing deals.
Dow Jones Industrial Average
climbed as high as 13,489 intraday Monday, aided by falling Treasury yields amid more weak housing data. But the stock market turned south sharply at around 2 p.m. EDT amid rumors of more hedge fund blowups tied to the subprime mortgage market and news that deals in the high-yield bond market to finance recent leveraged buyouts were continuing to struggle.
The ghastly images conjured up by many traders are of hedge fund Long Term Capital Management's collapse in 1998, a financial event that damaged all markets.
The Dow plunged to as low as 13,300 in reaction, but ended the day down nearly flat, off just 0.1% at 13,352.05. The
fell 0.3% to close at 1497.74 after trading as high as 1514 and as low as 1493, while the
finished the day down 0.5% at 2577.08.
After making new highs, "investors get nervous by definition," says John Bollinger, president of Bollinger Capital. Nervousness has been reinforced by the news in the credit markets, amounting to a consolidation process for stocks, he adds. "Demand for stocks has not gone away, but investors are a little leery, and not willing to push things very hard."
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Indeed, bulls were unable to sustain a push forward Monday as all eyes remained on the credit markets. Analysts are working out how much liquidity might be sucked out of the system based on what may soon amount to tighter lending standards to investors who use leverage, a.k.a hedge funds and private-equity investors.
The brokerage and banking stocks fared poorly again Monday amid speculation of more hedge fund problems. Bear Stearns fell 3.2% amid reports of a possible
Securities and Exchange Commission
investigation and cautious comments from Merrill Lynch analyst Guy Moszkowski, as
fell 2.5% and
J.P. Morgan Chase
slipped 0.7% in sympathy, helping drag the Amex Broker/Dealer Index down 1.5%.
"The funds' problems have clearly shown that the credit extended to the
hedge fund industry is too large," Axel Merk, manager of the Merk Hard Currency Fund, writes of the now infamous Bear Stearns funds. He suggests that the types of derivatives the banks held as collateral are not suitable to back up hedge funds that want to make bets on borrowed money. This willingness by the banks to ignore risk has led to low volatility and little reward for risk in the marketplace.
"Markets need risk to properly price assets," wrote Merk. "The Bear Stearns debacle highlights that the industry has gone too far, and that it is high time that credit be reined in."
Risk is indeed rising to its rightful place of importance in the high-yield bond market as the leveraged buyout binge seems at an apex. Several low-credit quality, high-yield bond deals to finance buyouts were struggling even more Monday after hitting a wall last week.
The deal to finance a buyout of
education business finally priced late Friday night with a coupon 0.25% higher than originally expected at 10.75%, and the bonds traded about 2 points lower than their issue price in the open market Monday. They yielded 10.90% by the end of the day, according to Matt Fuller of Standard & Poor's Leveraged Commentary & Data unit.
The deal to finance the buyout of
U.S. Foodservice business was sliced again in size, to a total of $650 million from an original $1.55 billion, according to Fuller. The expected coupon for the offering was also revised another 0.75% to 1% higher than originally expected.
"It is a tale of two markets," says Fuller, making a point to note that spreads in the high-yield market overall have widened only slightly and that higher-quality issuers like
Sierra Pacific Power
tapped the market recently for financing at lower rates without opposition from investors.
While riskier deals struggle, "the market is taking a well-deserved break and spreads are widening at a measured pace," says Brian Hessel, managing partner at Stonegate Capital.
Moody's Investors Service's John Lonski agrees, noting that Long Term Capital Management precipitated a much more drastic widening of credit spreads than the market has seen thus far. He characterizes recent widening of risk premiums on low-quality debt as a normalization of the risk spectrum.
Indeed, he notes that premiums on high-quality corporate bonds have actually narrowed compared with the moderate widening of the low-quality debt as investors are reminded why such bonds are called "junk."
Meanwhile, homebuilder stocks also were among Monday's worst performers amid the worries about the mortgage market and a flat report of May existing-home sales, while inventories grew to an 8.9% month supply. The Philadelphia Homebuilders Sector Index slid 1.7% on the day while shares of
fell 1.7%, 2.2% and 1.3%, respectively.
While Bollinger and others say stocks will likely rebound from recent volatility, some analysts have a more dire outlook. Rod Smyth, chief investment strategist at Wachovia Securities, warned investors of a possible "multimonth consolidation for the S&P 500 with downside risk to 1440" as stresses in the credit markets threaten the "liquidity-driven exuberance phase for stocks."
At the very least, most expect that lending to hedge funds will not be as free and easy as it has been. What seemed on Friday to be an orderly unwinding of the Bear Stearns funds' leveraged positions might yet prove messier still.
In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click
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