This past week has followed the standard horror movie script to the letter (so far). Last week’s article An Eagle A Black Horse And A Load Of Bulls*t told of how the banks had taken blow after blow from the Crunchy Credit Monster. But it looked as though a spirited defence, using higher dividend payments, had stopped the monster in its tracks.

It’s hard to simulate a deafening roar in a blog, but that’s what happened this week as multi-crunches attacked from all directions, leaving traders stunned and bewildered. I’ve knocked out a quick user’s guide to the main new worries to hit the markets, together with a couple of old ones still going strong, but first an apology and a bit of advice:

Z and I are running an unofficial competition to write the longest piece, and you guys get the rough end of it. Before starting, arm yourself with a strong coffee, and perhaps a doughnut. And if need be, get up and have a scratch half-way through. It’ll still be there when you come back.

This adaptation of War & Peace is an update on the sub-prime credit-crunch turmoil. If you’re a newbie and need a bit of catch up, her’s a coupl of earlier pieces on the subject:

Subprime:He Cannot Make The Payments So Charge Him More
Subprime 2: Credit Crunch?

We’d Like Some More Money Please (Margin Calls)
Sure, this one’s been around the block a few times, one or two of us might have experienced it ourselves in January! For those of you with a puzzled expression a margin call happens when the Initial Margin Requirement isn’t enough to cover the potential losses on an open position. The bank, broker or Spreadbetting firm will ask for extra money to cover the risk of further losses, or offer to close the position. Still confused? Why not check out the margin stuff in Tutorial 2; it’s got voices as well now.

As markets continued to deteriorate there’s been a spate of high profile margin calls:

Peloton Partners were the first victims. They were a highly regarded hedge fund that made an 87% profit last year by correctly backing the ‘sub-prime going tits up’ argument. Sadly for them they believed in the miracle of lower interest rates and turned the position around too soon. Now their $2 billion fund is bust.

Focus Capital, a $1 billion hedge fund was forced to sell its investments after failing to make margin calls. The thing is, this wasn’t a portfolio of toxic sub-prime waste, but investments in Swiss mid-cap shares.

Thornburg Mortgages was a specialist in ‘jumbo loans’ for exotic (or was that erotic) houses at the luxury end of the market. This week’s announcement that they were unable to meet margin calls saw the share price fall by over 70%; there’s a real risk of the firm going bankrupt, according to the credit rating agencies. Watch this fast-moving story; Thornburg is teetering on the edge and might be no more by the time this goes out!

Other funds, including Highland and Carlyle Capital, have been mauled by falling prices and multiple margin calls. Shares in Carlyle have been suspended. Like some one in the hedge fund community said last week, “Peloton knew their stuff. If they got caught out, so will a lot of others.”

Hedge Funds Deserve It So Why Do We Care?
Sometimes it’s worth stating the blinding obvious, selling off (or liquidating as it’s known in the trade) portfolios leads to lower prices. As these people close their positions it sharply pushes the price in the direction of the current trend. So if FTSE was falling before, closing out a big long position will yank it down further. This excess volatility leads to greater uncertainty, more worry for everyone and increased laundry bills for traders.

But here’s the tricky bit; lower prices in what? Some liquidations involve dumping the toxic trash, or variations of (loans, bonds, and dodgy stuff made out of loans and bonds, like CDOs). This week saw the yield difference between corporate bonds and government bonds (the credit spread) rise to record levels. This reflected the ‘sell at any price dilemma faced by some funds.

Also, the sons of Frankenstein that created the CDO monsters, made them too damn difficult to price in the normal way. Instead they’re priced by the banks using Stephen Hawking and an excel spreadsheet. CDOs rarely trade, which means that their home-made prices don’t change until the market sees a new price. Each new price, which is inevitably a really crap bid, will force all the banks to mark down the value of their assets. This means they’ll be more likely to get a margin call, so they’ll have to sell something…..get the picture?

Some funds only need to raise enough money to meet the higher margin calls. A lot of the talk on Monday was of funds selling profitable positions (gold and oil) for this reason. Last week Focus Capital was selling Swiss shares.

As Dry As The Sahara (Liquidity)
This crunchy problem goes hand in hand with the last one; if money’s tight the banks tend to ask their leveraged clients for more dosh. An early Christmas present from the central banks meant that banks could borrow enough to pay for the Christmas parties (and remain solvent over the New Year). But since early January short-term (LIBOR) money rates have been steadily rising. In Europe 3-month money now costs 4.4%, compared to 4% official rates. The difference is even more marked in the UK where 3-month LIBOR is 5.77% compared to base rates at 5.25%. On March 19th the £10 billion of pre-Christmas funding assistance by the Bank of England is due to mature. I’d stake my last Mars bar on the Bank re-newing this commitment, but there’s a lot of uncertainty out there.

Take a look at how 3-month rates have almost returned to the panic levels seen in the Autumn (remember, you get the interest rate by subtracting Short Sterling from 100. The current rate is 100-94.26 = 5.74%).

These higher money rates reflect how tough some banks are finding it to raise funds from the markets. A leaky report last week showed how worried the Irish authorities were that funding restrictions would mean less money to dish out on mortgages and business loans. Several private equity deals have had to be scrapped because that particular piggy-bank is empty.

M&Ms (Monolines And Municipals)
I think a quick introduction to monolines is in order; they have nothing to do with fast Japanese trains that speed around the skyways of city centres. Monolines make their money by insuring other people’s bonds against default (a sort of modern day Kray twins). This improves the bond’s credit rating and means that a lower interest rate can be paid on the bonds. For years low default rates meant that business was like taking money off a baby. Then along came the sub-prime crisis and exposure to billions of Dollars of possible defaults.

Markets feared a re-make of Armageddon, but there too many people suffering from tight scrotums on Wall Street to allow this one to fail. The rating agencies were lent on enough to hold off downgrading the main monolines, and a rescue package for AMBAC is supposedly ‘in the post’. The significance of this deal is evident in the way the stock market has been up and down like a bride’s nightie, depending on the latest news of a deal, or a problem with the deal, or a big rights issue.

There isn’t a market comparable to Municipals in Ireland and the UK. Although local authorities have the ability to issue bonds (and often used to), they mainly depend on hand outs from central governments. However, in the more liberated US, cities and states are more autonomous in how they raise money. US municipals, like schools and hospitals, raise billions through the bond markets. They use insurance from the monolines to make their debt higher quality and therefore cheaper to fund. But the fear of the monolines going tits up sent a large shiver through the municipal market, with many investors, and banks, avoiding their bonds altogether.

The average yield on Municipal bonds has gone from 3.63% in January to 6.52% at the end of February. This is a bit like a mortgage squeeze on local authorities and those higher payments will be met by, yes you’ve got it, the people who live there.

Full Circle Back To-Mortgages
Yes, this was where it all started, but that was the crap, now it’s the better quality stuff. The next ones on the list are called Alt-A mortgages, and no they’re nothing to do with shortcuts on your keyboard. These babies were originally dismissed as OK, because they were the meat in the middle of the prime and sub-prime mortgage sandwich. However, as the US housing crisis drags on the effects are working their way up the food chain.

HBOS bowled a googly last week when it revealed a £7.1billion exposure to Alt-A mortgages, but didn’t make any provision for bad debts against it. According to Bloomberg the amount of sub-prime mortgages outstanding is $650 billion, the amount of ALT-A mortgages is a mindblowing $950 billion. ALT-As was the market that went schitzo in February, bringing down Peloton and Thornburg, which brings us nicely back to the beginning.

So, Where Does That Leave Me?
Only a week ago I wrote that I was a buyer of banks on weakness. But I make decisions as a trader, and as a trader I’m quite happy to say, “Nope, with credit starting to crunch like a hungry bear, I’m re-evaluating.”

It also leaves me even more confident in my short FTSE position. Sure, there’ll be euphoric rallies; we’ll probably see one if the AMBAC rescue attempt comes off. But I’m looking to stay short, and add to my position if I can get the timing right.

In the script of the classic horror movies the monster has one final frightening hurrah before collapsing in a pile of cheap plastic. This crunchy monster looks far from dead to me.