Investment Commentary by Albert Lam

Markets have been extremely volatile lately. The primary cause of this correction is the indiscriminate lending, creating this sub-prime loan mess. Banks have in turn bundled these problematic sub-prime loans into new exotic financial instrument known as CDOs (collateralized debt obligations) and CLOs (collateralized loan obligations). These CDOs and CLOs are then off-loaded, in various risk tranches, to financial institutions and their unsuspecting investors around the world. Of course, hedge funds often take the junkiest tranches. The size of these bad debts is estimated to be around US$100 billion, according to the US Federal Reserve Department. However, more aggressive parties have estimated the size to be around US$200 – US$300 billion. Regardless of the estimate, this amount is not huge enough to change the fundamentals of the real economy. The US GDP is estimated below US$15 trillion, the world over US$50 trillion. However, the damage to sentiment and financial markets is more severe. Sentiment has been greatly affected because many parties have bought into the CDO and CLO structures. The bottle of poison has been shared by many. The good news is, because the poison was diluted to many, very few will be badly hit as the toxicity is also “diluted”.


Now comes the next fear – credit crunch. Financial institutions are a lot more careful on lending because they do not know who is exposed to the CLOs and CDOs and what the quality of their holdings is. The immediate result will be tighter lending practices and higher cost on borrowings in the short term until more clarity emerges on the actual exposure on sub-prime loans. Such uncertainty explains the fear. Central banks from developed economies have pumped in hundreds of billions of dollars of liquidity into the market recently, which helped to inject some stability into money market system. Central banks in Asia ex-Japan are standing by, armed with their US$3 trillion in foreign reserves.

As if the situation is not negative enough, we are now facing the prospects of the unwinding of the Yen carry trade. Many investors and hedge funds have taken advantage of the cheap borrowings from Japan (effectively shorting the Yen) over the years to invest in financial instruments to capture higher returns. This “no-brainer” is fine as long as the Japanese Yen does not appreciate too much. However, when hedge funds and leveraged traders that are exposed to CLOs and CDOs face redemption and losses, they need to sell both their good and bad holdings to pay back investors who want to sell out. In this sort of fist fight, by-standers get pummeled, too. When carry position unwinds, they will also pay back the yen borrowings (effectively buying the Yen). In the process, we are seeing some unwinding of the Yen carry trade. This will cause the Yen currency to appreciate which would trigger more unwinding. The end result is lower liquidity in the financial system which is negative for capital markets.

This short term volatility will eventually clean up some excessive liquidity in the system and clear up and wipe off the exposure of the sub prime loan mess. Then market will resume its uptrend on a cleaner foundation. Thus far, the impact on the real economy is minimal and we expect the strong fundamentals to sustain this uptrend in the market.

On the technical front, the DJI is testing an important support level at the upper channel at 12,200. If this level breaks, the selldown could become more severe as the major support is at the lower channel support at 11,000.

The STI has broken through the upper channel support at 3,150. The next test will be the psychological support level at 3,000. The worst case scenario will be a test on the lower channel support at the 2,800 levels.