the Contrary Investor

August 10, 2007

Credit Crunch

Filed under: Goldman,Short — contraryinvestor @ 11:24 am

creditcrunch.jpg Sometimes the Contrary thing to do is to put aside your own general contrarian view and agree with general sentiment. The current tightening in the credit markets are invariably (OK not invariably, but probably) going to have an additional impact on the global equity markets. At present the S&P 500 is still up 2.5% year to date and despite all the “pain” some investors claim to be feeling, the markets have still not fully repriced the risk associated with excesses of the last two years of easy credit. The sub-prime lending of the corporate market, covenant-lite deals represented 17.9% of the levered loan market at the end of July, up from 10.8% at the end of the first quarter. The market will not be feeling indigestion from these loans for some time. While the repricing in the CLO/CDO market may have seemed sudden to hedge funds such as Sowood Capital the fact is that gobal default rates still stand at only 1.38% (a number that will invariably revert to the mean of around 3.2%). As the default rate and market volatility continue to increase stricter credit standards will lead to reduced money supply and likely economic contraction. In order to hedge the risk of my portfolio and profit from a likely market down turn I would normally short the S&P 500 (SPX) (though not the day after a 387 point drop).

However, with at beta 1.7 and two hedge funds which are currently takings losses (Goldman Sachs North American Equity Opportunities and Goldman Sachs Global Alpha) I chose instead to short Goldman Sachs (GS). Goldman will almost certainly weather the loses at its funds with out much impact to earnings. Yet, with Goldman being Goldman headlines about trouble at the world’s premier investment bank will inevitably multiply. As was seen with the trouble at the two Bear Stearns hedge funds that were liquidated last week, we can expect the negative publicity surrounding hedge fund troubles to weigh down GS shares. The hedge fund trouble at Goldman will only act as catalyst making this *trade* more appealing. Shorting Goldman becomes particularly of interest when one considers that despite the news of trouble at a second fund circulating Thursday GS traded down (on 08/09/07) only 5.72% in line with Morgan Stanley(-5.47%), Merrill Lynch (-4.46%) and less than Lehman Brothers (-7.15%).

While Goldman will certainly live fight another day the general economic conditions and potential negative headlines make Goldman a short. My instrument for this operation will be the Jan 2009 $140.0 puts (VSDMH). The 23% decline necessary to reach this strike price was achieved by Bear Sterns in less than a month after the announcement of its hedge fund woes. Mostly likely the performance of Goldman’s two funds will not be as bad as that of Bear Stearns. I will be using GS as a proxy for overall market performance, due to its high beta, and the hedge fund imbroglio can be taken as a bonus.

UPDATE (08/13/2007):

I hate to say I told you so but, I told you so

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