The Risk Averse Alert

Ca rumba! The fallout from the Lehman Brothers bankruptcy is mildly disturbing...

At issue are Credit Default Swaps (CDS) written to insure Lehman debt. On Friday (10.10.08) an auction of insurance on $110.5 billion in senior Lehman notes determined investors who bought Lehman CDS should get 91.375 cents for every dollar of Lehman debt insured.

Apparently, sellers of the Lehman CDS are expected to deliver $270 billion.

Friday's auction occurred outside of Lehman bankruptcy proceedings. The auction has little to do with what bondholders will recover once Lehman's bankruptcy, filed Sept.15, has been fought out in court by creditors. Rather, this auction appears only to set the value of Lehman CDS coming due.

(The information above was culled from this Bloomberg story.)

According to the London Telegraph, "the deadline for payments [on the Lehman CDS in question] is Oct 21."

From the New York Times we learn "The danger is that the claims on the Lehman default are so large ... that settling them could leave some companies with large, perhaps even crippling, losses and heighten the turmoil in the financial markets."

Trouble is “No one knows who owes this money, how much each counterparty owes, or whether any of these counterparties will now be in trouble themselves, with further potential problems for the financial markets,” according to New York State insurance superintendent, Eric R. Dinallo,

"Market participants were expressing particular concern about the amount of money that the American International Group, the insurance giant that was effectively nationalized, would have to pay as it settled its swap positions on Lehman Brothers’ debt."

I wonder ... if the bulk of Lehman CDS was written by AIG, might this be a blessing in disguise? With the government (and its relatively limitless resources) effectively running AIG, the risk of a widening blowout of the financial system might already be contained.

The issue of settling Lehman CDS has implications you probably have been hearing about. According to the London Telegraph, "The lack of clarity [is exacerbating] the deep freeze in the credit markets, as banks are reluctant to lend to each other when they do not know if the debt will be repaid."

Yet Joel Telpner, an attorney at Mayer Brown in New York who specializes in credit derivatives transactions says, "we don't have any explicit evidence indicating that [Lehman CDS] sellers ultimately are not going to be able to pay the amounts owed to buyers." ("Lehman Credit-Default Swap Payout Could Climb as High as $365 Billion" Washington Post, Saturday, October 11, 2008)

So, that's encouraging. Likewise, I imagine some significant portion of capital needed to pay Lehman CDS coming due was raised last week when the stock market was drained. One can only hope.




On Tuesday, October 7, 2008 I presented a chart of the NYSE Composite with a possible Elliott Wave count labeled. Although not reproduced here, you see a typical Fibonacci relationship between wave a of (b) of (2) and wave c of (b) of (2). Namely, wave c is 1.618 the length of wave a.

Per the Elliott Wave Principle's guidelines surrounding price channeling, the NYSE Composite's decline since September 22nd probably represents a case of what's called "throw-over." Fifth wave throw-over also occurred going into the January '08 low and it should be duly noted that, subsequently, the market stabilized.

Did "throw over" in January presage the disaster that has become 2008? Possibly.

Might fifth wave "throw over" occurring in the formation of wave c of (b) of (2) be presaging the coming wave (3) [down]?




Here is a closer look at wave 5 of c of (b) of (2), which, itself, is forming a fine price channel. Note how wave iii of 5 features the deepest sell-side RSI. This helps confirm the wave structure I have labeled here.

One thing I don't like about this possibility of wave 5 of c of (b) of (2) forming over the past seven trading days is the very fact the deepest sell-side RSI since September 22nd was registered. Normally, I would have expected this to occur during the formation of wave 3 of c (on Monday, 9.29.08).

However, this might be just another instance of capitulation registering late in the game, much as is the case with the NYSE High-Low Differential. (By the way, Friday saw a record number of stocks trade at new 52-week lows on the NYSE. According to OptionsMonster, 2,518 stocks out of 3,423 issues listed on the NYSE registered a new 52-week low on Friday.)

The same can be said for the NYSE Bullish Percent Index.

(As an aside ... given the deeply oversold condition of both these measures ... among others ... I wonder if normal technical divergences need to register before the market rallies strongly?)

Contrarily, the chart of the NYSE Advance-Decline Differential I presented on Tuesday continues confirming the Elliott Wave count I am suggesting for wave c of (b) of (2).

So, it is indeed possible bottom is in. If all is well, there might be an incredible rally coming. However, it also is possible the fallout from Lehman Brothers' CDS coming due is about to explode onto the scene.

Being the market is both so completely fear-filled and so deeply oversold, one might expect a powerful move whichever way the wind blows from here...


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