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Market Focus: Subprime Woes Watched Closely By Traders

Even as the Dow Jones Industrial Average briefly crossed the 14,000 threshold Tuesday, benchmark ABX subprime mortgage indexes, used by investors to hedge subprime mortgage risks, have been chalking up new all time lows in recent days and that has traders talking.

The slide in the series of ABX indexes, maintained by Markit.com, gauging loans made in last year’s second half wasn’t confined to the most toxic levels of debt, the BBB- tranche, but spread to the highest levels of the ladder, AAA, which fell to 95-cents on the dollar after hovering at close to 100-cents on the dollar for the past seven months. Further down the ladder, the ABX.HE BBB 07-1, a notch above triple-B minus was hit the hardest, falling by more than 9%.

John Brady, senior vice president of Man financial in Chicago has one explanation. “We are seeing a technical trade in the ABX as a new index is coming to the market on Thursday. So some of the selling that went on in the index yesterday may have been what some traders call a roll trade.”

But not everyone is as sanguine. Barry Ritholtz of Ritholtz Research & Analytics worried aloud on his blog The Big Picture, “it looks like either a fund is getting liquidated across all asset qualities -- or someone is panicking. “ He also noted that “that AAAs contain up to 8% toxic sludge, while the double AAs contain up to 12%.”

Concerns about subprime were large enough to spark a flight to quality in Treasurys pushing the 10 year Treasury lower by 5 basis points to 5.05% Monday which in turn diminished the attractiveness of the dollar.

As the dollar continued to trade in record low territory against the euro and at more than two-decade lows versus the British pound, the dollar index, as basket of currencies, continued to slide, falling to 80.53 as subprime plays a role in trader decisions in the foreign exchange.

“80.39 is a big level for us on the dollar index,” said Kamal Sharma, currency strategist at Bank of America in London. That’s the December 2004 level that we’re watching closely to see if more selling will be sparked. Comments from Fed chairman Bernanke at his semi annual testimony tomorrow will be key. Traders are waiting to see whether the Fed remains skewed toward higher inflation rather than slower growth.”

Noting the recent acceleration in the dollar's decline since early July, Sharma says the dollar selling is beginning to look “overdone”, but he notes that subprime woes have been giving traders an “excuse” to sell the dollar amid concerns that if foreclosures rise at a more rapid pace "domestic consumers could be hurt and thereby force the Fed to cut rates" later in the year.

As for the stock market's reaction to subprime, damage has largely been confined to groups like the The S&P Homebuilding index which has dropped over 25% this year as benchmarks like the Dow and the S&P have rallied.

"The issue is the credit ramifications for those who have leveraged themselves to take positions in subprime loans. This is going to result in significant losses for those investors/speculators and the market can live with that," said Michael Metz, chief investment strategist at Oppenheimer. "What the market can't live with is a phase of forced liquidations at hedge funds which are leveraged to the hundreds of billions, but frankly there's no clarity on that issue."

Metz says the toxicity of what's occuring in subprime debt is making "stocks look like the least overpriced and dangerous" of the asset classes for now. He also notes that "leverage in the system is not tied to corporate America where balance sheets "look great".

"Not to sound cynical, but the stock market has one claim, it's going up," says Metz who says traders will have to look over their shoulders as "no one knows who's exposed and to what degree" to leveraged investments tied to sagging mortgage securities market.

Analysts Comments

Among notable comments from Wall Street's analysts:

American Express was upgraded to Buy from Neutral at Goldman Sachs while Discover Financial was initiated with a Neutral. Starent Networks initiated with a Buy at Goldman. Waters has been initiated with a Hold at Deutsche Bank. Pike Electric and Comfort Systems initiated with Sells at KeyBanc. AuthenTec initiated with a Market Perform at Morgan Keegan. Wet Seal initiated with a Buy at Merriman. BHP Billiton downgraded to Hold from Buy at Deutsche. Cognos upgraded to Strong Buy from Market Outperform at JMP Securities. BEA Systems was upgraded to Outperform from Neutral at Credit Suisse. AMR, UAL Corp and Delta were upgraded to Neutral from Reduce at UBS. Sapient upgraded to Outperform from Market Perform at Friedman Billings.

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