Today's comment is by Mike Burnick, our Senior Editor, Global Markets Analyst and editor of Global Market Investor.

Dear A-Letter Reader,

The ongoing train wreck that is the U.S. housing market, and the closely related sub-prime lending debacle, has been unfolding for quite some time.

Only recently however, did we begin to see the affects on broader financial markets. Now it seems, these credit market aftershocks are spreading - which threatens to knock out a key support to the global equity rally.

By now, nearly everyone is familiar with Bear Stearns' hedge fund blowup. Today the Wall Street Journal printed the post mortem: "Investors in two troubled Bear Stearns Cos. hedge funds that made big bets on sub-prime mortgages have been practically wiped out." 

It seems one of these funds, heavily invested (and leveraged) in sub-prime securities gone bad, is now worth ZERO.

Meanwhile investors in the other fund can count themselves "fortunate" to get back 10 cents on each dollar they invested! As a result, Bear Stearns has had to shell out US$1.6 billion of its own money as "rescue financing."

In other words: "Throw us a lifesaver because we're going down!"

Collateral Damage Begins to Spread on Wall Street

For a while, it appeared any collateral damage was limited to only the riskiest areas of the sub-prime securities market. After all, that's where Wall Streets big boys should expect the occasional landmine to go off.

Both Treasury bonds and corporate fixed-income markets tumbled at first, when the magnitude of the hedge fund losses first came to light a few weeks ago, but markets quickly stabilized and investors by and large remained calm.

A story in Bloomberg news however reveals that perhaps all is not well in the state of corporate finance on Wall Street after all.

According to the story, "Goldman Sachs Group Inc., JPMorgan Chase & Co. and the rest of Wall Street are stuck with at least US$11 billion of loans and bonds they can't readily sell."

As I have written about previously, merger and acquisition (M&A) activity this year is surging, setting new records not only in the U.S. but in Europe as well. This is one of the reasons that global stock markets have performed so well, because private equity firms are constantly on the prowl to buyout public companies around the world.

According to a recent report by Northern Trust, a record US$415 billion of stock was "retired" from the market last year, with private equity led buyouts and other M&A activity playing a very big role.

Obviously, such strong buyout activity in the stock markets helps provide major support to share prices. It keeps a "bid" under the market, helping dampen volatility for instance, and minimizing declines in the major indexes. That's because the private equity and hedge fund crowd is in the market and they're ready to buy shares.

Junk Bond Market Joins Sub-Prime Sector in the Dog House

Of course much of this buyout activity by private equity firms such as Blackstone Group is financed with high-yield bonds - also known in less politically-correct terms as junk bonds .

In fact, this year's record buyout activity "helped push sales of high-yield bonds and loans worldwide up more than 70% during the first half of the year to a record US$708 billion" according to Bloomberg .

But in the wake of the widening credit market crunch, first triggered in the sub-prime lending sector, recently the junk bond market has been getting hammered also.

In fact, junk bond spreads narrowed to a record low of just 2.4% over U.S. Treasury bonds in June. That's down from a peak of more than 10% in 2002. And these spreads have widened considerably since then.

The corresponding decline in the market value of junk bonds (which move in the opposite direction of rising yields) has triggered the biggest rout "in high-yield debt in more than two years," according to Bloomberg .

As a result, Wall Street's aforementioned best and brightest are stuck holding an estimated US$11 billion worth of loans and bonds, some of them at steep losses, which they can't unload given current market conditions.

Will the Buyout "Bid" Vanish as Bond Losses Mount and Liquidity Dries Up?

Meanwhile, back in sub-prime land, conditions are going from bad to worse!

A popular benchmark index that tracks different classes of sub-prime bonds, hit new lows yesterday.

According to the Wall Street Journal (emphasis mine ), "in the past few months, the portions of the index that tracked especially risky mortgage bonds with junk-grade ratings had been falling. But now, the portions of the index that track safer mortgage bonds, with ratings of triple-A or double-A, are also falling sharply ."

It is now becoming all too apparent that credit market woes are spilling over to the broader financial markets. And the ever-present liquidity that has support all asset classes in recent years may be at risk of drying up.

Wall Street firms are beginning to suffer widening losses. First they were losing on their sub-prime holdings and now they're losing on junk bond positions. Plus who knows what kind of hit they are taking on murky derivatives tied to both!
Against this backdrop however, it's reasonable to expect a further contraction in liquidity as Wall Street's losses mount, and keep them from investing in new "deals."

Watch out for the other shoe to drop - when the private equity, M&A inspired "bid" in the market, turns around and becomes an "offer." As in: An offer to sell stocks rather than buy - so they can raise cash to pay for margin calls generated by growing losses in other parts of their investment portfolios. At that point the whole liquidity dynamic begins to run in reverse.

All I have to say is: Look out below!

MIKE BURNICK, Senior Editor & Global Market Analyst

P.S. Click here to read a special Sovereign Society report on how you can save your portfolio - and even profit - from the reckless acts of private equity companies, known as the "locusts" of the financial markets.