Credit Market Overview

September 16, 2008

CEC Portfolio Composition

Given recent events in the market I thought it would be of value to review what has happened and the moves made in the CEC Portfolio while everything is still fresh.

In late August Crude did a two day reversal moving up $5.62 on the 21^st and then down $6.59 on the 22^nd. The move down heightened the talk of demand destruction and the CDS/equity relationship in many of the energy names required the initiation of short positions. A second big move down on September 2^nd added more energy names to the short side and the move then continued lower but in a more orderly fashion.

Interestingly, during the second part of this move energy stocks stopped following Crude and also became temporarily disconnected from the moves in the CDS market which were still widening and pointing towards lower stock prices. The graph of the energy ETF’s (XLE and OIH) vs. Crude or the commodity ETF USO showed a widening of price differential to historic levels as oil continued lower but the stocks began to rally, even in the face of a troika of hurricanes making their way across the Gulf of Mexico,

With Ike bearing down on Galveston and what had been a reasonably profitable month slipping away a partial hedge was put in place using the XLE ETF to counter some of the short exposure and allow Ike to pass. The shorts in the energy names comprised roughly half the short exposure in the CEC Portfolio and only half of that exposure was hedged.

Ike passed through relatively benignly this weekend, at least with regard to the energy infrastructure and by Sunday morning Crude had broken down to a double digit price. The thought at that point was to remove the hedge on Monday morning and let the CDS/equity relationship continue as before.

Sunday however brought other news and the collapse of Lehman and merging of Merrill and Bank of America threw the financial world into disarray with the S&P futures trading off 45+ points in the pre-market session yesterday.

The market has experienced a number of binomial events this year and prices have acted accordingly moving up or down a few hundred points in short order creating or erasing trading profits.

Given the overall short exposure of the CEC Portfolio and the profit that now existed it was decided to capture that profit and begin, from a non-biased standpoint, to evaluate the CDS/equity relationships for new positions. As such the book was collapsed at 9:41 yesterday.

The risk of an announcement by the Treasury or the Fed with some intervention meant to act as a soothing balm for the pain just inflicted by not backstopping a deal involving Lehman seemed a reasonable probability and the more conservative approach seemed to be to take the money and run.

After booking the morning’s trades the rest of the day was spent re-evaluating moves and by the close a number of new shorts and a few longs were back on the books.

The CEC Strategy has always been based on the discretionary interpretation of the relationship between moves in the CDS and equity market for the 400+ names in the CEC Universe. The volatility in the market place, the frequency of Government intervention and the amount of cash on the sidelines have all combined to make the markets this year some of the most difficult to trade in my entire Wall St. career.

The ultimate goal of the Strategy is to create profits and prevent losses. Towards this end the approach might not seem at times to follow a prepared script but that is only the result of a market that appears not only to have thrown away the script but also to defy logic.

Enjoy the day.

Jim Delaney