It ALWAYS spreads, and by the way, it ALWAYS overshoots

Rats in Taco Bell Goldilocks' oatmeal

Oh, and it never matters, until it does. Last week, markets rediscovered risk. This week, they’re in line for a sharp reminder that – as then Federal Reserve Board chairman Alan Greenspan said 18 months ago – “history has not dealt kindly with the aftermath of protracted periods of low risk premiums.” And Goldilocks? Well, she was a burglar, and she’s outtahere as the Three Bears Police Department's sirens echo through the woods.

Sirens? For anybody listening, they’ve been background noise for a while. A series of unrelated accidents – the MotherRock and Amaranth implosions, Thailand’s brief fling with investment controls, Venezuela’s asset expropriation adventures, and, of course, the smoldering US housing market and oft-denied but now clearly evident leakage of subprime issues up the credit quality chain – dismissed as either immaterial or “buying opportunities.”

But it always starts like this. Unrelated blips, like bad ticks on a market feed. Every economist in the world using the word benign, and predicting stock market gains. Insider selling on the rise. Criminal investigators call on a company already looking down the barrel of a “going concern” non-endorsement from its auditors. Systemic corruption uncovered at “victim” global brokerages. Bid lists, furiously hit on the ask just a few weeks ago, ignored.

The crowd gets antsy. The exit door can’t spin fast enough (see: New York Stock Exchange, Tuesday afternoon). Stuck with positions they can’t get out of, the wrong-way leveraged sell what they can to satiate the margin clerks, while the merely nervous protect hard-won profits. Last week’s Dow stumble wiped out almost four months of gains; Friday’s close, at 12,114.10, was the lowest since Nov. 10 2006 (12,108.43).

It’s overdue. It’s healthy. It’s 5 percent more or less. It’s not the end of the world. But a lot of fingers are badly scorched, as much by correlation – everything went up together, so was it really a surprise that that gold didn’t turn out to be a great hedge? – as the move itself.

Some of the tells I’ll be watching this week:

The Monday Morning Put: (Mostly) Monday morning merger and LBO announcements have fueled market gains for more than a year. Haven’t had a bid yet? It’s coming, even if some of the more monstrous, in all senses of the word, recent speculation – Alcoa, anybody? – hasn’t actually come to pass, and the record $45 billion offer for TXU didn’t hold things together last week. Private equity’s war chest still overflows, but it confronts a conundrum: Will targets be significantly cheaper in the weeks and months ahead? And, if so, will they be down enough to outweigh both higher borrowing costs, if historically narrow corporate and junk bond spreads widen (and they’ve started), while lenders, under growing regulatory pressure, begin demanding enforceable indentures, as opposed to the “convenant-lite” deals done so recently?

The Mortgage Massacre: That stuff about how the subprime problem wouldn’t spread was always a pack of lies, and can now be seen for what it is. How far can it spread? Well, it’s already in General Motors, the bank with an attached automaker, to the tune of something in the neighborhood of $1 billion. It seems likely that the boys and girls at Cerberus, among the largest hedge fund/private equity players, aren’t standing around the water-cooler saying what a great idea it was to buy half of GMAC last year.

Hank Paulson and the Bernanke Helicopters, the hot new boy band, already did a sound check: “the economy is healthy, employment is healthy, we're watching the situation closely, blah blah blah.” The concert? A rate cut, more Treasury repos, understanding tellers at the New York Fed’s window, and sooner rather than later if someone “too big to fail” steps on an IED.

CD* Contamination: It would be ironic if, the week after Warren Buffett toned down his usually vigorous condemnation of derivatives (Berkshire Hathaway Inc Shareholder Letter 2006 (see Page 16)), some of the problems percolating away in the various CD* – collateralized debt obligation, credit default swap – markets came bubbling to the surface. New York Federal Reserve Bank president Timothy F. Geithner and the International Swaps and Derivatives Association have both run victory laps over the last few months, claiming – accurately – significant progress in addressing issues identified in the Great Credit Derivatives Paperwork Snafu of 2005.

Progress, however, is far from ‘fixed’, and if, as at last seems more likely than not, the flow of credit events starts looking like a spring tide, it’s only a matter of time before the fallout: How much are these things worth (remembering Buffett’s past comments about the different valuations placed on illiquid instruments by buyers and sellers)? Who owns them, and are the current alleged sellers of alleged protection good for it? Past dislocations, such as the May 2005 Ford/General Motors imbroglio, were narrow and easily contained; all bets are off in the event of more widespread and complicated crumplage.

Financial services: Few sectors have been more consistently buoyant, and few sub-sectors more sterling than the broker-dealer community. From Jan. 1 2005, the Amex Broker-Dealer Index – a commonly-cited proxy – ran up 70 percent, from 152.60 to an intra-month high of 259.23, in Jan. 2007. It had pulled back a little more than 10 percent, to 231.55, by Friday, Mar. 2, but it has substantial exposure, both direct and indirect to, among others, the Monday Morning Put, the Mortgage Massacre and CD* Contamination.

Notably, some of the biggest names - including several...ahem...victims of the long-running insider trading ring busted last week - have pulled back more sharply than the index itself.

Yen frenzy: It’s my personal view that the yen carry trade got way too much credit for the market ramp, and its alleged unwinding is probably getting way too much blame on the way down. At least some of the yen’s recent gains are seasonal: Japanese companies traditionally repatriate cash for the Mar. 31 close of their fiscal years; given the generally friendly business conditions of the last 12 months, and the fact that the currency was, at least until last week, on sale, they’re probably repatriating rather more than usual this time around. A couple of things to keep in mind:

• Japan doubled its key bank lending rate, all the way to 50 bps, on Feb. 21. The DJIA has been down seven of the eight trading days since. Causation, or mere short-term correlation?
• Even at 50 bps, the Japanese currency is pretty much the cheapest in the G7 world. What’s really changing things is the exchange rate against other currencies, but its ramp did not start until Tuesday, Feb. 26 (it actually declined after the sort-of surprise rate announcements) implying that, to the extent the trade is being unwound, the unwinding followed – rather than led – other catalysts.

Hello Volatility!: Play with the VIX and the VXO all you want, but these numbers put the change in the market character in terms I can understand: from Dec. 1 2006 to the market peak on Feb. 20 2007, the average intraday trading range in the Dow Jones Industrial Average was 154 pts. Last week, it more than doubled to 316 pts, exacerbated by Tuesday’s 550 pt performance. Since Feb. 21, it has averaged 256 pts. If the patient dies, it’ll be of cardiac arrythmia, not boredom.

As this piece goes to pixel early Monday morning, Asian markets are solidly red with the Nikkei 225 off almost more than 600 points, or nearly more than 3.5 percent. US futures are showing S&P E-Minis off 11.25 13 pts; the Nasdaq-100 down another 16 and change 20; and the DJIA off by 120 or so. The dip-buyers will have something to work with in the morning.

Disclosure: NakedShorts is short GM, a bunch of homebuilders, and XHB, the homebuilders ETF. He would be short a whole lot more if it wasn’t for slack-jawed terror of private equity marauders, and whoever it was who bought the bottom-in-the-housing-market story between roughly Jul. 2006 and Jan. 2007. Slack-jawed terror.