As the World Falls Into Recession…….
Oct 7, 2008
Posted by Jody Eisenman | Filed under crisis
Events are moving rapidly. I am reminded of a famous book called Future Shock by Alvin Toffler, who speaks that the acceleration level of change will increase dramatically. Events are now unfolding so quickly that I believe the Fed may have lost control of any ability to control this financial tsunami. Here is a summary of the last 24 hours:
1. The country of Iceland (known as the key to Europe in old table game called Risk) is on the verge of bankruptcy. They have apparently looked toward Russia (whose own stock market has collapsed) for a bailout.
2. As stated yesterday, Bank of America seems to be headed toward a potential crisis point. The stock dropped another 26% today. After the close, the stock dropped another point and a half on news of its secondary offering being priced at $22. Less than a week ago, B of A was considered a safe haven and was trading above $38.
3. The Dow lost over 500 points.The S&P 500 slid 60.66 points, or 5.7%, to 996.23, extending its 2008 tumble to 32% in the market’s worst yearly slump since 1937. The S&P 500 has tumbled 36% from its record high last year. Earnings at S&P 500 companies probably dropped on average of 5.6% in the third quarter, according to Zacks Investment Service. Financial companies are forecast to lead the drop in profits with a 64% decrease, followed by an 11% slide in earnings at retailers, hoteliers, restaurant chains and other so-called consumer discretionary companies. Based on estimated profit, the S&P 500’s PE ratio is 11.9x. How cheap is cheap? Perhaps something south of 10x–well south.
4. In a effort to ease the credit crisis, the Fed took the unprecedented step of guaranteeing commercial paper. This paper is issued by many, if not most Fortune 500 companies in order to fund day to day operations. This is the statement from the Fed:
“The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve’s existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.
While it’s not clear exactly how this would work, the Fed is saying that it will guarantee this paper across the board.
This has never happened in US history, and to me, this shows just how desperate the financial crisis really is. Without Federal intervention, I believe that much of this paper could default, leading to a rash of corporate bankruptcies this month. How exactly the Fed is going to pay for this is also unclear.
5. The credit crisis has led to an incredible increase in yields on bonds across the board. For example, two year A rated corporate bonds currently yield around 10%. Just a month ago, that yield was only 5%. I cannot find any point in US financial history when yields on investment grade paper have increased so rapidly.
Here’s another example: Let’s say you think that the financial stocks are a buy here (I don’t). You look at Morgan Stanley, which closed today around 17.60, down from a yearly high of 67. Well, instead of buying the stock, you could buy Morgan Stanley 3 month bonds which mature in January of 2009. These A rated bonds traded today to yield an incredible 42%! With yields like this, why buy equities?
6. The Fed is apparently considering a rate cut from 2% to 1.5%, or perhaps 1.25%.
According to my good friend and prominent economist Steven Nagourney, “On the surface, the case for a rate cut seems obvious. But, despite an extraordinary and historic two weeks on Wall Street, Bernanke & Co. have failed to deliver. And perhaps the lack of action today, a day of panic in global equity markets, is telling us something about policy – don’t look for a rate cut, at least not yet. Maybe we should be listening.
1. If there is one thing the Fed has taught us in the last year, it is that they are inclined to meet periods of financial turbulence with a rate cut. Hence growing expectation for a rate cut, expectations that were only heightened by the string of data that confirmed for almost all remaining doubters that the US economy had slid into recession by at least the third quarter, if not much earlier. Last week’s employment and ISM reports for September appeared to seal the deal on that call.
Relatively dovish Fed-speak appeared to confirm these expectations. And if a rate cut was coming, why wait until the end of the month, especially when equity markets needed a boost of confidence? Yet no rate cut emerged. Instead, some Fed speakers have come out against a rate cut, such as St. Louis Fed President James Bullard and Richmond Fed President Jeffrey Lacker. To be sure, perhaps they are simply out of step with the Board. But perhaps the Fed has come to the conclusion that, at least for now, interest rates are not the problem, especially since, relative to the rate of decline in the real economy, the Fed is well ahead of where it would normally be at this point in the cycle.
It is arguable that rate cuts have done little to stem the tide of deleveraging that is ravaging the banking system. Indeed, despite a policy path that appears determined not to remake the Fed’s mistake during the 1930’s by taking rates down quickly and flooding the financial markets with liquidity, the crisis continues unabated, as if the more the Fed does, the more financial markets need done. To be sure, perhaps the situation would be worse if not for the Fed’s actions, but those actions failed to produce anything remotely near the quick fix I think was originally envisioned by Fed Chairman Ben Bernanke. Some even think the Fed is making the situation worse via their liquidity provisions, prolonging the lack of interbank lending by providing an escape valve. Why try to reduce counter party risk when the Fed stands ready to be the riskless partner?
The lack of a rate cut at this juncture suggests the Fed is readying a new bag of tricks. They let us sneak a peek at that bag today, using the new powers granted by TARP to pay interest on deposits, thereby setting a lower bound on the Fed Funds rate that should nearly reduce the Fed’s need to sterilize their liquidity provisions via term auction facilities. At the same time, they extended the size of the TAF. These are clear efforts to fix broken credit channels, and this is likely the Fed’s focus, not interest rates.
But, as noted above, will an expansion of the existing liquidity provisions, or additional rate cuts, have any impact? Or are they simply more of already failed policies? The Fed is likely preparing for a significant new initiative, consistent with reports that the Fed, with the cooperation of Treasury, is preparing a program to purchase a broader class of assets than simply troubled mortgage backed securities. Outright purchases of commercial paper is what came to be on the table – not surprising as the growing credit crunch in this market threatens working capital, the lifeblood of daily commerce.
Would outright purchases be inflationary? Here is where the Fed would believe that the ability to pay interest on deposits is important – short term interest rates cannot fall much below the Fed Funds rate, as any excess money would simply flow into reserves at the Fed. The ability to pay deposits should automatically sterilize any excess money creation. This might also explain why the Fed would be hesitant to cut rates at this point; policymakers would want to see if the new system worked as expected before changing policy rates. We are in uncharted territory here, but if excess money created simply flows automatically back into the Fed’s coffers, inflation should not be a concern (assuming that outright purchases are equivalent to term lending). If credit channels suddenly loosen up, then interest rates may prove to be too low and inflationary, but the Fed hopefully, could react quickly by raising the Fed Funds rate and the interest rates they pay depositors.
Bernanke expects further rate cuts. Of course, it is impossible to rule out a rate cut, and it seems like a cut should be the baseline case. Indeed, the case for a rate cut should be a slam dunk, expect for a.) rates are already low and b.) we haven’t seen a rate cut yet. The latter point, especially given the intensity of the crisis over the last two weeks, suggests that looking for a rate cut is simply a case of barking up the wrong tree. It is what we have been conditioned to look for, and hence we are expecting it. But there is nothing like an inconvenient fact to undermine a perfectly good theory. With today’s action the Fed has simply moved well beyond rate cuts in searching for solutions to the current crisis, and outright asset purchases is looking like that next move.”
I believe that the government may have little choice but to take over the entire US banking system. The alternative may well be a depression.
