The automakers continue to lobby Washington for some sort of bailout/bridge loan/handout.  I believe that the reason this is going so slowly (as opposed to the bank bailout) is a combination of factors. The economy has gotten worse, foreclosures are increasing, public opinion is not very favorable and the first bailout doesn’t seem to have had much of an effect on the overall market. I do think that in the end, the government will agree to an assistance package but whether or not this will actually help rescue the industry temporarily or permanently is anyone’s guess.

According to an article in Bloomberg.com, the demand for top rated commercial real estate bonds has also completely collapsed. According to Barclay’s analysts, the spread of these bonds relative to benchmarks is now 11.9%. In January, it was 0.82%. These numbers are reflected in demand. A record $237 billion bonds were sold in 2007. The number for 2008 year to date is $12.2 billion.

Finally, according to John Lonski, the chief investment  strategist at Moody’s, current yields on junk bonds imply a default rate of 21%. To put this in perspective, the default rate was 15.4% in 1933 during the depression.

The spread between high yield bonds and treasuries is now astronomical. This spread was around 220 basis points a year ago. It is now close to 2000. What this means is that investors are unwilling to buy any bonds they perceive as risky. Unfortunately, investors are now defining “risk” as anything that’s not US government guaranteed. Under this scenario, companies cannot borrow or refinance their existing debt.  Unless this changes, I believe that we are going to be facing bankruptcies of unprecedented levels.  In this type of scenario, I further believe that any talk of a bottom in the equity markets is simply way too premature.

“The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.”

If you focus on the last sentence, you will see that the Fed actually thinks the credit situation will get worse going forward! This is not exactly awe inspiring for the financial markets going forward.

In other news, the NY Post is reporting that New York is starting to feel the pain:

NY Post: New York Gov. David Paterson said Tuesday that the recession, overspending by the state and Wall Street’s meltdown will result in a record $47 billion deficit over the next four years.

He says the current budget’s shortfall is $1.5 billion and the next fiscal year beginning April 1 will include a $12.5 billion deficit. A month ago, the current deficit was estimated at $1.2 billion.

“New York is at the epicenter of an extraordinary financial crisis on Wall Street,” Paterson said in releasing the state’s mid-year financial reports during a New York City news conference. “We will have no choice but to take bold and aggressive action to reduce state spending.”

Finally, here is an article from the NY Times regarding the across the board layoffs throughout corporate America: Link

So where does this all end? How low can we go? While no one can be really sure, I believe that the going forward earnings on the S&P 500 could be around $60. If you put a price earnings multiple of 12 on that, you come up with a target of 720. However, in a severe recession, this multiple could easily be at 10, or even less. Just to put things in prospective, General Motors was the largest company in the US during the 1930′s. The stock actually got as low as five times earnings (with a dividend yield of 11%). Although I’m not saying we will get there, a P/E multiple of 10 on S&P earnings of 60 would give you a level of 600. The index closed at 930 today.

Yesterday, the market was up over 10%. What this means to today’s action is probably zero. So far every major rally has had no follow through at all the next day. We could be up or down several hundred points. In fact, even looking at the market at midday is not really a good indication. Most of the market’s volatility seems to come in the last hour of trading.

It looks like Obama is going to win the Presidential election next week. While no one can be quite sure what his economic policies will be, I don’t think either he or McCain really has a firm grasp on the world financial situation. Why do I say this? Because each candidate speaks of all these wonderful programs they are going to implement if elected. We are now facing, by far, the biggest deficit in history. How exactly are they going to pay for these programs? Raise taxes in an economy where people are already suffering? Many Americans are suffering through job losses, housing prices (home foreclosures are now at record levels) and the severe declines in their personal and pension accounts. I believe that we are probably going into a very difficult economic climate going forward. I will speak more about this later today.

In other news, although the credit markets are still easing slowly, the municipal bond market is still very tight. Most institutional investors are reluctant to buy right now, forcing municipalities to rely on individual investors to buy their bonds. Although yields are rich compared to several months, and bond salesmen like Lebenthal are hawking bonds to individual investors, I would continue to remain cautious as long as the biggest part of the market (institutions) are staying away. In many cases, municipalities are faced with the unpleasant prospect of either delaying a new offering for awhile (something many cities and states are hard pressed to do given their immediate cash needs) or floating bonds at interest rates that are way above what they budgeted for.

Merrill Lynch believes many European banks are in trouble. According to a recent report, they think several large European banks (such as Paribas, Barclays and Deutsche Bank) may need to raise around 100 billion dollars in order to maintain their capital base. Although most European governments have been offering a huge amount of financial assistance, the scope of these problems are far above what  anyone has previously contemplated. Therefore, there is concern about how far the governments can actually go before creating a possible inflationary scenario. I will try to speak about this later this week as well.

I will leave with some quotes from the NY Post about an equity trader:

Joe Mazzella leaned forward and pored over the stock data blinking on the computer screen in front of him. With a few minutes to go before the markets opened on Wall Street, the trader psyched himself up for another wild ride.

He described the frantic pace his colleagues have seen the past few weeks as “going like the hammers of hell.” Fast-paced markets with huge swings have become commonplace – but that doesn’t mean traders aren’t anxious.

Mazzella, a trader with Knight Capital Group, shifted uneasily in his chair. Last week, the Dow had ended an eight-day losing streak that had sliced 2,400 points from its value, and Monday it surged a record 936. Tuesday was a relatively mild day, with the blue chips falling just 76. Now, with trading about to begin Wednesday, it looked like another bad day was at hand.

Just seconds before opening bell, the noise level in Knight’s Jersey City, N.J., trading room ramped up, with traders barking last-minute orders over loudspeakers. When the bell sounded, it was met by something unexpected – silence.

“That’s scary, it’s too quiet in here,” said Mazzella, a managing director at Knight Capital. “Nobody knows what to do in these kind of markets, nobody is ready to sell or buy and we’re all just sitting here watching.”

“What’s humbling is that you could be the best trader, best investor, or best analyst in the world, and this market will still bring you to your knees,” Mazzella said.

Robert Competiello, another trader, commented to a passer-by that some days have been like “juggling knives while balancing on an egg.”

“We need a rally, I’m telling you, buddy,” Mazzella told another trader on the telephone as the Dow dropped 500 points.

That rally never came. The market swung back and forth in the final hour of trading before giving in to a stream of selling in the last minutes. At Knight, the day began to wind down as it began, with traders screaming out orders before the final bell – which left the Dow down 733, its second-largest point drop.

“We just cut to the low like a knife through butter,” Competiello said as the closing bell sounded.

Maybe, but I wouldn’t bet my last dollar on it. LIBOR remains very high at 4.41 for 6 months. As a measure of comparison, 6 month t-bills yield around .43. So, there is almost a 400 basis point difference between the two, which is still incredibly high. In addition, consumer spending is dropping, unemployment is increasing, and the credit markets will probably take some time to adjust. In other words, even if credit becomes more available, it’s not like every company and municipality that needs cash desperately is going to get it immediately. Thus, I still believe that many of the weaker companies (especially financial ones) may still face eventual bankruptcy. Hardly a day doesn’t go by where another large hedge fund announces that they are facing huge redemptions and/or liquidation. There is clearly still a lot of skittishness in the financial world. Any new event could well trigger another huge selloff. In regards to this, readers should be aware of the Lehman settlement.

The Credit Default Market is estimated to be in excess of $50 trillion. The Lehman Credit Default Swap (CDS) settlement will take place this Tuesday, Oct 21 in the amount of approximately $360 billion. This sounds like a staggering number, and it is, but it is also widely believed that many of these CDS were hedged. In other words, the institution that was on the hook for say $10 billion may have purchased $8 billion in order to hedge their bets. Thus, some amount of this settlement will probably be having money simply going back and forth to the same firm. However, it is also widely believed that AIG was a major seller and thus on the hook for a huge amount. This, incidentally, is why the Fed chose to bail them out.  Many hedge funds were probably net sellers. Thus, they are on the hook for large sums. One of the reasons why the market has been so volatile this past week is due to hedge fund liquidations in order to meet these calls due on Tuesday. Should any of the banks have huge exposure, this could lead to a major potential market selloff. On the other hand, if the settlement goes smoothly (i.e. everyone gets paid as expected) then the market might very well rally strongly. I will try to update this situation as we get closer.

Many people have asked me where to put their investment money now. If you wish personal advice, please call me at the number on the right side of this page. In the meantime, stay safe!

http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP%3AIND

As you can see, the TED spread has traded below 1 (which signifies 100 basis points) for quite some time. In August of 2007, the credit crunch began as real estate began to fall. The first casualty of this on Wall Street were the problems with Auction Rate Preferred securities. At that point, the spread moved up on investor concerned, but generally traded in a range of between 1 and 2. Now we are much higher than we ever have been. Therefore, a drop from 457 to 432 doesn’t really signify much to me.

Now we have given back virtually all of Monday’s gains. I believe that we are going to see continued extreme volatility for awhile. Many people have asked me to explain why this is happening. The following are the major reasons for this in my opinion:

1. The credit markets

2. The economy. Here are some quotes by the head of the Federal Reserve taken from Bloomberg.com:

The U.S. faces “a very serious too-big-to-fail problem,” in which the insolvency of a large financial company could threaten a market collapse, Bernanke said in reply to an audience question. “There are too many firms that are in some sense systemically critical.”

No Imminent Rebound

Government efforts to calm financial markets and stem the credit crisis probably won’t result in an immediate economic rebound, Bernanke said.

“Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away,” Bernanke said in his speech. “Economic activity will fall short of potential for a time.”

If the head of the Fed feels this way, why should I feel any differently?

3. The Hedge Funds: Hedge Funds are generally large pools of capital, frequently heavily leveraged, that pursue certain strategies. Although originally named for “hedge strategies” (meaning that at least theoretically, they should be taking less risk), this has basically flown out the window in the pursuit of profits. Although each hedge fund is different, many pursue very high risk strategies.

Many of these funds are now failing. In addition, as investors get their statements and see their losses, they begin to demand their funds back. Here’s a hypothetical example: ABC Hedge Fund manages a billion dollars. They are leveraged 5/1, meaning that they actually have purchased 5 billion dollars worth of securities. For 2 years, their investment strategies produce annual returns of 15%/year. This year, with the market collapse, they lose 25%. Lets say DEF pension fund has 200MM invested. They decide they want out, and send the fund a notice of redemption. In order to meet this redemption, ABC must sell at least 5 times as much (or 1 Billion), and, they must to do it in a declining market. This, in turn, drops prices further. As you can see, this can lead to massive liquidations. As there are probably thousands of hedge funds out there with trillions in capital, you can see how even moderate amounts of redemptions can lead to massive selling of securities. Just today, one of the supposed “safer” funds, Citadel, announced that their largest fund has declined by 30% this year. This is a fund that invests in convertible bonds, which is generally considered to be less risky than common stock because of the dividends received from the bonds. An additional problem is that it is extremely difficult to sell most bonds today.

4. The economy continues to get weaker. Earnings are falling short of expectations, and stocks are declining on this news.

5. Consumer spending continues to decline. Americans have been seduced by expensive advertising that has convinced most of us that we must have 2 cars, an expensive home, flat screen tvs, personal computers, etc, etc..Unfortunately, the average American has little to no net worth. In this time of uncertainty, people are cutting back.

6. Unemployment is rising.

7. Real Estate. I have spoken about this many times

8. The major banks are still way too heavily leveraged to even consider making additional loans. Hopefully, the Fed’s new plan to own actual equity in these banks may help.

On a positive note, the state of California managed to sell almost $2 billion of short term bonds at rates between 3.75 and 4.5 pct. Last year, similar bonds sold for a yield of approximately 3.37.  Gov.Schwarzenegger purchased $100,000 of these binds personally.

However, the very next quote is:

“I don’t even want to imagine what might happen” if the markets react negatively,

Klaus-Peter Mueller, head of the German banking association, said earlier today in Washington before the blueprint was unveiled. The market response may be something “we haven’t seen at any stage in our lifetimes.”

This is from today’s Financial Times:

“World leaders are scrambling to finalise rescue plans for their banking systems before stock markets open on Monday, amid fears that the global financial system is on the brink of collapse. Britain, meanwhile, was preparing to pump more than £37bn into four of the its largest banks in a broad-based recapitalization that could see the UK government end up with controlling stakes in Royal Bank of Scotland and HBOS – Oct 12 2008″

OK, so clearly the world governments are now doing something that would have been unthinkable previously. Essentially, they are going to take stakes in the major banks (perhaps controlling stakes) in order to provide much needed capital. Hopefully, this will allow (or possibly force?) the banks to begin lending again.

I believe this is a much needed step. However, there are major implications to this. As it stands now, the US has now guaranteed the following:

1. Fannie Mae and Freddie Mac
2. The commercial paper market
3. The money market funds

In addition, they are looking to take equity stakes in the major banks. So, effectively, the age of privatization has ended. Welcome to Big Brother, as the government will soon effectively control most of the lending mechanisms as well. I’m sure the Fed’s plan is to hope to shore up these markets such that they can gradually withdraw and allow these institutions to function in a manner similar to how they have functioned in the past.

There can be little doubt that many of the smaller banks and lending institutions will probably either be absorbed by larger ones, or simply go out of business. As mentioned Friday, Morgan Stanley is believed to be a critical state right now. Although they continue to claim that Mitsubishi is giving them nine billion dollars, I am skeptical, as the current market capitalization of all of Morgan right now is only slightly higher. It would not surprise me if they become the next casualty. I’m pretty sure they’re in talks Paulson right now.

Meanwhile, the VIX (a measure of market volatility) is over 70, an astronomical number. Even Jim Cramer thinks the Dow might drop to 5000.

I think this is a necessary step, but it probably needs to be combined with an unlimited FDIC guarantee on bank deposits as well. I do believe this will work, but as I have been saying, we are really running out of time. I think that if the markets don’t react positively this week, we could be looking at financial Armageddon.

This is from Bloomberg:

“I don’t wish to spread alarm on the line people but the big issue confronting the market is I’m afraid the health and sustainability of Morgan Stanley and Goldman Sachs, Hugh Hendry, Partner and CIO at Eclectica, told CNBC early Friday. “It is unimaginable that they can be allowed to go, I suspect that they will be nationalized at some point today or over the weekend,” he added.

Last Friday, Paulson announced his new initiative, which is to use part of the 700 billion in TARP to actually buy equity stakes in these banks. One must realize at this point that the Fed is grasping at straws. Clearly, they have used up an amazing array of measures in an incredibly short period of time. Yet, this far, none have appeared to have any calming effect at all. I view this as a much needed positive sign.

If not, the crisis will actually get worse, as more and more companies and municipalities are forced to roll over debt in a credit market where there are very few buyers. Early indications on Dow futures show a decline of over 200 points going into Monday.

We are in an extremely precarious situation right now. The risks of a complete global depression cannot be ruled out. Hopefully, this can be averted. We are running out of time.

Unlike standard insurance policies, companies were generally not required to post any significant capital originally (it might even be zero; no one seems to be really sure). Therefore, no one is really quite sure if some of these policies will actually be paid. If, for example, Morgan Stanley has significant exposure (as is rumored), can they really pay off possibly tens of billions? And if they don’t, will the Fed bail them out or will they go under? If they were to go under, you would see a whole new set of CDS come due. Lending is already ground to a standstill. If for whatever reason CDS do not pay, I would shudder to think what would happen. As I write this, the TED spread is now 457 basis points, an all time high.

Of course, these are all hypothetical questions. I’m watching and waiting.