Archive for the ‘crisis’ Category
Why the Market Continues to Drop
Posted by Jody Eisenman | Filed under crisis
There was a lot of euphoria after Monday’s rise of over 900 points on the Dow. Late in the day, I posted that I would still be very cautious until I saw movements in the credit markets. In the last 2 days, the credit markets have eased, but not by much. The TED spread has dropped from 457 basis point to 432. Remember, this number was around 110 about a month ago. Here is a link to a chart:
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.
All Eyes Turn to Europe
Posted by Jody Eisenman | Filed under crisis
In a bold new initiative, a 15 country consortium have now agreed to guarantee new bank debt through 2009. According to Bloomberg, “The key measures announced today are: a pledge to guarantee new bank debt issuance until the end of 2009; permission for governments to shore up banks by buying preferred shares; and a commitment to recapitalize any “systemically” critical banks in distress.“
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.
MISTER MARKET’S WILD RIDE
Posted by Jody Eisenman | Filed under crisis
In an unprecedented trading day Friday, the Dow Jones shot up and down like a bungee cord. In the end, the Dow closed down 128 points after going through a 1000 point spread. Lehman’s CDS auction was set at 8.625, meaning that over 91% of the face value must be paid out. Whether or not all these can be settled is an open question that will be decided later this month. Despite all the Federal Reserve’s efforts, including a $700 billion bailout, the guaranteeing of commercial paper, and the increase in FDIC insurance, the credit markets have not improved. In fact, they have gotten significantly worse. In addition, we are witnessing a de-leveraging of financial assets at a dramatic pace. Simply put, you are seeing massive margin calls taking place that are leading to forced selling. This is due to both over leveraging and significant redemptions coming from investors in hedge and mutual funds. As these redemption notices come in, these funds are forced to sell into very weak markets. Of course, this leads to lower prices, which in turn begets more redemptions.
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.
