Nightmare On Wall Street
NIGHTMARE ON WALL STREET
The events of the past couple of weeks or so are piling up so quickly, our head is spinning. The daily gyrations of the market has everyone running for the Maalox, we are sure. Occasionally we have had to grip our desk. Maybe it is a good thing that unlike 1929, windows in office towers do not open. So is this it - financial Armageddon, a true nightmare on Wall Street?
The temptation is to say that we told you so, but gloating is not a very good trait. A new wave of financial instruments and complex financial derivatives that no one understood except the “masters of the universe” were of course at the root of the collapse. But it was more than just that. It was as if everything conspired at once to give us the perfect storm. Deregulation, highlighted by the repeal of the Glass-Steagall Act (which kept retail and investment banks separate); a long period of low interest rates; seemingly unlimited injections of liquidity into the financial system highlighted by some of most rapid and persistent monetary growth ever seen; and the aforementioned “financial weapons of mass destruction” as Warren Buffet called them that were used to help create an extraordinary array of products, many of which were peddled to Main Street from Wall Street.
Trying to keep track of all of these recent events, it seems like you need an advanced degree in finance just to figure out what is going on. But let's go back to July 2007. If you had asked us then if I thought Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers and Merrill Lynch would all disappear in a huge financial crisis within 14 months,we might have said that maybe one of them would. But all of them? That's just crazy.
We are on record as saying that a brokerage firm might go under because of the mess that was being unleashed. But if the collapse of Bear Stearns was flabbergasting, then the nationalization of Freddie and Fannie, the bankruptcy of Lehman Brothers, the swallowing of Merrill Lynch and the effective nationalization of American International Group (AIG) - well, we were just dumbfounded.
There will be those who now say that while the situation is bad, that the financial system has been bruised and humbled, we will recover. The world is not coming to an end, they will say. Well, we don't have a problem with that. We can point to the Great Tech Crash of 2000-02, when some $4 trillion of capital blew up. So far this one has eaten up about $2 trillion. The economy didn't crash and burn then and, so the story line goes, it won't crash this time either. Instead of looking upon this as a disaster, look upon it as an opportunity.
Some perspective is required. The Great Tech Crash saw the S&P 500 halved and the NASDAQ lose 80 per cent, together with the loss of numerous well-paying jobs. Some dot-com billionaires were reduced to mere mortals again. Some high-profile CEOs and CFOs went off to jail. But the banking system and the investment dealers, while absorbing some body blows, were at the end of the day still in pretty good shape. Some companies collapsed, such as WorldCom and Enron, and then Enron's collapse caused the demise of Andersen & Partners. Others were reduced to shadows of their former selves, like Nortel Networks. And don't forget that during that time we absorbed 9/11, although it was not a financial event.
In some respects that period helped set up today's events. The Federal Reserve pumped the system full of liquidity, lowered interest rates to abnormally low levels and then left them there. The deregulated banks and investment dealers and the no-regulation hedge funds and private equity funds, all abetted by the “masters of the universe,” realized that the Fed would keep rates low and supply plenty of liquidity whenever a problem came up. They took advantage of the situation, leveraging up their balance sheets and working overtime to come up with new and wonderful derivatives to move assets off of balance sheets so that they could do the leveraging game all over again. They were truly in their glory.
Except they forgot one thing. Main Street. While Main Street was the happy recipient of the largesse of the new financial order, they had no idea how to manage it. The housing market boomed, fuelled by the excess demand created by the vast array of new mortgage instruments (sub-prime, ARMs, etc). The mentality of “don't worry, play now, pay later” took hold. US household debt virtually doubled from the end of 2000 to Q2 2008 to $14 trillion (source: Flow of Funds Accounts). Eventually the bill came due. The low interest rates didn't last for ever, and when they went up on the house they couldn't afford in the first place, the defaults mounted far beyond the financial models of the “masters of the universe”. The credit line was now tapped out. The house of cards came unglued.
So this is different than the Great Tech Crash. While millions were lost, there was little contagion beyond the industry itself. This time it's the financial system and the housing market, and they are imploding at a breathtaking pace. With the credit collapse the financial institutions have tightened credit considerably and many who need credit including numerous healthy corporations can not obtain it. Because this is a financial/debt collapse it does have the real danger of spreading well beyond both the financial and housing industries. It has in fact begun to look like an old fashioned credit crunch.
The stock market is still way above the lows of 2002. The S&P 500 is only half way towards its lows; the NASDAQ has given up roughly one-third of its gains, while the Dow Jones Industrials has given up about half its gains since 2002. The Dow Jones Transportations is barely off its highs. But because it is the financial system imploding, the Federal Reserve and the US Treasury have had to get involved like never before.
Some have called it the socialization of Wall Street. They threw the laws of capitalism out the door and brought in the supposedly bottomless pockets of the taxpayer. To make taxpayers feel better, they are telling them that the alternative would be worse. And as a trade off there will be enormous pressure to re-regulate the financial industry.
So what did they do? Well quite a bit. One can call it prudent, the rebuilding of confidence, or one can call it panic, a sham, a debacle of immense proportions and political opportunism in an election year. It may be all of the above and more. We couldn't help but notice the obvious uncomfortableness of Henry Paulson as he made his announcements on Friday.
They nationalized Fannie Mae (FNM-NYSE) and Freddie Mac (FRE-NYSE). These two mortgage giants, which were always considered quasi-government agencies, financed over half of all US mortgages and had debts of around $5.3 trillion. They were well known for their political lobbying to get what they wanted. They were always undercapitalized, and when the losses mounted their capital was wiped out. In order to prevent a massive flight out of US agency paper (estimated some $400 billion held by China and Russia alone) and to calm international markets the Fed took the step of conservatorship, which is nationalization in all but name. The debts of Freddie and Fannie will be taken on to the books of the US Treasury although officially they are only adding $800 billion to the debt limit to accommodate losses. The shareholders were wiped out, and many banks holding the preferred shares as part of their capital base are now put in jeopardy. Losses have been estimated to be at least $100 billion but some analysts say they could go as high as $1.5 trillion. The taxpayer will be on the hook. Unanswered is whether Fannie and Freddie will continue to act as the lender of last resort for the mortgage market and take on many more billions of bad debt off the books of lenders.
Lehman Brothers, the fourth-largest investment dealer in the US, was allowed to go into Chapter 11 bankruptcy. Unlike the Fed's backing of the takeover of Bear Stearns by J P Morgan, for some reason it was decided they could allow Lehman to go under. Its shareholders were wiped out. It was booted off the NYSE and now trades on the OTC Pink Sheets. It is the largest bankruptcy in US history - larger than WorldCom and Enron the icons of the Great Tech Collapse. The collapse of Lehman led to questions: if Bear Stearns was too big to fail, why was Lehman allowed to fail? Barclays Bank is taking over Lehman's trading and investment banking assets. No word yet on the toxic part of Lehman's portfolio that wiped out its capital.
American International Group (AIG-NYSE), the world's 18th-largest company with assets over $1 trillion, was also in effect nationalized following a liquidity crisis and debt downgrade. In order to prevent a collapse, the Fed provided a credit facility of $85 billion in exchange for warrants and a 79.9 per cent stake in the company. The shareholders have been wiped out. The firm was 74 per cent held by institutions, primarily pension and mutual funds. Unanswered is how will AIG pay back the credit facility and there is the risk that $85 billion is insufficient.
The Federal Reserve and the G7 central banks provided huge injections of liquidity to balance the banking system and boost confidence. These injections, estimated to be in the area of $180 billion, were probably accomplished through repurchase agreements. We were unable to determine the quality of the collateral. The Federal Reserve for one has since this crisis broke in August 2007 taken on billions of dollars weak debt collateral while exchanging it for good US Treasury securities. Ultimately this could imperil the balance of the Federal Reserve itself.
The Fed left the funds rate unchanged this past week at 2.0 per cent. As global investors rushed to the safety of US Treasuries during the stock meltdown, interest rates on three-month and six-month Treasury Bills fell almost to zero. By week's end, yields were back up around 0.8 per cent for 3 month Treasury Bills.
In order to assist the Federal Reserve and at the request of the Federal Reserve, the US Treasury announced that it would initiate a series of temporary supplementary financing programs (in effect a series of special cash management T-Bills) over and above their regular issuance of Treasury Bills. This has led to the perception that the US Treasury is now bailing out the Federal Reserve.
The US Treasury announced plans for a multi-billion dollar taxpayer-funded program that will deal with the credit crisis. This will go before Congress this coming week. They are seeking $700 billion and another hike in the US debt limit to $11.3 trillion. They also announced a $50 billion program to shore up the $3.5 trillion money market deposit market. The funds would be used to back up funds which market money market mutual funds whose asset values had fallen below $1 a share. There is of course no guarantee that the measure will pass Congress without considerable trade offs. Actual passing of the emergency funds could in effect take weeks unless Congress is hurried into accepting the package. There is also no assurances that this number could not rise in the coming weeks and months.
Securities regulators came down on the practice of naked short-selling. Short-selling of numerous financial securities was banned outright. The London Stock Exchange also announced measures to deal with short-selling as did the TSX.
All in all, an absolutely incredible week. While the measures may have helped save us from a complete meltdown, there are considerable problems with a lot of this.
The bailout plan is being both praised and damned. Praised, because it averts what clearly may have turned into a major financial collapse. Damned, because it is a taxpayer-led bailout. Losses to the taxpayer could be at least $1 trillion and quite possibly higher well beyond the $700 billion currently mentioned. Nothing is said about what price they would pay for this toxic paper. There is no guarantee that Congress will approve this insane plan (some are calling it treasonous) although given the huge political donations to Congress and the Presidential candidates from the financial industry, the odds of the plan being rejected are probably very low.
The trade-off is that regulation will come back to the banks and remaining investment dealers, and probably to the hedge funds and private equity funds. There is no guarantee on the regulation, however, because the US is notorious for its furious lobbying and watering down of any regulation.
Some cite the potential to recover monies on this toxic paper at some point in the future, if things slowly turn around. This is a maybe, and not assured. Another justification for the deal is that it will allow the banks get back to the business of lending. Given the current credit crunch, loan granting has ground to a halt. Again, there is no assurance that they will start lending again. Conditions have changed, credit rules have tightened considerably, and the odds of them returning to the giveaways that occurred prior to this crisis is nil.
This is still the biggest crisis since the Great Depression and obviously the stakes are high. Some have compared it to the 1907 financial panic; it too was caused by a multitude of new financial instruments that blew up. It required the co-operation of a consortium of banks led by J P Morgan, plus an incredible (for the time) $35 million infusion from the government. We remind everyone that the stock market fell by 50 per cent during that crisis. In this current crisis we have fallen by about half that. Before this is finished, and it may take a few more years, we fully expect the stock market to lose at least 50 per cent.
The 1907 crisis led directly to the creation of the Federal Reserve in 1913.
Given the massive increase in the US debt ceiling in the past week because of Freddie and Fannie and the bank bailout the reaction in the bond market was vicious. US Treasury bond yields rose at their sharpest rate in 23 years. Yields had been falling earlier in the week, but then two-year bond yields rose some 44 bp on Friday to 2.16 per cent. Ten-year notes rose to 3.78 per cent, up 21 bp in a day. The bond market that didn't seem to react negatively to the bailout of Fannie, Freddie and AIG did react to news of the proposed bailout. The contagion on bonds spread into Canada as well, and bonds had one of their nastiest down weeks in years. The signal was clear: the great bond rally is over.
Given the negative reaction, we are not surprised to read stories that US debt may have to be downgraded. Some of this reaction came direct from S&P themselves. We note that credit default spreads on US Government debt has leaped to 26 bp the largest in memory. This is up from 17 bp only a week or so ago. Further, there are now serious questions in international circles questioning the right of the US dollar to remain the world's reserve currency. We can only guess that adding Fannie and Freddie's debt of $5.3 trillion (although pegged at only $800 billion for now), plus potentially at least another $1 trillion to come, will do that to you. As well the US budget deficit is already projected to be over $400 billion this coming year and could rise even further. It came as no surprise that the dollar had a monumental reversal over the past week and plunged.
The debt of the US is currently at $9.7 trillion before adding Fannie and Freddie, AIG and this bailout. It constitutes around 68 per cent of US GDP. Debt held by the public is roughly $5.3 trillion or about 37 per cent of GDP. Neither figure is particular devastating in itself. Around 40 per cent of debt is held by foreigner's primarily central banks particularly the Bank of Japan and the Bank of China. The budget deficit while the highest in the world is still only around 3 per cent of GDP again not particularly high. As well the US could virtually eliminate the budget deficit with a tax on gasoline bringing their prices more in line with Canada. What is not accountable in all of this is the unfunded liabilities of social security and medicare and others which brings it to $59 trillion. While the US debt is the highest in the world even we don't believe it is as drastic as some make it out to be although the unfunded liabilities should be of concern.
The US is experiencing some bleeding of assets. Reported figures show that it is continuing to experience net capital outflows. Purchases of foreign agency debt, stocks and corporate bonds all plunged in the past couple of months. Only heavy inflows into US Treasuries kept things afloat. We suspect that what was coming in was also geared to help the dollar. After a couple of weeks of declines, the Fed in its most recent report said that there was a $14 billion inflow from foreign official and other international institutions. Of that, over $3 billion was actually in agency paper. But given the plunge this past week in the dollar, there may have been significant flows out elsewhere.
The huge move in the markets on Thursday and Friday was we suspect primarily short covering because of the new rules on short selling, and expectation that officials will be successful in pushing through the new agency to buy all the toxic debt. We suspect that the follow through will be pretty muted into next week, and if Congress balks at this insanity (not that we expect them to) then this market could reverse to the downside quite quickly. But overall we expect foreigners to continue to use rallies to sell. We believe they want out. We also note that all this relief rally has done is bring us back to the breakdown point - a classic area of failure.
This brings us to the two bull markets that have been suffering in the past few weeks: gold and oil. Gold earlier in the week had one of its biggest up days ever, rising $85 an ounce. Gold was responding to fears that the announced bailouts were the beginning of the US Weimar Republic. With a bailout of this magnitude, thoughts of Weimar hyperinflation were utmost in a number of analysts' minds. We also understand that fear of a US meltdown was driving demand particularly out of the Middle East and Asia.
Gold, if you recall, is the only currency that has no liability attached to it. The US$ has nothing but debt, and with the addition of Fannie and Freddie and AIG and the bank bailouts, debt is just getting bigger. As we have asked before, which currency would you rather have - the debt-laden US$ or gold, a currency that has been around for thousands of years?
Not surprisingly, gold ran into sharp resistance at $900, its former breakdown zone. Initially it backed off but by Friday a falling US dollar and the panic move by government officials to bail out the financial institutions that caused the problem in the first place had gold rising again in price. Actually we would be happy to see an orderly gold rise; if it rises too quickly it attracts too much attention. Slow and steady would be better, but it is a very small market and if everyone piles in at once we could see a buying panic. Over the past few weeks the commercial COT has shifted to the long side (well, as much as they ever seem to be) with 38 per cent bulls in the latest COT report.
This tells us that gold and gold stocks should be bought on any pull backs, and on strength as well. We have read a number of analysts' reports on gold recently and while we were mistaken in our interpretation of the market that led us to miss this recent sharp drop, we are buoyed that many of them now see clearer days ahead. We acknowledged weakness in the market and long held the view that we would see a low in August or maybe September.
But one thing we all seem to agree on is that we could be on the cusp of a much bigger move. What we can't tell here is whether the huge ABC correction was it merely the A wave of a much larger degree, with a larger B wave and C wave to come? We also note that we could get a classic symmetrical triangle ABCDE type of correction as well. This would only be the bottom of the A wave. No matter how we look at it, we are embarking on a new wave to the upside. As the wave progresses we hope to be able to clarify the nature of the move.
Oil prices also improved sharply this week, including a big $6 increase on Friday. Oil was being driven by the overall improvement in the market that might translate into an improving economy and thus restore demand. As well the lingering impacts of Hurricane Ike on refineries saw a sharp drop in both oil and gasoline supplies as reported by the EIA this past week. We also note that war has once again broken out in Nigeria, and Nigeria provides almost five per cent of US supplies. Further in the background, the potential for a confrontation against both Iran and Russia has not gone away. If anything in reading intelligence reports from Stratfor and others the potential for war is looming larger even as these manoeuvres continue to occur far from the public eye.
If oil is rising because of a perceived demand increase due to an improvement in the economy, then that is of course fraught with dangers if bailout plan falls apart. But given the extremes in indicators for oil, gas and the energy stocks, a rally was overdue. Oil has resistance at $110 and natural gas at $8.00. Getting over those levels would be a positive development but overall we need oil to regain above $120 to tell us that we could be on a new up trend.
This past week has been historic for its volatility. The bailout of the US economy appears to be under way and the US seems bent on monetizing the debt. Bonds reacted immediately and viciously with a sharp sell-off. Gold is the only protector. Now I need a Maalox.
David Chapman is a director of Bullion Management Group the manager of the BMG BullionFund www.bmsinc.ca
Note: Chart created using Omega TradeStation. Chart data supplied by Dial Data.
Note: The opinions, estimates and projections stated are those of David Chapman as of the date hereof and are subject to change without notice. David Chapman, as a registered representative of Union Securities Ltd. makes every effort to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete.
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