Wednesday, September 24, 2008

Bailout or Bust?


More drama on Capitol Hill tonight as President Bush will address the nation to pitch the bailout and Senator McCain temporarily suspends his campaign, postponing the first debate, to come back to Washington to deal with the crisis.

Meanwhile, Treasury Secretary Henry Paulson had agreed to demands from lawmakers in both parties to limit the pay of executives whose companies benefit from the bailout:
"The American people are angry about executive compensation, and rightfully so," Paulson told the House Financial Services Committee. "Many of you cite this as a serious problem, and I agree. We must find a way to address this in legislation without undermining the effectiveness of the program."
Earlier today, the Federal Reserve chairman, Ben Bernanke, urged Congress to take quick action on the proposed $700 billion economic recovery plan, uttering this dire warning.

"Despite the efforts of the Federal Reserve, the Treasury and other agencies, global financial markets remain under extraordinary stress," Bernanke told the Joint Economic Committee. "Action by the Congress is urgently required to stabilize the situation and avert what otherwise could be very serious consequences for our financial markets and our economy."

Chairman Bernanke has every reason to be concerned. As the , stock market sags amid growing bailout skepticism, swaps spreads widened to a record, Libor jumped as banks continue to hoard cash and demand for T-bills soared today as investors get increasingly jittery.

The fallout from upheaval in the financial industry is spreading to the U.S. municipal market where municipal bond yields rose to a six year high.

The jump in Libor rates is wreaking havoc on the real economy as U.S. and U.K. homeowners get set to remortgage their loans.

Moreover, Citigroup estimates that hedge funds have now placed $600bn in cash, and that $100bn of this is held in money market funds, normally seen as some of the safest places to invest cash.

And hedge funds are not the only ones raising cash:

US mutual fund managers are also holding near to record levels of cash. The average actively managed stock fund has 5.4 per cent of its portfolio in cash, according to Morningstar. That is marginally below the record of 5.5 per cent at the end of 2007.

What else are hedge funds doing? According to The London Times, hedge funds are sticking to their short-sell strategy:

Some of the world's most aggressive hedge fund managers have stuck with substantial bets that the share price of Britain's largest financial institutions will fall, despite a four-month ban on short-selling imposed by the City regulator.

Paulson & Co, the US fund run by John Paulson, who made an estimated personal fortune of more than $3 billion by betting against the American mortgage market last year, is one of two hedge funds to have gambled heavily against the price of Barclays, the UK's third-largest bank. The fund yesterday disclosed a 1.18 per cent short position in Barclays, equating to just under £374 million of the bank's underlying value.

Lansdowne Partners, the hedge fund investor known for its long-term position against Northern Rock, has also been betting against Barclays, whose shares have taken a pummelling in recent months. The fund, which spent four years betting on the decline of Rock, now nationalised, is short in 0.5 per cent of Barclays. This means that it has sold shares worth £151 million, expecting to buy them back more cheaply at a later stage.

All this leads me to agree with Toro's Running of the Bulls Market Blog's comment, Worst Credit Crisis Since Depression, Stocks Down Less Than Average:

What's wrong with this picture?

I keep hearing the powers that be that this is the worse credit crisis since The Depression. When I look at the credit markets, it is easy to see the tremendous stress. For example the TED spread - the difference between Eurodollar LIBOR rates and 3 months T-bills and a proxy for risk in the inter-bank market - was as high as 3.09% today, up from the close of 2.50% yesterday, and at levels we saw last Wednesday and Thursday when the end of the world was supposedly upon us. Also, corporate spreads are as wide as they have been in at least decades.

Yet, from the peak in October, stocks are down less than 25%. According to a piece I read from Ned Davis Research today, the average return in bear market since World War II has been a decline of 27%. Also according to NDR, the duration of this bear market has lasted a little less than the average bear market.

We are in recession, the broad market is not cheap and de-leveraging is ahead of us.

So, why do the bulls tell us that the bottom is near?

Please enlighten me. I'm confused.

I believe that stock investors are betting that some form of bailout is imminent. Let's hope so or else the "Mother of All Bailouts" will turn into the "Mother of All Busts".

Let me end this brief comment with some sunny news. Yesterday, the U.S. Senate approved a tax credit package that included an 8-year extension for solar energy investment tax credits:

The measure still requires House approval; according to Reuters, the White House has pledged to support the measure.
Solar shares rallied on the news but gave up some gains in afternoon trading as bailout concerns took precedence.

I still believe solar stocks are in the early stages of a long-term secular bull run, however, in this environment no sector will escape a selloff if the bailout turns into a bust. Tread carefully.

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