Wednesday, September 17, 2008

Great Crash of 2008?

The nightmare on Wall Street continued today as the DJIA plunged by almost 450 points, one day after the Fed guaranteed an $85 billion bridge loan to AIG.

Once again, today's action was volatile and brutal, particularly in the financial sector where shares of brokerage giants Goldman Sachs (GS) and Morgan Stanley (MS) plunged by 18% and 26% respectively.

It was panic trading today as investors fled into gold and U.S. T-bills, worried that even money market funds are exposed to the credit crisis:

Three-month bill rates may be the lowest since the 1930s based on monthly figures on the Fed Board of Governors' Web site. Daily figures go back as far as 1954.

Reserve Primary Fund, the oldest U.S. money-market fund, yesterday became the first in 14 years to expose investors to losses after writing off $785 million of debt issued by Lehman.

Shareholders pulled more than 60 percent of the fund's $64.8 billion in assets in the two days since Lehman folded. Losses on the securities firm's debt forced the fund to break the buck, meaning its net asset value fell below the $1 a share price paid by investors.

"The panic going round the money market world is what they've been investing in is not as safe as they thought it would be,'' said Dominic Konstam, the head of interest-rate strategy in New York at Credit Suisse Securities USA LLC, another primary dealer.

"If the banks don't want to lend to each other they don't want to lend to the banks. That means where else are they going to put their money -- they're going to put it in T-bills for safety.''

The cost of borrowing in dollars for three months jumped the most since 1999 as banks hoard cash. The London interbank offered rate, or Libor, rose 19 basis points to 3.06 percent, the British Bankers' Association said. The increase is the biggest since Sept. 29, 1999, during the run-up to the new millennium.

The jump in Libor and rising demand for bills widened the gap between what the U.S. and banks pay to borrow in dollars for three months to the most since the October 1987 stock-market crash. The so-called TED spread soared 85 basis points to 303 basis points. It was as low as 75 basis points on May 27.

"I'm extremely worried about what is happening to the money market mutual funds that have announced they've broken the buck,'' said Ajay Rajadhyaksha, head of fixed-income strategy at Barclays Capital Inc. in New York. "That unfortunately can spiral in the sense that it makes it more difficult for all companies to raise short-term money because the money-market funds tend to be buyers of short term debt.''

The cost of protecting against a default by Wall Street firms Morgan Stanley, Goldman Sachs, Wachovia Corp. and Citigroup Inc. approached or surpassed record highs reached yesterday, trading in credit default swaps shows.

The Treasury's $31 billion sale of four-week bills yesterday drew a high discount rate of 0.3 percent, the lowest in the four-week auction's history.

In another sign of risk aversion, yields on emerging-market bonds have soared as investors moved money into Treasuries. The yield on Russia's 7.5 percent dollar bonds due in 2030 has jumped 91 basis points to a four-year high of 6.97 percent, according to JPMorgan Chase & Co. data. Yields on Venezuela's 9.25 percent bonds due in 2027 have surged 2.24 percentage points this week to 13.53 percent, the highest since May 2003.

Why are investors so jittery? Part of the problem is that the "AIG bailout" does not cure the underlying problem plaguing the global financial system:

The AIG rescue "smacks of sweeping the problem under the carpet rather than solving it in a structural sense,'' said Padhraic Garvey, head of investment-grade debt strategy at ING Bank NV in Amsterdam, in a note to clients. "We are still in the midst of the flight-to-quality environment.''

Is this 'flight to quality' just a gross hysterical overreaction? Some think so.

UBS analyst Glenn Shorr this afternoon sent out a note to clients urging the market to “stop the insanity” with respect to the steep decline in Morgan Stanley and Goldman Sachs:

Shorr thinks this is unreasonable. “If this [meaning, the threats to Morgan and Goldman] is not an issue of liquidity like Bear Stearns, and not an issue of solvency, like Lehman [Brothers (LEH)], we find it disconcerting that the illiquid CDS market (or the rating agencies) can have so much influence on the fate of these companies and alter the landscape of the brokerage industry.”

Shorr goes on to point out that “Both Morgan Stanley and Goldman Sachs have strong capital and liquidity positions (both boosted liquidity in 3Q) … both firms have pre-funded their issuing needs for the next 6 months, and they have reduced bad asset exposures…” Shorr takes a swipe at the arguments that both firms need to be merged into commercial banks: “banks go out of business too last we checked — and at this rate, following money fund redemptions, deposits could be around the corner.”

But when virulent deleveraging kicks in, nobody is immune, especially not the giant banks and brokerage firms that control most of the trading in the credit default swap market. That is why counterparty credit risk is exploding to new record in recent days.

What will be the fallout from Lehman and AIG? We are seeing it right now. Bear in mind that they are scrambling to sell assets into an already depressed market, reinforcing the death spiral of forced liquidation.

Importantly, virulent deleveraging is impacting all assets, including alternative assets like hedge funds, real estate, and even private equity.

One good thing is that the Lehman bankruptcy will shed some light onto the commercial property market:

We know housing is a mess, but commercial property has been the quieter side to the real estate disaster. All across the United States, pension funds invested heavily in office buildings and malls and warehouses, frequently through private-equity "opportunity funds" that employed high levels of leverage. They buy on 70 per cent to 90 per cent borrowed money. So with just a modest drop in values, these investments can crater. Collectively, the opportunity funds have around $200 billion US in equity. How much of that is gone?

Many analysts suspect prices are down about 15 per cent to 25 per cent from last year. REITs, which hold another $300 billion in equity but use just 50 per cent leverage, have already "priced in" a solid drop in values. They're down 25 per cent from their high last year. So are the pension funds sitting on $100 billion in losses?

The opportunity funds haven't come clean. The problem with big private funds is that so much depends on what the managers tell you. And managers are notoriously self-serving fellows.

That brings us back to Lehman. Its critics argued that its managers were taking an overly charitable view of their assets. That's what landed them where they are now. And it’s why we may all benefit from its liquidation, either in part or as a whole.

... Suppose Lehman’s properties sell for rock-bottom prices, leading to massive write-offs at other investment banks and funds. Would we be better off not knowing? Japanese banks played that game for a long stretch in the 1990s. They refused to write down or unload the foolishly expensive investments they made in U.S. properties. They ended up fighting deflation and watching their stocks fall for well more than a decade.

I suspect that Lehman wasn't the only one taking an "overly charitable view" on their assets. In fact, in this environment, I wonder how banks, insurance companies and pension funds are valuing their private equity, real estate, infrastructure and other illiquid holdings. I suspect that there is a lot of creative accounting going on.

Anyways, back to the main topic. Are we heading towards the Great Crash of 2008? Who knows? It's already pretty bad but it will likely get worse.

The Dow is dangerously close to breaking important support levels. However, some analysts believe that once the SEC's new rules against naked short selling go into effect tomorrow, it will be bullish for the markets. Others think the rules will do little to stem the market's decline.

But even if the market rallies from here, I tend to agree with Gary Shilling that the worse is yet to come:

So far the recession has hit the financial sector hardest. Phase three will broaden it to depress gross domestic product (which was, as the bullish Ken Fisher notes, up in the second quarter). Phase four will extend that damage as the recession goes global. That, in fact, has already begun, with economic weakness from our financial crisis spreading across Europe and Japan. Housing bubbles abroad (Spain, Ireland and the United Kingdom) are collapsing, consumers are retreating and exports to the U.S. are withering.

Developing countries like China and India are dependent on exports to the U.S. and will be hard hit. American consumers have been on a spending spree for a quarter-century, kidding themselves that paper gains on stocks and house prices are a form of saving. They're way overleveraged, but they never stopped as long as credit was available. Now it's gone. The dollars they raised from home equity loans and cashout refinancings are disappearing. Their credit cards are maxed out. Many of them owe more on their cars than the cars are worth. At the same time that lenders are tightening the purse strings, consumers are facing job cuts and high food and energy costs.

And what about that credit derivatives mess which is hanging over credit markets like a Sword of Damocles? The AIG debacle highlights the problem plaguing the credit derivatives market and by extension, the entire global economy:

While it may look superficially similar to the recent implosions of such investment giants as Fannie Mae, Freddie Mac and Lehman, the takeover and bailout of AIG is quite different, and means that the market is entering the next and even more dangerous phase. What is driving the fall of AIG – and potential government losses that may far, far exceed the $85 billion bailout announced late on September 16th - is not mortgages or real estate (directly), but fears that AIG’s huge, global credit-default swap positions will unravel. The $62 trillion dollar credit derivatives market is 50 times the size of the subprime mortgage derivatives market, and is indeed larger than the entire global economy.

And that in a nutshell is why we are seeing central banks across the world pump billions of dollars into the ailing financial system.

Will it be enough to stave off a global financial crisis? Let's all hope so, but my gut is telling me that this crisis has now entered a very dangerous phase.

With each passing day, the light at the end of the tunnel is looking dimmer and dimmer and the end result might be devastating.

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