Monday, September 15, 2008

Shock and Awe!


The crisis on Wall Street prompted by the collapse of Lehman Brothers and fears over AIG resulted in the biggest fall for US stocks since the September 11 attacks to their lowest level for nearly three years.

On Monday, the Dow Jones industrial average tumbled 504 points, or 4.4%, to finish the session at 10,917, ending below the psychologically significant 11,000 level. The broader S&P 500 index plunged 58 points, or 4.6%, to 1.194, breaking below its July lows. The tech-heavy Nasdaq composite index sank 81 points, or 3.6%, to 2,180.

Market breadth was overwhelmingly negative. On the New York Stock Exchange, 30 stocks declined in price for every one that advanced. The ratio on the Nasdaq was 24-3 negative. Trading was active, reports S&P MarketScope.

European markets also stumbled, though they finished above session lows. London stocks were off 3.9%, Frankfurt was off 2.7% and Paris was down 3.8%. Asian markets were closed for holidays on Monday but they are getting whacked tonight.

Emerging markets took a dive as well as commodity producing nations, such as Russia and Brazil, and those with high external financing needs, such as Turkey, came under particular pressure.

In Canada, the S&P/TSX plunged over 500 points, in large part because of tumbling energy stocks as oil prices closed below US$100 a barrel for the first time in six months. The Canadian market was also hurt by financial stocks due to the turmoil in the U.S. financial sector.

It also did not help that Canada's third-largest insurer, Sun Life Financial has C$334 million ($312.7 million) in bonds and about C$15 million in derivatives contracts tied to Lehman, which it will now have to write down.

Given its strong links to other financials through derivative contracts and other types of exposure, the shock of Lehman’s bankruptcy filing raised fresh concerns over the health of other more important financial institutions.

The biggest concern today was AIG as it struggles to survive financial chaos:

Golman Sachs and JP Morgan Chase are understood to be putting together a $75 billion emergency funding package for AIG to keep the embattled American insurance giant afloat, after the US government asked them to lead a rescue of the group.

The government’s request for the emergency credit line came as local and federal officials scrambled to help AIG to raise about $40 billion as soon as possible to head off the imminent threat of a downgrade of its credit rating, that could ultimately lead to its demise. Goldman and JP Morgan declined to comment, while an AIG spokesman confirmed only that the group was “working on a number of alternatives”.

It is understood that Goldman and JP Morgan are working with AIG to determine how much money it needs and talking to other banks about the possibility of syndicating most of the bridge loan.

The government’s dramatic intervention came this afternoon after AIG had earlier secured approval from New York state authorities to liberate $20 billion (£11.2 billion) from its own balance sheet.

...

It was reported that the Fed had hired Morgan Stanley, the Wall Street securities firm, to negotiate the terms of a loan agreement for AIG. The Fed declined to confirm the appointment.

However, if the Fed presses ahead with a loan, it would mean that the loss-making insurance group would have secured up to $60 billion to shore up its tattered balance sheet.

Shares in AIG, once the world’s largest insurer, more than halved when trading opened in New York yesterday and ended the day down 61 per cent at $4.76. (settled 45 per cent lower amid anticipation that it was preparing to update the market about its financial health.)

The firm, which has generated $18.5 billion of losses during the past nine months, is considering selling off its consumer finance group, parts of its reinsurance business and its financial products unit in a battle to raise cash.

It is understood that Kohlberg Kravis Roberts, TPG and JC Flowers, the buyout investors, held talks with AIG over possible asset sales, but no agreements had yet been reached.

Speculation was mounting that AIG might also sell off its aircraft-leasing division, the second-largest of its kind worldwide behind the Commercial Aviation Services.

There were also reports that AIG had been holding talks with Warren Buffet, the billionaire investor who runs Berkshire Hathaway, but that discussions had now ended.

AIG's troubles are worrisome for some investors because of the company's enormous balance sheet and the risks that troubles with that company's finances could spill over to the companies with which it does business. Moreover, its failure would have disastrous ripple effects:

The company is also a substantial owner of state municipal bonds. A downgrade of its credit rating could have a big economic impact on the state and the wider us economy. The group employs about 3,000 people in the UK and 116,000 worldwide.

As the crisis deepens, it looks like government officials are becoming more selective in their bailouts:

"It's a return to pure capitalism, the survival of the fittest -- the government can't and won't bail everybody out," said Justin Urquhart Stewart, investment director at 7 Investment Management in London.

"Investors will now retreat to the trustworthy banks, though that's not a phrase that trips off the tongue easily nowadays."

Bank of America agreed to buy Merrill Lynch in an all-stock deal worth $50 billion, seeking a bargain as the world's largest retail brokerage sought refuge from fears it could be the next victim.

"It's just shockingly fast how it happened," an employee for Merrill in Asia said. "It's hard to believe there will be no more Merrill Lynch," he said of his firm, known as The Thundering Herd.

So was the U.S. government right not to bail out Lehman Brothers? According to Nouriel Roubini, the NYU economist who predicted this disaster a long time ago, the Fed might be right to let Lehman fail but its policy response is "dangerous and reckless". He also stated that what is going on right now is a really scary situation because the stock market, the credit market and the CDS market are all getting whacked at the same time:

"The immediate problem is the derivative default swaps market, in which a plethora of institutional accounts and dealer accounts are at risk,'' Bill Gross, manager of the world's largest bond fund at Pacific Investment Management Co. in Newport Beach, California, said in an interview with Bloomberg Radio yesterday. "It induces a tremendous amount of volatility and uncertainty.''

The Markit CDX North America Investment Grade Index, linked to the bonds of 125 companies in the U.S. and Canada, rose 37.5 basis points to 189.5 as of 9:45 a.m., according to broker Phoenix Partners Group. The Markit iTraxx Crossover Index of 50 European companies with mostly high-risk, high-yield credit ratings jumped 68 basis points to 614, according to JPMorgan Chase & Co. prices.

Anatole Kaletsky of Gavekal blames US Treasury Secretary Henry Paulson for turning a drama into a crisis and openly questions whether the real economy can withstand the turmoil in financial markets:

The past few days' events, however, have raised two alarming qualifications to this generally reassuring story. The first is that the decoupling between financial and economic conditions that I have been expecting - and which has broadly happened - can only be a matter of degree.

The non-financial economy can shrug off a certain amount of bloodletting in the City and Wall Street, but if the turmoil escalates to the point where a country's entire financial structure starts collapsing, the consequences are bound to be dire for non-financial businesses and jobs.

This tipping point has not yet been reached in America or Britain. But it suddenly seems perilously close - with stock market prices plunging on Monday to the point where serious questions could be raised for the first time about the viability of key financial institutions such as AIG, Citibank and Bank of America, or of UBS in Switzerland or of Halifax, Royal Bank of Scotland and Barclays in the UK.

Why are these banks suddenly in such deep trouble? This brings us to the second alarming qualification to my optimism about economic and financial decoupling.

It could be that the divergence between the financial and real economies, instead of resulting in a better-than-expected performance of the real economy, will take the form of a much more catastrophic financial crisis than the economic fundamentals seem to justify. Such a financial catastrophe could then turn what would have been just a modest economic slowdown or mild recession into a genuine disaster.

Mr. Kaletsky then takes aim squarely at US Treasury Secretary Henry Paulson:

The risk of such a disastrous divergence between the worlds of finance and economics, with the financial system spinning completely out of control despite an otherwise decent outlook for the US and world economies, is much greater today than two weeks ago. And the reason can be reduced to one name - Henry Paulson, the Secretary of the US Treasury.

By deciding essentially to wipe out shareholders in Fannie Mae and Freddie Mac and acting even more harshly to the shareholders of Lehman Brothers this weekend, Mr Paulson has sent the clearest possible message to investors around the world: do not buy shares in any bank or insurance company that could, under any conceivable circumstances, run short of capital and need to ask for government help; if this happens, the shareholders will be obliterated and will not be allowed to participate in any potential gains should the bank later recover.

This punitive policy towards the shareholders in Fannie, Freddie and Lehman, who had put more than $20billion of capital into these companies in the hope of keeping them alive, means that no US bank or insurance company can hope to raise any extra capital in the foreseeable future.

This is true of both domestic investors and the Middle Eastern and Asian sovereign wealth funds, whose trillions of dollars of assets were, until a month ago, viewed as an ultimate safety net for the Western financial system.

Both groups have been so badly burnt by Mr Paulson that they are unlikely to support any refinancing by an American bank. And because governments and central bankers elesewhere, particularly in Britain, have loudly praised Mr Paulson's punitive treatment of shareholders, investors would presumably reach similar conclusions about the folly of helping any British bank.

The upshot is that any US or British bank that suffers unexpected losses or is subject to a powerful speculative attack by stock market short-sellers has nowhere to turn. And that in turn means that the total liquidation of a large financial institution in America, Britain or Europe is now seriously conceivable for the first time.

There is some merit to what Mr. Kaletsky is arguing, but the reality is that Wall Street sowed its seeds of destruction a long time ago in what CBC aptly calls "The Great Wall Street Swindle" (click on hyperlink to watch an excellent short documentary on how this mess was formed and how it spread to Canada and across the world).

And now what? Well, the good news is that it's only Monday. But the bad news is that it's only Monday. So expect more pain tomorrow and perhaps for the rest of the week:

The market was expected to remain fractious when trading resumes Tuesday. Besides its continuing concerns about AIG, Wall Street will be waiting anxiously for the Federal Reserve's regular policy-making meeting. The central bank is widely expected to keep rates steady, but the market will be looking for signs from the Fed that it is willing to lower rates amid the nation's continuing economic problems and also because the price of oil has retreated sharply from its highs of $147 in mid-July. The drop in oil gives the inflation-wary Fed more room to maneuver.

Some traders argue that the Fed is losing control as the Fed Funds soared to its highest rate in a decade:

Fed funds traded as high as 6 percent, or 4 percentage points above the central bank's target rate for overnight loans between banks, according to ICAP Plc, the world's largest inter- dealer broker. The margin was the greatest since Bloomberg began tracking the data in 1998. The rate dropped to as low as 0.5 percent after the Fed added the temporary reserves.

The central bank uses repurchase agreements, or repos, to buy or sell Treasury, mortgage-backed and so-called agency debt for a set period, to help maintain enough money in the system to keep overnight interest rates close to the target. They don't signal a policy shift.

Futures show traders boosted odds to 68 percent that the Fed will cut rates when policy makers meet tomorrow to offset financial market turmoil.

My bet is that the Fed will cut rates tomorrow but that this will have little if any effect to offset the financial market turmoil. In fact, given the latest downgrades on AIG, you might want to brace for the tsunami tomorrow.

It's getting scary out there. You'd better try on your crash helmets tomorrow morning before the Fed's announcement just to make sure they fit snugly.

***Important Update on CDS Market (16/09/08)

From FT Alphavile, CDS Report: Correction Continues:

European credit derivative markets opened in great turmoil once more on Tuesday following the biggest single-day correction ever witnessed for the investment grade indices in both the US and Europe on Monday.

The investment grade indices were again hardest hit because they contain the financial names, the banks and insurers, that are being battered in the wake of the collapse of Lehman Brothers and the desperate efforts to keep a struggling AIG, the world’s biggest insurer, on its feet.

The Main US CDX investment grade index opened early, with Markit Group seeing enough trades to provide intra-day prices from about 6.30am New York time. The spread on the index leapt to 217.5 basis points, up more than 23bp from Monday’s close, easily surpassing the record levels hit during the crisis that lead up to the bail out of Bear Stearns in March.

AIG’s cost of protection leapt by almost 1,000bp on Monday, to 1857.10bp, according to Markit, meaning it costs $1.86m annually to insure $10m of companies debt over five years. This is a theoretical spread, which in fact would be broken up into a very large upfront payment for protection plus a smaller running premium.

In Europe, banks and insurers were both hit hard. HBoS saw the biggest move in the index, mimicking the drop in its share price. Its cost of protection rose 57.8bp to 369.2bp. Deutsche Bank was next among banks, rising 23.75bp to 140bp, followed by RBS, up 19.4bp to 178.3bp, and UBS, up 18.1bp at 192.5bp.

The biggest insurance company move was Aegon, up 25.3bp to 217.5bp, followed by Axa, plus 20.25bp to 148.3bp, and Aviva, plus 19bp also to 148.3bp.

The main iTraxx Europe index of investment-grade corporate debt was a 27.4bp wider before at 152.9bp, after jumping 22.8bp on Monday. The iTraxx Croxssover list of junk-rated names was 31.2bp wider at 631.5bp, inside Monday’s intra-day high of about 640bp.

The extent of the volatility and and trading chaos in the markets was illustrated late Monday evening when Markit Group, which runs the indices, announced that dealers had voted to delay the upcoming 6-monthly index changes by one week.

The index “rolls”, which refresh the lists of companies to be included via a dealer poll of the most liquid qualifying names, are traditionally among the busiest periods for trading in credit default swaps, which provide a kind of insurance against non-payment of corporate debt.

But the huge uncertainty over the mark-to-market value of contracts taken out with Lehman Brothers in the indices and in single company names is causing a huge amount of stress in the CDS markets, according to traders.

One trader on Tuesday morning said that people were finding it hard to keep up having already to cope with the technical defaults of fannie and freddie and trying to sort out their risk related to those names they have now been hit with the unprecedented failure of a major counterparty in the market.

Volumes were said to be heavy as banks scrambled to cover their exposures and realign their books.

“Needless to say that the Lehman bankruptcy is unprecedented in terms of size and complexity and, as we write, there are numerous questions and very few answers (the market has truly found itself in unchartered territory),” wrote analysts at one UK bank.

“There are (understandably) more unknowns than knowns in terms of how the mark-to-market of trades with Lehman as a counterparty will be resolved. The reset of cash and CDS hedges done with Lehman is bound to continue putting pressure on CDS spreads.”

And this From Reuters, CDS index rolls over, postponed amid market turmoil:

Credit derivatives dealers have voted to delay the rollover of U.S. and European benchmark credit default swaps (CDS) indexes for a week given the turmoil following the Lehman Brothers Holding (LEH.P: Quote, Profile, Research, Stock Buzz) filing for bankruptcy protection.

"The decision to call a vote was prompted by the exceptionally high trading and clearing activity observed in today's CDS markets," Markit said in a statement late on Monday. Most of Markit's CDX indexes in the United States and iTraxx indexes in Europe will now roll on Monday, Sept. 29, instead of Sept. 22 as initially planned, Markit said.

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