Long Term, Financials Look Good

When looking at the Dow Jones, it is easy to figure out why we have had such a huge downturn. Many don't understand what has really happened as the political system and current Presidential race have skewed the information as politicians point fingers instead of fixing the problem.

The reason why what really happened is difficult to disseminate is it would mean the average citizen would have to accept some blame. Where I live, we didn't have a huge housing boom, but did benefit from some increased real estate values. This is why I find it acceptable that the average person here doesn't understand, but in other areas this ignorance is making me scratch my head.

In actuality, the problem didn't start with brokerages, but with Fannie and Freddie back in the late nineties. During the Clinton administration, they started a homes for everyone project. This on its own wasn't a problem, but it started some of the lower documentation lending to first time home owners. This allowed new families to get homes in an environment that wouldn't have normally allowed it. So is it President Clinton's fault? No, not exactly.

The next step and most important was 9/11 and the dotcom bubble. Huge market speculation caused the NASDAQ to soar to all time highs, inflating PE ratios to unsustainable heights. When it burst and was followed by tragedy, people fled the stock market and seized up the credit markets. Interest rates were cut to re-inflate the economy at a time when rates should have been raised. This flood of money led to more speculation, as it was cheap and more importantly helped the housing market to see wild speculation. The Fed lowered rates to a low 1% during this time. So is it Greenspan's fault? No, not exactly.

Brokerage houses had all of this liquidity and asked for more leverage, as investors pushed for increasing profits and the overseas markets wanted to buy more US debt. The SEC granted companies such as Goldman Sachs (GS), Merrill Lynch (MER), Morgan Stanley (MS), Lehman Brothers, and Bear Stearns the ability to leverage their portfolios from 12 to 1 to 40 to 1. This decision was based on a major increase of mortgages lent, and the brokerage houses packaged these mortgages in securities. This seemed to be a brilliant plan, as very smart people were able to invest in as much as 20% subprime and still sell the bonds at a AAA rating.

When housing markets in California, Nevada and Florida began to cool, home prices decreased. When they decreased, speculators could not unload a home that was worth less than what they bought it for, and thus defaults began to escalate. This coupled with the longest bull market in history ready to turn bear have placed us here. Now we have corporate profits falling for a possible five straight quarters, and that has many saying the recession is here.

So is it Goldman's fault or even President Bush's? I don't think so, it looks like greed got us here.

Lastly, the leverage still should have been fine, as these securities were backed by mortgage insurance. The problems were that the failures were so extreme that the mortgage insurance companies began to fold. Without insurance the ratings went down rapidly on downgrades. Shortly after JPMorgan (JPM) bought Bear Stearns, constituents from all over stated they did not see any reason for bailing out speculators. The public's inability to understand caused even more carnage.

When Lehman went under, we saw how they were tied to the entire world. Its CDOs and other exotic securities were linked to other companies that had purchased them, along with other countries that had purchased the debt. By allowing such a large and complex company to fail, other large investors knew that they had no way of knowing what debt was where. If you don't know who will have to write down debt, it makes it impossible to value what you own.

The most interesting thought with respect to this transparency is why the Federal Government didn't make companies show how much of this debt was on the books. The reason seems to be that some major companies were so exposed it could cause a domino of failures. I believe that Bernanke knows that if he waits until the credit markets unlock and the defaults are done, these companies will be worth much more. The best way I can explain it would be to come over to your house, which has depreciated by 30%. This $500,000 home that you have made every payment on is now worth $350,000. Since I hold your loan, I don't like the fact that it has depreciated in value. I then ask you to pay me the $150,000 difference. This is why they will allow companies to amortize these losses over a longer period.

There are many things involved in this crisis that are brand new, but in truth, different variances of this same problem have happened over time. If we go back to 1986, there was the S&L crisis. More than a 1000 fail with losses totaling $519 billion. In 1997 there was the Asian currency crisis. This caused Long-Term Capital Management and its $129 billion in assets to fail. In 2001 we experienced accounting scandals and the bankruptcy of Enron. All of these caused investors to lose equity, but until they happened many people profited.

If we are to look at what is next and what an investor should do, there are many short and long term plays. Shorting oil and gas is interesting going ahead. If these prices go lower, it should help the airlines and many of the transports. I would guess there will be continued high defaults in homes and more banks going under, but this places a nice long term play on the financials as they will be afforded the luxury of any of their needs to go in and buy up these cheap assets. The big banks are great if you have a five year time period, but don't expect large increases in stock prices until things clear up a bit. Fixed income assets over the next five years are the best if retirement is within this time frame.

If we are to compare Europe and the US's current environment to that of Japan, it took Japan two decades to recover. I don't believe it will take the US that long as the problem is being addressed much more aggressively. Going forward, look for the market to trade sideways for a while, as it will trade between 8000-10,000. I believe that picking winners in this market will be difficult, so exchange traded funds may be the best as it will give you broad market exposure when you place a position. When the market moves down to 8000, buy some of the beaten stocks on the losses. When the market rises to a higher level, do the opposite.

Stock position: None.

Comments

[ashizashiz:]

RE: "...I believe that Bernanke knows that if he waits until the credit markets unlock and the defaults are done, these companies will be worth much more..."

I have news for you Mr. Happy, it ain't.

Let's take Credit Markets, for example. And just to make things really interesting, I'm gonna ignore LIBOR and TED for the moment.

OK, project this: you are standing in front of a line of 100 people, stretched out perpendicular to your view.

OK, so you have 20 Billion Dollars. (Well, not actually real dollars: more like virtual dollars in guarantees....ya, debt.) Anyway...

You have 20 Billion Dollars. And the person who gave you the 20 Billion $ expects you to lend it out to 5 of the people in the line. And the LIBOR is coming in, and the TED spread is falling, and everything in 'the numbers' seems to point to this being a good way to make some cash: loan the $ out at a nice % of return, build on the 'principle', repay the 20 Billion $ and make a tidy li'l profit. Because that IS the name of the game here: PROFIT.

Hmmmm, but wait. There's a pretty good chance that at least 10-20 of these folks have a locked safe full of CDS "assets" that they are just praying that they can settle...not through continuing the lending cycle down to the consumer, but through holding onto the cash until their swap-based exposure comes to light, and then having the reserves on hand to settle margin calls without having to go belly up. Hmmmmm....kind of a crap shoot here. To whom do you loan the $$$??? Whom do you trust? They all have their hands out. They all appear sincere and well-mannered.

Oh ya. Another dilemma. You yourself also have a lot of vulnerability with regard to CDS and other worthless instruments gathering dust in your own vaults. AND, there's a pretty good chance---because these derivatives are sold and traded through dozens, if not hundreds, of unregistered, unrecorded transactions---that you may have to face the piper sometime down the road as some OTHER institution gets called to the carpet and one of your CDS bundles is unfortunately involved in the maelstrom.

LIBOR is down, TED is down...things look good. But the reality of the CDS worm leaves the LIBOR and TED spreads inconsequential to your decision-making processes.

Your choice? You sit on the 20 Billion $$$ and pray it's enough to cover your vulnerabilities as the swaps hit the fan over the coming weeks and months. (Of course, the dudes who lent you the 20 Billion are pissed and they show up with guns. Hmmm, what to do what to do?)

"Risk" has changed in ways we could never have imagined 30 years ago. Due to the unregulated nature of the Derivatives market, and because the bonds and other instruments being 'insured' didn't actually have to be 'one degree of separation' from the seller, we have a multi-trillion dollar, multi-trillion tentacled parasitic beast just waiting to bore through the leg of a few major financials....and then it's bye bye baby.

In your world Michael, there will come a time when people will once again be able to service their growing debt, where real capital growth will lead to economic expansion, and where the Fractional Reserve system will once again find itself on solid footing. BUT THAT CAN NEVER HAPPEN AGAIN MICHAEL.

This time we're talking tens of TRILLIONS of dollars of worthless "assets" in the vaults and on the ledgers of the major and small and every size financial inbetween...WORTHLESS!... Unserviceable debt. So it's not "interesting" ("...The most interesting thought with respect to this transparency is why the Federal Government didn't make companies show how much of this debt was on the books....") that the FED left this part of the process out of its playbook...it is criminal. And until ALL of the books are opened and all of the trillions and trillions of dollars in CDS-based debt is broght into the light, the financial system guided by the principles of Fractional Reserves is dead.

[ED: Comment edited to remove abuse.]

2008 Oct 16 11:47 AM

[Mr.G:]

ashiz -you are right the kid filoon is wrong-by the look of his age he lived in a fairy tale his whole life and is in denial of whats going on - dont blame him because he was born after 1987 - he doesnt know anything else

2008 Oct 16 12:48 PM

[legmaker:]

Thank you for your comments I appreciate them and mr.g, thank you for the kind words on my age, I appreciate it. God Bless

2008 Oct 20 11:41 AM