On the Heels of Carlyle, Bear: Financial Panic Reaching Crescendo

The S&P 500 declined 0.4% last week, but that minor fluctuation in the index hardly does justice to the markets' extreme volatility and the extraordinary news backdrop, amid a dramatic acceleration of the credit crisis. Last week saw the collapse of Carlyle Capital, a hedge fund run by one of the world's largest and most respected private equity firms, and Bear Stearns (BSC), a prominent New York investment bank.

Both entities were driven to insolvency by the same cause - excessively leveraged exposure to distressed and illiquid mortgage debt. In the wake of the Carlyle news early in the week, the Fed announced a $200 billion credit facility under which it agreed to accept as collateral "private label" mortgage backed securities (rather than just government agency mortgage backed bonds). On Friday, the Fed deployed this new facility and helped orchestrate emergency funding to facilitate JP Morgan's (JPM) fire sale buyout of Bear Stearns. (Bear Stearns, whose stock once traded for $170, is being acquired by JP Morgan for a token $2/share).

Last week's actions by the Federal Reserve are the latest in a long string of government measures to "solve" the credit crisis. It is debatable how much worse the upheaval in the financial markets would be in the absence of government intervention. Undoubtedly, the Fed has slowed the pace of the de-leveraging and bad debt write-downs that were the inevitable consequences of an historic bubble in credit and mis-pricing in real estate and real estate securities. What is not debatable is the lamentable downward spiral of the U.S. currency, which has demonstrably accelerated as a result of the government's policies over the past seven months. Undoubtedly, currency markets have begun to increasingly discount the "nationalization" of U.S. credit problems - both by the Federal Reserve and our federal government.

In the short-term, currency markets have likely overstated this risk due to the misperception that the Fed is now "printing money" to buy up bad mortgage debt. For a further discussion of this topic, please see this excellent discussion by John Hussman on the mechanics of the Fed's short-term credit facilities, which amount to the temporary, not permanent, assumption of mortgage credit risk. To be sure, there is proposed legislation in Congress that would involve a direct government bailout of bad mortgage debt, but let us hope this does not become law.

The Federal Reserve Open Market Committee formally meets today, and the market expects the Fed to cut the federal funds rate by an additional 75 basis points to 2.25% (down from 5.25% last August). We have argued that aggressive Fed rate cuts have been counter-productive; they have exacerbated inflationary trends in the commodity and currency markets, while doing little to prevent the repercussions of the bursting of the credit and real estate bubbles. While the Fed has been slashing the fed funds rate over the past seven months, commodity prices have exploded higher and the U.S. dollar has plunged to astonishing record lows versus the Euro and 13-year lows versus the Japanese Yen.

The Fed asserts that its rate-cutting actions are motivated in large part to support the housing sector, but 30-year agency-backed mortgage rates today stand at 6.37% - 15 basis points higher than year-ago levels. Further, considering that an increasing share of the household budget must be directed to food and energy, as well as other costs that are increasing at a rapid rate, a persuasive argument can be made that the Fed's actions are undermining rather than helping to resolve the problems of housing affordability and supply.

As mentioned in earlier commentaries, we have thought the ultimate bear market risk in the S&P 500 is in the range of 1200-1225. It is conceivable we will reach those levels this week, as the financial panic appears to be reaching a crescendo, at least in the short term. Aggressive traders may choose to enter limit orders to buy an S&P 500 ETF at the 1200-1225 level. At these prices, the S&P 500 will have fallen to valuation levels (based on normalized earnings that smooth business cycle fluctuations) that have marked the end of 70% of bear market declines since World War 2.

Given the current state of credit and currency markets, it is certainly possible that stocks could fall into the 30% of bear markets where stocks become extremely cheap, we view this as unlikely. The U.S. economy has overcome many financial crises in its history; although it looks as though the U.S. financial world is falling apart, with the passage of time, we suspect that the present time will approximate the point of maximum financial market distress. One silver lining in the media last week is that in a Wall Street Journal survey, over 70% of economists now believe the economy has dropped into a recession. Bear markets driven by recessions don't end until recession is taken as an obvious fact. We appear to be rapidly approaching that point.

Comments

[Lisa]

"The Fed asserts that its rate-cutting actions are motivated in large part to support the housing sector, but 30-year agency-backed mortgage rates today stand at 6.37% - 15 basis points higher than year-ago levels."

That sentence alone made this excellent article worth reading. It's good to get some wider perspective.

[clitosil]

Why is it that so many analyses only look back to the end of WWII? Is there no financial history before then??