John Hussman: Expect More Blowups Among the Financials

Excerpt from the Hussman Funds' Weekly Market Comment (3/17/08):

In my view, the recent interventions by the Federal Reserve – $100 billion in “Term Lending” financing and another $200 billion “Securities Lending Facility” - are, in fact, large interventions. But investors should fully understand that these only address short-term liquidity problems, not solvency problems. In other words, they make it easier for various financial institutions to carry on their day-to-day transactions for a while. But they do not lower the probability of continued major losses on defaulting mortgages.

... even if the mortgage securities used as collateral go into default while they are in the hands of the Fed, the primary dealer still has to repurchase them from the Fed after 28 days, at the original price plus interest. The Fed does not take on the risk of default for the collateral, since it will get paid back as long as the member bank makes good. Instead, the only risk that the Fed takes on is the possibility that the primary dealer itself – a major U.S. bank – will go bankrupt during the 28-day period that the Fed holds the collateral. While the risk of a major bank failure has increased in recent months, the vast majority of the securities briefly held by the Fed will remain the problem of the institutions that owned them in the first place.

Having plunged from a 52-week high of over $159 a share, Bear Stearns agreed over the weekend to be bought out by J.P. Morgan for the equivalent of (I'm not making this up) $2 a share. Now, I've been looking for a lot of trouble amidst financials, but that even I didn't expect. There will probably be further blowups and losses in the coming quarters, and more than a few entities will probably not survive in their present form - being liquidated or acquired by stronger institutions. I still think the concern from certain corners about anything more than a deep recession is overstated, but I'm not sure whether the Fed has retained enough credibility to forestall more blowups, and I remain concerned that the market hasn't even considered the potential losses in credit default swaps. The single largest trader in the CDS market is, perhaps ironically, J.P. Morgan.

...

In bonds, we continue to observe a periodic flight-to-safety at all maturities in Treasuries, but this should be viewed as speculative pressure, not investment merit. On an investment basis, the prevailing yields-to-maturity are by definition not at a level that can provide compelling long-term total returns for investors. In the Strategic Total Return Fund, we are in the unusual position of being invested primarily in Treasury bills, with about 15% of assets in precious metals shares. This, of course, isn't the sort of position that we would expect to hold for a significant period of time, but at present, it is exactly the sort of position that I hope will let our shareholders sleep at night.

Editor's note: Relevant sector ETFs include the iShares Dow Jones U.S. Financial Services Index Fund (IYG), Financial Select Sector SPDR ETF (XLF), Vanguard Financials ETF (VFH). See also the full list of sector ETFs.