Government Intervention Perks Up Markets But Bottom Talk Premature

Last week we wrote that things were coming to a head in the financial markets, and indeed we saw sharp reversals in a broad range of asset classes. The S&P 500, after beginning the week at new bear market lows, gained 3.1% for the week alongside an impressive rebound in the financial sector. The commodities sector, which had become extremely stretched on the upside, finally corrected, and in a way that reminded investors how volatile the asset class can be.

The Dow Jones-AIG Commodity index sank 8.6% last week, but is still up 7% in 2008, versus a 9% year-to-date loss in the S&P 500. After briefly trading above the $1,000 mark, gold fell back last week to close at $919, still nearly $300 higher than last August when the credit crisis (and the government's inflationary response to it) began. We believe this correction in commodities provides an opportunity for investors who don't already have exposure to the asset class to begin to average into positions. In the case of gold, which is a uniquely valuable asset in these times of blatant government sponsored inflation (discussed below), we view the worst case scenario to be a drop to the $800-850 range, but investors without any gold exposure should begin to take a position now.

In light of the astonishing measures taken by the federal government and the Federal Reserve in recent weeks to "solve" the credit/mortgage/housing crisis, it is not surprising that those measures appear to have gained some traction the financial markets, at least in the short term. When one inventories the extraordinary steps recently taken, it becomes apparent that the government is on a path to do whatever it takes to prevent the free market from finding a bottom in terms of the value of home prices and related mortgage-backed securities.

1. Last Tuesday, the Fed cut its short-term interest rate target 0.75% percentage points to 2.25%, continuing one of the most aggressive monetary easings in history. The Fed has now cut the federal funds rate by a full three percentage points since last September, to the benefit of the financial sector and leveraged market participants and the detriment of savers and individuals whose investments are in conservative fixed income investments, which now produce a negative real (after inflation) return.

2. Working jointly with J.P. Morgan (JPM), the Fed kept Bear Stearns (BSC) a second tier Wall Street investment bank, from going bankrupt by agreeing to lend $30 billion against some of Bear's riskiest mortgage collateral. Through this acquisition financing, the Fed effectively puts the U.S. taxpayer at risk for defaults and losses on this $30 billion of mortgage-backed securities. In defense of its actions, the Fed claims that it averted a potentially devastating financial panic, but how many people honestly believe that the U.S. financial system would be brought to its knees by the bankruptcy of Bear Stearns?

3. A week ago Sunday, after the Bear Stearns deal had been cobbled together, the Fed announced that it would lend directly to investment banks through the "discount window" - the Fed's direct lending facility - on the same terms as it lends to commercial banks. This represented the first time since the Great Depression that the Fed has agreed to lend to institutions other than banks, and effectively prevents any of the major investment or commercial banks from going under since they can now borrow at 2.5% directly from the Fed. No wonder the commercial banks and especially the investment banks had such a huge rally last week after the market digested the implications of this policy. Lehman's stock, for example, rallied from a low of $20 last Monday morning to $49 by the end of the week! If this facility had been put in place a week earlier, Bear Stearns would have been able to stay afloat. It is a farce to see this morning that Bear Stearns' stock is trading at $10/share after striking a deal with J.P. Morgan and the Fed to be acquired at $2/share. Bear's shareholders are justifiably arguing that under the Fed's new lending facilities, and the federal government steadily moving in the direction of the nationalization of mortgage credit risk, Bear Stearns is worth a lot more than $2/share.

Of course, the Federal Reserve is not alone in working overtime to apply government fixes to the problems in our financial and real estate markets. On March 19, the Bush administration reduced the amount of capital Fannie Mae (FNM) and Freddie Mac (FRE) are required to hold as a cushion against losses. This agreement allows the government-sponsored entities (GSEs), the largest sources of money for U.S. home loans, to enlarge their already gigantic balance sheets. By reducing the capital requirements at Fannie and Freddie, effective immediately, the OFHEO freed up about $3 billion in capital at each company, which will provide $200 billion of immediate liquidity to the mortgage market, and allow the GSEs to purchase or guarantee about $2 trillion in mortgages this year.

We should all recall that the GSEs were originally chartered to facilitate home ownership by lower income Americans. As recently as 1990, the combined assets of the GSEs were $454 billion. Today, their balance sheets stand at $5 trillion, representing roughly half of outstanding U.S. mortgage debt. As if this further nationalization of mortgage credit is not enough, Congress is working on a proposal for the FHA to directly insure up to $400 billion in distressed mortgages. Before all is said and done, we would not be surprised to see the government making outright purchases of mortgage securities. This precisely what is being called for from a growing chorus in the both the public and private sector. According to PIMCO's Bill Gross, for the government to keep the financial markets from imploding it needs to buy troubled mortgage bonds from banks and securities firms.

Needless to say, these extraordinary government measures have put a floor under the financial markets and stimulated mortgage markets. Over the past two weeks, the Freddie Mach posted 30-year mortgage rate has fallen from 6.2% to 5.74%, spreads on agency-backed mortgage backed securities have tightened by 30 basis points and the share prices of Fannie and Freddie have shot up by over 50%!.

All of this government intervention makes it extremely difficult to assess the near term direction of asset classes. It does appear that last week marked the beginning of a counter-trend rally in the stock market, and a counter-trend correction in commodities. For the S&P 500, major resistance resides at 1400. Until the market can clear this level, all talk of a major bottom being in place is premature. Our best guess is that the extraordinary government intervention we are seeing will ultimately serve to prolong the necessary corrective processes in the financial and real estate markets. This implies an extended period of volatile sideways action in the broader stock market. Our working assumption is a range of 1200 to 1400 in the S&P 500.