Market Recap and Outlook: Week of Pain

by: Alex Cook

First it was Fannie (FNM) & Freddie (FRE). Then Hurricane Ike. Now Lehman Brothers (LEH). Last week hasn’t been pretty.

To recap, first the mortgage debacle. Fannie & Freddie have had it coming to them for a long time. Being a quasi-government sponsored entity opened up huge moral hazard risks. Likely how the situation started was that once upon a time, some politicians decided to try to help people get mortgages by giving sponsorship to the companies-but as with many subsidies, there were unintended consequences. Some of the main beneficiaries of Fannie & Freddie’s backing were private equity firms buying the debt obligations, rather than ordinary people trying to get mortgages. As far as going forward, we can only hope that the “conservatorship” status that the companies are in is a temporary phase. Fully nationalizing the companies would compound moral hazard problems; instead of screwing up and letting taxpayers bail them out of a big mess, they could instead royally screw up and let taxpayers bail them out of a colossal mess.

Markets reacted favorably to the conservatorship, and not entirely without good reason. Markets want some semblance of stability. Investors want to hear that the worst is over.

And, all this meant that maybe the worst was over, until we found out about Lehman Brothers. It looked like the company was going to hold together after they survived the summer, but apparently that was not to be and damage was worse than expected-or at least worse than reported. Lehman announced early in the week plans to sell assets to raise capital, which was a huge red flag. An oil & gas exploration company can sell assets to raise capital. A financial institution should never. (Editor's note: See updates on LEH here.)

The rest, in five short trading days, is history. LEH opened the week at above 17, and closed under 4.

Much has already been said about unscrupulous lending practices, too much money supply in circulation by the Fed, and financial institutions getting overzealous and investing in hedge funds with absurd amounts of leverage.

I have another theory to add to the list. Maybe much of this would have been inevitable even without the mortgage meltdown. After the Glass-Steagall Act of 1933, a New Deal era bill that mandated a separation between investment banks and commercial banks, was basically abolished in 1996, maybe consolidation in the financial sector was just the natural course of things.

But, since no self-respecting CEO would want to let his or her company simply disappear because of macroeconomic trends, they would have to take more risk to stay afloat and stand out. Perhaps if it wasn’t mortgages, SIVs and hedge funds, it would have been something else. Either way, we can clearly see the consolidation. Bear Stearns, Countrywide Financial, and Lehman Brothers are now relics.

And if all this wasn’t enough for one week, Hurricane Ike smashed up the Houston Metro Area. Reports of damage are still coming in, and millions are without electricity.

What does this mean for next week?

Expect gas prices to go back up for some time. Much of the US oil infrastructure is in the Gulf of Mexico, which just got hit by a hurricane.

Expect a bumpy ride in the financial sector. Lehman is trading huge fractions of its float in single days. As it turned out, apparently Bank of America (NYSE:BAC) wasn’t the only suitor for Lehman, so trading any buy-out rumors would be premature at this point. (Editor's note: see updates on Bank of America in terms of Merrill Lynch (MER) here.)

Watch out for AIG (NYSE:AIG). The Wall Street Journal has reported that AIG might be conducting an asset sale of their own in the nearby future. Ouchies. (Editor's note: see updates on AIG here.)

This could mean, though, that maybe the worst truly is over now.

We’ll have to see.