Five Challenges Ahead as the Corporate Soup Lines Grow 9 comments
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Like rescuers rushing to help Darwin-award wannabees who ignored dire warnings to evacuate Galveston in the path of Hurricane Ike, federal officials and Wall Street execs worked feverishly Saturday in an attempt to resolve the financial crisis now facing Lehman (LEH). It is the second ‘big five’ Wall Street brokerage to succumb to the financial tsunami after Bear Stearns, which took $29 billion in federal assistance to make the JP Morgan (JPM) purchase of the company work. But this time officials are doing their level best to convince potential buyers that no bailout should be expected.
It remains to be seen if officials can make this condition stick, but if no buyer steps up to the plate, the government will again have to act as buyer of last resort. Chances for a deal devoid of government-backed guarantees dimmed significantly Sunday when Barclays Bank (BCS), the last remaining bidder, walked away from negotiations increasing the chances of a Lehman bankruptcy.
But even if a deal is made, there is doubt that this will be the end of the crisis, prompting financial industry experts and investors to ask the all-too-obvious question: Who's next?
And then there are the banks... So far this year there have been a total of eleven bank collapses, which the bulls say is small potatoes considering that the Federal Deposit Insurance Corporation currently insures 8,451 banking institutions. But what resources does the FDIC have at its disposal, and what happens if collapses start to mount?
According to its website, the FDIC insures up to a maximum of $100,000 per account or $200,000 per individual (up to 2 accounts) in the event of bank failure. At the end Q1-2008, the Deposit Insurance Fund, monies used in the event of bank failure to repay depositors, totalled $52.8 billion – not very much when you consider this has to insure a total of more than $4 trillion which works out to a ratio of 1.3%.
Figure A – Performance chart over the last six months showing how financial stocks Lehman Bros., Merrill Lynch (MER), AIG Group (AIG), Freddie Mac (FRE) and Fannie Mae (FNM) have performed. As we see, FRE and FNM are essentially bankrupt as far as shareholders are concerned and there is little hope that stockholders of Lehman Bros and AIG will fare any better. Chart by VectorVest.com
The IndyMac Bank failure cost the FDIC $8.9 billion, wiping out more than 16% of the fund, helping to push the reserve ratio down to 1.19%. Eleven failures have put the agency very close to the brink and once reserves fall below 1.15%, the FDIC will need more cash according to its charter. Other potential problems include Washington Mutual (WM) bank as well as insurer AIG Group as the ripples continue to build with little end in sight.
Figure B –Six month performance comparison between Financials and Banks. As we see, they have performed similarly through this crisis. As long as the economy deteriorates and housing prices fall both sectors will suffer and more banks will collapse. Chart by VectorVest.com
So what happens if we get a situation like the Great Depression or S&L Crisis in the 1980s, when thousands of banks failed, which in both cases bankrupted the FDIC?
The Fed has already been forced to rescue failed mortgage companies Fannie Mae and Freddie Mac, assuming more than $5 trillion in potential liabilities “for the greater good.” And with each failure and rescue, hopes run high that this will be the end of the troubles. But each time, the situation continues to deteriorate and credit spreads rise.
For example, a 6.25% AIG bond due 2037 recently yielded 17%, which means investors are selling them at a huge discount according to the Wall Street Journal. The cost to insure Washington Mutual bonds have skyrocketed – it now costs approximately $3.7 million up front and $500,000 annually to protect $10 million in WaMU bonds. Another few bank failures and the FDIC will also be forced hat in hand to the Fed and Treasury Department for cash.
As if this wasn’t enough to keep investors from becoming complacent, we got news that at least one auto giant is also in trouble. GM’s (GM) Rick Wagoner was in Washington this week looking for a minimum $25 billion handout in the way of government-backed loans. Detroit is looking for a bigger $50 billion package according to WSJ.
All this with a recession that has yet to be confirmed by the NBER? It doesn’t take a rocket scientist to see what will happen as the economy deteriorates further.
Here are the realities we face, as I see them.
1) Although house prices appear to be falling more slowly, they are still dropping and this trend will not reverse tomorrow, next week or next month. And as prices fall, more mortgages will fail pulling more banks and lenders down with them. For example, foreclosures are still rapidly rising according to RealtyTrac, which reported this week that 303,879 properties went into foreclosure in August, well up from the average Q2 rate of 247,000 foreclosures per month. At this rate, the final tally for Q3-08 could be more than 900,000 foreclosures! This is also decidedly bearish for home prices and the banks holding the mortgages. (See Figure 7.)
As of the latest inventory figures from the National Association of Realtors, there are 3.9 million unsold existing homes, which represents an 11.1 month supply using the latest sales data. Add to this another approximately 500,000 unsold new homes. But foreclosures are clearly the housing market dark horse, expected to total more than 3.6 million more homes in the next twelve months at the current failure rate to already high inventories!
2) We are in a bear market and retail trading volumes (and commissions) will continue falling which will negatively impact brokers and others in the finance industry food chain. Two years from now the landscape for financial companies on Wall Street will look vastly different than it does today and it will be a tough period all round.
3) Even if Obama gets elected and follows through on his promise to raise corporate, personal (for the 5% of the population that currently pay 70% of the total tax burden), capital gains and dividend taxes, federal deficits will continue to rise and revenues fall. This is the reality in a deteriorating economy, and the more rapidly this occurs, the farther revenues will fall. As deficits rise, demands for Treasury bonds to foreigners will jump. Given the amount of debt in the U.S., how long will foreigners continue to finance it for rates below the real rate of inflation?
4) Baby boomers begin to retire en masse in 2009, when the median age of the biggest spenders (45 to 54 year olds) pass the median age of 50. This is creating a whole raft of problems which we are just beginning to see but at the present rate, our social security and pension system is in serious trouble if not already technically broke.
5) Last but not least, in good times or bad, the two post-election years have been the hardest on economies/markets and with the sole exception of the short-lived 1987 melt, every single bear market and recession since World War II occurred in the 24-month period after an election. There is no reason to expect a difference this time around. Realistically, it will probably be worse given that momentum is slowing and in spite of Houdini-tricked government stats to the contrary, a recession is already here.
I don’t care how optimistic you are, there is no way of putting lipstick on these market pigs!
Stock position: None.
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This article has 9 comments:
Daniel Kowkabany
(It puts a little perspective into the interface between politics and economics.)
However, my primary approach to markets is technical: I watch the charts, take a quick look at the fundamentals to see if they support the trade and make my buying and selling decisions accordingly...
But you bring up an interesting point. Larry Williams once said in a seminar that he is pessimistic every time he enters a trade, and he expects to lose. That way he won't overstay his welcome and ignore his stop loss. In other words, if his trade hits his stop, he quickly exits and doesn't ignore the signal because that is what he is expecting..... Its counter-intuitive when you think about it. Traders by nature are generally optimistic. But that can keep you in a trade longer than you should be and bankrupt you.
Nukldrager - Good point. I need to check the latest BIS (Bank of International Settlements) derivatives data. The problem is that is lags by about 6 months. But from the data I have been seeing, the size of the derivatives market began shrinking in late 2007.... Will take a look at it an do an article update when I have the info....
Cheers,
Matt
Good job though and an interesting analysis! So are you giving away Cramer's book for giggles and laughs?
That's not black humor, that's reality. Whose investments do you think the govt. was protecting when it nationalized the losses at fannie and freddie? China/Russia/Saudi Arabia to name a few. I wish I had enought political pull to make taxpayers responsible for any losses I might incur, but then again, the govt. is not dependent on funding from me for its continued operations.
I wish you luck because history is not on your side. I have done some fairly extensive research on the election cycle and the two years after a US election are hard on all markets and stocks pretty much world wide. The ratio for the Dow/SPX since 1902 works out to 93% of the gains occurred in the 26 months leading up to each election versus just 7% in the 22 months after. As well with the exception of the relatively short-lived Oct 1987 meltdown, every single major bear market and recession since WWII has occurred in the 2 years after a US election. The ratio of the Toronto TSX for the 2 years pre-election versus post-election since 1950 is 97:3 or 32:1. Not a very attractive probability (see tradesystemguru.com/co... )