Wiping Your Assets Clean: Aftermath of a 500 Point Crush

Too Big to Fail

I've said this before and I'll say it again, students of economics will study these moments in time as we are witnessing history. Unprecedented volatility in the markets and a very dangerous deleveraging process that continues to erode equity, wiping assets clean from once lofty secure valuations to now, what could be characterized as, nearly worthless confetti run through the office shredder. I'm not sure what's cheaper anymore, shares of Lehman, Freddie, Fannie, or a wholesale bundle of toilet paper at your local Costco.

The recent "conservatorship" (it's gotten so bad that we have to make up words to explain financial remedies) of Fannie Mae (FNM) and Freddie Mac (FRE) was absolutely necessary and inevitable. I applaud the effort by the Treasury Secretary, Hank Paulson, even though there are some that would argue in the safety of lecture halls, or the world of academia and economics classes, that the massive bailout will only encourage risky and reckless behavior in the future and continue this "moral hazard" by not allowing free market discipline to take effect.

It's disingenuous to me that self-serving analysts on mainstream media are allowed to carry on about hypothetical and, completely impractical, "free markets" when they ignore how serious the implications were if Fannie Mae and Freddie Mac were allowed to go insolvent. After all, we are talking about more than 50% of all mortgages and homes outstanding and, even more surprising, 70% of all recent home loans in the last 5 years.

Is it a taxpayer burden? Absolutely. But before I hear the cries of "why should I have to pay my taxes to bail out some speculator that shouldn't have been in a home to begin with," let's be honest and consider that the wave of concentric circles caused by the initial ripple effect of the sub-prime mess has far reaching implications that extend well beyond the initial impact zone.

And another thing, let's not forget that one of the ways our economy continues to extend credit is by selling Treasuries and government secured paper to sovereign wealth funds and other participants in the global markets. If we allowed these gigantic beasts to become slayed and defaulted on our debts, no country would buy T-bills again and that would wreck the entire financial system. I'm glad that Paulson came out publicly and indicated that the bailout of Fannie and Freddie was contractual in nature and could not be dismantled by some change in office. It's one of the main reasons that our Federal Reserve and monetary system remains, for the most part, independent of whatever regime is elected into power.

Unless you're a short seller with uncanny timing–many short sellers have been blown out by mistiming the bounces–who benefits from a systemic collapse of our financial system, then why would you root for a wipe out? Not only is it unpatriotic, but it is intellectually dishonest. Seriously, how much do we want to talk the markets down? After all, every single stock trades for more than what the true value is based on a p/e multiple. Do we really want to open Pandora's box and write everything down to true asset value? If this is the case, we are not talking about a ripple effect, we are talking about a seismic shockwave on the Richter scale of 10 that would wreck the markets–and this, folks, cannot be allowed to happen because the consequences are too severe for everyone.

And these ridiculous rating companies that failed to expose the risk to the balance sheets early on due to complicity, have now twisted the knife in the backs of these financial firms in a way that exacerbates the damage without allowing any capital raising to be enough. Now you want to cry wolf? The wolf has already come and gone after slaughtering the sheep.

Let's, for a moment, be intellectually honest about the situation and recognize that we are, primarily, a consumer driven economy and that 70% of our national GDP is directly attributable to the spending power of the American people. If you break the back of the consumer there is a potential economic collapse that may be as bad, if not worse, than the Great Depression. People and paid economists neglect how much our entire economy is leveraged to principal assets such as real estate. It is true that the primary retirement plan for most people is their home and the idea of building equity over time has been perpetuated for years as the means of success in America. The stigma of not owning your own home has placed a sense of deep insecurity amongst those struggling to get by with rent and bills.

The truth of the matter is that before anyone whines about another bailout, people need to appreciate that Chairman Bernanke and Treasury Secretary Hank Paulson are actively addressing the crisis. True, their moves can be criticized for timing and not all have done what was intended. But let's respect the fact that in complete contrast to our "do nothing Congress," of which both Senators in this fall election are running under at the top of the ticket, at least Bernanke and Paulson have been doing something. At least they are knowledgeable about the crisis and continue to move toward action rather than rhetoric and false promises once they are elected.

Lehman, Merrill with a Wink and a Nod from the Fed

Stunning, just simply stunning to think that another one of the historical franchises of Wall Street is not only insolvent, but not even worth the risk of acquisition by other firms. It's amazing to think that out of the 5 major investment banks of Wall Street, only Goldman Sachs (GS) and Morgan Stanley (MS) remain as independent firms. If you stop to consider the amount of recessions and turbulent economic cycles they survived, then this financial crisis is like no other in history judging by the carnage left in its wake.

The surprising news over the weekend was that Bank of America (BAC) acquired Merrill Lynch (MER) with significant premium to where it would have ultimately traded post-bankrupt shares of Lehman. I think it is clear that the acquisition was done with a "wink and a nod" from the Federal Reserve, indicating that while publicly they will not take a stance of placing a backstop to the deal, there is no question that Bank of America is "too big to fail" and will have access to liquidity and capital as needed. Otherwise, acquiring Merrill Lynch was simply premature to what the market would have traded at in the wake of a massive sell off in the financial sectors. It was shrewdly calculated that Lehman could fall on its own sword as long as the next line of defense in the financial markets, Merrill Lynch, was saved.

However, this is not a criticism, in fact, this is absolutely commendable strategic resolve by the Federal Reserve and Treasury to help stabilize the weaker links of the sector. As for Bank of America, short-term the firm will continue to struggle digesting the acquisition of Merrill Lynch considering they still haven't fully absorbed Countrywide Financial, but, over time, BAC will turn out to be one of the winners on Wall Street and last man standing as the economy recovers.

You should keep Bank of America on your watch list but stay away until the smoke clears. Their once secure dividend is really at risk and the upside remains capped until this credit crisis is stabilized.

AIG Limbo Dance: How Low Can It Go?

American General (AIG) is, unfortunately, too big to fail without devastating consequence to the financial markets. Characterized as a black hole of risky debt and leverage, AIG actually touches main street directly through structured retail investment vehicles like annuities and, certainly, their penetration in the overall insurance market. Even Kenneth Lewis, CEO of BAC, spoke of the unmentionable, that is the potential failure of AIG and the significance being catastrophic due to so many major banking institutions being intertwined, like trying to keep your head above water while being tied to an anchor of a sinking ship.

AIG is different than those firms that some on the sidelines take glee in the blowout of investment banks and the demise of other over leveraged financial institutions. AIG's penetration into retail and commercial business almost makes the potential reach of a collapse unquantifiable, a true "X-factor" that might not be solvable. This is not an argument about saving the shareholders who risk being busted out like Bear Stearns or Lehman Brothers. This is about recognizing the serious implications of how tangled the web is that Wall Street weaved with upwards of a Trillion dollars in leveraged assets, beyond the comprehension of any intelligent human being.

In terms of viable assets, property and casualty, or the insurance division of AIG remains viable and a source of secure revenues over time. However, dipping into unchartered waters of the whole sub-prime mess of structured vehicles and residential mortgage losses has made even one of the most recession immune companies at risk for collapse.

Letting Lehman Brothers fall was a wise decision by the Fed because the markets could absorb and digest the effects over time, but AIG, I fear, may actually have more critical and systemic effects that could not be written off so easily.

I haven't touched any of these debt riddled balance sheets of the financial sector for a long time even though price comparison to historical levels remains deceptively enticing, like the flesh eating Venus fly trap that patiently waits for its prey.

Consider household life insurance and the unintended effect it would have on working American families that have limited direct exposure to the overall stock market. While life insurance is state regulated, it is very unclear as to how any hard-working family could be fully compensated if AIG was defunct. And when I hear people say, rather dismissively, what does all of this have to do with me, I can only answer that you are either woefully naive about the entangled domino effect or simply indifferent to the suffering of others.

Imagine the many people that have paid monthly premiums for years on end to contribute to their life insurance policy, and now, in the later years remain inaccessible to being underwritten by a new policy. Either do to sickness, age or other "risks" that insurance actuaries like to use as reasons to cancel or deny coverage.

The impact of this would be tremendous and a complete mishandling of the trust of so many regular Americans that depend on the security and protection for their families.

If Congress, Republicans or Democrats, were truly serious about helping American families, they need to create legislation that provides a guarantee to consumers that pay into life insurance in the possible event of the company folding or filing for bankruptcy. Unlike providing a backstop to over-inflated mortgage paper, life insurance is a business model that retains consistent revenue due to monthly premiums and the necessity to keep paying or risk cancellation.

Life insurance is the security blanket for many American families and, as such, should truly be restructured so that all insurance companies are required to contribute funds and capital to a pool designed to "insure the insurers" upon default.

Gambling on AIG

I am not recommending anyone jump in here–in fact, please don't. However, I did take a very speculative nibble–and I mean small because this is toxic stuff–on AIG with a very specific strategy. I would never speculate on any individual position more than 1% of an entire portfolio allocation. The intraday volatility knocked a once, colossus-like firm down to $3 and it set up nicely as a risk to reward scenario. Because of the volatility, I don't think even the market makers were accurately able to determine what the correct premiums were for in the options and, therefore, set up a very unique collar trade by my own metrics.

Folks, AIG is not an investment, it's an outright gamble. Unfortunately, it's not just shareholder chips that are laid on the table here.

For the sake of the economy and the markets around the world, I hope AIG survives, but as a trader direction is less important than volatility. AIG will move dramatically toward zero or bounce on a recovery. We shall see very soon. If you touch this stock you better anticipate it can go to zero. I don't believe it will be allowed to collapse as Lehman did, but I put on a hedged trade with the understanding that it could.

I would anticipate that AIG will either secure funds to help facilitate the 40 billion bridge loan they requested, or private equity may step in. Honestly, this is a time when our fearless leaders should be knocking on the door of sovereign wealth funds with their tin cup because AIG has global implications when it comes the capital markets.

I hate to say it, but if they let this fall and the dreaded domino effect continues, those survivalists may be right in stocking up on guns, ammo, canned food and bottled water.

Understand, the very same fate handed to Fannie Mae and Freddie Mac that decimated shareholder equity could happen. But I believe AIG will have to be salvaged because the consequences are far too severe.

Make Rate Cuts Conditional and Incentivize a Reason to Lend

As I write this article, we all will await the manipulative response by the futures markets as they try to press the downward move and the rest of the global markets open in reaction to today. Tomorrow, the Federal Reserve will be expected to take some type of action–I hope not a rate cut–but simply a very aggressive statement of policy and plan of action to stabilize the deterioration of the markets.

I've addressed this issue before in a previous article, but it is worth mentioning again. Rate cuts are meaningless unless you can incentivize institutions to extend credit. What the Reserve ought to do is raise rates to strengthen the dollar and continue the downward pressure on commodities and the oil markets. In turn, they should use the "discount window" for what it was intended, by lowering the rate for those that are willing to extend credit in the capital markets well below prime rate.

This would set up a very unique "arbitrage opportunity" for the strongest financial institutions and truly help to alleviate and fix the problem that is broken in the credit markets. It would motivate banking and financial institutions to put their money to work based on conditional access to lowered rates if, and only if, they used the borrowed capital to pump liquidity into the economy.

We stand on the precipice, and more than ever before, Chairman Bernanke and Treasury Secretary Henry Paulson need to show the markets leadership. I have been a staunch supporter of their actions that have been more than our political leadership has provided. They may not be perfect, but they don't seem content to sit on the sidelines and hold meaningless hearings and do nothing.

I fully anticipate some serious resolution to occur tomorrow. Understand, we are in an option expiration week and a "Triple Witching Hour" at that. The VIX, or volatility fear index, has hit a yearly high above 30% and the cost to insure portfolios now reflects major concern.

The consequences of not bailing out Fannie Mae and Freddie Mac is not fully understood and, we hope, will never be fully realized. Perhaps, this recent bailout, a dramatic 500 point decline and, hopefully, some needed liquidity and market stabilization could be the much needed enema for all the toxic slime clogging up the arteries of our economy. Perhaps, from this moment forward, we can begin to consolidate around a true bottom and repair the decimated shares of the financial sector to lead the markets higher in the S&P 500, DJIA, and Nasdaq.This is the perfect time for the Fed, Treasury, and SEC (amended short selling rules) to step in and, quite literally, blow all the shorts out of the water this week, right now at this very moment, before it's too late…

If I could vote for Bernanke or Paulson over the two choices we are left with in Obama or McCain, I would because at least they have a common sense understanding of the economy and have committed to taking action instead of spouting out empty rhetoric for change. When I listen to the Democrats and Republicans attempt to exploit the issue to their own election ambitions, I am disgusted because they really don't have a clue when it comes to providing a solution.

Yes, folks, we are witnessing history. And whatever action or inaction is taken, history will be the ultimate arbiter and judge. Change? Don't bet on it, even if you think you're voting for it.

Disclosure: Author holds small, speculative "collar" AIG position (long shares, long puts, short calls).

Comments

[iNVestorUnrest:]

This is a very interesting article. Why isn't this featured more prominently when it seems to address exactly what's going on in the market right now when it comes to the debacle of this AIG and the resulting Federal reserve meeting in the next few hours or so?

I've been reading all these other articles on AIG on the front page and very few dare to talk about how to play it or how it effects the rest of the market.

That is an very interesting way to play AIG with maximum volatility up or down. I'll be interested to see how it works out.

2008 Sep 16 01:36 PM

[wise invest...:]

1 BILLION SHARES TRADED IN THE DAY! OUTSTANDING

2008 Sep 17 02:21 AM

[notsosmart:]

are you wiping with all the valueless paper?

2008 Sep 17 02:31 PM

[Zekeko:]

nice articles. Just read this because your article on short sellers was impressive read.

2008 Sep 25 12:01 AM