Putting the Perception and Reality of the Financial Crisis Into Perspective 11 comments
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On August 29th, I submitted a somewhat provocative commentary titled "Financials and Ted Spread could Signal a Bottom for Corporate Profits" to SeekingAlpha. To say the least, it caused quite a stir and generated some extremely passionate responses.
Based upon the model of chaos theory, let us apply the war metaphor to the stock market which is merely a feedback mechanism for the economic business cycle. In battle, the power of focus and emotional detachment may enable one to rise above or see through the fog of war and distinguish perception from reality.
If one is able to transcend this fog, then discerning when to heed either perception or reality can be equally or more challenging. Since the previous article referenced the July 15th bottom for financial stocks, this will be a starting point for analysis.
From July 15th thru Aug 29th, the SP-500 was up +5.59% while the DJ US Financial index was up +22.22%. Not being sucked into the euphoria of the moment, it was still hard to ignore the multiple bottom formation pattern being formed in the financial index without questioning the fundamental significance of this event.
Then, perhaps as well as now, the consensus opinion had written financial stocks a one-way ticket to hell in a handbasket. In the month to follow, this would turn out to be quite true for AIG (AIG), Lehman (LEH), Merrill (MER), and Washington Mutual (WM). Of the 5 major investment banks (Bear Stearns (BSC), Lehman, Merrill, Goldman (GS), and Morgan (MS)), only two managed to survive, i.e. Goldman Sachs and Morgan Stanley. Yet the latter two succumbed to a symbolic death as they were forced to abandon their investment banking models.
Over the entire period from July 15th to September 26th, the SP-500 is off -0.16%, while the DJ US Financial index is ahead for a +22.45% gain. From August 29th to September 26th, the market saw the SP-500 retreat -5.44% and bastions of capitalism dissipate into thin air. However, despite the tremendous amount of wealth destruction that occurred during this period, the DJ US Financial index has held its ground with a +0.19% return.
No one plays a better game of 3 card monte than Wall Street. Where did the money go? The answer is the big money center banks. From August 29th to September 26th: JP Morgan Chase (JPM) +25.33%; Wells Fargo & Co. (WFC) +23.26%; Bank of America (BAC) +17.85%; and Citigroup (C) +6.11%, thus far deserving of honorable mention.
Wait a minute. It gets better. From July 15th to September 26th: Bank of America +98.16%; Wells Fargo & Co. +81.91%; JP Morgan Chase +55.51%; and still deserving of honorable mention, Citigroup (C) +38.39%.
The perception is that financials and the rest of the market are doomed for the abyss and this is still quite possible. One area of analysis that I may have overshot was on the TED spread.
The TED spread is the difference between Libor, which is based in eurodollars, and the 3 month treasury. Banks typically lend to each other at Libor. During healthy economic times, the spread will range from 40 to 60 basis points. After the Bear Stearns bailout and fire sale to JP Morgan Chase, it looked like the Fed and the markets were beginning to get the message even though problems remained unresolved.
Right now, the spread is screaming Emergency 911! as it has spiked dramatically upward. The $700bn Fed bailout, when it passes, will not cover all of the bad loans and nor is it intended to do so. However, it will hopefully create enough liquidity to prime the credit pumps for banks.
What is different at September 26th vs. July 15th or August 29th?
1) Volatility is higher than it was at the July lows or end of August and therefore there is a lot more fear and panic in the market.
2) A sincere effort is finally being made to address the financial confidence and liquidity crisis. The market and its banking participants have admitted that this problem is too big for them to solve on its own, or deny. Only the Fed has the liquidity and ability to hold these assets long enough until they revert to more realistic intrinsic values, and they will.
3) If implemented swiftly, government purchase of these bad assets would immediately reduce the amount of risk exposure to bad loans, positively impact the earnings trend (note this is not the same as positive earnings) and allow surviving banks to return to some level of normalcy. In essence, this would be the beginning of a bottoming process for earnings in financials and any other companies with business models highly dependent upon financing their operations and growth.
4) We know more bad news now than we did on on July 15th. Systemic risks become more urgent with the passing of time, but the fact remains that the value of the SP-500 benchmark index has not drastically changed since the July 15th bottom (although it currently sits upon a precipice).
On the other hand, the DJ US Financial index has achieved and maintained its remarkable gains. The market has rewarded those financial companies which have exercised discipline and severely punished those which have not.
5) The recent industry consolidation will increase market share for the survivors. Less competition equates to larger slices of pie and suppresses incentive to pursue high risk strategies for profits. The banking industry is about to embark on a 12 step program and shake its addiction to high leverage, credit default swaps, and laissez faire style regulations. It should be interesting.
Is all the above a suggestion that we are out of the woods now? Certainly not.
Besides the subprime mess, there is still the Alt A financing and Credit Default Swaps to manage. This current financial confidence and liquidity crisis should be a wake up call for the Fed, financial industry, and non-partisan oversight committees to proactively deal with these issues.
In the meantime, it is important to realize that market pundits and the financial media often generate a lot of unnecessary noise which influence market sentiment and distort clear vision. It helps to tune out this noise and comparatively analyze the fundamentals of a group while listening solely to price and volume. Sometimes the market tells a different story and its usually not the one that most people perceive.
Disclosure: None
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This article has 11 comments:
to indulge this vainglory. 3. Their joy of financing this deficit has greatly decreased over the past year. To perpetuate this stupidity, Congress has less risk if the bill is passed tonight! 4. The size of the monies owed may suggest major foreign banks could collapse tomorrow if Congress does not remove it's head from another part of it's anatomy!
This may suggest the best November solution is to vote for me, Honest John. You have your choice of VP's between my two CATS. Casey is a little arrogant, but has the welfare of the country at heart. Penny Cat is a more feeling type of individual who views decisions more from an emotional framework.
Please, input from more knowlegable people?
You know, given the candidates we have in front of us, it wouldn't take much for me to take you up on your offer. When confronted with lesser of two evil choices, people are wont to take a chance. And given the usual function of the Vice President, one of your cats would probably do.
Too bad there isn't a viable third party candidate. But the parties have removed that option. They know all too well that people are likely to grab at straws when given the kinds of choices we are.
As far as the original article and chaos theory goes, you need a model to use it. Have you got such a model? It can't be very good if it didn't see this coming. I had coworkers, working stiffs who aren't in finance, predicting this was coming years ago. They weren't using chaos theory, just common sense. They saw the flipping, people being priced out of the market, the mortgage sales mania, reverse mortgages, ARMs. Already ten years ago this was starting. I knew a guy who was selling mortgages, doing gangbusters business. He thought the sky was the limit. It reminded me of the traders doing the dot com mania thing at the time.
One cannot resolve a problem unless one understands the problem.
PROBLEM: Financial institutions have reduced their lending.
The problem results from the impaired equity portion of the balance sheets of these institutions, with the impairment caused by write-downs of their assets (loans).
Due to the losses they have taken, these institutions, by law, have had their maximum potential lending amounts reduced.
The amount they are able to lend is contingent upon the amount of their equity capital (EC), e.g., if an institution has an equity capital of one billion dollars and is able to lend up to 20 times its equity capital, it could lend up to 20 billion dollars.
After taking loan write-downs (losses) of two hundred million dollars, its EC would now be 800 million dollars, thus it would have its maximum lending authority limited to 16 billion dollars, i.e., a constriction of its legal authorization to lend.
This is the crux of the problem.
The institutions have funds, i.e., liquidity. But, without the legal authority to increase lending, they are sitting in stagnant water.
Those who say that one going to one’s ATM for a withdrawal may find a closed sign are, absolutely, lying or ignorant.
If one is a Representative or Senator and is lying, he or she should be Impeached and removed from Office.
Likewise, if that Representative or Senator is ignorant, he or she, apparently, is not, adequately, accepting his or her fiduciary responsibility of understanding a subject prior to advocating or voting for it, thus he or she should also be Impeached and removed from Office.
PAULSON PLAN: Purchase impaired mortgages from financial institutions with taxpayer funds.
Indeed, this would positively affect an institution’s EC, because the impairment (loss) would have been transferred to the taxpayers. This reversal of loss would be achieved by paying face price rather than market price, since if the market price were paid, there would be no effect upon EC.
This contemplated action is anti-capitalistic, immoral, and a method of stealing from taxpayers.
The taxpayers did not cause the capital impairment (this IS the problem, i.e., “It’s the balance sheet, stupid”).
Anyone involved with designing this scheme and voting for it should be incarcerated as co-conspirators to steal from the citizenry.
The scheme’s authors and those who advocate for it would be precipitating an admission that capitalism doesn't work, which is a lie.
Capitalism is the best economic tool ever devised, but as with any tool, it can be and has been abused.
Congress should accept most of the responsibility for creating the economic atmospheric conditions that enabled the abuse.
Further, any resolution of this financial phenomenon will not abate the underlying problems of the economy.
It is not the lack of lending that has damaged the economy. It is the economy, affected by greed, that has damaged the lending, but, of course, if appropriate corrective actions are not taken in regards to this financial phenomenon, our weak economics will be adversely affected.
If the Paulson plan were adopted, it would be the most massive SPE by multiples, the dollar would weaken, interest rates would go up, thus the decline in home prices would be exacerbated, and the EC would require further resuscitations.
BEST PLAN:
1) Allow some institutions to go the route of Countrywide, Bear Stearns, IndyMac, and Washington Mutual. I, also, like the AIG model.
2) Most rational institutions will do what UBS, Merrill Lynch, Goldman Sachs (just recently with Warren Buffett) have done, i.e., they have raised additional EC, usually by selling preferred stocks.
Months ago, when Merrill sold 6 billion (as I recall the amount) dollars of preferreds paying 9%, I knew they were desperate, and that this was just an early domino.
Goldman Sachs, from what I have heard, is paying Buffett 10% for the preferreds. Keep in mind; this is after-tax money. The only reason for Goldman Sachs to take a desperate (GS also gave Mr. Buffett 43,000,000 warrants to purchases GS common @ $115 per share) action was because it knew it was experiencing an EC impairment and needed to raise additional EC.
Please keep in mind that pain is not all bad. It is a signal that something is wrong and indicates that the source of the pain (problem) must be determined, analyzed, understood, and finally the best alternative action must be taken.
We are experiencing pain regarding this financial phenomenon.
3) As a last resort, it would be appropriate for the government to establish a fund (call it the RTC 2.0 AKA Peoples' Financial Fund) and use those funds to purchase (just as have Mr. Buffett and others) preferred stock from institutions. The fund should follow Mr. Buffett’s lead and demand additional potential remuneration in the form of long-term warrants.
The stock would receive dividends and would have a convertible feature to convert to common stock, at the option of the fund.
Further, until certain parameters were met, the preferred ownership would assume voting control, thus the matter of executive compensation would be moot.
We either believe in capitalism or we don’t.
We will have displayed a pragmatic solution well within the parameters of capitalism.
The U.S. dollar will strengthen.
The next step would be to address the underlying economics with the basic problem being unbridled greed.
We should not have a "shot" stimulant as we did earlier.
We need to eliminate the largess given to the very wealthy, in error, by the Bush tax cuts, and to reduce taxes on the middle-class on a permanent basis.
This will have an immediate positive effect upon our economics and we will be on the path to a rational economy.
I will appreciate all comments regarding the foregoing.
Michael Z
Sherman Oaks, Ca.