Don't Touch Anything Requiring the Use of Short-Term Lending Markets

Lifeline of the U.S. Economy

The rapid pace at which our financial markets are restructuring have many investors scared and intimidated.  I am asked by friends, family, and other associates about what to make of the shakeout in commodities, equities, and credit markets.

This often puts me in an awkward situation.  You see, today's market volatility presents and destroys financial opportunity on what seems to be a daily basis.  I have a hard time recommending to somebody a play that they can simply hold over the next 5 much less 20 years.  For that reason, if I don't see or talk to somebody rather frequently, I cannot share with them my favorite investment opportunities.

Dear Reader, that's the advantage you have.  I am willing to share my favorite plays with you because if profits need to be taken, or a position reverses, I can share the information with you immediately.  This allows the free flow of financial investment discovery.

Knowing that, I don't leave my colleagues out to dry.  What I can do is share with them, and now with you as well, the fundamental approach I've taken in analyzing the effects the credit crunch has on corporate America.  The beautiful thing is that it's very simply...

Don't touch anything that requires the use of short term lending markets.

Cash Is King

I know it seems overly simplistic, but we have to really look into this idea.  First and foremost, we have to understand that interest rates will be moving higher ("official" rates set by the Fed will go to zero...that's a different story).

Higher interest rates are simply another way to say that short term lending will be more expensive.  Companies who need access to these funds, and are on the margin, will not make it.

The best indicator of this are the credit spreads between government debt and short term lending rates.  Another great way to figure out where a company lies in the spectrum of solvency is to look at their interest rate swaps.  Interest rate swaps are simply a premium paid to have one's debt insured.  These are both ways to put a numerical value on a company’s ability to repay its debt.

These two indicators, especially the credit spreads, told us that Lehman, Washington Mutual, and Fannie/Freddie, were bound for bankruptcy or bailout.  Their credit spreads had gotten so bad prior to their failures that they were essentially non-existent.  That means that their debt was all but "no bid" at the debt auctions.

We are seeing a slightly less extreme case of this for the short term muni debt markets. Therefore municipalities like Jefferson County are unable to roll over their short term liabilities.  If buyers are unwilling to enter the muni debt markets, we will see the headlines start up regarding government intervention at the state level.

Then you have the industries like the airlines and auto production.  This is another situation where lenders are completely unwilling to lend at current prices.

Look at Sun Country.  Obviously there's an extraneous circumstance regarding the Tom Petters fraud, but Sun Country and the rest of the airline industry cannot enter the short term debt markets and finance obligations.  Sun Country had to force its employees to forego the first half of their pay for the first half of the year because Sun Country doesn't have the cash.

Expect bankruptcy to reappear in with the airlines, and Detroit is going to either need more federal money, or think about declaring Chapter 11 as well.  These you can take as facts.

Fed Tampering Again

All in all, when investing, we need to avoid companies that have to enter the short term debt markets to finance its obligations.  If a company has enough cash on hand, or the ability to raise private capital through equity stakes, they will be able to survive for now. 

Let's not forget that the automakers had a large amount of cash on hand that has allowed them to get this far.  As losses mounted, their cash dried up.  In that time, they couldn't turn their business around.  Now they are insolvent.  It's simply best to look for strong cash flows and profitable enterprise.

You don't have to believe me.  Look at what the Fed has been up to.  The most recent talk around the financial watering holes is an intervention into the commercial paper market as bid/asks have reached and moved past dangerous levels.

Right now, short term lending drives our economy.  Without it, violent contraction will ensue.  Look at the freeze in short term credit markets as a margin call on the debt addicted United States of America.

Comments

[Jimmy Lathrop:]

Great article.

2008 Oct 08 07:46 AM

[LiquidSoapD...:]

I'm a simpleton compared to many of you, and I could not make sense of your assertion that interest rates will be moving higher. Why? Which interest rates? I am not able to see what will bring interest rates up in the near future (other than rates offered by desperate companies). Are you just saying interest rates will move up... some day?

2008 Oct 08 09:00 AM

[georgiabell...:]

Liquid:
Although the Fed funds rate will likely drop, institutions will only be willing to lend if the spread between the rate at which they are borrowing and the rate at which they are lending is sufficiently large to justify the risk. Hence, higher interest rates for borrowers.

2008 Oct 08 12:51 PM

[LiquidSoapD...:]

GEORGIA BELL, the author just said "interest rates will be moving higher," which I interpreted as higher interest rates on our savings accounts (etc.), but you are interpreting as higher interest rates on loans I take out. Is there any reason to believe savings and money market accounts will be paying higher interest rates?

2008 Oct 08 10:04 PM

[Old Trader:]

Liquid,

Anything pegged to the Fed Fund's rate will drop (like savings accounts); anything pegged to LIBOR (LondonInterBankOverni... will spike.

2008 Oct 09 12:59 AM