Current Market Observatons April 2009

I have attached a comparative chart: 1.) Selected Case Shiller vs. S&P 500 vs. Gold and 2.) Statistical Analysis of selected markets since the recent decline in housing prices and equities.

It is interesting that the markets are starting to show some moderation in year over year numbers in the rate of decline, but this may also be due to a temporary moratorium on foreclosures by some of the major banks at the beginning of the year. Florida, Arizona, California, Las Vegas, and Detroit have witnessed the most severe decline from the highs reached in 2006. As all assets appear tied to the “Financial Bubble” created by easy money policy by the Federal Reserve in 2002 and repeal of some parts of the Glass-Steagall Act of 1933, a significant clearing of debt through write-downs, foreclosures, and defaults will persist as balance sheets and businesses are consolidated and revalued. This is one of the few times in history where the global economy has been the subject of a massive margin call due to the tremendous leverage existing in many pockets of the interlinked economies. Mortgages, CDSs, CMOS, CDOs, margin accounts, Hedge Funds, Prop. Trading desks, consumers, real estate investors have all enjoyed the elated returns of leverage in the good years, but as the underlying leverage for both individuals (real estate if one puts 10% down is 10:1 leverage), margin accounts, commodities, and various hedge fund strategies have been creative enough over the past to leverage up to 100:1. This works well when the trades and investments are in one’s favor, but as everyone gets caught on the same side of the trades, the resulting unwind is devastating as we are witnessing now.
Despite the deceleration in the Case-Shiller index in February, the decline in housing prices is tracking the "more adverse" scenario in the federal government's stress tests on major banks, which assumes a 22% drop in home prices this year, according to Bill McBride, who writes the Calculated Risk blog.
Falling home values have helped to plunge the global economy into chaos because financial institutions made too many bad bets that U.S. home prices would never fall. Homeowners have lost trillions of dollars of wealth.
With prices still falling at a rapid pace, millions of homeowners are finding themselves owing more on their house than it is worth. They cannot sell for what they owe, and they cannot refinance their loan. They cannot borrow against their home to finance their consumption.
Prices fell in all 20 major cities in February, led by a 5% drop in Cleveland, S&P said. In February, prices in the Dallas metro area performed the best, dropping just 0.3%.
Prices in all 20 cities have fallen significantly. Prices in the best market -- Dallas -- are down 4.5%. Prices in three cities -- Phoenix, Las Vegas and San Francisco -- are down 30% or more in the past year.
My concern is the Stimulus Plan is really a Tax Bill of Trillions of dollars, and Federal Reserve has now conceived a new means “quantitative easing,” whereby they expand the Fed’s balance sheet and buy mortgages, T-Notes, T-Bonds, and other debt instruments. At some point in time the leverage needs to clear the system, not be moved around in a clever shell game. The Global economy will continue to grow with the world population growth, and profits can be made from necessary goods and services, not from trading paper and inflated assets. The markets entered their “Bubble Phase” due to too much money, significantly leveraged chasing due few goods. When the consumer could no longer buy the products, borrow from their assets, or cover their debt obligations, everything began a slow, then accelerated decline.
Equities, Real Estate, and Financials have suffered the bulk of the decline. It appears that there is still a large amount of debt to be written down, and the cycle will continue until it clears the system. This may mean break ups / consolidations of many corporations, but more keen minds seem to understand the problem, though political inclinations may influence results more than rational reconciliations.

I continue to like companies that make necessary products where margins and market share can be expanded. This list of companies includes Apple, Amazon, Goldman Sachs, Research In Motion, Verizon, General Electric, and Morgan Stanley. I would be hesitant to chase this rally from the March lows for I believe there will be a retest of the 740-780 level in the S&P 500.

Ben

The Real Use of TARP Funds and why the Banks' Earnings are so GOOD!

The Real Trade Behind Re-Liquidating Balance Sheets (or where the TARP money is being deployed)

For the last year there have been substantial write-downs among all of the major financial institutions due to “toxic assets.” The premise behind the TARP (and various other alphabet soup programs) has been to ease the toxic assets off the books, or provide the financial institutions with the ability to remain properly capitalized and loan money to businesses. It is interesting that in today’s WSJ “TARP Cash Isn’t Moving Forward.” Where is it going?

GS, JPM, WFC et al are all reporting surprising earnings. Even in early March when the equity markets turned the CEOs of BAC, C, and JPM were promoting the story that they were making money and that times were not so dire for them. What did they know? They knew that the economy was continuing to get worse, asset values in real-estate, commodities, and other hard assets were continuing to deteriorate. They also knew that they were getting large sums of money from the government, easy access to the Fed window; trial balloons had been floated regarding “quantitative easing,” and “unconventional easing.” The Fed can only lower the interest rate so far, i.e. zero, but they can create an environment where by expanding the Fed balance sheet the effective rate drops below zero. It has been forecast that in order to make the policy appropriately easy that the “Taylor Rule” funds rate need to be at -8%, which would mean the Fed balance sheet would need to expand by as much as $10 trillion. The Fed expands their balance sheet by purchasing Treasuries of varying maturity.

This unconventional easing creates the opportunity for banks to releverage in the Treasury mark and arbitrage the spread by purchasing 5yr, 7yr, and 10yr Treasury Notes at yields ranging as high as 2.75%. As a straight cash trade this would be a good use of the TARP money; $5 Billion would earn $137.5 million over the course of a year. But this is where the creative folks of Wall Street earn their keep, they decide to purchase the 10 yr. Treasury for example on margin and finance the transaction in the over night / term repo market at 25 bps (.25%). This results in a positive carry of 2.50%. Now a large financial institution such as C, GS, MS, BAC could possibly leverage this transaction 50:1, 100:1, and 200:1. In this example let’s take the more conservative number of 50:1; this means for every $1 Billion in 10 yr. notes they buy at a yield of 2.75% they need put up (in repo terms this is called a “haircut) 2% or $20 Million. In theory every $1 Billion in TARP money that goes into this trade, the banks could purchase $50 Billion in 10 year US Treasury notes. This trade creates a positive carry of 250 bps (2.50%) (Yield-cost to carry) or $1.25 billion in income over the course of a year by leveraging just $1 Billion. Not a bad ROI. So for every $5 Billion ($250 Billion in T-Notes) of TARP money in this trade, the banks create $6.25 Billion; not a bad way to reliquidate the balance sheet.

The risk in this trade is substantial, and is similar to what creating the mess in the first place. Using margin through the Repo market means that if the Treasury Notes were to move against the trade by more than 2%, the trade would wipe out the TARP money; and moves above that threshold would eat into the banks’ capital once again. The risk is mitigated by the Feds unconventional easing through the purchase of Treasury Notes along the yield spectrum. If they sense the market is moving against the banks, they print more money and buy more bonds keeping prices at a steady level. If the Fed really wanted to create liquidity on the balance sheet of the banks they could drive the prices of the 10 yr Note up (lower yield) by 3pts; prices would go from 100 to 103 (yields would drop by approx. 30 bps to 2.45%. This would be the turbo-charged version of Fed helping the banks; the carry would result in $6.25 Billion per year, but the principal increase would result in a profit of $7.5 Billion; that’s a total profit of $13.75 Billion over a 1 year period on $5 Billion in TARP money. Perhaps it is becoming clearer why the banks are not lending, their return is far better in the Fed’s arena.

How can one know if this is really taking place? Let’s look at one of the major Wall Street bank’s recent 8 K filed this week. The average daily VaR (Value at risk jumped from 197 in the previous quarter to 240 with the increase in the interest rate sector going from 178 to 218. This means the bank believes it could lose $240 million in a day based on its risk model. This same bank showed total revenues from Trading and principal investments and Interest Income of $10 Billion, with interest expense of $2.4 Billion. This bank in particular has had the use of $10 Billion in TARP funds.

This trade and solution to build back banks’ balance sheets in very creative on the part of the Fed and the Treasury, for there is no way to fill the black hole of toxic assets by just taking them off the balance sheets, the hole can be filled by creating fresh $s to replace the losses. How long might this take? How long might this trade go on?

There is risk in the trade. Can the government through its unconventional easing support the prices in the Treasury Note market? The ultimate risks also involves the U.S. Tax payer for the positive carry that exists in the trade increase the amount of the Budget deficit over time. Effectively the leverage works in favor of the banks and Wall Street by creating a special trade where they are given money (TARP) for a trade, then allowed financing the trade with the Fed for next to nothing, and having the Fed support the prices of securities they are leveraging by expanding the Fed balance sheet. In other words, I give you a $1, you buy $50 of government debt and finance it with a positive carry of 2.50% for one year, and the government basically guarantees to buy the paper back at the price you paid or better (maybe they want to make you feel even better). At the end of one year your $1 has become $2.25 if the government just buys the debt back at what you paid. But let’s say the paper improves in price and yield drops (for everyone wants in on this trade) by 30bps; the government buys the paper you purchased at $1 ($50 total) for $1.03 ($51.50) your $1 has now become $3.75. I like this trade! So do the banks with your money! What could go wrong? The Fed may not be able to keep prices at current levels by expanding their balance sheet (ultimately our children’s debt), and at some point in time when everyone has the trade in place and it needs to be unwound there will be too many rushing for the exit. Look at what happened with the Yen carry trade and how it kept the value up as everyone looked to unwind.

Meanwhile this creative liquidity could bode well for all of the financial stocks for some period. This could super charge all of the markets.

Ben

GREENSPAN'S BUBBLES CONTINUE WITH OBAMA

If one goes back to when Greenspan's tenure as Federal Reserve Chairman started, there are four consecutive bubbles he created in order to perpetuate his theory of "perpetual prosperity." If the leverage built throughout the system has compounded around the world as a result of the creative financial engineering through CMOS, CDSs, derivatives, and other forms of leverage caused the tremendous run-up in prices from commodities, to equities, inflated earnings, real-estate, and consumer prices over Greenspan's tenure from 1987--2006, then the clearing / deleveraging of the system will not occur in a matter of months or even a few short years. As we witnessed in Japan, the process is going on over 18 years after their market imploded. In the 1930s it took WWII to turn around the devastation. It is "always different," according to all of the pundits, but the reality is that in order for tremendous leverage to clear the system, defaults must be allowed to occur where new businesses are allowed to grow out of the ashes of the poorly managed carnage of the leveraged follies of the past. How many balance sheets have been exposed to the benefits / detriments of leverage and the fictitious earnings over the last 20 years. It paid to have leverage from 10 to 1 to as high as 140 to 1. In an era fostered by an ever increasing money supply ( Greenspan actually stopped reporting M3 so we would not know the amount of $s being created by the Fed), leverage was the way to paint the numbers for earnings. Creative CEOs realized that to compete they needed to have the derivatives and their underlying benefits in the age of easy money. Unfortunately everyone drank the Kool-Aid, and now the prescription for what ails the system is for a stronger dose of Kool-Aid. The systemic problems cannot be healed by encouraging more borrowing to get ourselves out of debt. Would you lend your teenagers more money when they had maxed out their credit cards in order to help them get out of debt? Have the financial institutions been honest as to the real nature of their exposures? Let's look at the carnage that has spread throughout the system starting with Bear Stearns, Lehman, WAMU, Wachovia, AIG, etc. This does not even reflect the "zombies," that have been propped up in order to get one last taste of the elixir such as C, BAC, GM, GE, WFC, F, etc. Are the bail-outs only a means of propping up the world in an environment where debt needs to be cleared. Moving the debt around in a massive shell game / musical chairs only mean that when everyone finally comes to the realization that the "emperor has not clothes," or that there is only one chair in a room filled with hundreds of believers, panic will ensue; and from that point we can move forward. We are just beginning to hear fresh whispers of trillions more in toxic debt, under-funded pension plans (public and private), life insurance policies that are at risk, etc. Where does all of this end? Massive tax increases disguised as stimulus? Printing presses running 24/7 in order to create more money (was this not how we got here in the first place)? New forms of quantitative easing by the FED? How creative, let's buy all of the underlying debt and put it on the Fed's books with the money they have created out of thin air and hope that they can realize a profit on their trade later? This is just another form of "creative financial engineering" that everyone now wants to point the finger at Wall Street. Can we really be on the road to recovery when the world is willing to take the same road it took to disaster? The definition of someone who is mad or insane is that they continue to the same thing over and over again expecting a different outcome from identical behavior. Let's realize we cannot repeal Mother Nature and the road to recovery is allowing the clearance of debt through uncomfortable means, and the creation of products that people need to survive and perhaps enjoy life. Rampant consumerism is over, growth maybe slower, but people will learn to adjust. There will be stellar companies providing real services and value. As the German's cleverly coined a phrase, "trees do not grow to the sky." I recognize that this treatise may seem dour and discouraging, but sometimes a reality check is necessary when the tree is really falling on one's head.

Ben