What Goes Up…

Lots of sour faces on Wall Street and around the country today, as it appears the Fed’s panicked, ground-breaking intervention in the last three business days was not enough to keep the markets from taking a nose-dive after all. I can bet you the analysts weren’t the least bit surprised, as the evidence of an extended and substantial decline is as plain as Mount Everest.

Quick review. Bear Stearns finished last Friday at $30 a share, but near the brink of insolvency. Investors spent Friday trying to extract any of their funds out of the beleaguered Wall Street mainstay in what resembled a good old-fashioned “bank run.” The Fed coaxed J.P. Morgan to assume the investment house’s outstanding debt in a stock swap valuing the company at $2 per share. Yikes!

The deal would not be possible, however, without a new Fed policy that allows investment firms and stock brokerages to belly up to the Discount Window for loans, a privilege previously reserved exclusively for banks. This will come back to haunt the Fed, as they will find that every weasely Wall Street speculator will go on a spending spree with government-borrowed money, then come looking for a bail-out when the ferret farm they dropped a hundred million bucks on comes down with fleas. But I digress.

Then, yesterday another three-quarter point cut in interest rates, the second this year, a first in the history of the Federal Reserve. Markets soared on the news, adding over 400 points to the Dow.

All of this is to ensure that markets are liquid and able to meet short-term obligations. That’s the friendly version. The truth is that the money is to pacify jittery investors looking to pull their holdings into cash and precious metals. They’ve got the right idea, and it doesn’t take repelling gear to figure it out.

Hard-core traders follow market signals. P/E ratios, moving averages, debt to equity, and charts. Bazillions of charts. One of the tried-and-true chart signals market mavens swear by is called the “triple-top”. It’s when a stock goes up, then retreats a bit, then goes up just a little higher, then retreats, then goes up not quite as far, then plummets. So three peaks with a tall one in the middle, and watch out — the party’s over.

Go get a chart of the Dow Jones Industrial Average for a five-year period, and look at the most recent year. Oh boy…

There’s the reason the Dow tanked nearly 300 points the day after a 400 point gain. The market couldn’t help but go down, gravity isn’t selective. Yesterday’s exuberance was just like somebody playing, “You Shook Me All Night Long” three minutes before closing on Ladies Night: those guys who don’t realize the party ended an hour ago are still trying to squeeze the last few ounces of fun out of the thing, but when it’s over and the lights come up it’s just them, their buddy’s ugly sister, two fat waitresses and the janitor. That was the floor of the NYSE yesterday at 4pm.

Party is over, people. I’m saying we have the Dow below 10,000 by this time next year, and that may not be the bottom. Safe bet is in Euros right now, as the U.S. dollar is sinking with no end in sight. Gold also looks good, however these levels aren’t sustainable and investors with large holdings will start taking profits at some point. When gold goes south it goes like lightning, and you won’t know until it’s all over. So be careful.

I hate giving out this kind of advice, it’s depressing. But it’s a public service. You need to understand that the pundits on TV can’t tell the truth about this kind of thing, they’ll get sued and the government will pull their broadcasting license (don’t think for a second that doesn’t happen). All they can do is report on what has already happened and try to keep a stiff upper lip. Every one of those pukes had their Blackberry just beneath the anchor desk, frantically e-mailing their online brokerage with sell orders.

Anyhoo, they can’t sue me, and I don’t have a vested interest in anything one way or the other. Where else are you going to get unbiased advice?

Go. Be smart. It won’t last forever, it never does.

Going To The Mattresses

Tuesday the Federal Reserve’s Open Market Committee made a three-quarter point cut in the Fed Funds rate. So what does that mean, I should re-finance the loan on my Beamer?

Not hardly. It means, in short, that your mattress is looking like a good investment option right now. I’m not kidding.

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If you haven’t already, you first need to go back a couple of blogs and read my treatise on the causes and fallout from the Sub-Prime Mortgage Crisis. That’s where all this mess gets started.

Go ahead, I’ll wait…

So, you’re all up to speed on the hyper-capitalist mercenaries and the banks they swindled, we can move forward.

A few months ago, big banks like Citicorp, Merrill Lynch, and Goldman Sachs announced they were writing off hundreds of millions of dollars in bad debts. One by one the heavyweights of finance came out, tails between their legs, and admitted they had more sub-prime exposure than they originally realized. They took pretty sizable hits against quarterly earnings, their stocks all took a nose dive, and the markets followed suit with large percentage drops in indices all over the globe.

The U.S. Federal Reserve took a concerned stance, holding some between-session meetings and lowering some of the key interest rates under their control. The markets came under control, easing downward over a period of months while enduring slightly more frequent and variant up- and down-swings.

All seemed fine, given the circumstances. Until last week.

Citicorp announced that they had underestimated their sub-prime exposure during the last quarter, and would be writing off more debt. The net result was a four billion dollar quarterly loss. That’s not a typo, in 90 days Citibank lost four BUH-illion dollars.

That news had the weekend to sink in. Citicorp has entire skyscrapers FULL of accountants, financial analysts, auditors, statisticians, and actuaries. But even with all that financial acumen at their disposal, they still not only managed to invest in all of this junk, they lost track of exactly how much they owned. This raised innumerable questions.

Was there more? How bad would the next disclosure be? And that’s just Citicorp. There are hundreds of other banks who have already admitted to having suffered sub-prime losses: how much to THEY have that has yet to be uncovered? If Citicorp fell victim to this, who knows how many of these other banks have those kinds of losses looming in their future.

But Citicorp is huge, they can absorb a hit of this size. Some of these smaller banks might not be able to — we could be looking at some pretty big institutions going belly-up.

So on Monday the 21st, the other major world exchanges reacted to this weekend of festering financial worry. Tokyo, Singapore, London, all of the major indexes took a Hercluean nose-dive.

One of the things that is an observable feature of the world financial markets is the moderating effect of the U.S. market as the last voice of the business day. If Tokyo goes south and London goes south, but the U.S. starts lower but ends with little loss or even a small gain, then when Tokyo opens the next day things don’t go so badly. However on this day, Martin Luther King Day in the United States, U.S. markets were closed. There was no possibility of New York saving the day. The Asian markets would have to brave the storm on their own.

When Singapore followed Monday’s 5% loss with a 7% loss on Tuesday, apparently the Fed OMC members’ pagers went off with an invitation to an emergency meeting before the market open on Wall Street. The result was the three-quarter-point announcement, literally seconds before the market open in New York.

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The Federal Reserve Open Market Committee meets about once a month to discuss the condition of the economy, the various indicators that suggest the direction the economy is headed, and possible actions that may need to be taken to either stimulate or dampen the economy. These meetings are very closely watched by, well, pretty much every financial entity on planet earth, as their action (or lack thereof) will determine everything from that day’s market activity, to long-term demand for durable goods, to housing starts, to the trade deficit, to currency exchange rates. These meetings are planned out years in advance, and by the time the Fed actually does anything, the dubious entity collectively known as the “consensus opinion” usually has figured out exactly what they were going to do.

So if the Fed is usually as easy to read as a dime-store novel, why is everybody so bent out of shape? Because Tuesday’s Fed action was done in a between-session meeting, and came with no warning whatsoever. In fact, the Open Market Committee was scheduled to meet next week. Additionally, a three-quarter point cut is the first of its kind since 1982, and has been called a “once in a generation” occurrence by more than a few financial pundits. And Fed announcements are usually made around lunch hour, well after the market open, and well after the bulk of the big trades for the day have already gone through.

All of this points to one thing: panic. The Fed, under the inexperienced leadership of Chairman Ben Bernanke, is flummoxed and is overreacting.

Changes in the Fed Funds rate take about 9 - 12 months to have any effect on the broader economy. The Fed knows this. The rate they manipulated is related to the rate at which banks loan money to other banks. It has nothing to do with the consumer market whatsoever, and only indirectly affects the rates at which a business, for instance, would be able to obtain credit.

So why do it? Two reasons: to try to get central banks in other major economies to follow suit; and to instill confidence in the marketplace (both the consumer and the finance/investment players) that the US Federal Reserve is on the case, and the US economy is not going to fall into recession, or worse.

Did it succeed? Not even a little bit. The Canadian central bank moved their rate a quarter point, the European central bank didn’t budge (and in fact came out with a statement saying they thought the Fed was cuckoo), and the other major central banks are still giving the matter some consideration.

As for instilling confidence in the market, the immediate reaction seemed good. On the day of the announcement the market plummeted on the open, as predicted, but then rebounded to recoup almost all of its losses. But the rest of the week was bedlam. Huge swings in the market, near-5% intra-day swings in the major indices, and closing numbers either up or down 1 - 3%. Precisely the opposite of what the Fed was trying to achieve. Panic selling followed by bargain-hunter fits of euphoria, and SOES-bandit (day-trader) paradise which increases volatility with highly-leveraged large-volume trades. In simple terms, the market is in a state of unbridled chaos, and the major players all know it.

So what is going to happen? The major players in the marketplace are institutional investors: major banks, pension funds, etc. They have positions that represent large percentages of blue-chip companies’ floats. Those investors can smell the blood in the water, and are right now making contingency plans: one for a stay-the-course-but-minimize-volatility position for the middle-term; one for a gradual liquidation; one for a full-fledged flight to cash and AAA debt.

After the 1987 crash, the Fed installed what are called “trading curbs” designed to slow the process of automated trade execution when the market is headed south fast. Well, guess what: it’s been 20 years, every major institutional investor has a way around those curbs, and they have largely become immaterial. If things go in the toilet, we are looking at a 20 - 50% collapse in less than a week, and no stimulus package or rate cut will be able to prevent global recession.

There is only one position to take in the market right now: cash. Liquidate stocks immediately, regardless of loss, and wait this out. If we see a month straight with no swings of more than 1% of any major market index, it’s safe to get back in the game. Gold is still at historic highs, and might experience a bigger collapse than the stock market if there is no wealth left to prop up the high prices. Bonds normally respond inversely to stocks in terms of price, but the risk is no less in a market this volatile. So in the mean time, you can still earn 4% or more in a nice, sedate Money Market account with any one of a hundred institutions, including (in all likelihood) your current brokerage.

Trust me: in December 2008, a gain of 4% on the year will look like financial genius. You heard it here first.

Sub-Prime Mortgage Mess

I’ve been struggling to come up with a metaphor to explain this sub-prime mortgage crisis to people who don’t have a double-masters in finance and economics. Most of the time I get past the first part and it all deteriorates into descriptions of wholesale securities markets and bond ratings, and next thing you know I’m pulling out my easel. The snoring ensues shortly thereafter.

But I think I’ve got it. An analogy that even a third-grader can understand. We’re going to use third-graders.

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Say Alex forgot his lunch money, and goes to Billy to cover him. But Alex doesn’t want his parents to know he forgot his lunch money, so he and Billy work out a payment plan. Ten cents a day for 25 days, earn Billy a little interest for his trouble. So Billy gives Alex the two bucks, and Alex will start bringing an extra dime with him every day for the next five weeks.

However, Billy is an enterprising lad, and decides he doesn’t want to wait to get his money. But he’s already agreed to this payment plan, and he doesn’t want to be labeled a welcher. What can he do? He comes up with a plan that just might work.

He sets up a deal with Charlie, essentially “selling” the arrangement with Alex to him. Charlie pays Billy $2.25, and Alex will pay Charlie instead of Billy. No skin off Alex’s nose, he pays the same amount no matter who the recipient is, and Charlie makes himself a ten percent profit in a month.

But look what Billy comes away with. Overnight he has turned $2.00 into $2.25. But more than that, he has also eliminated any risk exposure he had in the transaction. What if Alex can’t live up to his obligation? Then Charlie is out the money, not Billy.

Wow, Billy thinks, this could really be the start of something. He sets himself up a little enterprise doing the same thing, only he finds out he can make even more money if he makes lots of little loans and them sells them together for one lump sum. Packaging them together like this has benefits outside of the lump sum as well. Some of the kids he loans to are steady payers, others aren’t so good. When he bundles the loans together he can “hide” some of the bad ones in with the good ones.

At a certain point Billy started running out of customers. But he found that if he altered the terms of his loan payment schedule, he could get more. He would let his borrowers pay only five cents a day for the first week, then fifteen cents a day for the rest of the loan to make up the difference (and put a little extra in his pocket to boot). This got him more customers, however he noticed that the repayment stability of these new customers wasn’t the best. No matter, as soon as he sold the loans and got his money, he was in the clear. It was somebody else’s problem.

This is the start of the sub-prime mortgage crisis. Lenders making loans to borrowers, then selling those loans on the secondary market packaged as mortgage-backed securities. Borrowers ran thin, the adjustable-rate (”sub-prime”) loan came into fashion as a means of getting new customers, and after a while the whole house of cards started tumbling down.

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Now comes the easel. Most people think of a bank as that small building on the corner where you deposit your paycheck and take your bottle of change to run through the automatic counter. That is called retail banking, doing business with the public. For most banks, retail banking makes up less than 1% of their business. The rest is wholesale banking, massive transactions with corporations and other institutions on a scale that makes retail banking look like a monopoly game.

Banks do business in the big-B: billions of dollars at a time. What do you do with that kind of money? Or more accurately, what do you do with that kind of money when you have a bank’s risk profile (zero)? You buy top-rated investment-grade securities: government bonds mostly, but also other things as well. A bank is first and foremost a business, one that serves to maximize return for shareholders. So like any other business, they are always on the lookout for new ways to make a buck.

There has been a trend in financial markets since the Reagan administration let the foxes guard the henhouse by eliminating most of the regulations guiding financial markets. That trend has been to take small securities and group them together into one package, selling them as one single entity. This has been the cause of many, many billions of dollars of losses all over the globe, because the structure of these instruments allows unscrupulous dealers to sell hamburger as filet mignon.

This is precisely what has happened with the sub-prime mortgage situation. Large financial institutions — Citigroup, Morgan Stanley, Merrill Lynch, companies that really should have known better — have purchased what are called “mortgage-backed securities”, income streams fed by the payments of regular everyday homeowners. These securities have been labeled as investment-grade, however it is now apparent that billions of dollars in questionable loans were buried inside these instruments. Loans started defaulting, the true value of the securities was called into question (none of the bean-counters knew how to calculate their actual worth), and the instruments became worth no more than the paper they were written on. Subsequently major financial institutions all over the world — investment houses, banks, pension funds, and so on — have written off tens of billions of dollars in losses, and they have no way to know how much carnage is still yet to come.

So now we have millions of families about to lose their homes. We have major financial institutions losing billions of dollars a quarter. But wait, there’s another player in all this: where is the middle-man? Where are the companies that made all the loans to begin with?

Packing up shop and laying off thousands of workers. They’ve made their money, they’re headed to the Caymans to enjoy it. These people have no exposure to the problems caused by this crisis, and with the mortgage industry falling apart there’s no more money to be made. So they’re closing up and taking off with the profits: hundreds of millions of dollars, swindled out of the pockets of homeowners and some pretty big corporations, or more accurately, their shareholders.

How will it end? The government will step in and provide assistance to homeowners, though it won’t be enough; apartments that stood vacant as recently as a year ago are now starting to fill up with former homeowners who have lost their homes; the large financial institutions are already rallying around each other to try to provide a massive fund for purchasing these securities from their current owners; and as usual, the perpetrators will get off Scot free.

One day the government will realize that their job is to prevent this kind of crisis from taking place. That is accomplished through regulation, something the government has been stripping away in recent decades. That trend needs to be reversed, immediately and with substantial vigor. The kids are out of control on the playground during recess, and the principal needs to start handing out detentions.