Traderbill's Financial Markets Weblog

…to screw things up. Yesterday, with one dissenting vote (Fisher of the Dallas Fed), the FOMC cut the Fed Funds rate by 50 basis points to 3% and the Discount Rate to 3.50%. The reaction was confused at first as bonds slumped by 1-1/2 points on the long and the Dow rallied by 60 points, declined by 100 from what at that point was the intraday high to up just 40, then marched back up to the session high of 12661 or up 180 and then along came Fitch with a downgrade on liquidity of monoline insurer, FGIC, and that was all she wrote. In about 35 minutes we gave back the entire rally, attempted a bounce and plunged to down 70 just before the close with a shortcovering (you didn’t think it was real buyers did you?) bid recouping about half the loss…whew! Another 275 point swing in just one session!

Not only that but we were saved by the bell as just after the close S&P said it cut or may cut the ratings on $534 BILLION of subprime mortgage securities and CDO’s, due to rising defaults. Sweet! That allowed bonds to get back half of their losses. Once again equity market concern has shifted back to where it should be: the credit markets…sans treasury market.

Last night, TB attended a meeting with an economist Donald Ratacjzak, who has an incredible track record. He is still on the faculty of the University of Georgia but consults for Morgan Keegan. The Rat as he is known (not in a negative connotation), just returned from China. He noted that there was no heat at the airport or in any public buildings due to a ban initiated by the government (who else?). You may have heard this yesterday but their power plants are maxed out and they even had to shut down their aluminum producing plants. Imagine that happening here? That is why aluminum futures were up 5.4% yesterday and other metals followed suit. Overall commodity prices were up 3% on the CRB and 3.6% on the GS Commodity Index. Remember the Olympics begin in Beijing on August 8…could be interesting!

He also said that he was in New Zealand when the did the emergency 75 basis point rate cut and instantly saw a 4% increase in costs. The Fed has now cut 125 basis points in just 7 business days! As for the reason for the cuts he believes the Fed has cut their focus on inflation (while maintaining that inflation is tame and declining in order to provide cover for the real reason which is credit conditions. Like TB, he does not believe the Fed cut the first time due to the SocGen debacle (after all it was just $8B and yesterday Citi alone announced they had obtained another $22B of capital). First, if the Bank of France didn’t tell the ECB it is highly unlikely they called the Fed, right? Second, if it was so bad why wasn’t there a coordinated rate cut? But the big question is what was so all-fired important about cutting before this week’s scheduled meeting? What TB believes is that the Fitch cut in the rating of monoline insurer AMBAC caused the selloff and that may have triggered the SocGen problem as it forced an unwinding of positions…TB heard SocGen trading volume was about 9% of the volume in Europe a week ago Monday. Furthermore the rating cut came after the close so our markets did not have time to react. Then when they saw the selloff in Europe Monday and overnight Tuesday they panicked (one hopes that that was not what happened as it is a bad thing when the Fed reacts to the markets…central banks are supposed to cure the cause, not the effect). As weak as our markets were, it is likely we would have dropped 400 points or so and then bounced back…after all it is only financial stocks that matter, right? …or is there more: such as the ratings that support all kinds of derivatives and without them corporations and hedge funds will be in violation of lending agreements triggering margin calls and trade unwinds…in other words: deleveraging! Panic deleveraging. Anyway, that’s TB story and he is sticking with it…you got a better idea?

Do you really believe stocks are cheap here? TB has two thoughts: first, No!…second…if they are cheap, they are only going to get a lot cheaper…you just had your countertrend rally. Still think it is bonds that are expensive? The Rat had this thought: why, with the Fed easing so sharply aren’t long treasury yields declining? On the 75 basis point emergency the cut, the 10 yr yields declined about 20 basis points, then rose to levels above where they were before the rate cut and have gone sideways ever since even with the 50 basis point cut yesterday…what gives?

The Fed has only a few weapons. First, they can “jawbone”, but we have a Fed Chairman who believes in being totally transparent (got to be good lookin’ cause he’s so hard to see), when Wall Street is as opaque as it can be…that gets you nowhere except letting them know your intentions so they can position themselves to make money…whereas Paul Volcker’s idea of transparency was to smash the windshield so you can see better…that will get your attention every time. Secondly, they can use the Fed Funds rate and to a lesser extent the Discount Rate to impact liquidity (but nobody wants to borrow at the discount window because they don’t want anyone to know they are having liquidity problems). Then there are open market purchase or sales of securities as opposed to repos to manage the Fed Funds level these are for more permanent adjustments to reserves. The last is reserve requirements but these are low and haven’t been adjusted in eons.  

The newest wrinkle is the TAF (Treasury Auction Facility)  auctions whereby the Fed allows financial institutions to bypass the market and discount window to gather liquidity.  In Dec. we had two of these 35 day auctions at $20B each …this month we just rolled them adding $10B to each…this is barely scratching the surface (and TB is told the market values are way off on these so in effect it is a bailout  …hope they don’t get stuck with the collateral). Contrast this to the ECB in Dec that injected $500 Billion in this manner  …now that is acting quickly not dipping your toe in the water. We may need perhaps $100 billion more and Bernanke has already said this will be a permanent facility…good luck.  

We may well be witnessing the biggest leverage unwind in history…or the biggest bailout. Ask yourself this: how did our regulators allow highly paid traders and salespeople to pull the wool over our eyes without even considering the impact of their actions? Now, the global governments are cleaning up the mess and many pension funds, even foreign towns, are paying the price. Have you heard even one government official demand redress (other than Congressmen for political reasons only)? Nope, that is how powerful the financial lobby is…the financial sector is the backbone of any capitalist society, right?

Just to keep this daisy chain ‘hummin,’ MBIA (MBI) reported after the close a loss of $2.3B or $3.30 a share…when your stock is trading under $14 that is going to be one big hit! Over the last 12 mos. MBI shares declined 80% (77% since 9/30/07), and 25% since yearend! The low was on 1/18 at $6.75, expect a retest of that low! They also took a $3.4B credit derivative mark-to-market loss. Now the other hit: they also saw “reduced demand for insurance” in Q3 substantiating the FT article’s claim that municipalities are shunning insurance…as are buyers…other than covenants why do you need an investment grade municipal to be insured (and at 0.25% of the principal per annum)? TB has noted in the 35 day auction market that yields rose to 5.5% on insured bonds   …5.25% on one that is a stand-alone AAA as it has been escrowed with US Government Securities! This is strictly a function of liquidity as corporate and hedge fund holders liquidate positions for fear of being in violation of their own indentures and lending agreements. Note that these 35 day securities are an arbitrage play as they buy a long dated muni and then securitize half of the position (sometimes as much as $100 million), then make a spread off the coupon rate and the rate they have to pay to the short term holders. If the spread gets negative they can always call the auction notes and either hold or sell the underlying bond …but the value has increased so much now that at most they will just eliminate the arb play. This is the opposite of back in 1994 when short rates rose, the yield curve inverted and long muni prices declined…yet to TB’s knowledge none of the investment grade vehicles had problems…then, and now however, hospital bonds and other lesser credits are yielding 6% or more in the auction note market. Yesterday, uninsured 35 day Cal paper was trading below the yield on insured adjustables! …and a $6M block of Cal G.O’s traded at 1.85%! Guess it shouldn’t be too surprising when investors are so liquidity/credit conscious that they are getting negative real returns on bonds out to 5 years! Still think this is just a puny subprime problem?

Ask yourself about whether a municipal bond needs insurance…how many defaults have there been of investment grade muni’s? Other than a few small speculative issues there has only been New York City (restructured and bailed out in a couple of years), Washington Public Power Supply System (WPPS – where only the single ‘A’ rated bonds defaulted and only because of huge cost overruns and a moron judge in Washington who said municipalities could not be locked into long term (take or pay) contracts when they do it every day; and Orange County (due to fraud and even then the problem was corrected in less than a year…the biggest municipal bankruptcy on record). TB would caution that weak muni credits…even insured ones should be avoided as this crisis could last for years and with property tax revenues declining sharply (due to delinquencies and reassessments), we could see more problems and definitely credit downgrades…for the most part however these will result in cost cutting in other areas as general obligation bonds have a first lien on all tax collections as do senior revenue bonds). Contrast to the Great Depression where 80% of the defaults were issuers rated ‘AA’ or better! Like the housing market the areas most affected will be major cities with severe growth problems and large low income ‘core’ areas…i.e. NYC, Philadelphia, Cleveland…you get the picture.

TB can’t wait for tomorrow and all that employment data…yahoo!