5/15/08…a crisis of confidence
May 15, 2008
Bloomberg Quote of the Day: “I feel very strongly that change is good because it stirs up the system.” - Ann Richards…not to be confused with Ann Coulter who has a different agenda.
…that is what we are experiencing yet most of us do not even know it…we feel it but don’t indentify it. This is not meant to be alarmist or a conspiracy theory, but a simple statement of fact. It is undeniable in a world where banks don’t trust their own balance sheets and are thus reluctant to lend…even to other banks let alone to other customers. TB has been thinking about many of these points since last weekend when he was catching up on reading, but every day something comes up to derail putting it to paper.
Today’s Topics:
1. The financial crisis we are in…how we got to where we are
2. Market implications
3. Are we going anywhere?
1. The catalyst for inking this missive was an article sent by a frend by Fortune Senior Editor Allan Sloan “On the Brink of DISASTER” …TB is not being dramatic, that is the way the title was written in the April 14, 2008 issue of Fortune, http://money.cnn.com/2008/03/28/news/economy/disaster_sloan.fortune/. As he writes, sit down with a drink and read this when you are relaxed, because it sums up the problems we are facing in a world gone mad…and led their by unrestrained capitalism.
If you want to know what is really happening to the economy you need to follow Merrill’s David Rosenberg…but you also have to keep in mind that he is a perma-bear which isn’t a bad thing in this environment. So when TB started his catch-up reading he looked thru Rosie’s daily missives. Then he read fellow daily writer Joan McCullough who, like TB, believes in capitalism but cannot believe what we have allowed to happen to it. As Douglas Elmendorf of the Brookings Institute said on CNBC we have had no regulation of the financial sector for at least seven years. This allowed us to get into the worst financial crisis since 1929 and through a belief that ‘it’s different this time,’ we thought housing prices would rise indefinitely…even though the historical growth rate matches GDP growth yet double digit growth rates were reported in many areas fore several years running.
But what is significant is that we ignored the obvious: as the average income of a homeowner was decreasing along with the downpayment which in many cases became negative when lenders started financing even the closing costs, their income was not increasing. As the Andres Agassi said in the Canon commercial “perception is everything.” That is what Americans are all about…having everything they want when they want it…no deferred gratification. No more American Dream of home ownership, or an expensive car, or jewelry, or even disposables…just buy it with plastic. You see someone driving a new Porsche or BMW or a big SUV…and looking at them, TB often wonders how they can afford it.
Statistics are a major reason we got to where we were. The word average is possibly the most misused word in the English language. All of the data we get from the government is based on the mean not the median. When TB reported that an income of $103,000 places you in the top 10% of US taxpayers (as of latest data, 2005, but there is little reason to believe it is much higher), TB got questioned by skeptics. That number in 1982 was $82,000…not much of a gain in 23 years while reported averages grew much faster (yet both Dem candidates say they would raise taxes but only on those making over $100,000 a year…compounding the problem of the AMT which the Dems created to ‘get’ those 80 or so rich people who paid no taxes…but you have a choice, you can vote for a GOP that has lowered taxes primarily or the top 1% of taxpayers). Since 2004, TB saw the impact of the alternative minimum tax and how it was an enormous barrier to entry to the middle class. We shelved all of our lending standards in the housing boom, which in TB’s humble opinion was a direct result of shelving Glass-Steagall in 1999, thus allowing banks to become financial supermarkets by merely placing everything in non-bank subsidiaries. Regulation of these thus fell thru the cracks with horrible results, the most visible being Citigroup under the steerage of Sandy Weill, who was aided and abetted by Robert Rubin who later became Vice Chairman and then had the nerve to stay he didn’t know or understand all of those derivatives gone bad, and if he didn’t understand them, who among you did?…that broad group includes people who were buying them without even understanding what they were buying and thus the underlying risks.
That is how Citi, JPMorganChase, joined the investment bankers in the risktaking game, and how Wells Fargo, a well-managed large regional bank became the largest originator of subprime mortgages.
That is how approximately 6% of the total mortgages, although they had grown to over 25% of the originations, which were subprime nearly brought down the entire global financial system.
That is how a seemingly simple investment like auction rate securities blew up when confidence fell and the underwriters had used up their capital writing down mortgage derivatives and they could no longer support their own auctions…unthinkable since it harmed their clients on both sides of the trade! It is why two-thirds of the auctions are still failing daily despite retiring about 40% of the debt and converting it to other forms of securitization, and why rates as recently as yesterday ranged from ZERO percent to 14%! To TB’s knowledge, none of the holders of these securities could have told you what the formulas under a failed auction scenario would be.
That is how a Wall Street invention, the Credit Default Swap (CDS) went from a way to speculate on corporate bond defaults to a form of insurance that grew algebraically rather than exponentially to a $44 trillion market today…with contracts piled on top of contracts and counterparties a blur, and why it will probably be the next shoe to drop.
As Sloan says, it would have been disastrous for the Fed to allow Bear Stearns to fail as it would have started a domino effect…primarily due to the CDS market…but what have we become where we help the greedy who created the mess while letting homeowners lose their homes or see their wealth eroded, and Sloan is talking here about honest homeowners, not scammers or speculators.
The cure of course was for the Fed to, in addition to the Discount Window for banks, offer three different lending facilities for banks, primary dealers, and other dealers…at rates on poor collateral that would make your mouth water…around 2.5%…and to swap it for US treasury obligations to the tune of more than half of the entire balance sheet of the Fed. But are we getting value or merely buying time?
2. Market implications. Normally one would think the market would be a mess and of course the financial sector has felt great pain yet the only rational explanation for why companies who behave badly are rewarded for their ineptitude is short-covering…anything else would be irrational…but the key is to see where those ‘bounces’ go…nowhere. To wit:
*Citigroup(C) since peaking on 5/18/07 has had a series of 10 lower highs and lower lows and may be headed for number 11. The rallies have generally occurred when they sold additional common and preferred stock and were fleeting. Also occurred when Vikram Pandit replaced Chuck Prince as CEO. Pandit headed up a successful hedge fund for them which has since been disbanded.
*Merrill (MER) peaked on 5/23/07 and has had 7 lower highs and lows…and rallies occurred on the ousting of Stan O’Neal as CEO and replacing him with John Thane who is not a risk manager. Then it rallied when they raised outside capital - convertible preferred - at a 15% discount to the market value with rights to renegotiate if stock declines over the next year. Then it rallied as they raised even more capital and maintained the dividend…take that one as far as you care…
*UBS (UBS)…where do we start there? Write-down after write-down. The stock fell 62% from 5/31/07 to 3/17/08 and is up 31% from the low…which still makes it down 50% from the high! On top of their other problems a whistleblower has reported them to German authorities over aiding tax fraud. Question: how many potential whistleblowers of various products are out there?…and as subpoena’s and lawsuits fly you can bet there will be more.
*AIG (AIG)…we just heard about them so suffice it to say they are a mess…and with a board that not only maintained the dividend with a huge loss and need to raise capital but increased it by 10%! As for the monoline insurers suffice it to say they are a mess and the rating agencies were not only asleep at the switch, they have fallen over on it! At least the stock is flatline!
*Freddie Mac (FRE). Since 5/23/07 stock has fallen 58%…and if you want to see how percentages belie the situation, on 3/10/08 it was off 74%! but since then rallied 57%…including a 9.1% rally yesterday due to a smaller than expected loss…see WSJ Heard on the Street on how they reclassified $90B of assets to Level III thus avoiding mark to market…and are raising another $5B split between common and preferred stock…that is what shortcovering is all about: it could have been worse!
Hopefully you can see what these follies are all about, and why TB believes financials are about to start the next wave down for the stock market…a market so thin you couldn’t slice it without destroying it. Since 3/24/08 we have set not one but three new low volumes for the year the last being Monday’s 1.05B share day and since last Friday we have averaged just 1.1B shares with yesterday being the best at 1.21B shares…yet we have had every conceivable technical formation…and stocks that are winners one day are losers the next…over and over. True, it is off the lows and flirted with taking out major resistance on several indices (other than Transports and Energy which are growing off the charts…strange bedfellows), but since the Dow closed above 13k on 5/2 it has been unable to advance over the past 8 sessions…even with the talking heads on CNBC raving about it. Meanwhile the S&P 500 struggles to stay above 1400 but had a major failure (as did other indices) yesterday when the intraday high was 17 shy of the 200 day moving average…the closest it has come since December even with a decline of 60 points in the 200 day! That is a fragile market…but you wouldn’t know it.
3. Are we going anywhere? By this TB means the economy where despite weak confidence numbers and production numbers of all sorts and instead spend our days divining whether or not we are in recession which is akin to how many angels will fit on the head of a pin! Call it what you want: it is a recession or worse which leads on a search for a new term to replace ’stagflation’ which has served us for nearly 25 years…thank you Gary Schilling. Furthermore, at the same time the Fed is bailing out the brokers, banks, and anyone else who caused this mess, inflation is a concern to them…but TB ponders whether it is self-correcting as demand necessarily falls given that we have removed the engine of growth for the past three years or more: mortgage equity withdrawals, replacing it with foreclosures. That is why relying on past ’similar’ conditions is futile…and misleading. At the same time they have weakened the dollar…the Index fell 14% from 8/16/07 to 3/17/08 (about coinciding with the market lows), yet we are thrilled when since then it has risen to 73 from 70.70 which still leaves it off 11%! That’s good news?
Joan McCullough was first to point out that the 0.6% gain in Q1 GDP was only achieved by a 0.8% gain in inventories…which most astute observers labeled as ‘involuntary’…offsetting a 0.2% decline in consumption. Would you as a businessperson build inventories in anticipation of future sales?…even with those rebates coming in? Joan breaks down the Inventory to Sales ratios of retailers:
Furniture, home furnishings, electronics, etc. 1.72x
Building materials, garden equipment etc 1.88x
Clothing and accessories 2.45x
General Merchandise 1.54x
Department Stores 2.15x
Now consider that the overall I/S ratio was 1.47x…huh? How could that happen? Grocery stores 0.76x!
So where do you think those credit cards are being used? You’re smart…you tell TB!…and Joan!
Next comes retail sales…in April +4.5% ex autos…forget auto sector that is a lost cause…even if they want them they can’t get a loan. Take out grocery stores, gas stations, bars/restaurants etc which are having major price inflation the were up just 1.86%. Yet Walmart (WMT) is within $1 of its 12 month high and that was the highest it has traded since April 2004. But they have slashed prices on food, gas, and drugs. Raising havoc with margins…meanwhile Target (TGT) languishes despite the average customer having an income about 50% above Walmart’s. WMT has a p/e of 16.6x forecast…consider the pet, Whole Foods (WFMI) which got trashed on lower earnings and still trades at 24x earnings! At the peak it was around 70 times…it’s a freaking grocery store and obviously organics give way to practicality!
So maybe McCullough is wrong…and Sloan is wrong…and TB is wrong…but if so by what metric are we measuring success? You can’t solve the problem until you identify it…and the problem is US!
Do not take TB’s word for any of the above…or anyone else’s…think about it….then you decide!
TB
Trader Bill thinks it is clear to anyone reading these missives that they are merely commentaries…as he sees it…and do not necessarily reflect the views of anyone other than his own. Information is gathered from sources he has found reliable, but no guarantees of accuracy are implied. These are merely observations of events in the marketplace offering in an attempt to offer a non-mainstream viewpoint. Hope you find it useful.
Copyright TBD Capital LLC May 15, 2008
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