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My Take On The Markets

September 25th, 2008 at 06:00 pm

Where do I even start? Ok, first let me say that I don't hold presidents responsible for economic issues. So, I won't be bashing Bush, Clinton or Bush.

Was it caused by real estate speculators, the mortgage brokers writing loans with out proof of income and employment and 100% + loans, was it caused by credit agencies rating all the paper off of SIVs and CDOs AAA and Aaa?

I believe the underlying problem started after the S&L crisis. Coming out of the S&L we hit a little recession where the unemployment rate hit 7.5% and middle management was being squeezed. From 1991-1992, the fed lowered the fed fund rate 375 basis points in less then 2 years. This made credit very easy to get, whether it was buying stocks, loans for companies, and yes even mortgages.

When everything is clicking, this added leverage in the economy causes the economy to expand. Jobs are easy to find, labor pay increases … life is good. But leverage can also cut the other way too.

You could even go further back in time. The S&L crisis caused a recession which caused the fed to loosen the economy. The deregulation of the 1980's caused the S&L crisis. The inflation of the early 1980's caused the deregulation as a last ditch attempt for the S&Ls to save themselves. In the 1970's, S&Ls didn't realize that their business models were fundamentally changing and didn't have a plan when inflation hit.

I could probably go on and on. One thing feeding of another. If I had to choose one thing, it would be the fed aggressively open up credit to everyone in the 1990s, and this has evident in all industries, corporations,

So here we are today. We have underlying assets devalueing or correcting (which ever term you want to use). When these assets started to devalue, firms went out and raised capital (in other words debt). Some of the headlines were Baclays raises 4.5 billion, Fifth Third raise 2 billion, Lehman posts 3 billion loss and sets 6 billion stock sale.

But recently something happened in the markets. The write downs of the assets didn't stop and investors stopped loaning money and buying preferred stock.

So now we are in September, AIG's assets deterred to a point where they had to keep putting up more capital and just couldn't do it any more. Lehman was basically shut out of the capital markets. Write downs are still occurring and financial ratios are still deteriorating.

So what has the government done? First is to save AIG. AIG is basically the insurance provider for the financial industry. If they went under, it would have caused a ripple affect of failures as hedged positions became unhedged.

The second issue was the common citizen losing confidence in the financial system. This was seen when there was a run on money market accounts. Money Market accounts invest in safe short term paper (except the cash enhanced which invest in CP on SIV and CDOs. Black Rock wrote about this last December). In any case, if everyone sells out of a money market fund, the portfolio manager must liquidate the fund. This causes them not to get full value and liquidate for less then a dollar. We say State Street lose 35% of its value in one day because of this.

So the government has now set up $400 billion to guarantee that money markets will have a dollar price. This has had the effect of stopping the run on the mutual fund industry and chances are the none of the $400 billion will be used. If the market works with out panic, the portfolio managers can unwind there positions without forcing to liquidate at a fire sale.

The next piece is to free up capital and let the credit markets work again. This is the $700 billion. Right now, the institutions carrying this debt bad assets keeps writing them down and doesn't have capital to lend and people with capital to lend don't want to lend it because these write off just keep continuing.

Some the $700 billion is there to buy this debt from the financial institutions. The consensus is that the price will be above the fire sale price currently out there put below the maturity value of the debt. The government will then hold the securities until the market recovers or keep them to maturity. There is talk of starting with the MBS (mortgage backed securities) and moving to others.

So a MBS is security that represents a pool of mortgages. So they take a bunch the 30 year fixed at 5.5% and sell a slice to the bond fund. Most people pay there mortgages so most of the mortgages in the pool will be fine. It's just this small percent that will default and no one knows how much it is. So there is now a supply of MBS and not a lot of buyers. The yield on these are 15%-20%, so the are already steeply discounted.

Now the government is going to come in and basically buy the securities so the yield might be 10% - 15% and hold until the market recovers or the pools mature.

Personally, I expect the government to make money on the AIG deal and the MBS deal and maybe loss less then a billion on the money market thing. Also the terms are that the money will be available if needed. This usually means that the government will sell treasury if the money is needed, they don't have it on hand.

There is an urgency to this. You don't want the credit markets to sieze.

So that's my take. Hope it may sense.

9 Responses to “My Take On The Markets”

  1. gamecock43 Says:

    It did make sense. I now understand what the bailout plan will do step by step...but does that mean it is fail proof? You said "you predict..." But are there any other possible outcomes? I don't know enough about the financial industry to have any kind of vision regarding this plan. The one you outlined sounds logical...but I am wondering if there are other possible routes for this to go. But if your fingers are cramping up...don't write a huge response. I might be picking at a dead bird here.

  2. merch Says:

    Nothing is fool proof. But I believe this is the most probable.

    Americans could panic and the withdraw all their money. And we are back to the great depression. But I'm not betting on that outcome.

    I just see a lot of things right in the plan. Reduce fear, install cofindence, and grease the wheels.

    Markets up big today too. About 2%.

  3. gamecock43 Says:

    I saw in the news that an agreement has been reached between parties regarding the plan. All systems a go!

  4. Broken Arrow Says:

    Thanks for the explanation merch.

    I believe this will work too. $400 is a nice compromise, all things considered. Also, not every dollar of this bailout needs to be invested, and some of this can still end up being profitable.

    But most importantly, it needs to grease the wheels and get it humming along again.

    The news also gave my GS stocks a 5% gain. Big Grin That's good enough for me for now.

  5. merch Says:

    Yea I saw it down this morning and then bounce off of 133. I was in meetings all day today. And my order at 133 didn't get filled. Oh well. Plenty of fish out there.

  6. baselle Says:

    It does make sense. My thought is that this will work if nothing else happens. However, if the depressed housing market is the driver, well, we have two more ARM reset peaks to go.

  7. merch Says:

    I'm with you, baselle. My the way I just saw this morning that Bamks in China were going to stop interbank lending with US intstitutions.

  8. Creditor Says:

    If the government will spend so many billion to save the markets....where is the money going and is it creating real wealth?
    Wouldnt it be more genuinely "wealth producing" say for example, to pay out a certain amount to every US citizen over the age of 18. This would amount to about 200 million citizens. If you divide that into the proposed 85 Billion Bale Out. You get $425,000 for each US citizen over the age of 18. If they each received this amount of money or even some large fraction of it imagine the number of homes that would be bought, cars purchased, college educations purchased, debts paid off, and taxes generated etc. We would have a whole new type of economy. If the 85 billion is paid in at the top of the economic food chain to save a few inept corporations basically nothing happens to actually stimulate economic growth.

  9. merch Says:

    Actually, it's $425 per citizen if you assume the population of 200 million. But you are assuming that the government has the money and this is extra money laying around. That's not the case. The government has basically approved the treasury to raise this money if needed.

    Which leads to another point, the government is not sending $85 billion over to AIG. It's a revolving credit line that AIG can use at 11.5% interest (technically 850 bp over libor 3m).


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