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Archive for the ‘Credit Crunch’ Category

Halt trading – give these computer drone traders a vacation, and let them come back to reality. Let congress vote on the future of General Motors, Ford, and Chrysler; whatever the result may be, let it settle without any trading.

If they choose to let the Big 3 file bankruptcy, they should facilitate it such that the American Autos have temporary access to a credit line. This would allow them to carry on business as usual without closing their doors; as they try to keep creditors away, they can straighten out their business model and break the unions, all while preventing a Chapter 7 bankruptcy – which would lead to liquidation and 100,000 jobs lost.

From here – during the halted trading – the SEC should reinstate the uptick rule, which should temper the volatility going forward (as we saw, banning short selling on Financials is NOT the answer…as soon as it is lifted? Bombs away!)

There should be nothing hindering any of the above actions, except the bureaucratic nature of our government, which we no longer have time for at this juncture.

While we’re at it, we might as well consider an interest rate cut, as it should at least have a placebo effect on the markets…the reason I say that is the effective Federal Funds interest rate has been well below the targeted 1% for quite some time:

effective-fed-funds

As for Barack Obama, he should take preliminary action in appointing some cabinet members; get an all-star team of financial geniuses for a special committee – Buffett, Summers, Volker, Soros, Roubini – some of the smartest people in the world live in this country, and their talent should be utilized.

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There’s really 1 reason that’s important, and the others don’t matter when considering this (from “The New Republic”):

“Bankruptcy need not mean that the company disappears.” But, while it’s worked out that way for the airlines, among others, it’s unlikely a GM business failure would play out in the same fashion. In order to seek so-called Chapter 11 status, a distressed company must find some way to operate while the bankruptcy court keeps creditors at bay. But GM can’t build cars without parts, and it can’t get parts without credit. Chapter 11 companies typically get that sort of credit from something called Debtor-in-Possession (DIP) loans. But the same Wall Street meltdown that has dragged down the economy and GM sales has also dried up the DIP money GM would need to operate.That’s why many analysts and scholars believe GM would likely end up in Chapter 7 bankruptcy, which would entail total liquidation. The company would close its doors, immediately throwing more than 100,000 people out of work. And, according to experts, the damage would spread quickly.

When poorly run ‘too big to fail’ companies went bankrupt in the past, there was ample credit to tide them over through the process of solving some of their inefficiencies. If one thing is clear, it’s they don’t have enough money to run their business this time around, and we cannot allow them go bankrupt and hope they fix this one on their own.

While the effect on the real economy would be devastating, the effect of a big 3 default on the credit markets is talked about much less. Credit default swaps make up a $62 trillion market – how many of these contracts were sold to protect GM and Ford bond investors against default (or bankruptcy)? That is a huge question, because AIG along with all of the bulge bracket banks sold this kind of insurance (where their reward from this side of the bet is limited to the price of the insurance, while the risk is having to cover the entire value of the losses on a defaulted bond – something they do not count on happening). If GM defaults, we could certainly count on more bleeding out of AIG who is undoubtedly intricately involved in this.

bond-defaultGM is rated ‘Caa2’ which is junk status, meaning that Wall Street brokered bets using the riskiest instruments (CDS’s) on the riskiest products (junk bonds).

Like with everything these days, no one really knows what will happen. So as usual, we’ll have to wait and see.

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George Soros wrote an Oped in The New York Review of Books over the weekend, which provides updated analysis of his most recent book, The New Paradigm for Financial Markets. It is very comprehensive, and does a good job explaining how past credit crises have culminated into this greater economic turmoil (and pretty much summarizes his entire book for free). It’s a seemingly long piece, but the complexity of this crisis would be difficult to describe in a briefer fashion. Here’s a bit from the article – which is an insight as to how he views the role of what Warren Buffet would call “geeks with their models”:

Financial engineering involved the creation of increasingly sophisticated instruments, or derivatives, for leveraging credit and “managing” risk in order to increase potential profit. An alphabet soup of synthetic financial instruments was concocted: CDOs, CDO squareds, CDSs, ABXs, CMBXs, etc. This engineering reached such heights of complexity that the regulators could no longer calculate the risks and came to rely on the risk management models of the financial institutions themselves. The rating companies followed a similar path in rating synthetic financial instruments, deriving considerable additional revenues from their proliferation. The esoteric financial instruments and techniques for risk management were based on the false premise that, in the behavior of the market, deviations from the mean occur in a random fashion.

The clear drawback in attempting to model the behavior of financial markets is that all results are grounded in the past; despite this glaring inefficiency, we continually revert back to their use in order to quantify risk. From the Financial Times:

When banks extend credit to hedge funds, they often use so-called “value at risk” models (VAR) to measure the risks attached to such loans. These models typically assess the riskiness of an asset by measuring how its market price has moved in the past.

During the Great Moderation, this approach cast a fabulously flattering light on the investment world, creating the impression that it was safe for banks to extend massive volumes of credit to hedge funds. Moreover, since banks typically use VAR to measure the risk attached to their own assets too, these models also seduced banks into feeling complacent about their own risks.

It would be ridiculous to say that models shouldn’t be used in the world of finance, however it’s clear we have become overly dependent on what they produce, particularly in trying to extrapolate characteristics which have often led us into problematic scenarios.

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Just found a cool site: www.arbitrageview.com

In addition to defining all of the different forms which arbitrage can take, this site has a section which lists all of the announced M&A deals which are awaiting approval; useful for a strategy called “risk arbitrage,” or betting that announced acquisitions will actually close – you purchase the stock of the targeted company, and short the acquirer (like Yahoo being targeted by Microsoft).

The name in itself is quite appropriate, because should the deal fall through (as the Yahoo and Microsoft did), you lose money on both sides of the bet (Microsoft goes up, and Yahoo goes down…this is the opposite of what the risk arbitrager thought would happen).

One of the most prevalent misuses of arbitrage came out of the Long Term Capital Management debacle. The members of the hedge fund had specialized in bond arb, by which they would use tremendous leverage (often 30 to 1) and make millions on very small moves in the fixed income markets (by selling one country’s debt short, and buying another). But once the rest of Wall Street got wind of their strategy, the already small margins were pinched by the increase in market participants.

This is what prompted the beginning of many dumb decisions they made over the next 2-3 years; They decided to apply their knowledge of market volatility from the world of bonds to the incongruous world of equities. They tried to find irregular relationships between companies, then act accordingly. Their stint with risk arbitrage resulted badly, as you might imagine…here’s an excerpt from the book which explains it all, When Genius Failed (p.146):

“Long-Term had dubiously invested in Ciena Corporation, a telecommunications company that was planning to merge with Tellabs Inc., and had continued to hold the stock even when it had crept to within 25 cents of the acquisition price. On that same day, August 21, the merger was postponed and Ciena stock plummeted $25.50 to 31.25 a share. Long-Term lost $150 million.”

That was one of their smaller losses in the grand scheme of things…

Even before the depth of this financial crisis unfolded, I’ve always believed that this is one of the most important books that one could ever read to have a broader understanding of the sheer greed and irrationality which exists in financial markets, to understand why it can does happen again continually, and how the culprits respond as it’s all going wrong.

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From the WSJ:

The S&P 500 has lost 22% of its value in 6 trading sessions.

BusinessWeek gives a nice synopsis of this crash like action. During the crash of 1987, we fell 29.57% in the worst nine-day period before bouncing 15% in two days…the bottom occurred on a Monday. The chart above doesn’t even show the Dow’s intra-day movement to 7884, but it is conceivable that we retest that low sometime next week; JP Morgan and Wells Fargo report earnings on Wednesday, which will certainly be catalyst (hopefully a good one).

One has to think that we’ve almost washed out all of the forced sellers, like the redemptions in Mutual Funds, liquidations of Hedge Funds, and the margin calls which we saw all week. (Please, look at a 5 day chart of Chesapeake Energy to fully grasp this….)

Aubrey K. McClendon, the billionaire chief executive of Chesapeake Energy Corp., has sold “substantially all” of his stock in the company over the past three days in order to meet margin loan calls, the company said Friday.

Chesapeake is no joke; they are a substantial player in the natural gas industry. Cramer also recommended the stock regularly on his show. This is the risk of using borrowed money to make investments, and what’s truly unfortunate is that most companies use credit in everyday operations, not just investing in the market. When people jabber on about the importance of the “TED Spread” or “LIBOR”, they are referring to issues like this. Many businesses were founded on the availability of money at cheap rates (LIBOR at 2.5%, not 6%), and with a liquidity crunch which seems endless, one cannot gage how long certain marginal companies can stay in business.

Fortunately for our financial system, the G-7 is on the case; they announced on Friday that they would take “all necessary steps” (sorry for the arbitrary nature of this quote, the transcript was ultra vague) to resolve the financial crisis, including the purchase of troubled assets, even common stock.

We’ll see how long this takes to come into effect.

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This Wachovia episode is only getting more interesting. Before there is a resolution to this cat fight, I thought it would be worthwhile to point out the pros and cons of each outcome.

This deal is a no brainer for everyone but Citi;

  1. Wells Fargo is using private money to buy Wachovia, meaning no tax dollars necessary
  2. They will assume ALL of Wachovia’s operations, not just commercial banking
  3. Wachovia shareholders get $7 instead of $1 per share.
  4. The Citi deal requires the “good bank/bad bank” scenario, where they take only the good stuff, and leave the rest to the FDIC to take care of.

The bad part of this outcome is placed solely on Citi; they said on Monday that cutting their dividend in half was an action to shore up capital for the Wachovia deal, but now without the acquisition, that argument is out the window. Also, before Wells Fargo came in with the $15 billion deal, there wasn’t any relative basis to say that Citi’s $2 billion offer was too low. Wall Street initially applauded Citi’s move to buy Wachovia, because it signaled that they had a strong enough balance sheet to be expanding in this environment. For a brief time, they were moving into the tranche of Wells Fargo, JP Morgan, and Bank of America (As told by the stock price hitting a 3 month high).

In short, we already know that Wells Fargo was in better shape than the pack; but we cannot prove that Citi, the only bank left with anything close to their astonishing $51 billion in write downs, is improving. The Wachovia deal provides them with an opportunity to signal to Wall Street that they will make it through this mess, and they will not need another loan from Abu Dhabi, or Prince Al-Waleed.

Considering all of this, maybe we are seeing resistance from the Federal Courts (besides the legal ramifications) because this is the only viable acquisition left on the table for Citi to make, and it would be able to offset any bad news to come.

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Black Monday…

Ironic, isn’t it? Credit markets are frozen (LIBOR is marked at 5.22%, as credit spreads widen even further). I posed a question in an earlier post trying to figure out where the rest of the world stands, and why they haven’t come to our aid…this should help explain:

The U.K. Treasury seized Bradford & Bingley Plc, Britain’s biggest lender to landlords, while governments in Belgium, the Netherlands and Luxembourg extended an 11.2 billion-euro ($16.2 billion) lifeline to Fortis, Belgium’s largest financial- services firm. Hypo Real Estate Holding AG, Germany’s second- biggest commercial-property lender, received a 35 billion-euro loan guarantee from the state, and Iceland agreed to buy 75 percent of Glitnir Bank hf, the nation’s third-largest lender.

Europe clearly has problems of their own, and won’t be able to come in like a “JP Morgan of the public sector” and save us all.

Meanwhile, the ban of short selling has A) done nothing to slow down the precipitous selling and B) perhaps exacerbated our down swing, because there are no outstanding shorts in financials to be covered.

Dow components on the banned short-sale list

GM     -11.89%

JPM    -8.93%

C       -6.40%

BAC   -12.72%

Maybe the SEC singled out the wrong guys; we haven’t heard much about CDS regulation latley, but various ETF’s which use Credit-Default Swaps to short financials (SKF, SEF) were both fully effective in delivering results today.

There was good news today for people who keep their money at Citi, though; they no longer have to pay $3.00 fees at Wachovia ATM’s!

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