Monday, August 25, 2008

Thank God for Stops

I had a few solid hits in the last report, a couple misses and some awful stock picks. My long stock picks all missed, but my short retail picks worked well, as did my outlook on the dollar, gold and EM's. But all of this seems a bit trivial when we are talking about the insolvency of institutions such as Fanny, Freddy, AIG, Citi, Wachovia and god knows how many more.

Giving myself the old Aussie pat on the back, my call on the coming mortgage meltdown over the past 15 months and general notes on the credit crisis have been accurate and timely, but I have missed how very deep, wide and long term the problems are. We have moved past Bear Stearns to much bigger fish, and more of them. And they are pretty much all diseased. The credit system is stuck and it can't resume flows until the BS's are opened, gutted and shut down or sold off.

Specifically, the banks still have major writeoffs coming on mortgages, credit cards, commercial mortgages, and leveraged loans. Even worse, they have their own major funding issues ahead of them: by the end of 2009, banks will have to refinance over $780b in debt, up 43% versus the last 18 months. This, coupled with a rise in spreads over Libor from 2bps to 200bps means more capital drained from the system, more asset sales by banks and a hit to interest expenses.

In the US, we must resolve the housing credit functions before we fix the other problems. F'nF are now responsible for 80% of all mortgage underwritings versus a 50% historic share. Thus, this is the new primary focus. The housing overhang continues to pressure mortgages which continues to destroy balance sheets in this mark to market system. Mortgage credit needs to get moving again, and that means strengthening F'nF. Real home prices are down to Q4'02 levels, home inventories are at record levels, mortgage rates are higher despite the rate cuts and capital is simply not going into housing finance.

They are essentially insolvent today without an explicit government put, and with level 3 assets in excess of $200b they need to raise a whole lot more capital. The government can't step in without a clear ability to show that common and preferred shares are worthless. And with much of their preferred shares owned by banks, it would only compound bank solvency issues.

Freddie just issued senior debt at 110bp above T's, but this debt pricing also was a bit misleading: it reflects the ability of banks to use the F'nF securities at the window to borrow money - 97% of value. That means they can buy the Freddie bonds, borrow money against them at the Fed and lever up for a 17% annual return. And, by providing liquidity for the bonds, they help support the idea of F'nF surviving, which boosts the value of the preferred shares.

So how does this roll out? First step is the governments resolution of F'nF. Second is restarting the mortgage credit markets. Third is clearing the housing overhang. This will all take several more months. In the meantime, the capital markets need to decide who stays and who goes. There is the need for an additional $500b in capital(?) for the banks and insurance companies; some will get the money, some will go out of business. That means big FDIC payments over the coming year to clean this up. Between F'nF and the FDIC, the government is on the hook for at least another $100b. That's on top of the crappy assets the Fed has been taking for loans.

A major part of the backdrop for this is the ongoing credit crunch triggered by the "Minsky Moment". The blood that fueled the US system has been debt and that is now hard to come by. That means growth slows - not just for a short period but for a multi year period. US consumer balance sheets will be rebuilt, expectations will be reset.

The US consumer has been led to believe over the past three decades of this credit blowout that everyone not only can get rich, but will be rich. That promise has been reinforced by the stock bubble, the housing bubble, tax cuts, ample credit and bad leadership. We forgot that rainy days do come, eventually. And it can rain for days and days.

We are about to enter a period of changed consumer expectations and behavior: "maybe won't ever be rich, maybe have to file for bankruptcy (harder these days), maybe can't really afford the lifestyle we have been living" translates into " saving money, spending on fewer big ticket items - no more TV's, boats, cars, football tickets, etc". The "resilient" US economy may have its roots in how it was financed as much as anything else.

The 10 yr treasury is yielding 3.8% and inflation is running at 6%. This can only happen in the following situations, assuming the bond market is its usual smart self: one, inflation is temporary and will be replaced by deflation shortly, or two, the markets are scared and money is flowing to less risky assets. Today, I suspect both are true. With the near collapse of Fanny and Freddy, and so many financial companies on the ropes, it looks as though there is another gut check coming. This puts more money into T's. And as oil and other commodity prices come down, and WW growth continues to slow, the markets are finally beginning to look for a deflationary debt liquidation ahead.

This scenario will continue the near term break in oil prices. Demand destruction continues, world wide growth will slow, recession may appear in many places so it's hard to see oil prices going anywhere but down for the next few quarters. This is good for all economies and will allow us all to get back on our feet more quickly. It is especially good for emerging economies, particularly India. This is not good for the energy sector, which should trade sideways and down until growth comes back.

The rate outlook should benefit the US dollar, as the Fed is close to the bottom on rate cuts while just about every other country has many cuts ahead - I do think FIFO is the right outlook for US rates and economic status versus others. The question, though, is how bad is the US economy and how long will it take to turn? I am watching the personal consumption trends to determine when the economy at least starts it final move to the bottom.

The cash rate in Australia is over 7% and rates are coming down. So what does the Aussie $ do? It drops 15% in a couple weeks. This situation gets more support from the improving US current account deficit - oil drops, exports still go strong (a solid year delay of increase in currency on terms of trade due to contracting) and the economy/consumer slows.

An additional support for $ strength comes from the move to safety as the US resolves the current crisis. The term for this $ strength is the question: many suggest we are in the process of a collapse in the US$ standard and that any bounce will not go far in the long run. I have no informed opinion on this issue... The outlook for gold follows closely to the $, in reverse. Gold broke to $850 and below - one of my predictions that worked - on $ strength. Hard to see gold working until we start getting cuts from ECB, BOE and others.

Any stock ideas I would have are of little help now. The most interesting charts show the bond and equity markets moving in opposite directions; if you trust bonds, then equities are going down Or is the debt market strength the result of the credit market logjam - a structural issue that could get fixed in the coming months... The Dow has hit its 50w and 200w MA's in perfect form and rolled right over, Lowry's continues to worsen and volumes are poor on the up days.

The retail shorts worked, and should continue, but all of the longs are now big question marks, and were thankfully stopped out ages ago. I am still looking at POT and other ag plays, as they seem to have the best EPS visibility. The bank trade on crisis days looks good from July, but that takes more cojones than I may have. We will have more of those days, I may be buying a JPM or BAC. The short bond position was a bad call and its hard to know what to do at this stage, so I have no opinion. Except keep yer stops.