Sunday, September 07, 2008

Crisis Averted! Again!

This past weekend, the US Treasury took over both Fannie and Freddy. They will now operate under the conservatorship of the US Government with new management. The portfolio of mortgages owned by F'nF will be wound down over the next couple years, the US government will receive preferred shares, thus protecting the existing banks' position in the same, and common holders will get the stub: likely worthless. Kind of like the junk portion of a CDO...

I think the idea here is to simply save the business of guaranteeing mortgages, backstop that function with the power of the US Treasury, and allow investors to resume purchasing F'nF backed paper. This should restart the financing system for the US housing market and begin to clear up another round of near term concern that the US will go into a deeper financial crisis.

As investors resume purchases of F'nF backed paper, premiums for this paper should drop and there should be a carry on effect on US mortgage rates. In addition, this should free up capital to participate in US housing finance. Hopefully, in the next few months, moderating rates and capital inflows will help the US housing market bottom and put an end to the ongoing deterioration of the US consumer balance sheet.

The markets will like this move: some of the often noted spreads that highlight the dysfunctional US finance system should tighten, bank and housing stocks should rally, and the flight to safety trades will likely unwind a bit. However, the outstanding CDS' on F'nF debt, $1.4t at last count, will need to be unwound as this rescue is a "triggering event". This will be the first stress test of the unregulated and translucent CDS market.

Despite this move by the Treasury, many of the problems of the credit crunch are still around. All the F'nF rescue does is restart the process of clearing housing inventory. Once resumed, more housing inventory hits the market pushing prices lower in the near term. This is the necessary step to clearing the housing market. So while mortgage rates should drop by 50-75bp in the coming months, easing refinancings and modestly helping incomes, this event doesn't actually change the debt level of the US consumer. The US economy is still slowing, jobs are still scarce, wages are stagnant, and the world economy is slowing even faster.

We wait for the US consumer's final capitulation. Saving F'nF and the recent fall in oil prices will push out this event, and both will dull it's impact somewhat. But I still think there is a "tap out" event coming by the US consumer that will mark a near term, buyable bottom. In the meantime, the sharp, almost frightening, moves down by most major currencies against the dollar suggests some serious position unwinding. The Aussie dollar has been hammered down 20% against the US$ in the past month and the Euro is now kissing $1.40.

The longer term outlook for the US$ is still pretty positive: the factors in play that determine currency direction are getting reshuffled in importance. Growth economies appear to be gaining the upper hand (US #1) while absolute rates and direction are still important. Current account issues seem to have faded.

On the equity front, the big tech consumer names like RIMM are looking pretty juicy: nice H&S chart, NOK puking, The City and Wall Street puking, and general consumer pullbacks make their product highly discretionary. The old economy $200 jean plays should also be good candidates - ANF. I am still involved in POT; I have held a small position, looking to build when I see a catalyst. I don't, yet, outside of Q3 EPS in late October. It's a blemish that became a boil. I am 95% ST munis and treasuries.

Demand destruction has worked its charms on energy, so it's tough to do anything long there. The engineering companies are in free fall, as are the materials companies. There may be a long commodity cycle ahead of us, but not before worldwide slowing growth take its toll. Still too early on the banks. Leveraged loans, commercial real estate, credit cards - write downs all still ahead, along with more residential real estate problems from prime (adj arm's). Deleveraging means these businesses suck now.

I am watching data for the state of the US consumer, the direction of US T's after the F'nF safety trade unwinds and the state of credit spreads in general. The ECB and BOE need to cut rates, inflation should continue to slow, euro banks will continue to get hammered from the slow closing of the ECB liquidity window, the Sukuk market is in turmoil with debates on legal structures, and China is how much we just don't know. So, still lots of uncertainty and it appears to still be growing.


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