Bailout “Hope Rally” = Eye of the Storm

(just time for a quick, somewhat unpolished update)

What I mean by “hope rally” is the rally off a (bear-market) low that is driven by the hope that some specified thing (the Bailout legislation in this case) is going to make everything all better. That is never the case, of course, otherwise it would be called the start of a new bull market.  Also, in the current situation, it’s almost certainly (effectively certainly) too early (time and price) in the bear market for a new bull market to start.

That’s why I make the eye of the hurricane analogy, because any “Bailout Reprieve” will (almost certainly) be only temporary.

Last week’s…

…feeble rally attempt failed by definition, since it took out its prior low.  A new rally attempt will come, of course, as they always do.  The question is when and from what level.  Time will tell.  The only things we know are: (1) that the patient (Mr. Market) is not healthy, and (2) the “recession denial” that has been going on for over a year is coming to an end.

All is not lost, however, because the darkest hour is before the dawn, and the sooner Mr. Market gets his capitulation, the sooner he can start recovering.  What is required is to flush the weak hands out of the market through distressed and forced sales.

That distress and capitulation has not happened yet, at least not on a large enough scale.

Anyway, I’m not trying to be “doom and gloom” here, just pointing out some of the psychological and sociological behaviors that are the markets and that have remained the same throughout human history.  This is why studying the market, and participating in it, is so fascinating.

Markets are simply a reflection of “us.” They are our true selves, where people act in their own self-interest, even if it means that together those actions cause damage (for example bank runs).

All these things must happen, of course. It’s like the little kid with the toothache who doesn’t want to go to the dentist and mom bails him out with drugs that treat the symptoms, but don’t cure anything.  That works for a few days, but the tooth still hurts, and it gets worse. Eventually junior has to go to the dentist, but because he waited, he suffered more, and possible more damage has been done, for example if an infection has taken root and spread because of the choices made, mom’s bailout, etc.  Anyway, you get the idea.

I’ll close with  a couple charts, then a reprint of Nouriel Roubini’s latest article:

As you can see on this quarterly (3-month candles) S&P 500 ETF chart, which goes back 15 years:

  1. The first bull market (green arrow) lasted about 5-6 years.
  2. The subsequent bear market (brown arrow) lasted about three years.
  3. That bear market had two 4-6 month rallies (green circles).
  4. The second bull market lasted about five years.
  5. We are only one year into the current bear market.
  6. There has not yet been a bear market rally that shows up on the quarterly chart, although we did get a few tradable mini rallies, the strongest of which went from March to May (see weekly chart, below).

There are other things we could discuss on these charts and others, but it’s time for dinner here in Gothenburg.  Cheers!

Financial and Corporate System is in Cardiac Arrest: The Risk of the Mother of All Bank Runs

By Nouriel Roubini

It is now clear that the US financial system – and now even the system of financing of the corporate sector – is now in cardiac arrest and at a risk of a systemic financial meltdown. I don’t use these words lightly but at this point we have reached the final 12th step of my February paper on “The Risk of a Systemic Financial Meltdown: 12 Steps to a Financial Disaster” (Step 9 or the collapse of the major broker dealers has already widely occurred).

Yesterday Thursday a senior market practitioner in a major financial institution wrote to me the following:

Situation Report: So far as I can tell by working the telephones this morning:

* LIBOR bid only, no offer.
* Commercial paper market shut down, little trading and no issuance.
* Corporations have no access to long or short term credit markets — hence they face massive rollover problems.
* Brokers are increasingly not dealing with each other.
* Even the inter-bank market is ceasing up.

This cannot continue for more than a few days. This is the economic equivalent to cardiac arrest. Then we debated what is necessary to restart the system.

I believe that the government will do another Hail Mary pass, with massive guarantees to the short-term commercial credit system and wide open short-term lending by the Fed (2 or 3 times expansion of the Fed balance sheet). If done on a sufficient scale this action will probably work for a while. But none of these financial measures affects the accelerating recession — which will in turn place more pressure on the financial sector.

Another senior professional in a major global financial institution wrote to me:

Today, in our trading room, I could see the manifestations of a lending freeze, and the funding hiatus for banks and companies, with libor bid only, the commercial paper market closed in effect, and a scramble for cash – really really scary.

Do you think this is treatable without a) a massive coordinated liquidity boost and easing of monetary policy and b) widespread nationalisation of some banks, gtess to others AND a good bank/bad bank policy where some get wiped along with their investors? The Treasury Tarp plan is an irrelevance if we are at a major funding crisis.

And to confirm the near systemic collapse of the system of financing of both financial firms and corporate firms Warren Buffet declared yesterday, as reported by Bloomberg:

the U.S. economy is “flat on the floor” after a cardiac arrest as companies struggle to secure funding and unemployment increases.

“In my adult lifetime I don’t think I’ve ever seen people as fearful, economically, as they are now,” Buffett said today in an interview with Charlie Rose to be broadcast tonight on PBS. “The economy is going to be getting worse for a while.’ …The credit freeze is “sucking blood” from the U.S. economy, Buffett said.

We are indeed at the cardiac arrest stage and at risk of the mother of all bank and non-ban runs as:

– The run on the shadow banking system is accelerating as: even the surviving major broker dealers (Morgan Stanley and Goldman Sachs) are under severe pressure (Morgan losing over a third of its hedge funds clients); the run on hedge funds is accelerating via massive redemptions and a roll-off of their overnight repo lines; the money market funds are experiencing further withdrawals in spite of government blanket guarantee.

A silent run on the commercial banks is underway. In Q2 of 2008 the FDIC reported $4462bn insured domestic deposits out of $7036bn total domestic deposits; thus, only 63% of domestic deposits are insured. Thus $ 2574bn of deposits were not insured. Given the risk that many banks – small, regional and national – may go bust (as even large ones such as WaMu and Wachovia went recently bust) there is now a silent run on parts of the banking system. Deposit insurance formally covers only deposits up to $100000. Thus any individual, small or large business and/or foreign investor or financial institution with more than $100000 in a FDIC insured bank is now legitimately concerned about the safety of its deposits. Even if as likely the deposit insurance limit will be temporarily raised to $250000 by Congress there will still be a whopping $1.9 trillion of uninsured deposits (or 73% of total deposits); thus, a huge mass of uninsured deposits will remain at risk as even small businesses have usually more than $250K of cash while medium sized and large firms as well as any domestic and foreign financial institution or investor with exposure to US banks has average exposure in the millions of dollars. Particularly at risk are the cross border mostly short term interbank lines of US banks with their foreign counterparties that are estimated to be close to $800 billion.

– A run on the short term liabilities of the corporate sector is also underway as the commercial paper market has effectively shut down with little trading and no issuance or rollover of such debt while corporations have no access to long or short term credit markets and they are therefore facing massive rollover problems (over $500 billion of rollover of maturing debts in the next 12 months). Indeed, the market for commercial paper plummeted $94.9 billion to $1.6 trillion for the week ended Oct. 1 (and down over $200 billion in the last three weeks). Especially banks and insurers were unable to find buyers for the short-term debt: financial paper accounted for most of the decline, plunging $64.9 billion, or 8.7 percent in the last week; but now even non-financial corporations are also experiencing severe roll-off in the CP market. Discount rates for investment-grade non-financial commercial paper spike to 599bp for 60 day maturities. More companies are borrowing against or tapping their revolving credit lines. This is largely due to the dislocation caused in the money markets by the failure of Lehman and the subsequent withdrawals from money market funds, which are some of the biggest providers of liquidity in the short term funding/commercial paper. Even the largest corporations are at severe stress: AT&T last week was forced to rely on overnight funding for its treasury operations, as lenders were unwilling to provide more long term financing due to fears in money market funds over investor redemption. The CEO said “It’s loosened up a bit, but it’s day-to-day right now. I mean literally it’s day-to-day in terms of what our access to the capital markets looks like,’’ Things are much worse for non-investment grade corporations and for small and medium sized businesses. As reported today by Bloomberg: Almost 100 U.S. corporate treasurers gathered for an emergency conference call yesterday to warn each other that banks are using any excuse to charge more to renew lines of credit. “Capital is fleeing to safety,” said Edward E. Liebert, treasurer of Rohm & Haas Co., who took part in the 90-minute call organized by the National Association of Corporate Treasurers. “Interbank lending is not free-flowing any more,” said Liebert, 56, chairman of the Reston, Virginia-based trade group. One bank charged a participant in the call 80 basis points to renew a routine $25 million credit line, according to Liebert, who wouldn’t identify the speaker or the company. Rohm & Haas, based in Philadelphia and rated BBB by Standard & Poor’s, is paying 8 basis points for a $750 million revolving line of credit provided by 13 banks, the treasurer said. A basis point is 0.01 percentage point. As the U.S. House of Representatives prepares to vote on a $700 billion bailout bill passed by the Senate, global credit markets are being squeezed by banks afraid to lend to each other and to even some investment-grade corporate clients. Treasurers are struggling to keep credit lines open so they can pay employees, fund pension benefits and purchase raw materials. “The banks are really starting to play hardball,” said Jeff Wallace, managing partner at Greenwich Treasury Advisors, a financial consultant in Boulder, Colorado. “They don’t want to give out any more money to people because they don’t have enough capital”. Banks are demanding renegotiation of interest charges or lending terms when “routine” amendments are requested on lines of credit, said Thomas C. Deas Jr., treasurer of Philadelphia- based FMC Corp. and an association board member.

– The money markets and interbank markets have shut down as – despite the Senate passing the bail-out bill – yesterday USD Overnight Libor was still at 268bp after reaching an all-time high of 6.88%; the USD 3m Libor-OIS spread widened to record 270 basis points; EUR 3m LIBOR-OIS spread is at record 130bp; the TED spread is at record 360bps (TED was 11bps one month ago); Money and credit markets are dysfunctional also in emerging markets ; and agency bond spreads are also at highs again.

So we are now facing:

– a silent run on the huge mass of uninsured deposits of the banking system and even a run on some insured deposits are small depositors are scared;

– a run on most of the shadow banking system: over 300 non bank mortgage lenders are now bust; the SIVs and conduits are now all bust; the five major brokers dealers are now bust (Bear and Lehman) or still under severe stress even after they have been converted into banks (Merrill, Morgan, Goldman); a run on money market funds; a serious run on hedge funds; a looming refinancing crisis for private equity firms and LBOs);

– a run on the short term liabilities of the corporate sector as the commercial paper market has totally frozen (and experiencing a roll-off) while access to medium terms and long term financings for corporations is frozen at a time when hundreds of billions of dollars of maturing debts need to be rolled over;

– a total seizure of the interbank and money markets.

This is indeed a cardiac arrest for the shadow and non-shadow banking system and for the system of financing of the corporate sector. The shutdown of financing for the corporate system is particularly scary: solvent but illiquid corporations that cannot roll over their maturing debt may now face massive defaults due to this illiquidity. And if the financing of the corporate sectors shuts down and remains shut down the risk of an economic collapse similar to the Great Depression becomes highly likely.

So what needs to be done? Even several hundreds of billion dollars in emergency liquidity support to the financial system by the Fed and other central banks in the last week alone have not been enough to stop the seizure of liquidity in interbank markets and the shut down of financing for the corporate sector as counterparty risk is now extreme (no one trusts any more in this crisis of confidence even the most reputable and trustworthy financial and corporate counterparties).

I’m not making a call as to how long the “hope” rally lasts, Not saying the “hope” rally

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