11 DAYS LATER

The global market events of the last eleven days remind me of the plot of the movie 28 Days Later. Only, in this case, the virus is a global solvency crisis and the zombies are bankers who are vomiting blood on us all as they fiend for additional capital.

Since the Dow Jones US Financial Index rallied 24% from the low on 10/10 to the close on 10/13, the index has given back all that gain and then some. And, the VIX index, which had posted record highs near 70 previously, is now well into uncharted territory, opening near 90 this morning before retreating.

In previous posts, I had pointed partial blame for the increase in volatility to the SEC short-sale ban that expired on October 8th. However, that was two weeks ago--- how could the volatility persist? One explanation could be that the short-sale ban had no impact on volatility and that the VIX (which measures fear, basically) is rallying because people are frantic and uncertain. However, I still believe that the SEC market manipulation that correlated to unusual options activity and a spike in the VIX is still contributing to the volatility and the fear in the market. I believe that the market came unhinged during the period of the short-sale ban, by which I mean that the normal corrective mechanisms of the markets were not behaving as expected, and those mechanisms have yet to return to normal function. This, in turn, is spooking investors who are already on edge thanks to the exceptionally poor performance in the financial sector, which is now spreading to the larger economy. They buy the dips and get bitten, looking for a snap-back rally that never materializes.

The markets, to a large extent, are disconnected from reality, unless we believe the 28 Days Later thesis that England is going to be reduced to a military compound of 10,000 inhabitants within 28 months. So, while I liked the movie a lot more than I enjoy watching the markets shred 401(k) accounts, I tend to think that what we are seeing is an opportunity in global equities the likes of which we haven't seen since the 1930's.

For example, shares of numerous companies in the water transportation sector (examples include OCNF, PRGN, ESEA, EGLE, SBLK) are trading well below book value and paying huge dividends with high profit margins. This can only be explained by the 28 Days Later thesis in which global trade shuts down and everybody heads for the basement.

So, while taking a bite at this market likely means getting bitten, sometimes the best opportunities to invest come when the zombies are roaming the streets and everyone is running in panic.

END OF SHORT SALE BAN USHERS IN BIGGEST TWO-DAY RALLY IN FINANCIAL STOCKS IN HISTORY

Those that feared that the end of the short-sale ban would trigger a sell-off in the shares of financial services companies were right: the stocks declined for for exactly one trading session, then set off on a two day rally that increased the Dow Jones U.S. Financials Index, between the lows marked near the open on Friday to the close of the markets today, by nearly 24%.

The global credit crisis is now officially a five-alarm blaze: the central banks of the U.S., England, the E.U., Japan, and China are working in a historically unprecedented and coordinated fashion to calm the markets and prop up the global financial system.

Central bankers are finally coming to the realization that the global financial crisis is NOT a liquidity crisis, but rather a crisis of confidence based on the rapidly deteriorating credit worthiness of financial institutions small and large. This crisis is the culmination of years of banks chasing after each other to sell debt against ever-weakening standards, fueled by artificially low input costs in the form of a Fed Funds rate that stayed too low too long, and exacerbated by investment banks that sought in 2001, and were given, a regulatory increase in reserve requirements from 7x to 40x.

Since Alan Greenspan cut the Fed Funds rate to 1% in the wake of 9-11, and the Wall St. banks sought regulatory relief in the same period and used similar arguments (increasing the M2 money supply will help ward off a post 9-11 recession), you could say that Osama bin Laden may have finally succeeded in what he set out to do: end the longest period of free and unfettered economic growth in the history of the planet.

While I do not believe that this crisis will result in the end of social democracies and the fundamental tenets of free market economics, nor result in the kind of suffering that marked the dark years of the Great Depression, the period that started with Ronald Reagan in which the financial markets facilitated individuals and businesses to take wild risk, to pursue a crazy dream, or to rapidly turn a small business with a great idea into a multinational powerhouse is over.

In the upcoming decades, for better or for worse, we will be back to a time when cash is king, when credit will be meted out conservatively, in which businesses will grow gradually over time, and in which Americans will be forced to make hard choices in which they must figure out how to do more with less. It will be a simpler time, to be sure. And, it will be a time of dramatically lower earnings per share growth.

This fear has been at the heart of the recent stock market sell-off, and is why a two-day, 24% gain in financial stocks only takes them back to where they were three days before. The fear is that, in a period of single-digit earnings growth, the years of +20x P/E ratios is over, that this recovery will NOT be like the others.

While I was long skeptical of the extremes in valuations that led to boom and bust cycles, I somehow prefer that to the future that I now see taking shape. The old future was one that was marked by optimism, by self-confidence, by Greenspan's "irrational exuberance", in which you could take a business plan written on the back of a napkin and find investors willing to front you a cool million to get it off the ground. Somehow, that feels more American to me, even if it proved wildly irresponsible in many cases, than the future that now seems to be in store for us.

Christian Antalics

FINANCIAL SHORT SALE BAN SET TO EXPIRE

The SEC's ban on short sales of a market basket of financial firms is set to expire at 11:59 p.m. Wednesday evening.

You can say that, if the intent of the ban was to support the price of the targeted stocks, the effort has failed: from the close of 9/17 (the last full day of trading before the ban was imposed) through the close today, financial stocks were down nearly 40% more than the Dow.

Additionally, volatility is now at record levels; the VIX index, which basically measures levels of fear in the financial markets, is nearly twice as high as it was in the early stages of this crisis (and at the highest point since the index was created over 18 years ago):

Why would volatility have continued to rise in the face of a ban on short selling, which we might think would calm the markets? Short selling, rather than the parasitic behavior that the SEC and the CEO's of financial firms perceive it to be, is just one more tool that investors can use to hedge, or limit risk. By restricting short selling, the SEC sent a signal to investors to stay out of the market until the short sale ban is over. Since the vast majority of investors take long positions in stocks, this translated into a generalized buyer's strike. Why would this be? On one hand the ban on short selling increased the risk of taking long positions in financial companies as hedging those positions had become more difficult; and on the other hand the ban gave investors the perception that the ban would result in pent-up selling pressure that could precipitate a new leg down in financial stocks once the ban was lifted.

Since financial stocks lead the stock market as a whole (no stock market rally can be sustained in the face of a decline in financial stocks), why would any investor take ANY position in the stock market during the period of the short sale ban? During the period of the ban, the U.S. stock market lost over $6T in value, losses that would have been realized by anyone who was scared out of the market or was forced to sell by virtue of a margin call. Therefore, we can reasonably argue that Christopher Cox and the SEC helped the pension funds of the United States lose $6T by their wrong-headed decision.

So, now that the ban is set to expire, what can we expect to happen? While it is very hard to say, I believe that the end of the ban will usher in a rally in financial stocks, for the same reasons that I attribute the steep market declines to the ban. Able to hedge positions, investors will feel safer taking those positions. And, any good news could easily trigger short covering rallies, which were out of the picture when short selling was banned.

Moral of the story: don't mess with the free market.

Christian Antalics

CENTRAL BANKS CUTS RATES IN TANDEM

Prior to the start of trading in New York, central bankers around the world cut rates by equivalent amounts in an effort to avert a deflationary spiral and to prevent a run on any one currency. This decision was especially difficult for the Europeans, who have been reluctant to accept the thesis as presented by Paulson and Bernanke. However, healthy declines in global indices pushed their hand. Above, France's Prime Minister Francois Fillon delivers a speech during a special debate on the global financial crisis at the National Assembly in Paris October 8, 2008.

Time will tell if the concerted rate cuts have the desired effect. In the short-term, a cut in the Fed Funds rate will reduce the cost of commercial bank's primary input by 25%, which should flow through to their bottom line. However, the Fed has been shoveling low-cost short-term money into the financial system to the tune of nearly $1T since September in an unprecedented effort to keep U.S. banks solvent and liquid. Therefore, it is somewhat doubtful that the rate cut will have as big an impact as it would otherwise.

And, if the U.S. and world economies should finally gain traction, the amount of cash sloshing around in the system could trigger runaway inflation.

At the moment, however, the central bankers seem to fear a deflationary spiral more than an inflationary one. This is an interesting hypothesis, considering that there is ample anecdotal evidence that core inflation, excluding volatile food and energy, is running north of 5%. If inflation rates are running this high (even higher if we count the grocery store and the gas station), interest rates will trend higher regardless of the Fed's efforts to peg rates at a low level. In fact, LIBOR (an index that tracks the rates that banks charge for short-term loans to one another) peaked at 5.39% today, but should ease slightly in light of the concerted rate cuts.

What does this mean? It means that the world economy is locked in a crisis of confidence and that the largest banks are no longer confident that the counter-party to their short-term loan will be around long enough to pay the loan back; they are therefore demanding an insurance premium which is shown by the wide spread between the Fed funds rate and LIBOR. This insurance premium, however, virtually insures that the bank accepting those terms will be at increased risk of failure, so the lending bank basically refuses to lend, regardless of how cheap their access to cash may be.

At the moment, however, the Federal Reserve is actively shooting the U.S. dollar full of holes. It is only by virtue of the global nature of this crisis that the dollar has not collapsed completely. The Japanese yen is now on parity with the U.S. cent, something that happened only once before, in the period between July 1994 and August 1995. This dramatic decline in the value of the U.S. dollar, especially if it continues to worsen as can be reasonably expected, is inflationary and reduces the buying power of those on fixed incomes.

Rather than flooding the financial system with liquidity (which isn't getting down to the inner workings of the credit markets due to the fear of bank failure), why doesn't the Fed start a program of loan guarantees for a rate equal to half of the historical spread between Fed Funds and LIBOR? In other words, banks that subscribe to the program can make interbank loans at a rate close to the historical average and have the assurance of the U.S. Treasury that the loan will be repaid. This program, in my opinion, would be cash-flow positive for the Treasury, and, since it will get to the heart of the credit crisis, will increase bank liquidity and reduce the risk of bank failure.

The Federal Reserve announced a program earlier this week that is similar in some regards to my proposal. Essentially, the Federal Reserve began buying commercial paper on the open market with the hope that they could help the market become "unstuck". However, participants in this market know perfectly well that the Fed is a buyer of last resort who is participating in the auctions out of a sense of necessity, rather than because the Fed believes that commercial paper is a good investment. Therefore, this is yet another liquidity move that fails to get at the heart of the problem, which is the fundamental solvency risk of U.S. institutions.

Christian Antalics

WELLS FARGO BID FOR WACHOVIA SHOWS THAT THE FREE MARKET IS NOT DEAD

Today, Wells Fargo announced a nearly $16B bid for Wachovia, prompting the latter's stock to pop nearly 60%. Days earlier, the Federal Reserve and FDIC had engineered the sale of Wachovia to Citigroup for $2B and had agreed to provide over $300B in loan guarantees. Wells Fargo's bid is 8x larger and does not involve implicit or explicit government guarantees!

If this level of interest exists in Wachovia, why did the U.S. Government short-circuit the free market and put over $300B of taxpayer money at risk? Are we to assume now that similar government deals involving Bear Stearns, Washington Mutual, and Merrill Lynch were similarly flawed? What does it say, in general, about government interventions into the free market?

Clearly, the sweetheart deal that the Feds gave Citigroup needs to be cancelled and the terms of government-sponsored deals involving Bear Stearns, Washington Mutual, and Merrill Lynch need to be reviewed to see if any institutions were unfairly enriched and if any taxpayer money was improperly put at risk.

Christian Antalics

PORKY PAULSON PLAN PASSES SENATE

The U.S. Senate passed this evening, by a wide margin, legislation that has at the heart of it the Paulson Plan:

AUTHORITY.— The Secretary is authorized to establish the Troubled Asset Relief Program (or ‘‘TARP’’) to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the Secretary, and in accordance with this Act and the policies and procedures developed and published by the Secretary.

So, the U.S. Senate blinked and granted Hank Paulson authority to spend an amount greater than the gross domestic product of Australia with virtually no strings attached.

Not only is this unprecedented, but it is of questionable economic and constitutional merit.

This legislation will do the following:

• Will cause the shares of financial stocks to rally as investors will perceive that the risk of outright failure due to "troubled assets" has diminished significantly.
• Will guarantee that the Treasury, and by extension the U.S. taxpayer, will be saddled with the absolutely worst bonds and securities that banks and other institutions, both U.S. and foreign, have clanking around in their basements.
• Will potentially provide the banks with an incredible windfall as they unload toxic assets at above market prices, and buy them back later at "fire-sale" prices.
  
• Will put extreme pressure on the dollar and will prove to be highly inflationary.
• Will dramatically limit the discretionary spending authority of the U.S. Legislature.
• Will increase the risk of a credit downgrade on U.S. Sovereign debt.
• Will cause U.S. interest rates to rise as inflationary pressures increase.
• Will be viewed in hindsight as a boondoggle the magnitude of which can never be repeated.

That being said, if the legislation helps unglue the stuck wheels of lending, that will be a good thing. However, as I mentioned in previous posts, the credit-worthiness of U.S. businesses and individuals is at a historic low, and any extended period of economic weakness will worsen this condition. In other words, the credit markets cannot come completely "unstuck" until the balance sheets of businesses and individuals regain their strength.

So, we'll see what the House has to say about it, but it looks like a done deal.

UPDATE 10/2/08

Continued study of the Senate TARP bill revealed a clause that could render the entire bill unworkable:

PREMIUMS.—

IN GENERAL. — The Secretary shall collect premiums from any financial institution participating in the program established under subsection 9 (a). Such premiums shall be in an amount that the Secretary determines necessary to meet the purposes of this Act and to provide sufficient reserves pursuant to paragraph (3).

AUTHORITY TO BASE PREMIUMS ON PRODUCT RISK. — In establishing any premium under paragraph (1), the Secretary may provide for variations in such rates according to the credit risk associated with the particular troubled asset that is being guaranteed. The Secretary shall publish the methodology for setting the premium for a class of troubled assets together with an explanation of the appropriateness of the class of assets for participation in the program established under this section. The methodology shall ensure that the premium is consistent with paragraph (3).

MINIMUM LEVEL. — The premiums referred to in paragraph (1) shall be set by the Secretary at a level necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected.

The key language here is in the final paragraph, "The premiums referred to in paragraph (1) shall be set by the Secretary at a level necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected." What the legislation is calling for is bond insurance, or credit default swaps, both of which are at the heart of the financial crisis, as they have become prohibitively expensive.

The point of the TARP legislation, as I understand it, is to pay banks and other holders of distressed assets a price above the current market, or "fire-sale" price that they could currently earn if the assets were liquidated through public auction. How the Secretary of the Treasury is going to structure the purchase of toxic assets such that the taxpayer is "fully protected" without charging a premium that puts the net price of the assets below the fire-sale price, I have NO idea, but it will be very interesting to watch him try!

Christian Antalics