Risk vs. Reward

Risk versus Reward

The stock markets have been showing signs of a short term recovery over the past 2-3 days.


As I stated previously on this blog, I expected the markets to fall into a corrective cycle (as they have done) followed by a rally into year end (which is what I think we are setting up for now). HOWEVER, while that is encouraging, I am not confident this is sustainable and the current financial situation worldwide deserves very careful consideration.

I will post the charts soon but for now I want to go beyond the usual technical analysis to give you a bit of a top-down view of what I see happening currently in the worlds financial markets.

Please note I am not calling for the end of the world as we know it………the doom and gloom types have been wrong so many times over the years it is comical. HOWEVER, I have a very bad feeling that this time it could very well be different. As such, I cannot stress how important vigilance is to the current situation and being able to analyze the potential outcomes.

Bottom Line: I truly believe now is not the time to be overly aggressive in equity positions. If I’m right, this could save you a fortune (50% + in your accounts). If I’m wrong (which I truly hope I am), this could cost you next to nothing in terms of lost capital gains if you are in cash. Because we are dealing with pensions here, I feel I would be remiss if I didn’t err on the side of safety when talking about the current market situation and the possible outcomes.

I am not sure how many of you have been following the various gyrations in the banking/financial system over the past month. This is a rather lengthy but simple (I hope) summary to explain what is happening, where we are currently at, and most importantly where we might be going. Hold on tight; this is not for the faint of heart.

As you all know, this mess started years ago (2002) when the Federal Reserve decided to lower their rates to historically low levels. This was done to restore confidence in the American consumer to stave off a recession. As a consequence of their actions, the FED did indeed avoid a recession but in the process produced a much bigger and more dangerous bubble in the form of the housing bubble.

The setting of interest rates well below “neutral” encouraged two types of purchasers. The first is those who didn’t have a home; the traditional low income “renter”. This group should never have been able to purchase a home in the first place but due the very low interest rates combined with “no doc” liar loans (those loans where you signed a piece of paper stating your income but in no way did you have to actually prove what you stated you earned) combined further with “teaser rates” (those where the initial interest rate for the first 2 years is low but then resets to a much higher rate) combined to allow these people to qualify for mortgages they would never have been able to get in the "real" world. Plain and simple; they should never have been able to buy a home but the system allowed them to. They are now defaulting in record numbers.

The second groups are those who were home owners with good credit scores. These were the “flippers” who purchased multiple homes with very little-to-no down payments in the hope of flipping them quickly for a profit and not having to make payments on their purchases. This worked until the music stopped and they were left holding inventory in a declining housing market. They are now dumping those unit’s into a falling housing market.

At some point the process had to reverse. This is now ongoing. Those who never should have owned a home in the first place are now not making payments on their mortgages and are facing foreclosure. Those who have multiple units (the flippers) are now offloading their units at a loss into a continuing falling market. The end is not in sight yet.

On the mortgage side of the question, here is what happened. In an attempt to spread both the risky and sound mortgages amongst a large amount of investors (which, in theory is a good thing), the investment banks took these mortgages and “bundled” them in “tranches”. In other words, they took some very strong mortgages and bundled them with some very weak mortgages. Then they did some financial engineering within these bundled investments (by writing various derivatives upon those loans known as credit default swaps) to “counteract” the effects of any defaults within those bundles. So far, so good.............as long as everyone "sips from the same kool-aid".

At this point they sent them off to the rating agencies to be rated. Due to the “financial engineering” within these tranches, what would normally have been a bundled mortgage tranche classified as a BBB or less (ie, "junk bond grade") instead was turned into an "investment grade" bond product due to the derivative function built into the product. In short, the rating agencies were “encouraged” via the obscure countering nature of the derivative function within the tranche to rate these structures at a much higher rating level (AAA or AA) than these bonds were deserving of. Also another reason I'm sure this was done was because of the substantial fees the rating agencies earned as a result of the shear volume of these “investment grade” products they turned over (as investment grade products, due to the their perceived safety, have a much wider audience to sell to as many conservative investment funds cannot accept bonds below investment grade) .

Once the bundle was rated, it was sold by the investment banks to various conservative investors, pension funds, money market accounts, etc around the world (many of which thought they were buying a AAA rated bond portfolio where in fact they were buy a junk portfolio dressed up as a AAA rated bond portfolio). These are known as known as Mortgage Backed Securities (MBS) and also Structured Investment Vehicles (SIV’s).

Everyone was happy with the deal as long as the housing market continued to expand and everyone was making tons of money. The problem now is the U.S. housing market is in a full blown recession (maybe soon to be depression). Mortgage defaults are skyrocketing and prices are plunging. Many of these “investment grade” bonds are now worth a market value well below face value (in some cases only 25 cents on the dollar) and the banks and brokerage firms who hold them are in big trouble. This is not just a few banks or a few brokerages; it is ALL OF THEM.

The combined write-offs to this point have been in the range of 50 billion dollars. The expected write-offs could top 600 billion dollars. The problem is no one really knows what the real number is for one very good reason; NO ONE REALLY KNOWS WHAT THESE THINGS ARE REALLY WORTH.

Because the market for these products has seized up, the banks who are holding them don’t want to sell them into the market as they know they will only get 25 cents on the dollar for them. No one wants to take the loss on these things. Those banks that can hold on at this point are sitting on them or taking limited write-downs and praying this whole thing blows over (or until the government intervenes to save them). In an effort to do so, they are doing something called “mark to model” which means they are reporting their holdings in these products based upon their theoretical market model value as opposed to a “mark to market” valuation where they would be required to report their price based upon the current market value. In other words, they are lying in an attempt to stave off having to admit the true value of their holdings are well below that which they are currently reporting.

At this point, trust is broken. One bank won’t lend to another bank because he doesn’t know how much the other guy is lying about his holdings in these things. He is wondering if he lends to the other guy whether he will ever see his money again. That in a nutshell is what is happening currently.

No trust = no lending........No lending = no credit...........No credit = no money flow..........No money flow = deflation.

While there have been many write-downs over the past month, here is the latest example this week.

First, Citibank (the largest bank in the U.S.) was given a cash infusion of 7.5 billion dollars by the Abu Dhabi Investment Authority. The stock market went up substantially as it was viewed as “trust” in Citi by the ADIA. What was missing in all this “happy news” is that the interest rate the ADIA insisted upon for their investment was 11%! This is not a normal loan; this is a loan shark loan. This shows you how tough things are right now at the biggest bank in the U.S……..and where does that leave the smaller banks if Citi needs to do this to attract capital?

Second, E-Trade announced it was getting an “investment” from a hedge fund called Citidel. What they did was unload 3 billion in mortgage backed securities (mostly composed of HELOC’s; home equity line of credit loans) to them for 800 million dollars. That is 26 cents on the dollar. The real problem is most of these loans were made to real homeowners with real equity in their homes; not the more toxic loans that were made to those who should never have gotten the loans in the first place. So the question that begs to be answered is……..if these “good” loans are currently marked to market at 26 cents on the dollar, what are the more toxic ones really worth? And what about all those other banks (ALL BANKS) who also hold HELOC’s……….the market is telling us their holdings are now worth 26 cents on the dollar; whether they want to admit it or not.

One example; Washington Mutual is a large U.S. bank heavily involved in the mortgage market. Their current “loans held for investment” (of which some are HELOC’s; how much they are not reporting) are $237 billion dollars mark to model; based upon E-Trade and their latest sale the true mark to market value of those loans is $165 billion less than what they are valuing them at. Problem is…………Washington Mutual’s current net assets (assets minus liabilities) are $24 billion dollars. Even if only a portion of their loans are HELOC and they decided (or were forced) to mark to market, they would be bankrupt.

They are only one example of many and that is why this banking crisis is so important. Where could this all end? Recession/severe recession/1930’s style depression. The degree is unknown; all that is known is this is BIG TROUBLE.

So what needs to happen? Here is a cut and paste from someone who put it in very easy to understand terms:

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They know what is coming! Did you see Kudlow last night? He, and the rest of his crowd, were clamoring not for a rate cut but for 100 to 150 bips of rate cut - right now!
Why?

Because they know what's coming. A massive recession. Bank failures - lots of them. Perhaps even a DEPRESSION.

But, you sputter, can't The Fed fix this? Save the day? Ride to the rescue?
No, it cannot.

What has to happen?

The Fed needs to step in right now and force all of their "bank customers" to take ALL of their off-balance sheet crap back onto their balance sheet and mark it to the market.

Right now.

Period.

If this forces some of them out of business, then so be it. The FDIC will not fail in this situation, contrary to some of the doomsayers. The FDIC's "formula" is to merge the insolvent organizations, using whatever value is left to make those with under $100,000 in deposits whole, while throwing under the bus the common equity holders, any preferred equity holders, and everyone else who happens to have a putative "claim" on the bank.

This is the only way to fix the problem, and whether Bernanke (and Paulson) like it or not, it is what is going to happen.

Lending will not return to normal until confidence returns and confidence requires transparency and truth. So long as market participants continue to lie and obfuscate, lending will remain locked up. PERIOD!

The only choice is to either force transparency now in a manner that is somewhat controlled or we will continue to spiral downward into the dirt, with the disclosure and cleaning out happening through bankruptcy as we reach the depths of a DEPRESSION.

Yes, I used the "D" word.

If The Fed doesn't quit screwing around and act NOW, we're headed for one.
1930s style.

Ben, wake the hell up. The answer isn't playing with system liquidity.

YOU ARE FIDDLING WHILE ROME BURNS.

The problem is that everyone involved in this mess on the banking and "investment" side has been lying through their teeth. E*Trade is just one example - not two weeks ago their CEO said "we could suffer $1 billion in writedowns and remain well-capitalized", strongly implying that the damage was less than that.

Well, guess what - less than two weeks later they sold $3 billion "worth" of loans for $800 million. That is $2.2 billion in direct losses, or more than double what they claimed their maximum exposure was just two weeks before!

IT IS ALL LIES!

Let's count a few of them:

· Treasury (and others) - "Subprime is contained"; "Housing will turn around this year"; "there's no impact on the rest of the economy." All lies.

· Bernanke - How many do I need to count? Testimony in front of Congress that is just flat false. How about a contempt citation guys?

· CEOs up and down the line. Too many bad press releases to count. AHM anyone? CFC? Projected profits for 4Q? All the investment banks taking writedown after writedown, one after another.

· E*Trade, as I noted - "We can absorb more than $1 billion and remain well capitalized", strongly implying that the damage was less than that. Now we find out its $2.2 billion - and we don't know if they're done. I moved my accounts; that proved to be false statement #2; you don't get to bullshit me more than once!

I'm tired of this crap, you should be tired of this crap, and those who are buying this "rally" when every institution that has made claims that they have their exposure under control ends up being shown to be a LIAR as soon as a week or two later, are just plain fooking stupid!
(Oh, and don't look but metals are getting SMASHED today. I told you so.)

Deflation is in our future - the worst-case scenario for anyone in debt. Why?
Because our government is refusing to do its damn job of regulation and has refused to get the handcuffs out and slap 'em on the CEOs and others who have made these insanely-rosy projections and statements, while at the same time encouraging and enabling the hiding of liabilities!

As such confidence has collapsed between parties in the market, and this WILL lead to a collapse in lending and credit - the destruction of money, which is the definition of deflation.
It has already started and is going to get MUCH worse.

If you're in debt and can't get out, you're finished. Sorry; that's how it is.

If you can get out of debt in the next few weeks and months, do so. If you have cash, conserve it. Save. Keep your powder dry. Do not be stupid and listen to people like Cramer who said last night that "cash will be the biggest losing asset class."


Bottom Line:

The markets appear to have entered a corrective bullish uptrend. Under “normal” circumstances, I would be all over this banging the drum to buy equities. However, given the current unique situation I think it is wise to re-assess your current positions.

In my case, I will follow the charts and if they direct me to increase my equity exposure I will do so (and those who are willing to risk their positions; I invite you to join me). However, should this turn for the worst I will be out in a flash.

For those who are risk adverse, I would highly suggest you be very careful with your equity exposure at this point. Should you be in cash and this crisis happens to blow over or be contained……..you will have been in cash and side-stepped a unique financial crisis that was averted. However, if this thing turns nasty…..you’ll be thanking your lucky stars you were in cash when the deflationary collapse occurred.

As always, I am not currently offering financial advice. I think it is up to each of you to assess your own unique position/risk tolerance and decide if you want to be aggressive into a highly explosive financial crisis or safely positioned in cash.

My current position as of tonight remains unchanged at 50% equities/25% USD/25% Euros. As soon as this changes you will know.