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Billions in Liquidity, None to Spend
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ShareOK, a lot has happened over the last two weeks, and it is hard to know where to start. In the first place, you the taxpayer are now the proud owner of most of the mortgage finance industry in the country -- the takeover of Fannie (FNM) and Freddie (FRE) -- and also the owner of the largest insurance company in the world, AIG (AIG) . In a bid to stem moral hazard, the shareholders of each of these firms were essentially wiped out, the bondholders however were bailed out.
Both the bondholders and the stockholders of Lehman Brothers (LEH) were effectively wiped out. This led to the original money market fund, a fund with $63 billion in it, breaking the buck and suspending redemptions for a week. This is only the second time a money market fund has broken the buck, and the last time it was a very small fund that it happened to.
Fear rules the Street, and banks are afraid to lend to anyone, even each other. In a bid to find a safe place to park money, the interest rate on the three month T-Bill actually went negative briefly. I guess it is hard to find a mattress big enough to hold billions of dollars, but effectively that is what a zero rate on a T-Bill is. That is the first time that has ever happened -- the closest parallel was in January of 1940. Think about it, this is a bigger flight to safety than before the U.S. had engaged in World War II!
If that's not enough, Merrill Lynch (MER) was forced into a shotgun wedding with Bank of America (BAC), a $50 billion deal (all stock and based on the prices at the announcement) that was reached with as much due diligence as most people use when buying some candy at the checkout lane at the grocery store.
Three of the top five investment banks at the start of the year are either gone or
subsumed by large commercial banks, and it looks like the remaining two, Goldman Sachs (GS) and Morgan Stanley (MS), are desperately looking for dance partners. Meanwhile, the largest S&L, Washington Mutual (WM), is hanging by a thread. If (when) it goes under, it will use up most of the existing FDIC insurance fund. Either Congress of the Fed will have to replenish it, most likely to the tune of over $100 billion.
By any honest accounting of the moves already taken, the budget deficit is rapidly approaching the $1 trillion (with a "t") mark. Whoever wins the White House is going to face a mess on his hands greater than any faced by an incoming president since FDR. Oh, and in the middle of it all, Hurricane Ike shut down 20% of the nations refining capacity for a few weeks and left millions with out electricity for at least as long. Talk about taking a few shocks to the system.
But heck, things could have been much, much worse; if Bush and McCain had had their way a few years back, a big chunk of Social Security would have been in the hands of Lehman Brothers and Bear Sterns. The New Deal programs were put in place for a reason in response to the Great Depression, as ways of preventing its reoccurrence. We have spent much of the past decade dismantling those programs, but some of them still survive and should help to slow the decline.
But the damage from the unraveling of the FDR-era reforms has been great. The primary cause of this mess is a lack of regulation. The first great step in this direction was the unwinding of Glass Stiegel in 1999. To what I am sure is his great shame Bill Clinton signed this legislation (although given the margins it passed through the GOP-controlled Congress it would not mattered if he had vetoed it or not). The main provision of Glass Stiegel was the separation of Commercial Banks from Investment Banks. This helped insulate the Commercial Banks from the volatility of Wall Street.
That egg can no longer be unscrambled, as each move to shore up this teetering financial system has moved us farther and farther away from it. J.P. Morgan (JPM) has bought Bear Stearns, Bank of America is buying Merrill Lynch and quite probably by the time this is published Morgan Stanley and Wachovia (WB) will be married. Barclays of England (BCS) picked up the carcass of Lehman Brothers. Citigroup (C), of course, long ago picked up Smith Barney.
We are in the middle of a massive deleveraging, in effect those bad or close-to-worst-case-scenarios I have been writing about for the last few months are coming to pass. By and large Bernanke and Paulson are trying to do the right things, and has shown incredible creativity in fighting this fire. I have to say on legal and constitutional grounds I am not all that crazy about the appropriation and spending of hundreds of billions of dollars without Congressional approval, but this is a real emergency and I suspect that Congress will approve of it ex post facto.
A massive deleveraging means that lots and lots of dollars are going to money heaven. The Fed is trying to offset that by creating as much money as it can as fast as it can. The metaphorical printing presses are working overtime in an attempt to keep up. The Fed is using a fire hose of liquidity to try to put out this fire, but more and more it is not looking like a simple house fire, but a raging wildfire driven by hot winds and heading right for an Oil refinery. It is a seven-alarm fire and other fire departments like the European Central Bank, the Bank of England, the Bank of Japan, etc. have been called in to help out.
Once upon a time, many moons ago (actually, about six) the Federal Reserve would only lend to Commercial Banks, which were under its direct supervision, in its role as lender of last resort. It would only take Treasury paper as collateral. Then along came the Bear Sterns situation and they started to open the window to Primary Dealers, also known as the big Wall Street Investment Banks, and started to take Agency paper (i.e. Fannie and Freddie debt) as collateral.
With its latest moves, the Fed will take any "investment grade" debt and even equities as collateral. We know the rating agencies have been right on top of things with their determinations of who is investment grade, right? Seriously, the collateral at the pawn shop on the wrong side of the tracks is now better than what the Fed is taking onto its balance sheet. That balance sheet is what backs all those "Federal Reserve Notes" in your wallet. Now the window is so wide open I don't think it is fair to call it a window anymore. A window implied something that can be open and shut, with some sort of cashier sitting at it. This is not a window, it is a gaping hole in the side of a building.
I still do not think this is the time to try to bottom-fish in the financials. Yes, there may be tradable rally's as governments force short sellers to cover and directly inject liquidity into these firms, but for many of them the question is not liquidity, it is solvency.
Do not be tempted to by firms like Citigroup, Wachovia, Bank of America or Morgan Stanley. If you have to be in the market, look for either stable demand firms with rock solid balance sheets -- along the lines of Proctor and Gamble (PG) or PepsiCo (PEP) or some of the Energy names that have been beaten down with the recent decline in oil prices. Offshore drillers like Transocean (RIG) and Diamond Offshore (DO) look particularly attractive to me in here. Big Integrated Oils like Exxon (XOM), Conoco (COP) and Chevron (CVX) all have fortress balance sheets and are a very good place to hide.
Read the full analyst report on FRE
Read the full analyst report on AIG
Read the full analyst report on WM
Read the full analyst report on JPM
Read the full analyst report on WB
Read the full analyst report on BCS
Read the full analyst report on PG
Read the full analyst report on PEP
Read the full analyst report on FNM
Read the full analyst report on RIG
Read the full analyst report on DO
Read the full analyst report on XOM
Read the full analyst report on COP
Read the full analyst report on CVX
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