Wednesday, October 1, 2008

bleaker than ever

today's stock market rally gave me few reasons to be hopeful. as I continue to report on and research this credit market meltdown, I see no reasons for any kind of hope at all.. things are bleaker than ever.

an experienced debt restructuring expert described "a malaise that knows no refuge" and said companies are now facing shorter and shorter periods they can exist under stress before being simply liquidated.

the disruptions of the last 2 weeks alone are utterly without precedent and will disrupt people's lives for years to come. look at the chart below.. this is the difference between the 3month eurodollar rate, which banks pay to borrow from each other, and 3 month treasury bills.

this is essentially what people have been calling the "TED" spread. all that matters is that, the higher it goes, the worse off we are. think about it like this:

joe's pizza asks the bank for $100k to buy a new pizza oven. let's say joe is a great customer and the bank believes he will pay it back because the oven will let him double his business.

let's say the bank doesn't have $100k available. normally, it would borrow this from another bank at this interbank rate. but now banks are dropping like flies (wamu, indymac), they charge each other much higher rates on these loans. after all, if they lend to another bank and it fails, that loan becomes a "bad asset", requiring a "writedown". if your depositors find out, they might "worry", causing a "bank run", costing you your job.

the end result is that joe can't install his oven.

let's say joe already borrowed and needs to refinance his loan. now the bank is scared and won't lend... now maybe joe winds up getting cooked himself. this is what happened to pilgrim's pride recently... an interesting story.. they were basically unable to renegotiate certain things on their loans and will probably wind up as "dead meat." if you don't know pilgrims pride, they are not a bank.. they are a meat processor... because their industry is "stable" and "non-cylical", banks have been willing to lend them more money than other industrials that might be more sensitive to a bad economy.

the end result is that now even "safe" companies are at risk in this credit crunch. because the interbank rate is so high, as is illustrated above, joe doesn't get his loan, nor does pilgrim's pride.

pilgrims pride is probably the very early leader in a wave of companies that get squeezed by tighter lending standards. companies that should be able to keep going will suddenly find they cannot raise the cash needed. banks will be less willing to extend new loans or to tolerate covenant violations. already suffering elsewhere, they will simply refuse to help out -- thus shortening the time available to get their house back in order... it's something like a vortex... the closer we get to the center, the faster it goes. that's the stage we're going into now.

the problem is that this has only really happened in just the last 2 weeks. I cannot overstress the brevity of this crisis so far. before, we had falling house prices and moderate job losses. now we're looking at a virtually inevitable wave of corporate failings. as my source above said, the lights are going out in factories across middle america. industrials, one of the few sectors with bullish stock charts, will be the next to roll over.

let's look at some people I can actually quote:

in typical wall street fashion, credit suisse's ken elgarten tries to put a positive spin on the credit market by saying stocks will do worse over the next month... but his bullet points tonight are grim:

• Ongoing challenges in the short-term funding markets. Away from Tier 1 industrial credits, the CP market appears reluctant to fund BBB and lower-rated issuers, forcing many to tap bank lines. We don’t anticipate that this will begin to ease until after some of the initial assets are transferred to the TARP.
• Q3 earnings season kicks off next week; early releases (WAG, RIMM) and recent profit warnings (GE, CSX) have painted a less optimistic picture for 3Q. We believe that many companies will guide expectations significantly lower.
• Financial firms’ need to raise capital. GS and JPM have raised capital in the equity market recently. With delinquencies likely to rise for credit cards, HELOCs, auto loans, and prime mortgages, smaller financial institutions are less likely to attract equity capital and could put further pressure on spreads if earnings come below expectations.
• Additional pressures: 1) angst over the European bank failures; 2) possible hedge funds liquidations; 3) mounting concerns about insurance company/regional bank portfolios; and 4) ongoing unwinds from LEH/WaMu.

over at merrill lynch, michael hartnett is talking about the potential for a "bank holiday". on a historical note, FDR's first act as president was to declare a bank holiday to stop runs on the banks.

I dont have time to write a lot more, but I will note that my recent observations about the poorly concieved financial bailout plan were essentially echoed by economic genius martin feldstein... simply that the only way to fix things will be to stop home prices from falling. propping up the prices on mortgage bonds is like pushing on a very long rope... it won't accomplish much.

speaking on charlie rose, feldstein also said this could be a very long and deep downturn unlike what we've seen before...

interestingly, on a longer term note, he also said "the fed is extending credit on a scale that makes me nervous".

I have previously expressed big concerns about inflation. I know this worry is now on hold as we face a short-term deflationary situation as banks fail. but I want to highlight that I think inflation is coming. at a certain point, the government is going to try to goose this economy back to life with deficit spending, and that's going to spur inflation. importantly, company inventories continue to fall. that means that when things do recover, there will be little cushion to absorb the demand. and, I am betting that rebound in demand will come from deficit spending.

finally, let me just add that all the major deflationary events I have been able to find -- the US in the 1930s, japan in the 1990s and hong kong after 2000 -- were all preceded by appreciation in local currencies. we face the opposite -- something like 5 years of a falling dollar.

I just dont buy the deflation argument. my scenario is that the US will print money and other countries will eye our economy with nervousness. we'll issue treasuries that will meet with less and less foreign demand.

foreign central banks will start selling some of their treasuries.

US inflation will spike up as the economy responds to fiscal stimulus.

other economies with smaller debt burdens will grow much faster. yes, you heard it here first... decoupling is not dead. it's taking shape, but isn't yet fully formed. for countries like brazil, russia and even germany, I think the recent stock market carnage was more akin to 1987 for us -- they are still in the early stages of their expansions. we've been at it since the 1980s and now have built up too much debt. they are much better positioned for growth.

this foreign economic strength at the same time of our malaise will further drive down the dollar... longer term, I still think the comparison to latam in the 1980s holds. it will just take some time to pan out. inflation, devaluation, dis-investment and stagnation can all occur at the same time. and, the political risk here is also much greater than I think people realize. no one wants to say that about the USA, but they will over time.

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