Wednesday, October 29, 2008

Leverage is a Bitch

Good Evening Folks!

Ahhh.... Another day, another Fed rate cut. Its now official folks, Helicopter Ben has officially matched Greenspan's Fed Funds Rate of 1%. Hooray! The housing bubble days are back! NOT!

So how did the market like the rate cuts? Well, Bennie was looking good for awhile until the last 10 minutes of the trading session. The DOW virtually collapsed at the close and fell over 300 points which took the DOW into negative territory. The GE news at 3:47 was one of the culprits. Take a look:


The Fed and the Treasury continue to scramble around like little rats in an attempt to pump massive amounts of liquidity into the system. Its the same old story week after week. Everyday another multi-billion dollar bailout is announced. The latest one today involves other countries:

"Oct. 29 (Bloomberg) -- The Federal Reserve agreed to provide $30 billion each to the central banks of Brazil, Mexico, South Korea and Singapore in its biggest effort yet to curtail the spread of financial market turmoil beyond developed economies.

The Fed set up ``liquidity swap facilities with the central banks of these four large systemically important economies'' effective until April 30, the central bank said today in a statement. The arrangements aim ``to mitigate the spread of difficulties in obtaining U.S. dollar funding in fundamentally sound and well managed economies.''

My Take:

Hell Hank, lets just bailout the whole world! The story and thesis remain the same folks. We are in the middle of the largest debt unwinding in the history of the world. This Ponzi bubble was blown up on leverage, and it will be torn apart as the leverage is taken out of the system.

This is what happens when you deregulate a bunch of greedy bankers. In 2003, the investment banks on Wall St were deregulated and allowed to lend out money at a 40-1 leverage rate off of their capital. This means that they lent out $40 on every $1 of capital that they had. All of the hedge funds and world banks all followed suit as the debt bubble grew to historic proportions.

This is all fine an dandy when the game is working and assets continue to rise in value. However, when this trend reverses, the leverage that allowed you to dramatically increase your profits on the way up now exacerbates your losses as assets come screaming back down. We are now witnessing this historic explosion of a giant debt bubble via deleveraging.

Banks can now only lend at a leverage rate of 12-1 instead of 40-1. This creates a giant black hole/loss of wealth in the financial system. What the Fed and Treasury are now trying to do is use their balance sheet to fill this black whole and keep the game going.

The problem with this premise is all of this wealth was nothing but an illusion! The Fed is trying to replace wealth that was never liquid. Many Americans assumed that they were worth $400,000 if they bought a house for $200k as the credit bubble rose and got it appraised a few years later at $600,000. The reality here is you were only $400,000 wealthier if you SOLD.

Most did not, and many others bought at the peak. Markets crash when there is a lack of liquidity in the system. The Fed is throwing money out of helicopters in an attempt to get banks and to lend and consumers to borrow. The problem is you can lead a horse to water but you can't make him drink!

The banks don't want to lend because they have about as much money as I do in my front pocket. The consumer doesn't want to lend because he is worried about keeping his job abd he is already in debt up to his eyeballs.

The banks have a severe disaster on their hands from a leverage standpoint:

If you use the example above, the problem the banks have now is they are stuck holding millions of homes at the $600,000 price tag when there was 40-1 leverage in the system.

The brutal reality is that the banks are all now facing is is there is now only 12-1 borrowing leverage in the system available for housing. This is about a 70% reduction in lending capacity(from 40-1 down to 12-1)!

It doesn't take a math genious to realize how screwed the banks are in this situation. They own billions of mortgage assets at peak prices that now must be sold into a lending pool that's 70% smaller. Its not hard to guess whats going to happen to housing prices over the next several years when there is 70% less money available to borrow. Can you say WATERFALL? Bank profits will WATERFALL down right along with them!

A very smart pigmen(who is way up the food chain) loves to laugh when he hears CNBC talk about all of the money that's "sitting on the sidelines". His quote to me after hearing this was "yeah right, let me know how much money is on the sidelines when they take the 40-1 leverage out of the system". This is the same guy that told me two years ago that Merrill Lynch was going to be the next Enron.

Bottom Line:

Tomorrow will be dominated by the GDP number tomorrow. If we get a bad print, we could see a giant flush. I am still very bearish on equities. What a shocker right??

The market is over priced for two key reasons.

1. 70% of the leverage must be taken out of the banking/financial system.

2. The economy is about to slam into a brutal consumer led recession.

This is a one two knockout punch IMO. The Fed is now about out of bullets. What are they gonna do go to zero? It will be Japan 2 if they do. The interventions are looking more and more desperate in the eyes of investors.

Sheila Bair from the FDIC announced today that she wants a $600 billion bailout for homeowners. You have got to be kidding me with this idea...Gimme a break! Socialism here we come! What an embarrassing situation for this country. We will never be able to call ourselves capitalists ever again after stomping all over the free market system.

If you are leaning to the long side(good luck to you), I would wait for a pullback before trying to chase this rally.

As for myself, I scaled into another short (SDS) this afternoon on the Fed rate cut bounce. Which ever way you are positioning yourself, play small and scale yourself into positions.

Stay hedged and be diversified in either event.

Until next time!

4 comments:

Jeff said...

Well here it is. The potential homeowner bailout.

I guess being practical and living within your means is a mistake. I may go out and buy a McMansion tomorrow and then default on it.

This is all going to end badly. Why would anyone pay their mortgage if they go through with this?

Stop paying so you can get a better deal! Unbelieveable. I thought I have seen it all.

This is sickening:


Officials with the Treasury and the Federal Deposit Insurance Corp. are nearing agreement on a plan under which the government would guarantee the mortgages of millions of homeowners now struggling to avoid foreclosure.

According to three sources familiar with the discussions, the plan would cover up to three million homeowners. It would cost between $40 billion and $50 billion and cover as much as $600 billion in mortgage loans.

Under the program being discussed, the lender would agree to reduce borrowers' monthly payments based on their ability to pay. The reductions could be achieved by lowering the interest rate, slashing the amount owed or extending the repayment period.

http://www.washingtonpost.com/wp-dyn/content/article/2008/10/29/AR2008102902605.html?hpid=topnews

flippy said...

This isn't Japan of the 90s part deux...we are a not a net debtor country like Japan was. We're more like Germany right before WW2, or Argentina in the 90s. We're not going to see a decade of slow deflation as we endure the hangover of our credit bubble.

When the money stops flowing in to our country, hold on to your hats.

My question to you Jeff, is what are you doing to ensure your assets are protected for the if/when the capital flow in stops and rampant inflation hits?

Jeff said...

Flippy

thats a great question.

If we hyperinflate its not going to matter because we are all screwed.

I am still hoping we get a Japan style deflation. I have to agreee with you though, longer term inflation is going to be a critical issue.

In an inflationary environment you have to assume the Fed may raise rates through the roof in order to fight it. In that case, fixed income like CD's and bonds will become quite attractive because of higher interest rate returns.

Cash will become king in this environment as well. For example mortgage rates may rise to over 10% which will cream housing prices.

You may be able to buy a house without a very small or no mortgage if you build a nice cash position because houses will become very cheap.

Unlike the 70's incomes will be down in this inflationary environment because the unions are dead. This will be devastating to the consumer IMO.

I would own some gold as a hedge against inflation. TIPS are also a nice protection against inflation as well.

Some say buy the DOW and assets in a major inflationary enrinment as the currency hits the roof. WIthout wage increases this go around, I don't see this working too well this go around.

Regardless, having some exposure in equities makes some sense. The DOW will probably be way down at the point the inflation spikes.

I dread the day when this happens but after all of these bailouts, its inevitable.

GL

J

Jeff said...

I meant the currency will devalue not go through the roof!..oops!