–Today’s Daily Reckoning has some important work to do, and events are happening almost faster than we can reckon with on a daily basis. As we write the Fed has cut the discount rate again and announced a new lending facility for primary dealers…see below for more details on what it means. Buckle up, buttercup. It’s going to be a wild ride.
–First, we need to catch you up on exactly what happened over the last three days with Bear Stearns on Wall Street. Next, we ask “who’s next” in the financial world if investors and clients flee the investment banks. The answer may surprise you. We’ll also tell you what else you can expect the Fed to do this week.
–Most importantly, what are the investment consequences to the events of the last four days? It’s not just a question of who has the most to lose. We already know that. Everyone stands to lose a lot, most of all highly leveraged investment banks, asset managers, hedge funds, and speculators. But there may be a few surprise winners in the currency and commodity markets.
–The biggest losers will be consumers everywhere. Global monetary policy is entering a new, highly accommodating phase. That means real interest rates are headed below zero. If you think inflation is out of control now, wait until you see what happens next. But first, the story from the Street.
–Bear Stearns was on the receiving end of an indirect loan from the Federal Reserve on Friday. Though Bear is the fifth-largest securities firm in the U.S. (and the ninth largest bank in the world), it’s an investment bank, not a commercial lender. The Fed can’t loan directly to investment banks, so the loan had to be routed through a willing third-party, in this case JP Morgan. It turns out that last week’s big US$200 billion loan facility was probably set up to make this three-way transaction possible.
–The Fed loaned to Bear via Morgan as Bear’s investors and counter parties deserted it last week. The loan was designed to give Bear time to explore “strategic alternatives” before the run on its assets left it insolvent. Bear saw some US$17 billion in customer withdrawals last week, according to Bloomberg. Once the perception took hold that the firm was in an irreversible slide, nothing but direct Fed action could stop it.
–The UK Telegraph reports that Bear’s CEO Alan Schwartz told investors that , “Bear had faced withdrawals from counterparties, customers and lenders since the start of the week, but these peaked on Thursday, and accelerated late in the day. The run came from hedge fund clients wanting to withdraw excess cash from prime broking accounts, as well as from derivatives clients, counterparties and fixed income clients.”
–Bear simply didn’t have the capital to hold out until March 27. That’s when the Fed’s new direct US$200 billion lending program kicks in, making funds available to anyone, anywhere, at any time. Bear was on the brink late Thursday in New York, and made a call to the New York Fed.
–In arranging the loan, the Fed performed exactly the role it was originally designed for, but one it hopes never to have to exercise: lender of last resort in a financial crisis. The fact that the Fed has had to lend directly to a major American bank to prevent its total collapse should not leave you with any illusions about how serious the situation is in America’s financial sector. “The US Federal Reserve is attempting to prevent a downturn in the US economy from turning into a repeat of the Great Depression,” says David Uren in today’s Australian.
–More on what happens next below. –As we write, we read that JP Morgan has indeed bought Bear for US$2 a share. Bear went for about half its current market value. But it went. According to the terms of the deal, the Fed is still on the hook to fund about US$30 billion of Bear’s “less liquid assets” until Morgan can figure out what to do with them.
–This is progress for Bear. But as for financial markets, we don’t reckon this puts the whole mess behind us and accordingly expect to see a much higher gold price. Probably oil too. Averting a collapse at Bear prevents a percolating sense of panic, but only just.
–According to banking analyst Richard Bove, of Punk Ziegel & Co, Bear has US$176bn worth of securities and $40bn in loans out to other companies. That all goes “whoosh” in a bankruptcy and leads to more selling. Bear’s remaining clients and the counter parties want their money or their assets back.
–Next question. Who’s next?
–Well, you might want to keep your eye on firms that have already been in trouble, like Citigroup (NYSE:C). Also keep an eye on earnings announcements from the Street this week. Bear itself announces fourth quarter earnings (or lack thereof) after Monday’s close. On Tuesday, Goldman Sachs (NYSE:GS) is expected to report a 50% fall in 1st quarter earnings and a write down of US$3 billion. Morgan Stanley (NYSE:MS) reports on Wednesday.
–The one to watch for, though? Lehman Brothers (NYSE:LEH). The stock is trading near a 52-week low. “Lehman has been a focus of attention because it has a large fixed-income business and was a major player in the market for mortgage-backed securities. Last week, in a sign of investors’ rising concerns, the cost of buying credit insurance on Lehman jumped to a record,” according to Michael Mckenzie in the Financial Times.
–By the way, we recognise all this is U.S. centric. What about the Aussie market?
–Though the Aussie banks don’t have as much direct exposure to bad subprime debt as their U.S. counterparts, the general skepticism about financial shares—and the massive unwinding in leverage—will affect heavily indebted Aussie financial shares. Take your pick. We reckon it’ll be rough seas for all of them this week.
–Does anyone have anything to gain from this? Aside from short-sellers having a field day with the financials, the obvious beneficiary from the liquidity squeeze should be precious metals. If we had an extra $10k today, we can think of worse things to do with it than buy a handful of Aussie gold juniors. In the bigger scheme of things, U.S. dollar-denominated assets stand to lose, too. That could be Australia’s gain.
–As the greenback weakens on America’s continued financial woes, flows of capital the U.S from Asia’s savers may find their way here to Australia, where the currency is rising and resources are plenty. Also, the earnings prospects for Australia’s resource exporters are considerably better than for, say, your average U.S. retail or financial stock.
–One risk to be aware of: broad asset deflation, including resource stocks and commodities.
–If the crisis at Bear becomes an all-engulfing crisis, we can’t imagine any assets will be spared from falling prices. “This is going to go all the way up the chain,” Chris Whalen from consultancy Institutional Risk Analytics told the Wall Street Journal. “There is a risk that all broker dealers are going to become an endangered species if the credit crisis is not sorted out. If they can’t fund themselves, they will have to shrink. All the other firms are in danger, too.”
–If you view the current crisis as a massive margin call on a heavily indebted United States, then the case for falling prices is even clearer. Lenders are demanding that borrowers either put up more collateral to secure their borrowings…or reduce debts by selling assets to raise cash. Assets to be sold include property and shares, and that includes resources shares too, and perhaps even precious metals like gold and silver.
–But let us take a minute to clear up a point about whether the Fed’s latest line of attack on the credit crisis is inflationary. We think it is and that in addition to falling prices for financial shares, you’ll see rising prices for things denominated in U.S. dollars (which despite this morning’s early rally faces dark times ahead).
–Has the Fed literally been printing money? No. Technically, the Fed has been creating liquidity in the banking sector by exchanging liquid U.S. Treasury notes and bonds for illiquid mortgage-backed securities. From the Fed’s perspective, it’s an asset swap.
–If you like looking at balance sheets, then take a look at the following link: http://www.federalreserve.gov/releases/h41/Current/h41.pdf
–What you’ll find there on page two is evidence of a change in the composition of the assets on the balance sheet. You’ll see that the Fed has about US$709 billion in Treasuries on its balance sheet. Last week, it reduced those holdings by around US$86 billion. That was offset, roughly, by an increase of US$60 billion in what the Fed’s balance sheet calls “Term auction credit” and a US$34 billion increase in standard repurchase agreements.
–So let’s be clear. No. The Fed is not literally printing new money to lend to Wall Street banks. What it IS doing is trading its stock of healthy (if you can call them that) U.S. Treasury bonds, bills, and notes for illiquid, not-healthy-at- all, mortgage backed bonds. Fed followers argue the Fed can actually make money on this deal by demanding a large discount on the collateral and charging borrowers a hefty fee for the temporary asset exchange.
–Blah blah blah.
–The Fed’s current collateral-laundering policy is clearly inflationary. While not directly increasing the liabilities of the U.S. government (yet) the Fed only has about US$700 billion Treasury’s it can lend out for 28-days at a time (or longer, if it sees fit.) The promise to lend up to US$200 billion as of March 27 eats into this US$700 billion. And that leads us to what comes next.
–First, this morning Australia time the Fed today lowered the discount rate on direct loans to commercial banks from 3.50% to 3.25%. It also, as we expected, extended the terms of this emergency loans (collateral swaps) from 30 days to 90 days.
–Next, according to the Fed’s release, “the Federal Reserve Board voted unanimously to authorize the Federal Reserve Bank of New York to create a lending facility to improve the ability of primary dealers to provide financing to participants in securitization markets.”
–“This facility will be available for business on Monday, March 17. It will be in place for at least six months and may be extended as conditions warrant. Credit extended to primary dealers under this facility may be collateralized by a broad range of investment-grade debt securities. The interest rate charged on such credit will be the same as the primary credit rate, or discount rate, at the Federal Reserve Bank of New York.”
–The Fed said, the cut in the discount rate and the new lending facility are “designed to bolster market liquidity and promote orderly market functioning. Liquid, well-functioning markets are essential for the promotion of economic growth.”
–Will the Fed’s surprise Sunday double-barreled policy action turn the tide for stocks on Monday?
–If not, there is always the Fed funds rate to cut on Tuesday. The Fed will almost surely lower short-term rates again this week from 3% to something like 2.5% or even 2.25%. Keep in mind this puts real U.S. interest rates below the rate of inflation. Negative real rates are obviously inflationary.
–But here’s the other thing. If the current liquidity crisis spreads beyond Bear Stearns, the Fed will be compelled to make all of its US$700 billion in Treasury assets exchangeable to distressed firms. It has said as much in accepting a “broad range of collateral” in exchange for short-term funding. Once the Fed depletes or exhausts its inventory of Treasuries it can swap for illiquid assets, what does it do?
–It has to go out and buy more Treasuries on the open market. And to do that it WILL need to create new cash, which is definitely inflationary. The Fed hasn’t yet monetized bad mortgage debt by creating new cash to buy it from banks. Instead, it’s trading good debt for bad debt.
–We reckon—the way this thing is playing out—that the Fed is going to have print more money soon. It will either print more money to buy more Treasuries to lend to illiquid, poorly capitalized financial institutions (Fannie Mae and Freddie Mac come to mind).
–Or, if things really get desperate, the Fed will have to create new cash to directly purchase impaired assets from financial institutions. This is why it’s called “monetising debt” by the way. The central banks turns liabilities into cash by printing new money to buy the debt from its current owners.
–This kind of deal bails out the owners of the bad debt (the investment banks and mortgage lenders). It keeps the financial system alive. It prevents the further sale of assets and the loss of depositor’s money. And it prevents a complete collapse of confidence in the financial sector, as happened in the Great Depression. But it does it all at a great cost: the viability of the U.S. dollar as the world’s reserve currency.
–This brings us to the last big consequence of the weekend’s events: dollar supremacy. For yeas the American government has been spending more than it taxes in it taxes. It’s been free to do so because Asian savers have happily recycled their trade-surplus dollars back into American financial assets.
–But in this margin call on America, the U.S. government may be the biggest loser of all. It is going to have to pay a lot more to borrow. As global investors shun U.S. stock and bond markets because of the falling dollar, interest rates on long-term U.S. bond will have to go up. The U.S. government doesn’t have any collateral to offer foreign lenders. It can only pay whatever the market demands in order to lend money to a government that has a US$9 trillion debt.
–When a hedge fund borrows money from a bank, it uses securities or assets as collateral and than borrows many times that collateral, using the borrowed money to ramp up the total return. Only it doesn’t always work. Sometimes the collateral falls in value, as has been the case with residential mortgage backed securities in the U.S.
— As the value of the collateral falls, the lender wants his money back. He demands cash, which forces the borrower to sell (delevering). Or in Carlyle Capital’s case last week, the lenders simply seize the collateral.
–The U.S. government has posted a kind of collateral in its borrowings with the rest of the world. That collateral is the future wages and salary of American workers. It’s American tax dollar that pay the interest on sovereign American debt.
–Americans will be working harder than ever to pay foreign bond holders. First, they’ll have to pay more to borrow now for the wars in Afghanistan and Iraq and the big social spending promises at home. But most of America’s obligations to foreign investors are in three- and ten-year notes.
–In fact, the U.S. must annually roll over (re-finance) about US$1 trillion in bonds and notes to keep the government open for business. The cost of financing that borrowing is about to go way up. It will be a real, immediate impact on the American economy. The consequences of years of deficit spending by the government are about to hit home in the United States.
–Australia is vulnerable to America’s day of reckoning, too. The bear market in credit is an equal opportunity wealth destroyer. But it hits hardest with those who’ve borrowed the most. And as the dollar buckles under the strain of the Fed’s increasingly desperate attempts to keep the system liquid, we’d expect a much, much higher gold price, and would not be surprised at all to see parity for the Aussie dollar.
The Daily Reckoning Australia