Dow Loses 307 Points, ASX/200 to Follow?

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First they came for the mortgage lenders. Then they came for the banks. Who it will be next? The bond insurers. More on them below. But first, the market has remembered itself.

“When reminded about how bad things are, the market remembers it should go down,” Art Hogan, the chief market strategist at Jefferies & Co, told Marketwatch.com. And down it went.

The U.S. benchmark Dow lost 307 points in the ugliest day of the year. A market that closes on its lows going into the last trading day of the week is a market headed for more losses. No one likes to be long over the weekend when there are so many landmines out there in the credit market.

You’ll have to wait until tomorrow to see what the Dow does. But it’s already Friday here. The ASX/200 would have to lose about 313 points to make a new 52-week low. It would be a 5.4% drop. That would be a shocker. But today could be a shocker all over the planet.

In America, the broader S&P 500 is at a 15-month low. The Dow is just 233 points above its 52-week low of 11,926. A decline of 1.9% would bring it down to a new 52-week low. We’d be back where we were in March of last year. And just where were we then?

Interest rates in America were higher and gold and oil and commodities were much lower. Gold was US$640 on March 5th last year. On March the spot price for a barrel of West Texas crude was US$59.91. Even after losing $2.60 today in New York, gold at $877 is still 37%. Oil, at today’s New York close of $89.83, is 50% higher.

Last year this time, the Fed had just lifted the Fed funds rate by twenty five basis points. It actually raised rates two more times before the credit crunch began in June and July. Then came three rate cuts and the current rate of 4.25%.

This will sound strange, but we rolled out of bed this morning more chipper than in a long time. The mal-investment of the last five years is being liquidated. That’s going to be bad news for the stock market and the economy for most of this year.

But if stocks do price in the bear market in credit, we may, eventually, finally, get back to a world without so many financial distortions. Having preserved your capital, you may find some great entry points for long-term positions in good companies.

But not just yet. The liquidation has just begun. And the Fed is going to fight it. Yesterday, former Treasury Secretary Larry Summers told the U.S. Congress to pass a US$150 billion stimulus package. They probably needed beach towels to wipe up the drool after hearing that. Congress loves spending money.

Today, Ben Bernanke put his oar in the water. In answer to a question in Washington about the size of a stimulus package, he said, “Some have floated packages that would range in size from $50 billion to billion to $150 billion – all of which are in the range of ‘reasonable’.”

Socrates is choking on his hemlock. To hear a stimulus package of that size called “reasonable” by the man charged with protecting the purchasing power of American money shows you the U.S. dollar is well and truly doomed. Such is the fate of all paper money, eventually. But until then, a lot of people are going to get crisp new bills to spend in America.

“Getting money to people quickly is good, and getting money to low and moderate-income people is good, in the sense of getting bang for buck,” Bernanke added. People who need money tend to spend it quickly when they get it. How this “saves” the American economy from the housing crash, the long-term decline in its industrial base, or the over-indebtedness of is government and people… we have no clue.

Investors don’t believe it either. Rate cuts and spending aren’t going to do the trick. Let us return to the very wise Art Hogan. “It is going to take more than just monetary policy to clean up the mess we’ve made with this economy,” he said. He’s right. It takes liquidation… ripping the rot out of the system… before you can recover.

The Fed is fighting the recovery, not aiding it. As long as it does that, it prevents transparency in the financial system and a point at which we can begin to make accurate earnings forecasts again. Stocks don’t like it.

Still, don’t be surprised if the fiscal stimulus is paired with some monetary looseness, another rate cut. How big and when? Well the RBA will probably stand pat, citing market weakness, although be surprised if it takes a hawkish line on prices when it next meets on February 5th.

And the Fed? There is a case to be made for a full one percent cut. Sounds panicky? Maybe. You should still consider it. First, it gets the head back ahead of the news cycle and behind it. This could either destroy confidence or begin to restore it. These are desperate times.

The Fed’s the worst case scenario-one it surely must be aware of-is that trouble with bond insurers accelerates, threatening the US$45 trillion market for credit default swaps.

“A growing crisis at Ambac Financial (NYSE: ABK), one of the biggest bond insurers, is raising questions about Wall Street’s exposure as counterparties to the bond-insurance industry coming off a period in which the big banks are reeling from more than $100 billion in write-downs of mortgage-related securities,” writes Liz Moyer at Forbes.

No one talks about bond insurance in polite society. Like undertaking and actuarial work, it is both necessary and dreadfully boring. But the bond insurers might be the ultimate repository of lending risk in this bizarre world financial order unraveling before our eyes. They have the most to lose. Everything.

Bond insurers offer insurance for bond issuers. The insurance encourages bond buyers. The trouble for the bond insurers is that they’ve insured a lot of credit derivatives too. Moyer says, “Ambac guaranteed $38 billion of debt linked to subprime mortgages and has exposure to $45 billion of other mortgage investments.” Yet those numbers are tiny compared to $45 trillion in credit default swaps outstanding.

Concerned with the amount of risk faced by the bond insurers, and chasing a horse that’s firmly out of the barn, the credit ratings agencies are threatening to downgrade the credit ratings on Ambac and fellow bond insurer MBIA. Ambac fell as much as 60% on Thursday. MBIA fell as much as 40%.

Who wants to be long this weekend again?

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Good analysis.

    Investors in commercial credit default swap CDOs essentially face the same risks as “other” bond insurers.

    I am very surprised that some bond insurers are in trouble already. My time guestimate for this sort of event was a bout 6 months off.

    On reflection, the absence of the expected lag is frightening. It is an early indicator of recession severity that comes from the heart of current corporate performance.

    Coffee Addict
    January 18, 2008
    Reply

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