Wednesday, September 3, 2008

A September to Remember is on its way!

RGE Monitor's Newsletter Good Morning!

Last week the FDIC released the Quarterly Banking Profile for the second quarter. FDIC chairman Sheila Bair sums the results up as ‘pretty dismal.’ In particular, Q2 earnings were 87% below the Q2 2007 level (i.e. $5 billion vs $36.8 billion) trimmed by sharply higher loan loss provisions (total $50 billion). Unfortunately, noncurrent loans have been growing even faster than the boost in reserves for the ninth consecutive quarter: the industry’s ‘coverage ratio’ fell accordingly to 88.5 cents of reserves for every $1.00 in noncurrent loans, a 15-year low. Banks have little choice but to build up loss reserves substantially in coming quarters, which occurs at the cost of earnings.

Whereas expected losses are booked against earnings in the form of loan loss provisions, unexpected losses result in capital writedowns. Already, global bank capital writedowns exceed $500 billion (out of the $1 trillion estimate for the entire financial system), the very number the IMF set as a ceiling for global bank losses in April. Far from being over, S&P acknowledges that “we’re at best maybe halfway through this cycle,” and therefore we may be navigating towards Nouriel Roubini’s $2 trillion global loss estimate. Interesting new research by the Federal Reserve Board shows that foreigners hold 39% of ABS backed by U.S. assets, meaning that 39% of associated mark-to-market losses will occur abroad. In numerical terms, and assuming a 20% markdown, this translates into roughly $475bn.

The 19 primary dealers on both sides of the Atlantic were at the forefront of the crisis so far and account for over 50% of writedowns. With equities and commodities following fixed income markets down there’s nowhere for investment banks to hide. Analysts are slashing the Q3 earnings outlook across the board and a recent survey among institutional investors reveals that another big financial firm is expected to collapse within the next 6 months.

Regional and smaller banks are vying with large banks and primary dealers for fresh capital ($350bn raised so far globally), but the window of opportunity is closing fast. The number of ‘dead men walking’ - in John Mauldin’s words – is rising quickly as is the number of banks on the FDIC list that are considered as troubled (i.e. 117 in Q2 up from 90 in Q1). Ironically, the FDIC might be itself on track to turn into one of the biggest casualties of this financial crisis. See “Can the FDIC Handle the Coming Banking Bust‌?”

A rather unexpected additional source of stress for banks are the GSEs. The FT last week reported that U.S. banks and insurance companies are the primary holders of Fannie&Freddie’s $36bn preferred shares. The latter were downgraded heavily in view of an imminent government intervention. The costs to the taxpayer of any government intervention are adding up accordingly from the initial $25bn CBO estimate to over $100bn among prime credit losses, preferred share and subordinated debt writedowns.

Turning to the non-bank sector it is clear that even the shadow banking system is in deleveraging mode. Hedge funds are closing in record numbers amid a dismal average performance especially in the past two months. Furthermore, cost efficiency considerations fuel a move towards ever higher asset concentration among the top 100 players. See “Shake-Out in the Hedge Fund Industry: Who Are the Haves And the Have-Nots?‌

Some life has also returned to the heavily battered monoline insurer market. New York State Insurance Superintendent Eric Dinallo helped broker an agreement for MBIA to reinsure $184 billion in municipal bonds for the lower rated Financial Guaranty Insurance (FGIC). Analysts see the movement as a positive first step for all parties involved: MBIA, FGIC and the muni bond market. Recent deals with investment banks to relieve monolines –against a fee- from their CDO guaranty obligations are a further sign of the industry’s self-healing efforts.

Also in the Monitor:

Pirate's booty

Commentary: Get ready for a September to remember

By Todd Harrison
Last update: 12:01 a.m. EDT Sept. 3, 2008
NEW YORK (MarketWatch) -- As the boys of summer prepare for the playoffs, hardcore fans around the land are readying for an entirely more violent collision.
With football season upon us, our collective attention now turns to the metaphorical line of scrimmage in the markets. Tensions are high and the stadium packed, for the winner of the September battle could run the schedule into year-end.

The Bears unleashed an all out blitz in July, only to be caught flat-footed by Washington offensive coordinator Hank Paulson. The crafty veteran is a master of market-timing patterns and he shrewdly called plays designed to punish those who over-pursued the weak side. See related MarketWatch column.
Following a summer when headlines trumped tan lines, starters returned to their turrets this week with game faces affixed. With one month left in the quarter and four remaining in the year, they'll leave it all on the field for fear that if they don't perform, they won't make the 2009 roster.
It's been more than a year since credit scars first emerged and they were quickly dismissed as non-relevant bruises rather than potentially career-threatening injuries. As more and more players -- and, in some cases, entire organizations -- were carted off the field, it became increasingly obvious that the game has forever changed.
The subprime scare morphed into arguably the worst financial contagion in history, a cumulative comeuppance borne on the back of the tech bubble and magnified by engineering gone awry. See related MarketWatch column.
After years of giving the all-pro market drugs with hopes of masking the underlying discomfort, it's begun the unenviable yet unavoidable process of taking medicine through time and price. It's not fun -- and it will take years to fully flush through the system -- but it's a necessary evil that must be endured.
'The autumn wind is a Raider, pillaging just for fun. He'll knock you around and upside down and laugh when he's conquered and won.'
Steve Sabol, NFL films
We've already discussed the primary time horizons with which to view financial markets and that remains a viable and valuable context to any conversation. To be sure, the destination we arrive at pales in comparison to the path that we take to get there. See related MarketWatch column.
Getting credit when credit is due
In July, we wrote about the potential for a rally into the election. It was an unpopular view at the time, but higher lows have since been made and the trend -- however ginger -- is still intact. See related MarketWatch column.
The twist to the current plot is the yawning disconnect between equity and credit markets. While the former storm has shown moxie in recent weeks, the latter matter is an entirely different category in terms of the potential implications.
Much has been written about the $230 billion in debt that is coming due in Fannie Mae (FNM) and Freddie Mac (FRE) by the end of the quarter. These two troubled institutions are the elephants in the room that won't go away. Well then again, perhaps they will. See related Minyanville column.
There was a brief celebratory spark in the media and markets early last week when Freddie successfully financed $2 billion. As Kevin Depew mentioned on Minyanville, however, it was akin to a man finding a quarter in his pocket on the way to bankruptcy court.
Assuming the debt of government-sponsored entities is backed -- a virtual lock given the unsettling consequences that would occur if it weren't -- the resolution of their equity would have profound implications for global markets through the lens of the dollar.
But wait, there's more.
Financial institutions have $871 billion in debt coming due into year-end.
If corporate America can successfully roll those obligations and buy more time, odds are we'll see a sharp upside equity rally.
If, however, sufficient appetite doesn't emerge for that credit, the potential exists for an unmitigated equity disaster.
The boys on the Beltway know this all too well and we should expect a wave of announcements in the coming months designed to spur the herd higher.
Therein lies the risk to downside bets, a coordinated agenda that is by design the recipe for a short-squeeze.
While stocks are the world's biggest thermometers, credit markets are the backbone. As such, the end game of these agendas is to induce an appetite for credit so corporate America can effectively issue secondary -- and in many cases, dilutive -- offerings.
Thus far, the litany of conduits, discount windows and auction facilities hasn't been able to do that. While they've kept stock markets afloat, credit spreads remain at levels last seen during Bear Stearns (JPM) . I expect to see new "inventions" of financial engineering introduced with time.
You can call it socialism, manipulation, intervention or desperation but make no mistake, the mandate is to avoid the unthinkable -- a stock market crash that sends an already fragile socioeconomic situation into a downside spiral that sucks the global capital market structure into an abyss.
Yes, it's scary but pretending it doesn't exist won't make it go away.
A microcosm of this looming dynamic will be the surge in September credit issuance.
It's critical that this debt be absorbed by the marketplace or there will be a line outside the Treasury longer than the Million Man March. See related Minyanville item.
Risk appetites and social mood shape financial markets and the reaction to this September supply will reverberate around the world.
Lucidity is your friend
Minyanville has monitored these cumulative imbalances since 2006 and discussed the writing on the wall last summer. See related MarketWatch column.
To be sure, the credit crisis has already infected the economy, starting with the home builders, spreading to the financials, engulfing financials in drag such as General Electric (GE) , General Motors (GM) and Ford (F) and will eventually phase through retail, technology, credit card companies and commodities.
That's the orderly scenario, a stair-step through industries until debt is destroyed and a more sustainable economic foundation takes root. It's akin to credit cancer and once it spreads through our entire financial body, we'll be in a position to enjoy the globalization-themed "outside-in" recovery that awaits.
The other option is an outright car crash, a collision where credit seizes, capital markets freeze, price discovery permeates and social mood shifts as we come to terms with the new world order.
Neither of these options is something one would wish for but hope has never been a viable investment thesis. Indeed, my stylistic approach has always been to sell hope and buy despair.
By some measures, the gloom and doom is palpable. Through a short-term trading lens, that could prove bullish, particularly if credit markets improve.
Through a big-picture secular lens, however, denial is prevalent as most market prognosticators believe the worst is behind us. Heck, there are still debates about whether or not we'll enter recession and that, in and of itself, is disturbing.
As the owner of a small business and someone who shares your journey through life, it's my sincere wish that we'll navigate these complex times and look back at this column as the turning point of a multi-year, economic expansion that benefits us all.
Until we're able to view that process with the benefit of hindsight and a dose of humility, capital preservation, debt reduction and financial literacy remain core tenets of my particular approach. End of Story

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