Cramer: I Was Too Bullish
10/10/08 - 06:15 AM EDT
In the end, I was too bullish. I didn't think things would get so bad that they would sell what they could sell because they couldn't sell anything else. And that's what happened to the soft-goods components of theDow Jones Industrial Average.
If you remember my Dow 8400 crash scenario last month I put drastic but realistic price tags on a host of companies - including zero for General Motors(GM Quote - Cramer on GM - Stock Picks) (prescient, I guess). But I did not think that Johnson & Johnson(JNJ Quote - Cramer on JNJ - Stock Picks),Coca-Cola(KO Quote - Cramer on KO - Stock Picks),Procter & Gamble(PG Quote - Cramer on PG - Stock Picks), and Kraft Goods (KFT Quote - Cramer on KFT - Stock Picks) could be so easily annihilated.
My bad.
I am working on some new downside targets, but it is obvious now that we could be taking that soft-good fortress to levels that look ridiculously cheap, and will probably be ridiculously cheap, at the end of this crash.
Unlike the others, though, they are self-financing and in the end this is a selloff rooted in anything that needs financing, and if it doesn't, it just might stop down 10% from here.
Here's the reprise of the piece:
Let's run through the Dow 30:
1. Caterpillar(CAT Quote - Cramer on CAT - Stock Picks) can retreat back to $43 where it started both before the housing boom and before the energy boom and before BRIC became a dominant force. All of its markets will be challenged with housing downturns worldwide and energy prices retreating from highs, something that I think will happen as economies slow.
2. Citigroup(C Quote - Cramer on C - Stock Picks) -- $14. This is where it traded before the short-selling rules were created on July 15, and this is where it is going without a financing and a big investment. It might not stop there if there is no relief at all. I am really bearish on this stock without a plan.
3. Du Pont(DD Quote - Cramer on DD - Stock Picks) has a lot of businesses that are less cyclical than people think and a safe dividend. I would be surprised if it went much below $40, where I would like to buy it.
4. American Express(AXP Quote - Cramer on AXP - Stock Picks) has turned into a terrible lender with a product that is viewed as something that is no longer indispensable, courtesy great marketing by Mastercard(MA Quote - Cramer on MA - Stock Picks) and Visa(V Quote- Cramer on V - Stock Picks). This stock's headed to $31, maybe lower, as it is really a weak sister in the Dow now. 5. Disney(DIS Quote - Cramer on DIS - Stock Picks)traded at $25 when people thought there was nothing to it other than a declining advertising business and an expensive group of theme parks. This is a company I will buy for Action Alerts PLUS if it hits that downside target.
6. United Technologies(UTX Quote - Cramer on UTX - Stock Picks) is a BRIC derivative for certain with too much aerospace and a defense business that could be hurt by an Obama election. Knock it back to $51, which would be a repeal of the whole BRIC move.
7. Coca-Cola (KO Quote - Cramer on KO - Stock Picks) talked recently about how it is not immune from a retail sales slowdown; when it did, the stock retreated to about $48, where it would surely be headed again.
8. 3M(MMM Quote - Cramer on MMM - Stock Picks) is a play on worldwide growth in a number of industrial areas, and worldwide growth is on the decline beyond what this fine firm is ready for. It could have a huge decline in earnings, and I am putting it at $50.
9. General Motors(GM Quote - Cramer on GM - Stock Picks), without a plan and without a handle on Delphi and on the right kind of cars, will burn through the bailout money quickly and disappears. Yes, it goes bankrupt. Stocks don't get down to where they are like this one if something hasn't become out of control. This one's out of control.
10. General Electric(GE Quote - Cramer on GE - Stock Picks) -- I think it could trade down to $20. The decision to end the buyback, which was just wasting a gigantic amount of money, is now behind them, so all it would have to contend with is lower earnings and a less turbo-charged report.
11. McDonald's(MCD Quote - Cramer on MCD - Stock Picks): This one's going to suffer for pennies by a stronger dollar, but not much more, and it just boosted the dividend. I think it would be a gift below $57.
12. Home Depot (HD Quote - Cramer on HD - Stock Picks) retreats to where it was on that July 15 low, $21, where it finds buyers for that dividend.
13. Bank of America(BAC Quote - Cramer on BAC -Stock Picks): With the plan, this is the biggest winner in the Dow. Without the plan? Sorry, it revisits the low of July 15 as it has to get rid of these bad mortgages it is stocked with. Target is $18.
14. Chevron(CVX Quote - Cramer on CVX - Stock Picks): This is a slow-growth company with decent oil assets that would quickly go down to where its dividend made it compelling. Call it $54 as in a falling-oil environment -- perhaps down to $70. You will see price/earnings shrinkage continuing.
15. Hewlett-Packard (HPQ Quote - Cramer on HPQ -Stock Picks): This company's acquisition of EDS is going to work and help numbers for years, but the stock will still have to revisit at least its recent lows on fears of a worldwide tech slowdown; call it $41.
16. JPMorgan (JPM Quote - Cramer on JPM - Stock Picks): This company keeps doing everything right, but the plan would make this the best bank on earth other than Bank of America. Without the plan, it goes to its July 15 low of $31.
17. Pfizer (PFE Quote - Cramer on PFE - Stock Picks): Here's a company that can only make more money by firing people, which is a good strategy until you run out of people. Still, the dividend is safe for at least another two years, so I think the stock stays at $18.
18. Kraft (KFT Quote - Cramer on KFT - Stock Picks): A food company that is getting better run is nothing to rave about, but this new addition to the Dow sure beats the disastrous runAIG (AIG Quote - Cramer on AIG - Stock Picks) has had. I think it can drop a couple to $30 but not go much below that because it is so defensive.
19. Alcoa (AA Quote - Cramer on AA - Stock Picks) is a great mystery. During the great 21st-century commodity boom that say Phelps Dodge and Alcan disappear, this homely little aluminum company has done nothing! Now it is free to go to $19, as the boom is totally over.
20. Johnson & Johnson (JNJ Quote - Cramer on JNJ- Stock Picks) is a super stock. Well managed, great earnings, good pipeline, I think it goes up a couple from here.
21. Boeing (BA Quote - Cramer on BA - Stock Picks): Here's one that could get cut in half if the strike doesn't settle and the airlines around the world contract. It could go as low as $24. It's one of the most vulnerable stocks in the Dow because of its clients' stress and voracious need for hard-to-get capital.
22. Intel (INTC Quote - Cramer on INTC - Stock Picks)retreats back to where it was during the last tech recession -- $13. Think of it this way: It bought back a lot of stock. That money was wasted.
23. AT&T (T Quote - Cramer on T - Stock Picks) faces landline challenges and corporate weakness. In a disaster scenario, it could lose a third of its value. Call it $21. I only say that because look at what the competition, outfits like Qwest (Q Quote - Cramer on Q - Stock Picks) and Winstar are selling for with slackened to no growth. Bad geographies. At the bottom, there will be a lot of fretting about the dividend.
24. Verizon (VZ Quote - Cramer on VZ - Stock Picks) needs more phone lines, more frivolous texters and photo-senders and a heck of a lot of clients for FiOS. None is likely to happen in this environment. I could see the stock retreat back to $26. It didn't help that they bought Alltel ... for now. Same dividend worries as above.
25. Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) is like Intel. Bought back a lot of stock. Nothing to show for it, and it now goes to $21.
26. Wal-Mart (WMT Quote - Cramer on WMT - Stock Picks) either stays the same or goes up, because that's where everyone will shop -- they'll all be trading down in retail.
27. Merck (MRK Quote - Cramer on MRK - Stock Picks) is pretty much where it is going to go. It's a challenged company with safe yield. $31.
28. IBM (IBM Quote - Cramer on IBM - Stock Picks)could be facing a huge headwind of global recession, and I think that its business is far more economically sensitive than people realize. It could lose as much as 50 points -- it used to be that low for a long time -- sending it to $60. This and Boeing are probably the two most severe cuts, and the ones I am most likely going to be too pessimistic about if things get a little better.
29. Procter (PG Quote - Cramer on PG - Stock Picks)stays at $68 or goes a little lower, not much. The company is set up to win in this environment.
30. Exxon (XOM Quote - Cramer on XOM - Stock Picks): If you repeal the whole oil boom, which is what will happen in a worldwide recession or worse, Exxon's failed buyback strategy will be revealed for what it was: a giant money pit. The stock could retreat to $57, as it has minimal dividend support.
At the time of publication, Cramer was long GE, Wal-Mart, Procter & Gamble, Chevron, JPMorgan, Johnson & Johnson, Kraft, and Hewlett-Packard.
Saturday, October 11, 2008
Panic Creates Sale of the Millennium
da thestreet.com
Panic Creates Sale of the Millennium
10/10/08 - 12:26 PM EDT
Terry Savage
The markets have been hit by the financial equivalent of a neutron bomb. It has left the companies standing, but destroyed the value of the shares that represent their businesses.
Either the financial world as we know it is coming to an end -- or it's not. We'll only know in hindsight. But unless this is the proverbial "black swan," the totally unimaginable and unique event that annihilates capitalism, this panic will subside.
It's impossible to predict how low markets will go. But since stocks represent real assets, at some point cooler heads will decide there is value at these lower prices. When that happens, we'll look back on this as the sale of the millennium.
One good sign: People are starting to ask if markets can go to zero. Well, for sure, that would be a bottom. But that desperation is also a pretty good sign that even the most sophisticated players are ready to, or already have, thrown in the towel.
Instead of playing guessing games, let's see what history has to say about these losses. The S&P 500 is now down more than 40% from its peak in October 2007. That's not the worst bear market we've ever seen.
Market historian Jim Stack at InvestechResearch.com says the worst percentage loss came in the bear market of 1929, where the loss from peak to trough was 86.2%.
The runner-up for bear-market losses came in 1937-38. The market rebounded in the early '30s but fell more than 50% in 1937-38.
And in the bear market of 1973-74, the S&P 500 lost 48%, a figure that was matched in the tech wreck of 2000.
So the current decline, coming from lofty numbers, doesn't yet match the worst the market has seen -- and survived. As Stack notes: "The final market bottom is defined as the point of maximum pessimism on Wall Street."
Investors are always saying it's "different this time" to justify markets that go to excessive valuations. The most recent example was the belief that technology changed everything.
Now many investors fear that it's different on the downside, that this time the market collapse will never find a bottom. That's as unlikely as the belief that the market will always go up.
What is different this time is that we've turned millions of ordinary Americans into pension fund managers -- without an investment education, without risk-management tools and without self-discipline that comes from experience. It's not easy to see money melt away, and with it your retirement plans and dreams. And, thus, the panic is more widespread and personally targeted.
But one thing is sure: Panic selling is what creates market bottoms. And those who sell out at the bottom lose their chance of regaining value in the future, if and when their stocks rebound.
There are no guarantees in life or in the stock market. There is only historical perspective. History shows no one ever got rich betting against America. And that's the Savage Truth.
Panic Creates Sale of the Millennium
10/10/08 - 12:26 PM EDT
Terry Savage
The markets have been hit by the financial equivalent of a neutron bomb. It has left the companies standing, but destroyed the value of the shares that represent their businesses.
Either the financial world as we know it is coming to an end -- or it's not. We'll only know in hindsight. But unless this is the proverbial "black swan," the totally unimaginable and unique event that annihilates capitalism, this panic will subside.
It's impossible to predict how low markets will go. But since stocks represent real assets, at some point cooler heads will decide there is value at these lower prices. When that happens, we'll look back on this as the sale of the millennium.
One good sign: People are starting to ask if markets can go to zero. Well, for sure, that would be a bottom. But that desperation is also a pretty good sign that even the most sophisticated players are ready to, or already have, thrown in the towel.
Instead of playing guessing games, let's see what history has to say about these losses. The S&P 500 is now down more than 40% from its peak in October 2007. That's not the worst bear market we've ever seen.
Market historian Jim Stack at InvestechResearch.com says the worst percentage loss came in the bear market of 1929, where the loss from peak to trough was 86.2%.
The runner-up for bear-market losses came in 1937-38. The market rebounded in the early '30s but fell more than 50% in 1937-38.
And in the bear market of 1973-74, the S&P 500 lost 48%, a figure that was matched in the tech wreck of 2000.
So the current decline, coming from lofty numbers, doesn't yet match the worst the market has seen -- and survived. As Stack notes: "The final market bottom is defined as the point of maximum pessimism on Wall Street."
Investors are always saying it's "different this time" to justify markets that go to excessive valuations. The most recent example was the belief that technology changed everything.
Now many investors fear that it's different on the downside, that this time the market collapse will never find a bottom. That's as unlikely as the belief that the market will always go up.
What is different this time is that we've turned millions of ordinary Americans into pension fund managers -- without an investment education, without risk-management tools and without self-discipline that comes from experience. It's not easy to see money melt away, and with it your retirement plans and dreams. And, thus, the panic is more widespread and personally targeted.
But one thing is sure: Panic selling is what creates market bottoms. And those who sell out at the bottom lose their chance of regaining value in the future, if and when their stocks rebound.
There are no guarantees in life or in the stock market. There is only historical perspective. History shows no one ever got rich betting against America. And that's the Savage Truth.
Four Ways to Help Us Out of the Crisis
da thestreet.com
Four Ways to Help Us Out of the Crisis
10/10/08 - 09:25 AM EDT
The catastrophic turn of events in the financial markets this month were actually exacerbated by the Treasury's "fixes" themselves.
From my "front lines" perch as a hedge fund manager that traverses up and down capital structures (loans, bonds, convertibles, preferreds, equities, options, etc.), let me offer four key observations and solutions that the equity-centric media coverage may have missed:
Problem No. 1: The Fannie(FNM Quote - Cramer on FNM - Stock Picks)/Freddie(FRE Quote - Cramer on FRE - Stock Picks) "bailout" eviscerated the preferred markets.
When Treasury Secretary Henry Paulson put Fannie and Freddie into conservatorship, he also eliminated the dividends on $36 billon of preferred stock, and that move sent formerly AA-rated securities to mere cents on the dollar overnight. Treasury's flawed assumption was that the agencies are special entities and that the treatment of their preferred shares ought not to affect the preferred securities of other financials. How utterly wrong and naive.
In the days following the "rescue" of Fannie and Freddie, the market for financial preferreds was essentially eviscerated, virtually eliminating any hope of recapitalization through public markets.
Why is this relevant? Aside from the direct consequences of many regional banks having to write their agency preferred investments to nearly zero and further eroding already-thin capital ratios, the overall market for preferreds is significantly larger than the amount of agency preferred outstanding. In fact, this market was one of the only capital markets that remained open to financial institutions in the last eight to nine months, and it raised nearly $80 billon during this period from straight and convertible preferred issuance.
It's one thing to "punish" common equity holders who arguably have lived off the "fat of the land" when Fannie and Freddie reaped abnormal profits, but it's entirely another thing to pull the rug out from under a class of investors (senior to the common) who stuck their neck out to recapitalize financial firms in need less than one year ago! This has caused preferred holders to hedge their exposure by heavily shorting the underlying stocks, further blowing out their cost of capital for the underlying companies.
Although Korea Development Bank walked away from purchasing a stake in Lehman for various reasons, the rapid erosion in financial preferred shares didn't help instill confidence in the prospective buyer.
Solution: Treasury should reinstate the dividends on Fannie and Freddie preferred shares and emphasize a renewed commitment to keeping the preferred asset class viable. The increased cost to taxpayers (roughly $644 million quarterly) is paltry compared with the hundreds of billions we're currently debating about in Congress, and it paves the way for private capital to re-enter the marketplace. This is ultimately what is needed to sustain any recovery.
Problem No. 2: Lehman's bankruptcy has severely eroded confidence between counterparties.
While it was arguably OK to draw the line and appease the "moral hazard" hawks by letting Lehman go, it was a disastrous mistake to not guarantee Lehman counterparty risk -- especially when Barclays was allowed to feast on its carcass. We have not even begun to see the shoes that are about to drop here, as Lehman was a very pervasive counterparty to innumerable sell-side/buy-side accounts.
While the face amount of credit default swap contracts has never been released, as of May 31, Lehman's net derivative position was $47 billon, cash collateral was $45.6 billion, and cross-product and counterparty netting was $43.3 billion. Keep in mind that the face amount of the derivative portfolio could be orders of magnitude greater than its net value. As a result of the bankruptcy, any over-the-counter trades done with Lehman have now been terminated.
To make things immeasurably worse, any associated profits from these trades have to be treated as senior unsecured claims in bankruptcy court. (By the way, Lehman's senior unsecured bonds are now trading at 15 cents on the dollar. This means that if I hypothetically had $1 million of profit in any over-the-counter trade I had on with Lehman, $850,000 of that "profit" just evaporated, and it would remain to be seen when I'd even get the remaining $150,000 back.
Furthermore, if I had cash collateral against any of these trades, or if I had prime-brokered my portfolio at Lehman (there is supposedly more than $40 billion of prime brokered assets that might be stuck), the cash and positions that are rightfully mine have yet to be returned, and the word is that it could take months. The knock-on effects of this disaster could be huge, and this will be widely felt, not only financially but also psychologically, because it undermines the validity of any and all transactions involving counterparty risk.
Ultimately, our financial system revolves around mutual trust, and not backstopping Lehman's counterparty obligations severely damages that trust. Perhaps the only good thing is that this debacle will speed up the move to a clearinghouse mechanism for the CDS market -- something that should have happened years ago.
Solution: Treasury should backstop Lehman's counterparty obligations. It may cost a lot now, but it could obviate future bailouts, since we don't yet know how widespread the damage is. They should have done this already by imposing counterparty guarantees as a condition for letting Barclays buy the assets for a song, but now it might be too late for that. Once again, Treasury needs to take on the mantle of leadership. The "moral hazard" problem should be dealt with, but not at the expense of confidence in the financial system as a whole.
Problem No. 3: The FDIC protection threshold is too low, and the FDIC is undercapitalized as it is.
With the collapse of IndyMac, "Main Street" mom-and-pop depositors already got a frightening dose of what a bank run could mean to their life savings. WithWashington Mutual(WM Quote - Cramer on WM - Stock Picks) on the brink, we are running the risk of overwhelming the FDIC, since WM's roughly $145 billion in retail deposits is three times the size of the FDIC's reserve. Obviously, depositors with more than $100,000 should be worried, but even much smaller, theoretically insured accounts are running scared in this environment.
Solution:To prevent bank runs, the feds must make it abundantly clear that the current limits on the FDIC should in no way mean that insurance is about to run out. Depositors must know that their cash is safe. In addition, the FDIC protection limit should actually be increased to multiples of the current $100,000 (it seems Jim Cramer agrees with me). While it might cost more for existing thrift failures being processed by the FDIC, the psychological impact of knowing you have a bigger umbrella will prevent potential bank runs and obviate the need for a massive FDIC bailout of a giant bank or thrift failure.
Problem No. 4: Grudging incrementalism plus a short-sale ban equals death spiral
As the fallout from Fannie/Freddie cascaded into Lehman, which then careened into AIG(AIG Quote -Cramer on AIG - Stock Picks), the Treasury devised yet another incredibly punitive, confiscatory "bailout": taking 80% of the equity in AIG in return for making an $85 billion bridge loan at an interest rate of more than 12%. Wow. When did the U.S. government get into the loan-sharking business? Was this seizure meant to engender confidence in our free market system?
The mistakes that the Fed and Treasury have repeatedly made since the onset of this crisis have been ones of grudging incrementalism. Each time they act, the timidity with which they apply Band-Aids instead of the required tourniquets ultimately results in even lower confidence in the system. Even worse, these Band-Aids are laced with a toxic ointment that kills both good and bad cells, so that the wound is never allowed to heal cleanly.
The culmination of these actions led to the harrowing near-deaths of yet another two bastions of Wall Street, Goldman Sachs and Morgan Stanley. It was the fear of government-inspired intervention and seizure that caused the run on these companies, not the "evil shorts," as the SEC and Treasury would have everyone believe. Yet, incredibly, the response was to ban short-selling of financials (and the list is expanding).
This is yet another example of a ham-fisted response to a problem that the feds themselves created, and this particular action may have the most insidious unintended consequences. If one is not allowed to hedge one's exposure via short-selling of equities, one is forced to get creative in how to limit one's exposure.
The resultant creative hedging practices inspired by this ban on short-selling is leading to wholesale panic-selling in the rest of the capital structure (everything senior to the equity, from preferreds to bonds to even secured bank loans), not to mention countless equity indices, precipitating a self-fulfilling "death spiral" in many of the names that are ironically on the no short-sale list.
Not only that, the short-sale ban has effectively shut down one of the most important asset classes that was once available to the financial sector -- the convertible bond/preferred market - because its main participants are arbitrageurs who require the ability to short out their equity exposures for bona fide hedging purposes. Over the last eight or nine months, financial institutions raised close to $40 billion in this asset class, when almost all other financing avenues were effectively shut. The law of unintended consequences has obviously struck again with this short-sale ban, basically shutting down another public capital market.
Solution: Lift the short-sale ban, albeit gradually, by reducing (not expanding) the list day by day. The old uptick rule could be reinstated as a compromise. Market participants must be allowed to hedge their exposures, or the resulting damage to other parts of the capital structure will force the underlying companies into a "death spiral."
Let the Pakistan ban on short-selling this year be a model for what not to do. After short-selling was banned on June 23, the Karachi SE-100 Index staged a massive 1,300 point rally for three days before collapsing 26% in the weeks and months after. Does the market response in the U.S. sound eerily familiar so far? Let's not wait for a 26% drop to find out.
Four Ways to Help Us Out of the Crisis
10/10/08 - 09:25 AM EDT
The catastrophic turn of events in the financial markets this month were actually exacerbated by the Treasury's "fixes" themselves.
From my "front lines" perch as a hedge fund manager that traverses up and down capital structures (loans, bonds, convertibles, preferreds, equities, options, etc.), let me offer four key observations and solutions that the equity-centric media coverage may have missed:
Problem No. 1: The Fannie(FNM Quote - Cramer on FNM - Stock Picks)/Freddie(FRE Quote - Cramer on FRE - Stock Picks) "bailout" eviscerated the preferred markets.
When Treasury Secretary Henry Paulson put Fannie and Freddie into conservatorship, he also eliminated the dividends on $36 billon of preferred stock, and that move sent formerly AA-rated securities to mere cents on the dollar overnight. Treasury's flawed assumption was that the agencies are special entities and that the treatment of their preferred shares ought not to affect the preferred securities of other financials. How utterly wrong and naive.
In the days following the "rescue" of Fannie and Freddie, the market for financial preferreds was essentially eviscerated, virtually eliminating any hope of recapitalization through public markets.
Why is this relevant? Aside from the direct consequences of many regional banks having to write their agency preferred investments to nearly zero and further eroding already-thin capital ratios, the overall market for preferreds is significantly larger than the amount of agency preferred outstanding. In fact, this market was one of the only capital markets that remained open to financial institutions in the last eight to nine months, and it raised nearly $80 billon during this period from straight and convertible preferred issuance.
It's one thing to "punish" common equity holders who arguably have lived off the "fat of the land" when Fannie and Freddie reaped abnormal profits, but it's entirely another thing to pull the rug out from under a class of investors (senior to the common) who stuck their neck out to recapitalize financial firms in need less than one year ago! This has caused preferred holders to hedge their exposure by heavily shorting the underlying stocks, further blowing out their cost of capital for the underlying companies.
Although Korea Development Bank walked away from purchasing a stake in Lehman for various reasons, the rapid erosion in financial preferred shares didn't help instill confidence in the prospective buyer.
Solution: Treasury should reinstate the dividends on Fannie and Freddie preferred shares and emphasize a renewed commitment to keeping the preferred asset class viable. The increased cost to taxpayers (roughly $644 million quarterly) is paltry compared with the hundreds of billions we're currently debating about in Congress, and it paves the way for private capital to re-enter the marketplace. This is ultimately what is needed to sustain any recovery.
Problem No. 2: Lehman's bankruptcy has severely eroded confidence between counterparties.
While it was arguably OK to draw the line and appease the "moral hazard" hawks by letting Lehman go, it was a disastrous mistake to not guarantee Lehman counterparty risk -- especially when Barclays was allowed to feast on its carcass. We have not even begun to see the shoes that are about to drop here, as Lehman was a very pervasive counterparty to innumerable sell-side/buy-side accounts.
While the face amount of credit default swap contracts has never been released, as of May 31, Lehman's net derivative position was $47 billon, cash collateral was $45.6 billion, and cross-product and counterparty netting was $43.3 billion. Keep in mind that the face amount of the derivative portfolio could be orders of magnitude greater than its net value. As a result of the bankruptcy, any over-the-counter trades done with Lehman have now been terminated.
To make things immeasurably worse, any associated profits from these trades have to be treated as senior unsecured claims in bankruptcy court. (By the way, Lehman's senior unsecured bonds are now trading at 15 cents on the dollar. This means that if I hypothetically had $1 million of profit in any over-the-counter trade I had on with Lehman, $850,000 of that "profit" just evaporated, and it would remain to be seen when I'd even get the remaining $150,000 back.
Furthermore, if I had cash collateral against any of these trades, or if I had prime-brokered my portfolio at Lehman (there is supposedly more than $40 billion of prime brokered assets that might be stuck), the cash and positions that are rightfully mine have yet to be returned, and the word is that it could take months. The knock-on effects of this disaster could be huge, and this will be widely felt, not only financially but also psychologically, because it undermines the validity of any and all transactions involving counterparty risk.
Ultimately, our financial system revolves around mutual trust, and not backstopping Lehman's counterparty obligations severely damages that trust. Perhaps the only good thing is that this debacle will speed up the move to a clearinghouse mechanism for the CDS market -- something that should have happened years ago.
Solution: Treasury should backstop Lehman's counterparty obligations. It may cost a lot now, but it could obviate future bailouts, since we don't yet know how widespread the damage is. They should have done this already by imposing counterparty guarantees as a condition for letting Barclays buy the assets for a song, but now it might be too late for that. Once again, Treasury needs to take on the mantle of leadership. The "moral hazard" problem should be dealt with, but not at the expense of confidence in the financial system as a whole.
Problem No. 3: The FDIC protection threshold is too low, and the FDIC is undercapitalized as it is.
With the collapse of IndyMac, "Main Street" mom-and-pop depositors already got a frightening dose of what a bank run could mean to their life savings. WithWashington Mutual(WM Quote - Cramer on WM - Stock Picks) on the brink, we are running the risk of overwhelming the FDIC, since WM's roughly $145 billion in retail deposits is three times the size of the FDIC's reserve. Obviously, depositors with more than $100,000 should be worried, but even much smaller, theoretically insured accounts are running scared in this environment.
Solution:To prevent bank runs, the feds must make it abundantly clear that the current limits on the FDIC should in no way mean that insurance is about to run out. Depositors must know that their cash is safe. In addition, the FDIC protection limit should actually be increased to multiples of the current $100,000 (it seems Jim Cramer agrees with me). While it might cost more for existing thrift failures being processed by the FDIC, the psychological impact of knowing you have a bigger umbrella will prevent potential bank runs and obviate the need for a massive FDIC bailout of a giant bank or thrift failure.
Problem No. 4: Grudging incrementalism plus a short-sale ban equals death spiral
As the fallout from Fannie/Freddie cascaded into Lehman, which then careened into AIG(AIG Quote -Cramer on AIG - Stock Picks), the Treasury devised yet another incredibly punitive, confiscatory "bailout": taking 80% of the equity in AIG in return for making an $85 billion bridge loan at an interest rate of more than 12%. Wow. When did the U.S. government get into the loan-sharking business? Was this seizure meant to engender confidence in our free market system?
The mistakes that the Fed and Treasury have repeatedly made since the onset of this crisis have been ones of grudging incrementalism. Each time they act, the timidity with which they apply Band-Aids instead of the required tourniquets ultimately results in even lower confidence in the system. Even worse, these Band-Aids are laced with a toxic ointment that kills both good and bad cells, so that the wound is never allowed to heal cleanly.
The culmination of these actions led to the harrowing near-deaths of yet another two bastions of Wall Street, Goldman Sachs and Morgan Stanley. It was the fear of government-inspired intervention and seizure that caused the run on these companies, not the "evil shorts," as the SEC and Treasury would have everyone believe. Yet, incredibly, the response was to ban short-selling of financials (and the list is expanding).
This is yet another example of a ham-fisted response to a problem that the feds themselves created, and this particular action may have the most insidious unintended consequences. If one is not allowed to hedge one's exposure via short-selling of equities, one is forced to get creative in how to limit one's exposure.
The resultant creative hedging practices inspired by this ban on short-selling is leading to wholesale panic-selling in the rest of the capital structure (everything senior to the equity, from preferreds to bonds to even secured bank loans), not to mention countless equity indices, precipitating a self-fulfilling "death spiral" in many of the names that are ironically on the no short-sale list.
Not only that, the short-sale ban has effectively shut down one of the most important asset classes that was once available to the financial sector -- the convertible bond/preferred market - because its main participants are arbitrageurs who require the ability to short out their equity exposures for bona fide hedging purposes. Over the last eight or nine months, financial institutions raised close to $40 billion in this asset class, when almost all other financing avenues were effectively shut. The law of unintended consequences has obviously struck again with this short-sale ban, basically shutting down another public capital market.
Solution: Lift the short-sale ban, albeit gradually, by reducing (not expanding) the list day by day. The old uptick rule could be reinstated as a compromise. Market participants must be allowed to hedge their exposures, or the resulting damage to other parts of the capital structure will force the underlying companies into a "death spiral."
Let the Pakistan ban on short-selling this year be a model for what not to do. After short-selling was banned on June 23, the Karachi SE-100 Index staged a massive 1,300 point rally for three days before collapsing 26% in the weeks and months after. Does the market response in the U.S. sound eerily familiar so far? Let's not wait for a 26% drop to find out.
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