Special Market Commentary for September 14th 2008 - Credit Crisis Deepens

The events unfolding tonight are indeed unprecedented. If you have not been following the events taking place this weekend I will summarize what we know at this time.

It is important to be mindful that these events are still unfolding. There is likely to be more announcements, speculation, and conjecture about what has happened this weekend, and what will happen going forward.

With that in mind here is what is happening right now:

• Lehman (LEH) was unable to secure a buyer of the company and it is being said that Lehman will be filing bankruptcy papers before midnight tonight.
• Bank of America (BAC) is reportedly buying Merrill Lynch (MER). The share price that has been announced is $29 p/share. There is a swirl of stories circulating this evening as to why this transaction took place and who was pushing for this to be done.
• American International Group (AIG) - news reports coming in regarding AIG are very fluid and still unfolding. What is known so far is that AIG is attempting to stave off a ratings downgrade by the ratings agencies. AIG has been attempting to sell assets or find sources of liquidity this weekend in order to keep their current rating. It is being reported that AIG may have been unsuccessful in finding capital and may be asking the Federal Reserve for bridge financing. It is not known at this time if AIG refused capital from private parties due to unacceptable terms or if private parties backed away from assisting AIG altogether.
• Tonight the Federal Reserve has announced new measures to provide additional support to the financial markets:

Release Date: September 14, 2008

For immediate release

The Federal Reserve Board on Sunday announced several initiatives to provide additional support to financial markets, including enhancements to its existing liquidity facilities.

“In close collaboration with the Treasury and the Securities and Exchange Commission, we have been in ongoing discussions with market participants, including through the weekend, to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses,” said Federal Reserve Board Chairman Ben S. Bernanke. “The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets.”

“We have been and remain in close contact with other U.S. and international regulators, supervisory authorities, and central banks to monitor and share information on conditions in financial markets and firms around the world,” Chairman Bernanke said.

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities.

The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

These changes represent a significant broadening in the collateral accepted under both programs and should enhance the effectiveness of these facilities in supporting the liquidity of primary dealers and financial markets more generally.

Also, Schedule 2 TSLF auctions will be conducted each week; previously, Schedule 2 auctions had been conducted every two weeks. In addition, the amounts offered under Schedule 2 auctions will be increased to a total of $150 billion, from a total of $125 billion. Amounts offered in Schedule 1 auctions will remain at a total of $50 billion. Thus, the total amount offered in the TSLF program will rise to $200 billion from $175 billion.

The Board also adopted an interim final rule that provides a temporary exception to the limitations in section 23A of the Federal Reserve Act. It allows all insured depository institutions to provide liquidity to their affiliates for assets typically funded in the tri-party repo market. This exception expires on January 30, 2009, unless extended by the Board, and is subject to various conditions to promote safety and soundness.

There are numerous details that are still not clear at the time of this writing. S&P futures trading this evening are down significantly and are still falling. The US Dollar is falling against a wide range of currencies and gold is up to $787 (closed at $768.30 on 9/12).

It should come as no surprise to our long time readers that the credit markets have deteriorated to the point of bringing down another of Wall Streets oldest firms. Lisa and I have worked diligently to keep you apprised of the economy, financial markets, and the big picture for many months.

As traders how do we handle this historic event? First and foremost; if you are new to the stock market  and have been sitting on the sidelines wondering if you should start buying stocks then this is NOT the time to begin your trading/investing endeavors. Patience is paramount at this time.

If you are already invested in the markets you must be mindful of the first rule of trading: ‘Capital preservation is priority one‘. Any long positions in equities must be monitored for stop loss threshold levels being met. We will not be averaging down any long positions. If you are already holding short positions in equities then stay put. If you are holding short positions there is nothing wrong with taking your profits off the table and then wait for the markets next move before taking new positions.

It is important to note that even the most professional traders are tonight scrambling trying to determine how to position themselves and/or how to unwind positions they already have. These are times when swing traders are best to sit on the sidelines. Only experienced day traders should be attempting to play the market tomorrow.

Our long term view of the markets remains as it has since September of 2007, ‘bearish’.

On a personal note mark this day on your calendar. If the events being reported by the press are factual and Lehman does file for bankruptcy, then this will be a historic event in the United States financial markets.

Stock Market Summary for February 11th 2008

Three-card Monte… A favorite game among con artists. Try and guess which card is the ‘money card’.

In our current banking and financial institution situation everybody is playing the "three-card monte" and the con artists are the companies who are trying to keep moving around the losses.

Today we learned that the auditors would not sign off on American International Group’s (AIG) financial statements. The auditors discovered "material weakness" in how it reported the value of certain credit default swaps. This all comes back to the issue we brought to our readers attention back in December. We said back then that auditors were likely to not sign off on the books if they saw anything questionable in how a company was coming up with values for certain assets. For our long time readers you will recall our many discussions on the "level 3" assets. Those assets for which a value can not be obtained by a mark-to-market or a mark-to-model system of asset valuation. Level 3 is known on Wall Street as mark-to-wild ass guess. Companies who have already suffered losses (or who don’t want to reveal losses) will place as much questionable assets into the category of level 3 assets and then calculate their value by using a system which does not tie in directly to any current market value. And this was going to lead to trouble later, and later has arrived.

When we discussed back in December the possibility that auditors were going to be digging through these assets very carefully it was because the entire independent auditing business got burned with Enron. When Enron imploded it took their auditors with them because the auditors were just as guilty as the company for moving assets around so that the losses would not show on the books. When Enron was found guilty of fraud and deceptive accounting, the auditing firm of Arthur Anderson was viewed as an accomplice and it destroyed that auditing firm which had been in business since 1913.

The current situation with collateralized debt obligations (CDO’s), structured investment vehicles (SIV’s), and other forms of ‘packaged loans’ which have been harder to unload than trying to sell sun tan lotion to an Eskimo are littering the books of many companies. And these companies are trying to find ways to place a value on them that will not reveal their true worth, or at least hide them until they are worth more. And the auditing firms are blowing the whistle and calling ‘foul’. In the case of AIG it would seem that this may have been the case. The auditors don’t like how the company was deriving value for some of their assets and now it appears that AIG will have to restate prior earnings. Whenever a company has to restate earnings it is bad news. We expect to see more companies in the future who will have their accounting firms blowing the whistle.

Today’s trading in the markets was lack luster. As Lisa stated in an earlier post the retail sector (RTH) has been seeing some interest as speculators are betting that all of the bad news is "baked in" the share prices. If your a gambler and like taking on high risk trades then I guess you can jump in with the other high risk players. But smart traders wait it out, wait to see if retail sales begin to flatten out and then start an upward trend. Those who are jumping into the financial and retail sectors are betting the worst is over. This is a bet we are not willing to take with our money yet. Some may look at a chart of the retail sector and say "the bottom is in.. time to jump in" for fear of letting some large gains slip by. Fear of missing that "big trade" is what has led to many investors ending up in the soup lines at the local homeless shelter. Betting on a bottom and waiting for a "confirmed" bottom are two different things. Waiting for signs of stability and a new up trend is the smart way to trade. Do you think that by waiting for better risk to reward profiles to present themselves to us will evaporate all of the gains to be had in the markets? Of course not, the stock markets have been around for a long time, there is lots of money to be made when the time is right. The smartest traders are like tigers, always stalking and waiting for their prey to be in just the right spot before striking. And it is those who wait and know when the time is right to strike that take home the prize to the family more times than the ones who chase everything that moves.

Talking heads are claiming that a bottom has been established in the markets now, wait a second… I have lost count of how many times I heard someone say "the bottom is in" since August of last year. We are still in a bear trend, and until we see a healthy bull trend redevelop we are waiting and stalking… We still feel that there are more lows to come.

A few months ago the US Government established the "hope now" effort to assist home owners with their mortgage if they were on the brink of foreclosure. Tomorrow we are going to get another Government program called "project lifeline". This one now goes another step in actually stopping foreclosure on a home until the banks can work out new terms. I don’t know how this can be accomplished without some rules being broken somewhere. Contracts and bank lending laws are all of a sudden going to be ignored?  Three months ago is was "hope now"… now things have deteriorated so much that we have gone from having "hope" to now needing a "lifeline" … sounds rather ominous to me. What is next… "project abandon ship" ?

Tomorrow morning I will post the retail sector chart and where that stands currently.