There can be only one!
In the movie Highlander, a bunch of immortals run around trying to chop each other's head's off because, in order to get the ultimate prize (and they aren't even sure what it is), there can be only one survivor. There are only about 20 of these immortals left on earth and they could all lead fabulous lives for eternity but they go at each other tooth and nail in a contest that only one in 20 will win.
Well, doesn't that sort of sound like our investment banking sector? They all made hundreds of millions but that was not enough so they wiped out their competitors and leveraged their assets and got more aggressive and we removed regulations to let them get even bigger and then they made tens of billions but that was not enough so then they turned on each other and this quarter there were just 5 majors left in the US: GS, MS, BSC, MER and LEH. In just the past 3 months we are now down to 2. And who oversaw this carnage? Former GS CEO Hank Paulson.
That's all I'm going to say about that matter, Don Harold puts it very well in today's video that the time to point fingers is past and now is the time for leaders to step forward and for people to pull together and do what we have to do to get through what is now officially a crisis. How do we fix this? Can we fix it? What would be the way to move forward? Clearly the system is fundamentally flawed and while it's always good to try not to panic, that doesn't mean it isn't good to be prepared. I outlined a worst-case for members in chat this morning:
- C is going to get crushed again as they are still heavy in the Alt-A market and LEH (and probably now AIG) will cause a significantly lower benchmark for marking the securities. Looks like about $8Bn more writedowns for C using LEH’s math (and they have no choice if the assets actually sell down there) as they have $16.4Bn of Alt-A marked at 80 cents on the dollar while LEH looks to be going out at .39 and I will repeat my usual "wah-wah, out of $2Tn in investments" mantra for C and still call them a buy whenever they stop this round of falling. Let’s not forget that this is an assumption that Alt-A loans held by C, which are not sub-prime but not as well documented as prime, are going to lose 61% of their value. That’s a 60% default rate with NO recoverable value on the properties – let’s hope not!
- I want to keep an eye on whoever is buying up all this paper, they are probably going to hit the jackpot (BAC just bought a ton) over the long haul, providing we are not sinking into an actual depression where 2/3 of the homeowners lose their homes. The problem with these crazy write-downs is that funds with cash can come in and buy a loan virtual portfolio for .40 on the dollar, put the squeeze on anyone who’s not paying and accelerate the foreclosure process and then get just 60% for the homes (let’s say about 1/3 of Cs virtual portfolio = $5Bn) and get back $3Bn out of the $6.4Bn they paid for it and they are left with $11.4Bn worth of loans that are NOT behind on their payments that they bought for net $3.4Bn.
- Great for the firms that do it but bad for the local housing markets as homes go for .60 on the dollar, that can lead to more failures with funds swooping in to buy virtual portfolios for .30 and selling homes for .50 on the dollar, causing more failures allowing funds to swoop in and buy virtual portfolios for .22 on the dollar and profitably selling homes for .40 on the dollar. This is what I warned about ages ago when I said that Paulson’s policies were setting us up for a good old fashioned land grab by the banks. And what’s the biggest investment bank left with relatively little competition? GS!
That's the reality. I've been saying for a year now that policies aimed at bailing out lending institutions one by one were the wrong way to go and the only real cure is to stop, not slow, the actual defaults. The worst thing is, the above action I described will accellerate them. As more and more foreclosed homes get dumped on the market, comp values decline and it sets of a domino effect that can make things much worse. Last Thursday I said, looking at the global picture, that 24% off the peak may not be enough of a drop for the Dow to give us a bottom, now we will see some lower numbers for sure.
The same play we discussed last Monday, the SKF calls, is our best defensive play today. That combined with the mattress play strategy I recommended in the same post are still the most logical ways to cover a broad virtual portfolio against a continuation of today's drop. This morning we were looking at the SKF Jan $140s, which were $16.70 on Friday and were $80 back on July 15th. They will open higher of course but the logic applies to any strike, bearing in mind the SKFs topped out at $200 but, if we are really falling apart, that may not be the final floor.
Last week we looked at the Oct $90s for the same price, those are now $28.35 and were $110 back on July 15th. Why am I now looking at January? Because a reversal (not looking as likely) like we got on July 16th will chop 1/2 the value of the Octobers very quickly but the Jan $140s bottomed out at $11 last week (down 30%) and I would think it’s not too likely we’ll hit that so fast that the position can’t be unwound. When you look for protection it's got to be about the risk/reward of the situation, if you can invest 10% of your virtual portfolio in a position that will triple or better in a worst case and the other 90% of your positions are expected (in the same drop) to lose less than 1/2 of their value, then that's pretty good protection.
I know a lot of people feel this is a time to throw up their hands, cash out all bullish positions and turn bearish and that would be great if we are heading to a full collapse (then again, in a full collapse are you sure you'll get paid on your shorts?) but I'll just say the same things I said to bears who turned into bulls at 14,000 – be very careful! I do think the LEH bankruptcy is a good thing, it will give us some real prices on their assets and allow the rest of the industry to put defensible prices on their own assets. We may not be happy with the final figure, but it's a figure we can work with at least, no more loss estimates that scale from $200Bn to $2Tn depending on who has the microphone (hopefully).
Even as I write this (8am) gold is calming down considerably ($774, up $10) and oil is down at $95.40 as the hurricane did little actual damage and, as we discussed this weekend, there are a lot of barrels that need to be dumped by SPECULATORS (I can say it now without fear of being laughed at) who are still holding 229Mb of crude contracts for October delivery at $102 as of Friday. A lot of those speculators were praying for a Ike to be very destructive and that didn't happen, we'll see how many long buyers of oil there really are as they have to roll out to longer months or take a big hit to cancel contracts (189Mb+ of 229Mb contracts will be canceled by the traders who had no intention of ever accepting delivery by next Monday in a scam that still goes on).
The front page of the WSJ says it all: "Crisis on Wall Street as Lehman Totters, Merrill is Sold, AIG Seeks to Raise Cash" in huge letters with awful charts for each company above the headline. So what do you expect is going to happen this morning? It's not about where we open, it's about where we settle. Will we hit the July 15 lows: 10,827 on the Dow, 1200 on the S&P, and NYSE is already well below 8,089 we hit then and will probably break last week's 7,860. For the Nasdaq we are certainly going to open lower than our 2,167 bottom for the year and the Russell has a long way to go to hit 647 again and perhaps is the best index to short if things start falling further. Why aren't the 2,000 small caps failing? That's a great question and my usual answer is because the real economy is not as bad as it seems but today is not the day for that discussion. Oct $700 puts were $16.20 on Friday and would be $40 in the money back at July lows so also good protection in those brackets.
Why October on the Russell? Because I don't believe they will fall as fast as the rest so there will be a chance to get them without too much excitement premium and they can be stopped out reasonably if there is some Federal action to save the markets. Today is all about protection, not profits…
China's Central Bank cut interest rates today while the markets are closed for a holiday. It's a small cut, just .27 to 7.2% but it's the first time in 6 years the PBOC has lowered rates. They also reduced the reserve requirements, another move to free up liquidity but the Asian markets that were open (Japan is also closed) fell off sharply with India down 4.7% and Taiwan down 4%. Australia came back late in the day and closed down "just" 1.8%. European exchanges are down around 4% ahead of our open as the ECB also puts more cash into the system.
Let's not forget that $150Bn hedge funds have sitting on the sidelines. Perhaps they will need it as they liquidate the rest of their virtual portfolios or perhaps this is the moment they have been waiting for, let's watch our levels and guard against the worst but as Jim Cramer says – "No one ever made a dime by panicking." Speaking of panic, though – GLD is the ETF that tracks gold and is down to $76 from $95 on July 15th. The more money the Fed dumps into the fire, the better for gold so the Jan $77s at $5(ish) are one way you can play gold to the upside.
It's going to be a very tough day, best of luck to all.
