Deal Or No Deal Friday

Wow, what a night!

I discussed the shenanigans in Washington and the WM disaster in last night’s post so let’s try to move on and figure out how this impacts everything else.  Ed Harrison has a great factual outline of the JPM deal, who just picked up $307Bn in laundered assets for $1.9Bn.  JPM is writing down $31Bn out of WMs $176Bn in mortgage loans, making the assumption that housing prices will fall 8% and defaults will rise by 10% – not exactly a rosy outlook on the economy.

Let’s not sugar-coat this, this is a crisis and the only reason everything did not fall apart this week is because the global markets were under the impression that the US had a plan, now panic is setting in and LIBOR jumped to 4.4% overnight, meaning liquidity is quickly freezing up, grinding all the world’s wheels to a halt. “It’s just a complete breakdown of the interbank lending market,” said Sean Maloney, a fixed-income strategist at Nomura International Plc in London. “We are now in a very fear-driven environment. Banks are no longer lending to each other.”

Belgium bank Fortis is selling off assets and credit default swaps on the bank have almost doubled overnight to a record 472 basis points and contracts on the subordinated debt jumped 279 points to 717.  This is a total vote of no confidence by investors.  3-month Euribor (EU interbank lending) rates jumped from 3.14 to 5.14% overnight, indicating banks are refusing to lend to each other.  The ECB, BOE and Swiss National Bank are combining to provide $74Bn in one-week funding and the Fed threw $13Bn into the pot as well.  The one-week maturity had “the most tension” because banks need funds to bolster balance sheets before the end of the third quarter, BNP’s Patrick Jacq said. The U.S. plan “is the key so that liquidity can improve. As long as confidence is not restored we will see tension in money markets.‘

In Asia banks are facing a similar liquidity issue with interbank lending rates there up to 3.78. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, widened 8 basis points to 310 basis points. It rose yesterday to the most since Bloomberg began compiling the data in 1984.  It was 111 basis points a month ago.

On the whole, the Nikkei held up well, dropping "just" 113 points but slipping below 11,900 as international investors flee to the relative "safety" of the Japanese market but it may not last even there. "If good news about a U.S. bailout plan doesn’t come out by Monday morning in Japan, it may cause a further sell-off," said Fujio Ando, senior managing director at Chibagin Asset Management. In that case, he said the Nikkei may target 11600.  The Hang Seng dropped 252 points (1.3%) and the Shanghai was flat but the Bombay Sensex fell 3.3% and was saved only by the closing bell, heading into what is going to be a very tense weekend as investors around the world pray for action from Congress. 

Europe is down 2% ahead of our open as Russian banks slip into crisis ($57Bn of foreign capital has been withdrawn since August) and HBC is cutting 1,100 Jobs, further panicking the financial sector.  The Fed has upped the capital available to global markets to $290Bn but, so far, it’s not helping…  According to the WSJ: "The Wall Street financial crisis will reconfigure the world economy and the U.S. will fade as the world’s dominant economic force, German Finance Minister Peer Steinbrück said in German parliament Thursday."  German Finance Minister Steinbrück said that the U.S. didn’t sufficiently regulate investment banks and criticized Anglo-American free-market policy as an "insane drive for higher and higher profits," adding that yields of 25% can’t be generated in the long term.

Overall, not a pretty picture.  It’s difficult to commit to the short side because we MIGHT get a deal over the weekend that can reverse things yet again but the SKF (ultra-short financials) calls are a good way to cover exposure as the ETF was at $200 during our July meltdown, which makes the Jan $115s at $17 a reasonable protector.  In the past 5 days, those calls have traded as low as $14 (last Friday) but that’s not a bad price to pay for insurance over the weekend.

The demise of the dollar can be played with the FXE (Euro) or FXY (Yen) ETFs.  The FXEs were at $160 on July 15th, now $140 and Nov $147s were last traded at $2.65.  The FXYs are already back near the July highs of $95.0 but Dec $94s were last sold at $2.53 and the March peak for FXY was $103.46.

As I’m writing this, Rick Santelli just concluded a heated exchange on CNBC by actually walking away from the camera in disgust.  Hopefully someone can find a clip later but Rick, who sits on the trading floor and feels what is about to happen in less than an hour at the open, is trying to convey to the guys in the studio the total sense of panic that the government’s actions (or lack of it) is causing among traders.  We will, no doubt, have a huge sell-off and it may lead to a huge relief rally if we do solve the problem but, as Warren Buffett said on Wednesday – "If the government does not act then WE WILL go over a precipice." 

Panic is the one thing we cannot afford.  As investors flee banks like WB (down 30% pre market) the cause more ratings downgrades, more need for liquidity, more failures followed by more write-downs and on and on.  This is what Paulson and Bernanke warned us about on Tuesday yet here we are on Friday, with apparently less of a plan than we had then!  While index puts may be tempting, they are very dangerous as the announcement of a deal can happen at any time and shoot the markets back up.  Some put spreads may be better ideas and we’ll look at them during the day and, of course, our usual mattress plays are always useful in a down market.

Gold may also go up in a panic but it will be tempered by a massive global slowdown.  GLD options are very expensive but you can use that to some advantage by selling the $83 puts for $2, which means if gold goes below $83 you will end up owning it at $810 an ounce on Oct 17th.  With the current price at $870, it’s not a bad discount assuming that everything isn’t all better by then and the world’s faith in our financial system and our currency isn’t fully restored by then.  Another way to play is to spread the $78 calls at $9.15 against the $86 calls at $3.90 which makes your break even $83.25 with a maximum gain of $2.75 (52%) on a close above $870 at October expirations.

It’s all up to our leadership, only the government can save us now and that’s a very scary thought!