March Madness (4/08)

During the last thirty days, the Federal Reserve issued a steady barrage of extraordinary monetary stimulus aimed at easing the credit crunch and preventing the ongoing economic downturn from worsening.  The first steps on March 7th to expand the Fed’s Term Auction Facility to $100 billion now appear benign compared to the actions that followed.  On March 11th, the Federal Reserve extended liquidity operations in its Term Securities Lending Facility to $200 billion of Treasury securities and announced that it would accept AAA-rated mortgage-backed securities as collateral.  Then on March 16th, the Fed opened the discount window to securities dealers through its Primary Dealer Credit Facility and lowered the discount rate by 25 basis points to 3.25%.  Not only was this the first weekend cut in the discount rate in a quarter century, the move allows securities firms to borrow from the Fed on the same terms as banks for the very first time. 

What is important here is that the Fed is utilizing non-traditional tools to deal with the credit crunch, with the objective of freeing market liquidity by allowing otherwise illiquid securities to be exchanged for cash or Treasury securities.  Alas, there is mounting evidence that these measures are serving its purpose.  Spreads between high quality and low quality debt have shrunk in recent weeks. Collateralized-debt obligations (CDOs), perhaps the most illiquid of all securities backed by layers of subprime mortgages, are beginning to trade after having been all but frozen for the last few months.  UBS shares rallied on plans to raise $15 billion of new capital and Lehman Brothers raised $4 billion of fresh capital on terms more favorable than the market expected.  Blackstone raised $10.9 billion for a new real estate fund and even Citigroup has announced a deal to unload $12 billion of leveraged loans to private equity.  The early signs point to a thawing of credit conditions and the Fed’s unconventional moves are having their desired effect. 

Without question, the most unexpected and unconventional action occurred on March 17th with the announcement of the Fed-engineered buyout of Bear Stearns by J.P. Morgan Chase for $2 per share or $236 million.  Bear Stearns had a market capitalization of $3.5 billion on Friday, March 14th and a market capitalization of $20 billion in January of 2007.  The vaporization of value in Bear Stearns was truly astonishing.  Perhaps even more astonishing, the Federal Reserve provided $30 billion in financing for Bear Stearns’s most illiquid mortgage securities as part of the deal.  With the bail out of Bear Stearns, it is clear that the Federal Reserve sought to avert the cascading impact and subsequently deeper economic consequences that a Bear Stearns bankruptcy would have caused, despite the “moral hazard” it has certainly created.  Fed Chairman Bernanke testified before Congress that the bail out “was necessary in the interest of the American economy”. 

While Bear Stearns shareholders took steep losses and many Bear employees will lose their jobs, there is little doubt that Bear was bailed out.  J.P. Morgan CEO Jamie Dimon stated that his bank “could not and would not have assumed the substantial risk” of buying Bear Stearns without the Fed’s involvement.  To appease restless shareholders, J.P. Morgan did finally raise its bid from $2 to $10 per share.  J.P. Morgan will also guarantee another $25 billion that the Fed had lent to Bear Stearns, separate from the aforementioned $30 billion loan, under the Primary Dealer Credit Facility that was announced over the weekend just prior to the initial $2 bid.  CEO Dimon summarized it best in stating that “buying a house is not the same as buying a house on fire”. 

It is now clear that the firm most leveraged to the subprime mortgage crisis was Bear Stearns.  It was hedge funds managed by Bear Stearns that first disclosed massive losses last summer due to subprime mortgages.  It was Bear Stearns that had a leverage ratio of almost 30 to 1, with one-third of its collateral backed by mortgages.  And it was Bear Stearns that relied on short-term “repo” financing for a full one-third of its liquidity needs.  When counterparties doubted the safety of Bear’s collateral, Bear’s repo financing dried up.  At the same time, the credit agencies downgraded Bear’s debt to near junk status, which seemed to substantiate the doubts and further limited the firm’s viability.  Banks and other counterparties ultimately refused to do any business with Bear and the 85-year-old institution could no longer sustain operations as an independent entity.   

Many analysts compare the Bear Stearns episode to the 1998 Federal Reserve orchestrated bailout of the hedge fund Long-Term Capital Management.  While only time will tell, we are cautiously optimistic that the Bear Stearns bailout may signal a bottom in the stock market correction that began last fall, similar to the 1998 bottom made during the Long-Term Capital Management fiasco.  It is indeed quite ironic that Bear Stearns was the only one of Wall Street’s largest investment banks that refused to participate in the bailout of Long-Term Capital Management.  With the shock of the Bear Stearns announcement and spike in volatility that ensued, the market had every opportunity to take out the recent January lows.  Yet those lows have held ground and the market has been able to sustain a fairly impressive rally, even in the wake of such incredible news.  To technicians, it appears that the market may have successfully “tested” its recent low and formed what is known as a “double bottom”.  As in previous market bottoms during times of economic crisis, the market is able to sustain a recovery even as the news flow remains negative.  Even though the economic news is likely to remain negative for some time, the markets have already priced in a lot of bad news and will begin to look forward to the eventual economic recovery. 

To achieve this recovery, the Fed also pulled out its big guns with more traditional monetary policy and lowered the Fed Funds rate by 75 basis points to 2.25% on March 18.  This was only the second time the Fed cut rates by so much since it began announcing rate decisions in 1994.  Having cut rates by 300 basis points within six months, the Fed is demonstrating its resolve and taking aggressive measures to get the economy back on track. 

Meanwhile, all is not lost on the economic front.  The weak U.S. dollar and strong growth overseas are driving a boom in exports, which is helping offset, the weakness in the U.S. housing market.  With government spending still rising and consumer spending expected to remain at least stable, 1st quarter GDP will likely register a near 1% gain, hardly booming but positive nonetheless.  Consumer spending and GDP ought to get a substantial boost in the second quarter with $100+ billion of fiscal stimulus pumped through the system in the form of tax rebates.  And by the third quarter, the impact of the Fed’s massive rate cuts to date will be in full bloom.  Additional volatility may lie ahead, but stocks appear attractively priced and will soon begin to discount the economic recovery that lies ahead. 

According to Ned Davis Research, in analyzing stock market returns after the low reached during all recessions since 1945, the S&P 500 has been up an average of 16 percent three months after that low, 24 percent six months later and 32 percent one year later.  These historical averages bode well for stocks, if we are at or near the low for what is likely to the recession of 2008.  To bet otherwise, one would have to expect the current economic environment to become much worse and for the recent monetary and fiscal stimulus to be ultimately ineffective.  This has been a bad bet in the past and we belive that worthwhile gains lie just ahead.