McMillan Letter

By: Mark McMillan | Mon, Dec 29, 2008
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12/29/2008 9:56:09 AM

This week, I depart from our regular format in order to reflect on a bit of recent history and its effects on the real estate, credit, and financial markets. I want to focus on some specifics in order to decide what the important events and manifestations were and the cause and effects related to them. I will take this input to form an opinion on where I believe the market is headed and where the best opportunities are for us to profit going forward.

The important things to focus on are the concepts of leverage, the availability of credit, derivatives and their lack of regulation, and the intertwined nature of today's financial markets. I will start with a timeline of events leading up to the realization of the "perfect storm" of the housing market bubble bursting, financial markets rolling over, and credit markets freezing up.

Long term readers know that I place a lot of emphasis on Fed policy. In this review of the past, I hope that readers understand why I place this emphasis. It is my contention that, while not omnipotent, Fed policy has enabled some of the largest asset bubbles as well as caused significant swings in the valuation of the U.S. dollar. The timeline below is an attempt to set the stage for how the markets arrive at where they are today.

Housing Market Bubble Begins to Burst
By late 2005, signs of the U.S. housing market top were coming into focus. The chart below, supplied by the National Association of Realtors (NAR), clearly shows that by the end of 2005 single family home prices had topped. 2006 saw a rapid fall from that precipice that has continued through today.

Note that the fall-off in housing prices precipitated the increase in defaults in home loans. Specifically, sub-prime loans and Alt-A loan default rates began to climb. Alt-A loans were the loans made without requiring proof of income, etc. Both these loans collected very little to no down payments for prospective homeowners to receive a mortgage. Many were also made as adjustable rate mortgages which increased as the Fed raised interest rates. Interest rates began to be raised in mid-2004 and the Fed didn't stop raising rates until mid-2006.

It was obvious that homeowners that didn't put anything down on property were not going to be able to refinance out of the adjustable rate loans they entered as housing values were actually in decline through the first half of 2006 while the Fed was still in process of raising interest rates. Those loan payments were going to increase within one to two years of the loans having been originated. Unless something drastic happened to increase the income of those homeowners, many were going to default on their loans, which is what has happened.

Bear Stearns Hedge Funds Collapse
In July of 2007, rumors abounded that several hedge funds were in trouble. Some of the rumors turned into reality as two Bear Stearns hedge funds collapsed. The Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund collapsed due to bad bets on the subprime credit market.

These funds bought Collateralized Debt Obligations (CDOs) and Mortgage Backed Securities (MBSs) with borrowed money in order to leverage the returns. The models used by these hedge funds didn't account for a possible collapse of housing prices. They counted on the continued rise in home prices and that interest rates would remain stable. Neither of these conditions was maintained. When the defaults by homeowners began, it caused the income streams from these loans to collapse so the real value of these securities dropped. The entities that loaned money to these funds became concerned about the value of those securities and demanded more cash be put up. To raise the cash, the funds had to sell some of those assets. Other hedge funds learned of the Bear funds plight and began driving down the value of like assets, causing them to sell more funds at further reduced prices and led to the collapse of the funds.

Bear Stearns did inject $1.6B into the funds to ensure temporary liquidity, but it became a crisis of confidence and nothing could save the funds due to the leverage required to cover the annual 1 to 2% management fees and the 20% haircut on the profits made by the funds.

Bear Stearns Collapse
On March 14th, JP Morgan Chase, in conjunction with the Federal Government, provided a 28-day loan to Bear Stearns in order to prevent the market collapse that would result if Bear Stearns became insolvent. Two day's later, JP Morgan Chase announced a merger with Bear Stearns via a stock swap at $2 per share. That amount was later raised to $10 per share to diffuse the anger of Bear shareholders. Recall that as recently as January 2007, shares of Bear Stearns traded at $172 per share.

The Treasury lets Lehman Brothers fail
On September 4th, 2008 rumors of Lehman's lack of sufficient capital appeared in print. Short sellers smelled blood and continued to drive the share price lower.

On September 12th, the Fed called together bankers from the largest banks to determine how to arrange a bailout for Lehman Brothers. The Fed insisted that it would not guarantee Lehman's debts so a suitor would have to assume those liabilities. Bank of America balked at this because they were focused on acquiring Merrill Lynch. The other leading candidate was Barclays, the large UK bank. Barclas wanted a guarantee from the treasury so they could limit their exposure to problem loan securities.

When the Treasury refused to make that guarantee, a glimmer of hope was still there that a deal could be had. Perhaps the consortium of banks brought together by the Fed could underwrite the deal. At the eleventh hour, the Financial Services Authority, the UK equivalent of the SEC, put the kybosh on the deal and Lehman was allowed to fail.

On Monday, September 15th, the failure of Lehman brothers was made public. In conjunction with that announcement, the acquisition of Merrill Lynch by Bank of America was also made public. The Dow dropped 504 (4.4%) points that day while the S&P-500 lost 59 points (4.7%). That was the beginning of the unraveling of the equities markets.

Reaction of the Credit Markets
How did the credit markets react to the near collapse of Bear Stearns and to the eventual collapse of Lehman Brothers? Take a look at the Ted Spread to see what happened to interbank lending rates.

In looking at the chart of the TED Spread, it is obvious that credit was cut-off essentially overnight as banks no longer trusted each other to repay loans and the cost of interbank lending skyrocketed. Clearly, the Fed's actions to produce liquidity have had the desired effect and rates are coming down.

Before I move on to explore the immediate situation, there is a need to understand one more aspect of Fed policies gone awry. When the Fed decides to stimulate economic activity by reducing interest rates, or they decide to raise interest rates in order to combat inflation, their initial actions may have the desired effect but may also produce adverse consequences.

The Fed was behind the housing bubble
When U.S. equities markets began to collapse in 2000, the Alan Greenspan led Federal Reserve decided to reduce the Fed Funds rate. In point of fact, the initial top in the S&P-500 was in March 2000. This was followed by a failed second attempt to reach that level in September of the same year. From there, equities entered a two year period of downward movement with alternating rallies in between. I have chosen to look at the S&P-500 as the broadest index for equities, even though the most dramatic losses were by the NASDAQ while the Dow Jones Industrial Average side-stepped most of those dramatic losses.

It seems apparent, in reviewing the chart that the Greenspan Fed was typically late to the party while the Bernanke Fed seems to be getting out in front. I draw this conclusion from the Greenspan Fed making policy changes and changing Fed Funds and discount rates after equities have signaled problems in the economy.

Recessions and how they are dealt with by the Fed
The National Bureau of Economic Research (NBER) is the official body responsible for determining the start and end dates for recession in the U.S. They announced the start of a recession in March 2001 and end of that recession in November 2001. Following that announcement, they suggested the start date may be revised to November or December 2000. Their criteria for dating the peaks and troughs which define recessions and expansions include:

Since the other three criteria tend to fall when employment falls, it is regarded as the primary indicator of a recession by the NBER.

That same body has declared that a recession started in December 2007. They haven't provided an end date yet, which makes the current recession longer than most with a minimum duration of a year or more.

The Fed has its own data to review and doesn't have to wait for the NBER to proclaim a recession. The Fed often focuses on jobs and GDP, in terms of economic health, and they also keep a close watch on inflation.

When you look at either the condition of equities markets, it appears that the Bernanke Fed is out in front of the situation, more than the Greenspan Fed. When you look at what was happening in the official unemployment rates published by the Bureau of Labor Statistics, it may be a dead heat.

While it appears that the Fed is tracking employment closely, and when unemployment is on the rise, they consider easing, the stimulus for tightening hasn't yet been reviewed. Many would suggest that comes from concerns over inflation, which is properly left to next week's letter as we study where we are today in the state of the economy and the markets.

Market Outlook and Conclusion

This week, I am taking a different approach to supplying a market outlook. I am still looking for the market to eventually retest the bottom and will occasionally share a chart with you as I see significant turning points for the market. Rather than post charts on the market, I thought it would be better to frame the background information I presented in the timeline above into a perspective I see for the market today and in the immediate future. I also believe it will be useful to our readers to share our forecast for the markets in 2009.

Unfortunately, I don't have time to cover both subjects here so I am going to devote the next two weeks to these subjects. I hope you like the new format, because you are who I am writing for. If you would like to see something covered that I am not writing about, please don't hesitate to write. If you think that something is too technical or uninteresting, etc., I would certainly like to read your opinion.

In summary until next week then, interbank lending has improved a bit as seen when you look at the TED Spread, which was covered earlier. The yield on the 10-year note was nearly unchanged rising one basis point to close at 2.14%. The media has suggested this represents a flight to quality. I believe it is simply front running the Fed.

The other major factor has been the price of oil. Oil closed the week at $37.71, up from a bit more than $35 a day earlier. Demand and supply will come into alignment as supply is ratcheted down by OPEC. There has been some demand destruction overall but the fundamental need for oil is still there and I believe it is in the process of forming a bottom.

A sharp break upward or downward is imminent and there should finally be some action worth trading shortly.

As stated last week, for now, there is little advantage to tying up a large amount of cash in the market. The important thing is to have cash when probabilities of return are highest.

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Mark McMillan

Author: Mark McMillan

Mark McMillan
The McMillan Portfolio

Mark McMillan

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