Systemic credit risk; AIG on brink of collapse

The world’s biggest insurer, AIG, is going under… if they can’t get some big loans they will surely implode.

This will continue to feed the downward spiral of financial markets and put pressure on every other institution, raise interest rate spreads and continue to force the market in to a state of illiquid volatility.

If you or anyone you know has policies with AIG, you may want to cancel them and move them elsewhere.
Again, I’m afraid this is only the beginning.  Washington Mutual will fail and Wachovia will fail or be bought out by a bigger bank by end of the month.

Merrill Lynch’s deal to be purchased by Bank of America is in FLUX.  It may not happen.  Anyone doing business with Merrill should closely examine how this may impact their accounts.  Especially if the deal falls through and Merrill fails.

What happens next is systemic credit risk spreads throughout the system, forcing debt to be much more expensive.  All these financials count on cheap money to leverage their operations.  This will cause the remaining independent brokers (Goldman Sachs and Morgan Stanley) to have to partner or merge with money center banks.  It will consolidate money and power to a few hands. There are about 2000 banks now.  At the end of this, there may be less than 1000.

Fannie and Freddie bail out

I’m very concerned about the ever increasingly blurred line between the private and public sector. The bail out of Fannie and Freddie will serve to boost confidence in the short term, but I feel it is probably going to cost the tax payers trillions in the long run.

The FDIC is now running out of money to pay out depositors.  They will have to borrow from the Treasury.  This is going to be another financial event where the tax payers will shoulder the burden for bad banking practices.

I feel that once this crisis comes to an end, the financial landscape will be extremely consolidated and muddled.  The government will be in a position with incredible moral hazard with so many private sector investments.

The leadership that was from the strength in commodities has vanished.  Financials have bounced back but are still down on average over 30% YTD.  They are by no means leading us higher. 

As for the next bull market, I can not find a catalyst that will be suitable to stimulate a resurgence of equity values.  Financials will be strangled with regulation and unable to create structured investment vehicles with the flexibility they previously enjoyed.  Fees will be compressed and many brokers will have to find new lines of profit or fail completely.  Green energy isn’t going to find a catalyst without energy prices continuing their parabolic run.  The consumer is spent and the technology sector is going to suffer from that next.

My outlook may seem bearish now, but I feel that it is actually the most bullish outlook I can muster given the global and domestic economic conditions that are giving way to an unprecedented slowdown that is only in the first stages of affecting us.

Fed sits tight at 2%

The Fed has no room to move in either direction; inflation is high and growth is slow.  Unemployment remains stubbornly high while at the same time, despite the correction in commodities, inflation is also a great concern.  The amount of money (debt) creation the Federal Reserve and Treasury must engage in to prevent the credit bubble from catastrophically failing will have deleterious effects on the US dollar and put increasing pressure on the consumer to remain afloat.

Home foreclosures are bound to continue increasing as home prices continue lower amidst tighter credit standards for mortgages restricting potential buyers and up ticks in adjustable rate mortgages increasing monthly payments to unaffordable levels.  In addition, the price increases for agriculture and energy have yet to hit the consumer fully.  Some increases are still being passed on and will be for some time.

The credit bubble, which started as a subprime crisis, has spread to affect assets of all classes and created great uncertainty in the fixed income markets.  Many question the fundamental underpinnings of the debt driven US economy given that the consumer is under the aforementioned pressures, the Fed is tied down and the dollar, while strong lately, has still weakened nearly 40% in the last six years.

In my estimate, we are about one third of the way through navigating this crisis, and thus far too much ammunition from the Fed and Treasury has been expended.  I am looking for the S&P in the triple digits by years’ end and home prices down another 15-20%.

Where are we now in the bear market recession?

So, Fannie smells like its namesake and Freddie is more like Frauddie.

What has inspired this recent massive confidence boost?  Wait, who said it was confidence?

The SEC says, “Thou shalt not short”, and the blood that flowed in the streets retreated back in to the respective institutions in which it had spouted from.

The Treasury says, “We will buy the risk on the taxpayer’s dollar”, and somehow gold and silver decrease in value and the dollar holds its ground against other currencies.

The Fed says, “We have to raise rates” out of one side of it’s mouth while also saying, “The risks have markedly increased” from the other.  And yet the markets accelerate up in leaps and bounds.

What really happened?  Why are financial stocks rallying?  Because you can’t short them as easily if you’re a market maker or institution.  Any short positions that don’t have shares borrowed must be unwound.  Is this a magical cure-all for the financial markets?

Is Paulson’s plan for a blank check of nearly $1 trillion dollars to Mac and Mae a way to say, “Everything is OK”?

We have to examine the core underlying message here carefully to paint a more accurate picture of what’s going on behind the scenes.

Paulson needs lots of cheap money and fast to bail out a cataclysmic decline in Fannie and Freddie’s paper.  Meanwhile, Fannie and Freddie already out diluting their share holders with new issuances.  Why is that good for share holders?  They’re effectively seeing their shares watered down.  Oh wait, it’s harder to short during the next 27 days because of the SEC, so these stocks aren’t really rallying, they’re just floating on ether.  Ultimately the Fannie and Freddie share holders will see the equities go to 0.  Only the debt holders, particularly Japan, China, Russia and other governments, will come out with any cash.

Plosser of the Fed says, “We must raise rates sooner than later”, yet the financial system is still in peril.  Raising rates would boost the dollar slightly, but the fundamentals are weak because of a spiraling out-of-control current account deficit that may rise to $12T by 2010.  That would be a near treble from 2000’s level, which suggests the fundamental value of the dollar is being cut down by 66% (or a by two thirds) to 33% of its original value in 2000.  Wait, WHAT?  That’s correct, we aren’t even near the end of this fun ride yet.

In fact, it’s likely about to become much worse as savvy hedge funds and institutions find other ways to short weak companies, using options, derivatives and shares listed in other countries with more lax regulations.

At the same time the US government fancies itself the regulator of all markets now.  They’d like to tell speculators how many crude contracts they’re allowed to hold, after being told by the Federal Reserve, CFTC, independant researchers and many brokers that this will simply create more problems.  If there are less speculators, the markets will become less liquid, volatility will increase and the fundamental supply demand story isn’t over.  We may or may not be at peak oil, but one thing is certain, oil’s uptrend since $1 a barrel in the 1900s is far from over and Boone Pickins’ prediction of $300 oil by 2012 seems more than reasonable.

Where does that leave us?  We are in an area of extreme uncertainty.  Every rally is questionable.  Every dollar we hold in our bank accounts, retirement accounts and wallets are declining in value significantly.  Stagflationary pressures are now globalizing and the world economy seems poised for a marked slowdown.  We can hope and pray that this will pass and everything will be just fine, but after the second biggest bank failure in FDIC history (and more to come), we are nowhere near out of the woods, yet.