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Category 5 Credit Market Hurricane!

Fri, Sep 26 2008, 16:10 GMT
by Mike Larson

Money and Markets

I'll never forget Hurricane Jeanne, which struck Florida four years ago this week.

My wife, young daughter, and I huddled in the shower of our older house as the battery-powered TV flashed tornado warnings and updates on the storm's 115-MPH winds.

Every now and then, I'd peek out the only unshuttered small window we had, only to see it raining sideways and watch electrical transformers exploding in flashes of blue flame.

And I'll always remember how the walls of the house practically "breathed" — flexing inward and outward ever so slightly — as Jeanne's winds tugged at them.

Scary times, to say the least. It reminds me a lot of what's happening in the credit markets right now, only what we're seeing there is no Category 3 like Jeanne ...

It's the Biggest, Baddest Category 5 Financial Cyclone The Markets Have Ever Seen! Just look at what's happening out there ...

#1. London Interbank Offered Rates (LIBOR, for short) are surging. For instance, three-month U.S. LIBOR jumped 29 basis points (0.29 percentage points) today after rising 27 basis points yesterday. At 3.77%, LIBOR is well above the federal funds rate of 2%.

These are the rates at which banks lend short-term money to each other. The surge in rates shows that banks are hoarding cash, rather than lending it out.

#2. The yield on the 3-month Treasury Bill is plunging — to as little as 0.46% this week from 1.66% two weeks ago. This is the lowest T-Bill rates have been since at least 1954. This shows that investors are fleeing any and all forms of risk, pursuing safety above all else.

#3. A major U.S. money market fund — the Reserve Primary Fund — recently "broke the buck." In other words, losses on Lehman debt forced its net asset value below the $1 level.

Money market funds are supposed to be extremely safe, and breaking the buck is exceedingly rare.

#4. The TED spread — the difference between the yield on three-month Treasury bills and three-month LIBOR rates — blew out to 326 basis points. That's the highest level I can find, and my Bloomberg data goes back to 1984. Think of this as a risk spread — how much riskier financial institutions think it is to lend money to each other rather than the U.S. government. The fact it's off the charts speaks volumes.

#5. Two-year swap spreads have exploded, hitting 166 basis points at one point this week. This is the highest level in at least a couple of decades. And it's yet ANOTHER sign that financial market players are panicking over the credit quality of their counterparties and the possibility of a full-scale meltdown.

Clearly, the credit market problems Martin and I have been warning about over and over again for the past few years are coming home to roost.

We suggested some ways for Congress to deal with the crisis without busting the U.S.'s own credit and causing counterproductive moves in interest rates. You can read our paper here. It appears that the actual bailout plan is somewhat different, though final details and all the implications of them are still being worked out.

The Biggest Question of All: Will the Bailout Work? That Depends on Your Definition of "Work" ...

First, it may help some banks avoid some additional losses, but it won't help all banks do so.

Depending on what the government pays for these crummy assets going forward, the plan could actually cause even MORE losses.

Plus, the sheer magnitude of bad debt out there is enormous. Even if the government buys some bad paper, plenty more loans will still sour, plenty more banks will see earnings tank, and plenty more banks will fail.

Second, the bailout package won't magically make lenders take on huge risks again.

After all, they've been burned big time. I don't think we'll see the ridiculously easy residential mortgage, commercial mortgage, auto loan, credit card, and leveraged buyout lending that we saw from 2002 through 2007 for a long, long time. I'm talking years, not months or quarters.

Third, the cost of this bailout will be gigantic.

Even before this latest proposal, the U.S. had committed hundreds of billions of dollars to various rescues. That includes more than $25 billion to bail out Bear Stearns, $100 billion each for Fannie and Freddie, and $85 billion for AIG.

Treasury is also talking about spending at least another $50 billion to backstop money market funds (the ultimate cost is unknown).

Not to be left out, the auto industry looks like it's getting its own $25-billion bailout in the form of government-supported low interest loans.

And of course, the latest package has an initial price tag of up to $700 billion.

All told, we're looking at more than $1 TRILLION in bailouts — and it's not like we have all that money sitting in a bank somewhere. We're a nation that spends much more than it earns, and borrows the rest.

The White House was ALREADY projecting that the 2009 federal deficit would be $482 billion. Now, with the additional bailouts announced and proposed, we could be looking at tacking another $1 trillion — or more — onto that number. This would push the budget deficit so far into the red, we'll all be swimming in crimson ink.

To fund those deficits, we're going to have to borrow an ASTRONOMICAL amount of money. The Treasury just held a record $34 billion sale of 2-year Treasury Notes. That was followed by a $24 billion sale of 5-year Notes, the biggest such sale in more than five years. Those numbers will only go higher with time.

In fact, Congress is raising the federal debt ceiling to a whopping $11.3 TRILLION to account for this additional borrowing.

The likely impact: All the additional supply will drive bond prices LOWER and interest rates HIGHER. Heck, 10-year Treasury Note yields have already surged from around 3.4% to almost 3.9%. That will blunt the impact of the bailout by driving financing costs higher on all loans whose rates are benchmarked to Treasuries.

Last, this crisis long ago stopped being just a financial one.

This bailout bill won't prevent the "real" economy from sliding into recession. Factories are closing. Layoffs are rising. Spending is slowing. And the downturn that began in the U.S. is spreading to other economies overseas.

Heck, just yesterday we learned that durable goods orders plunged 4.5% in August — more than double the decline economists were expecting.

Meanwhile, initial jobless claims soared to 493,000, the highest since the period right after the 9/11 terrorist attacks. Some of that gain stemmed from Hurricanes Ike and Gustav. But the trend higher is clear, and a sign of real economic weakness.

So I still think you have to be cautious with your investing strategy ...

I suggest keeping the lion's share of your money in safe havens such as Treasuries or Treasury-only money funds.

And for your more speculative funds, I think it's a good time to target some of the stocks that will get hit the hardest as the post-bailout euphoria wears off. For more on my favorite way to do that, click here.

Published on  Fri, Sep 26 2008, 16:14 GMT