Friday, March 21, 2008

Have we made a bottom?

This truly is Good Friday. The market isn’t gyrating up or crashing down. It is a day of peace and reflection. Time to reflect on the market’s recent euphoria in celebration of the Fed rate cut, rescue of Bear Stearns, and retracement in commodity prices. Have things changed? Have we seen the bottom? Is it time to back up the truck and load up on equities?

I don’t think so. We may have plateaued as far as the impact on the major institutions of the “credit crunch.” Just as the institutions abandoned all of the historical lending norms to put volume on the books, the regulators have, or are about to, changed the rules so that the crisis will not be as severe and immediately painful.

Here are a few of the changes:
1. Investment banks can now access the Fed’s discount window for funding
2.The funding can go up to 28 days and be rolled-over and over
3.Collateral can be mortgage backed bonds and the margin is less than the market’s pricing
4.Fannie and Freddie are now allowed to maintain less capital which allows them to leverage their balance sheets an additional $200B.
5.Bear Stearns is shotgun married to J.P. Morgan with the Fed’s blessing. The common shareholders are essentially sacrificed to keep the bondholders whole and avoid a cascading of credit defaults in the derivatives market.
6.Margin requirements are changed on commodities futures with the aim being the a reduction in the inflation inferno.
7.Finally, this will happen soon. Under the charade of fairness, since all types of institutions are not required to mark to market their securities, regulations will be weakened allowing bond pricing at cost if the company says they are held till maturity. The market marks become a footnote item and the write-offs are rebooked and capital is replenished. Nothing changes except everyone is now happy and the losses will dribble out over time.

Regulators and Wall Street need to “put some lipstick on this pig” to calm the markets, but they also realize they need to de-leverage the economy and try not to let this crazed lending/securitizing happen again. So, losses must be taken. Who will they let fail? I think they are going to let the losses bubble up from the bottom of the credit heap which will hurt smaller companies and give the big banks a couple years of yield curve profits to help rebuild their balance sheets. The big guys won’t get off easily as the Fed’s will demand dividend cuts, new capital through rights offerings and expensive preferreds., and curtailing credit to make capital go further.

The last item is the economic killer. It’s already happening on main street. Community banks have lent too much, too easily to builders and developers and the delinquency numbers are growing rapidly. Losses will be large and lots of banks will be shotgunned. Individual creditors won’t be missed as they are too small to be noticed.We’ve already seen this in mortgage brokers, small builders, and real estate related service companies. Retail can’t be too far behind. Recreational manufactureres like boating and RVs are hurting and general freight movement is getting softer. The jiggling of regulations may keep big institutions alive for now, but it won’t stop a serious recession since big and small banks, as well as the CITs and captive finance companies, will need to curtail lending.

Not only will the banks reduceB lending now that they have realized that they’ve been stupid to sacrifice prudent risk rules for growth, but consumers have seen the dangers of spending and borrowing frivolously. Even when offered, many consumers will say NO. It’s going to be difficult to gin up the economy through debt.We, as a country, may have to start making things again that the rest of the world wants and export ourselves back to prosperity. But that will take years.

All this rambling convinses me that we aren’t near a bottom as the economy will continue to weaken and analyst’s forecasts will have to come down and with lowered future cashflows you will see lower P/E ratios. So I don’t plan to borrow a pickup anytime soon to start loading up on stocks.

For now make a list of all the stocks you would like to own and keep that at the ready. You’ll get your chance, but not now. Like Charles Barkley says: “I could be wrong, but I doubt it.”

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