Credit Hurricane To Make Landfall

An incredible (yet sobering) article by Benet Sedecca. Some highlights:

Another important takeaway was that the older and more experienced investors were the more concerned they were. After all, if you haven’t lived through a credit crisis, it's hard to fully appreciate what that unwinding of a credit crisis looks like. When we consider that the build-up of credit and derivatives during this past cycle is so unprecedented, the more difficult the unwind is likely to be.

...

If I'm correct, the next stage of the credit crisis, which I firmly believe is at our front door, could make the first stage feel like a walk in the park. This is when the hurricane makes landfall, and many that didn’t evacuate as they were instructed to (those taking credit risk at present no matter how disturbing the economic data has become will wish they had). Let’s say the storm comes and lasts six to nine months, and the newly elected president will likely blame past administrations and possibly wish they had never run for office, likely having a term of "one and done."

...

If you're lucky enough to make it past the front part of the hurricane, a seemingly calm period takes place (the eye) and once again, people feel relieved, see the sun and hope that the back end of the storm will break up as it hits shore. This could happen in 2009 at which point Stage 3 shows up, and the back end of a hurricane can be the most damaging and is the knockout punch.

I think this could be a late 2010 event, which could be followed by a huge rally in markets worldwide in both credit and equities. It's possible that this would be a cyclical move within the confines of the secular bear market that began in 2000, but one that we would love to be positioned for. The investor that recognizes the issues we face and is prudently positioned (sometimes with positions to the downside using defined risk via puts) will likely be able to weather the storm, while those that hope it is over will wish they had paid more attention to the news flow. Virtually every data point that I am seeing these days gets worse by the day, yet the data is being greeted with complacency. Since the Fed has played the ultimate ‘Moral Hazard Card’ by back-stopping banks and brokers with their repo lines and term facilities, I suppose many feel that the Fed will be there to bail them out. I think they are sadly mistaken and that the Bear Stearns will be nothing close to an isolated instance.

...

According to Bloomberg, there are now over 668 publicly traded companies with Level 3 Assets on their books, which is 133 more than just last month. What I find highly interesting is that the companies aren’t limited to just banks and brokers. We are increasingly seeing them on the balance sheets of insurance companies like AIG, Metropolitan, Hartford, etc.

...

... it could force other holders to sell as well, or at a minimum, raise more assets to cover their write-downs/write-offs. And while the market has been open for those willing to raise money in the capital markets, it is open at stubbornly high rates. National City raised money at 9 7/8% and then 12% before it was forced to sell a huge amount of shares at a multi-decade low of $5 per share that effectively diluted existing shareholders by 50%. Key Bank, which operates in almost identical markets as National City as does Fifth Third Bancorp, has had to pay nearly 9%. Merrill sold a $2 billion preferred deal at 8 5/8%, J.P. Morgan at 8.1%, Fannie Mae and Freddie Mac at 8 ¼%, Citigroup at 8 1/2%, Regions Bank at 9%.

To drive home the point, below is a chart of bond yields dating back to the 1920’s. Note that in the 1930’s Treasury Bill yields plotted, just as they have today, except that BBB rated bonds actually spiked simultaneously as the Fed eased to 1%. Does that have a particularly familiar ring to what is happening now?

...

There are only two companies that have over 3:1 Level 3 to capital and both of those are being acquired (Bear Stearns (BSC) by JPMorgan) and Countrywide Financial (CFC) by Bank of America. Others that are high on the list are Merrill Lynch (MER), Morgan Stanley (MS), Goldman Sachs (GS), Fannie Mae (FNM) and Lehman Brothers (LEH).

...

My belief is that at some point in the next six to twelve months, the financing window will shut, and shut hard. When these companies can no longer fund themselves, it could be curtains for many of them, and there will likely be many forced marriages. When one thinks about it, the JPM/Bear deal was a shotgun marriage with the Fed and Treasury Department acting as matchmakers. This is how many of the brightest folks I know feel the next wave will look like—the Fed will simply try to retard the speed of the crisis by innovatively creating new financing facilities and have more "good bank/bad bank" marriages. In truth, I really don’t know of many banks that are truly "good" in the pure sense of the word, so you may say they may be "not-so-great/bad bank" marriages with a shotgun at the altar.

...

I am looking for a sawtooth pattern where the economy drifts in and out of recession for many years until many of the excesses are wrung from the system. This should not be a great time for long only equity investing. Rather, an absolute return approach with capital preservation at the core, which includes credit risk avoidance for the most part.