Lehman Results are In: 8.625 cents on the Dollar

Source: Credit Fixings

International Trade (August)

Source: BEA

When a $103 Billion Increase in Fed Funding was Pocket Change...

After last week's spike in the Federal Reserve's Bank Credit, $100+ Billion seems like pocket change. How things have changed...

Source: Federal Reserve

Five of Ten Largest Dow Drops... in 2008

Source: Investment Postcards

The U.S. Banking System is Over-Rated

In a survey by the World Economic Forum, the U.S. ranked as the 40th soundest banking system. Per Reuters:

The United States, where some of Wall Street's biggest financial names have collapsed in recent weeks, rated only 40, just behind Germany at 39, and smaller states such as Barbados, Estonia and even Namibia, in southern Africa.

and

The World Economic Forum's Global Competitiveness Report based its findings on opinions of executives, and handed banks a score between 1.0 (insolvent and possibly requiring a government bailout) and 7.0 (healthy, with sound balance sheets).

I'd put us significantly closer to a 1 these days...

Speechless

Are Equities the Least of Our Worries?

Per Paul Krugman:

Stock prices are, however, the least of our worries. The money markets are frozen; the TED spread is 4.14%.

G7 meeting tomorrow, IMF-World Bank over the weekend. Now is the time for major action — an announcement of coordinated capital injections, liquidity measures, and more. If we’ve had nothing except vague assurances by Monday ….

I'd have to agree. Equity market crashes are painful. No credit market = no global economy.

Muni Close-end Funds SCREAMING Buy?

Back in February Fortune ran a nice article as to why non-taxable municipal bonds "muni's" were a buy NOW:

Forget what you may have read in the newspaper about state budget problems or bond insurer meltdowns. This is a perfect time to be buying municipal bonds. The economy is slowing, the Federal Reserve is poised for more interest rate cuts (boosting bond prices), and a Democratic win in November would probably lead to higher taxes on the rich, thereby enhancing munis' tax advantages. Throw in munis' microscopic default rates, and you've got an ideal landing spot for investors weary of the stock market roller coaster.

In theory I agreed with all the points. The article even pinpointed the danger of investing in muni close-end funds, which trade like stocks:

With a fund, given the vagaries of interest rates, bond prices and net asset values, there's no way of knowing what price you will get when you decide to sell your shares.

However, the author did not understand how large a risk this really was in an environment where returns of stocks and close-end funds become highly correlated, which is what happens when EVERYONE is deleveraging (i.e. selling) at the same time. Throw in the bad press many of these close-end funds had after the auction-rate security debacle and you get an investment (in a high-quality muni close-end fund) down as much as 35+% since February (of which about 10-15% is due to the underlying muni bond exposure).

What the author failed to foresee was that the while municipalities have low historical defaults (and high quality municipalities will likely remain that way through the turmoil), technical factors in credit AND equity markets were about to deteriorate, causing twice the pain for close-end muni funds:

Forced Muni Selling by Banks / Hedge Funds:
Broker-dealers and hedge funds were forced (and continue) to unwind major muni positions, shedding as much as 20% of all the outstanding issues held at brokerages, in an attempt to delever and raise capital.

Frozen Credit Markets:
There are currently no natural buyers of any risk in credit markets and muni bonds are no exception. Fear has driven many traditional investors to the safety of Treasuries. Thus, anyone selling muni's gets a significantly lower price, which in a mark to market and illiquid world becomes the new price. Long dated muni's currently trade at a yield 1.45x that of Treasuries (with the tax savings associated with muni's, this should be at or below 1x given conservative assumptions).

No Demand for Close-End Funds:
Muni close-end funds traded at a roughly 5% discount to the net asset value of the underlying holdings as recently as May of this year. The recent market turmoil has caused this discount to spike to 20+% in many instances as owners are unloading close-end funds, along with their equities (i.e. throwing the baby out with the bath water).

So where does this get us? The 20% discount presents a significant cushion and opportunity going forward. It is important to note that muni's have survived many brutal economic environments in the past, but did see high levels of defaults during the great depression (unlike many bears on the blogosphere, I do not see us approaching anything near that level - hopeful news here).

To be extra safe, I would sacrifice yield for additional credit quality, although in an environment in which a AA rated municipality is in trouble, it is highly likely a AAA one will be as well. However, in a low yielding environment (such as this one), I am happy to take on the risk associated with a AA rated muni-close end fund, at the current 20% discount, which yields MORE THAN 8% AFTER TAX in many cases. That is the equivalent to a before tax yield of 9.4% (if your tax rate is 20%) and a whopping 10.5% (if it is 35%). Considering the risk embedded in the S&P 500, and an average return on the S&P 500 (including reinvestment of dividends) of only 8% over the last 20 years BEFORE taxes, I like the risk-return profile.

My obvious hope is the market rebounds significantly, but even if the underlying asset values and close-end continue to sell off due to continued selling pressure, I'll collect my boring 7.5% tax free coupon until the cows come home.

Note: Before any investment, please do your own research. 'Muni X Close End Fund' is "based" on a real fund (i.e. it's real).

Discount Shopping Thrives; Luxury... Not so Much

The $25.9 Trillion Global Equity Market "Correction"

Source: Bespoke Investment

Global Response...

Fed Funds Cut to 1.5%... Will It Matter?

The cost of borrowing for investment grade corporations has skyrocketed in recent months to a whopping 6% above the Fed Funds rate.


Will the rate cut matter?

Investment Banking Heads Made $1 Billion+

Twelve of the highest paid executives of the investment banking world that helped create the current disaster made over $1 Billion from 2003-2007.

The top paid.... Dick Fuld from Lehman Brothers who (in a leaked email) responded to an internal suggestion that he and other senior bankers forgo their bonus this year:

Don't worry -- they are only people who think about their pockets.

I guess when you rake in more than $250 million over a five year stretch, you no longer have to worry about your pockets...

Source: NY Times

From Wall Street to Main Street... Credit Frozen

The Federal Reserve just released Consumer Credit data for August and it isn't pretty. For the first time since early 1998, seasonally adjusted month over month consumer credit outstanding turned negative AND this was BEFORE markets completely froze in September.

People, it is NOT all about just Wall Street anymore!

Write-downs / Capital Raises to Date...

Source: Bloomberg

Is the Euro Decline a Signal of E.U. Trouble?

There is some great analysis as to why the Euro is plummeting / Yen is rallying over at Investor Insights, but David Merkel is much harsher in his analysis of the Euro and E.U.:

It is possible that the current crisis could destroy the Euro, and possibly the EU. I think of the Confederation, where the economic pressure became so great that an extra-constitutional coup took place to create the Constitution, and implicitly, the fiat Dollar that we live with to this day. Without political unity, fiat currencies have short shelf-lives. Alternatively, the crisis could create a Federal Europe where the central government has significant powers to the degree that France in the Eurozone would be similar to Texas in the US. I don’t see that as likely; there is not the same degree of trust across the Eurozone as there is in the US.

Cliff dive below:

Who Bravely Dares Must Sometimes Risk a Fall

Yesterday we detailed how a spike in the VIX has historically presented a buying opportunity. Today, we'll analyze what to expect from this past month's historic collapse.

Over the last month (defined below as every 22 trading days to account for the different length of a month), the S&P 500 has lost almost 15% of its value. Of the past 14,282 one-month rolling periods (going back to 1950) this is the 34th worst period (only 0.2% were worse)! We've finally seen short-term investors running for the hills and Cramer invoked even more fear among his boo-ya viewers telling them:

"Whatever money you may need for the next five years, please take it out of the stock market. Right now. This week. I do not believe that you should risk those assets in the stock market."

For the record, if you NEED a certain amount money in any five year period... do NOT EVER invest it all in equities. Not sure why Cramer didn't relay this bit of advice to his viewers BEFORE the recent 40% drop, but I digress...

So with Cramer thinking Armageddon and EVERY contrarian investor drooling over Cramer's comments, we ask... how have equities performed after similar five day periods of (under)peformance?

Looking at the data all the way back to 1950, equity markets have actually done quite well, returning more than 15% over the ensuing 12 months following a similar one month drop.

Again, while I am not bullish on equities as the economy still has a lot of unwinding to do (and lets not forget that whole frozen credit market thing), I will keep an eye out for buying opportunities in select names (i.e. canned food and taser companies).

Quote: Tobias Smollet

30 Year Treasuries Below 4%

Source: CNN Money

Hedge Fund Returns (September)

Source: Barclay Hedge Fund Indices

Anything I've Ever Done that Ultimately was Worthwhile... Initially Scared me to Death

VIX (the ticker symbol for the Chicago Board Options Exchange Volatility Index) is:

A popular measure of the implied volatility of S&P 500 index options. Referred to by some as the fear index, it represents one measure of the market's expectation of volatility over the next 30 day period.

VIX has soared to 45 in recent days as fear and uncertainly has reigned supreme. While I am bearish on equities for a variety of reasons (valuation, economic slowdown, credit crisis, etc...), maybe I should reconsider. As the title of this post implies (a quote by Betty Bender), it has been worthwhile to invest when the markets price fear at this level.

Comparing the daily VIX level against the following 12 month returns of the S&P 500 (since 1990), equities have performed exceptionally well with VIX at similar levels.

In fact, looking at all periods when the VIX has ended the day above 40, the S&P 500 has averaged a return greater than 23% over the next 12 months.

Long Bonds, Short Equities

We've looked at this in the past with our post Where's the Equity Premium?, but worth noting again. Over the past 11 3/4 years, equities have underperformed bonds in the U.S. (comparing the S&P 500 with the Lehman Brothers Aggregate Bond Index INCLUDING REINVESTED DIVIDENDS / COUPONS).

Unfortunately it is even worse from an investment point of view. Investors typically don't buy once and hold, rather they continually invest. Assuming an investor had invested $1 per month in either stocks or bonds, they would have an identical return over the past 16 YEARS!

With the earnings component of equities under pressure and the relative cheapness of U.S. Bonds, look for bonds to continue their recent outperformance in the months / years to come.

EconomPics of the Week (10/3)

Armageddon Trades
"Armageddon" Trades Anyone?
Armageddon Trade of the Day (10/1)
Armageddon Trade of the Day (10/2)
Thriving in an "Economic Pearl Harbor"

Bailout
Calm Before the Storm...
Bailout Can Work and At No Cost to Taxpayers
Bailout Approved in a Landslide
Senate Passes Bailout....
We Have a Bailout.... No More Fear
It Makes the Bailout Seem "Cheap"...

Federal Reserve
Federal Reserve Bank Credit Balance Swells
No Response to a 25% Increase in Fed Liquidity

Economic Data
Full and Part Time Hiring Freeze
Payroll Down 159,000, Unemployment Remains at 6.1%...
"Auto Sales Start to Look Like Home Sales"
ISM Manufacturing (September): Deflation on the Way
Case Schiller Price Index (July): Deflation Coming...
Again we ask... Where's The Stimulus?
Don't Trust the GDP Deflator? Don't Use It

Equities / Fixed Income
Venezuela Up 0.2% YTD, Everything Else... Not So M...
Corporate Debt Spreads Continue Spike
You Are Not Alone!
Lets Hope for a Better Day...

Banks
Greed is Global
Concentration Risk Among U.S. Deposits

Politics
Does "Most of Them" Include EconomPic Data?
Congress vs. Registered Voters
Swing District Congressmen Doomed Bailout

Gallup Poll: Obama Back in Charge... Thanks to Palin

Thriving in an "Economic Pearl Harbor"

Warren Buffett may have called the current economic crisis an "Economic Pearl Harbor", but his holding company Berkshire Hathaway seems to be surviving the war. While the S&P 500 is down 12% over the past 3 months, Berkshire Hathaway is up 16% due to some smooth dealmaking with Goldman and GE.

Bailout Approved in a Landslide

Source: Dealbreaker

Full and Part Time Hiring Freeze

It's one thing that full time employment is stagnant. It's another that both full and part-time employment are (businesses will typically prefer to hire part-time workers during slow times to maintain flexibility in the face of uncertainty).

Unfortunately, looking at the chart below (and data from the BLS going back to 1968), that is what is happening... the first time since the BLS reporting began.

Payroll Down 159,000, Unemployment Remains at 6.1%

Unbelievably the Birth / Death figures still show an ADDITION of 9000 financial and 12,000 construction jobs respectively. When the Birth Death revision finally occurs, the unemployment figure will be ugly.

Source: B/D, Employment

Federal Reserve Bank Credit Balance Swells

Source: Federal Reserve

Armageddon Trade of the Day (10/2)

Before we dive into another installment of Armageddon Trade of the Day, I need to say thanks to someone... my good friend Dom, who for years has predicted the end of the world. Without his negativity towards society's greed and corruption, none of this would be possible.

Okay… back to another Armageddon Relative Value Trade, which was derived from something EconomPic Data reader Scott so eloquently detailed regarding the danger of relying too much on hunting for food (as civilization screeches to a halt):

There aren't enough animals to hunt in North America to make much of a difference. Any sane model of food-supply breakdown, and the populace turning to hunting, takes game animal populations to near zero very, very quickly.

Which doesn't make it a bad trade, it's a good trade predicated on people rushing to an obvious but bad plan.

Great point Scott. In fact, this details not only the limitation of hunting for your own food, but also the struggles livestock corporations will face when they are swarmed by hungry scavengers day two... three tops. Thus, my short of the day is… iPath DG AIG Livestock ETF (humorous symbol COW... but there is nothing funny about the world coming to an end).

For my long, lets just do the reverse. What we’ll all need is our own source of sustainable food on an individual basis. How does this sound?

AeroGrow International, Inc. engages in the development, marketing, and distribution of indoor aeroponic garden systems for gardening, cooking and small kitchen appliance, healthy eating, and home and office decor markets worldwide. The company offers indoor gardens and proprietary seed kits that allow consumers to grow vegetables, such as cherry tomatoes, chili peppers, and salad greens; various fresh herbs, including cilantro, chives, basil, dill, oregano, and mint; and flowers comprising petunias, roses, snapdragons, pink geraniums, and phlox.

Mmmmm.... cherry tomatoes and chili pepper salad. The world can not end soon enough.

Venezuela Up 0.2% YTD, Everything Else... Not So Much

Source: Investment Postcards

Corporate Debt Spreads Continue Spike

Bailout Can Work and At No Cost to Taxpayers

While I do think there are better alternatives than the current plan, something is needed. HOWEVER, I absolutely think this plan can help unfreeze the credit markets and recapitalize the financial institutions at a small or no cost to taxpayers. How? Let’s first rewind to see how we got into this mess using a very simple bank I'll call Bank A.

PART I) UNFREEZE CREDIT MARKETS

Background
In mid 2007, Bank A was doing well with $100 in assets and $60 in liabilities, thus had equity of $40. Unfortunately all the assets bank A owned were subprime mortgages, which now have a market value of $50. Which means Bank A currently has negative equity of $10 and is insolvent. As such, no other bank will provide lending to Bank A as they will fold with no government intervention. This would be fine (and a natural part of capitalism), except Bank A is intertwined with Banks B, C, D, and E and if Bank A goes bankrupt, all these banks go bankrupt. Thus, credit markets are frozen (i.e. NOBODY can get a loan).



Bailout
Under the bailout the Treasury buys the assets currently priced at $50 for $90 (I will explain later why this won’t cost taxpayers money), Bank A uses the proceeds to make $90 of loans to small businesses / individuals that need credit (for things such as payroll), Bank A’s equity rebounds to $30, Bank A is now solvent (and other Banks are once again willing to lend them money), and the credit markets are now functional (i.e. if you have decent credit, now you can get a loan - forgot the "old" days of easy money).

PART II) LIMITED OR NO COST TO TAXPAYER

Won’t this cost taxpayers money you ask? After all, they did buy assets worth $50 from the bank for $90? Nope... fortunately for the U.S., the Treasury can borrow money on the cheap.

Value of Assets to Bank A
Assuming Bank A's subprime assets pay $4 coupons per year over 8 years and returns the $100 principal in year 8 (I understand this is not how subprime deals work, but lets keep this simple) and requires a return on capital of 15% (bank capital ain’t cheap these days), the assets are worth the $50 shown above (the NPV calculation is shown in the chart below).

Value of Assets to Treasury
However, the Treasury currently has the ability to borrow at less than 4% / year for 10 years (the current yield on the ten year bond is ~3.7%). Assuming the same cash flows as above, but discounting them at 4% per year instead of 15%, the assets are worth $100 (again the NPV is shown below). Lets assume the Treasury pays Bank A $90 for these subprime assets "worth" $100. In this case, it doesn't only not cost taxpayers a cent, but they “receive” $10.



Conclusion
The bailout will not solve all the economic problems we are currently facing. In fact, not even close. We still have a massive amount of leverage in the system that needs to be unwound. However, if this bailout is done right, it should help unfreeze credit markets (which are currently non-functioning) at little or no cost to taxpayers.

Senate Passes Bailout....

Armageddon Trade of the Day (10/1/08)

Back by popular demand, we present our Armageddon Trade of the Day (I may need to come up with a graphic for this....)

Our original trade emphasized canned food and taser guns on an absolute basis, but this time around we're getting fancy and moving to relative value trades involving a long and short (though we may not be able to short ANYTHING soon). Again... anything I'd go long are stocks that will do well, should the civilization screech to a halt, while those I'd go short... well you get the drift.

And the Armageddon Trade of the Day is.... Long Paper (hey we need to keep track of food rations somehow) / Short Computers (rule #1 when the world screeches to a halt... there is no electricity).

Btw- my original post was picked up by Prospect and Reason and some great suggestions include cheap booze, ammo, cigarettes, and my personal favorite... cat food. However, the best analysis comes from Joshua Corning who compares the advantage of hunting rifles over M-16's...

M-16 is an elegant high maintenance weapon that requires way to much in overhead. In the long run deer hunting rifles have an advantage.

One day, EconomPic Data too will have a funny message board (Jake slowly wipes tear from eye)...

"Auto Sales Start to Look Like Home Sales"

Source: WSJ via The Big Picture, AutoBlog

ISM Manufacturing (September): Deflation on the Way?

Less than 50 = Declining; Greater than 50 = Increasing



Source: ISM

Greed is Global

Per Infectious Greed:

Europeans banks have long been gaming their regulators, having far less than the actual capital reserves that they needed given their balance sheets. AIG filled the hole, selling credit defaults swaps to European banks via which they could tell regulators that they were adequately covered -- at triple-A, no less -- while carrying less cash than required.

How large scale was this "gaming"? According to AIG, about $379 Billion of their $527 Billion default swap portfolio:

"represents derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather than risk mitigation."

According to analysis done by CEPS, banks were levered as much as 60x. The biggest culprits? UBS, ING, Barclays, and Deutsche bank.

Remember these names and let the write-downs continue...

Does "Most of Them" Include EconomPic Data?

Yikes! This really isn't funny anymore...