Last week you already know that stocks were in bad shape, but you may not have realized that the credit markets were even worse. This is important because this bear began with a worsening of credit in mid 2007, and it will end with an improvement in credit at some point.
In that context, you need to know that credit markets suffered four really bad days the week before last, then improved dramatically, and then was pounded again to finish the week, and then finally resulted in the plunge on Monday.
According to independent credit analyst Brian Reynolds, investment grade credit spreads—basically the cost of corporate debt—was back to its worst levels of the year on Friday, and junk spreads were even worse. Investment grade spreads are now where junk spreads were 15 months ago, which is pretty shocking.
A huge part of the problem with credit was an unintended consequence of the bankruptcy of Lehman Brothers earlier in the month. The problem was that the Treasury Department and Fed had led the markets to believe that they would backstop primary dealers when Bear Stearns was rescued in March. The market expected Lehman Brothers to be rescued, and when it wasn’t, it had widespread repercussions. (See also: "Lehman and Wamu in Death Pact.")
The most important effect for our focus now was that Lehman bonds and commercial paper were widely held in money market funds, and the holders of that paper had no idea it was about to be declared worthless. That cost one of the largest money market funds in the country to lose so much money that it "broke the buck," or allowed its net asset value to fall below $1.00.
The fund then quickly lost more than half of its $60 billion in assets—a run on the fund, if you will—and that caused all other money market funds to get the shakes. As reported to you in a daily report, money market funds experienced their largest exit of dollars in history last week.
This is more critical than many realized because money market funds are the largest buyers of a type of short-term corporate financing instrument known as "commercial paper," or CP as its known in the trade. Most brokerages, banks and major corporations finance their business on a day-to-day basis through the issuance of CP, and so I told you that if you want to see a Depression-style event in this country, try cutting off this type of working capital. (See also: "Why the Treasury Hit the ‘Reset’ Button.")
The Silent Killer
Well that is basically what brought down Washington Mutual last week. It couldn’t finance its operations any longer through commercial paper, and with the bank teetering on total disaster the feds rushed in and brokered a rescue by JP Morgan (JPM).
This is also what almost brought Morgan Stanley and Goldman to their knees a week ago. It’s also why General Motors (GM) was forced to draw down its line of credit, which is always a last resort at troubled firms. When the multi-trillion-dollar money markets stop buying CP, it cuts off the air supply to business. Game over.
And that is why one of the key elements of the new bailout program announced by the Fed and Treasury last week includes a virtually limitless supply of federal funds, via nonrecourse loans to money market funds. This type of loan, for those of you who aren’t bankers, is one that basically don’t have to be paid back. It’s a nice deal if you can get it. If the feds had not done this, the nightmare scenarios for last week would have been too hellish to contemplate.
In this context, you can see that something truly needs to be done to provide relief to American businesses via some sort of assistance package. Call it a bailout if you will, and heap scorn on all parties, and curse the bankers’ greed to the heavens, but if you want to see any semblance of our country’s business infrastructure working on Monday you better hope that members of Congress come to a workable agreement, start supplying the money fast, and stave off total disaster.
Debtaholics on Wall Street
I hate the idea of a bailout of Wall Street for all the usual reasons. But one that I have not mentioned forcefully enough is that we are just enabling its bad behavior again. The Street has always been built on borrowing, but leverage in the past 10 years got completely out of control—and now the deleveraging, or "un-borrowing," of money is what is killing company values.
One part of me wants Congress to put the Street into rehab, because otherwise this latest methadone treatment is just going to create the next problem. Seven years from now, we are going to be dealing with another debt crisis, as cheap money now will create another bubble, somewhere, just as sure as I am talking to you today.
The rescue effort is necessary, though, because unless we give foreign investors the confidence to know that we won’t let the credit markets burn to the ground—as we did with Lehman Brothers—then they are going to pull their money from our financial system and country, and it will be very, very ugly—and a thousand times more costly than the price tag discussed in Washington this week. (See also: "How to Play the Wall Street Bailout.")
The Fed and Treasury got us into this mess, no doubt—they under-regulated borrowers, and they made money so cheap that extreme leverage seemed logical. But now they are trying pretty hard to get us out, and we are stuck with depending on them for a solution.
For a crude analogy, think of the Fed and Treasury as a couple of big strong guys you went out drinking with. After a few too many beers and good times, you strongly warned them not to drive but they overpowered you and strapped you in the back seat for the ride home. Going down the highway, they swerved back and forth before finally running off the road and rolling the car. Now you’re in that car together in a ditch, and there’s the smell and sound of gasoline leaking.
Fortunately, the crash has sobered them up. And as much as you hate them for getting you in this mess, you now depend on them to get you of the car before it explodes.
Opportunity From the Ashes
With any luck, our sobered-up government leaders are going to rescue us from an entirely foreseeable predicament that they themselves helped create. One side of me wants them to learn a lesson and suffer, but rationally you have to realize that if they blow up—so will thousands of innocent people, including ourselves. So let’s let them execute the rescue now and worry about punishment later.
At this time we don’t know the full outline of the plan as it will be revived and revised for passage, , but it sounds like it will at minimum reduce risk premiums and slash the many further risks to the economy. In taking bad loans off banks’ books, the plan will create new balance sheet capacity—which means the banks can start making loans again to help businesses expand. It will also help narrow credit spreads, which will make credit cheaper and lead to improved earnings.
Financial institutions should be the greatest beneficiaries of this effort, as they are the ones who will be most relieved of mistakes. And the Fed will steepen the yield curve as well, helping to make the banks’ profit margins as healthy as possible. So it may finally be time, if the plan emerges as expected on Sunday, to look at that group seriously for the first time in two years.
If the credit package emerges this way in Washington, I’m not saying the bear market is over or the recession is over. But as mentioned last week, we could at minimum see a material, tradeable rally that even those with a bearish long-term posture would not want to miss. More on all of this later in the week once we know exactly what is in the plan, and get a better idea of who winners and losers might be. To learn how to money in a rally like that, come check out Trader’s Advantage.
This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.