One thing Wall Street doesn’t like is a surprise. That’s why the biggest ratings firms in the world hire analysts by the thousands, who predict down to the penny what publicly held companies will earn per share each quarter, whether a stock soars or slumps (i.e., by issuing ratings like “Buy,” “Sell,” “Underperform,” etc.), and otherwise provide an objective third-party opinion on a company’s upcoming products or performance.
So, it may not be nice to say, but since a lot of people are thinking it anyway: Wall Street blew it with the banking crisis.
And now they’re in Washington, waiting for Capitol Hill to offer to print up billions in taxpayer dollars to rescue financial giants that were once thought to be “fail-safe,” as now those that are left standing (some, albeit barely) are considered to be “too big to fail” and must be rescued at almost any cost.
SURVIVING THE SMACKDOWN
As traders and, well, big fans of making profits in the equities and options markets, of course we want to see the markets thrive. But for the stock market and the overall economy to stop the bleeding and start healing, what about those who are losing more than just their tax and investment dollars in the grand-scale cleanup of the credit mess?
Many Americans and legislators are asking why the taxpayer should bail out Wall Street types with $700 billion when it is the homeowners who need help. They’re basically saying, “Who cares if a bunch of investment banks and other complex financial institutions mired in complex transactions fail? Let them fail. Let’s take our medicine and get on with life.”
Perhaps that’s why the bailout plan failed to pass Congress in its current form. But with more than 40,000 Wall Street jobs already lost or otherwise on the line before all is said and done, is there really enough that can be done to turn the beat-down around?
WHERE HAS ALL THE MONEY GONE?
To understand the extent of the crisis, we have to know how much leverage we are talking about. This requires that we look at debt both on- and off-balance-sheet. We also have to delve into the nuts and bolts of how American companies fund their daily operations.
America’s total on-balance-sheet debt (i.e., household, business and financial, and government sectors not including unfunded pensions and medical promises) is now at about $53 trillion — the highest debt ratio in history. Eighty percent of the total debt was created since 1990.
That sounds high.
But wait — you haven’t heard anything yet.
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OFF-BALANCE-SHEET DEBT
About 10 years ago, a way to trade put options on debt emerged. This market is called the credit-default-swap (CDS) market.
Originally, it was designed to be an insurance program for lenders. For example, if we loaned Wachovia Bank (WB) $1,000,000, we could go to an insurance company like American International Group (AIG) and pay a premium of about $3,000 a year to protect our principal.
If Wachovia — whose banking operations were just scooped up by Citibank (C) — defaulted, then AIG would pay our $1,000,000 back to us, much in the same way an insurance company will pay you for your lost home if it is destroyed by fire.
In 2005, large hedge funds realized they could buy credit-default swaps for low premiums and, if the companies defaulted, receive large amounts of cash. These hedge funds did not originate a loan and seek to buy insurance; they simply bought a CDS.
Essentially, they had a put on the debt of a company.
If the company did well, the hedge fund would lose its premium paid. If the company did badly, then they would receive a ridiculous amount of money.
Even if the company did not go out of business, the price paid for the debt insurance policy would rise (i.e., the spread would widen) and they could sell their policy (CDS) for a profit.
In spring 2007, institutional investors could pay as little as $3,000 annually to protect $1,000,000 worth of Lehman Brothers (LEHMQ) debt. What a great investment when Lehman collapsed! Yet, what a problem for those companies who underwrote those insurance policies (CDS) on LEH!
A decade ago, the CDS market was about $1 trillion. Today, it is about $72 trillion in notional dollars (although there is some double-counting and other complexities). It is all off-balance-sheet. It is not regulated. It is much bigger than the total debt load of the United States that is on-balance-sheet.
For comparisons’ sake, the market capitalization of all publicly traded companies in the world is slightly less than $50 trillion.
NUTS AND BOLTS
American companies — run-of-the-mill, S&P 500 (SPX) non-financial-sector companies — use short-term debt to fund their daily operations. This debt typically carries terms of 90 days or less.
This short-term debt (i.e., working capital to fund operating activities) comes from money-market funds. Money-market funds have been able to offer investors slightly higher yields than Treasuries because they primarily buy short-term corporate debt.
Because the companies are large, have been around for years and the debt is short-term, money markets have been considered very safe.
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WHOSE FAULT ARE THE DEFAULTS?
The condition of the credit market was worse on Friday (Sept. 26) than it was the previous Thursday (Sept. 18 — pre-bailout). And that was before we saw the Dow Industrials (DJI) lose 6% with their 777-point drop after the bailout package failed to pass Congress.
If the S&P 500 were to trade in-line with the credit markets, it would be trading between 900 and 990 today. This is based on the current yield on corporate debt versus the current earnings yield on stocks (the inverse of the price-to-earnings ratio).
In any event, fear of default is running high in the credit markets. About two weeks ago, the U.S. government made a bet. It decided to let Lehman Brothers go out of business without government interference.
The lenders to Lehman, including money-market funds, got hammered on their Lehman debt holdings. Since then, about a half-trillion dollars have been pulled out of money-market funds and put into short-term Treasuries.
With money market accounts losing funds at such a rapid rate, U.S. corporations are finding it increasingly difficult to fund their short-term capital needs.
When a financial bailout package, we will very closely monitor the credit market to see if there is a credit pricing recovery. If not, this could be a powerful leading indicator for equities and very worrisome for equities.
