We had reaffirmed last week that stocks were in a confirmed bear market. We also categorically stated that a pullback rally within the larger downtrend was overdue and should be used solely to lighten up on long-only exposures. Stocks played to script this week notching up modest gains despite heightened volatility that usually accompanies an options expiration week. Stocks gained sharply mid-week following Warren Buffett's bailout plan for the monolines and a narrower-than-expected trade deficit. But comments from Ben Bernanke and a remarkably weak consumer sentiment survey spoiled the party. The front-line indexes closed out the week with a respectable 0.5%-1.5% gain. Most indexes witnessed an 'inside week', that is in keeping with the idea of a consolidation after recent steep losses.
While our call for a rebound in global equities seems to be coming true (Asian equities managed their first weekly gain in 2008), the outlook remains largely unchanged. We view the current rebound as a mere pullback within a longer downtrend. A major sell signal on longer time frames (weekly, monthly and quarterly charts) spread across global indexes and across multiple sectors suggests tougher times ahead for equities. 1400 levels on the S&P 500 will continue to be a formidable resistance in this pullback.
We review the major economic headline this week - a drastic shift in consumer sentiment over the past few weeks that makes a recession now appear increasingly plausible. Although the Fed has dropped is benchmark Fed funds rate by 225 basis points in six months, it has had only limited success in bringing borrowing costs down for consumers and borrowers. Nevertheless, the market believes this failure is the very reason why the Fed will further reduce rates. This negative feedback loop has the Fed pushing on a string in vain. Further, the complete freeze in the relatively obscure auction-rate bond market is the latest shoe to drop in the sub-prime contagion that has now spread world-wide. We finally wrap up with Warren Buffett's keen sense of timing, that could potentially strike gold for Berkshire Hathaway amidst a pile of toxic waste.
The Gloom Is Spreading
The University of Michigan's consumer sentiment index tumbled to 69.6 in its preliminary February reading from 78.4 last month, marking its lowest point since February 1992 when the economy was emerging from a recession. The component of the index that gauges consumers' expectations - a possible sign of their willingness to spend - dropped to to 59.4 from 68.1.
As noted in the chart above, the dip in consumer sentiment is startling. Consumer confidence is now even below the lows seen in 2001-2002 recession and close to its worst levels since the early 1990s, when unemployment rate was up over 7%.
The New York Fed's 'Empire State' index, a widely tracked gauge of manufacturing growth fell for the fourth consecutive month in February to its weakest level since April 2003. The general business conditions index slipped alarmingly to minus 11.72 in February from plus 9.03 the previous month, the first negative reading in almost two years. Readings below zero signal contraction.
These reports are not isolated. Best Buy, the largest U.S. consumer electronics chain, cut its full-year revenue and earnings forecast this week driven by what it termed 'soft domestic customer traffic in January... and weak near-term outlook'. The ABC News/Washington Post Consumer Comfort Index fell to its lowest reading since November 1993. Fewer than half of Americans surveyed rated their own finances positively, again a first since 1993. The Economic Cycle Research Institute [ECRI], a New-York based independent forecasting group, noted that its Weekly Leading Index skidded down to an annualized growth rate of minus 9.1 percent for the week ended February 8, its lowest reading since November 2001.
The evidence favoring a recession is mounting. Economic growth screeched to a 0.6 percent stall in the fourth quarter. A quarterly survey issued by the Philadelphia Federal Reserve suggested a 47 percent probability of contraction in GDP this quarter and a 43 percent chance in the second quarter, levels not seen since the recession in 2001. Economists surveyed by Bloomberg and WSJ earlier this month forecast even odds of a recession. A contracting labor market (payrolls declined for the first time in four years in January) and sharp weakness across the services sector that accounts for 85-90% of the economy (ISM non-manufacturing index fell off a cliff to its lowest since 9/11 ) amplify the chances of the economy turning over into a recession this quarter. The housing slump has only accelerated further over the past few months. Builders broke ground at an annual rate of just over a million homes in December, the fewest since 1991. The National Association of Realtors estimates sales of existing homes fell more than forecast in December, while prices of single-family homes posted the biggest annual drop probably since the Great Depression.
Corporate earnings are also taking a hit. Bloomberg data suggest that the S&P 500 companies that have reported 4Q 2007 earnings thus far posted an average 15 percent decline in earnings. The outlook for the first two quarters of the year is not much better either, with analysts expecting a 1.4 percent and 0.7 percent decline in earnings. The only bastion of hope is the rise in exports, driven by sustained weakness in the dollar and more resilient economic growth abroad. US trade deficit shrunk 6.2 percent to $711.6 billion in 2007 from its record set in 2006, the largest annual percentage drop since 1991 and its first decline in six years. But as global growth falters, partly weighed down by the slowdown in the US, it remains to be seen if there would be enough takers for US exports going forward.
The gloom has spread steadily over the past few months, with the odds of a recession rising as economic data has turned nastier. Former Federal Reserve Chairman Alan Greenspan now believes that the economy is "clearly on the edge", putting the odds of an economic contraction at "50 percent or better", up from his guesstimate of a one-in-three chance just a few months ago. His successor, Ben Bernanke, asserted in a Congressional testimony that policy makers were prepared to lower rates further as the economy hurtles in its downward spiral, vowing to provide "adequate insurance against downside risks." He essentially said, as nearly as a Fed Chairman can, that we were indeed headed towards a recession. The telling statement: "More-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth." This sense of caution, despite the "substantive additional action" of a 125 bps rate cutting blitzkrieg in January - the fastest pace of monetary policy easing in over two decades - will only serve to heighten anxiety in the minds of market participants.
History has taught us that economies do not normally slip gradually into recession; they plunge spectacularly as they turn over. This usually creates glaring discontinuities in the incoming economic data, of the sort clearly on display in the survey reports of the past few weeks. A degree of panic seems to have set in that could possibly tip the scales in a stalling economy, pushing it into a free fall.
Pushing On A String
Let's recall that statement from Bernanke again... "more-expensive or less-available credit seems likely to continue to be a source of restraint on economic growth" We know where this is coming from, with the Fed having cut the Fed funds rate by 225 basis points in six months. But deteriorating credit conditions have undone pretty much most of what the Fed has done. The yield on Baa corporate bonds – a better measure of what drives actual business spending than the Fed funds target rate - has stayed largely constant, widening its spread over the Fed funds rate.
Data compiled by Merrill Lynch suggests that companies are paying more to borrow now than before the aggressive Fed rate cuts in January. Rates on so-called jumbo mortgages – mortgages with a value of over $417,000 and those not guaranteed by Fannie Mae and Freddie Mac - have increased in the past month, according to Bloomberg. Lenders and investors alike are demanding greater compensation for offering credit as losses continue to mount on sub-prime mortgage securities amid concerns of a cut in credit ratings of bond insurers. The increase in credit spreads has contrarily resulted in an effective tightening of financial conditions that the rate cuts were partly meant to address. It is as if the Fed were pushing on a string. The market perceives elevated borrowing costs will force the Fed to make further rate cuts, thereby reinforcing the "negative feedback loop" that has been in vogue all through this crisis. Traders now place a 100% chance of at least a 50 bps rate cut on or before the FOMC meeting on March 18.
A crisis that began with loans made to a small group of home-buyers with shaky credit has disrupted pretty much the entire financial ecosphere. Indeed, small towns in far-flung Norway have lost money due to the sub-prime contagion in the US. It has proved to be much more than a credit crunch... it has become a crisis of confidence.
Crisis Of Confidence
Another shoe dropped this week in this saga with the state of Michigan suspending a major student-loan program led by the sudden collapse of the estimated $300 billion auction-rate securities market. Auction-rate securities are another one of those complicated securities that seemed to offer something in return for nothing. They are long-term securities that unusually behave like short-term bonds. The securities purportedly offered borrowers, typically tax-exempt local governmental or quasi-governmental authorities – a school district, hospital district or a municipality - a method to borrow long term without paying the relatively higher interest rates that investors usually demand to lend long term. This was achieved by the covenants of the bond that required securities to be auctioned every 7, 28 or 35 days. Investors (typically short term money market funds) did not mind this at all because they got an asset that seemed as good as cash - investors wanting to cash out their bonds could sell it back to the investment banks who subsequently sold it to newer investors – and yielded higher than bank deposits.
Because the borrowers bought insurance from monoline insurance companies that then imparted an investment grade rating to the bonds, investors simply looked at the rating and made their decision. In theory, the market was always running the risk of auctions failing for lack of enough willing buyers... but that possibility seemed very remote. Issuers also ran the risk of invoking the covenant penalty clause that compensated the buyer for the lack of liquidity - if an auction failed, the interest rate that the borrower had to pay jumped up. But since the possibility of the market failing seemed so remote, borrowers continued to pile on the market.
Circa credit crunch 2007. What seemed remote is now reality. With the sub-prime genie out of the box, the creditworthiness of monolines is in serious doubt. Ambac (ABK), MBIA (MBI), FGIC and other monolines have been downgraded by rating agencies and face an imminent danger of having their ratings cut. A rating cut would be akin to a death knell for these monolines. Without their ratings, they would have nothing left to sell.
Also, it is a big big problem for those who bought into those ratings. With not enough buyers to take all the paper that was insured by these monoliners, markets are failing. Investment banks are being forced to take that paper that they helped to sell. Investors' confidence in the financial order seems shaken. Investors no longer trust assurances given to them, having already witnessed what happened to those naive enough to believe that their sub-prime filled toxic waste was safe. A loss of faith and confidence can quickly become a self-fulfilling prophecy. New investors will refrain from parking their money in these auction-rate securities knowing very well that they are not as good as cash, making these securities appear to be even worse investments.
In the last few weeks, a series of auctions have failed, leaving investors stuck with illiquid securities and borrowers facing hefty penalty rates. Fathom this. The Port Authority of New Jersey, which had a failed auction of $100 million last week, saw their interest rates leap from around 4% to 20%! Quick back of the envelope math... that's an extra $300,000 per week. The collapse of this market does not reflect any new problem with the borrowers; the Port Authority is as financial sound today as it was a fortnight ago. Instead this reflects the latest shoe to drop in the broader credit contagion. There are many other bonds from solid issuers that are quoting at over a 10-15% yield, up from 4-5% just a few days ago. Less than 1% of tax-exempt bonds actually default. Most of these are good-quality issuers (some even sovereign), yet the interest rates are higher than CCC junk bonds.
This has obviously put pressure on politicians to act. Eliot Spitzer, the Governor of New York, threatened monolines this week, giving them three to five days to find sufficient capital to resolve the crisis. Or else the state steps in and takes charge. It is in this context that Warren Buffett's offer to take over $800 billion worth of municipal bonds from the monolines seems like a masterstroke.
Buffett's Alchemy
This week, Warren Buffett offered to take over $800 billion worth of the tax-exempt insurance business guaranteed by the troubled big three monolines - MBIA, Ambac and FGIC. Buffett's Berkshire Hathaway Inc. would assume the risk of this debt in exchange for a hefty fee. The offer would exclude the bond insurers' sub-prime related obligations that caused over $5 billion in losses last quarter. According to JP Morgan estimates, a total of $2.4 trillion of debt is insured by the bond insurers, with potential losses ballooning up to $41 billion if the value of this debt continues to decline.
The offer seems like a non-starter at first glance. If the monolines were to actually agree to this deal, they would be ceding the book of business where there is value currently - the fattest, most profitable part of their business - giving up all the unearned premiums on the municipal bonds that they have insured. It would leave them with all the toxic waste from the various structured vehicles insured by them.
The looming prospect of major bond insurers losing their AAA credit rating has dominated the attention of the credit markets, as indeed the stock markets. Until this issue is resolved, states and municipalities will find it tougher and more expensive to borrow. In January, states and localities sold barely $20 billion in bonds, the lowest total for a month in two years, as issuers large and small postponed sales until there was more clarity on the insurers' health. Those municipalities that managed to sell debt are paying more to borrow. Since the middle of January, the yield on the Bond Buyer 20 General Obligation Bond Yield Index has climbed almost 20 basis points, from 4.15 percent to 4.33 percent.
It is important to realize that there are other larger issues at stake as well. If Buffett succeeds, investment banks who are counting on the cash flows from the monoline municipal bond business to offset burgeoning toxic waste losses, would likely get nothing at all. They would thus surely look to step in and recapitalize the insurers, which although expensive, would be less than the losses they stand to incur if the monolines fail. UBS estimates that investment banks around the world could have to write off another $203 billion if the monolines go upside down, in addition to the $150 odd billions already lost.
There are other proposed alternatives. One idea is to break up the monolines into two parts - the good part that holds the tax-exempt insurance business cash cow, and the bad part that gets dumped with all the sub-prime and structured vehicle nonsense. FGIC apparently plans to do just that, having requested the New York state insurance regulators for a license to create a standalone municipal company. The other is for the insurers to raise some capital on their own, albeit a difficult task in partially frozen credit markets. Some even suggest that the government should get involved in order to prevent a major systemic crisis.
In this context, Buffett's proposal would be a win-win situation for Berkshire Hathaway as well as municipal bondholders... though certainly not for the bond insurers and possibly even the investment banks. Having said that, the regulators and the politicians would love to see this happen. Berkshire is one of the few companies with an impeccable AAA rating and it can easily take on the mantle of insuring the pile of debt, allowing issuers to lower their borrowing costs. At the very least, this move could potentially remove some of the systemic risk ("solve the crisis in one stroke of a pen" - Buffett). To us, it seems like a brilliant move in a developing end-game that could checkmate the monolines into giving up the attractive municipal insurance business ("high return, low risk" - Buffett) that Buffett covets so much. He would probably do a much better job of running it in any case. For Berkshire Hathaway and its share-holders, Buffett could just be the alchemist who managed to turn toxic waste laden garbage into gold!
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