Tuesday, September 11, 2007

Liquidity Crisis - A Little Reflection Gives Compelling Answers - Impending Stock Market Crash - Real Estate Bubble has Burst

The media shouts of a liquidity crisis and the financial markets are in turmoil, the terrible words recession and depression are being uttered by many and people are drawing upon similarities between 2007 and the former stock market collapses of 1987, 1929 and the recessions of the early 1930's, 1970’s, 1990's, 2000's . The question is how much do you really know and what do you need a know to make a considered opinion and protect yourself?

Historical Crashes & Depression/ Recession

Black Monday, October 19th 1987, came at the end of two record years where leveraged buyouts, mergers and acquisitions financed by junk bonds (In leveraged buyouts, a company would raise massive amounts of capital by selling junk bonds to the public. Junk bonds are simply bonds that have a high risk of loss, so they pay a high interest rate. The money raised by selling junk bonds, would go towards the purchase of the desired company.) drove the market to an artificial and unstable high. The Dow lost 22.6% of its value or $500 billion dollars, equivalent to more than 2000 points today.

The savior was Alan Greenspan who started to slash interest rates, inject money and renew consumer confidence. Thus the market was completely recovered within 12 months and on its way to new highs.

The great depression 1929 - You have to love October, the 29 crash was on the 28th and 29th when the market went from 400 to 145 and some $5bn was lost.

Charting the two great crashes shows an alarmingly similar picture with very similar profiles including the increased artificial liquidity, utilization of Margin in one Futures in the other to provide accentuated leverage and the need to a sharp correction to re correlate the market to true value.

Whatever scale one chooses to use the similarities are hard to deny

A recession occurs when GDP (Gross Domestic Product) falls for 2 or 3 consecutive quarters, illustrating that the economy is not growing as it should. Redundancy and job cuts as well as burgeoning debt are commonly associated with such times. Recessions often follow market corrections.

It is interesting to compare and contrast the recession of the 1930’s with that of the early 2000’s – had we not had the real estate bubble growing out of Fed Easing, who knows what the outcome would have been!

Current Market Value vs Prior times

This is one of the most important factors to understand when looking at current market volatility. Due to the incredible and unprecedented rise in market value (nearly 16000 in its high of 2007) there is an equal and equivalent rise and fall in daily trading range, thus a 200 point rise is equal too a 20 point rise when the market was at 1600. That is what makes the chart below so scary!!!

What’s happening now?

Countrywide Countrywide Financial (CFC) is being blamed by many as some corporate evil at the center of this crisis, but they are merely a scapegoat and one of the larger more visible symbols that people can vilify. Whilst their Chairman would seem to be profiteering and cashing out share options as fast as they can be written (over $100m in the last 12 month) it is not their "fault" that they are laying off thousands of employees to avoid bankruptcy CMO’s, QIV, SIV's, Conduits, Securitization and Private Equity.

The essence of success in business and trading is to buy or make something and sell it for more. To do this successfully initial capital is required. The best source of capital (liquidity) is to borrow someone else’s money and pay them less to borrow it than you can make by using it. Then your internal rate of return, the amount of money you make on the money you invested personally is magnified exponentially. The same is true of Margin within stock investing.

CMO’s (Collateralized Mortgage Obligation) MBS's (Mortgage Backed Security) are the method in which banks lend money to someone to buy a property, then to free up the money they invested so they can invest it again and make more money, they sell it on bundle as a CMO or MBS.

QIV (Qualified Investment Vehicle), SIV's (Structured Investment Vehicles), special purpose entity (SPE) while you may not have heard of these yet, you will be, this is as method for a bank/ company to transfer debt off its balance sheet. When reporting to shareholders, or borrowing money a bank or company wants to have the maximum number of assets and the least amount of liability. By moving liability into these off balance sheet entities their listed/ published balance sheet looks better (This is how 10’s if not 100’s of Billions in debt have been hidden from the public eye)

When defaults start to occur in this arena as they already are, credibility will be reduced and investors will panic and people will sell their investments to avoid loosing them! As in 1929, 1987, 2000 if there are not enough buyers prices will drop to bargain basement levels where astute investors will swoop in and sweep up cheap stocks.

The Federal Reserve

This is one of the most critical influences on the economy right now, which is why everyone watch Ben S. Bernanke comments so closely.

Alan Greenspan believed that consumer and investor confidence were to be boosted or at least supported at all times and many decisions seemed to focus on this. However Greenspan made some drastic mistakes, in 2001 – 2003 he cut interest rates so low that he created the real estate bubble.

What Was The Real Estate Bubble

Savy investors were able to sit back and watch the real estate bubble happen, capitalizing on less experienced individuals who worked out how much they could afford to borrow at “current” interest rates with no eye to the future and what they would do if they were to rise factoring in capital appreciation into their calculations. (the old saying of past performance is no indication of future performance!!!!!!)

Furthermore the teaser rates offered on loans to allow people to buy ever increasingly expensive real estate were inevitably due to reset and brokers were able to glibly assure people that they could just refinance closer to the time and not too worry about it!!!

Well unfortunately teaser rates and sub 5% mortgages are gone for now and people have to pay “very real” interest on their mortgages. The truth is that at some point we have to endure a correction and reach a bottom, to cut rates heavily to save the consumer will merely put off the same event till some time in the future and whilst it is sad to say, that is not truly in anyones best interests!!!

The Government

Whilst this is a somewhat more contentious subject it is not one that can easily be avoided. More money has been printed during the 8 years of George W Bush’s presidency than under all other presidents combined. Trade deficits are at their worst levels ever, the dollar is exceptionally weak and many central banks are moving more assets into Euro’s as a result. This does not bode well for the economy.

Furthermore in times of recession, a war is “sometimes” entered into by the US government driving substantial military spending and diverting attention overseas. This isn’t really an option as the USA is already essentially at war still in Iraq. It is rumored that the war gas been so expensive to date that the military will have to scrap or put on hold the F35-JSF (Joint Strike Fighter) project for lack of budget. That could potentially although not significantly impact America’s global military dominance.

How to Capitalize on this Information????

So September is the only month in the year that statistically shows losses! Meanwhile October is the month of Crashes!!!

Real Estate

1) The real estate bubble is bursting, expect to see significant price decreases and increased foreclosure over the next several years (unlike the stock market an adjustment cannot happen overnight).

+ Prices will decline throughout 2008 and into 2009 leaving great buying opportunities for those with Cash in late 08 early 09. Don’t buy for capital appreciation as it won’t happen till the beginning if not middle of the next decade at the earliest! (2010-2012)

2) Expect to see the commercial market decline 10-15% over then next year to two years as leverage is reduced and people will be unable to finance acquisitions

3) Expect to see more mortgage originators file for bankruptcy (possibly even Countrywide to clear off some debts) The Chairman has sold $10-100’s millions in options over the last 12 months (you would expect him to buy stock with the proceeds due to the bargain basement prices – preferred stock (issued at $25) reach mid $9 range during August

4) Expect to see at least 1 major home builder file for Bankruptcy


1) Don’t be surprised to see a bank failure or something close spark the next stock market crash, QIV may well be the cause of financial illiquidity of a medium sized banking institution

2) Whilst people are stating that Credit Card Companies are being unfairly hit as they do not hold any sub prime mortgage assets, do not be surprised to see credit default rates rising from 3% upto around 6%. When you have lost your home and your credit is not looking good, why not write off those pesky credit cards of $10,20 or even 30k+ at the same time.

3) Writing covered calls and selling puts on any open long positions seems like a great hedging strategy

4) Staples and super solid stocks – as those chosen by the like of Warren Buffet make for great long term holds as do any stocks that take an unfair beating

5) Most of all sit on the sidelines and play out September and October ready to capitalize in December.

"Plan for the Worst Case Scenario and Be Happy when the Best Case Occurs" - Jonathan Rose

You asking what all this means, for a prediction. Whilst one cannot foretell exactly and the markets have been known to do the unexpected, i am predicting a 500+ (probably 1-2,000 point drop) towards the end of October...caused by a liquidity short fall by a major bank, Countrywide becoming insolvent (or admitting it is) a major house builder filing for bankruptcy or someone finding out that the banks are carrying in excess of $250Bn of off balance sheet debt that they need to do something about and can't!!!

Don't say I didn't warn you!!!!

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