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Jeff Saut: "Sgt. Pepper's..."


The worry here is that the collateral crunch spills over into a credit crunch.


Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"It was 20 years ago today, Sgt. Pepper taught the band to play..."

Except in this case it was 20 years ago last Saturday that the D-J Industrial Average (DJIA) peaked at 2722.42 and started a decline that would culminate with the infamous 23% price crash on October 19, 1987. I mention this today not because I am expecting another crash, but because I have been discussing my day-count sequence for the past 26 sessions. As stated, "Once a selling, or buying, stampede begins, they tend to last 17-25 sessions only interrupted by 1½-3 day pauses/corrections before they exhaust themselves." While a few stampedes have lasted 25-30 sessions, it is rare to have one extend for more than 30 sessions. In fact, the longest such stampede I have chronicled was the 38-session upside move into the August 25, 1987, parabolic peak.

Fast forward to 2007, where I began my "selling stampede" day-count sequence on July 20 and proffered that said stampede ended on Thursday, August 16. Clearly the setup for a trading price-low was right, following a 20-session Dow Dive that lopped 10.6% off of the senior index.

Moreover, the downside finale seemed climactic enough with a 750-point, 2½-day panic plunge accompanied with some of the worst "finger-to-wallet" readings seen since the Long-Term Capital Management Crisis. Consequently, if this was the typical selling-stampede, we saw the low on August 16. However, on the off chance that we might still be in a selling skein, I have continued my day-count with today being day 27. So, how did we get here?

For the Benefit of Mr. Kite

For the benefit of Mr. Kite, and Ms. Kite, following the tech bubble bust and the September 11 tragedy the Fed slashed interest rates to generational lows, figuring that low rates would bolster housing and consumer spending until business investment could recover. And boy, did that strategy work as real estate took off on a binge that would make even a drunken sailor blush.

As home prices rose, the financial community found increasingly fancy ways to extend the boom with vehicles like 110% no-doc mortgages, interest only loans, 2/28 subprime loans, etc. Further enhancing the financial wizardry was the ability to "securitize" these loans, which shifted the default risk from the lenders to investors. The only problem was that these "securitized" financial vehicles became so complex that most investors didn't really understand what they owned. As Barak Laks of Alpha Beta Capital, remarked, "To price one of these things correctly [it] takes a week with a smart person, and they have to mark thousands of them. The manpower [just] isn't available."

She's Leaving Home

At first the delinquency rate on these loans was low. The rating agencies, therefore, rated the securitized tranches favorably. Lured by rising home/condo prices and easy financing, the bubble grew to where, at its peak in mid-2005, there was only a three-month supply of homes available here on the west coast of Florida at the then-prevailing selling rate.

However, as Herb Stein once remarked, "If something can't go on forever it won't," and as real estate prices peaked the supply of homes rose. We now have roughly a 27-month supply of homes, and prices have fallen to the point where many of the owners are "upside down," causing mortgage default rates to rise. Consequently, "she's leaving home.... bye, bye."

Fixing a Hole

"I'm fixing a hole where the rain gets in... except the hole is now getting bigger and bigger."

Indeed, with a bloated supply and falling home prices, the S&P rating folks have even admitted that the Residential Mortgage-Backed Securities (RMBS) losses are "going to be far in excess of what we had originally predicted and even well out of what Street research is telling us." Currently, the size of the problem is unknowable, but it is anything but contained and has leached over into the commercial paper market.

Interestingly, it is believed that more than 50% of the $2 trln commercial paper market consists of asset-backed securities. Moreover, as the Wall Street Journal wrote on August 7:

"Investors were so many steps removed from the original loans that it became hard for them to know the true value and risk of securities they bought. Some were satisfied with a triple-A rating on a CDO (Collateralized Debt Obligation) – seemingly as safe as a U.S. Treasury bond but with more yield. Yet as default rates ate through the cushion of lower-rated tranches with unexpected speed, rating agencies were forced to rethink their models – and lower the ratings on many of these investments."

The result was the various markets had no idea how to value many of these financial vehicles so the "bids" disappeared. As confidence waned, concerns about counterparty risks swirled and holders of certain kinds of commercial paper refused to roll it over. It wasn't so much a liquidity crisis, but rather a collateral crisis. With a seizure in the financing mechanism, the Fed was forced to act.

I Get By With a Little Help from My Friends

With the seizure of all markets ranging from money market funds to distressed debt, the banks began shutting down their lending operations and that was when the Federal Reserve was forced to act. As the astute GaveKal organization notes:

"Indeed, while the central bank does not need to care if speculative buyers of real estate in San Diego get taken to the cleaners, it needs to respond when the market for commercial paper just freezes up. And central banks did come out with (nearly) all guns blazing:

a) The ECB dumped more money into the system than it did after 9/11.
b) The Fed cut the discount rate and encouraged the four biggest banks in the US to borrow $500 mln each from the discount window on Friday.
c) In addition, for Citigroup and BofA, the Fed temporarily waived limits on the amount of capital they could lend to their broker-dealer subsidiaries.
d) The Fed also decided to consider asset-backed commercial papers (ABCPs) as collateral for central bank loans.
e) The Fed basically changed the rules of the game and threw what remained of the Glass-Steagall Act out of the window by allowing banks to use the cash acquired at the discount window to fund their investment banking arms. Paired with removing the stigma attached to borrowing from the discount window, this last policy move could mark a very important change for the Fed (much more significant in the long-run than a few token US $500 mln to the biggest banks)."

Getting Better All the Time

So far, the Fed's strategy has worked. The rumor of a Fed rate cut leaked out mid-session on Thursday August 16, with the DJIA sporting a 343-point intraday decline, and caused a sharp rally that left the senior index off only 15 points by the closing bell. The next day the Fed indeed cut the discount rate. While underlying concerns have not yet faded by all that much, the commercial paper market appears to have stabilized and the DJIA has gained some 850 points from the recent lows. Consequently, as stated, if this was a typical selling stampede, we likely have seen the low.

A Day in the Life

While things have gotten better, it is worth remembering that "bottoms" are a process and tend to take time.

In both the 1990 and 1998 selling stampedes, the markets peaked in July, but bottomed after a number of downside tests, and retests, in the September/October timeframe. The risk here is that the contagion continues to spread from the financial community to the consumer. We can already see some of the "spillage" with the mortgage industry laying off over 40,000 workers, London home buyers delaying purchases, credit card companies raising interest rates to certain clients, grace periods shortening, and the list goes on. I think the situation will become clearer over the next 60-90 days, which fits with the September/October timeframe.

Consistent with this, I am taking my time and slowly recommitting some of the money that was freed up from my rebalancing efforts over the first seven months of the year. My stock universe of choice remains the large cap, defensive names preferably with a yield.

The call for this week: The worry here is that the collateral crunch spills over into a credit crunch.

Consequently, what we need is stability in the housing, commercial paper and the equity markets over the next 60-90 days to complete the bottoming process. And other than that, I've "got nothing to say but it's O.K. ... good morning, good morning, good morning".

* With all due credit to The Beatles for their timely lyrics, and apologies for my inability to carry a tune.

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