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No Credit for Financials, Part 2


And the stock market will be next.


This is the second installment in a 2-part series. Part 1 can be found here.

The Credit Market: Has the Door Shut on Financials?

Over the years, I've written extensively about the historic build-up of credit. Now, we're at Zero Hour: Credit builds, the economy slows, the ability to finance debt ends and debt creation ceases to have a positive impact on the real economy.

While I thought this day would come, I admit that it came a bit faster than I was expecting.

Financial entities like banks, broker/dealers, regional banks, finance companies and insurance companies need credit at reasonable rates in order to finance themselves. I've been concerned for many years that the door to raise new capital in debt markets would finally shut on banks, brokers and others.

For many regional banks like KeyCorp (KEY), Zions (ZION), Regions (RF) and National City (NCC), the door is already shut; if they wanted to raise capital in the debt market at the levels at which their outstanding issues regularly trade, they would have to pay 12 to 15% - hardly economic levels. GM (GM) bonds trade near 27% yields. Washington Mutual (WMU) trades north of 15%.

Then there are the "good banks," like JPMorgan (JPM) and Wells Fargo (WFC). JPMorgan recently sold $600 million of preferred stock at 8.75%; Wells Fargo sold $1.3 billion at 8 5/8%, plus underwriting fees.

Below, I offer up a few guesses as to what other issuers would have to pay to issue preferred stock.

  • Lehman Brothers (LEH): 11-13%
  • Merrill Lynch (MER): 11-12%
  • Morgan Stanley (MS): 9-10%
  • Citigroup (C): 9.5-10.5%
  • CIT Group (CIT): 12-15%
  • Fannie Mae (FNM)/Freddie Mac (FRE):15%
  • Keycorp: 11-13%
  • National City: 13-15%
  • Wachovia (WB): 10-12%
  • Zions: 13-15%
  • GM/GMAC: Not possible.
  • Washington Mutual: Not possible.
  • Ford (F): Not possible.

None of the aforementioned interest rates seem terribly appealing to me, so I guess you can say that the market is officially closed for many.

Consider: Citi brought a 5-year corporate debt deal to market at 3 3/8% above Treasuries, the highest ever for Citi, which was nearly 1% cheaper than their outstanding bonds were trading that morning. AIG (AIG)sold $3.25 billion in 10-year notes 4.33% above Treasuries, or 8.25%, compared with $2.5 billion sold in December at 1.8% above Treasuries.

So even those who can get deals done are selling at desperate levels. Why? Because they're well aware that they must raise capital while they can.

Shareholders like those at Merrill Lynch can only withstand a certain amount of dilutive pain via extraordinary issuance of new stock, because debt is so expensive. American Express (AXP) debt is 4.25% above Treasuries, 62% more than similar debt 3 short months ago.

As you can see, my worst fear is upon us: The door on credit may already be closed for financial companies.

Many who haven't witnessed a credit crisis have asked me if this sort of occurrence is extraordinary. My answer is usually "no." In fact, considering the magnitude of the issues we're facing, the markets are actually performing much more rationally than I would have expected, at least for now.

I'm certain that the markets have a bit more of a bid to them due to frequent rule changes by the Federal Reserve, Treasury Department and SEC, as they desperately try to help beleaguered institutions. But in the end, it only slows the problem down - it doesn't stop it altogether.

What I'd like to point out, however, is that this is one of only a few times that corporate bond yields have risen so quickly as the Fed eases (other periods include the 1930s, the mid-1970s and the early 1990s), as you can see in the chart below.

Click to enlarge

What Does the Credit Market See that the Equity Market Doesn't See?

Many days, I feel that, even if you'd given me tomorrow's economic headlines a day in advance, the stock market would still do something contrary to what I would've been positioned for. Mind you, I don't feel all warm and fuzzy admitting this fact, but there's been a random tone to equities of late, particularly sectors and commodities.

Last Thursday morning, I came in to work positioned for a hotter-than-expected CPI report and a very weak unemployment report. My firm got both right - really right. One would think that stocks -- particularly retailers and anything in the 'consumer discretionary" area -- would get hammered, but instead they rallied fiercely.

Is this a function of being short the consumer - a "crowded trade"? Most likely, but it makes one wonder how S&P futures magically rally on bad economic news.

In fact, it seems like the worse the news, the stronger the rally. I'll leave it to "conspiracy theorists" as to why this is happening, but markets do eventually find the "right" level. In Atlantic's case, we believe it's 30 to 50% below current levels.

I have already written about CPI statistics, but the employment picture's downright horrible. As they say, "It's a recession when your neighbor loses his job; it's a depression when you lose yours."

Initial claims for unemployment have now soared to an average of nearly 425,000 per week (a very recession-like number); continuing claims for unemployment has increased by nearly 300,000 in just 3 months time. This is not what the doctor ordered, and it adds to my cautious view.

Click to enlarge

Earlier on, I said I believed the stock market was the riskiest I'd seen in my career - certainly an understatement, of sorts. Given the evidence I've detailed here (credit markets, inflation, debt, unemployment, etc.), one would think that stocks should be "on sale." In historical terms, "on sale" means in the neighborhood of 10 to 12 times earnings.

Let's assume for a moment that the pie-eyed Wall Street strategists are correct in their $85 assumption for the S&P 500 in 2008. If they were correct, and stocks traded cheaply due to existing risk, we could look for 850 to 1000 on the S&P, rather than the 1300 level seen as of Friday's close.

Now, let's consider where stocks would trade if we used the actual earnings number of roughly $50 per share; we currently trade at north of 26 times earnings.

I know that I must respect the tape, and I know that the reaction to the news is more important than the news itself, but it's hard to pay 26 times earnings for what we're buying. Let's give the market and economy the benefit of the doubt and assume that we're looking at trough earnings. These should trade at 15 to 17 times earnings, which yields 750 to 850.

So it's hard for me to be bullish, though I'm still not stubbornly bearish - just cautiously positioned with limited downside risk. Better safe than sorry.

Click to enlarge

One last item before I close: The VIX (the Chicago Board Options Exchange SPX Volatility Index, a measure of future risk) has been at lows since the credit crisis began last year. I find this fascinating, and my firm is taking advantage of this, purchasing market volatility while it's cheap. Something tells me that when we get to the "recognition" phase of this market cycle, the VIX will be much, much higher.

Click to enlarge

As I sit and wait for Tropical Storm Fay (likely to be Hurricane Fay by the time it arrives here in Florida), I keep thinking back to a piece I wrote called Credit Crisis, Part 2. There, I referred to a hurricane scenario, in which we're hit with the first wave, followed by a bit of a lull; then comes the full-fledged frontal assault.

The credit market, to be sure, has dramatically worsened since that time. As I've stated, it's ceased to function normally in the financial space. I now think it's the stock market's turn.

When will be "there"? When everyone stops asking if we're there yet.

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No positions in stocks mentioned.

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