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Jeff Saut: Let the Markets Straighten Out, Fly Right


Credit spreads haven't narrowed in months.

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.

"Somebody's got some splain'n to do!"

- Ricky Ricardo

What a mess! I can't shake the image of Ben Bernanke and Hank Paulson running up and down the dike sticking their fingers into holes only to see another one appear. Over the weekend the Dynamic Duo tried to plug a couple more holes, namely Freddie Mac (FRE) and Fannie Mae (FNM), but as in the story of the little Dutch boy, I'm not so sure other "holes" aren't going to appear.

At the time of this writing, the rescue plan had not been revealed, but newspapers suggest the two companies will be placed into conservatorship, their boards will be replaced, there will be a capital infusion from the government and the companies' $1.6 trillion in debt will be explicitly backed by the US Treasury (as of this morning this appears to be what has indeed happened). What is not being discussed is the obscure world of credit default swaps. A credit default swap (CDS) is designed to transfer the credit exposure of fixed income products between two parties. According to the Investopedia site:

"The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap should the bond default on its coupon."

Here is the rub: In a world of very complex, interconnected derivatives, there have been some $62 trillion of "insurance" contracts (read: CDSs) written against Fannie and Freddie with a fair value of $2 trillion, according to The New York Times' Gretchen Morgenson. Ladies and gentlemen, hundreds, no thousands, of financial institutions have bought them and since the CDS market entails private, not public, transactions, nobody knows how they will unwind in a bailout. Here's what one UBS analyst wrote on the subject:

"If we reasonably assume that the Treasury would only intervene in the event that Fannie or Freddie is declared significantly undercapitalized by its regulators, then interest payments on the qualifying subordinated debt is automatically deferred for up to five years. Because nonpayment of interest would be seen as a credit event, entities that have bought protection (read: CDSs) on Fannie's and Freddie's subordinated debt would be entitled to payment by the entities that wrote the insurance."

Indeed, "what a mess," for many of the counterparties that wrote said insurance swaps did it so enthusiastically that they don't have sufficient capital to make good on the CDSs they underwrote. Since many financial institutions are carrying these CDSs on their books at a value that when marked to market "post bailout" may turn out to be substantially less than what they think, there would be an attendant "hit" to their book value and capital ratios. For these reasons, the bailout scheme will likely have to ensure that such a sequence of "credit events" does not occur. However, with such actions the government is increasingly embracing "moral hazard," and encouraging speculation by cushioning speculators' losses, which is a pretty slippery slope to take!

Whatever the "Mac and Mae" saga turns out to be, I'm sure Wall Street is going to view this as another Bear Stearns "moment," and rally the troops amid chants of "The worst is over and it's now back to life as normal."

But is it really that simple? I doubt it because the deleveraging process, following the greatest credit binge ever seen, is going to take longer than most think. Manifestly, the regulators will no longer permit the banks to securitize lending and move those loans off of their balance sheets. Additionally, the money markets will impose vastly more stringent discipline on how they finance the banks and other financial intermediaries. By default, therefore, the financial sector will never again grow at five times the nation's GDP.

According to David Roche, as paraphrased from The Financial Times, the impact of these events will be far reaching with five consequential shifts:

"First, scarce capital will be priced to reflect risk and, being more expensive on average, will be invested more productively. There will be fewer profits owing to the shuffling of increasingly leveraged assets... Second, global imbalances that have their genesis in over indebtedness of Anglo-Saxon consumers, such as the U.S. current account deficit, will wane... Third, the excesses of the credit cycle and global capital flows have boosted structural inflation in emerging economies. They will no longer export disinflation and rich countries will no longer enjoy immunity from domestically generated price pressures.

Disinflation is dead!... Fourth, the Anglo-Saxon free market model will be blamed for the excesses of the credit bubble. There will be a move to correct its excesses across a broad front. The eurozone social Marktwirtschaft will enjoy a renaissance. Taxes will be higher for both corporations and the rich. Market regulation will increase. And fifth, the U.S. will remain the biggest and most powerful global economy – but, in relative terms, its economic and geopolitical power will continue to decline."

Whether you agree or disagree with Mr. Roche, his comments are certainly worthy of consideration because it really is different this time. Typically consumers default first on their credit cards and then stop paying their mortgages. This time, however, many homeowners refinanced their mortgages to pay off their high interest rate credit card debt, but subsequently ran those credit cards back up and are now defaulting on their mortgages. With home prices falling, unemployment rising, and the deleveraging process in full swing, is it any wonder the powers that be are so worried?

Regrettably, it is difficult for me to envision a discernable trend for the equity markets until the credit markets straighten themselves out and that is just not happening as credit spreads above U.S. Treasuries have not narrowed in months (see the following chart from the "must have" Bespoke website).

Click to enlarge

Still, while I've counseled participants all year that it is a mistake to get too bearish, I've also suggested it's a mistake to get too bullish, as 2008 has (so far) proven to be more of a trader's market than an investor's market.

And this "nationalization" of Freddie and Fannie may indeed be the spark for yet another trading rally. Unfortunately, at least for me, over the past few weeks I've recommended selling most "long" trading positions, bought into that mid-July "low," since history suggests you should look for an end of the summer rally in the first part of September followed by a stock-slide into early/mid-October that sinks the footings for the year-end rally.

Moreover, none of the characteristics normally associated with a major market "low" were visible at those July "lows," even though I was pretty bullish back then. If last week's 1217 intraday low (basis the S&P 500) is viewed as a downside retest of the July low at 1200, with an attendant throwback rally, I'll clearly have missed it since the trading account is virtually in cash. As for the investment account, I continue to emphasize clean balance sheets, decent fundamentals, and dividend yields consistent with the neutral swinging, low return environment I envision. I continue to invest, and trade, accordingly.

The call for this week: Late last week I was telling accounts that if Friday's action mirrored "Thursday's Thumping" (-344 points), unless somebody in the government came out and did something over the weekend, the equity markets could be set up for a mini-crash. Since I don't take such "coin toss" bets, I'm not in place to benefit from this morning's "Mac and Mae" mania.

Alas, as Charles Dow opined, "The successful investor must be willing to ignore two out of every three money-making opportunities." Or as Sun Tzu said 26 centuries ago, "Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat!"

P.S. - Where the heck is Franklin Raines!?
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