MarketView for October 3

Summary

 

It was a week on Wall Street that most would rather forget as the Street suffered through its worst five days in seven years after being pasted again on Friday over fears that the $700 billion financial rescue package may not unblock credit markets and stave off a recession. It was the first time the S&P closed below 1,100 in almost four years. Keep in mind that I have been forecasting a recession since last November and was adamant on the subject last February.

 

Financial stocks, which had traded sharply higher on the expectation the bill would be passed, fell after the House vote. The primary reason was profit-taking with the markets was now focusing on the tough economic road still ahead and on the big question of how the bailout will be implemented.

 

The monthly jobs report earlier in the day suggested the economy may finally meet the official definition of a recession. Employers cut 159,000 jobs in September, the ninth straight monthly reduction and the steepest decline in five and a half years.

 

Three-month dollar Libor rates, key benchmark rates for the banking industry, climbed to 4.33 percent, the highest since early January, while the euro-denominated equivalent surged to a record high.

 

Overall, it was a week of extreme volatility for the stock market. On Monday, the Dow posted is biggest point decline in history after the House of Representatives rejected an initial bank bailout plan, while the volatility index hit a record high. The S&P 500 on three days posted moves bigger than 4 percent. The S&P 500 and the NASDAQ had their worst week since September 2001, and the Dow had its worst week since July 2002.

 

On Friday, shares of Wells Fargo fell 1.7 percent to $34.56 after the bank stepped in to buy Wachovia, topping a government-backed Citigroup bid for some of the bank's assets. Wachovia's shares jumped 58.8 percent. Citigroup fell 18.4 percent to $18.35.

 

The Dow Jones home construction index fell 6.6 percent, with D.R. Horton, the largest domestic home builder, down 8.4 percent at $11.07.

 

The Institute for Supply Management said its index of non-manufacturing activity eased slightly to 50.2 in September from 50.6 in August. A reading over 50 implies growth, so last month's soft reading showed the sector was virtually stalled.

 

Bailout Passes – Now What

 

Grinning like a group of Cheshire cats, House Speaker Nancy Pelosi, President Bush, Treasury Secretary Paulson and compatriots posed for photo ops after the passing of the bailout package. You would have thought they had just saved the world from calamity. Actually, to some extent they did. However, it would have been more appropriate if they had hung their heads in shame because all they did was bring us back from the precipice of a disaster that in many ways they were responsible for.

 

Nonetheless, Congress did finally approve a $700 billion bailout package for banks as efforts to head off a spreading global financial crisis remained on hold awaiting the outcome. The House of Representatives approved the financial rescue plan by a vote of 263-171. That vote sent the measure to U.S. President George W. Bush, who quickly signed it into law, concluding two weeks of haggling in Washington that had roiled and captivated global markets.

 

Meanwhile, California said it was running out of money. California, Governor. Arnold Schwarzenegger warned the Treasury Department that it could be need of short-term federal loans because it has been shut out of frozen credit markets. California, a state with an economy on par with Spain's, warned that its cash reserves could be exhausted by end month, bringing state services to a grinding halt.

 

"The economic fallout from this national credit crisis continues to drain state tax coffers," Schwarzenegger said in a letter to Paulson.

 

France said the world stood on the "edge of the abyss" and European leaders divided over their response to the banking sector's difficulties. Paulson, who had been the administration's chief lobbyist for the plan, said regulators would get going quickly to implement the emergency power to start buying up distressed assets from banks.

 

French Prime Minister Francois Fillon, whose country is hosting an emergency summit with Italian, British and German leaders on Saturday, said only collective action could solve the financial crisis. He said he would not rule out any solution to stop any bank failing.

 

"The world is on the edge of the abyss because of an irresponsible system," Fillon said, alluding to widespread anger over past lax regulation of financial markets and excessive lending.

 

Fillon said President Nicolas Sarkozy would propose at the emergency meeting measures to unfreeze credit and coordinate economic and monetary strategies.

 

In Britain, Prime Minister Gordon Brown shook up his cabinet and authorities took three separate steps to try to shore up the financial system.

 

Bad news mounted in the European financial sector. Interbank lending and credit to businesses and private individuals has all but seized up. Central banks have injected billions of dollars to maintain some flow of funds. Worries grew that even if Washington agrees on the package, it will not be enough to resolve deeper-rooted weakness in the global economy.

 

Divisions have emerged within Europe over the past week, with Ireland offering guarantees on bank deposits, prompting a flight of capital from British lenders to Irish banks, and Greece promising to safeguard savers' cash.

 

EU partners said Ireland's move could break competition rules and threatened the unity necessary to ensure an ordered approach to turmoil ahead.

 

Dutch-Belgian banking and insurance giant Fortis was broken up on national lines, with the Dutch government taking over its operations in the Netherlands, after an earlier rescue effort and asset sale failed.

 

In Switzerland, UBS AG, hardest hit among European banks by its exposure to subprime-related holdings, said it would cut 2,000 investment banking jobs -- on top of the 4,100 positions cut in the past year.

 

Ahead of the vote, stocks moved higher on hopes for the bailout plan and the deal to buy Wachovia. Wells Fargo, one of the strongest banks, said it did not need the government help that Citigroup required in an earlier effort to rescue Wachovia.

 

A collapse in the housing market and resulting bad mortgages have shattered confidence in the financial sector, with banks across the United States and Europe needing support from governments or outside investors if the credit markets are to return to a degree of normalcy.

 

More Jobs Lost

 

Employers cut 159,000 jobs last month, a ninth straight monthly reduction and the deepest in 5-1/2 years, the Labor Department reported on Friday, a strong suggestion the economy may be in recession. The Labor Department report showed 760,000 jobs lost so far in 2008. The unemployment rate in September held at a five-year high of 6.1 percent as 121,000 people quit the workforce.

 

The bleak hiring outlook and a separate report showing a sluggish service sector that barely grew last month added to a string of recent negative news, including weak personal income and spending, declines in manufacturing and declining factory orders and shipments. September's job losses were much more severe than had been expected the Street.

 

The September job cuts follow revised losses of 73,000 jobs in August and 67,000 in July and show the decline in employment is accelerating. Some 51,000 manufacturing jobs were lost last month on top of 56,000 cut in August, the 27th straight month in which manufacturers slashed their payrolls.

 

Job cuts were nearly across the board in September in every major category with the exception of government, which added 9,000 jobs. The average work week in manufacturing industries was the lowest in three years at 40.7 hours. Overall hours of work in all industries slipped to 33.6 a week in September from 33.7 in August, the lowest number for that statistic since November 2004.

 

Hurricane Ike, which hit the Gulf coast and a strike at aircraft maker Boeing did not impact the data because the employees affected were on payrolls for at least part of the Labor Department's survey period.

 

Crude Falls...Again

 

The price of crude oil fell again on Friday, dragged down as demand concerns outweighed optimism after a rescue bill for the U.S. financial sector was signed into law. Domestic sweet crude for November delivery settled down 9 cents per barrel at $93.88, after a drop of $4.56 per barrel on Thursday, again over concerns that demand is falling prey to economic conditions. London Brent crude settled down 31 cents per barrel at $90.25.

 

High fuel prices and the wider economic crisis has hurt consumption in top consumer the United States, knocking crude off a record peak over $147 a barrel struck in July.

 

Although the bailout program might stem to some degree the downturn in the economy, it is likely to do little to bolster the declining demand for oil demand, at least in the short-term.

 

Wells Fargo Upstages Citigroup For Wachovia

 

Wells Fargo agreed to buy Wachovia for $15 billion, upstaging a government-backed Citigroup bid for Wachovia's banking assets in a deal that will place Wells Fargo in the big leagues of consumer banking.

 

Citigroup demanded Wells Fargo drop its surprise bid, which comes four days after Wachovia preliminarily agreed to sell its banking assets to Citi for $2.2 billion with partial government guarantees on $312 billion of Wachovia's mortgages. Citi said Wachovia had signed an agreement to refrain from negotiating with other parties, even if the two parties had not signed a definitive merger agreement.

 

Regulators said on Friday they had not looked at the Wells Fargo bid, which would not require any government backing. The lack of government support may make the Wells Fargo bid more attractive for regulators.

 

Citigroup's shares fell 18.44 percent, their largest one-day decline since October 1987. The Wachovia acquisition would have helped it strategically, and the government-brokered deal also was seen as a vote of confidence from regulators.

 

If Wells Fargo is able to consummate the deal, it will be taking a material risk. It will acquire $122 billion of "option pay" mortgages, where borrowers can choose every month whether to only pay interest on their mortgages, pay down some portion of their loan, and sometimes to pay less than the interest due. In a plummeting housing market, such assets are seen as highly toxic, and Wells Fargo said it expects to write the assets down by $32 billion over time.

 

The bank estimates the total assets it is taking on will have to be written down by $74 billion in the years following the deal. Wells Fargo will issue up to $20 billion of securities, likely mostly common equity, to help offset those losses. These are big numbers for Wells Fargo, whose net worth as a company as measured by balance sheet shareholders' equity, was about $48 billion at the end of June.

 

Citigroup was just bidding for Wachovia's banking assets, but Wells Fargo is also buying brokerage Wachovia Securities and asset manager Evergreen as part of this deal. Those businesses could also be hit by economic slowdown.

 

Wells Fargo may also be able to receive support for some assets through the $700 billion government program to buy bad assets that the House of Representatives approved on Friday afternoon. The strategic benefits to Wells Fargo are compelling. Wachovia has a strong branch presence on the East Coast, patching a major gap in Wells Fargo's network. Also, Wells Fargo’s largest shareholder is Warren Buffett's Berkshire Hathaway, who is not known for backing poor performers.

 

Banks have been scrambling to build or buy branches, which allow them to raise money from depositors. In a credit crunch, deposit funding can be cheap compared to borrowing in bond markets. Wells Fargo is one of the few major domestic banks that has remained consistently profitable during the credit crisis, despite being headquartered in California, the state that has suffered most during the U.S. housing crisis. Citigroup, meanwhile, has posted more than $17 billion of net losses in the last three quarters.

 

Winning the Wachovia branches would have helped Citigroup bolster its relatively weak network of branches, which number about 1,000 compared with Wachovia's 3,300 and Wells Fargo's 3,400.

 

In a joint statement, bank regulators at the U.S. Federal Reserve and the Office of the Comptroller of the Currency said they would work with all parties to achieve the best outcome. The Federal Deposit Insurance Corp said it stands behind its previously announced agreement with Citigroup.

 

For each share of Wachovia, investors will receive 0.1991 Wells Fargo share, which is equal to $6.88 a share based on Wells Fargo's closing price on Friday of $34.56. Wachovia closed at $6.21 on Friday.

 

The combined company will base its East Coast retail and commercial and corporate banking business in Charlotte. St. Louis will remain the headquarters of Wachovia Securities. Wells Fargo, which would retain its name once the banks combine, is based in San Francisco.