MarketView for September 19

Summary

  

Moves to rescue the financial system and restore confidence in shaky markets sent share prices sharply higher on Friday, ending a week when the financial landscape underwent the most dramatic reshaping since the Great Depression. The S&P 500 index had its largest two-day rally since October 21, 1987, two days after the 1987 stock market crash.

 

Led by U.S. Treasury Secretary Henry Paulson, officials are working on a solution to mop up hundreds of billions of dollars worth of bad mortgage debt. Meanwhile, the United States joined the United Kingdom in temporarily banning bets that financial stocks will fall, while the Federal Reserve said it will use $50 billion to back money-market mutual funds.

 

The moves came at the end of an agonizing week for Wall Street, in which Lehman Brothers filed for bankruptcy, insurer American International Group was bailed out by the government and Merrill Lynch was forced into a shotgun marriage with Bank of America. Investors had worried that the confluence of crises severely threatened the stability of the U.S. economy.

 

But even with the furious two-day rally, stocks still ended essentially flat in a week marked by extreme volatility -- with the Dow plummeting more than 500 points on Monday, only to rise on Tuesday and drop again on Wednesday.

 

Short sellers, who profit when stocks fall, have been blamed for contributing to the demise of Lehman Brothers and the steep declines in other financial stocks this year.

 

Shares of Washington Mutual surged 42.1 percent to $4.25 after the Wall Street Journal reported that Citigroup was considering making a bid for the U.S. savings and loan. Citigroup shares were up 22.7 percent to $20.65.

 

Shares of Morgan Stanley were up 20.7 percent to $27.21. Shares of rival Goldman Sachs climbed 20.2 percent to $129.80. Morgan Stanley's talks with Wachovia, China Investment Corp and other institutions continue although the rebound in its stock price gives the investment bank more time to consider its options. Wachovia's stock surged 29.3 percent to $18.75.

 

Treasury and Fed Launch All-out Attack

 

The Fed and the Treasury Department garnered for action and launched an all-out attack against the worst financial crisis since the Great Depression, readying a plan to tap hundreds of billions of dollars in taxpayer funds to buy up toxic mortgage-related debt.

 

Capping a week that has reshaped Wall Street, Treasury Secretary Henry Paulson told Congress that rapid action was necessary on a program to let the government purchase large quantities of bad debts held by banks and other financial institutions. Losses on these debts have choked the financial system, forcing lenders into bankruptcy.

 

After having taken a series of other emergency steps that failed to erect a firewall against the spreading credit turmoil, the Government is finally directing their attention to the underlying crisis -- the rising tide of bad mortgage debt.

 

Paulson offered few details on Treasury's evolving plan but said he would work through the weekend and next week with Congress to get a program put in place. Congressional aides said they expected to see more details within 24 hours.

 

Rep. Steny, the Democratic leader in the House of Representatives, said the chamber would likely take up a bill to implement the plan early next week. House Speaker Nancy Pelosi said lawmakers would stay in town past their hoped-for adjournment next Friday if needed to pass it.

 

"We must now take further, decisive action to fundamentally and comprehensively address the root cause of our financial system's stresses," Paulson said at a news conference. "We're talking hundreds of billions. This needs to be big enough to make a real difference and get at the heart of the problem."

 

Paulson and Fed Chairman Ben Bernanke have already put close to $1 trillion of taxpayer money on the line to try to keep credit flowing, and the new effort could double that amount. At a meeting with congressional leaders on Thursday night, Paulson and Bernanke made the case for aggressive action to get ahead of events that could devastate the already weak U.S. economy.

 

"When I heard his description of what might happen to our economy if we failed to act, I gulped," Democratic Sen. Charles Schumer of New York said, referring to Bernanke's appraisal.

 

At his news conference on Friday, Paulson said the latest plan was the best hope of ultimately protecting the public purse and avoiding a grave recession.

 

"I am convinced that this bold approach will cost American families far less than the alternative -- a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion," he said.

 

The plan is reminiscent of the Resolution Trust Corp, a government agency set up to help the nation out of the savings and loan crisis in the 1980s. The RTC, however, took whole institutions under its wing whereas the new fund under discussion would remove bad assets from the balance sheets of financial institutions to help revitalize them.

 

The major effort marked the latest dramatic government bid to prevent credit markets from freezing up over huge losses on subprime and other mortgage debt.

 

The Treasury also said on Friday that it would siphon up to $50 billion from a fund established in the 1930s to conduct foreign exchange market intervention to backstop the rattled U.S. money market mutual fund industry. Money market fund assets dropped by a record $169.03 billion in the week ended September 17 as jittery investors pulled money out.

 

The Treasury said it would back money market funds whose asset values fall below $1 a share. Separately, the Fed said it would lend money to banks to finance purchases of certain assets from money market funds.

 

A panic in money markets set in on Tuesday, when the Reserve Primary Fund, a fund whose assets had tumbled 65 percent in recent weeks, fell below $1 a share in net asset value because of losses on debt issued by Lehman Brothers.

 

The Treasury also said it would step up a program announced this month to directly buy mortgage-backed securities in the market, and said Fannie Mae and Freddie Mac would also increase their buying -- a further effort to get credit flowing.

 

Here's a look at some of the major developments in the credit crisis:

 

Friday, Sept. 19

• The SEC temporarily banned short selling on nearly 800 financial stocks
• Treasury said it would insure money market mutual funds.
• Dow up 370 points, extending gains from Thursday on news of a U.S. rescue plan.

 

Thursday, Sept. 18

• Treasury and, Federal Reserve officials brief congressional leaders Thursday night on financial crisis, began crafting massive rescue plan
• Putnam Investments closes a $12 billion money-market fund after institutional clients pull out

• The Federal Reserve and global central banks pump $180 billion into money markets.
• President Bush vows action on troubled economy.
• Oil prices briefly spike above $100 per barrel as investors sought a safe haven in commodities.
• Lloyds TSB announces a $21.85-billion for HBOS PLC, Britain's largest mortgage lender
• Reports continue to swirl about a potential buyout of Washington Mutual.
• Dow up 400 point on news of rescue plan.

 

Wednesday, Sept. 17

• Gold up as high as $90.40 per ounce as investors flee stocks.
• Rumors begin to swirl that Morgan Stanley may seek to merge with another bank
• The SEC bans some aggressive forms of short-selling.
• Dow drops 450 points after government bailout of AIG

 

Tuesday, Sept. 16

• Federal Reserve announced $85 billion loan to AIG, took 79.9 percent stake in company
• Barclays PLC acquires Lehman's North American investment banking and capital markets businesses for $250 million in cash.
• Goldman Sachs reports its worst profit drop since going public in 1999 – a 71 percent decline.
• Federal Reserve leaves its benchmark rate unchanged at 2 percent
• Morgan Stanley reported better-than-expected earnings

 

Monday, Sept. 15

• Lehman Brothers declared bankruptcy, the largest ever in the United States
• Bank of America agrees to acquire Merrill Lynch in a $50 billion deal
• Dow falls 504 points after Lehman, Merrill Lynch news

 

Treasury Doubling MBS Purchases to $10 billion

 

The Treasury Department intends to double its planned purchases of mortgage-backed securities to $10 billion this month as part of its broad plan to stabilize markets and deal with problem bank assets. Treasury spokeswoman Jennifer Zuccarelli said the increase would accompany unspecified increases in MBS purchases by Fannie Mae and Freddie Mac.

 

The Treasury has not yet begun purchases in the open market, and may make more MBS purchases in future months, subject to the national debt limit, she said.

 

The Treasury announced as part of its takeover of Fannie and Freddie on September 7 that it would purchase $5 billion worth of MBS to promote confidence and liquidity in the housing market. Under the takeover, the Treasury set up a mechanism to inject up to $100 billion in capital into each institution if needed.

 

Buffett's "time bomb" Explodes

 

Wall Street, specialized insurance known as a credit default swaps are turning a bad situation into a catastrophe. Credit default swaps -- complex derivatives originally designed to protect banks from deadbeat borrowers -- are adding to the turmoil.

 

Five years ago, Warren Buffett called them a "time bomb" and "financial weapons of mass destruction" and directed the insurance arm of his Berkshire Hathaway to exit the business.

 

Recent events suggest Buffett was right. The collapse of Bear Stearns, the fire sale of Merrill Lynch and the meltdown at AIG all point to the fact that credit default swaps played a key role in the demise of these financial giants. Over the last three quarters, AIG suffered $18 billion of losses tied to guarantees it wrote on mortgage-linked derivatives.

 

When the credit default market began back in the mid-1990s, the transactions were simpler, more transparent affairs. Not all the sellers were insurance companies like AIG -- most were not. However, the protection buyer usually knew the protection seller.

 

Growing to $46 trillion at the first half of 2007 from $631 billion in 2000 meant that tremendous changes were taking place. An over-the-counter market grew up and some of the most active players became asset managers, including hedge fund managers, who bought and sold the policies like any other investment.

 

And in those deals, they sold protection as often as they bought it, although they rarely set aside the reserves they would need if the obligation ever had to be paid.

 

In one notorious case, a small hedge fund agreed to insure UBS AG, the Swiss banking giant, from losses related to defaults on $1.3 billion of subprime mortgages for an annual premium of about $2 million.

 

The trouble was, the hedge fund set up a subsidiary to stand behind the guarantee, capitalizing it with just $4.6 million. As long as the loans performed, the fund made a killing, raking in an annualized return of nearly 44 percent. However, in the summer of 2007, as home owners began to default, things got ugly. UBS demanded the hedge fund put up additional collateral. The fund balked. UBS sued.

 

The dispute is hardly unique. Wachovia and Citigroup are involved in similar litigation with firms that promised to step up and act like insurers but were not actually insurers.

 

And as hedge funds and others bought and sold these protection policies, they did not always get prior written consent from the people they were supposed to be insuring. Patrick Parkinson, the deputy director of the Fed's research and statistic arm, calls the practice "sloppy." As a result, some protection buyers had trouble figuring out who was standing behind the insurance they bought. And it put investors into webs of relationships they did not understand.

 

Moreover, firms booked all these derivatives assuming bad things would never happen. It was like writing fire insurance, assuming no one is ever going to have a fire, only now they're turning around and watching as the whole town burns down.

  

Greatest 3-day Price Gain for Crude Since 1998

 

Oil prices rose almost 7 percent on Friday to cap their largest three-day rally in a decade on expectations the government bailout plan would boost liquidity across the battered financial markets. Domestic crude settled up $6.67 at $104.55 per barrel, bringing gains since Wednesday to 14.7 percent – the largest three-day surge since December 1998. London Brent settled up $4.42 per barrel at $99.61.

 

Nonetheless, the price of crude oil remains sharply lower from its peak above $147 per barrel in mid-July, pressured by mounting evidence that high energy costs and economic troubles are undercutting global fuel consumption.

 

Oil prices also received a boost on Friday from weakness in the dollar and disruptions of supply from the hurricane-hit United States and from OPEC-member Nigeria. In addition, about 89.2 percent of oil production in the U.S. Gulf of Mexico, the source of one-quarter of domestic crude output, remained idle as of Thursday following Hurricane Ike, along with about 14 percent of the country's refined fuel capacity.

 

Difficult Time Likely for Stocks Next Week Despite Government Bailout

 

While a government plan to remove billions of dollars of bad debt from bank balance sheets has lifted spirits, few on Wall Street will enter next week ready to declare a new bull run for the stock market. Yes, the outlook is brighter. However, questions still remain regarding the size and scope of the measures that will be taken as well as their ability to contain a credit crunch that has kept global markets lurching from one crisis to another for more than a year.

 

Whether stocks will have the ability to hold at current levels next week is far from clear. Some say the temporary ban on short selling was lending support to the market on Friday that otherwise would not have been there. Nonetheless, look for Wall Street to remain wary of taking on even minimal risk next week. The government's rescue plans may even contribute to this. Historically, rescue plans have not been a panacea.

 

While economic data is likely to take a back seat to credit issues this coming week, as the market waits for more details about the Treasury's plan to buy up risky loans corroding bank balance sheets, at some point, the focus will have to return to the economy and that news is not likely to warm the cockles of anyone’s heart.