Sunday, October 05, 2008

The End of the Beginning

With the passage of the rescue package by Congress, we have started the next phase of this contagion.   

I cannot say that this package will have any effect outside of psychological.  It might help settle the overnight LIBOR rate drop from its record highs as some confidence comes into the system.   The problem is, like a lot of things that get passed as legislation these days, is that rushed bills like this are like a condom - they let you feel good when in reality you're getting screwed.   Perhaps that is a harsh judgement, but the problem we have here is primarily about capital, not illiquid assets.

Let me put it to you this way, any institution who sells their toxic assets at a fair value to the Treasury for government bonds is only exchanging an illiquid asset for a liquid asset.  While this may help the liquidity of the institution in question, it does not address the problem that it is woefully undercapitalized.  Insufficient capital leads to bank runs, and the inability of banks to make new loans and extend credit.   In other words, we still will have a significant contraction of lending as banks still de-lever their balance sheets.

And we have not addressed how the "shadow banking system" of hedge funds and SIVs are going to get clobbered on this.  They, as it stands to the best of my knowledge, are not eligible for the rescue plan.  They will have to liquidate their positions as they lose capital to redemptions.  Hundreds, if not thousands, of hedge fund will be going bust as they face increasing redemptions, the inability to refinance on the commercial paper market, and with large illiquid toxic assets on their balance sheets.  This gradual unwinding of trillions of dollars of assets and liabilities will depress the stock markets for at least another year.

So, looking into the crystal ball, I see the following trends for the next year or two:
  1. Several large banks will still fail and will be taken over by the FDIC.  Dozens, if not hundreds, of regional and local banks will be too.
  2. The S&P 500 will drop below 900 points by the end of 2009.  We should expect a 25% decline in the markets as companies continue to de-lever.
  3. Credit card and auto loan defaults will hit record highs over the next year.
  4. Home prices, as measured in the S&P Case-Shiller index, will bottom out for most markets by Q1 2010.
  5. Depressed demand will bring oil down to under $70/barrel.
  6. Gold will be off its record high, but not much due to the debasing of the U.S. dollar that this rescue plan creates.
  7. One of the big 3 automakers will not exist as a stand alone entity (either bought out or Chapter 11) by the end of 2010.

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