The news in the financial markets continues to be quite grim. Over the past few business days, Washington Mutual was seized by its regulators and quickly sold to JPMorgan Chase bank. Today the regulators assisted in the forced sale of Wachovia to Citigroup. Then this afternoon the United States House of Representatives rejected the Troubled Asset Relief Program ("TARP") program that would have enabled the Federal government to purchase up to $700 billion in "toxic" mortgage assets. Once the news of the no vote spread, the equity markets quickly turned even further south, ending up with the largest ever loss in the Dow Jones Industrial Average. Ahead of Tuesday's end of the month and the third quarter, the market for commercial paper is virtually frozen and what trading there is for very short terms, often overnight and generally a week or less.
In light of all of the above, several clients and professional contacts have reached out to Lars Toomre for his perspective on where things might go from here. In short, I am quite pessimistic. There is an old saying that the markets have a tendency to extract maximum pain for many parties before a correction can start. I fear that the sell-off witnessed this afternoon in the equity markets will continue and get worse as investors wonder which institution might be next. Also, I sense that equity investors are beginning to adjust downward their expectations for future earnings as consensus begins to build that the United States and perhaps the world is entering a major recession.
As bad as the equity markets might be, I am even more worried about the debt markets. The bankruptcy filing of Lehman Brothers has had far more repercussions than the Federal regulators originally projected. If you have not read the front-page story from the September 29th 2008 Wall Street Journal entitled Lehman's Demise Triggered Cash Crunch Around Globe, go read it now!
Lehman Brothers was one of the two largest dealers in commercial paper plus it had quite a bit of its own commercial paper outstanding. Its absence as a market maker has hurt the commercial paper market. The breaking of the proverbial buck by Reserve Primary Fund (due to the amount of Lehman Brothers commercial paper it held) caused many larger investors, primarily corporations and institutions, to question whether money market funds were money good. Hence, more than $150 billion of the $1.7 trillion money market funds were redeemed and much of the cash apparently has been parked in Treasury bills driving such holdings down to yield just a few basis points.
All markets are driven by the marginal buyer and seller. With few buyers in the commercial paper market, the rates required to roll over outstanding commercial paper have risen quite a bit and could well go even higher if the financial panic stays constant or worsens even further. The coming year-end is going to be truly horrendous as almost all financial institutions want to hold as much cash as possible and make their all-important year-end balance sheets look as pristine as possible. Hence, I suspect that there will be limited funds available for commercial paper issuers who want to take out bank loans instead of rolling their paper. Also, with such uncertainty about financial credits, it is also will be likely that issuing longer term debt in the corporate bond market will be very difficult, if not impossible for all but the safest credits.
Finally, market participants do not seem to be focusing on what is going on in the hedge fund sector. Many hedge funds are suffering net losses for the year and as a result, many hedge fund investors are submitting redemption notices. Even though most hedge funds have substantially reduced their leverage, many still employ leverage in the range of 3:1 to 5:1. The redemptions and margin calls from the decline in the equity markets will cause yet more selling from hedge funds. Hence, I would expect that many markets will be under pressure from further hedge fund deleveraging.
Toomre Capital Markets LLC ("TCM") consults with clients who are involved with structured finance securities, derivatives and other "hairy" investment opportunities like weather derivative contracts and life settlement portfolios. Many of these investment alternatives are illiquid, even in the best of times. As a result, we have a keen appreciation of what is termed "liquidity risk". Two of the clients today independently asked that I highlight a past post entitled Can Wall Street be Trusted to Value Risky CDOs?. Both found it extremely helpful and useful in thinking about the value of liquidity and what may lay ahead for the rejected TARP program.
Reader comments and thoughts are welcome.