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MarketThoughts Special Commentary: They Don't Come Much Bigger than AIG (and the GSEs)

(September 17, 2008)

Dear Subscribers and Readers,

In light of the recent events (the Lehman bankruptcy, the takeover of Merrill Lynch by Bank of America, and the effective nationalization of AIG by the US government) in the financial markets, I want to briefly update our stance on the stock market in the foreseeable future and for the rest of the year.

In our July 13, 2008 commentary ("The Lender of Last Resort") - as a response to the Federal Government's "backstopping" the GSEs - we stated:

Deep in our hearts - especially those that have studied financial history and financial bubbles - we all know that the worst-case scenario usually occurs at the final unwinding. The Panic of 1907 ended with the near closing of the NYSE (and the wholesale collapse of stocks) while the telecom bubble ended with the bankruptcies of Global Crossing and Worldcom. So this is not a total surprise, although many punters thought the failure of Bear Stearns signaled the end, as opposed to the near collapse of the GSE's. Make no mistake: The near collapse of the GSEs has to be the “whale.” With $1.5 trillion in agency debt and over $5 trillion in agency MBS outstanding, they don't come much bigger (the collapse of Bear Stearns and IndyMac are mere footnotes compared to a potential collapse of the GSEs). More importantly, most analysts and investors out there are misguided in believing that the near-collapse of the GSEs are bearish for the stock and housing markets. This would only be true if the Feds do not act. This near-collapse has now compelled the Treasury, Fed, and now Congress (they should have passed the $300 billion housing bill before July 4th) to finally be proactive and put a cushion under US housing. That is, perversely, the near-collapse of the GSEs is actually bullish for the US financials and general stock market, as – given the latest “backstop” by the Federal Reserve and US Treasury (note Paulson can act without Congress' approval as there is more than $41 billion in the Exchange Stabilization Fund at his immediate disposal) – there is no doubt that the Feds will flood the US mortgage/housing market with more liquidity over the next several months. Given that much of the US financials (and structured finance indices such as the ABX indices) has now discounted the worst-case scenario, my sense is that we have now put in a sustainable bottom for the S&P. This bottom should at least provide us a solid two to three-month rally. Finally, just like with all financial crises, the lender of the last resort - in providing liquidity to a market that is in an extreme sense of panic - will eventually make money on its "investments." Just ask JP Morgan and his father, Junius Morgan, the Hong Kong Monetary Authority when it intervened and bought stocks on the Hong Kong Stock Exchange in August 1998, and of course, Warren Buffett, who provided life-saving liquidity to GEICO in 1976 and small cap market other issues during the mid 1970s.

The stock market (as measured by the Dow Industrials) bottomed on July 15th - and would subsequently embark on a four-week rally that would take the Dow Industrials approximately 7.5% higher (on a closing basis). While they certainly "don't come much bigger than the GSEs" (perhaps with the exception of a country with a GDP the size of France's or Italy's), we had not anticipated that more financial firms would fail in the wake of the Federal Reserve's "backstop" of the 19 primary dealers (including Lehman) and the Federal Government's "backstop" and subsequent nationalization of the GSEs on September 6th. To make this worse, last week ended with the potential of three large financial institutions failing all in the space of a few days - those being Lehman Brothers, Merrill Lynch, and AIG. The size and complexity of the latter is especially problematic. AIG's subsidiary, AIG Financial Products, was a major player in the CDS market, and had lost the parent company more than $10 billion in 2007,and $14.7 billion in the first six months of this year alone. RBC Capital Markets estimated that if AIG had failed, its counter-parties would have been exposed to a loss of approximately $180 billion. No doubt this would also bring down other financial institutions, including overseas ones. Moreover, many investment funds are invested in AIG debt and commercial paper. Earlier on Tuesday, the $62 billion "Reserve Fund" money market fund "broke the buck," ending with an NAV of 97 cents on the dollar, having written off its stake in Lehman Brothers' commercial paper (with no intent of making up shareholders for their losses). This is the first loss in US money market funds since the 1994 bankruptcy of Orange County. Should AIG have allowed to fail, then there is no doubt more money market funds would have broken the buck as well. The size of the losses would be so sizable that many money market funds would not have been able to make them up. In such a scenario, there is a good chance we could also see a general run on money market fund assets - which would in turn cause rates on commercial paper and other short-term financial products to spike up further.

With the Fed's $85 billion loan and the effective nationalization of AIG, the Federal Government would receive a 79.9% equity stake through its holdings in AIG equity participation notes. More importantly, this act will alleviate a significant amount of "10-sigma" systemic risk. With Morgan Stanley reporting higher-than-expected earnings yesterday evening, and with US mortgage rates declining drastically, there is no doubt that liquidity issues in the US financial system has dissipated dramatically over the last 12 hours. Moreover, global central banks, including the ECB, Bank of England, the Bank of Japan, and the Reserve Bank of Australia have also pumped a significant amount of liquidity in the global financial system, helping to alleviate the intra-day spikes in short-term borrowing rates. The People's Bank of China has gone one step further - reducing borrowing rates by 27 bps and easing reserve requirements at the same time. More importantly, the People's Bank has also signaled that it stands ready to ease further if they need to - and it is now evident that the Chinese government (especially since it is now in the midst of putting into place a more "dovish" fiscal policy) is now focused more on promoting growth, especially domestic spending, than fighting inflation. Finally, Congress has essentially promised the domestic automarkers (i.e. GM, Ford, and Chrysler) at least $25 billion in direct government loans (at a 5% interest rate) in order for them to adopt new design/production technologies and to survive in the current slowdown environment. With the possible exception of JP Morgan, Bank of America, Citigroup, GMAC, and General Electric, financial institutions certainly "don't come much bigger" than AIG and the GSEs.

In an environment where banks are refusing to lend, the Federal Reserve and the Federal Government have essentially stepped in to provide this vital function - first with the Bear Stearns bailout, then with the GSEs, and finally now with AIG. Next up would be direct loans to US automakers. With the exception of the direct loans to automakers, both the Federal Reserve and the US Treasury have indicated that this "bailout" option would not be cheap - neither for the equity holders or at the executive level. Obviously, this does not mean that more financial institutions won't fail - especially as global housing prices are still for the most part declining and especially since both the ECB and the Bank of England have refused to ease their respective monetary policies. For now, however, the short-term bleeding is close to being over, as a substantial portion of the "10-sigma" systemic risk has been taken out. Once "the smoke clears" in a couple of days, we should at least see another short-term rally in the stock market. Whether that translates into something more sustainable (e.g. a rally that lasts until the end of this year) will depend - to a large extent - on global monetary and fiscal policies. For now, we will just sit and wait.

Yours faithfully,

Henry To, CFA

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