The Perfect Financial Storm

Yesterday the Federal Reserve decided to effectively lend $200 Billion to primary dealers (investment banks) to ease the credit crunch caused by the sub-prime mortgage mess. In response, the beleaguered stock market soared over 400 points, its third best day ever. Traders apparently decided that the Fed move, designed to be open-ended, would put a floor beneath an otherwise downward spiraling bond market.

It might, but they're overlooking a larger and more ominous reality.

Yes, the Fed move will provide investment banks greater liquidity and free up capital to lend and commit to transactions, but it won’t solve all their problems. The sub-prime crisis has spread into other asset classes, including “Alt-A” loans and asset-backed paper, whose underlying instruments are not easy to value. This uncertainty, rather than an actual material decrease in value, caused a panic that effectively froze these multi-multi-billion dollar markets. Basically, every institution holding these bonds tried to sell them at the same time, and without buyers to take them, their values plummeted. In the best scenario, it will take continued Fed support to gradually restore order to these markets and allow rating agencies to reaffirm or adjust their views. The market will slowly re-price these instruments and buyers will eventually emerge, but it will take time.

Meanwhile, few new financings will take place, merger activity will slow to a trickle and lending will remain greatly diminished. Wall Street earnings will plummet, as will the earnings of most hedge funds, money managers, builders, brokers and the like.

More importantly, the Fed action will do nothing to mitigate broader forces crushing the economy. First quarter earnings will be coming soon, and it’s hard to imagine they will be anything but dismal. Real estate has been hammered, and everything connected with housing will be down significantly. Meanwhile, heating costs are way up. Gasoline is heading toward four dollars a gallon (yes Dubya, FOUR), and oil just passed $110 a barrel with no ceiling in sight. Consumption will have to suffer.

But the real harbinger of bad times ahead is employment. As last month’s shocking employment report demonstrated, jobs are getting hammered, with additional layoff announcements coming daily. Thousands more will be booted from the financial and real estate sectors soon, and retail and manufacturing will surely follow. We’ve seen this pattern before. Communities lay people off, retail stores begin to sag, inventories begin to rise, earnings go down, expansion stops, ad budgets are slashed, all in succession.

The stock market downturn has almost certainly not reached a bottom. The recent Fed-prompted rally was merely a bear rally, a “sucker’s rally”, a positive distraction from a much more pernicious and cyclical bear market. Last month’s shocking employment numbers were just the tip of an iceberg that will slowly emerge over the course of the coming year. In the short run, it’s hard to imagine where any good news will come from. With gasoline, heating oil, medical and other basic costs skyrocketing, consumption and retail sales won’t rebound any time soon. With credit tight, housing and finance won’t rebound any time soon. The weak dollar will help our balance of trade, but that will take time to add to our bottom line. And with the impotent and incompetent Bush Administration at the helm, we can expect no meaningful leadership to soften the blow.

In short, things are going to get worse before they get better. A few of my friends wonder if this could be the beginning of a second great depression. I doubt things will get that bad, but with the national debt soaring, Iraq draining our treasury, oil prices and medical costs skyrocketing, lending in a slump, we could be facing the perfect financial storm. At least the next President, whoever it is, can’t possibly be as hideously incompetent and lacking credibility as Bush, and this alone may help lift the markets and consumer confidence once the November election is settled. As a wise friend was fond of saying in the face of catastrophe, more will be revealed.

- JT Compton
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