Tuesday, September 16, 2008

Michael Cembalest on the Market.

September 14, 2008, 11:59 pm

Market update: Tonight, Bank of America announced plans to acquire Merrill Lynch, while the Wall Street Journal reported that Lehman Brothers faces the possibility of liquidation after the departure of Bank of America and Barclays from acquisition discussions. There are also reports that AIG passed on a private equity capital infusion, and is instead seeking Fed assistance to bridge asset sales to enhance capital ratios and stave off a ratings downgrade. Should a Lehman liquidation occur, it would set off a chain reaction of unexplored consequences for financial markets. In the note below, I have tried to focus on what's taking place in short term financing and derivative markets that appear to be driving these events, and what the implications are for portfolio investing, both in the short term and over the long run. In recent weeks, J.P. Morgan's business heads from around the world have been advising the Federal Reserve, Treasury and other regulatory bodies, and we are disappointed that some adverse outcomes might not be avoided. As has been the case since the onset of the credit contraction in June 2007, J.P. Morgan's senior management, capital levels and risk management have been a source of strength and stability for our wealth management business.

"Release the hounds". Earlier this year, the Federal Reserve used its balance sheet to try to prevent contagion from spreading through the financial system, and to help banks and brokerage firms with problems financing high-quality collateral. It was worth a shot, and it seemed like a good idea at the time. But the price any market pays for intervention is a lack of "price discovery": no one really knows what things are worth. The markets are now confronted with the opposing forces of rising cash balances, vanishing liquidity, and falling asset values. At this point, of all the unpleasant choices facing the financial system, releasing the hounds and allowing over-leveraged entities to fail might be the quickest path to a more stable foundation for investing. But there's still a very important role for the official sector to play, even with last week's foreswearing of using taxpayer funds to facilitate mergers, as it relates to the repo markets (more on this below). The news on this latter issue is positive.

When no suitors line up to buy a bank or broker-dealer whose stock falls by 95%, it usually reflects a lack of faith in how positions are marked, rather than a comment on future business prospects. There are signals of price confusion everywhere (a). One solution to this impasse is a more violent form of price discovery that takes place when entities fail, and assets are sold en masse to willing buyers. With visibility on what large blocks trade for, investors in smaller size would finally get a better sense of the clearing price. The de-leveraging virus claimed its first victim in June 2007 with a mortgage hedge fund that was leveraged 25 to 1. It spread to other entities, whose leverage is noted in parentheses: structured investment vehicles (11 to 1), stat arb hedge funds (10 to 1), monoline insurance companies like AMBAC (100 to 1), Swiss banks (65 to 1), publicly traded stocks mimicking mortgage hedge fund strategies (32 to 1), entire brokerage firms (30 to 1), and then more recently, Fannie Mae and Freddie Mac (75 to 1). Leverage in insurance company financial products subsidiaries is sometimes unknowable; one firm with close to a half a trillion in exposure was leveraged over 200 to 1 right before the credit markets turned in June of 2007.

The Fed does not have the inclination nor the ammunition to prevent such entities from falling short of capital. So, what lies ahead may be more business failures, and more selling pressure across equity and credit markets from today's levels, perhaps more than we anticipated a couple of months ago. I don't know how long it will take for over-leveraged assets to find a new home, and a new price. Sovereign wealth fund injections appear to have been premature, and serve as a cautionary tale for bottom-fishing too soon. But the wall of cash is indisputably rising on many fronts:

- Emerging economy central bank reserves grew by $1.4 trillion in the last year, creating a giant stock of petro- and export-dollars, much of which is eventually transferred to Sovereign Wealth Funds
- Global money market assets have skyrocketed, and at $5.7 trillion, represent levels not seen before, whether scaled by GDP or equity market capitalization. U.S. and Global money market fund assets have risen by 41% and 32% since the onset of the credit crisis in June 2007
- Money in global savings accounts and money market funds surged from $21 trillion to $35 trillion from 2003 to 2008, rising by 65%
- In June 2007, the net number of fund managers overweight cash was 4%. That number is now 53%
- Net credit balances in NYSE cash and margin accounts are now over $150 billion. The prior peak over the last decade was $50 billion in 2001, after having troughed at a debit of $125 billion in early 2000
- S&P 500 technology, healthcare, consumer and industrial companies hold cash balances as a percentage of assets that are at 10 year highs
- Short interest on the stock exchange is at its highest level since 1976. Some of this is a reflection of the growth in market-neutral hedge funds, so it's close to impossible to distill how much true short interest exists. But the rapid increase in short interest from 3% to 4.6% of total shares over the last year is more a reflection of the latter than the former
After the wave of selling that could hit equity and credit markets in the coming days and weeks, there are reasons to suspect that this wall of capital might be unleashed. Recall that the U.S. spent the better part of the 1980s and 1990s trying to convince Latin American countries to "trust the markets". Developing nations were advised to open their economies to foreign investment, allow banks and utilities to fail or be sold, balance budgets, avoid moral hazard, and most urgently, to allow prices to clear. The Japanese were admonished in the 1990s for keeping "zombie banks" alive, and more recently, Asia was advised to relinquish energy price subsidies, remove distortions and allow economic activity and energy prices to find naturally clearing levels. Price discovery that emerges from business failure may be a necessary component of a recovery this time as well.

But there's a fine line between trusting market mechanisms and an unsupervised collapse. It's been 6 months since the Bear Stearns failure, so the Fed and Treasury can rightly assert that banks and brokers had time to sell assets and raise capital, and that lending facilities were made available to finance high-quality collateral. While assisting individual firms is off the table, there's still the question of the $11 trillion repo market, a short-term collateralized lending market that banks, broker-dealers and hedge funds use to finance securities (b). If this source of financing were to seize up, the consequences for the financial system would be much worse than any one firm's failure. To address these risks, the Fed made a series of major announcements. First, it will allow for broader use of the Primary Dealer Credit Facility by expanding the universe of eligible securities (c). Furthermore, a global group of banks announced plans to use their own capital to establish a $70 billion private sector credit facility, providing a backstop for those securities that are not eligible for the PDCF. The Fed also announced an increase in its Treasury Securities Lending Facility to $200 billion. Putting all these pieces together, the Fed has created a broad enough public and private sector backstop so that the extension of collateralized lending, which lay at the heart of the entire financial system, can keep on beating.

As a result, with evidence that price discovery is underway, and that the Fed/Treasury are not going "cold turkey" from facilitating mergers in March to being bystanders in September, we will not make dramatic risk reductions and sell into declining markets with limited liquidity. The benefit of not going into this crisis over-invested gives us some flexibility to take advantage of severe dislocations. For those interested, we do not have any exposure to Lehman in our $480 billion money market fund complex.

On a personal note, after very long weekends like this one, I think back to the multiple financial crises through which J.P. Morgan persevered since I joined in 1986, and provided a port of call to clients irrespective of how bad the storm got. What made it possible was a combination of strong leadership, a very strong balance sheet, risk management that has real teeth, and a diversified business model. Not too much has changed since then; people fear being unprepared to see Jamie Dimon the same way they did with Lew Preston 25 years ago, and that's a very good thing. I expect that we will be sending out additional updates during the week as events unfold.

(a) Price confusion: Merrill's sale of super-senior collateralized debt obligations in July at 22 cents on the dollar reopened the discussion on the Street's higher marks on similar positions. Another example: while Wachovia is recovering 65 cents on the dollar on foreclosed "option arm" loans (its Pick-a-Pay program), secondary markets for similar loans are pricing in less than half of that. High yield and leveraged loan managers tell us of securities they find ludicrously cheap at 75 cents on the dollar, but they're afraid to buy since the price could drop to 60 if forced sellers emerge. Other examples are markets like leveraged loans, where median and average prices decline together, indicating little differentiation of credit quality.
(b) There are few official aggregate statistics on repo markets. According to Tim Geithner at the New York Fed, tri-party repo agreements were around $2.5 trillion as of June 2008. Tri-party repo refers to arrangements under which money market funds provide collateralized financing to banks and brokers. For broker-dealers, tri-party repo markets are like plasma: in 2006, broker-dealers used repo to fund 40% to 50% of their entire balance sheets. Separately, there are bi-lateral repo arrangements between banks and brokers. The primary dealers that report to the New York Fed reported $7 trillion of repo exposure in the first quarter of 2008, according to the Securities Industry and Financial Markets Association. Estimates of European repo markets are another EUR 6.5 trillion, according to the International Capital Markets Association. What are the risks to repo markets? Lenders in repo markets are primarily relying on over-collateralization to secure their loans. But as volatility increases, traditional financing haircuts associated with high grade securities have proven insufficient, resulting in residual, unwanted credit risk for lenders.
(c) This does not entail significant increased risk of taxpayer money, since the Fed's haircuts are generally larger than the private sector's, and the Fed, like the Federal Home Loan Bank, ranks senior in bankruptcy.
Sources for cash balances: International Strategy and Investment Group, Investment Company Institute, Merrill Lynch Fund Manager Survey, New York Stock Exchange, Bloomberg.

Michael Cembalest
Chief Investment Officer
JPMorgan Private Bank