Ginormous Stimulus = Ginormous Rally

Posted by jeff

Thu Sep 18th, 2008 06:20 PM

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The Fed, ECB, Bank of England, Swiss National Bank and BoJ plan to pump $180 billion into the world financial system. That on top of the more than $230 billion pumped into various markets by central banks so far this week (not to mention the massive bailout fund apparently being worked on by Congress, the Fed and the Treasury department). Amazingly (tongue firmly implanted in cheek), some of this money managed to get into the stock market. Hmmmmm! Let's flash back to the early 1990s. The banking system is on the ropes; many graybeards who were in the markets then will tell you that most of the major banks were bankrupt (on a mark-to-market basis). There were no loans being made. The fed lowered rates like crazy and held them there, and still banks really weren't able to lend. In fact, this is when and why the Commercial CMBS market was born (some good background info here). The lower interest rates could not be transmitted as increased money supply to the economy due to the banks acting as bottlenecks. There were, however, two key ways that lower rates were able to help the economy. The steep yield curve allowed banks to borrow from Uncle Sam at low rates at one window and walk around to the back door and lend the government back the money at a high rate. After a couple of years bank balance sheets were in better shape and they could start to lend again. The second and more immediate impact from lower rates was a huge refi wave. Rates hadn't been this low since the sixties and people took advantage of this to lower their interest costs.

Back to present day. We all know that banks aren't lending, and I can tell you from my own business that banks continue to back away from more areas of lending. First it was construction loans, non-recourse loans even for investment properties, and now it's commercial property loans (I'm generalizing, as we can still find some willing to lend, but it's a trend).

Unfortunately, there is very little consumer refi opportunity. Anyone who wanted to refi a mortgage on a property they have owned for a long time, and have decent equity in, was able to do so after the dot com collapse when 30-year fixed mortgage rates got down into the low fives and briefly into the high fours (if I remember correctly). With plummeting residential real estate prices and stricter lending standards, putting lots of cash in consumer pockets through refis is unlikely. Eventually, there may be an opportunity for commercial building refis as banks who will lend can earn unbelievable spreads vs. their cost of funds. (Many loans made in recent years were for five-year terms and will be up for refi in the next couple of years anyway.) Many of the loans outstanding today are variable rate and keyed to LIBOR. If the world's central banks can figure out how to wrestle LIBOR lower it would also help cash flows of companies and individuals.

Come to think of it in the case of the early 1990s, there was one more place where the creation of money manifested itself and that was ........the stock market. The wealth effect of a stock market fueled by lower rates and P/E multiple expansion, eventually helped corporate earnings and household wealth expand too.

I don't know where all the money being sprayed around the world financial system will go, but it will end up somewhere. We know much of it will be destroyed over the next few years as bad debts melt it away. With most of the transmission mechanisms for getting money into the economy broken, a ban on short sales in the offing and massive liquidity being pumped out, it's possible that some of it could find its way into stock markets, which might respond with a mystical levitation act. (Of course gold levitated too, proving you can fool most of the people all of the time, but there will always be some gold bugs who know the dollar is really worthless.)

It just gets weirder and weirder.





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