Credit Distress Easing; Spreads "Screaming In"

Posted by urbandigs

Fri Oct 17th, 2008 12:49 PM

A: You know, I'm starting to realize that this crisis will have multiple stages; the credit crisis stage, the financial distress/recapitalization stage, the equity correction stage, the weak macro economic data stage, the main street stage, and the city/state budget stage...But I must say, after 15 months or so since the credit crisis began, I am getting more and more bullish. That doesn't mean stocks will fly, although I am long at these levels and out of my short positions, but it may mean we have seen the worst of the credit distress.

Few things to note:

OCT 27th - The fed's commercial paper facility will begin. I am hearing very positive things about this facility and I have gone long stocks due to the combination of a nasty adjustment and the actions that are upcoming to ease the credit distress. I want to be long heading into the launch of this facility.

EARLY NOV - The TARP program will begin buying toxic mortgage backed securities. Now, $250Bln of this $700Bln plan has been injected directly into the banking sector. Some $125Bln was allocated to the 9 largest firms, and the rest likely injected into the regionals/smaller banks. With the TARP program about to begin, this injection of capital likely removes the element of an immediate capital raising that would come about from the first marking down of assets as the treasury begins their reverse auctions for toxic paper; and price discovery results! Look at it as a 1-2 punch. First inject the capital, then clean up the balance sheets. It seems there was little choice from the major banks to take this injection, thus removing the element of volunteering for injections that may have uncovered perceived weakness at specific firms.

In the past few weeks, we have seen the following credit indicators show extreme distress:

a) TED spread
b) LIBOR
c) Commercial Paper spreads
d) Corporate Bond Spreads

Now, I'm hearing from my contacts that spreads are "SCREAMING IN"; we'll see tomorrow by how much. I think we have experienced the worst of this distress, and the upcoming facilities by the fed and treasury likely will mark that the worst is behind us. For some time, the credit markets have been leading the equity markets; so if we do see substantial easing in the credit markets, we could see a relief rally in stocks.

However, we are not out of the woods and credit indicators are still at elevated levels. I just think we saw the worst already, unless an unforseen event arises. I still see problems with:

a) CDS - credit default swap industry & counterparty risks; which is about to be regulated and placed on an exchange
b) Fed's Balance Sheet - quality of collateral being put up by financials? Unsecured loans? Reining in all the facilities that were put in place to combat this severe credit crisis?
c) Rising unemployment
d) Weakening GDP
e) City/State budget crisis upcoming
f) Prolonged consumer led recession
g) Heavy regulation upcoming in financial system / credit system
h) Upcoming tax liabilities as a result of massive treasury issuance
i) Rolling over of treasuries as they mature may yield higher rates; long end of curve seeking significantly higher rates in years to come making borrowing more expensive

So, I still have concerns. But I think they will soon shift from the credit crisis, to the financial rebuilding, on to the pressure in stock market as economic data is very weak, on to main street, and then on to city/state budget issues. The chain reaction of events that started with the bursting of the housing & credit bubble are yet to show their ultimate effects, and time will expose who overleveraged themselves and are forced to sell assets at prices lower than they hoped.

For now, I am significantly more bullish than I was only 6 months ago, when I knew the worst of the credit crisis was ahead of us and that stocks have not yet priced in the severity of the situation we face. Today, I think we are much closer to the end of the credit stage of the crisis (those that went to the Yale Club heard my comments on Wed regarding my thoughts that we are nearing the end of the 'worst' part of the credit crisis & the fed's upcoming CP facility towards the end of the discussion - anyone have audio of this?). I see Barry Ritholtz feels the same way:

"For most of the past 2 years, I have invariably been the most bearish guy in the room. This has been true whether I was at a meeting or conference, on TV, in print, or simply out having dinner. The lone exception were anytime Nouriel Roubini was also present. Then I would be the 2nd most bearish person in the room.

Lately, I am the most bullish guy in the room -- and I have to tell you, that is just plum weird to me."
The future holds the next few phases of this deep and prolonged recession, and it will hurt. For now, lets get the credit system fixed, confidence restored, trust, and lending going again without sacrificing quality/standards or being forced to lend. But this has to happen if better times lay ahead. Lets hope that the next administration puts in place the right combination of execution of facilities, policies & regulation, so as to cushion the blow to the average Joe without placing too much debt burden on us all. Or is it too late for that?

If Mish had his way, we will eliminate:

1) The Fed
2) Fractional Reserve Lending
3) Micromanaging Interest Rates

What do you think?

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