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Well, it has been an “interesting” two days to say the least.
Bond insurance did not light the powder keg. Bond insurance IS the powder keg.
Emerging markets shed 15-20 percent on Monday and Tuesday. India's BSE 30 plunged 20 percent from Friday afternoon to the Tuesday close; Hong Kong dropped a comparatively milder 10 percent, although it remains 30 percent off its high in late 2007. Germany, France, Brazil, Spain, Mexico, and everywhere else experienced cumulative double-digit declines on Sunday and Monday nights, American time.
Americans awoke to a bright-and-early 75-basis point Federal Reserve cut. The Dow opened down 450 points, but by the end of the day was down a mere 150.
Bernanke's rate cut decision was a godsend to gold, murder to the dollar, and impossible to justify all around. Gold rallied 5 percent in the three hours following Bernanke's announcement, and once again hovers around 890 (from the 840s on Martin Luther King Day). The conventional wisdom for the panic was a combination of popping bubbles in Asia (much akin to the “Asian contagion” of late February 2007), combined with the fear that the bond insurance industry (the “monolines”), Ambac in particular, is headed for default.
What's a monoline – or bond insurer, or whatever – you ask? A bond insurance company like Ambac goes around to municipalities and other institutions with weak credit. Say South Bend, Indiana wants to raise money for a new public school through a bond issue. Unfortunately, South Bend's credit rating is poor, because of a default that happened 15 years ago (I don't know if that actually happened. This is a hypothetical scenario here.) Because of its bad credit history, South Bend must pay a high level of interest, say 400 basis points – 4 percent per year – above the interest rate on US Treasuries, for investors to be willing to buy South Bend's bond.
Enter a bond insurance company, such as Ambac. Ambac offers to insure South Bend's school bond for, say, 50 basis points per year, meaning that Ambac will pay investors back if South Bend defaults on its debt. South Bend, which would have otherwise had to pay 400 basis points over Treasuries for the bond issue, instead “rents” a AAA rating from Ambac, and only has to pay, say, 50 basis points over Treasuries (plus 50 basis points to Ambac, for insuring the bond against default). It's a win-win all around.
Bond insurance was such a win-win, in fact, that the two biggest players in the industry, MBIA and Ambac, now collectively insure over $1.2 trillion in municipal bonds (most of which is low risk), plus a few tens of billions in CDOs and higher-risk debt which recently plunged in value. If Ambac gets its credit rating downgraded from AAA to A, then every single bond issued at AAA because of Ambac's insurance guarantee also gets downgraded from AAA to A.
You can easily imagine the chaos that would ensue if $1.2 trillion of bonds were downgraded. Borrowing costs would spike all over the country, local taxes would go up to meet those costs, and a few particularly overextended municipalities would probably file for bankruptcy. The mere downgrade of the smallest bond insurer in the industry, ACA, from AAA to CCC, crushed the credit ratings of $60 billion in insured debt, and precipitated billions in bank writedowns, notably $3.2 billion fourth-quarter writedowns at Merrill Lynch alone.
So, are we at the precipice of financial Armageddon? Everyone has an opinion, and mine is that we aren't. MBIA, Ambac, ACA, and the others are in trouble because they did not plan for nearly as many defaults as are currently happening in their high-risk debt. They do not have the capital to meet their writedowns, and their playing it close to the edge means that $1.2 trillion in municipal debt is very close to getting knocked down.
However, an outsider with experience, a reservoir of market respect, a real AAA credit rating, and a large capital reserve would have no problem getting back into the business. That man, as it turns out, is Berkshire Hathaway's Warren Buffett. But Buffett won't get back in until there's lots of blood in the water and he can take over the bond insurance industry on the cheap, and that means that some chaos must be allowed to happen.
However, the federal government is in no mood to let markets operate efficiently. A “real” bailout of the financial markets would almost certainly entail bailouts for MBIA, Ambac, and FGIC, the three main bond insurers. Smarter investors who got out of the business when it became overextended, such as Buffett, will be effectively cheated, and American taxpayers will have to shoulder the price of MBIA's and Ambac's incompetence.
The Federal Reserve's recent 75 basis-point cut makes no sense when the Monday/Tuesday financial panic is viewed in this context. 75 basis points was nice; proportionally, it's the largest cut in Federal Reserve history. But it does nothing to change the fact that the monoline industry, the fault line of the latest credit panic, is short tens of billions of dollars in capital requirements. There is no rationalization for the Fed's latest move, except that the Fed is at least as panicked as the markets are, and views rising asset prices as some kind of market entitlement.
Taking stock
My “reflation” predictions last week were, ahem, a tad premature. Now, if you visited our blog, http://cartmanist.wordpress.com, you would have read on Thursday that we said to stay out until at least one of the Ambac/MBIA pair goes bankrupt. But, I suppose that's having it both ways.
I never thought the monoline problem was as big of a deal as the market apparently does, considering that a Buffett ride to the rescue is only a matter of time – if market prices are allowed to set themselves, without undue interference from government institutions.
Unfortunately, as of Tuesday morning, that option is not on the list. The government is simply not willing to allow markets to function on their own. The Fed will cut at least 50 more basis points at the end of January, bringing the Fed funds rate down to 3 percent.
At some point, the Federal Reserve will cut too much, and the Saudis and Chinese will dump dollars on a scale never seen before. But we aren't there yet.
I was catastrophically wrong with regards to Treasuries. I do not understand why anyone would want to own Treasuries when they are earning negative real interest, and when the US government consciously favors the stock market at the expense of bonds. One of the greatest traders I know—one of the greatest short-term traders in the game, in fact—went short bonds on Thursday and Friday, and was utterly mauled by Tuesday's move into Treasuries. I may be stupefied, but I know I'm in good company.
As I said in August and November, the Fed's reflationism will have zero positive impact beyond a very short time horizon. Remember the August panic, followed by all that Fed rate cutting, and how jubilant the market was? By November the market was back over 14,000, because so many money managers were so stupidly superstitious about what the Fed can and can't do. Look where that got us.
The latest round of cuts is even more desperate, and will be even less effective. As always, be long gold. Stay away from most assets until there is some resolution of the monoline sector, whether by bankruptcy filings by Ambac and/or MBIA, or a federal government bailout.
If a major monoline goes bankrupt, the markets will experience true chaos, and the ready buyer will experience a true buying opportunity. Federal intervention, on the other hand, will be another short-term reflationary shot in the arm. It will be good for gold, bad for America, and bad for the markets. And something else will hit the fan two months from now.
So, if there is much rejoicing in the news over an Ambac/MBIA bailout this week or next, don't buy into it. I don't have much in the way of recommendations (except being long gold, as always) until that situation resolves itself, one way or another.
The Bottom Line
Gold: Long
USD: Neutral
EUR: Neutral
GBP: Short
AUD: Long
--Alex Forshaw,
Editor in Chief
http://www.bestwaytoinvest.com
PS: If you enjoy our commentary, be sure to check out our newsletter's blog, http://cartmanist.wordpress.com, for further market commentary.
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