Federal Reserve acts to break bearish market psychology
The Federal Reserve announced an extension of the "Term Auction Facility" to $200 billion and also announced that it would accept a broad variety of mortgage backed collateral. How did this announcement cause the Dow Industrials to rally 3.5%, the S&P 500 3.7% and the NASDAQ 4.0% in day?
To explain, it helps to understand the Fed's monetary tools. The Federal Reserve Bank can set the cost of money by targeting the Fed Funds Rate, currently 3%. The Fed can also target the supply of money through "Open Market Operations." Banks and primary dealers can hold reserves either in cash or in treasury securities. If held in treasury securities, the reserves cannot be loaned. If the bank should sell the bonds, and obtain cash, those funds can be loaned. A bank must hold 3-10% of that money in reserve, and lend the rest. Let's say that a bond worth a $1,000 is sold. The bank reserves 10% or $100 and lends $900 to a corporation, which holds that money in their checking account. The bank can reserve 10% of that deposit - $90 - and lend the rest. Depending on a variety of factors, the multiplier effect of the original sale is between 7 and 10, so for every $1,000 the bank has in cash, between $7,000 and $10,000 in loans can be made.
On a daily basis, the Federal Reserve Bank will fine-tune the money supply through Repo's and Reverse-Repo's (Repo is short for Repurchase Agreement.) A bank will sell securities to the Federal Reserve with agreement to repurchase the bonds (usually the next day) at the same price, adjusted for a day's accrued interest. Sometimes the term is a couple of days or longer depending on market conditions.
The Term Auction Facility is an extension of the Fed's Repo Desk, but with a couple of distinctions. The major difference is that instead of taking in treasury bonds and giving cash, the Fed will take in mortgage backed securities (the hard to price bonds which have caused a lot of trouble in the last 6 months) and deliver an equivalent dollar amount of Treasury Bonds. The T-bonds are highly liquid and priced continuously, so no one doubts their value. Those bonds can readily be sold, raising cash which can then be loaned. The mortgage backed securities are illiquid, trade infrequently, and their fair market price is often a guess based on a model. By doing the swap, the Fed removes an overhang of these MBS from the market and also establishes a firm price for them.
How does this benefit the financial system? As we have commented a number of times in the last several months, the world (not just the US) economic system is in the throes of a world wide "margin squeeze." Thousands of hedge funds and the proprietary trading desk of many banks and dealers have reaped substantial economic rewards in recent years by buying a low quality, high yielding assets such as corporate bonds, high yield corporate bonds or mortgage backed and financing them by shorting lower yielding treasury bonds. If the trader owns an asset with a 6% coupon, financed by shorting a 4% treasury, the yield spread is 2%. Typically, for every $1,000 invested on the long side (e.g. a corporate or MBS) the trader would have shorted $980 worth of treasury bonds, putting up only 2% in actual equity. Theoretically, if there's no fluctuation in bonds prices, the trader earns $20/year on $20 of equity, or 100% returns. In practice the returns, while substantial, are less.
The nightmare occurs if the markets suddenly decide to sell risk and buy safety. In the above example, the corporate or MBS might be marked at $900, not a $1000, while the treasury might be marked up to $990. In a very short time frame, our out of luck trader could lose $90 versus $20 of equity. In recent months, prices for non-treasuries, particularly mortgage based bonds, have fallen sharply. As the rate of foreclosure increases, the principal value of certain mortgage backed securities fell from par of $100 to $80, $60, even $40. Meanwhile, as investors flock to safety, treasury prices rise while treasury yields fall. At least a dozen hedge funds have failed since February with 100% losses to their investors, on top of other hedge funds which went out of business last fall. As each fund fails, their collateral is liquidated at fire sale prices by the dealers, which depresses prices across the market and sets the next fund for failure.
Although we never invest on margin, our clients are none-the-less being impacted by the forced collateral sales. The old Wall Street saying is "When you can't sell what you want, you have to sell what you can." In recent weeks there have been weird disruptions in seemingly unrelated markets such as preferred stock and municipal bonds. Due to capital losses, primary dealers abandoned support of the floating rate municipal bond market. About a month ago, for an afternoon, you could have bought a triple AAA rated Port Authority of NY/NJ bond with a yield of 20% for one month (the next day, the yield had fallen back to the normal 3% range.)
Liquid US large cap stocks are also being sold wholesale. Oracle, Intel, IBM, Cisco and Apple all announced record revenues and earnings in January; the stocks are all down 30-45% YTD, giving these companies the best valuation in 20 years.
Strategy
The monster one day rally unfortunately doesn't mean we're out of the woods yet. Although we're not technicians, quite a few market participants are focused on whether the markets can remain above key "support levels." After falling to 18 months lows earlier this week, the Dow was below a technically important level of 12000, while the S&P 500 fell below 1300. After the March 11th rally, both averages are above those levels, but barely. As we have said for weeks, "There are no natural buyers in the market right now." Individual investors have been liquidating equity mutual funds at a brisk pace, regrettably capturing the lows for the year.
A number of clients have asked us if there a way we could "step out" of the market for a few months until the carnage is over. There is no practical way to do this, primarily because we have no way of predicting when the Fed will step in to support the market; because selling stocks and buying them back a few weeks later generates substantial gains taxes and because when the market does, rally, it gaps up 2% or more and there's no way to catch up.
Instead, we have checked and rechecked our companies to make sure that their fundamentals remain sound (i.e. real products, real revenues, real earnings, reasonable valuations.) Whatever cash is left over will probably be invested in April. The Fed will cut rates at least 0.50% on March 18th, possibly 0.75%, which will give the stock market a short term boost. More critically, we're waiting to see the next earnings reports from Morgan Stanley (3/19), Bear Stearns (3/20), Merrill Lynch (4/17), Citigroup (4/18) etc., to see if the rate at which these banks are writing down the value of collateral is diminished (worldwide, the write-down totals nearly $200 billion.) These banks all have new management as of December, who were incentivized to mark down the problem bonds aggressively and blame the cost on previous management. We expect to see the rate decline, but we'll hold on further investments to be sure.
