Cashing In On Panic

By Jason Goepfert

(Observer's note: this article led me to a very informative fellow blogger's website focusing on market volatility. I mark it here for my own reference - Bill Luby's blog site. The mid-term anxiety is killing me. ... I wish I could survive and then I'll reorganize my site to give it a nicer look.)

On the VIX and More blog, Bill Luby presented an interesting indicator this afternoon that takes a ratio of the VIX implied volatility gauge to the yield on the 10-year Treasury Note.

The ratio makes sense as a measure of fear or uncertainty in the market, since the VIX tends to spike higher during those times, while a rush to the safety of government debt tends to lower the yield on Notes. So when we see times of extreme duress, it should coincide with spikes higher in the VIX / Treasury Ratio.

The problem with the indicator is the limited history of the VIX. However, we can get around that by computing historical volatility on the S&P 500 instead - the two are very closely correlated. By doing that, we can get a history of the measure all the way back to 1962.

When doing that, we do indeed see that big spikes in the indicator have only occurred during panic situations. "Extreme" for this measure could be considered anything over a ratio of seven (meaning the level of S&P volatility is seven times greater than the yield on the 10-year Notes), and our current situation now qualifies.

The table below shows all dates when the ratio went from below seven to above seven. Note that there were some dates in fairly close proximity as the Note yield jumped around a bit at these times. Instead of removing them from the study, I included them so we could see all the dates.



We can see from the table that results going forward were exceptionally positive, and consistently so. Looking across the time frames from one week to three months, there were few negative returns, and the averages were several multiples of random returns during the study period. The combination of a high volatility level and low Treasury yield corresponded to some excellent buying opportunities over the past 45 years, with essentially no failures.

Airlines May See a Relief Rally Soon - Morgan Stanley

(Observer's note: this article was originally posted at seekingalpha.com on 3/25. When I started this blog I intended to avoid posting articles on specific company stocks, but this one is an exception because I consider of studying AMR price movement for the time series analysis project, given the fact that the presented company has a relatively long history without bankruptcy interruption. I need to find multiple factors affecting AMR price movement, right now what I can think of is oil spot/future price. ... need to find at least another one. Any suggestion?)

Morgan Stanley is out with a superb positive call on Airlines:

Firm is revising their estimates and price targets lower for $105/bbl oil and Morgan Stanley’s most up to date economic forecasts. Looking forward, as their Bull/Bear/Base summary highlights, they expect significant volatility in airline equities. However, contrary to the consensus view, the firm would not initiate short positions at current prices.

In fact, they believe airline equities are poised for a relief rally in the near-term and suggest that nimble investors position themselves accordingly across legacy airlines.They are still not recommending the space to long-term holders, but are on the lookout for a change in either 1) macro forecasts or 2) the potential for a "Tipping Point" catalyst.

They expect to see broad capacity cuts across carriers, specifically the legacy airlines, within the next month or two. Fundamentals are deteriorating, but if MSCo's EBITDAR estimates and expectation of multiple expansion is correct, the stocks have already priced in a relatively bearish outlook (base case).

Following the consensus view on airlines has historically been an unprofitable strategy. Over recent years, broad changes in consensus have led to the reverse outcomes in airline share performance. The recent numerous airline downgrades across the sell-side should pique the interest of investors looking for outsized returns.

Firm uses AMR as an example of this effect due to its relatively long price history which is uninterrupted by bankruptcy. This suggests that the next immediate absolute move in AMR is likely to be higher (as they expect it to be for the industry if they are correct about a relief rally).
Notablecalls: Wonderful call by MSCO's William Greene. I expect AMR (NYSE:AMR) to move up today following these positive comments. Why?

- First, AMR showed me yesterday that it can move upward. We had a rumor on NCN yesterday that British Airways has sent a letter to AMR board with 3,2bln (about $13/ share) offer to acquire the airline. The stock made a swift 10% upward move intraday (I'm sure you can spot it on the chart). The path of least resistance is up!

- Secondly, my gut is telling me oil is coming down at least in the near term. That should boost airlines.

I would also keep an eye on Southwest (NYSE:LUV), the only Overweight rated Airline stock under MSCO's coverage.

Who Will Be Next Bear?

By Bennet Sedacca
Tags: MER, JPM, BAC, LEH, BSC, FRE, FNM, WB, MS, WFC, CIT

(Observer's note: this article is lengthy, and overacting to the past events in some ways. But there are some very good points worthy of pondering at. I highlighted the lines on Fed March balance sheet. This is not the invisible hand, rather, it's black hand under table.)

There are two kinds of people in the world, my friend. Those who have a rope around their neck and those who have the job of doing the cutting.
- The Good, the Bad and the Ugly

The Great Debt Experiment has now morphed into the Great Credit Unwind, and we are asking ourselves how this will all end. My answer has been ‘I Don’t Know,’ as I wrote in my piece last December. The reason for the answer was that I felt (and still do) that the buildup in debt, leverage and derivatives is so unprecedented that the fallout from the buildup should be unprecedented as well.

So while I keep hearing tales of bailouts and a bottom forming in the credit markets, I could not disagree more. In my mind, the unwind has just begun and if anything will accelerate in coming months as more and more companies, mostly financial institutions, will have an incredible need for capital—capital that is needed to simply remain in business. This may sound draconian, but as I have been saying for years, when the unwinding process begins, it will not be pretty.

Forced Marriages: The Good Bank/Bad Bank Scenario

Several weeks ago, I wrote about the balance sheet issues surrounding Bear Stearns (BSC) and Lehman Brothers (LEH). Considering how leveraged these have become, any misstep is magnified and results in a lack of financing, which is critically needed to remain solvent. Simply stated, if your balance sheet is levered 35 to 1, and you have four times as many 'Level 3 assets' as you do capital, you could be in deep trouble if one or more counter-parties decides they don't want the other side of your trades.

This occurred in the case of Drexel Burnham Lambert about 20 years ago, and happened to Bear Stearns two weeks ago. Since all of the major investment banks, commercial banks and hedge funds are so intertwined, the Federal Reserve stepped in and took $30 billion of 'hard to price' securities off the hands of J.P. Morgan (JPM) and let it buy Bear Stearns for a song. Whether or not it'll be able to retain Bear's talented people after giving them $10 per share (down from $160 last year) remains to be seen. Many of these talented individuals could flee to other firms in exchange for large signing bonuses and we still don't know exactly what was on the balance sheet of Bear after the $30 billion of truly esoteric securities were handed to the Fed.

This type of behavior occurred in Japan in the early 1990's after its real estate and stock market bubbles were deflated. The good bank (in this case, JPM) gets a steal while the bad bank (in this case, Bear Stearns) gets the shaft. The question in my mind, however, is how many "good banks" are left to absorb all of the "bad banks"? In a nutshell, I believe the answer is "not enough." In the middle are the "not-so-good banks"—those that are too big to be taken over and too leveraged to play "good bank." I guess they are just stuck in the middle.

Yes, I'm stuck in the middle with you
And I'm wonderin' what it is I should do...
Clowns to left of me, jokers to the right
Here am I stuck in the middle with you.
—Stealer's Wheel

Bad Banks Defined

Without naming names quite yet, what would you think of a company that accomplished the following in 2007?

• Wrote down book value from $39 billion to $32 billion or from $41.35 to $29.34 per share.
• Increased shares outstanding from 868 million to 939 million.
• Increased Treasury Stock from 351 million to 418 million.
• Increased long-term borrowings from $147 billion to $201 billion.
• Increased preferred stock issuance from $3.1 to $4.4 billion.
• Increased Total debt to common equity to 2816.81%.
• I could cite 20 or more similar financial ratios and they are all stunning.

Who is this firm? Merrill Lynch (MER). This is not a 'market call' on Merrill, although my firm does maintain a position in Merrill options, but this would certainly be considered a "bad bank" in my book. Could it end up in the hands of a "good bank" like JPM? Maybe, maybe not. It has a wonderful brand name and footprint in the investment banking space, but you need capital to survive in the industry, and with the write downs I expect in coming quarters, many of these firms will have a huge need for capital just to remain viable.

Some statistics on another potential bad bank:

• Wrote down book value from $35 billion to $31 billion or from $32.67 per share to $28.56 per share.
• Increased long term borrowings from $127 billion to $160 billion.
• Increased total debt to common equity to 2496.53%.
• Maintains an $88 billion position in Level 3 assets, or 283% percent of shareholder equity.

Who is this firm? Morgan Stanley (MS). Again, these numbers seem tragic to me when I consider what would happen if the company was actually forced to write down its "hard to price, hard to sell" assets.

There are only two solutions in my mind for what can happen to these firms. They can raise capital or sell themselves, perhaps for not very much. The capital raises I foresee in the second quarter might be something for the record books. Fannie Mae (FNM) and Freddie Mac (FRE) may need to raise up to $20 billion this year through a combination of preferred, convertible preferred stock and equity to get their financial ratios into OFHEO compliance, as they are being asked to pick up the slack of the hundreds of mortgage lenders that have gone bad and the commercial banks that are now backing away from lending. I just read a news story where UBS (UBS) may need to raise upwards of $16 billion. Merrill, BankAmerica (BAC), Wachovia (WB), Morgan Stanley, HSBC (owner of Household Finance), and many others will not be far behind.

How long will market participants be available to buy all of this new paper? My general take is not for long. While the Fed takes rates closer to zero, most large preferred stock deals have remained in the 8% area. If Merrill et al needs to raise upwards of $100 billion just to remain solvent, what rate would I pay for this paper? I hate to say it, but it would be somewhere north of 10% and as high as 12-15%. I just don't see the value when I can buy Fannie/Freddie paper at 8 ½%. And what happens if they have to pay that rate? Profitability shrinks. In other words, the credit unwinding is like watching a train wreck in slow motion.

There are other bad banks, such as CIT (CIT), a global and consumer finance company that is slowly eating away at its capital base. It's in so much trouble that it recently had to draw down a $7 billion credit line just to avoid insolvency. It might fit very well into the likes of a GECC. Again, common shareholders may not like the price but it could be a great big/bank fit. Another bad bank might be Cleveland-based National City Corp (NCC). It's recently been forced to pay 12% in a corporate debt offering and nearly 10% in a preferred stock offering. Rumors circulate almost daily about an imminent buyout, but if you were a buyer, would you really want to buy a bank that has HELOCs (home equity letter of credit) on homes in industrial states such as Ohio and Michigan and in the previously hot states of Florida and Nevada?

Not to mention all of the smaller, regional and community banks that based their lending model around real estate based loans. So you see, the problem is much more pervasive than many think. Then there is FGIC, which was just downgraded to junk bond status the other day. I am sure Ambac (ABK) and MBIA (MBI) are not far behind as their models are hopelessly broken. They had perfectly good business models until greed took over. I think they will all just disappear.

OK. All of this is rather sobering, so the real question becomes how does one take advantage of these opportunities? For quite a long time, my firm was long GSE preferred equity and short preferred equities of broker/dealers, particularly Bear, Lehman and Merrill. But two weeks ago, when the shotgun wedding of JPM/Bear finished and rumors began circulating about Lehman’s solvency, I removed all short side bets against the brokers and shrunk the long position in Fannie/Freddie.

Since that time, however, I have initiated short positions in preferred shares in the 'not-so-good' banks, like Wachovia, Wells Fargo (WFC), etc. It seems ludicrous to me that we can buy Agency preferred shares with a 'tax equivalent yield' around 11.5% and short preferred of Wells Fargo that are fully taxable and yielded barely 7.2% at the time the trade was initiated.

In other words, I am getting paid to short credit risk. The reasoning behind this trade is that I'm a bit afraid that if a good bank bought a bad bank and I was short their debt, the debt could be assumed by the buyer, making the debt worth more, even while possibly wiping out equity holders. And to short the debt of the good bank that is getting a great deal (even though I have to admit being short JPM preferred stock as it's hopelessly overvalued in my book) may not be the best way to go.

But the ones in the middle that are too big to buy and in too poor a shape to absorb a struggling bank seems the best bet. Keep in mind that this is not a bet against the common shares, just the preferred shares, as I expect that the tidal wave of issuance could "re-price" the entire sector, and in the meantime we will simply collect the "positive carry." A worst case scenario in my mind is that the entire preferred stock space is re-priced and my longs and shorts fall together. While possible, it's not the most likely scenario, but I'm prepared for such an occurrence.

FRE 8 3/8% Preferred Stock

WFC 7% Preferred Stock

What about the buyer of last resort, the Federal Reserve? The Fed releases its balance sheet weekly and below is its latest balance sheet as of March 27th. Year-over-year direct holding of Treasuries fell by a whopping $151.9 billion and were replaced with assets from the balance sheets of not only commercial banks, but also from primary dealers. This is unprecedented activity by the Fed. They used to only lend at the discount window to troubled commercial banks. And they only took Treasuries as collateral. But now they take in not only Treasuries, but agency paper, and more importantly, non agency AAA CMO's.

We do not have a listing of the exact securities they have on their balance sheet, but if you were a primary dealer with a host of securities that were 'hard to price' or 'hard to sell' and were AAA rated, wouldn't you hand them over to the Fed in exchange for Treasuries?

If I owned securities that were falling in value and had deteriorating credit, I would be left to sell my securities into the open market and take my loss. So "where is my bailout when I make a mistake"? It seems that the Fed, unless it's granted a lot more liquidity from Congress, may have set a rather dangerous precedent of stepping directly into what used to be a free market and now is tinkering with a financial system that needs more than a band-aid. Rather, it's in need of a tourniquet.

Condition Statement of Federal Reserve Banks, March 27, 2008

Ouch! That's My ARS! About a month back, I wrote an article entitled Pain in the ARS. ARS, or Auction Rate Securities are now beginning to make headlines and could prove extremely damaging to investors and the dealers that sold them to investors. ARS work in the following way. Suppose that you want to build a closed end municipal bond fund and be able to pay the broker 7% selling concession, charge 1% a year, and still pay the buyer a reasonable return. The only way to accomplish this is to leverage the fund. The fund levers up by selling ARS, or preferred stock at rates below the rates the fund earns on long term bonds purchased; essentially a "positive carry trade," and this worked for the last 20 years or so. Even though the securities have 40 year maturity dates, they are auctioned off every seven or 28 days, depending on the issue.

The securities yield a bit more than traditional money market funds and were considered "cash equivalents" when in reality they are very long term bonds that reset every so often, so long as there is a buyer and the auction doesn't "fail" to attract enough buyers to reset the rate. What happens in a failed auction? The owner cannot get their money back from the brokerage firm—they simply have to stick it out until enough buyers are found to avoid failure.

When brokerage firms were flush with cash and making lots of money from traditional activities like investment banking, auctions never failed. The dealer simply stepped up and bought the remaining ARS and kept the auction from failing. These days, however, the dealers, like UBS (UBS), Merrill and Morgan Stanley are in dire need of capital themselves, leaving the investor to hold the security, perhaps for the entire duration, or 40 years.

This brings to light several important points. First, you are stuck in the security for possibly a long time, but failed auctions pay investors the "maximum rate" as defined by the prospectus, which on the surface sounds good. But in reality, most of the shares associated with closed end bond funds have a maximum rate of 110% of commercial paper.

Blackrock Muni Insured Floating Rate History

Blackrock Muni Insured Maturity Data

Note the "workout date" of 12/31/49. That is 41.75 years for those counting. And with the commercial paper index plummeting along with Fed Funds, I fully expect commercial paper rates to settle as low as 2%, which would net the ARS holder a whopping 2.2% and no liquidity.

So what is happening? UBS announced on Friday that it'll begin to mark the securities to market (as if there actually were a market). They haven't yet disclosed their pricing methodology but I have one of my own. If someone asked me to buy this security, I would demand a yield of 10%. After all, I can buy agency preferred stock at 12% tax equivalent yield with loads of liquidity. Where would that bond trade? Yikes: something on the order of 23 cents on the dollar, as my table below shows.

Theoretical Price for a 2.2% ARS

There are actually some examples that are actually worse than this. Some student loan-backed ARS have reset to zero coupons. What would I pay for a forty year security with no yield? Zero.

So brokerage firms are about to feel some heat. Investors, no matter how naive, were sold the ARS with the belief that they actually were cash equivalents. The securities will now be reclassified and written down in price simultaneously. The investor will no doubt sue, and the brokers, who to be frank are barely compensated for placing ARS in the client account, may be rather upset as well as the phones begin to ring off the hook. And this is a huge market—somewhere in the vicinity of $300 billion. When they get written down, expect the class action suits to start flying, right at the folks with no balance sheet.

The greedy are now being penalized. It's now possible that the good, the bad, the not-so-good and the ugly will all get hurt at once. Such is the unwinding of greed.

Copyright 2008 Minyanville Publishing and Multimedia, LLC. All Rights Reserved

Less Corn Could Mean Higher Food Prices

By Mary Clare Jalonick, Associated Press Writer

Farmers Planting Less Corn, and That Could Mean Higher Grocery Bills for Consumers

WASHINGTON (AP) -- From chicken nuggets to corn flakes, food prices at grocery stores and dinner tables could be headed even higher as farmers cut back on the land they're planting in corn this spring.
Corn prices already are high, and a drop in supply should keep them rising. Combine that with the huge demand for corn-based ethanol fuel -- and higher energy costs for transporting food -- and consumers are likely to see their food bills going up and up.

Farmers are now expected to plant 86 million acres of corn this year, the Department of Agriculture predicted Monday, down 8 percent from last year, which was the highest since World War II.

Corn is almost everywhere you look in the U.S. food supply. Poultry, beef and pork companies use it to feed their animals. High fructose corn syrup is used in soft drinks and many other foods, including lunch meats and salad dressings. Corn is often an ingredient in breads, peanut butter, oatmeal and potato chips.

Corn components are even used in many grocery store items that aren't edible -- including disposable diapers and dry cell batteries.

When the corn that goes into those products goes up in price, increases eventually can be passed along to consumers.

And corn prices have skyrocketed in recent years, almost tripling since 2005.

Corn began its latest surge in early 2007, rising from just over $3 per bushel to record prices above $5 per bushel today. If prices hold steady or rise, the average yearly price per bushel in 2008 will be the highest ever, according to USDA statistics.

Corn climbed higher Monday following the release of the USDA report, with the most-active contract briefly hitting an all-time record of $5.88 a bushel on the Chicago Board of Trade before settling at $5.6725 a bushel, still up 6.75 cents.

They have been pushed along by the burgeoning ethanol industry, which turns the crop into fuel, and by rising worldwide demand for food.

"People who are working families, just barely making it and already paying higher prices for gas and home heating oil are going to be shot in the pocket by higher food prices," said Carol Tucker-Foreman of the Consumer Federation of America.

Richard Lobb of the National Chicken Council said recent increases in the cost of corn feed have been absorbed by larger chicken companies, such as Pilgrim's Pride Corp. or Tyson Foods Inc., that provide feed to poultry farmers. But that could change.

"At a certain point we have to readjust and get back to square one," Lobb said. "The only people who have money ultimately are consumers."

Tucker-Forman of the Consumer Federation of America and Scott Faber of the Grocery Manufacturers Association both say rising food prices could be stemmed if Congress would pull back subsidies for the ethanol industry.

The number of ethanol plants has almost tripled since 1999 and more are being built, according to the Renewable Fuels Association. Such plants could gobble up more than a quarter of the country's corn crop.

"Food prices being driven by the food-to-fuel mandates will most significantly affect the working poor," Faber said.

Matt Hartwig of the Renewable Fuels Association said the higher prices can't be blamed only on the ethanol industry.

"There are a host of factors contributing to higher corn prices -- surging global demand to feed people and livestock, a weak dollar encouraging exports, and rampant speculation -- that have a far greater impact than America's ethanol industry," he said.

According to the Agriculture Department, corn planting is expected to remain at historically high levels but may dip this year because of the high expense of growing corn and favorable prices for other crops, such as soybeans.

As many farmers have switched, soybean planting is expected to be up 18 percent this year, at almost 75 million acres. Farmers are also expected to plant more wheat this year, which could lower retail prices for pasta and bread.

Soybeans for May delivery fell the 70-cent limit Monday on the Chicago Board of Trade, settling at $11.9725 a bushel. Still, soybean prices are up 45 percent since March 2007.

The Department of Agriculture report is based on sample surveys of 86,000 farm operators in the first two weeks of March.

Terry Francl, a senior economist for the American Farm Bureau Federation, predicted Monday that corn prices will continue to rise but he said consumers shouldn't panic just yet.

Many farmers will take a look at the report and decide to plant corn instead of other crops, he said, and weather conditions could also change things.

"We're going to have to wait until we go through the spring planting season," he said.

John Hoffman, a soybean grower from Waterloo, Iowa, and president of the American Soybean Association, said farmers will always find ways to grow more crops to stabilize prices. Though high prices are good for the farmers, there's bound to be a correction, he said.

"There's an old saying out on the farm that the cure for high prices is high prices."

Where the corn ends up: http://www.ncga.com/education/unit9/u9l1.asp