Weekday Commentary from Jim Puplava
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The Impossible
Unsinkable ships sink ~ words from "The Impossible" by Joe Nichols ~
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Wednesday, October 9, 2002
The Unthinkable is Not Impossible
On Wall Street, they are worried. At the Fed, they are burning the midnight oil. In bank boardrooms, they are passing out Maalox. The unthinkable may be about to happen. A systemic risk that causes the financial system to implode is now a distinct possibility. The $110 trillion worldwide derivative market may be about to unleash a storm of undetermined consequences. Nobody has a model that can predict the possible outcome. How do you account for something never seen before? It has been more than 70 years since a storm of this magnitude has been seen or experienced. Most who work on the Street or in the trading rooms of large financial entities have never seen a 100-year storm. Very few alive today remember the consequences, much less lived through the carnage of the Great Depression and the stock market crash that preceded it. To many, seeing the Dow lose 88% of its value as it did during the bear market of 1929-32 is inconceivable. The fact that the Japanese Nikkei has lost 78% or that the NASDAQ is down 78% doesn’t seem to register. Everyone expects a market bottom and the worst of the storm is over. Nobody is watching the barometer; which is dropping rapidly.
One hundred year storms have a way of surfacing when you least expect it. In the financial world, bear markets have a way of fooling the majority of investors most of the time. Just when you think it's over, it isn’t. Just when you think a bottom is in, the market heads lower. When you think the news can’t get any worse, it worsens. The truth of the matter is nobody knows where the current storm will head and what damage it will bring. All that the experts can do is bet on probabilities. What lies on the tail end of the curve is that 10-sigma event that is incalculable. The models don’t factor it in -- just the probability of its occurrence. The extent of the damage, the long-term consequences, the impact upon lives, economies and governments can only be a guess. History can only alert us to the consequences and remind us that these storms do reappear throughout history. An archduke is shot, a naval base is bombed, a dictator rises to power, a government is overthrown, and suddenly 10-sigma events erupt and a daisy chain of dominoes begin to fall in unison.
Business cycles, market crashes, depressions and wars haven’t been eliminated despite the reassurance from experts and politicians that they will no longer happen. Economic and financial modeling is good at giving you probabilities, but not predictions. They can tell you about the probability of the unexpected, but not when they will occur. Nor can they predict the consequences. The truth is that no one knows what fury a $110 trillion derivative market will unleash if it does in fact implode. In 1998 a hedge fund called LTCM with 1.25 trillion in derivatives nearly brought the financial system to its knees. It would take the Fed, along with 14 other banks, to organize a private sector bailout. At stake were LTCM’s lenders who could be dragged along with it. An emergency bailout package was put together and a crisis was averted.
A Bank in All The Wrong Places
A lesson should have been learned, precautions taken and safety measures put into place. They weren’t. Instead the world of derivatives has grown by over 20% a year since then. More importantly, the players in the derivatives market have become more concentrated. One bank alone, J.P. Morgan Chase, accounts for $26 trillion of this $110 trillion market. Everyone knows J.P. Morgan Chase is in deep trouble. This bank accounts for over one half of the US bank held derivatives and nearly 25% of all derivatives held worldwide. It is a bank in all the wrong places and it is hemorrhaging from multiple sides of its businesses. The problem in this derivative market is that everyone is trying to offload risk. Hedging risk costs money. The greater the risk, the higher the price of covering that risk. Unexpected events such as hurricanes, floods, fires, mudslides or earthquakes raise the cost of insurance premiums. Hedging risks in the financial markets operate in the same way. When markets plunge and gyrate daily, when borrowers default, when profits evaporate, when credit spreads widen, when bond ratings are lowered, or when geopolitical events surface as in war or terrorism, risk premiums soar.
Playing Hot Potato
Off loading risk suddenly becomes a financial hot potato. In the derivative market, because of the degree of leverage and risk involved, everyone is trying to pass that risk on to someone else and net out their risk to zero. That seldom happens because someone somewhere is stuck holding the hot potato. You don’t always know who that is until the storm hits. Those who thought they were hedged suddenly find they are left exposed because the counter parties to their hedges have now become insolvent. It is a lot like having an insurance policy to cover against earthquakes. Suddenly a major quake occurs with damages so severe, that all insurers are suddenly at risk. That is the problem we have today with the greatest insurer covering over 50% of the US market and 25% of the market worldwide. Risk has been concentrated on one particular insurer: J.P. Morgan. Derivatives now account for anywhere from 20-40% of the bank’s revenues. The word “bank” is used loosely because J.P. Morgan looks and acts more like a hedge fund run on methamphetamines and steroids. Morgan’s $26 trillion derivative book is highly illiquid because most of its derivatives are of the OTC variety. These are highly specialized and customized contracts whose real value isn’t known until they are sold.
Most OTC derivatives are custom tailored to meet the needs of specific clients with specified risks. This makes them highly illiquid and vulnerable to panic selling in the event of a crisis. This proved to be LTCM’s undoing when it occurred. In the volatile markets of 1997-98 when credit spreads widened, risks multiplied. Instead of going from divergence to convergence, divergences widened as they are today. In the corporate debt markets, the yields on investment grade bonds are now 2.5% above Treasuries of the same duration, the widest in at least 10 years. Junk bond defaults are averaging 9-10%. Gaps between junk bonds and Treasuries are now approaching 11%. According to today’s Bloomberg, the spreads between Treasuries and junk bonds first hit the 10% level on August 14th and have breached that level 11 times since then.
Never Underestimate the Impossible
The reason this is important is that the majority of derivatives (85%) are interest rate related. Somebody big is sitting on the wrong side of that divergence. The mathematical models aren’t very good at predicting if and when a 10-sigma event will occur. They happen and then the models try to adjust. But these models are not dealing with the impossible at a time when impossible lurks everywhere. Talk is beginning to surface everywhere in financial circles of the possibility of systemic risks resurfacing in a possible implosion. HSBC Holdings has voiced concern of the impact on banks and insurers. Merrill Lynch’s chief financial officer, Douglas Flint, told a press conference, “We do worry about systemic risk.” Germany’s third largest bank, Commerzbank AG, was forced to deny rumors this past weekend that it was experiencing a liquidity crisis. The OECD (The Organization for Economic Co-operation and Development) is stepping up it’s monitoring of reinsurance firms. Insurance companies and money center banks, especially the big ones, have now become the center of attention as credit agencies, government entitles, and world organizations monitor a rapidly dropping financial monitor. Everyone is praying that the storm clouds will disappear. They are getting darker instead. Can the impossible or the unthinkable occur? In the words of singer/songwriter Joe Nichols, “I’ve learned to never underestimate the impossible.”
Complacency Rules
Meanwhile on Main Street, the vast majority of investors still have their heads in the sand playing ostrich. Complacency is everywhere despite market losses of over 27% in the Dow of over 27%, 32% in the S&P 500, and 43% in the NASDAQ. I can’t remember a time such as this when risks were so prevalent, yet sentiment was so complacent. Wall Street keeps reassuring the general investment public that things will be okay. You often hear the mantra, "This is it, we have now hit bottom," and yet prices go lower. Some are selling, but we haven’t reached that panic state yet. We haven’t experienced a series of 90% down days, which are characteristic of bear market bottoms. Even yesterday, with the markets rallying, it was only a surface rally. Market strength was only skin deep. Declining issues beat advancing issues on both the NYSE and the NASDAQ. Down volume swamped up volume on the NASDAQ. There are no signs of market leadership emerging other than the subtle strength of gold. The markets will have to digest the beginning of third quarter earnings season which kicks off next week. Pro forma earnings have lowered to such a low level that companies will no longer need pole vaults to hurdle them. Comparisons on a pro forma basis to last year after the events of 9-11 will make this quarter look good. Pro forma profit targets have been lowered from 30% at the beginning of the year, 17% as of July, to today’s projections for little more than 5%. Still there is an even more important element to come into play. What will companies say will happen in the fourth quarter when estimates still remain too high? As actual results come in, the markets should be set up for greater volatility characterized by sudden plunges and parabolic lifts.
Today's Market
Today's headlines point to more stresses in the financial system and in the economy. Job layoffs were a common theme along with possible bankruptcies. Abbott Labs will cut 3% of its workforce. AT&T, the perpetual restructuring company, will cut 4.3% of its cable-television payroll. EDS will be sued by employees for a loss of $407 million in its employee’s 401(k) plan due to a drop in the company’s stock. SunTrust reported that it would take a $98.7 million charge for bad loans as non-performing assets rose by 14% to $594.7 million. TXU, the Texas power company, is asking banks to drop terms forcing it to pay $500 million should a European unit of the company default as energy trading plunges.
Meanwhile the day’s headlines point to more stresses in the financial system and in the economy. Job layoffs were a common theme along with possible bankruptcies. Abbott labs will cut 3 percent of its workforce. AT&T, the perpetual restructuring company will cut 4.3 percent of its cable-television payroll. EDS will be sued by employees for a loss of $407 million in its employee’s 401(k) plan due to a drop in the company’s stock. SunTrust reported that it would take a $98.7 million charge for bad loans as non-performing assets rose by 14 percent to $594.7 million. TXU, the Texas power company is asking banks to drop terms forcing it to pay $500 million should a European unit of the company default as energy trading plunges.
These are just today’s business headlines. On the political front, the socialist candidate Lula in Brazil is emerging as the likely winner of Brazil’s run off election. Venezuela is on the verge of a political coup as Hugo Chavez begins a political witch-hunt of his opposition and citizens riot in the street. Venezuela is the 4th largest oil exporter of oil to the US. A war against Iraq is looking more likely and the government is alerting us that renewed attacks of terrorism are possible. These are the kind of headlines that don't breed confidence in the markets.
This lack of confidence and risk in the financial markets explains much of gold bullion's strength. The latest sell off in shares of gold and silver companies is another leg of a wider sell off by weak hands into stronger hands. A lot of the share accumulation of precious metals stocks over the last few quarters has come from the day-trading crowd looking for a way to make a fast buck. They neither understand nor comprehend that they are dealing with a precious commodity that is returning to its historical role as money. Those in the know, and who have strong financial hands are accumulating at the expense of the ignorant and ill-informed. They will be back in the metals after they explode. Several key silver stocks are looking to break out as option spreads and short positions are unwound. The metals markets are a lot like a volcano. You never know when they are going to erupt. But when they do, it will be similar to the eruption of Mt. St. Helens. Gold and silver are commodities that are in short supply, with growing investment demand, and limited options for investment. When they take off, their rise will be parabolic -- not gradual. The residents below aren’t aware that the volcano is rumbling. Short-sellers, take care.
Today's market was predictable. The major averages suffered their broadest decline in over four years as many analysts lowered their profit expectations on GM and GE. The S&P 500 hit a new five-year low; while the venerable Dow closed below 7,300 -- something we haven’t seen since October of 1997. We seem to be slipping back to the past at ever increasing speeds. It also looks like the inevitable may have a possibility of occurring. After the market close, Moody’s Investor Services cut J.P. Morgan’s long-term debt rating one more level, citing the bank's inability to maintain acceptable profitability. As the bank's credit rating is lowered, it begins to raise the issue of counterparty risk. The downgrade is causing many of the bank's customers to take their business elsewhere because of Morgan’s growing risks. As earnings falter, it leads to more downgrades. At some point, the bank may be swamped as it finds itself with more at risk in the derivatives market than it has capital to support. Many experts estimate that the bank's value at risk runs in the tens of billions. A failure by Morgan could become the first of many ten-sigma events. For greater understanding of derivates I would suggest reading Rogue Waves Part II, and Rogue Waves and Standard Deviations Part 1 and Part 2.
Volume came in at 1.82 billion on the NYSE and 1.75 billion on the NASDAQ. Market breath was horrific with losers outdistancing winners by a wide margin, 28-5 on the big board and by 26-9 on the NASDAQ. We may be seeing the impossible. Time will tell.
Overseas Markets
European stocks fell, led by auto manufacturers including DaimlerChrysler and PSA Peugeot Citroen after Morgan Stanley lowered profit forecasts for companies in the industry. Fiat SpA dropped as company executives met with labor unions to discuss more job cuts amid sliding sales. The Dow Jones Stoxx 50 Index slid 0.5% to 2277.00, retreating for a fifth day. It has lost 7.4% since last Wednesday's close. Seven of the eight major European markets were down during today’s trading.
Japanese stocks fell, driving the Nikkei 225 Stock Average to a 19-year low for a fourth time this month. Mizuho Holdings Inc. and UFJ Holdings Inc. slumped to their lowest levels since they first started trading. The Nikkei lost 2% to 8539.34. The average has lost more than a fifth of its value in the past three months. The Topix index shed 1.9% to 844.29.
Bond Market
Government bonds remained well bid across the board as fixed-income investors reacted to more troubles for equities. The 10-year Treasury note climbed 17/32 to yield 3.57% while the 30-year government bond gained 20/32 to yield 4.66%.
© Copyright Jim Puplava, October 9, 2002