Q1 08 Bear Market Review: The Story Begins and Ends with Bear Stearns

Thursday April 3 2008
John Bougearel




Having chronicled this bear market now day by day and blow by blow for the past 9-10 months, one Wall Street firm, has played the lead role in this unfolding drama ~ Bear Stearns. Scene one of this whole dramatization began with two Bear Stearns hedge funds blowing up in  June 2007,  and then telling their investors in July  2007.  The second act was took place in August with the entire global credit markets seizing and Countrywide financial plunging to its ultimate demise. The Q3 07 seizures in the credit markets led to the earnings recession in the financial sector in Q4 07, with Citigroup and Merrill playing prominent roles in Octobler.

In November,  the financial markets began to to seize up once again, prompting the Fed to create a new lending facility called the Term Auction Facility or TAF. This auction window provided the extra year-ed funding by  the financial sector.  That kept the financial markets until the New Year when the economic data showed that the ....

Recession Had Struck in December 2007
The December ISM report on Jan 2 2008 showed the manufacturing sector had contracted. This was followed by a December Non-Farm Payroll report on January 4 08  that showed US companies had shed -22,000 jobs instead of the  60,000 jobs it thought they had created. Oops, that was all it took to send the stock indices plummeting as the Q4 08 earnings season arrived. E

Credit Rating Downgrades and Jerome Kerviel's $7 Billion of Fraudulent Trades
Q4 07 earnings from the financial sector were predictably horrid. But more troubling were the mounting Credit Rating woes that issued from the bond insurers/monolines. To top off all the bearish sentiment in January 08,   it was revealed that Societe General's junior trader Jerome Kerviel had racked up $7 billion in Fraudulent trades. To rectify the situation, Societe General risk management department liquidated Jerome's fraudulent equity book over the holiday weekend on Sunday January 20th without regard for the havoc this would wreak on the global equity markets. As a result the global equity markets plunged dramatically.

Surprise 75 bps Fed Funds Rate Cut on January 22
When the US stock market opened on the eve of Monday  January 21st,  it  plunged  5% triggering the circuit breakers for the first in more than five years. The US equity markets remained lock-limit down on the morning of Tuesday January 22nd when the Federal Reserve stepped up with a surprise emergency 75 bps rate cut. This served to stabilize the markets for that day. However, market fears of credit rating downgrades began to grip the market again, and down they plunged back to the lows on Tuesday Jan 22 on Wednesday Jan 23.

NY State Insurance Regulators Hatch Monoline Bailout Plan on Jan 23
Not knowing what else to do to stop the renewed fears of monoline credit rating downgrades, the NY State Insurance regulators came up with a cockamamie $15 billion bailout plan. This was the greatest plan that never was! Stock market participants hedging themselves against an imminent credit rating downgrade and promptly covered their short positions. So relieved were they that the stock market rallied 11% in 8 trading sessions during this short covering rally.

February 08 Featured "The Monoline Bailouts" and "Credit Rating Downgrades that Never Were"
It looked like a capitulation low was set back on January 22-23 . But no, the rumor set forth of "monoline bailouts" never evolved. the negotiations in fact, and not surprisingly, broke down. Wary market participants began to put the short positions back out there waiting for the other shoe to drop as these monolines were up for another credit rating review and potential downgrade without a capital raise. By this time, the muni auction rate markets began to fail ~ and not just in a small way, but in a big big way. The big banks that were supposed to backstop these auctions simply hoarded the cash, causing 100's of municipalities to lend at the penalty rates which were in some case 4 to 5  higher than the auction rates they were accustomed to. The New York Port Authority is a case in point when their auction rate was jacked to the 20% penalty rate.

Miraculously, for the monolines, the Credit Rating Agencies did not downgrade either Ambac or MBIA, the two major bond insurers at risk. Yes MBIA did manage to raise about $3 billion and Ambac $1.5 billion, and they made promises to not underwrite policies for six months. But the fact that no downgrades were forthcoming smacked of complicity amongst the credit rating agencies. We will never know for sure why the downgrades never occurred, but the generally held view is this is probably a very very good thing the credit rating downgrades never happened.

Still Something was Rotten in Denmark in March 08
On Friday February 29 08,  we learned that Ambac  had deceived the financial markets that they were going to be able to successfully negotiate a capital raise. Market participants did not take kindly to that ruse, and promptly set about hedging themselves against some further unknown. March began on such ill-footing that it prompted CEO of FTI Consulting Jack Dunn to  observe on March 5 "There is a palpable crisis  of confidence. You can't imagine how tight credit is right now."

During the week of March 5, auction-rate bond failures showed "no sign of abating." Almost 70 percent of the auctions in the $330 billion market failed according to Bloomberg. This prompted Thomas Tucci Head of gov't bond trading at RBC to quip "``Every day is like the 1987 stock market crash. ``There isn't a day when you're not at the edge of your seat. The system is at daily risk.

You Walk Away
Moody's Economy.com estimated too, that 8.8 million or 10.3% of all US homeowners would have zero or negative equity in their homes by the end of the March. Almost 1 million U.S. homes were seized last year, the highest ever and more than double the pace of 2006, according to RealtyTrac in early March. On March 7, Friedman, Billings and Ramsey concluded the "$11 trillion US home mortgage market needed $1 trillion in new investment to halt the slide in home prices.






By March 11th, the Fed had to create a new window called the TSLF or Term Auction Lending Facility which would accept mortgage backed securities up to $200 billion that was creating all the tight credit. Many analysts, including Goldman Sachs and Citigroup were quite skeptical of this new term securities window noting that "credit concerns are likely to persist and averting a drawn out recession is becoming increasingly challenging."

"There are multiple problems weight on markets that must be cleared out before sentiment turns" said Alberto Espelosin at Zaragoza in Spain.

No Warning on Bear Stearns Insolvency
Turns out, one big weight on the market that had to be cleared was the Bear Stearns risk. Remember them? They were front and center at the start of this whole humdinger back in June and July 2007.  Rumors were flying about that they had solvency and liquidity issues throughout the month of March. On March 14th, the day Bear Stearns announced they were insolvent CEO Alan Schwatz, had this to say: 

``Bear Stearns has been the subject of a multitude of market rumors regarding our liquidity.`We have tried to confront and dispel these rumors and parse fact from fiction. Nevertheless, amidst this market chatter, our liquidity position in the last 24 hours had significantly deteriorated.''

The insolvency of Bear Stearns prompted the Fed to seize their assets and turn them over to JPM. The financing to Bear Stearns through JPM required a vote  by the Fed's Board of Governors because the company isn't a bank. Bernanke actually deployed a rarely used Fed law legislated in the 1930's and last used in the 1960's that allows it to lend to corporate entities other than a bank with a special board vote. In testimony to Congress's Joint Economic Committee on April 2 2008, Bernanke  said he hope he does not have to undertake a similar measure ever again. 

Much Ado of this Credit Crisis is being made over the appeal of the 1933 Glass-Stegall Act on Nov 12 1999

The Glass-Steagall Act of 1933 separated commercial and investment banking after "excessive risk-taking contributed to the Great Depression. Glass-Steagall protected bankers against themselves. Bankers are sheep. They don't mind going over the cliff if everyone else goes over the cliff" said Jean Marie Eveillard of First Eagle Global Fund in NY.

To Sum

The blowup of Bear Stearns on March 14 2008 brought to a close the first quarter of 2008.  For the time being, much like the blowup of the Bear Stearns hedge funds on June 20 2007 brought to a close the second quarter of 2008. We can treat these two separate Bear Stearns events as bookends ~ prologue and epilogue to the credit crunch thus far. At least we have heard for the last time Bear Stearns role in this systemic financial crisis.

As the stock market vis-a-vis the SP500 enters Q2 2008 it sits at a very important crossroads or fence if you will ~ the 2007 Year low at 1364. This is an extremely important market structure or anchor for market participants to be aware of from this point forward. Above 1364, and we can say the US equity markets are "stabilizing" perhaps allowing them to even challenge the 2007 year close at 1477.  But below 1364,  the stock market remains on very shaky and  uncertain ground and quite capable of plunging to new move lows when the bear market resumes.

While the next directional trade may indeed be a strong market rally, be not duped into believing that to be a signal the worst has past. Indeed, when sentiment becomes once again complacent, be very wary, the next phase of the bear market will be about to begin. How that phase will look I am not sure. But here are a few ideas,the subprime contagion could spread to commercial real estate loans, credit default swaps, CDO's, and to Europe and other global economies. In fact, the one cushion we had up to this point was the global economy functioning as a cushion to the US economy. Lose that cushion, and the next landing in the economy will hit us even much more severely than what has hit us in the past 9 months.

Meanwhile, unemployment is still on the rise and is expected to remain on the rise until sometime in 2009. If the rule is that the stock market only discounts 6 months out, and unemployment isn''t projected to peak until 2H 09, then expectations for 2H 08 should hardly be as rosy as economists are both forecasting and hoping it to be.

Event-Driven Investment Research
jtb@financialfuturesanalysis.com
SuccessfulTradingTips.com

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