Sunday, September 14, 2008

Unprecedented market day ahead

With the significant financial market scramble this weekend, the equity and credit markets will be tested early this Monday morning in Europe and then follow through into the U.S.(many Asian markets including Japan and China are closed for a holiday). The impact of the news will likely be difficult to digest initially. It's safe to say that the derivatives markets have never gone through such a test and that the impact on the largely unregulated hedge fund industry is a concern. At the time of the '87 crash most derivatives markets were small and by today's standards simple, mainly fx and interest rate, and the hedge fund industry was relatively small. In the near total seize up of the credit markets in the 1998 LTCM and Russia debacle the derivatives markets were larger, but there still was almost no such thing as credit derivatives, and the hedge fund industry had grown but remained small compared with today.

So there's likely to be a rough start to the day as the market absorbs the news and the tone of trading, is it orderly and liquid or does it become chaotic, is judged. The day's result, however, is far from certain on the downside or even, dare it be said, in a late day recovery. No one knows.

Lots of lingering issues overhanging the market are being dealt with in a crisis mode. That is seemingly how difficult decisions of this magnitude get made. Lehman files and parts of the company get firewalled to operate until picked up at huge discounts to their probable long term value. Lehman's $50 billion plus face value of unquantifiable assets are segregated, and the market says goodbye to Lehman as an ongoing firm. That is the biggest risk of chaos but Fed money flowing out with all kinds of collateral allowed should provide liquidity along with a sort of bad bank consortium of funds from ten other major banks.

With it now clear that there will not be another Bear Stearns type Fed backstop deal, BofA dropped its due diligence of Lehman and then Merrill and BofA ran as fast as they could to each other, Merrill for survival with honor of sorts and BofA for a firm with the presumption of considerable value over the long term. That's good news.

The biggest wild card tomorrow is AIG due to its extensive involvement in the credit derivative markets and mortgage securities markets. AIG is just too big and complex at this point for anyone to acquire but they will put out restructuring and refinancing plans of some type in the morning. Without any leadership available from the gutted securities research industry, getting a handle on AIG will be a huge market challenge, one that may be addressed simply by the word "sell" until notified otherwise. That this global insurance powerhouse with its huge and pioneering base of business in Asia has come to this so quickly is stunning, even more of a sign of the stress of these times than Bear and Lehman, but there's no denying that it's in trouble(interesting 13-F filing's show that all of AIG' s top 15 institutional shareholders chose to add more shares in the second quarter, that's what stunning means).

A few big banks will be watched tomorrow as well. WaMu is a relatively simple business but may need a buyer to step forward. The WaMu option ARMs Alt-A book of $53 billion is a big problem for any buyer but JPM could perhaps stomach it at $1 a share. Unfortunately, if things get really ugly Wachovia is not out of the woods yet either, given that its option ARMs book is more than twice as big as anyone in the industry, over $122 billion, as its Golden West acquisition was the west coast market leader in this innovation with WaMu a distant number two.

May trading be liquid and orderly!


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