What Has Fed Done for Us Lately?

You may have already seen the little drop in the market on Thursday but we wanted to emphasize a few minor points about it. The biggest news of the day is centered on the situation that Citigroup finds itself in. We have been discussing SIV's here off and on for a while now, that would be Structured Investment Vehicles, and C (Citigroup) is purported to have several big ones. The reports are that there are about $350 billion of assets in all SIV's and C's SIV's have $80 billion or over 20%. When the Super SIV was being proposed, C was/is one of its biggest supporters and the reason is that they have a lot of exposure.

We don't want to get into SIV's tonight but they are a part of the underlying problem in the financial world. The problem in the real world is that mortgage debt is in the process of being submerged. We refer you to Friday's WSJ where there should be a front page article that gets pretty close to what is going on.

Before the market opened on Thursday morning, an analyst decided to downgrade C and said that it may have to sell some assets or lower its dividend in order to shore up its capital base. This sent stocks in Europe down and led to a drop in the US markets as well. We care about this because it is stock market related but there is significantly more going on in the real world.

Deeper into the article we find out that the bulk of the resets on ARM's have yet to come. This sentence is followed up with "The percentage of subprime mortgages...that were more than 60 days behind in their mortgage payments topped 20% in August..."

The next topic is CDO's, collateralized debt obligations, some of which are based on mortgage debt. Some of the riskier tranches, classes, had been trading at 50 cents on the dollar in August and now they are 17.4 cents. For the triple A tranches, which the rating agencies had, repeat, had rated there, some of them are 79 cents on the dollar after being about 95 cents about a month ago.

And, then at the top of the stack there is a tranche called Super Senior. These are the problem for many investors, banks. "In October alone, ratings firms Moody's InvestorsService, Fitch Ratings and Standard & Poor's have downgraded or put on watch for downgrade more than $100 billion in CDOs and the mortgage securities they contain. In a glimpse of how much banks have at stake, Swiss-based UBS holds more than $20 billion of super-senior tranches of CDOs. They're among the reasons UBS, which reported a third-quarter loss of 830 million Swiss francs ($712.8 million), has warned that its investment bank is likely to face further losses in the current quarter."

We wanted to put these big numbers into some perspective. We read about billions of dollars and we think it's a lot of money but how much is it? Back in 1998, a hedge fund called LTCM, Long Term Capital Management, had leveraged itself against what they thought were solid trading positions.

What ended up happening was these trades went against them and their leverage destroyed their capital. When that happened it put a huge strain on the banks that had lent them the money against their margin. At the time, the stock market felt the liquidity strain and LTCM almost took down the entire financial system were it not for the intervention of the Fed and the banks.

Here is why we have spent the time to discuss this: The consortium of banks that discussed this bailout for LTCM were considering less than $4 billion between all of them. Less than ten years later three banks are trying to set up a Mega SIV that will be about $80 billion. Anyway, we just thought it might help put some of these huge dollar amounts, being thrown around like it was play money, into a recent live situation that was thought to be large enough to dismantle the financial system.

So when the Fed lowers rates on a Wednesday by 25 bps, the world celebrates but the reality is that those few bps will not cover the mortgage problems that are going on out there right now. Of course, meanwhile the housing market continues to deteriorate with prices expected to fall more in the coming year. Are they kidding?

The stock market is now going to have to figure out some way of convincing everyone it's ok to buy stocks. Even the Asian markets are down this evening.

We have thought it might be a good idea to put together a new index, one based on the four Horsemen. We are in the process of designing an index that properly reflects the four stocks and gives us a sense of the speculative juices that the market has. We thought maybe we should do just an arithmetic index by just adding up the prices, like the Dow; or, should we use a capitalization method like the NASDAQ. We will try to put this together next week so we can watch it daily.

In the mean time, the stock market is in some trouble now. There should be some more downside to come. Let's see what happens.