7/31/08 (GDP shrinking, Exxon, Discount Window ???)

Traders,

Yesterday we saw another big run in the INDU and the SPX – but the NDX and broader based RUT didn’t really get the same kind of rocketing move to the upside. Then we saw a massive gain in oil after its fall from the 140 level as the surprise that we are still outstripping supply with demand. What really gave this market a jolt to the upside was more government intervention – rather than a shift in fundamental solvency. The SEC extended its short ban until August 12th, which was set to expire the other day, the FED extended the Discount Window to non-members to January 2009 and increased the loan period to 3 months from 30 days, and the President signed into law the first of probably many bailouts – extending Freddie and Fannie’s debt leverage ratio.


While on the surface having the government riding into the rescue might seem like a good idea, the reality is that it means things have yet to find a bottom, may get worst, and have made it less transparent as to which companies are solvent and which are not.


I have been asked, recently more often, why I make such a big deal about the Discount Window being open to non-members – so I wrote something up on it last night and attached it to the end of the market preview. It’s a very simplistic view of the situation – but should lay out the big picture as to what is going on.

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GDP - contracting – go figure!

Don’t hold your breath that we are out of the woods yet – you’ll pass out. The economy grew at 1.9% for the 2nd quarter, less than expected. What was also alarming was the revision of the last quarter in 2007 – which showed a significant contraction as well. While that doesn’t sound so bad on the surface, being the economy is in a very weak state, the estimates from economist had already included the billions of dollars in stimulus distribution for the 2nd quarter in their 2.3% gain (average). Thus the 1.9% gain fell far short of expectations – which has some economist very concerned. What would the 2nd quarter look like – without that massive stimulus check? I even heard one economist yesterday – when talking about his estimate – that the stimulus distribution is artificially propping up the GDP, because it is just a massive loan that tax payers will have to pay back anyway.

The revisions to the downside are also rather concerning – the 1st quarter was revised down to .9% from 1% - a clear sign of contraction and giving elevated levels of the probably of a recession (if you want to measure recession by government math). Spending is very clearly slowing down and while we still may yet see positive growth (while contracting) in the GDP numbers – it’s clear that Main Street is feeling the pinch.

The news has sent the futures down fast and hard – as even the economist who predicted conservative increase from the stimulus checks were wrong and contraction was bigger than anticipated.

However – you will probably hear some talking heads “Kudlow” – say stuff like – "Hey, this economy is strong – we are still growing! I don’t see recession anywhere!" Ignore the spin on TV. You are the best judge of economic conditions. Look at your wallet, your savings account, your home equity, interest rates. Then go to fill up your gas tank, go buy some food, go to the store. It really doesn’t matter what we label it, recession, contraction, etc. It doesn’t matter what the numbers are. The reality is simple – regardless if we are in a recession or not – we are contracting and deleveraging. Keep it simple!

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Exxon profits less than estimated.

While they are still seeing healthy profits, they came in lower than estimated. While oil prices have been going up, consumption has been going down. Important to remember that consumption maybe going down in THIS country on the world stage we are still pushing a very narrow spreads between consumption vs. extraction (supply and demand).



Still the numbers are impressive $2.22 a share, up from $1.83 a year ago. That’s almost $12 billion for the quarter. Don’t tell Maxine Waters – she’ll want to take some of that money (the excessive profit tax). What people don’t realize is that while the revenues seem massive – the costs are going through the roof as well – squeezing margins for the oil companies.

Exxon is spending $52 million a day in searching for new oil reserves and even more in R&D. So while their revenues are going higher, so are their costs – and thus shrinking margins. Top that off with consumption contracting (for now) on our shores. Well – that is why they missed estimates.
Please do NOT support ANY excessive profit taxes! Once that door is opened – it will never shut. You want to force companies to move overseas, start putting a cap on profits and tax them more.

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ImClone get’s bought out.



While Martha Stewart served jail time for selling a small amount of shares of this stock based on insider trading and the ex-CEO is starring through the bars of his cell – the company they tried to dump shares in is now a takeover target by Bristol-Myers! The stock is up big in the pre-market, 30% higher than yesterday’s close. Bristol-Myers have been a large share holder and partner of the company for some time. The deal is to consolidate an already strong strategically relationship.



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GMAC – stick a fork in it.

GM a long time ago started seeing their profits (margins) shrink to almost nothing. The costs of building and selling cars stop making sense and they needed to figure out something NEW to keep profits rolling. GMAC was born – let’s FINANCE our own cars to the public. The problem is – it looks REAL GOOD on paper – but the reality is there IS RISK. Accounting gets a little funky too. When you sell a car via financing – do you book the sale as a profit today? Not really – since you just gave someone the car and you are collecting money on a monthly basis. If financing cars is easy money (or so they thought), why not houses? And now what started as a Car company has turned into a finance cars company, has turned into a mortgage company. What? How did that happen?



Now here is the big problem – what happens when people stop paying! Opps – didn’t think about that. Add to that their RELATIONSHIP with GM (yeah – remember they make cars!) and the 0% financing of vehicles just to get them off the lot. Guess what, at 0% finance you just gave away a car for free and expect the buyer to pay you pack with NO interest! That means NO PROFIT!

To sum up GM and GMAC – I can’t put it any better than what Mr. Habeeb (Manager of Calvert Asset Management - $8 billion dollar fund) said, “It’s a disaster!”

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Futures Pre-Market

Well they were up and looking good until the GDP missed estimates (even after the stimulus check). Ouch – we are seeing a good smack down in the pre-market. Spreads are pretty wide and the whip-saw positive to down negative reversal probably has some ARB traders on the sideline to close the fair value spread at the opening – rather than trying to leg in from the futures side. Expect a gap down. But this will be a volatile day - we could close up or down big.

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Support / Resistance

Well we visited those resistance levels even pushed a little through them – but now we have given up (based on futures pre-market) and heading back down. We could get a knew jerk back up to. Expect BIG volatilty today.


INDU 11,500 (We close above it after a good 2 day run – but now we are looking to head back down through 11,500. Even though we are above 11,500 I don’t know if you would call it a support area – but rather more of a straddle area. If we can’t close at or above 11,500 well – that means it is resistance. Otherwise treat it as a straddle strike – NOT support!)

NDX 1850 (This is a rough resistance area – but could also be a straddle strike. The futures are pointing to a 20 point lower opening. Watch the close.)

SPX 1275 (More volatility – treat 1275 as a straddle area – both 1250 and 1300 are in the cards. But don’t get long or short hard deltas.)

RUT 700 / 720 (We didn’t get the kind of rally that the INDU or SPX did yesterday – volume has been a little lighter of late too. Keep an eye on these two levels.)

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Conclusion

I was recently asked about the Fed and The Discount Window lending money and why it’s a bad thing. First, I am not an expert so I recommend anyone that IS interested in the inner workings of the FED (well there are some good books so read up on it). However – (from a Keeping It Simple, Stupid = KISS view) – there are TWO RATES.

One is called the Target Rate; this is the one that everyone traditionally pays attention too. It is just that a TARGET! The FED set a “suggested” rate for the banks, only members of the Federal Reserve, to lend each other from their reserve pools. It is important at this point to remember two things – banks NEED to have X amount of capital vs. their debt to meet regulation requirements (to remain in good standing as members of the FED). All the banks have posted money to a Reserve Pool that is used to lend to one another.

The Discount Rate, on the other hand, is the ACTUAL rate that you can borrow money DIRECTLY from the FED. This is has been called "The Lender of Last Resort" – since you are now borrowing from the Government (or Tax Payers). Traditionally the Discount Rate is HIGHER than the Target Rate – to discourage banks from borrowing from the FED. See the FED wants the banks to borrow from each other – not from them. When banks do borrow from the FED it is a clear sign the bank is having problems. Why? Well first you have to ask, why would you pay a higher rate (at the Discount Window) if you could just borrow from other banks at a lower rate (at the Target Rate). Banks are embarrassed to go to the Discount Window because it is usually a sign that there is something wrong.

Now here is the big issue, when Bear Stearns went BUST that Friday and the FED brokered the bailout they did something else, something unprecedented. They enacted a special rule, only in case of emergencies, to OPEN the Discount Window to NON MEMBERS. That’s right the FED Opened the Discount Window to lend money to non-members. This is rather shocking; he didn’t even get Congressional Approval to do so. He just DID it and he may of had to. Of course in recent testimony he felt he had no choice because the entire monetary system was at risk. Mainly because of the trillions of counter party over-the-counter trades (private transactions between banks – that are based only on their credit) at Bear Stearns. Additionally – there COULD BE more Bear Stearns out there.

Now remember this – these banks are holding questionable illiquid positions (CDOs collateralized debt obligations, SIVs structured investment vehicles, etc.) These are trades that do NOT trade in the traditional stock market - but are rather (for lack of a better term) just like “Office Pool Bets” – you are trusting that the other bank has the assets to pay you when the time comes. Well a large portion of these bets were backed by – you guessed it – mortgages (prime, sub-prime, sub-subprime, etc.) – The banks trusted that these were GOOD bets (based on the implied credit was good) – because companies like Moody’s gave them AAA credit rating. (It’s important to note at this point that AAA credit means as SAFE as a Treasury bond). Well we all know good those ratings are.

So the FED has argued the NEED for keeping the Discount Windows OPEN to not just the members, but also these non-member firms (investment banks) that have been granted access to borrow money. The FED can NOT keep the window open indefinitly and stated it would close in September 2007. The recent Congressional Hearings were to establish if that was ENOUGH or if the FED required more power or changes to its mandates. Note: Yesterday the FED announced the window will be open until January of 2008.

These write-downs are on these CDO/SIV type positions. These positions are VERY illiquid there is really NO market for them – unless a buyer shows up. These positions are also MASSIVE. So the banks use a formula (a guess) as to what the values of these positions are. It’s not like the stock market where you can just look up the price, they have to (like a home) appraise the value and come up with a price. Well just like the housing market – the price doesn’t mean much if you can’t find a buyer. These arbitrary prices are called “Marks” the method is generally referred to as “Mark-to-Market” – except there IS no market. Buffet likes to call it “Mark-to-Myth!”

What does this have to do with the Discount Window? Well these banks are holding these positions – that are suffering losses (write downs) and they NEED money to hold them. So they need to borrow money from someone – hey let’s go over to the Discount Window to borrow money. When the Window was open there was a MAD RUSH and we are talking not millions being borrowed to carry this stuff, not 100s of millions, not even billions, we are talking 100s of billions of dollars in loans to float these banks to carry these positions.


So HOW much is being borrowed? Sometimes a picture is worth a 1,000 words.

http://goldmoney.com/en/commentary-print.html

Now in the Congressional Hearings one of the Senators pointed out that the FED has lent out over $200 billion. Bernanke’s response, remember we are not BUYING or INVESTING – these are only short-term loans. He further reminded the Senator that not ONE loan has failed. Well – that is not too comforting. It’s not comforting because the money being lent is used to back those very questionable positions that these banks are writing down. It’s not like the FED lent $200 billion on some secured tangible hard asset that is transparent, he is lending money to the banks and investment firms that have installed a turnstile in door of the CEO office where even the CFO’s don’t have a handle of the risk or positions they are holding.

So there is some scrambling going on, first – those that are NOT members of the FED, like Merrill Lynch, Lehman, etc that currently going to the Discount Window know that it will be closed (now) in January. So if they want to keep drinking from that well – they need to merge with a bank that IS a member or else look elsewhere.

The reason that it is HARD to believe that the worst is NOT behind us is the following:

Why, yesterday, did the Fed extend the Discount Window from September to January for none members?

Why, yesterday, did the SEC keep the ban on the shorting these same firms in place through August 12th?

Why are these companies selling their shares to raise money and continue to go to Sovereign Wealth Funds for additional capital?

Why did the President sign the emergency bailout plan on 400,000 mortgages – for the government GSEs to take over and tax payers to back – bailing out these lenders?

Why are these banks continuing to warn of MORE write downs?

We have seen Indymac fail; now two more large regional banks have also failed this last week. Rumors are there is a behemoth in the works that is about to crumble (no names – sorry).

While true, none of these loans have failed – as Bernanke has pointed out – the concern is that while they may NOT have failed (YET) – we should NOT just ignore the risk.

These Congressional Hearings are rather interesting (you have to weed through many STUPID questions or little lectures by some of our less informed Congress members) – but these are the times that the entire future of our country – its heart – the economy – is pumping hard and the arteries are clogged in a mire of Political Favors, Socialistic Agendas, Nationalistic Plans, and Government THINKS they know best decision making.

We may have an endless supply of paper – that doesn’t mean we should continue to print Ben Franklin’s picture on it!

We are on a very precarious road to hyper-inflation. We laugh at those over in Zimbabwe printing 10 million dollar bills, we laughed at the Mexico’s NEW pesos, we laughed at that (once) worthless Canadian nickle, we laughed at the Russians in the 90s wheel-barrels full of rubles crossing the border to turn in for just a loaf of bread, we blame the ECB for our inflation because they will NOT lower rates, we blame the Chinese for pegging their currency. We need to stop laughing and pointing fingers. Those Congressional Hearings are ANYTHING but funny. We ignorant fools have borrowed our way to prosperity and now the Piper has come to town and needs to be paid.

Remember this….
“No nation in the HISTORY of civilization has DEVALUED themselves to Prosperity!”
We are on the fast track.

I am not trying to scare you or even some doom and gloomer – this is just reality – Fiat Currency COULD work – only if the Government is transparent about inflation, money supply M3, and NOT on the Bailout campaign.

It’s in the government’s hands now – we have relied on mommy government over and over again to get us out of problems. They still can – but we have a polarizing Congress, a hated Administration, and election year that is ripe with Socialism. Those are not helpful signs of getting through these problems easily or quickly.

The market WILL find a bottom. We are a tenacious lot. We have and will survive worst things. However –until we are ABLE to see the bottom, it's very muddy and uncertain.

As we continue to prop up share prices and bailout mortgages and companies - we will not KNOW the full extent of the problems.

People talk about a transfer a wealth all the time. What about the talk fo the transfer of losses from the risk takers to the government to the tax payer?

Where is the bottom? Currently there is none - because we will NOT let anyone fail.

DON'T BOTTOM PICK - this market will rally hard and also sell off hard - until we work through these problems.