The story of how the credit crisis came to be – and how you can profit from it in 2008…
[This is the second of two parts. The first part ran yesterday.]
Yesterday, I took you through the beginnings of the current credit crisis. An over-reliance on the rating agencies and a lack of quality analytical support laid the foundation for the crisis. Money market participants were already in trouble – they just didn't know it yet. And that's when the banks stepped in.
The "Revenge" of the Banks
The banks, and especially the money-center banks, have lost a huge part of their deposit and lending business to the money market funds. But they still get the first call from borrowers, which sometimes they cannot service. The banks, which are highly regulated, may have hit their line limits to the client, or to the sector, or they might lack funding or enough free capital.
Now, with money market funds around, the banks can sell the commercial paper to them, collect a fee, and keep no exposure to their client.
If you were a bank, what if you could somehow get the benefits of a sizable part of the deposits and lending that you have lost to the money market funds, without carrying additional risk in your balance sheet? Enter Citigroup Inc. (C) and creative structuring.
Two new asset classes were born amounting to a parallel, non-regulated banking system…
Here's the thinking: If you cannot hold the credit in your bank's books, why not structure it into an obligation that can be rated highly by the rating agencies?
Once structured and rated, you can then include the structure within a fund that you manage.
But here comes the best part. Rather than investors getting the returns of the high-yielding assets in the fund, you will have the fund incorporate as a structured investment vehicle, or SIV, which will then be funded very cheaply… say the Fed Funds Rate plus two basis points.
So you, as a bank, get the full benefit of the interest- rate differential between the low funding cost and the much higher-yielding paper that you decide to buy into the SIV.
But, the buyer of the commercial paper of the SIV, who is funding it runs the credit risk, for a couple of basis points! Therefore, the paper in the SIV does not count against your capital base and is unregulated.
The whole operation is predicated on counting on benevolent assumptions by the rating agencies and the greed of money market funds to pick up two basis points extra with their surplus funds at the end of the day. This was essential.
And the rating agencies had to deal with their own conflict of interest : They were being paid by the banks' SIVs, which they rated for every new structure at origination and for monthly follow-up reviews.
The banks' SIV business grew profitably like wildfire, thanks to complacent money market funds and benevolent assumptions from rating agencies. Today, the 10 largest managers of U.S. money funds have about $50 billion in short -term SIV debt .
Yet, when the market found out that these SIVs were contaminated with major "radioactive" sub prime mortgage paper that needed to be marked down deeply, they ceased investing in the vehicles and demanded their money back, creating the money market crisis.
U.S. Federal Reserve Chairman Ben S. Bernanke recently admitted that determining market values for much of that paper posed huge challenges.
What's ahead and how to play it…
Lawrence Fink, the head of BlackRock Inc. ( BLK), a top fixed-income firm, recently said " it is going to get a lot worse." He believes that the credit markets will not recover until some mortgage-related assets, including some complex securities, are liquidated.
His views seem in line with those of bond-king Bill Gross, the leading fixed-income manager in the world, who heads PIMCO. Mr. Gross believes that the weakness in housing and its effects on the billions of dollars imbedded in the complex mortgage-related products represent the major threat. And that the Fed might need to lower interest rates to as low as 3% to keep the economy afloat.
He believes, like us, that the Fed needs to worry more about the real economy and employment, and take care of inflation later, should it reaccelerate.
Right now, this all boils down to one thing: It's a near guarantee that volatility lies ahead in the markets.
During the Korea meltdown of 1998, I remember hearing from an unimpeachable investment source that "in times of financial distress, I love financial assets."
In the past, if you had invested with the benchmark banks and companies that seemed dead in the water, but would no doubt survive, you will reap incredible profits once they recovered. And the recovery came along strongly within a year or two.
And there's another powerful force at play. After the devaluations in Mexico, Asia, Russia, Argentina and Brazil, those countries' stock markets proceeded to run up considerably. The overarching lesson comes through loud and clear. When a country's currency becomes cheap, then the entire country is on sale – both financial assets and real assets.
Foreigners quickly jump at the opportunity to pick up bargains, knowing that the currency weakness, especially in the case of an economy as flexible and competitive as the U.S. economy, will be a temporary phenomenon. So timing becomes less important for them, since they know that they are buying very cheap. Notice Abu Dhabi buying 8.1% of Advanced Micro Devices Inc. ( AMD) recently. There is more of that to come.
To add more fuel to the fire, as Frank Holmes from U.S. Global Investors Inc. ( GROW) recently cited, 100 years of data demonstrates that the stock market rallies in presidential election years.
So we have three strong potential catalysts: A central bank that's cutting interest rates, a super-cheap greenback, and a presidential election year.
Hence, I look for a very strong 2008 for U.S. stocks, especially in high- tech, pro-cyclical sectors, in exporters and in select , beaten- down financials that will survive and thrive.
In addition, the global- growth story is intact: Eastern Europe and countries like India and Brazil will continue to thrive, despite market volatility.
[For Part 1 of this report, please click here. The report is free of charge].