Chris Lau - Seeking Alpha

Saturday, September 20, 2008

What Credit Crisis?

Business reports around the world are reporting last week's trading activity was net neutral. For example, the Toronto Stock Exchange was up 1% for the week. The Bush Administration is creating another bailout package that will cost US $700 Billion. This is a massive amount. Worse is that this is on top of the cost of saving AIG ($80B) and Fannie And Freddie Mac ($200B combined). The total deficit excluding these items will be $482 Billion.

It has taken me months to really comprehend why the credit market is seizing. Mortgages were given out to many homeowners who should not have qualified in the first place. Why? There were "workarounds" against the checks and balances associated with calculating the risk these homeowners would default. The repackaged debts, CDOs, and other instruments that were created still actually have value, but there is no market for them. What do you assign investments that have no buyers? Zero. Yet these debt obligations have property backing them, so its book value should not be zero.

The government is effectively buying all of the above illiquid debt obligations and creating a market for them. This should solve the problem of the credit market seizing up. In fact, this was so severe that several money market funds had a redemption value of $0.99 for every $1.00 deposited. Investors were even buying US 30 day T-bills were paying almost 0% interest.

The action taken by the Government was necessary. Now, as stock investors, we must review the consequences of this drastic bailout, and make a few assumptions.
Let's start with the logical assumptions:
  1. Credit markets open up again, making it easy for consumers to borrow again
  2. Consumers re-gain confidence and boost spending
  3. Companies boost revenue because consumers are happy again and buying their things
  4. Companies do not lay off employees because their sales are steady
  5. Companies import raw materials, developed products thus aiding in economic growth for China, India and Europe
  6. US Consumers take out mortgages and buy homes, and assume that housing prices will not fall the next month
  7. US Consumers take on more credit card debt, and don't mind paying the high credit borrowing rates
Assumption #2, Consumer Confidence, will be a key factor in ensuring the latest banking sector bailout succeeds.

Consequences to stabilizing the Financial Sector:

  1. The US will buy debt and increase Money supply, fueling inflation
  2. Higher consumption = Higher supply of products = Greater demand for oil, metals, and other commodities
  3. Interest rates will need to increase, creating higher borrowing costs
  4. The US dollar will weaken
  5. The US is spending $400B a year just to pay for the interest on the debt. This will severely limit the ability for the next President to fulfill spending promises.
It's clear that the cost of this massive government action will be severe inflation. Therefore investors need to do the following:

  • Buy gold (trades inversely to the price of the US Dollar)
  • Buy commodities, especially oil
  • Sell US Government Bonds (I can no longer recommend TLT)
  • Begin to take a position on the consumer discretionary sector and semiconductor sector
The VIX (Volatility Index) peaked on Thursday @ 42.16 and is headed down. Stock markets will probably trade in a range but may risk re-testing lows reached early last week.

...and On Toronto Real Estate?

The renewed bank sector stability in the US will have a positive impact on Ontario's economy. Home buyers will be less fearful that the weakness in housing in the U.S. will spread here. As always, I would recommend home buyers monitor the health of the commodities market and the job market. These two factors are good indicators for the health of home buyers.

I recommended TLT on September 4th. It is now a SELL.