April 2007 Newsletter
Issue Four, Volume Eight

THE ATTACK OF PANIC

By Mike Gasior

This edition of my newsletter will be brief, to the point, and a continued effort to get myself caught up for this year. Thus, the April edition.

After watching the market events of last week, I felt compelled to address what I have witnessed take place and try to apply some of my own experiences and observations of the past 27 years. In my most previous newsletter of just a couple weeks ago, I wrote that this was a classic "buyers strike" occurring and that IT was the cause of the recent market tumult. I continue to believe exactly that, but there seemed to be some cause for celebration on Friday due to the Federal Reserve cutting the discount rate by .50%. This lead to the Dow Jones Industrials rallying 233 points and many observers and prognosticators to predict that the turmoil is over and this was the magical beginning of a new bull market and new stock market highs.

It's not.

There are serious and grievous problems in the financial system and economy that will not be fixed by this almost meaningless .50% cut in the discount rate, which I will address momentarily. Before I get all ugly on you, let me quickly inventory the events which I have witnessed occur during the past 27 years.

--I saw the U.S. Government issue 20-year, non-callable bonds with 15.75% coupons in November of 1981. I saw 21% yields on money market accounts that same day.

--I sat at my Quotron machine and watched the U.S. stock markets decline 20.7% in a single day, which would be the equivalent of about 2,700 Dow Jones points in today's terms.

--After topping off at nearly 40,000 in late 1989, I watched Japan's Nikkei index then drop to almost 7,000 over the next 14 years. Even today it stands more than 60% lower than it was almost 18 years ago.

--I was a participant in the birth of the mortgage backed, asset backed and structured securities markets in the early 1980's and sold massive quantities of these products to an array of customers.

--I got my first hedge fund customer in 1982 when the entire industry was smaller than some of the larger hedge fund firms of today.

--I saw Michael Milken literally invent the "junk bond" business and grow it into a massive industry. If you're unaware, the non-investment grade bond market (the more polite term that people in that segment prefer) is vastly larger than it ever was in Milken's day.

--I watched the elected treasurer of Orange County California drive them into bankruptcy by borrowing money and investing in structured products that carried AAA credit ratings.

--Only months after Orange County went down the tubes we saw a 28 year-old trader bankrupt one of the largest and most respected merchant banks in England, Barings. He managed to do it by trading options and futures in one of the smallest markets in the world, Singapore.

--In 1998 we saw the Federal Reserve intervene to bail out a hedge fund, Long Term Capital Management, which Wall Street had allowed to bring the U.S. financial markets to the brink of disaster. With less than $4 billion in investor monies, the fund was carrying around $140 billion in actual securities positions and about $1.25 trillion in notional derivatives positions.

--During the late 1990's investors placed massive valuations on Internet and technology stocks, some of which had very dicey business models, and brought the NASDAQ to a level of 5,000 points. Today it sits at about 50% of that level.

--And on Friday, I saw traders rejoice that the Federal Reserve was "watching" and had come to the rescue of the markets with their .50% reduction in the "discount rate". This story is barely underway with much more still to be written, and there will not be nearly enough life rafts when things are finally over many months from now and some ships sink. I urge you to find your life raft soon.

Now please understand first and foremost that NONE of what I have said or am going to say next is meant to be investment advice that anyone should take action based on whatever I think. I didn't particularly like giving investment advice when I got paid to do precisely that, and none of you are paying me for any advice now. What I simply seek to do here is put things into some historical perspective and context, and urge people to be realistic and pay attention to what we know for a fact and not traffic in hyperbole and wishful thinking.

Let me start with this fact. Central banks around the world, including the Federal Reserve, are in a panic right now and are acting as such. Period. Paragraph.

The action taken by the Federal Reserve on Friday to reduce the discount interest rate and extend the lending period from overnight to 30 days, or more, borders on hysterical on their part. It is far from anything that could be considered "good news" since they even admitted as much in the accompanying statement that made the dramatic observation that "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward." Boy oh boy, that certainly is great to hear coming from an outfit not known for forthcoming statements.

What drove me to write this newsletter and get it out quickly was hearing all the comments and adjectives being used to describe the actions of Chairman Bernanke and the Fed such as "genius", "surgical precision", "exactly what was needed" and other such nonsense. More amusing was the endless stream of talking heads, traders and other people on television commenting that the rate reduction proved that the Fed was "paying attention" to what was going on in the markets. I guess the Fed wasn't paying attention when they pumped tens of billions of dollars of liquidity into the markets using their open markets operations during the two weeks prior to the rate cut. I even heard others go as far as to say that timing the announcement just prior to the stock market opening was particularly exquisite because Bernanke wanted to "crush" and "send a signal" to the bears and the short sellers.

All of this is simply crap. Benjamin Bernanke could not give one damn about any bear or short seller, and they were furthest thing from his radar screen.

There was one driving factor for the rate cut and it might have temporarily accomplished its goal of preventing the failure/bankruptcy of several large players in the mortgage business. Even though Countrywide Mortgage secured an emergency line of credit for about $11 billion prior to the Fed move, it would only have kept them treading water for a period of time and they may have ultimately failed anyway. There also was abundant rumor that Washington Mutual, Thornburg Mortgage or others might fail too. It was already too late to save First Magnus Financial who announced they would lay off 99% of its workforce on Friday and close all 300 of their offices. Wachovia and Bear Stearns both reduced their staffs as well last week.

What is both interesting and concerning (especially to a Benjamin Bernanke) is that Countrywide, WAMU and Thornton didn't mismanage their businesses, hold any particularly risky investments, or were mired in the sub-prime fiasco gripping other firms. Their simple problem is/was that the credit markets are STILL so seized up that they were finding it almost impossible to find funding with anybody. When organizations such as these cannot find funding, they're out of business. And fast too. This is a concern to the Federal Reserve and other central banks.

Now we are at the heart of the matter and finally talking about the issue that was not fixed on Friday.

It is the current credit crunch.

I listen to Jim Cramer on a quasi-regular basis and I think he is an extremely bright and street-wise guy. He likely knows bigger people than me, but I agreed with him totally a little over a week ago when he was talking about how this thing was much worse than people thought because I was hearing the same thing from people on trading desks all over Wall Street. Unless you are looking to sell the absolute highest quality fixed income products, you may have a very difficult time finding a buyer because there are none, and that's the issue. I spoke with plenty of people last week and I heard time and time again that if you are trying to unload any amazingly wide range of products you may find it difficult to find anyone making a bid for them.

I heard Cramer on CNBC on Friday say that had the Fed not intervened, that there well could have been a 1,000 point or more decline in the market. I completely agree with that. Then I heard him say that we're now on track for a 14,500 point Dow. I could not disagree with that prediction more.

We have extremely serious problems within the financial markets right now that are far from fixed and will take considerable time to work out. While traders cheered the move Friday and are suddenly expecting a reduction of the fed funds rate of perhaps 50 basis points either at the Fed Open Market Committee meeting on September 18th, or maybe even before, even that doesn't fix anything. Please remind yourself that the Fed would only cut interest rates so dramatically because they felt there was dire risk to the economy and the last time they were so aggressive in 2001 and 2002, it lead to the housing bubble we're still stuck with. In truth, I believe it may only serve to make things worse due to the much discussed "moral hazard" issue.

"Moral hazard" is an old economic concept with its roots in the insurance business. The idea goes like this: If you protect someone too well against an unwanted outcome, that person may behave recklessly. Someone who buys extensive liability insurance for his car may drive too fast because he feels financially protected.

The problem of the last few years is there was excessive and poor credit given to ALL kinds of people. These range from homeowners who took out not only sub-prime mortgages, but also people with outstanding credit who took out far too large conforming mortgages with adjustable rates and corporations that were allowed to become much too overextended. To make matters worse, lots of this debt was packaged into structured securities. These securities were most likely structured by humans on Wall Street with PhD's in mathematics and whose resumes often list "NASA" as a former employer. These humans had help doing this structuring using computer technology that NASA probably wishes it could afford. Finally, people who would likely have trouble finding their ass with both hands then bought many of these securities. The securities are now held by a host of institutions all over the world and not a single damn person can honestly tell you what any of them are worth. If you listen closely you will hear the sound of people's butts tightening up all over the globe right this moment.

I've spent my entire adult life around Wall Street and I have always refused to apologize for our sometimes rough language, morbid sense of humor and gossipy nature. But please pardon me for sharing with you some of the content from one of the hundreds of emails I've received in the last couple of days that ranged the gamut of rumor, humor and catharsis.

A friend wrote me on Friday that he had heard of a brand-new structured product called a "Constant Obligation Leveraged Originated Structured Oscillating Money Bridged Asset Guarantee", or "COLOStOMyBAG" for short. He made mention that it should fit in quite nicely with the ocean of acronyms for the structured products that now crowd the markets because "it's basically full of sh**." Crude perhaps, but I thought it quite nicely encapsulated an attitude that permeates the feelings of the trading crowd right now that Main Street is largely unaware of.

To now add insult to injury, a gigantic market for credit derivatives has sprung up over the past seven years, which in many instances is larger than the size of the actual debt securities upon which they are derived. The notional value of credit derivatives has been doubling (or more) every year since the year 2000. The butt tightening continues here.

We have a large problem and I tell you directly here that you should not listen to a single person who tried to quantify what the risk in the markets are, because they DO NOT KNOW.

The Federal Reserve, European Central Bank, Central Bank of Japan, the Reserve Bank of Australia and others have injected in excess of $400 billion U.S. into the financial system in the past two weeks. This, and the sudden reduction of the discount rate in the U.S. on Friday are all items of evidence that resulted in my stating that the central banks around the world are in "panic". They know and understand that there is a massive and severe problem and are trying desperately to prevent the collapse of a major, global financial institution. The moves they've made have prevented one so far, but I think it is still fairly early in this process, and if THEY don't know how this will play out, what do you think YOU should be doing right now?

I just read an article that says that some of the world's most respected wealth managers in Zurich (not money managers...wealth managers) are telling their rich clients to raise cash and ride out the storm. People always seem to forget that there are some days to go out sailing and other days you should be tied up securely at the dock.

So my point in all of this is that there is still much more that has got to happen before this all of this is "over" and nothing is close to being fixed yet.

The markets have sent a loud and clear message to the Federal Reserve that they EXPECT the Fed to drop interest rates, but here are the risks if they do:

--It may embolden more risk taking and speculation, making the ultimate disposition of these risks even worse than what we face now. Thus, the "moral hazard".

--The U.S. dollar, which has already been in free fall, will fall further. Foreign investors who have been financing the vast majority of U.S. government and private debt start selling it, driving bond prices down and long-term interest rates up.

--Inflation will rise.

--Real estate will collapse even more severely than it is already going to do.

Jim Cramer said Friday that the Dow is now on track for 14,500 thanks to the move by the Fed. Mike Gasior thinks you'll see 12,500 and even 11,500 before you see 14,500. I also think the credit markets will be worse.

Sorry for the bad news but I'm not hearing enough realistic and honest talk and I'd like for all of you to think defense and not get hurt. I've always been one to warn people to not "fight the Fed", but right now the Fed is literally the only thing you've got going for you and at the moment the market seems conned. Don't you get conned too.

JUST AN ASIDE

I was watching "Closing Bell" on CNBC on Friday afternoon because I was curious to see if the market would hold onto the gain and close positive when I saw Maria Bartiromo. Not particularly unusual, but she was outside. She was outside the New York Stock Exchange with a microphone interviewing tourists lined up there, asking them assorted dopey questions about where they were from and so forth. Then she was across the street at Federal Hall, where George Washington took his oath of office and she was made an honorary Junior Park Ranger. What is this all about?

I was honestly waiting for her to "throw it over" to Al Roker who could give us the market forecast and then kick off the new CNBC summer "Wall Street Concert Series". I'll vote that the first artist be Snoop Dogg so we can hear him remind traders to be more like him:"I've got my mind on my money and my money on my mind."

Please CNBC, stick to what you do fairly well, which is report financial information and leave the foolishness to your colleagues over at The Today Show. If I'm ever curious about "Is your dog psychic?" I'll tune in over there. If I need to know what the markets are doing, I'll watch CNBC.

But definite congratulations to you Maria on your Junior Park Ranger status. I'm certain your family is very proud.

TO MY FRIENDS IN THE CAYMAN ISLANDS

I know hurricane Dean is bearing down on you with perhaps category 5 intensity, but my many friends in the Cayman Islands are in my thoughts and prayers. Please take adequate precaution and stay safe. I'll see you again later this year.

TO MY FRIENDS IN BERMUDA

Congratulations to those many friends of mine in Bermuda who were pulling hard for Tiger Woods to finally win a major championship and qualify for the "Grand Slam of Golf".

Now many of you who don't follow golf very closely may not know, but there is a terrific event at the beginning of every season called "The Grand Slam of Golf", which features the winners of the four, golf majors. This event had previously been played in Hawaii, but starting in 2008 it will be played at one of my favorite golf courses on earth, the Mid Ocean Club in Bermuda.

With all deference to the winners of the first three majors of 2007, while all terrific golfers, none possess the media draw that a Tiger Woods brings to any event. So Tiger's win at the PGA Championship is exciting news for Mid Ocean and Bermuda and I'm very happy for both.

Copyright 2007, Michael Gasior. All Rights Reserved
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