Quite a Puplava write up today...
Wednesday September 18, 2002 Market WrapUp
Financial Stress & Systemic Risk
Today the bank of Japan announced it would start buying stocks from banks laden with $200 billion in shares. The actions by Japan’s central bank
are the third rescue operation in four years. The bank will buy shares directly from the hemorrhaging portfolios of major banks. In Japan the
process of monetizing financial assets has begun. It remains only a question of time before similar operations begin here in the US. J.P. Morgan
stunned the financial markets with news that its earnings would be far below expectations due to a quadrupling of bad loans of $1.4 billion during
Q3. Trading profits at the bank fell from $1.1 billion from the previous quarter to just under $100 million. This is a bank in deep trouble and in all
the wrong places. The markets shouldn’t have been stunned by the news. Anyone with an IQ over 100 should be able to look at Morgan’s
derivative book, now at over $25.9 trillion, and see this isn’t a bank, but a hedge fund--a hedge fund that makes LTCM and Enron look like t-bill
money market funds. Look at the risks taken by LTCM and Enron and then multiply that by a power of 10. This bank looks, acts and resembles a
hedge fund run on steroids, methamphetamines, and caffeine.
Its high risk lending and high risk trading operations have begun to backfire on the bank in spades. They are losing money in lending and it looks
like they could lose money on the trading side. The bank’s profits, which peaked at $5.73 billion in 2000, have fallen steadily since then. Profits
fell 71% in 2001 to $1.69 billion. Many analysts expect them to earn nothing in the third quarter, and it’s anyone’s guess as to what the fourth
quarter will bring. The bank’s $47 billion in outstanding bonds were downgraded by S&P and by Fitch. S&P said the worst might not be over for
the troubled bank. With its debt downgraded to A+, it hurts the bank. More importantly, if the bank’s debt is lowered one more notch to A, it could
be the beginning of the end. An A rating could start a downward spiral. Credit-rating cuts mean higher borrowing costs for J.P. Morgan. Investors
begin to demand higher yields to compensate for higher risks. Because the bank derives so much of its revenue from trading high-risk derivatives,
a lower credit rating means that trading partners would demand more collateral to do business with the firm. When you consider that the bank’s
derivative book now exceeds $25.9 trillion, this factor becomes significant. Lower ratings could begin a downward spiral caused by the unwinding
of the bank’s derivative book in a situation similar to what happened to Enron. In the case of Enron, it looks conservatively managed when
compared to operations at Morgan.
In addition to the bank’s lending and trading risks, measures of operating performance have declined significantly. Whether it is return on equity,
return on assets, or return on investment, gross margins, operating margins, profit margins, or measures of financial strength, all have shown
measurable declines as reflected in the table below.
In addition to the deterioration of the bank’s operating performance and the increase in non-performing assets, the company’s dividend may be in
jeopardy. The company earned only $1.69 billion and paid out dividends of $2.697 billion. Bank officials said they would continue to pay the
dividend if “provided that capital ratios remain strong and earnings prospects exceed the current dividend.” Those are big ‘ifs’ at a bank that is
loaded up with $25.9 trillion in its derivative book. It appears the company is going to have to take very dramatic steps to shore up operations and
capital, including a return to higher profitability. Management is running out of time and is now looking at firing employees. According to
Bloomberg, the bank needs to boost earnings to 44 billion in 2003 and avoid trading and credit losses in order to avoid another downgrade by
Standard and Poor’s. The next downgrade could be the undoing of this blue-shoe bank. S&P’s analyst, Tanya Azarchs, in a conference call said,
“There is considerable risk of another bad quarter.” Another cut, to A or below, “is a breakpoint that has some significance and could hurt J.P.
Morgan’s trading business. It could cause a downward spiral.” The analyst declined to make an estimate if S&P would downgrade the bank again
saying, “We cannot downgrade just because it might cause that downward spiral.”
J.P. Morgan isn’t the only problem coming from the financial
sector. Mortgage loan delinquencies are growing on FHA loans.
They increased from 11.3% to 11.8% in the second quarter. The
third quarter is also expected to show an increase. Worse still, the
Fed reported on Monday that consumer and business borrowing
jumped at the fastest rate in over a decade. According to the Fed’s
flow-of-funds report data, debt outside the banking sector surged by
7.8% in the second quarter, much faster than the 4.8% increase in
the first quarter. Total nonfinancial debt, which includes home
mortgages, consumer credit, and government and business debt,
now totals $19.99 trillion and is still growing rapidly. The flowing
graphs of Freddie, Fannie, Sallie, and MGIC Investment
Corporation, which provides private mortgage insurance coverage
in the US, is an ominous portent of things to come. Financial stress
is starting to show up in all of the usual places, with lenders and
financial intermediaries. This is but one more hurdle the markets
will have to deal with in the next few months.
Another problem facing the US economy and other western economies is the rise in oil prices. Crude oil futures rose to close above $29 a barrel
on Wednesday as OPEC members reached an informal agreement to leave output levels unchanged. There was widespread agreement between
members to leave things as they are. The majority of producers favor no change. It now looks like OPEC is ready to put the squeeze on Western
economies, keeping prices high enough to make more money, but not too high to encourage new exploration. Oil companies have been
complacent and conservative with their exploration budgets due to the belief that high oil prices reflect a war premium only. Inventory levels
have been declining steadily as winter approaches. There is simply no margin for error. If supplies are disrupted due to war, or if a normal or harsh
winter occurs, prices for energy could soar. Rising energy prices would be the death knell of a struggling economy here in the US and Europe.
European economic growth for the second half has been cut in half to 0.3%. For all of 2002 it is expected to be only 1.0%. The major countries
within the EU are expected to delay the target dates for eliminating their budget deficits. For many economies unemployment is now surging.
The unemployment rate in Germany is now 9.7%. Higher oil prices will exert a greater downward effect on EU economies, which are more
dependent on Middle East oil. It may be one reason that appeasement is more pronounced in Europe.
Looking at today’s markets, J.P. Morgan’s earnings warning raised investor fears over growing financial problems. Companies in just about every
sector are having problems meeting their lowered earnings expectations. It was the busiest day in over a month on the NYSE. There was heavy
selling all day with the markets staying in negative territory for most of the day. There was heavy buying in the futures markets, but it failed to stem
the tide of losses. There are just too many negatives for a stock market that is extremely overvalued, outside of metals and energy. The spin for the
turn around was that it was due to short covering and the end of selling by investors. Nice try, but it doesn’t fly. The short-sellers are just getting
started. There are simply no convictions for remaining or investing in stocks. Analysts have lowered once again pro forma earnings estimates this
quarter from over 11% to 9.7%. Bear in mind we are still not talking about the bottom line, which is much worse. We are likely to see more
scandals surface in the weeks ahead. The SEC chief, Harvey Pitt, has already alerted the financial markets that more indictments are coming.
Today Merrill Lynch fired a pair of executives, Vice Chairman Thomas W. Davis and Schuyler Tilney, an investment-banking manager. Both men
refused to testify in an SEC and Department of Justice probe into Enron related matters.
For most market participants, the fundamentals look as if they are worsening. The rose is coming off the rose colored glasses in terms of a second
half recovery. It simply isn’t going to happen, so the markets are going to go through an adjustment process that should take stocks below their
July lows. The earnings shortfalls, the weakening economy, higher oil prices, systemic financial risks, and an upcoming war, and possible terrorist
attacks are just a few of the negatives the markets face this fall. Given these realities, it is hard to see markets rising unless the Fed starts
monetizing the stock market in a similar way as the Bank of Japan. That possibility has already been discussed in previous Fed papers as another
tactic if monetary policy fails to forestall a recession and bear market.
Washington and Wall Street have a major problem staring at them, which is the individual investor. While pros and company insiders have exited
the markets, John Q. is still hanging on. The present state of mind of most investors is to ignore the problem of hemorrhaging monthly statements
that have been declining for almost three years. Right now investors are in an ostrich state of mind, preferring to ignore their losses rather than
confront them. If markets fail once again this year, which now appears likely, a capitulation phase may soon begin. Selling and redemptions
would beget more selling and send prices even lower. Key support levels remain at the July 24th lows, which should be shortly tested. Stocks
prices headed even lower after the closing bell in after hours trading when EDS warned it would not meet estimates for the third and fourth
quarter. Analysts keep lowering the benchmarks and companies keep missing them.
Volume picked up on the sell side with NYSE volume coming in at 1.48 billion on the big board and 1.56 billion on the Nasdaq. Market breadth
was once again negative by 19 to 13 on the NYSE and by 20 to 13 on the Nasdaq.
Overseas Markets
European stocks dropped, pushing the Dow Jones Stoxx 50 Index to its lowest in almost five years, as a government report indicated the French
economy is faltering. All eight major European markets were down during today’s trading.
Asian stocks fell after a U.S. central bank report showed factory production unexpectedly dropped in August. Japan's Nikkei 225 Stock Average
lost 0.8% to 9472.06.
Treasury Markets
Treasuries closed with losses following a session of erratic trading. The 10-year Treasury note inched down 6/32 to yield 3.845% while the 30-year
government bond slumped 12/32 to yield 4.75%. Thursday will see the release of weekly initial claims and August housing starts.
© Copyright Jim Puplava, September 18, 2002 |
