Stocks and Mutual Funds

Federal Regulators seized Washington Mutual late Thursday, and was purchased by JP Morgan Chase for $1.9 billion.

With over $900 billion in deposits, Washington Mutual was the nations largest thrift, and is the largest bank failure in U.S. history. WaMu’s significant sub-prime exposure led to its downfall, as it had trouble raising the capital to meet customer withdrawals, according to regulators.

The bank, they said, will be open for business as usual on Friday. The acquisition by better-capitalized JP Morgan, is likely to prevent a run on the bank, but JP Morgan did announce that it will likely sell equity to raise working capital.

JP Morgan has become a leader in the financial merger during crisis time, acquiring Bear Stearns and now Washington Mutual.

Stocks had another tumultuous day, starting up, but the S&P 500, Nasdaq, and the Dow ended more than 1% down.

Concerns over the Treasury Secretary Paulson’s $700 billion bailout bill have mired the market over the past two days, and the uncertainty is going to continue until legislation is passed.

Paulson has requested a program that is “not punitive,” while Congressional leaders are likely going to make it difficult for banks to use the new facility, temporarily penned the Troubled Asset Relief Program (TARP). Paulson is an old Goldman chief executive, and it is unclear where his allegiance is.

One thing that is clear is that the language being used is the same language that was used when the Patriot Act was rushed through Congress. There is an “imminent threat” to the national economy. Legislators “must act now,” and there is “no time for hesitation.”

As a deliberative body, it is the job of Congress to find the best solution, and work through all possible outcomes. While they rarely do this job well, forcing through a bill on the danger of an immediate threat is no way to handle a banking crisis that is over one year old.

Fed Chairman Bernanke and Paulson smelled this one a mile away, when the first Bear Stearns CDOs were written off in July of 2007 — 14 months ago. That they have waited until the economy is at the precipice of danger is not the fault of ill-equipped representatives.

Smart money is maintaining liquidity and using any strength as an opportunity to sell potential liabilities. There will probably be an upward surge to Dow 12,000 when Congress passes a law, but it is not likely to last. Buying opportunities are likely in the coming nine months: Dow 9,500 will be back.

The Financial Service Authority in the UK banned the short selling of securities until January, when the policy is to be reviewed.

The Dow ended up 410 points after falling as low as 150 down during the day’s trading.

The upside momentum came as rumors began swirling after Senator Charles Schumer of New York proposed forming a new agency to deal with ailing financials. The murky details can be found at the Wall Street Journal.

It would appear that regulators are attempting to set up a holding cell for distressed securities, though they would likely place limits on who or what entities would be eligible for this black hole. It is also not clear how this toxic debt would be handled without negatively affecting either taxpayers or the currency, or, likely, both.

Looking at the actions of regulators over the past months, it is clear that they won’t bail everyone out: Lehman was proof of that. Conversely, the losses of the Reserve Primary Fund (and the subsequent $90 billion in redemptions that followed) caused by the Lehman bankruptcy may lead the to try to bail out everyone. But they will most likely play favorites based on how strong the financials are of the entities involved. JP Morgan Chase, for example, was clearly favored by the Fed during the Bear Stearns intervention. Bank of America, on the other hand, is currently digesting the assets of both Countrywide and Merrill Lynch, so may be at higher risk.

What is clear is that equity is not out of the woods yet, and the jump experienced today was premature. In every bailout scenario (Bear Stearns; Freddie Mac; Fannie Mae; Lehman Brothers and AIG) common shareholders were basically wiped out. Lehman stands as the exception in that it was allowed to file for bankruptcy, thus wiping out both equity and bond investors.

The other thing that’s clear is that the bilout will be at the expense of taxpayers and homeowners, not to benefit them.

According to reports from the New York Times Blog, Washington Mutual has hired Goldman Sachs to broker its sale to the highest bidder. Wells Fargo, JPMorgan Chase, and HSBC are among the suitors Goldman has been in discussions with, according to the report.

Stock in WaMu, the country’s largest thrift, has suffered a plunge of almost 95% over the past year due to falling value of mortgages, as it was among the market leaders in Option-ARM mortgages. The stock closed Tuesday at $2.01.

AAA-rated Reserve Primary Money Fund, managed by Reserve Management Corp. in New York, held over $780 million in Lehman Brothers debt, spearheading the fund’s two-day 60% plunge to a value of $23 billion.

The only other money market fund to break the buck was Community Bankers Mutual Fund in Denver, which failed due to derivatives in 1994.

Reserve Primary, which had assets valued at over $64 billion as recently as May 31, halted redemptions as of 3 p.m. Tuesday, September 16, 2008.

For more on Money Markets and “Breaking the Buck,” see the FDIC website:

http://www.fdic.gov/bank/analytical/fyi/2004/051904fyi.html

For the details on Reserve Primary

http://www.bloomberg.com/apps/news?pid=20601087&sid=aycQDd9pEdCA&refer=home

http://money.cnn.com/news/newsfeeds/articles/djf500/200809161914DOWJONESDJONLINE000750_FORTUNE5.htm

It has been reported that federal regulators have agreed to take control of AIG, in exchange for an $85 billion two-year term loan. The loan will allow AIG to continue operations as assets are sold off in order to meet the obligations of the firm.

AIG, a Dow Jones Induatrial Average component since May of 2004, is the first component of the index to fail in many years. Currently against the ropes due to an estimated 28-to-1 leveraging, GE is the Dow’s oldest component, and may be the next to require capital assistance.

The Federal Reserve has posted its press release:

For release at 9:00 p.m. EDT
The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.

The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.

Source

http://www.bloomberg.com/apps/news?pid=20601087&sid=aeQ3Rjc3twg0&refer=home

http://www.reuters.com/article/newsOne/idUSHKG1567720080917

On Sunday Bank of America agreed to purchase Merrill Lynch for .8595 shares of BAC for each share of MER.

Investors, wary of regulatory and due diligence hurdles before the deal is finalized, largely stayed on the sidelines, leaving quite a spread between BAC and MER share prices until Monday’s close. Merrill was up about 15%, while Bank of America shares fell 20% on the day.

Bank of America, still digesting it’s $4 billion appetizer, Countrywide, seems to be at risk of overeating, at least until the full weight of Countrywide’s debt has been revealed.

The deal will be dilutive of Bank of America stock, which explains CEO Kenneth Lewis’ elation.

With bankruptcy of Lehman Brothers and the JP Morgan purchase of Bear Stearns, only Goldman Sachs and Morgan Stanley remain among the U.S. five top independent brokers.

158-year old brokerage Lehman Brothers Filed for Chapter 11 bankruptcy protection Monday, the largest such filing in U.S. history.

With som $600 billion in outstanding debt, Lehman is unable to meet its obligations, but is in talks to sell off its profitable assets.

Shares plummeted to under $0.20 per share early Monday.

As of June 30, 2008, Legg Mason Partners Aggressive Growth Fund (SHRAX) was the largest mutual fund holder of Lehman stock.

The Treasury announced a plan to bring Fannie Mae and Freddie Mac under the Federal Housing Finance Agency.

With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.

These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free. Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.

Market discipline is best served when shareholders bear both the risk and the reward of their investment. While conservatorship does not eliminate the common stock, it does place common shareholders last in terms of claims on the assets of the enterprise.

Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses.

The full affect of this on the markets will take weeks to months to bear out, but common shareholders are going to get the worst of it, followed by the owners of preferred shares.

Here is the Treasury’s statement on the action taken.

The agreement issues to the Treasury “…warrants representing an ownership stake of 79.9% in each GSE going forward.”

Here is the treasury’s fact sheet on the preferred stock issuance.

As of June 30, top holders are big guns:

http://finance.yahoo.com/q/mh?s=FRE

Legg Mason Value Trust is run by one of the most respected managers in the business, Bill Miller.

http://finance.yahoo.com/q/mh?s=FNM

Another highly regarded mutual fund house Dodge and Cox is up there with 5% of Fannie.

If they unloaded after 6/30, they took a huge loss, but not as big as if they’d held it.

D&C has already issued a statement, looks like their stock fund was 1% (about $500m) Fannie as of Friday:

https://www.dodgeandcox.com/pdf/FNMA_comment_20080907_final.pdf

Alcoa announced that its profits were 37 cents per share, down from 75 cents per share in the year-ago period. Analysts expected profits at 48 cents per share. Revenues were $7.4 billion, versus $7.9 billion during last year’s first quarter.
Officials cited the higher cost of energy and raw materials as well as the downtrend in the US Dollar for the decline in profits.
Alcoa is traditionally the first major company to announce its quarterly earnings, and is seen as an indicator of how the season’s reports will unwind.  Be careful how much you read into this stuff, though, as it’s often laden with hazy rhetoric. Consider the following conclusion from Marketwatch:
Alcoa’s report is seen as ushering in another rough period for corporate results, with earnings for S&P 500 companies seen declining 10.9% from the year-ago period, according to Wall Street targets. Still, that’s an improvement from the showing they made in the fourth quarter when earnings fell 25.1%, the worse quarterly performance since at least 1991.

Analyst estimates were that Alcoa’s profits would be down 36%; in reality they were down 50%. Analyst estimates are that S&P 500 earnings will be down 10.9%, and they will likely be lower in reality, possibly lower than last quarter’s -25.1%.

Financial journalists always have a way of making things seem better than they really are. I expect a bumpy ride this earnings season, and aim for capital preservation and risk aversion.