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Stock-Markets / Credit Crisis 2008 Sep 19, 2008 - 07:57 AM GMT

By: Money_Morning

Stock-Markets Best Financial Markets Analysis ArticleJennifer Yousfi, William Patalon III write: U.S. stocks rallied the most in six years yesterday (Thursday) - with traders actually cheering the ticker action from the floor of the New York Stock Exchange - on the news that the federal government is taking steps to shore up the unraveling U.S. financial system and end the global credit crisis.

After two straight days of sharp selling, U.S. stocks whipsawed their way to major gains yesterday on investor hopes that federal government moves will halt a global credit crisis so severe that some leading market experts are talking about a depression-like downturn . The blue-chip Dow Jones Industrial Average jumped 617 points from its low of the day after U.S. Sen. Charles Schumer , D-NY, proposed plans for a new agency that would function during the current financial crisis much like the Resolution Trust Corp . did during the Savings and Loan Crisis of the late 1980s and early 1990s.

Institutional investors and regulators both here and overseas are taking steps to curtail speculative short selling.

For the day, the Dow rocketed 410.03 points, or 3.86%, to close at 11,019.69. The Standard & Poor's 500 Index - which tumbled 4.7% twice this week - rebounded from its lowest level since May 2005 to zoom 50.12 points, or 4.33%. With its close at 1,206.51, the broad U.S. stock index recovered most of Wednesday's 4.7% drop.

Both the Dow and the S&P 500 posted their biggest percentage gains since October 2002, Bloomberg News reported.

The tech-laden Nasdaq Composite Index roared ahead by 4.8%, rising 100.25 points, and closing at 2,199.10.

Seven stocks climbed for each that fell on the New York Stock Exchange, the Big Board's broadest rally since April.

Wachovia Corp. ( WB ) soared 59%, Citigroup Inc. ( C ) added 19% and Bank of America Corp. ( BAC ) advanced 12%, which caused the KBW Bank Index to post its biggest gain since July. Morgan Stanley ( MS ) rose 3.68% for the day - erasing an earlier 46% loss - while Goldman Sachs Group Inc. ( GS ) closed down 5.68%, almost fully reversing a 25% decline after three of the top U.S. pension funds stopped loaning shares of U.S. brokerages to speculators who wanted to sell the institutions "short."

"Any actions regulators or other entities or players take to try to slow down the bear raids will be received positively,” David Katz, the chief investment officer of Matrix Asset Advisors in New York, told Bloomberg . "There's no reason a Goldman Sachs or a Morgan Stanley should be forced to sell themselves in a shotgun wedding if they've got economic models that work, and they do."

Gold futures surged for a second straight day yesterday, with the benchmark contract eclipsing the $900-an-ounce mark for the first time in six weeks, as investor anxiousness over the fate of the global financial system sent them scurrying into hard assets.

Gold jumped $70 an ounce on Wednesday - its largest one-day gain ever - to reach $846.60 an ounce. The yellow metal yesterday tacked on an additional $46.50 an ounce, a jump of 5.5%, to end the day at $897 an ounce on the Comex division of the New York Mercantile Exchange ( CME ). At one point, the contract traded as high as $926.

In electronic trading, however, gold last fell back $40 to $857 and U.S. stocks staged a massive late-afternoon rally, amid signs that investors are starting to gain confidence in measures to provide capital to troubled financial firms.

The recent jump in gold prices "can be attributed to large amounts of money fleeing to the yellow metal as a safe haven in these troubled times," Sam Kirtley, editor of , told .

Kirtley noted that the financial crisis "will probably worsen over the coming months," meaning the money that the central banks are pumping into the system is adding to inflationary pressures - a reality that is "certainly showing in gold [prices]." [For a related story on the actions of the global central banks elsewhere in today's issue of Money Morning , please click here ].

Another expert agrees that the financial crisis "will probably worsen," but was far less sanguine about any benefits.

Jeffrey E. Gundlach, chief investment officer at The TCW Group Inc ., a Los Angeles-based mutual-fund firm, told clients on a conference call late Wednesday that the crisis in credit and housing is actually getting worse - and could last for years, if not decades.
In the deteriorating climate he sees unfolding, Gundlach said, the S&P 500 could fall another 30%, Citigroup could become an "AIG-sized debacle," default rates could soar even on prime mortgages and a banking crisis will emerge in Europe.

According to Gundlach, financial institutions may suffer write-offs that could surpass $1 trillion before conditions improve. That means there's still a long way to go. As of late August, credit losses and write-downs at the world's 100-largest banks and brokerages topped $506 billion, Gundlach said.

"This is no market for old men," Gundlach, who also manages TCW's flagship Total Return Bond Fund ( TGLMX ), told MarketWatch . "This is no market for old-school thinking."

Gundlach said housing prices would decline for several more years, the kind of slump not seen since the Great Depression . Indeed, it's possible that home prices will be sluggish until 2022.

"If it's like the Depression experience - and it sure is shaping up that way - it could take several years," he said. "Maybe we won't see a bottom in home prices until 2014."

Government Intervention?

Having savaged the U.S. financial sector since it surfaced in the summer of 2007, the credit crisis evolved into a crisis of confidence - which has manifested itself as a liquidity crisis. And that liquidity crisis is no longer confined to the financial sector. It's spilled over into the energy sector, as well. With that, two government officials stepped up with competing plans to help ease the domestic economy through this difficult time.

Sen. Schumer and U.S. Rep. Barney Frank, D-Mass., head of the House Financial Services Committee, have called for the creation of entities similar to the Resolution Trust Corp. that was created by federal government in the 1980s as part of its S&L bailout plan.

A government-run asset-management operation, the RTC took assets that had been held by insolvent S&Ls, and found ways to repackage them and sell them off. The RTC was widely heralded as a bold and innovative creation, and its success was one reason the S&L debacle was put to rest much sooner than experts predicted, and cost the taxpayers much less than many had feared.

Ex-Treasury Secretary Lawrence H. Summers and former Federal Reserve chairmen Alan Greenspan and Paul A. Volcker are all in favor of the plan.

But current U.S. Treasury Secretary Henry M. "Hank" Paulson Jr. remains admantly opposed to an RTC-like entity, according to BusinessWeek, and is proposing his own plan.

Reports of a government intervention raced across the newswires late yesterday afternoon - just in time to give the stock market a last-chance boost for the day - but details of the plans remain sketchy as news operations provided conflicting descriptions.

Fears Roil Commercial Paper Market

The U.S. commercial paper market - consisting of short-term corporate borrowing - recorded its biggest-percentage-point decline in more than a quarter century yesterday as the bankruptcy of brokerage giant Lehman Brothers Holdings Inc. ( LEH ) and the takeover of insurance heavyweight American International Group Inc. ( AIG ) sent a stampede of investors into government securities, Bloomberg News reported.

Commercial paper is a short-term debt obligation with a maturity ranging from two days to 270 days. It is issued by corporations, banks and other institutions to investors with surplus cash, which companies can use to finance their day-to-day operations. But a crisis of confidence among investors who fear they may not get their money back has made it impossible for firms to raise cash, creating a liquidity crisis big enough to shove otherwise solid firms into bankruptcy.

These investor liquidity fears had a major side-effect recently: By literally pouring cash into Treasuries, investors yesterday sent investment yields on the three-month T-bill to their lowest levels in at least 54 years, Bloomberg stated.

Thanks to this "flight to quality," the U.S. commercial paper market actually declined by 2.9%, or $52.1 billion, to a seasonally adjusted $1.76 trillion for the week ended Sept. 17, the U.S. Federal Reserve said yesterday. Without the seasonal adjustments, the market declined 4.2%, or $74.1 billion, to reach $1.68 trillion.

That was the biggest-percentage-point decline in at least 26 years. It was also the biggest slump in corporate short-term borrowing since December, Bloomberg reported.

"There's a loss of confidence in the market. You don't know if one of the banks you're trading with is next," Ina Steinke, a money-market trader for Norddeutsche Landesbank Girozentrale AG, Germany's fourth-biggest state-owned bank.

But this is one example of how a catastrophe on Wall Street can lead to major problems on Main Street since money-market funds are among the biggest buyers of corporate commercial paper.

Investors pulled $80.7 billion from taxable money-market funds in the week ended Sept. 16, including $39.6 billion of withdrawals from the Reserve Primary Fund. Total assets in U.S. money-market mutual funds fell 2.5% to $3.45 trillion, according to Money Fund Report , a Westborough, Massachusetts-based newsletter.

The Reserve Primary Fund and the Reserve International Liquidity Fund Ltd. became the first two money-market funds since 1994 to "break the buck," meaning that their net asset values (NAV) fell below the $1-a-share price paid by investors. [For an in-depth look at the money-market-fund mess , check out a related story elsewhere in today's issue of Money Morning ].

The list of firms facing liquidity shortfalls after spooked investors and short-sellers sent their stocks diving over the past week continues to grow as Morgan Stanley ( MS ), Washington Mutual Inc. ( WM ) and Constellation Energy Group Inc. ( CEG ) all scrambled to restore investor confidence.

Morgan Stanley's Search

With the commercial-paper market evaporating - causing its ability to operate to do the same - Morgan Stanley escalated its frenetic search for a well-capitalized partner to help it restore investor confidence.

Morgan Stanley shares have lost more than 40% in the past week, leaving Morgan Stanley Chief Executive John J. Mack seeking a tie-up with a commercial bank.

Mack yesterday held a conference call with the investment bank's 8,000 brokers to encourage them to do all they could to reassure clients that the firm was financially sound.

A Morgan Stanley spokesman declined to comment on the details of the conference call but said that "it was a message of strength and confidence," Dow Jones reported.

" How do you prepare for this? " said an anonymous Morgan Stanley broker. "Things are way above my ability to control. I just need to take care of my clients for now."

Anxious to avoid the fate of former rivals Lehman Bros. and Bear Stearns , Mack has been in talks with Charlotte-based Wachovia Corp. ( WB ), as well as other potential investors including London's HSBC Holdings PLC (ADR: HBC ), and even state-controlled China Investment Corp. , which manages part of that country's $1.8 trillion in foreign-currency reserves.

The China sovereign wealth fund already purchased a 9.9% stake in Morgan Stanley late last year. According to reports, China Investment is considering a purchase of as much as 49% of the struggling U.S. brokerage house, although a deal has yet to be reached.

" Morgan Stanley must be talking to any suitor ," Roger Lister, a credit analyst at the DBRS Inc . rating firm in New York, told Bloomberg . "I'm not sure whether a merger with a bank will solve the problems. It's not a deposit-base issue but a crisis of confidence [issue]. And getting a capital infusion from the Chinese or somebody else brings huge dilution due to the depressed stock price, which scares investors even more."

No Suitors for WaMu

Big Wall Street firms aren't the only financials in trouble as Seattle-based Washington Mutual, commonly known as WaMu, was officially up for sale yesterday after management hired Goldman Sachs Group Inc. ( GS ) to conduct an auction for the struggling thrift.

But despite WaMu's ranking as the sixth-largest U.S. bank, there were no bidders.

Fred Cannon, analyst at Keefe, Bruyette & Woods, said that while WaMu's franchise and retail branch network on the West Coast of the United States made it an attractive prospect for such East-Coast-based banks as JPMorgan Chase & Co. ( JPM ), any potential buyer would have to be able to withstand an accounting hit of as much as $37 billion from the thrift's deteriorating mortgage portfolio , The Financial Times reported.

That's a bitter pill to swallow and will make the thrift a tougher acquisition to digest - even with its $310 billion in assets, which includes an alluring $140 billion in deposits, that any buyer would get along with the corporate keys for WaMu.

Without a buyer, Goldman will need to investigate other options for its struggling client, including such possibilities as a piecemeal sale of assets, or a creative capital injection. But in a market as dry as this one is from a liquidity standpoint, raising capital in any form figures to be a Herculean task.  And WaMu's overexposure in the subprime mortgage market has made it particularly unattractive.

"The winning business [of the future] is going to the universal bank model, similar to that in Europe and Asia," Bob Ellis, senior vice-president at Celent, a Boston-based consulting firm that specializes in financial services, told BusinessWeek . "You'll have a strong retail bank, a retail brokerage, and an investment bank. That's the winning model-by design or default."

" The lesson I'm learning from WaMu is that it's dangerous to be a one-trick pony ," Ellis added.

Buffett to Constellation's Rescue

While Morgan Stanley and WaMu were still searching desperately search for a White Knight, Constellation Energy found its savior in the energy unit of iconic investor Warren Buffett's Berkshire Hathaway Inc.   ( BRK.A , BRK.B ).

Berkshire's MidAmerican Energy Holdings Co. agreed to buy the distressed energy firm for about $4.7 billion, a 50% discount to Constellation's market value from just one week ago. And while Berkshire isn't a deposit bank, the rock-solid credit rating of the cash-rich investment holding company will be enough to guide Constellation through the current crisis.

The deal came together quickly as the looming threat of a credit-rating downgrade from both Standard & Poor's and Fitch Ratings Inc. drove Constellation's shares down almost 60% in the past week, putting the energy firm in a liquidity squeeze.

" The reality is that it all came together in the last 48 hours ," MidAmerican CEO Gregory E. Abel told Reuters .

"Pretty much from the time we started the dialogue, we've been working to see if there's a balanced outcome we can deliver for all the various stakeholders," Abel said.

The all-cash deal equates to $26.50 per Constellation share, a 7% premium over Wednesday's closing price. As part of the deal, MidAmerican will receive Constellation's power plants - including three nuclear power plants - as well as its flagship utility, Baltimore Gas & Electric.

Once MidAmerican and Constellation iron out the details of the merger agreement, MidAmerican will make a $1 billion emergency cash injection in the liquidity-starved utility.

" Warren's got the cash and he's got the platform to fold it into at MidAmerican Energy ," Greg Phelps, who oversees $3.5 billion at MFC Global Investment Management in Boston, told Bloomberg .

"With the deep pockets Berkshire Hathaway's got, credit risk will be a thing of the past for the trading business," Phelps added.

Fitch reaffirmed Constellation's long-term debt rating at "BBB" on the news, with a stable outlook. Standard & Poor's also left its rating for Constellation at "BBB," though noting the rating remains under review until after the planned capital infusion.

News and Related Story Links:

By Jennifer Yousfi, William Patalon III
And Jason Simpkins

Money Morning/The Money Map Report

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