Wednesday, October 22, 2008

Stock market risks increase

Markets in Asia are falling apart. The Euro and Pound are now in a free fall against the dollar. Now we see that many Latin American companies are losing vast sums of money, because they gambled huge sums on currency bets:

Throughout Latin America, companies are telling investors they have lost millions, in some cases billions, of dollars due to foreign-exchange gambles that, in some cases, had little to do with their core businesses.

A few days ago, we found out that Citic Pacific lost $2 billion speculating in currencies. Does anybody think that these are only isolated cases? And these are the bets made on napkins--The currency derivative bets whose losses we only find out when they go sour. And I'll bet these are the "double-up" swaps. What that means is, when someone wants to hedge their currency, these sophisticated investment banks, convince these companies, that they can hedge their bets for less cost. The catch is, that when the currency moves against you, after a certain point, the deal will double. Now you have twice the problem, in a losing position.

Remember in 1995 when the Indonesian noodle maker lost $300 million on these "double up" swaps, when they were hedging their rupiah? Look at the games now played in our financial market. How much larger are these losses now? They will be staggering.

Like a forest fire, deleveraging will hit all aspects of the economy. Mortgages were just where the losses came first. We then saw it in the market's wild swings with hedge fund deleveraging and jettisoning their stocks. We see it in the price of oil where speculators, who juiced the price are now getting killed. Now we are seeing it in currencies and in the currency derivative bets. Yesterday, the WSJ brought up another beauty-the unwinding of synthetic CDO's:

LONDON -- A recent rash of bank failures is wreaking havoc on a large but little-known corner of the credit markets, in a development that could mean more write-downs for banks and higher borrowing costs for companies everywhere.

Even as some lending markets begin to recover from last month's demise of Lehman Brothers Holdings Inc., the securities firm's default -- together with those of other U.S. and European banks -- is causing new dislocations in the multitrillion-dollar market for complex investments known as synthetic collateralized debt obligations.

That could mean trouble for banks, hedge funds and insurance firms around the world, which used synthetic CDOs as a way to invest in diversified portfolios of companies without actually buying those companies' bonds. Many synthetic CDOs contain a heavy dose of exposure to financial companies, including Lehman, U.S. thrift Washington Mutual Inc. and recently nationalized Icelandic banks Glitnir Bank hf, Kaupthing Bank hf and Landsbanki Islands hf.

But it doesn't stop here. How about the costs in underfunded pensions on corporations balance sheets? Goldman came out with a scare piece on that yesterday to tag team JPMorgan's warning Monday:

The recent erosion of pension plans could potentially hurt profit at aerospace and defense companies profit, an analyst warned Monday.

JPMorgan analyst Joseph Nadol told investors that the funded status of pension plans among companies like L-3 Communications Holdings Inc., Lockheed Martin Corp. and Raytheon Co. could slip this year to a range of 70 percent to 80 percent due a falloff in current asset values.

At the end of 2007, plans at Boeing Co., Northrop Grumman Corp., Lockheed Martin and United Technologies Corp. were at least 90 percent funded, according to Nadol.

But with sizable changes in market performance and interest rates over the past two weeks, plans have declined, which could force companies to pay higher cash contributions to maintain requirements.

"The expected decline in plans' funded status will likely require additional cash contributions," Nadol, wrote in a note to clients.

He estimated that funding requirements could force an annual cash contribution of roughly $550 million at Lockheed Martin and contributions in the range of $200 million to $350 million at Boeing, Northrop Grumman and Raytheon

Goldman also had a piece on pensions but let me bring your attention to this article in the NY Times, with commentary from a Goldman analyst:

But few companies today meet that standard. A study by Goldman, Sachs & Company, the investment banker, shows that the use of high interest rates is widespread among pension plans of Fortune 500 companies.

Of 366 concerns surveyed, 300 based their valuations on rates higher than 7 percent. The overwhelming majority used rates of 8 percent to 9 percent, and some were as high as 12 percent. Only eight companies in the survey used rates below 7 percent.

"Many companies are vulnerable if they are forced to reassess the interest rates in their pension plans," said Gabrielle Napolitano, a portfolio manager and author of the Goldman, Sachs report. "This is something that will increase their pension liability, and could constrain corporate cash flow as companies may have to make bigger contributions to their pension plans."

Wait, I forgot to mention one thing. This piece was written, November 29, 1993! In 1994 the S&P was down 1.47%, but 1995 was up 34.1%, 1996 was up 20.27%, 1997 was up 31.02%, 1998 was up 26.67%, and 1999 was up 19.51%. Obviously these liabilities became an asset. But it's the same story. History repeats itself.

Pension problems, by definition come out after stock prices are down considerably, but it doesn't mean it can be dismissed. The blue chip companies are the ones with the best pension plans. And an unfunded liability, will just make investors compress the multiple of which they'll pay for the companies that are supposedly safe.

Besides credit risk, market risk, execution risk, and economic risk, we also have stupidity risk. And this time, the stupidity isn't from bankers, but from CEO's. We have had a rash of buy-outs that haven't been completed because of core incompetency at the top. How did Jerry Yang from Yahoo turn down $31 cash from Microsoft? How did Bill Miller say that price undervalued YHOO? Now it's 12! SanDisk got a cash bid for $26 from Samsung, that the Chairman Dr. Eli Harari said substantially undervalued the company. Yesterday, the Nikkei news service said that Samsung was going to go forward with the deal. They didn't. So you now have "information" risk in this market. Today the stock is under 12 after Samsung withdrew the offer. No one yahooing here either!

Now we have to contend with country risk. First it was Iceland melting. Now Argentina is on the verge of defaulting on their debt, and hijacking their pension system.

Tomorrow on deck, we get the lies from our Federal Reserve, when they allegedly will tell us how much the bonds that they own from Bear Stearns are supposedly worth. Maybe they can have the TARP buy those.

And then, we get the early OPEC meeting, with their vain attempt to stabilize oil prices. They don't have a snowball's chance in hell of pulling that off.

And now that Argentina is on the ropes, what will happen next to those rogue nations that are dependent on oil for their economic well being?

The risks in this market just seem to get greater each day.

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