RISK PREMIUM ANALYSIS: Every Which Way But Up!

For the Tenth Week of 2008

Despite ongoing hearings by Congress to address the worsening housing market and credit crisis, stocks are still not showing any signs of a rebound.  This week the Dow Industrials drifted below 12,000 with little fanfare.  Our Risk Premium Index points to much lower levels ahead, perhaps testing even the 11,000 threshold.  The Risk Premium Index continues to indicate that the bear market is entrenched and that a downward revaluation of stock prices shows no signs of abating.  

HOPES FADE FOR A 100-BASIS POINT CUT IN FED FUNDS RATES ON MARCH 18TH

We look to an additional cut in the Fed funds rate on March 18th of at least 75-basis points, lower than the 100-basis point estimate predicted by a consensus of economists right after the previous reduction to 3.0% in mid-February.  Some economists feel that the Fed may lower rates by only 50-basis points.  We feel that the Fed cannot ignore the ever-more troubling economic news which saw job losses in February climb to their highest levels in five years and home foreclosures reached record levels.  The systemic weakness in the economy and the growing consensus view that a recession is underway are also factors which we feel will lead the Fed to opt for a higher rather than lower cut.  With the lag effect the benefits of reductions initiated in late 2007 have yet to be reflected in the economic data, especially the hard-hit housing sector.   We hope that the Fed will be more aggressive and cut rates by 100-basis points.  Lowering the Fed funds rate is the best tool in the Feds “tool kit” for addressing the housing free-fall.  Anything less than a maximum effort to bring interest rates down is not considered a positive, especially in light of statistics released this week showing that homeowner’s share of the equity in their homes fell to 49%, a record.

THORNBURG FAILS TO MEET MARGIN CALL

There was further negative news.  Thornburg Mortgage, a higher – end mortgage lender, faced a liquidity crisis and was unable to meet a margin call, forcing the company into a 30-day grace period before creditors could force it into Chapter 11.  Home mortgage default rates have reached the highest levels in recent times and there is no reason to feel that housing prices will cease falling or that the cost of home ownership is lessening.  And as if the credit markets were not bad enough, now comes news that banks and brokerages are demanding that hedge fund customers repay their loans or put up more cash or collateral to offset the declining value of mortgage-backed bonds and other securities held in their portfolios. Given the illiquid nature of the market, the compulsory sale of securities would come at significant discounts.  The net effect was to pressure all sectors of the market and raise questions as to whether or not Thornburg would be among the first companies unable to satisfy margin calls, thereby accelerating the downward spiral of the credit markets, not to mention the chilling effect on stocks.

AMBAC MANAGES TO SELL $1.5 BILLION OF EQUITY

Ambac gave the market some pause this week when it announced on Wednesday afternoon that it would release the details of a rescue plan at the close of trading.  For two hours the market waited with anxious anticipation only to be disappointed to learn that Ambac’s bail-out plan involved selling $1.5 billion of stock, consisting of $1.25 billion common stock and $500 of “other equity instruments,” substantially diluting existing shareholders’ holdings.

When it was all was said and done, Ambac secured $1.5 billion of equity which was raised through: $1.25 billion of common stock, priced at $6.75, a $50 million private placement sold to Cerberus Management, a private equity firm.  An additional $250 million was raised through the sale of “equity notes,” which are effectively convertible securities, thereby bringing the total equity infusion to a grand total of $1.5 billion.  Ambac announced that it would generate an additional $600 million by suspending its risky structured finance business for at least six months, a move expected to raise its capital base to $2.1 billion.  This capital raising program seems to have appeased the rating agencies and the capital markets since the ability to raise $$2.0 billion of equity as an intermediate goal enabled Ambac to evade a downgrade at this time.

Ambac managed to sell $1.25 billion in common stock and $250 million in equity equivalents (securities which receive “equity treatment” by the rating agencies). Both Moody’s and S&P responded by commenting that the $1.5 billion equity infusion would suffice for now and stave off a ratings downgrade.  The outlook, is still listed as Negative.  In our opinion, Ambac is to be commended for the ability to secure as much as they did in a market that seemed unreceptive to its earlier financing plans.  The market was frustrated with Ambac’s recapitalization plan in that investors had been hoping for a larger capital infusion.  Shares of Ambac closed the week at $7.33, down 72% since the end of last year.

THE FED EXTENDS A $200 BILLION LIFELINE FOR BANKS IN THE FACE OF HIGHER JOBLESS FIGURES AND DATA INDICATING THAT AMERICANS ARE GETTING POORER

The mounting sense of financial disarray encouraged the Fed to introduce a new emergency measure to bolster inter-bank liquidity and make it easier for banks to borrow funds. The Fed plans to expand to $200 billion the amount it lends to banks in one month.  The news could not have come a moment to soon as the Fed’s announcement came on the heels of news that the U.S. lost 63,000 jobs in February, the second strait down-month in a row. The sharp rise in job losses heightens the probability that the U.S. economy is in a recession.  And as if the economic news for the week wasn’t disturbing enough, recent data showed that American households are getting poorer, with wealth falling in the fourth quarter by $533 billion to $57,718 trillion.  The lower wealth figures do not augur well for an upswing in consumer spending, dashing hopes that consumers will lead the economy out of a recession thus making the low cost retail benchmark, Wal-Mart, the store of last resort.  As we have noted in the past, the profile of each recession is different.  We do not share the view that consumers can, or will, pull the economy out of this slump since housing is pulling the economy down, and only when it begins to rebound can investors expect a reversal in the current economic decline.  Housing by its nature has a long turn-around cycle.  Given the unprecedented housing crisis, expectations of a short and shallow recession do not seem realistic.  We are looking to at least 2009 before the housing sector returns to health. 

A BACKDOOR APPROACH TO LOWERING INTEREST RATES

Barney Frank, chairman of the House Financial Services Committee, has called upon the Federal Reserve Chairman Ben Bernanke to suggest possible ways to  help reduce foreclosures.

The House committee has proposed providing the Federal Housing Administration a $20 billion grant to purchase troubled mortgages and asked the Federal Reserve for its assistance.  While this amount pales in comparison to the amount of troubled mortgage debt, it should provide more targeted relief than the President’s stimulus plan.  Such an initiative though would have to clear many hurdles before it could becomes law, not the least of which would be a positive ruling by the Treasury Department regarding the tax consequences of a partial loan forgiveness contained in the mortgage moratorium and bailout proposals. A negative ruling would probably offset the benefits of these proposals.

Bernanke’s support for the House’s proposals came in a speech before the Independent Community Bankers of America.  The endorsement by Bernanke is critical because the chairman acknowledges that lowering interest rates (i.e. the monthly carrying cost of mortgages) may be insufficient to turn the housing market around.  The fact that homeowners have negative home equity, which means that a house is worth less than its mortgage, increases the chance the homeowners will walk away from their homes, resulting in a higher delinquency and foreclosure rates. Homeowners face the added burden that if a lender foreclosures on a house at a price lower than the face amount of a mortgage, the difference is considered a taxable gain by the IRS.  It is important to stem the tide of foreclosure rates because as long as the U.S. has an increasing delinquency rate, banks and other lending institutions face the specter of additional write-off’s, effectively weakening their balance sheets which have already been decimated by non-performing mortgages.

The House committee hopes that a Federal government intervention will help homeowners as well as reduce investor fears of a major bank failure.  In this regard, the Fed is stepping outside of its monetary policy brief.  Bernanke had a clear opinion on the subject and advocated some type of loan forgiveness in order to stem the rate of foreclosure, thereby alleviating some of the pressure in U.S. home sales.  Home prices have been declining nationwide for over a year. At the end of 2007, 7% of home mortgages had negative equity and some estimate that this figure could rise above 20%.

Our Risk Premium analysis remains in bearish territory as the market appears to be “pricing risk” in, resulting in contracting P/E multiples.

For the week ending March 14th the risk premium results are illustrated by the yellow line:

§      The Industrial Risk Premium ended at 6.93% versus 6.72%

§      The Transportation Risk Premium decreased to 7.22% from 7.24%

§      The Utility Risk Premium remained unchanged at  6.76% n 

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