This is a Pretty Crazy Market

This is a pretty crazy market, but then it has been since last summer. I have been working hard just to stay even with my portfolio. With your fresh funds from the sideline to bring in gradually, you should do very well over time.

Regarding the Fed / JP Morgan / Bear Stearns situation, I suspect there will be more of those down the road. Lehman may be one, Washington Mutual might be another. Even Fannie Mae and Freddie Mac may go that route. This is really the only way for the Fed to get the market restarted. It is a variation on a theme that has been recommended by many financial market experts.

The basic idea that is being implemented is that when a financial company like Carlyle Capital (failed on Wednesday) and Bear Stearns (almost failed Thursday), which are both loaded with mortgage and commercial securities that are below AAA (subprime, Alt A or other), freeze up and have their loans called back, the Fed will orchestrate an asset rescue. With Carlyle, the Fed just let that private banking company fail. Carlyle had to turn over its loan portfolio, which was collateralized by its value, to the banks to whom it owed short-term money. It had a 30:1 leverage ratio, so it was bound to fail in this environment. Carlyle, like many private banks and hedge funds, had played the "carry trade" game, which is to borrow high quality paper short term at lower rates, and then lend long term, for poorer rated debt at higher rates, and earn the spread between the two.

If the borrowing is at 4% and the lending is at 6%, then the spread is 2%. 2% does not impress wealthy clients. So, the private bank or hedge fund borrows 30 times its capital short term from bigger banks and now it can show a leveraged return of 60%, which does impress those clients. This works as long as the short term money stays cheap and the banks continue to renew the loans. But if the merry-go-round ever stops and the bigger banks refuse to renew the short term, low rate lending, then the game is over.

Bear Stearns is a much larger publicly traded banking company that the Fed did not want to see fail because of the negative psychology it would create in the Market. Apparently, the Fed approached JP Morgan Thursday night and asked it to rescue Bear. Bear had margin calls on Thursday it could not cover (just as Carlysle did on Tuesday). The Fed said it would guarantee all the loan securities that Bear sold to JPM, and it would loan JPM funds from its new TAF program to pay for those loans that were acquired. This is a way for the Fed to help Bear without a tax payer "bail-out", without violating the requirement that the Fed only accept AAA rated paper as collateral for loans under the TAF program. JP Morgan will carry the lower rated paper on its books, but it will be "insured" by the Fed. Bear will still have some equity value (it has not been wiped out but was cut in half today) and has another 28 days to try and get itself straightened out. The public is supposed to be reassu red by all of this.

But instead today, the public saw through the entire situation and showed concern that this was the first of many bank failures that must be rescued by the Fed. There are much bigger banks in trouble (Citi, BAC, WM, Wachovia, Fannie, Freddie), so the concern is "where will it all stop"? It is a legitimate concern / question. I personally feel that the Fed's moves will eventually clear the deck on the worst of the problems. Once those problems are in the open and secured by Fed guarantees to the more sound banks, it should free up the better loan securities to begin trading at something near normal prices. If the banks start trading those securities again, they will be able to gradually mark up their books and improve their capital ratios and move away from the brink of failure.

But there is a slim chance that the Fed will not be able to stop the snowball. If that happens, there will be general carnage in the banking industry and in the economy. We will have a depression (or the modern day equivalent).

Because all of this is creating so much uncertainty in the banks, I shorted several on Thursday and Friday (C, BAC and WM) to protect some of my long positions. I will take the shorts off when it looks like this gets resolved convincingly.

The high yield CEs like BDJ, VVR or DHG do have exposure to the financial stocks. Those are normally the source of higher dividends than the market average. There are also REITs in these high yield funds, along with pharma, industrial and energy stocks. As I have been suggesting, I think high yield CEs are a decent risk because of the diversity and the dividends. All the banks will not go bust with the current Fed strategy. They will be consolidated by the Fed, the weaker to the stronger. There will be winners and losers. So, the diverse CE's will have their share of each as well and will eventually prosper.

I agree that Oil and Gold must be near short term highs. They can't go to the moon, at least without a breather. What will turn them around is some success in the financial markets with clearing up the problems that are undermining the economy and the dollar. I agree that a pullback to at least $900 is likely for gold and to $90 for oil, and maybe 10-20% less for each. But we are in a long term bull for commodities, so any pullback would be a buying oppty, though it will probably not feel like it at that time.

The Canroys should be going along for the ride right now. Chesapeake is setting new highs and it is very similar in its business mix (oil and gas) to the Canroys, except it does not issue much of a dividend. If the tax situation in Canada does not get resolved, the Canroys may eventually look like Chesapeake by converting from LLCs to incorporations. They will reinvest their profits in additional production to minimize taxes. They can do so by increasing amoritization and depreciation with the new production investments.