Into the Abyss

No one knows where this market is heading or what it is currently doing. CFOs are perplexed at the relentless downward pressure on their share prices, even though their balance sheets may be in relatively good shape (I emphasize relatively). One of the main problems right now is market liquidity and borrowing costs. It simply costs a lot more money to borrow now than it did a week ago, a month ago, or a year ago. This is due to a complete lack of confidence in what banks are holding on their balance sheets, and how those assets are valued, in addition to a growing perception that perhaps the broker-dealer business model of Goldman, Morgan, and three of the casualties of the crunch - Bear, Lehman and Merrill.

Banks simply don't want to lend to each other because they have no idea of who might be next to fail. This has easily been one of the craziest two weeks ever. That's a pretty powerful statement. Consider this fact, one that I found truly outrageous and unbelievable when I first read it today on the WSJ website. For a brief period, investors actually bid more than par for 1 month T-bills. Think about that for a second. That's like me saying to you, "Hey, here is $101. In one month, can you give me back $100?". Investors, as the Journal noted, were thus saying to themselves, well, I'm going to go right ahead and take a loss on this, but at least the loss will be small and I'll know what it is. This is mindblowing. It has never happened before ever.

The game has completely changed for investors and traders. A year ago, heck, even a few months ago, there were people calling bottoms in the financials. Often, this was accompanied by an adage that basically said, "hey, these companies are big, safe, and they'll be around in 10 years, 20 years... so they are a solid long-run investment". You can't say that with any certainty anymore. Will Morgan Stanley be around in its current form in 1, 2, 5 or 10 years? Who knows. The company has a much stronger balance sheet than those that have failed. They have liquidity, but you never know what can happen once traders pummel the stock and capital providers lose confidence.

When will this all end? No one knows. It's going to be a long and painful process. Banks have to delever. Companies around the world bought complicated assets largely linked to the U.S. housing market for years. They did this by borrowing money. This borrowed money was for a period of time "cheap". Now the value of these assets are falling faster than a fan of the Ottawa Senators hopes during April. These assets need to be written down to appropriate levels - something many CEOs have been extremely reluctant to do due to the huge, huge losses that would be sustained. Once companies clean up their balance sheets, they need to repair them by rebuilding their capital base. The capital cushions have been diluted and eroded due to the aforementioned losses. Many banks were levered near 30 times. This has simply proven to be too much. Getting rid of all this debt will be long and painful, and will cost a lot of money. Consumers will be hit. Borrowing costs will rise. Hedge funds will be smoked. They rely heavily on leverage to amplify returns. Now debt is much more expensive, the returns won't be as rosy. The ripple effects will soon reach Main Street.

The philosopher George Santayana once opined that those who cannot remember the past are condemned to repeat it. The market must learn the hard way that too much leverage and risk that is hard to measure and quantify can engender great danger and many losses. One thing remains certain however, this is a tremendous learning experience for the market, and for observers of it.