The Overnight Report: New Lows

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By Greg Peel

Wall Street had its worst session since 9/11 last night. Prompted by the bankruptcy of Lehman Bros, a large fall was always expected. However, having opened down 300 points, the Dow and the broader market held in there for most of the day. It was only the last hour, and particularly the last few minutes, that saw the loss of nerve and new lows created.

The Dow lost 504 points or 4.4% to 10,917. The previous low on July 15 was 10,962 before the US Treasury said it would do what it had to do to save Fannie and Freddie. The S&P fell 4.7% to 1192 – previous low 1214. The Nasdaq fell 3.6% to 2179 – previous low 2212.

At midnight on Sunday in New York the 156 year-old investment bank filed for bankruptcy. Earlier Bank of America picked up Merrill Lynch for the knock-down price of US$44bn. The US entered the credit crunch with five major investment banks. Only two – Goldman Sachs and Morgan Stanley – remain.

The 300-odd point drop on the open was considered by the market to be “enough”. While there will be ramifications from across the globe as banks and brokerages attempt to assess and unwind their exposures to Lehman, and subsequently book losses, there is also a certain calm in the knowledge that in letting Lehman fail, the US government is finally allowing that which needs to occur as a precursor to rebuilding Wall Street. There will be much pain, but no more Chinese water torture.

However by mid-session Lehman’s demise had rapidly become yesterday’s news. The spotlight had turned on the world’s largest insurance company – AIG – shares in which dropped another 60% to US$4.76. They were above US$70 in early 2007.

Amongst its general insurance business AIG insures corporate loans, and in providing insurance is very active in the derivatives markets. The fallout from Lehman is one of defaulting loans. AIG insures such loans. The fallout from the collapse of AIG across global financial markets is considered to be a far more dramatic outcome than Lehman’s failure. Once again the call has been that the government “must” save AIG. On the weekend the company went cap in hand to the Fed.

The Fed said no. Instead it has put it to leading institutions JP Morgan and Goldman Sachs for the market to organise a private sector US$75bn bail-out fund. This news very briefly comforted the market, and the Dow bounced from 400 down to 300 down once more. But quickly the question was raised: where will the money come from? It is clearly in the interest of all Wall Street firms to prevent the fall of AIG, and under any normal circumstances such a bail-out would be a prudent use of bank capacity, but on Sunday a consortium of banks had already agreed to gather a US$50bn facility, which then went to US$70bn, to “backstop” the market from Lehman exposures. JP Morgan has acquired Bear Stearns and Bank of America just bought Merrill Lynch for US$44bn.

Even Monopoly players run out of money eventually.

As AIG’s shares sunk, so did the value of its bonds. At 50-60c to the dollar they are now considered beyond “junk”, and the risk is the ratings agencies will be forced to act at any moment. That would spell disaster, and the only solution is for AIG to raise emergency capital. But as the session closed last night on Wall Street the feeling was that AIG would be bankrupt before the week is out.

Obviously there was general carnage among banking stocks. JP Morgan fell 10%, Citigroup 15% and Wachovia 25%. Goldman Sachs fell 12% and Morgan Stanley 13%. Only shares in newly acquired Merrill Lynch remained flat, but shares in its acquirer Bank of America fell 21%. The financial sector index fell 10%.

The VIX volatility index rose 23% to 31.7. In every case this year when Wall Street has created new lows the VIX index has jumped above 30. This implies capitulation – the point at which the market becomes so scared it piles into put option protection. On each occasion a jump above 30 has indicated a new bottom, and the peak close of the VIX this year was 32.24 on Bear Stearns day.

Wall Street has been looking for the last great capitulation point which would signal the end of the bear market. Is this it? Put it this way – there is no point in trying to be a hero just yet.

The notable thing about previous market bottoms this year is they have all been accompanied by soaring commodity prices, meaning the commodity sectors have provided an offset. Not this time.

As America woke to find Hurricane Ike had not proven the disaster it may have been, the response was to sell oil down US$5.47 to US$95.71/bbl to finally enter the range FNArena has been suggesting since oil hit US$140.

Base metal prices took their lead from oil, and from the wider expectation of US financial fallout, being global recession. However the knee-jerk trashing that metals suffered was countered by very late buying from the bargain hunters. When the dust settled, tin was down 1%, copper 2%, aluminium 3%, lead 4%, nickel 5% and zinc 6%.

The fall in oil and base metals belied the usual equation, nevertheless, for Wall Street’s turmoil sent the US dollar into a tailspin. The dollar was sold off heavily against all major currencies and looks to have finally put its recent rally to the sword. The US economy has come back to the pack.

The good news is that gold reacted as it should and jumped US$21.90 to US$785.60/oz. The bad news is the Aussie gave up everything it gained in the previous session, to find itself almost two cents lower once more to US$0.8060. (This isn’t bad news for everyone of course.) The reason Aussie fell even as the US dollar fell is because of carry trade unwinding, which sees yen being bought against the greenback and Aussie sold. The Aussie’s plight is also in the hand of commodities prices.

The SPI Overnight fell 135 points, or 2.8%. Yesterday the ASX 200 breached its July closing low of 4815 before recovering to close at 4817. Today will see a clear breach. Shares in BHP Billiton ((BHP)) and Rio Tinto ((RIO)) closed down 10% in New York.

Tonight the Fed meets to make a rate decision. With the world having previously decided the Fed would remain on hold at 2% for the foreseeable future as it balanced a weak economy against inflation, the bond markets are now factoring in a rate cut. It is expected the Fed will cut to at least 1.75% to stem this latest tide of destruction. The Fed has increased its liquidity provisions for the market anyway, which does imply a cut. Will that pull the market up?

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