A tad askew from the traditional view

Tuesday, December 27, 2005


One thing is clear....some people are getting very nervous..... and it seems to be stemming from a combination of factors.....First, the yield inversion thing appears to be on the verge of happening and this is spooking a lot of investors....Second, new home sales have dropped 11% according to the Commerce Department.....So now, those that are nervous about a recession (that may be fordoomed by the Fed's yield inversion) are also concerned with the possibility of the worst of all scenarios - a recession coupled with a real estate collapse.

The nervousness apparently prompted a huge jump in option action on Monday....ROBERTINRIO'S site reported that 95,000 deep-in-the-money Walmart puts were sold yesterday. "That's ten million shares," according to ROBERTINRIO, and he goes on to point out that the open interest before yesterday was 5,000. He says the same was true yesterday for a lot of other stocks, too.

The bottom line here is that a large amount of money was waged on the possibility that there will be a crash in January. This should be of grave concern, but if there is any good news here it may lie in the old saw that says the more that investors anticipate something and the more that they invest accordingly, the less likely it is to happen. Another possible silver lining is that a recession might be kinder to the real estate market than a strong economic cycle that would include inflationary pressures. Interest rates would be lower in a recession, and lets not forget that much of the trillions of dollars of recent mortgages involved variable rate provisions.

Having said that, however, it is a fact that there are multiple areas of the economy that could trigger and be a major part of a financial panic. The stock market and the real estate market are perhaps just the most obvious. My personal favorite, as the most likely sector to cause all-around mayhem, is the short term money market. Think about it for a moment. All those huge corporations with hundreds of billions or more in combined short term debt, relying totally on the confidence of investors to roll their debt over, and over, and over - every day - over and over. Any interruption in confidence could have the potential to trigger immediate defaults and the aggregate amount of financing involved is way too large for the banks to be able to cover.

Think it's unlikely? Well, guess what. It's already happened once before, and that was at a time when the total short term debt was much smaller than it is today.

It might be appropriate to relate a little story here, because I happen to have had a ringside seat to this near disaster that few, in fact, know about. The events that are described below were not publicized at the time and, as far as I know, have since only been mentioned in a couple of books. It was in the early '70's, and the interruption in confidence in that case was triggered by the bankruptcy of the Penn Central Railroad, which had the effect of wiping out some short term investors. An ensuing panic began to chug forward erratically. Then, a baseless rumor started on Wall Street that Chrysler Financial would be next, and that company immediately found that it was unable to roll over its short term debt. The company president, together with a man named McGillicuddy from Manufacturers Hanover Bank, appealed to every major financial institution in the country for commitments of money. I was working at one of those institutions and sitting in on the meeting they had with us, and I can tell you that those two gentlemen were extremely nervous, and so were the officers of my company. I'll never forget one thing they said. They pointed out that, if this had happened to the much larger General Motors Acceptance Corporation, the maximum financing that could have been legally raised from every bank and every insurance company in the country would have been insufficient to cover that company's short term debt.

My company fell into line, as did many other lenders that the traveling roadshow visited, and we provided a substantial commitment. A day later, we were aware that the roadshow was at its last institution, Prudential Insurance, and we knew that everything depended on the Pru approving a $50 million commitment. At this point it would be accurate to say that the nervousness among my company's senior officers had turned to fear. The panic in the short term market was spreading and it was beginning to spawn false rumors involving other companies as well, such as Household Finance. If Chrysler Financial was to be unsuccessful in obtaining commitments for the total amount of money they needed, we all knew that they would immediately go into default, and that this would set off a chain reaction that would produce a major financial crisis. It was indeed a scary situation.

Well, as it turned out, Prudential approved the $50 million commitment to Chrysler Financial, and, as a result, there were enough commitments to cover the company's short term debt. In no time flat, the investors returned and Chrysler Financial was able to roll over its debt. Just like that. Not one penny of all those commitments was actually ever needed. As in most other areas of our economy, it was all just a matter of confidence. Once the debt was covered, everything returned to normal. The rumors went away, and everyone breathed easy.

For some reason, however, I couldn't help remembering that situation yesterday.........


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