The Stephen Hawking of Finance

Stephen Hawking is a genius, plain and simple. Any scientist, let alone a physicist whom attempts to explain both the beginning and end of time quantitatively—whilst including things like “sub-atomic particles all the way up to “black holes” along the ride has already made his mark in history. If there is a human being that can detail the history of the universe, it is Stephen Hawking.

The finance world has its superstars as well—Warren Buffett, Eddie Lampert, Mario Gabelli, Stephen Schwarzman, (I know I am leaving off quite a few and I mean no disprespect, but just to illustrate my point) etc.; and they are all due tons of credit. There is only one “man with a plan” however, and that man is John Thain.

An MIT Grad in Electrical Engineering followed by an MBA from Harvard set Mr. Thain up for a career on Wall Street that will be talked about for years to come. His first executive position was at Goldman Sachs as COO and President, only to leave for the NYSE in the aftermath of the Dick Grasso debacle.

A merger with Archipelago combined with the elimination of the “seats”—essentially renovating what was a sinking ship, John turned the NYSE into a public company (from a non-profit) with shareholders. In addition, he created the “Hybrid” trading system, allowing for both floor trading (Specialists), yet adding technology that would allow the NYSE to keep up with increasing volume. Finally, he pulled off one of the largest international exchange mergers with Euronext—as several similar mergers (on a smaller scale) have happened afterward (told you he was on to something).

Leaving the NYSE and taking the top spot at Merrill tells me a few things. First, the worst is over for MER. Any further write downs will be attributed to his predecessor (if there are any), so even if more debt needs to be dealt with, it’s not his problem. Second, when he does turn the company around, he will make an absolute killing. He made the money that was sitting around with the NYSE by being prudent and looking forward. The NYSE was at a low both financially and in terms of pride. The fact that Merrill allowed so many bad loans to sit on their books for as long as they have is not very dissimilar.

While I do not know the man personally, he comes off as simply a numbers guy. He will have no problem firing, laying off, etc. an entire division of hundreds of people if he believes Merrill will benefit. Many pundits have speculated the reason that CEO Larry Fink (Black Rock Hedge Fund) didn’t take the job was simply because he doesn’t have the heart to do what needs to be done, no matter how painful, to right the ship in Merrill’s case.

One can also nearly guarantee that Mr. Thain will bring along some of his old pals from Goldman which will essentially be a coup for Merrill. On another note which is amusing, one of the things that aided Stan O’Neal’s departure from MER was talking with Wachovia about a possible merger/acquisition/etc.—without receiving permission from the Merrill Board (no matter how innocent or exploratory it may have been). Since it has been a give that Stan is on his way out, Wachovia has pinched some of Merrill’s best producers on the brokerage side. Amusing nonetheless.

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Bernanke’s Monetary Flex-cuffs

Bernanke’s Monetary Flex-cuffs

Are they too tight?

Will the housing market have a knight in shining armor ride to its rescue?

If we use history as a guide, it would be more like 535 bureaucratic clowns, most in bad suits (a few with bow ties- though no economists) riding in environmentally unfriendly SUV’s to the rescue (not to mention those who are frequent no-shows, so more like 300 or so members of the House and Senate).

Treasury Secretary Hank Paulson has been active both behind the scenes (working as a liaison between the White House, Congress, the Fed, and Wall Street. He has also taken initiative working with Brokers to set up a “Super SIV” or Super Structured Investment Vehicle to help restore liquidity to the credit markets, specifically amongst Mortgage-Backed Securities and related entities like CMO’s and CDO’s. Funnily enough, even though this is a “private venture funded with private money, Paulson’s fingerprints are all over it.

Conversely, the FOMC’s (and Federal Reserve’s) hands are tied. Despite several strokes of innovation like boosting liquidity in the credit market via REPO’s, applying a little WD-40 to open the discount window for banks after hiring a cleaning crew to get rid of the cobwebs and also cutting the Fed Funds Rate by 75 basis points (which was preceded by an emergency cut of the discount rate (mirroring their ECB counterpart Jean-Claude Trichet’s move to lend to banks at 4%) to alleviate the crisis.

Sadly to say, Bernanke and the FOMC can do little more. The ramifications of easy money (characterized by lower rates in an economy growing at 4%+) have become visibly apparent and borderline dangerous.

The most obvious result has been the dollar slide, which has boosted commodities prices into an area sure to push inflation higher. $90/ barrel oil, $800 oz Gold and record prices at the pump have returned. The secondary and tertiary effects are not much better. Industrial goods requiring energy and commodities are seeing severe price augmentation along with the cost of transporting and storing these goods that is approaching a spike.

On the positive side, trade imbalances are shrinking as the weakening dollar has benefited exports, which represents a huge slice of GDP.

Two and Done?

It has been a real whirlwind of economic and financial activity here on Wall Street over the course of the last few months.

As the housing market continued its slide, the paper, bonds and other instruments (CDO’s, CMO’s, PIPE’s, etc.) backing these assets not only followed suit, but plunged and in many cases became totally illiquid. Nobody knew quite how to value them (disturbing especially since many carried ratings of AA or AAA) and bids all but dried up. Combine this with the 125 plus mortgage lenders/brokers that have gone bankrupt since the beginning of the year and you have all the makings of the beginning of a crisis.

Then the problem popped up in Europe, as lenders responded immediately by pulling back from lending and calling in loans. As a result, banks tightened practices globally and the ABCP (Asset Backed Commercial Paper) market seized up in response.

Enter Chairman “Helicopter Ben” Bernanke whom made the (under-utilized and antiquated) discount window available to banks and cut the discount rate 50 bps in between meetings. The FOMC also began conducting operations in the REPO market, essentially allowing banks to use bad paper as collateral for money (in the thought that soon the market would begin functioning).

The Fed then followed up on that with a rate cut during their regularly scheduled meeting and made clear that the risks of the credit market to the economic health of the economy outweighed those of price stability.

From August 16^th (viewed as the end of the world by some) to October 11^th, the S&P 500 and Dow Jones all hit new all-time highs.

Just yesterday, The FOMC followed suit with a second regular meeting cut of the Fed Funds rate, but shifting their language to straddle neutral.

Why?

Since the Fed flooded the market with money, Oil has broken $90/ barrel. Grain, Wheat, Flour and other food commodities logged all time highs. The US Dollar basket managed to set a record low, since they began tracking it in 1974.

Essentially, if inflation was under control before (which most believe it was), the FOMC’s actions have risked exacerbating further price inflation.

I don’t know that the Fed’s approach is right; then again I am not an economist. It seems that oil is the price stability bugaboo, and the Fed’s actions while certainly have contributed, are not the driver. New U.S. proposed sanctions on Iran, Turkey invading Northern Iraq and the insatiable quest for resources in Asia are far more culpable in pushing energy higher.

In fact if you look at the last two EIA Oil Inventory reports, analysts were expecting builds in oil stocks. That is stupid. If you were Exxon, Chevron, BP or some other oil Giant—would you build supply at $93/barrel or would you sell it on the spot market for cash, mitigating the risk of future price action lower? It is a no-brainer.

Interest Rate Hawks will say that how can the Fed cut the FF Rate 75 bps when the labor markets are tight, job creation is firm and GDP remains buoyant (3%+ last two quarters)?

The answer is simple. The data they cite already happened. The FOMC and Federal Reserve need to be focused on the future, because as it stands today this trend is unlikely to continue. There is no evidence to suggest the housing market has stabilized and that banks like CITI, UBS and Bear (just to name a few) are through taking these monster write-downs on bad loans—ones not confined to the sub-prime sector.

Look to the future