The juggernaut makes another step

The first post from this blog happened yesterday, after a 3-day rally of the insane bull run of the stock market. Therefore nobody can charge it as a go-with-the-herd movement. Today's precipituous decline was triggered by the French Paribas. With a very shabby excuse that they were closing three funds on the grounds that "with the currrent volatility they had no means to determine valuation", they prompted the intervention of the European Central Bank, which provided "unlimited" loans to the European banks at 4% interest rate. Not even after September 11th they made such a move!

The Fed doubled the reserve loans to overnight lending, from 12 to 24 billion dollars, a much more modest move. History will tell us whether the Fed was too timid, the Europeans were too bold, or if the latter had some other problems to address.

The fact of the matter is that the additional liquidity did not calm the markets, that experienced a steep decline worldwide. It might have added insult to injury, unnerving the investors even further.

AIG, one of the top insures in the planet, came out of the closet to inform that they were experiencing non-subprime default rates above average. This was the coup-de-grace Wall Street needed for the day.

Beware of "pundits" and soothsayers with interests vested in the status quo telling you that the fundamentals are solid, for they are not. That the stock market is for the long-runners, for it is not. The companies whose shares you hold now may not be alive in the near future. They just want you to provide the cushion for their bail-out.

Goldman-Sachs also came out of the closet today, announcing steep losses in some of their hedge funds. Dozens of small players are already history, but they are not big enough to deserve headlines.

There is another (very) negative driving force to the markets now. The second brouhaha brought in by the excess liquidity created by the Fed, the Leveraged Buy-Outs, is fizzling. Or maybe not. But now they are acting in the opposite direction. How come?

Up until now, they took money from investors to fund 10/12ths of the purchase of any target company. The rest came from their own pocket. However this should match no more than the cash flow (EBITDA) of the acquired. So far so good, a naive reader could think, for they still have to make money for the T part of the EBITDA. Wrong. The just downloaded the debt onto the company balance sheet, whose service would be tax-free!!!! The tax-payers financing the party! This means that any tiny improvement in that cash flow would mean huge profits for the Equity Fund that acquired the company. And if the company goes under because of such a hefty debt? The suckers that held the vast majority of the debt would be wiped out. Who are those "suckers"? Hedge funds, so the hell with them. But not only. University endowments, pension funds, union funds, etc. have also been part of that group. What will happen to that investment as the economy undergoes a (mild) recession? The decrease in cash flow will turn those huge profits into huge losses. Is it why Blackstone just went public? Time will tell. Maybe shorter than expected.

How the force is turning from positive to negative? Obviously the current liquidity squeeze is generating an increase in private-lending interests. As much as three percent in recent weeks. So the equity funds are cornered with three options:

1- End the party. Ho, ho, ho.
2- Increase their exposure. Ho, ho, ho, ho, ho.
3- Drive the price of the stocks down. Bingo!

The third option just happened today with Home Depot. Slighly more than 5% decline in the day. Because their highly-touted LBO has just gone sour, and they received a lower second offer from the equity fund buying them out.

And, please, for your own sake, don't get too excited with dead-cat bounces.