Evergreen Capital Management Claims That No Action Risks Widening Credit Crisis

Business Wire, Oct 14, 2008

Fed and Treasury Should Jumpstart Frozen Credit Markets - Buy Long-Term Investment-Grade Bonds, Preferred Stocks.

"The Bond Buyer of Last Resort"

BELLEVUE, Wash. -- It's no exaggeration to observe that since September 7, 2008, when the "rescues" of Fannie Mae and Freddie Mac were first announced, the financial markets have been in full-blown meltdown mode. The virtual wipeout of the GSE shareholders, shockingly including those owning preferred stock (with some $36 billion owned by regional and community banks), triggered a rapid chain reaction of frantic liquidation of nearly all equity and debt securities issued by other financial institutions.

It wasn't long before the mass selling engulfed preferred and debt securities in high-grade, nonfinancial corporations. Equity markets, which initially showed considerable resilience, also began to crack, and then plunge, as the implications of frozen credit markets hit home. Greatly exacerbating the crisis, the London Interbank Offered Rate (LIBOR) has exploded to levels indicating a total lack of confidence in the banking community's willingness to lend to itself, even for very short periods of time.

Similarly, the commercial paper market recently ground to a halt, effectively shutting down essential short-term funding for all but the strongest firms. This intolerable development forced the Fed to directly acquire commercial paper from corporations.

This last action by the Fed, however, provides a road map for a way out of the current credit calamity. It also offers an extremely high likelihood of producing massive profits for the Fed and the US Treasury while simultaneously turning an unprecedented rout of investment-grade debt securities into a powerful rally.

The key element would require the Fed to not only purchase commercial paper but also to aggressively acquire longer term investment-grade bonds and preferred stocks in the open market. This is in effect what the Treasury is preparing to do with the Troubled Asset Relief Program but would be much simpler and inherently safer for taxpayers. In fact, it would be virtually guaranteed to generate immediate and, eventually, enormous profits for the government (which clearly needs all the additional revenue it can get as tax receipts plunge and stabilization outlays soar).

The math is straightforward: The government can borrow in the short-term debt markets at rates around 2%. The average high-grade corporate bond is trading at 87 cents on the dollar and yields 8.5%, reflecting the incredibly depressed state of the nongovernment fixed-income markets. Just since the ill-fated GSE nationalization, high-grade corporate bonds have declined an astounding 20%. According to the Wall Street Journal, investment-grade corporate debt has not offered such high returns since the 1980s. Amazingly, this yield spike has occurred at a time of rapidly falling commodity prices and inflation, as well as during a time of collapsing risk-free interest rates. Thus, it's unquestionable that both unbridled fear and forced liquidation are totally overwhelming fundamentals.

Prices are even more distressed in the market for preferred stocks; many investment-grade issues such as Comcast trade at 60% of par value with yields approaching 12%. Consequently, the Fed's purchase of these securities would be even more lucrative for taxpayers. This is also a smaller market so that a commitment of tens of billions, rather than the hundreds of billions likely needed to rally corporate bonds, would have a dramatic and outsized impact.

Barring forceful intervention, further price declines are probable and could possibly accelerate. The implications of the credit markets collapsing are even more ominous than those of the recent stock market plunge. As the cost of capital soars and buyers evaporate, even at exceedingly elevated yields, long-term financing for corporate America is essentially impossible. Just as destabilizing, financial institutions, including traditional insurance companies that did not participate in esoteric activities such as buying sub-prime CDOs and selling Credit Default Swaps, are now also under extreme pressure as their conservative portfolios plummet in value. This raises the specter of further rating downgrades and even more forced liquidation of bonds and preferred stocks.

Amplifying this disaster is the fact that myriad closed-end mutual funds own these securities with some degree of leverage. The breathtaking decline in the value of yield securities is endangering their debt coverage ratios, precipitating even more forced liquidation, effectively setting off the mother of all margin calls.

Therefore, we have a self-reinforcing cycle (also known as a positive feedback loop but one with tremendously negative implications) that threatens to crash our entire financial system with horrific global implications. There is no doubt the situation is precarious in the extreme, but it is definitely not hopeless.

This is one of those rare times when the federal government can enjoy a high rate of return while at the same time producing an extraordinary societal benefit. Not only will it earn a fat spread between its cost of capital and lofty yields, the Fed (and/or Treasury) would be almost certain to realize substantial capital gains by investing large sums at irrationally depressed prices. Equally likely, once there is a bidder in the credit markets with unlimited resources preventing further absurd price declines, and driving prices back up, the astronomical sums of private money on the sidelines will be emboldened to join in the buying spree. Thus, an utter disaster can become, nearly overnight, a stunning victory.